The Investment Process

Investment Philosophy

Bedlam manages an unconstrained, concentrated portfolio of companies and thus avoids the artificial and backward looking constraints of index weightings. Through adherence to their team-based investment process, Bedlam seeks to strip out emotional bias, minimize risk and ensure returns are repeatable. The catalysts behind a company's key earnings drivers (never more than six) are identified through valuation and thematic screens, together with rigorous in-house modeling.

There is a strict target price discipline. They identify stocks for purchase with a minimum undervaluation of at least 20% based on two-year earnings forecasts. Bedlam looks for holdings with the following characteristics: compelling valuations, strong free cash flow, sustainable franchises and clearly identified catalysts. Concentrated portfolios hold 30-50 companies. Appropriate risk controls are in place to avoid excessive concentration by region or sector.

Idea Generation | Step 1 of 5

The process begins with running global valuation and thematic screens in parallel. At any given time there are typically four to six key themes under review. These will have arisen from fundamental internal research on sectors, together with studies on the capacity and credit cycles.

Capacity cycle - Bedlam views capacity as an important complement to supply metrics. Poor demand may be offset by supply side consolidation - for example, demand for gold today far outstrips supply, and has created significant supply side consolidation. Major producers currently find it cheaper to grow through consolidation rather than exploration and development.
Credit cycle - Bedlam analyzes consumer and corporate demand, and the availability of credit as a driver of private sector growth. They will also look at fiscal stimulus.

Simultaneously, Bedlam runs valuation screens across broad global sectors and identifies absolute value through the evaluation of the:

Earnings yield
Free cash flow yield
Price-to-sales to operating margins

The valuation screen looks for companies with a minimum under-valuation of 20% to the pre-set hurdle rate. In all countries, this rate is the yield on the domestic 10-year government bond, to which is added an equity risk premium of 3%. Thus if a hurdle rate is 8% (5% government bond yield, plus a 3% equity risk premium), then on a two-year forecast period, the screen will look for companies with a minimum earnings and free cash flow yield of 9.6% per year. This allows Bedlam to make global comparisons of companies that operate in the same sector but in different countries.

The result is that approximately 500 companies per year are screened as being appropriate for further analysis. This list is then refined through more detailed analysis of industry dynamics and the catalysts behind a given company and its earnings drivers. Bedlam thus identifies the companies that stand out as best within a sector and narrows the range to 250 companies per year.

Fundamental Analysis | Step 2 of 5

Proprietary financial models are constructed for these 250 companies every year. Each model is 100% internally generated by the assigned Bedlam analyst and includes an evaluation of the earnings and free cash flow yields, P/B to ROE, P/S to operating margins. Data sources include Bloomberg, Reuters, Starmine, broker research, company annual accounts, company visits and telephone calls to management, as well as to competitors and peers.

Through forensic accounting tactics, Bedlam generates a detailed financial model that consists of three years' historic and two years' prospective earnings. They don't forecast out further than this as the variables compound exponentially, thus become questionable. Based on this two-year earnings forecast, a target price is set. As previously outlined, there should be a minimum 20% under-valuation for a company to be bought.

Portfolio Construction | Step 3 of 5

Conclusions from each model are 'stress tested' by the entire investment team prior to purchase. Specific questions, issues and catalysts are addressed: risks to earnings are qualified and a final judgment on management competence is determined. There are normally a number of discussions with company managements and their competitors throughout the process prior to any stock purchase. From this analysis, entry and exit points are determined for each company.

Risk Controls | Step 4 of 5

Risk is measured primarily at the company level. The rigorous financial modeling, along with the team-based process which stress-tests each company model and the assumptions used, is designed to screen out pricing risk and threats to key earnings drivers.

Although unconstrained in the selection process, regional, sector, security and market cap risk control guidelines are in place for final portfolio construction. The maximum percentages are designed to be large enough to allow for investment conviction, yet to avoid concentration risk. There are also maximum percentage limits for large cap, mid cap and small cap allocations.

Sell Discipline | Step 5 of 5

Bedlam's sell discipline is event and price target driven; on a daily basis the investment team monitors performance comparisons to the original model, key management turnover and share dealing, any changes to cash and earnings catalysts. Target prices may be changed after the analyst reviews assumptions and forecasts triggered by price fluctuation or company events.

A stock is automatically reviewed and the underlying model revisited when 1) the stock rises 75% from the initial purchase price, 2) the stock rises to within 10% of the pre-set target price or 3) the target price is reached.
A holding is reduced if there is less than a 20% upside or there is no reason to revise the price target upwards. The holding is then reduced to a maximum weighting of 3%.
Stocks are sold when the target price is reached if the review shows no more upside, or if the rationale behind the original purchase materially changes such that there is no earnings visibility.

In all cases, the process remains the same; managers do not deviate from the sell discipline. Rules are rigorously applied so that no emotional attachment interferes with the sell discipline.