This article is authored by MOI Global instructor Kyle Mowery, Managing Partner of GrizzlyRock Capital, based in Chicago, Illinois.

Many investors of all types and styles were relieved to see 2018 finally come to a close. Growth and momentum investors trumpeting “quality” and “compounder” companies generally performed well through Labor Day, but the party came to a screeching halt once October rolled around. Long-only value investors went about their business quietly, but some long-short managers (including several very high profile managers) struggled mightily with many funds closing during the year. Even top quantitative managers slogged through quixotic markets.

Yet, 2018 is but a single year. For some managers, one year is a lengthy time frame while other managers view 365 days as far too short to accurately assess performance. The key for managers is to be brutally honest when assessing the most appropriate time frame and, more importantly, understanding their clients’ time frame. When these diverge, questions arise at exactly the wrong times and ultimately deteriorate client return. A successful balance is required between the manager and client to operate within an agreed upon time frame (as opposed to the manager’s “ideal” time frame) and the role of the client is to keep the goal posts consistent.

Our firm manages a long short value fund with low net exposure to market indices. We assess businesses for investment by looking at intrinsic value out three to five years yet, like most hedge funds, we report performance monthly and communicate with clients quarterly. Accordingly, most investors judge us monthly and quarterly as we assemble these periods into long-term performance. Even though we are value investors and take an intermediate-term time horizon of three to five years, the reality is we will be overly praised for solid quarters and overly blamed for poor quarters.

Accordingly, we apply our intermediate and long-term value investing methodology with an understanding that path dependency matters. A six-foot person can drown in a river that is on average 3 feet deep if they cannot handle the depths. While a somewhat pithy quote, many investors have let their clients down and/or gone out of business by failing to realize this critical point.

Over the seven years we have been operating our firm, the drivers of this quarterly path dependency have evolved. Accordingly, in June 2018 GrizzlyRock completed a multi-quarter process improvement project implementing style factor analysis and forwarded a white paper on the topic.

The following are key excerpts:

To accomplish GrizzlyRock’s mission statement of compounding capital over lengthy time periods, in 2012 we launched an effective and replicable strategy: value investing. Based on multiple academic and practitioner studies referenced in this paper, value as a strategy (both as a long / short and long only) has performed well over multi-decade periods. In fact, a May 2018 J.P. Morgan report claims “value stands out as the only style with positive average information coefficient for all factors over the past ~35 years.” Delving further into GrizzlyRock’s value investing methodology, we focus on free cash flow (“FCF”) generation as our primarily research lens. Our focus is well placed: historical studies indicate high free cash flow yield is an all-weather value factor performing well in all phases of the business cycle.

This project is a natural evolution of our investment process in a changing landscape. Fundamental business analysis as the core of GrizzlyRock’s process will remain firmly intact. Our expectation of driving Fund performance in unique securities also will not change. After completing this project, we conclude the following:

  • GrizzlyRock’s focus on high free cash flow generation relative to current valuation is a proven historical performance generator. We will continue to focus our long portfolio research on companies that generate significant free cash flow to earn the premium over time. Since GrizzlyRock’s inception, the free cash flow factor has not performed commensurately to some factors (such as low volatility). Based on over three decades of data, we expect the free cash flow factor to mean revert and perform over time.
  • Regularly quantify and track portfolio factor exposure. Awareness is the first step in integrating style factor analysis into our regular portfolio and risk management processes.
  • Factor performance is difficult to time as most factors show low persistence (i.e. consistency) quarter to quarter.
  • Short-term portfolio volatility due to factor contributions can be mitigated by investing in a portfolio of securities containing various factor exposures. While not attempting to run a “factor neutral” portfolio, we seek to mitigate portfolio level factor exposure.

As active managers, our core focus will always remain on the identification of and investment in drastically mispriced securities while managing risk to avoid permanent capital losses. However, continual improvement is vital for long-term success in an ever-evolving capital market. The outcome of our factor project has led to the following improvements:

  • Leverage technology to regularly review factor exposures at the following levels: overall portfolio, long and short portfolios, and individual positions.
  • Given the ability to track factor exposures down to the position level, GrizzlyRock pragmatically incorporates factor exposures into position sizing.

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