Meritage Value Equity

Our primary benchmark is the Russell 1000 Value Index. Our objectives focus on a three to five year time horizon and target to be in the top quartile of the universe of value managers and outperform the index by 2% annually with less risk. Mark Eveans is the lead portfolio manager supported by a team of 4 additional analysts. Mark is responsible for all final purchase and sale decisions.

Our primary research tool is a quantitative model that codifies the characteristics that we look for in companies. A 13 factor model combines 4 conceptual categories which are weighted as follows – Valuation (60%), Business Momentum (14%), Investor Sentiment (12%) and Management IQ (14%). We seek to own companies that are priced at a discount to their true worth based on a combination of the value of their earnings and free cash flow, the value of their assets or their private market value. We find that many of our holdings become buy opportunities because the market has erroneously extrapolated that weak short-term results will remain in place over the long-term.

By looking at value from numerous perspectives, our process helps us avoid stocks that appear inexpensive, but are that way for good reason – i.e., companies whose operating results will be severely affected in an economic downturn, companies with weaker balance sheets and companies that may appear to be priced at a discount relative to historic valuations but are experiencing an erosion of franchise value and are mature in their business life cycle.

Our strategy focuses on individual stock selection; however, we believe 45 to 60 stock positions in the portfolio are optimal, given our desire to own our best ideas and to effectively diversify. At any point in time, our holdings are spread across 15 to 25 different industry groups. Portfolio turnover averages around 45% per year.

Although this strategy is benchmarked against an index of large U.S. companies, our quantitative process encourages us to embrace values in all parts of the market. In that regard we will own up to 20% of the portfolio in non-U.S. stocks and invest in companies that would be classified as mid to smaller cap.

Benchmark – Russell 1000 Value Index
Return Objective – 2% Excess Return with Below Market Volatility

Research Methodology & Decision-Making

Meritage has codified the qualities we seek in a company into a 13 factor model combining 4 conceptual categories which are weighted as follows – Valuation (60%), Business Momentum (14%), Investor Sentiment (12%) and Management IQ (14%).

We begin with a broad universe of over 6000 companies and initially use a simplistic screen for quality and market cap to narrow the universe to approximately 3500 stocks.

These companies are ranked 1-100 using a bell shaped curve methodology to indentify a list of approximately 100 primary candidates and 300 secondary candidates. At this point, we employ a qualitative overlay, initially focusing on assuring the integrity of the data and understanding/interpreting the model’s results as to the strength and direction of individual variables.Then we review purchase candidates in detail, primarily to determine if the company represents an attractive value or if there are good reasons the company is relatively cheap.

Security Selection – Key Inputs

We use a process which is dominated by bottom up company research. The goal is to find companies that represent good value using methods similar to how a private buyer would evaluate a business. We do not seek to assess trends in key economic indicators on a regular basis, yet there are times when our bottom up work identifies particular strengths or vulnerabilities in specific industries and, when conviction is high, these insights will be used in our strategy and portfolio construction. This is particularly relevant for the more homogenous sectors where member companies are impacted by the same economic factors such as financial services, energy and materials.

Market Timing – Degree of Importance

Because we do not have confidence in the predictive ability to time markets, our portfolios are fully invested. There are times when our insights into the market “climate” will cause us to vary the quality and defensiveness of individual holdings, or the concentration of the portfolio; however, we recognize our clients have hired us to manage equities and primarily control their level of risk through asset allocation at the total fund level.

Risk Management – Diversification

Meritage differs from the majority of quantitative firms in our approach to portfolio construction. We are far from efficient market disciples and do not believe that there is anything particularly sacred about a cap weighted benchmark. In this regard, we are not sector neutral, allowing relative sector weights to be allocated primarily as a residual of our bottom up company insights. We do not think in terms of “active weightings” for individual holdings and will buy a stock based on its absolute and relative valuation levels – we never own a company solely for diversification purposes.

Additionally, we recognize that quant methods are vulnerable to company specific risks and there is a need to diversify to protect against absolute loss of principal. Portfolios contain 50 to 60 holdings and we do not manage to a target level of risk relative to a benchmark – over time, ex-ante tracking error has varied between 4 and 7%. Additionally, we invest across the cap size spectrum, and with client approval, will allocate up to 20% in non-U.S. companies.

Investment Time Horizon

Annual portfolio turnover has averaged 45% over the past 5 years. We have a longer-term investment mindset, but our valuation disciplines will guide us to risk manage current positions through adding or reducing size occasionally, in addition to our regular buy and sale transactions.

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