The goal of Delta’s equity investment program is twofold. First is to provide a cautious, risk averse approach to equity investing. Awareness of the trust placed in our investment responsibilities is always present, and to that end, risk determination is considered as strongly as rate of return possibilities in our decision-making. This is further buttressed by the fact that investment decisions are governed by long-term value, which guides portfolios through short-term market volatility. The second goal is to produce competitive investment performance results over the long-term. Though superior investment performance cannot be promised over every short-term period, Delta’s historical record demonstrates the ability to produce competitive performance over the long-term.
The choice of an investment manager requires not only identification with the manager’s goals, but also an understanding of how these goals are achieved. Implicit in this understanding are the characteristics of the manager’s investment philosophy. Five key characteristics have been identified with Delta’s equity investment philosophy and illustrate how the achievement of its equity goals has occurred in the past. While future performance cannot be guaranteed, conformance to these characteristics is.
Advantage is taken of the market’s fixation on short-term certainty by employing a long-term time horizon. When negative events occur, opportunities are created where the resolution of the event in an individual company is uncertain and longer than the market’s time horizon. This offers the ability to purchase a stock on an undervalued basis and sell later, upon resolution of the event, at full value. This process can then be repeated by reinvesting in another undervalued stock or, if none are available, holding the proceeds in reserve awaiting another opportunity. Only by making judgments on a long-term basis can advantage of the market be taken in this particular fashion.
Our method incorporates a long-term orientation both in the identification of opportunities as described above and in the analysis of those opportunities. Identification is carried out on a systematic basis using a computer database to seek out stocks that meet our unique criteria. These criteria center on recent under-performance in stock price combined with the long-term characteristics of well run, properly positioned companies. Analysis then allows us to determine if the company has the ability to continue with its long-term characteristics or to return to them over a reasonable time frame.
The time it takes for a short-term event to be resolved and the market to recognize the resolution of that event is generally unknown. If the correct analysis of a company is made and the stock is determined to be undervalued, patience is the key factor in making the investment successful. We demand that a company exhibit a number of qualities that give us the ability to exercise patience.
These qualities include a good financial position relative to the inherent risks in the business, a strong position within its industry or geographic niche with identifiable competitive advantages, a management that is honest and shareholder sensitive, a corporate strategy that makes sense in the context of the company’s position and abilities, a company that is understandable from an operational as well as financial standpoint, and a company where any negative events are not fundamental to the business or management.
Since emotional tides inevitably confront investors in the stock market, decision-making without discipline becomes faulty at best. Valuation plays a critical role in Delta’s investment program, as it is the agent that brings discipline to the process. A long-term fundamental value target is established for each company that is considered for the portfolio. With inputs derived from thorough company and industry research, long-term normality based assumptions are formed. From these, value is established utilizing a proprietary approach that combines the best of both discounted dividend and buyout analysis. If the current stock price is at a substantial discount to our derivation of its value target, a purchase is made. By the same token, when a stock reaches its value target, the sale process is initiated. Though our purchase and sale valuation targets are subject to change, we believe they provide a strong discipline to maintain rational decision making during uncertain times.
In an effort to achieve a competitive rate of return, investments must be made in an opportunistic fashion. It is important to recognize that risks are assumed when investments are made in this way. Therefore, we attempt to lessen risk in a number of ways. Initial portfolio positions are limited to three to five percent of the equity portfolio’s value and undue concentration in any one industry or economic sector is avoided. Cash reserves are employed when new investment opportunities are not available and risks are presumably high. Stocks are purchased at a discount to our derivation of the company’s long-term value, which cushions any subsequent disappointments. Finally, an investment is not made unless there is a complete understanding of the company and the risks are defined.
If a rational and logical investment method is consistently followed, the opportunity exists to achieve competitive, long-term performance. However, during shorter time periods, regardless of the merit of the approach, an investment style can underperform or outperform the market in general. Unfortunately, attempting to predict the short-term relative performance of different investment styles is often counterproductive. Consistency of approach guards against the emotional tendency to convert to the style that is currently outperforming. In this regard, the principals of Delta have practiced a long-term, value oriented style since the beginning of their careers. Though the details have changed, the basic tenets of stock selection, valuation, and diversification have remained constant.
FIXED INCOME PHILOSOPHY
The character of the fixed income markets, and the role fixed income instruments play in our portfolio policy suggests different goals for fixed income investments than for equity investments. Therefore, the goals of Delta’s fixed income program are first to produce a consistent income flow commensurate with available yields, and then second to protect principal by minimizing chance of loss. Essential to the achievement of these goals are the characteristics inherent in Delta’s fixed income investment philosophy.
Since fixed income instruments generally have a fixed coupon, a poor choice in terms of maturity selection can cause unrecoverable opportunity costs due to adverse interest rate changes. At the same time, because fixed income instruments have a stated maturity, credit problems can be debilitating due to an inflexible time limitation to recover from a problem. For these reasons, caution is called for in fixed income investing, which is accomplished by emphasizing quality and balancing the available alternatives in both credit quality and maturity.
In terms of quality, only bonds rated A or better by the major rating services are purchased. At the same time, portfolios are diversified by market sector, credit type, credit-worthiness, and issuer. This minimizes risk of credit problems, which can occur even with investment quality issuers and seemingly risk free market sectors.
In terms of maturity, fixed income portfolios are structured by setting an appropriate average maturity range around which individual bond maturities are spaced. This scales the structure of the portfolio to the needs of the account and cushions risk from dramatic yield and yield curve changes.
There is a strong, direct correlation between risk and return in the fixed income market. In other words, to achieve more return, more risk inevitably has to be assumed. Methods to generate more return generally fall under the categories of lowering credit quality, giving up trading liquidity, or varying maturity. Experience has shown these methods produce short-term gratification, but result in random exposure to risks that are larger on average than the potential return generated. For this reason, our philosophy is to remain disciplined and to accept what the market has to offer within previously determined quality and maturity constraints.
Both academic studies and our experience confirm that interest rate changes in the short run are essentially unpredictable. With this in mind, it seems counter-productive to base a fixed income method on anticipating short-term changes in interest rates. Due to the potential for reduction in portfolio turnover, it is more effective to react to interest rate changes and the absolute level of interest rates relative to historical levels. For this reason, a reactive management style is employed both in initially setting an appropriate average maturity range for a portfolio and in the reinvestment of cash flows. Given account needs, the level of interest rates, and the average maturity range chosen in instituting a new portfolio, we then seek the best opportunity in the market at that time for reinvestment of cash flow, whether created by maturities, calls or interest, subject to portfolio constraints.
In our opinion, the fixed income market is efficient due to the unifying influence of the treasury yield curve. In other words, yield differentials between different categories of fixed income instruments reflect current knowledge, and changes in these differentials are governed by unpredictable new information. When this is combined with our contention that interest rate changes are unpredictable in the short run, it implies that trading strategies are ineffective, and performance differences between investment managers are largely a function of risk choices and time period effects. Given this set of circumstances, cost control is critical to the achievement of an adequate long-term return, hence our insistence on frugality.
Cost control encompasses a number of portfolio disciplines. Foremost is a low portfolio turnover rate and consequently low transaction costs. This is achieved by the methodical nature of the reinvestment process. Portfolio turnover only occurs when there is a buildup of excess cash flow whether created by a maturity, call or interest. Another source of cost discipline is our predilection to purchase bonds from the most cost effective source whenever possible. This can take the form of buying bonds through auctions or utilizing a number of different sources to find the best offerings.