Reducing Volatility through Fundamental Analysis

Posted on May 15, 2008 by David Laidlaw 

The first dictate of the traditional Hippocratic Oath requires a physician to swear that he or she will prescribe regimens for the good of his patients according to his ability and judgment and never do harm to anyone. Laidlaw Group adheres to this duty by preserving capital and limiting volatility in the portfolios under its management.

Fundamental analysis serves as the first step in Laidlaw Group’s portfolio management. The firm’s managers screen the equity universe for highly profitable companies that sell for reasonable valuations and carry low levels of debt relative to their tangible assets. Each of these factors helps preserve capital in down markets. Profitable companies which are well-managed usually continue to operate profitably during downturns even though sales may slow. Additionally, companies with low levels of debt have much greater flexibility in facing challenges since they are not forced to raise capital during times of economic stress.

Laidlaw Group’s valuation methodology serves as the next line of defense in preserving capital. Most market losses occur when bubbles burst and expensive stocks with high built-in expectations fall. Stocks that sell for lower intrinsic multiples to earnings and book values necessarily fall less during hard times. Laidlaw Group runs rigorous multi-stage cash flow models based on conservative growth estimates to ensure they are not paying too much for the equities in their portfolios. The company also stress-tests its betas to make sure that accurate discount rates are used in its valuation process.

Laidlaw Group diversifies its portfolios across market sectors to limit risk. The firm will underweight sectors that are over-valued since market indices often become distorted during bubbles. For example, financial stocks became almost 25% of the S&P 500 after booking profits from the housing boom and have subsequently sold off to a more normalized 17% over the past 9 months. The distortions during the technology boom were even greater where tech stocks comprised 40% of the market capitalization of the S&P in early 2000. Laidlaw Group also includes both growth and value stocks in its portfolios to add to the inherent diversification of its accounts.

Finally, Laidlaw Group asks larger “what if” questions regarding how existing portfolios will respond to macro-economic shocks. For example, common wisdom holds that oil will continue to trade at high levels for the indefinite future due to higher consumption levels from the developing Asian economies and declining supplies. However, Laidlaw Group’s portfolio managers want to ensure a margin of error if this trend were to reverse itself.

Laidlaw Group’s investment process is rigorously applied to the management of the following styles: Large Capitalization GrowthMulti-Capitalization High Dividend and Smalland Micro-Capitalization. Each of these portfolios exhibit different traits, but share the same underlying investment philosophy.