Objectivity + Excess Return Identifier = Enhanced Opportunity Set
Investment managers are in the business of uncertainty. Uncertainty surrounds the markets and the companies that make up investable universes. Within an uncertain environment, investment managers are responsible for producing an intangible product – a return – for which a multitude of variables and the interpretations thereof can have a direct and meaningful impact on the end product.
At its core, investing is about understanding and interpreting information and subsequently making a decision, an investment, based upon in-depth analysis. While in-depth analysis is an essential component to an investment process, it alone doesn’t minimize the uncertainty of the future nor does it minimize how company information (i.e., level of revenues, operating margins and cash flow) will be evaluated and interpreted by investors. We believe quantitative techniques, combined with rigorous investment analysis can help minimize the impact of uncertainty and provide a runway for impactful investment results.
At Isthmus Partners, our proprietary Excess Return Identifier (ExRI℠) process assists us in identifying what we believe are drivers of future excess return and isolate our analyses on high quality companies that appear underappreciated by investors. It is through our proprietary ExRI℠ process that we find companies that meet our valuation and quality criteria and have predictive attributes that may lead to excess return. Through our proprietary process and thorough analysis, we enhance our clients’ opportunity set for success.
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One South Pinckney Street
Madison, Wisconsin 53703
At Isthmus Partners, three core principles drive our approach to managing assets:
- Valuation and quality must always factor into an investment manager’s decision making process.
- There is no substitute for independently assessing a company’s valuation and future growth prospects.
- Investment practitioners have a perpetual obligation to evaluate the risks and merits of going against the crowd.
“Our investment process is disciplined, repeatable and transparent.”
With these principles in mind, we evaluate companies similar to that of a business owner by evaluating the cash generating potential of a new asset, which ultimately guides us as to what a company is worth. We believe owning companies that create positive economic value (i.e., Return on Invested Capital > Weighted Average Cost of Capital) is a primary driver in earning excess returns over a market cycle. Through Isthmus Partners’ proprietary Excess Return Identifier process, we (1) focus on companies that have characteristics that may lead to the potential to generate excess return and (2) own companies that sustainably generate economic value whose underlying values are not fully appreciated by the investment community.
Isthmus Partners has three core beliefs that are consistent with our stated investment principles.
- US equity markets are highly, but not perfectly, efficient. We believe inefficient market behavior offers buying and selling opportunities to capture superior investment return. Using quality as a cornerstone, we own companies that trade at a discount to our estimate of intrinsic (underlying) value based upon conservative future growth prospects.
- Controlling risk is vital to producing consistent long-term investment results. We use diversification by sector and security to accomplish this goal.
- A patient and objective discipline supported by these fundamental tenets governs consistent and superior long-term investment performance.
What is Excess Return Identifier? It is the firm’s proprietary process that is designed to generate sector specific quality screens that focus on factors or a combination of factors, which we’ve identified are good identifiers of future excess return. Companies survive and thrive only if they create economic value by generating returns on capital in excess of the costs of capital (i.e., positive spread). For example, one of the many measures we test is the relationship between the four year average (short-term) spread and excess returns to determine if the four year average spread has historically been a good identifier of excess returns. By isolating sector specific variables that have led to excess returns in the past, we are able to probe a quantitatively superior sub-universe that meets our valuation and quality criteria. Our proprietary Excess Return Identifier process is exhaustive and the quality screens are recalibrated at least every two years, with changes made to the screens accordingly.
READ MORE — Quality and valuation
Quality and valuation are inseparable attributes and we utilize our screens to focus on those companies that have either consistently created economic value for shareholders or are showing a trend of improvement in creating economic value. Our quality screens enable us to rank potential securities based upon a company’s short-term and long-term average spread as well as its slope and short slope, which are measures of an improving economic value creation. We then use valuation techniques to further refine the list of potential securities. We primarily use discounted cash flow analysis to give us an initial sense of the enterprise value of a company. Companies with a sufficient discount to our estimate of intrinsic value advance to a fundamental analysis.
READ MORE — fundamental analysis
Once the eligible list of securities has been filtered, we apply fundamental analysis by examining trends in the balance sheet, income and cash flow statements along with other qualitative factors specific to each company. It is at this point in our investment process that we have arrived at a final intrinsic value of the company. Detailed written reports are shared with the investment committee and catalysts that will move a mispriced security towards our estimate of intrinsic value are known and agreed upon by the committee.
Isthmus Partners offers Small Cap Core Equity and Large Cap Core Equity strategies to institutional investors that seek to provide competitive, long-term performance.
Small Cap Core Equity
- Target between 60-65 small cap core securities
- All securities with market capitalizations using the following bounds (at time of original purchase):
- Lower bound: Market capitalization of the security representing the bottom one percentile of market capitalization in the Russell 2000® Index, subject to a floor of $100 million.
- Higher bound: Market capitalization of the security representing the top one percentile of market capitalization in the Russell 2000® Index.
- Strong sell discipline
Large Cap Core Equity
- Target between 40-45 large cap core securities
- All securities with market capitalizations above the following lower bound (at time of original purchase):
- Market capitalization of the security representing the bottom one percentile of market capitalization in the S&P 500 Index, subject to a floor of $2 billion.
- Strong sell discipline
Why Investors Choose Isthmus
Isthmus Partners is independent and autonomous, which means that we can respond quickly to investment opportunities. We think independently, act collaboratively and take action that at times involves going against the crowd.
- Excess Return Identifier (ExRI℠) – We believe our exhaustive excess return identifier process enables us to identify companies that possess properties that have led to historical excess returns – an additive element to a high quality strategy that you will not find elsewhere.
- Strong entrepreneurial culture.
- Transparent investment process and access to portfolio management team.
Share-Based Compensation Expensing: The Impact on Adjusted Earnings
The pressure to showcase positive earnings momentum via adjusting GAAP (Generally Accepted Accounting Principles) figures to “something better” has persisted for years. Adjustments that had been confined to items such as “restructuring charges” and “impairment charges” are now increasingly housing share-based compensation as well. In this latest edition of Isthmus Insights, we explore the prevalence of this trend in the aggregate and by sector.
Inventory Trends and What They Mean for Cash Flow
Our most recent whitepaper, Inventory Trends and What They Mean for Cash Flow, is not only timely and relevant, but it highlights the meaningful impacts inventory levels can have on the cost of operating an enterprise as well as available cash flow and how these components factor into calculating enterprise value.
The Quantity Theory of Money
In the summer of 2017, we authored a whitepaper titled, "The Quantity Theory of Money (the Equation of Exchange): The Expansion of the Money Supply, the Decline in Velocity and the Potential Impact of its Reversion on the General Level of Prices" in which we attempted to quantify the risk of a rising money supply and inflation using the Quantity Theory of Money. With inflation now the topic of the day, we revisited our analysis and asked ourselves, "what might happen to inflation if velocity were to head back toward historical levels?".
In our most recent whitepaper, we evaluated scenarios to determine what might happen if velocity were to revert to its mean in a slow and steady fashion as well as in a snapback fashion over the coming months and quarters.
The Disconnection of Style-Based Investing–
In the winter of 2019, we authored a whitepaper titled, "The Disconnection of Style-Based Investing" in which we asked the question, “As styles go in and out of favor, is this nothing more than sector rotation or sectors going in and out of favor?” We found that the data showed no distinctive difference between Growth and Value when these styles were redefined as GrowthIP and ValueIP.
The remarkable advantage of conventionally defined Growth versus Value prompted us to extend our original analysis through 2020 in our most recent whitepaper titled, "The Disconnection of Style-Based Investing - Round Two." In our most recent whitepaper, we explore how the notion of Growth versus Value holds up when one looks at style-based assignments within sectors rather than that used by S&P's methodology.
Small Cap Health Care: How Biotech is Influencing the Sector
The presence of biopharmaceutical companies within the investing landscape has showcased an impressive upward representation over the past decade, particularly as it relates to small cap investing. Biotechnology companies typically create drugs from living organisms, a method which contrasts with that of traditional pharmaceutical companies who create and sell drugs made from chemical-and plant-based compounds. From the standpoint of the investor, taking a stake in these companies is different than that of a more traditional health care company (a medical device company, for example). What we have observed is a bifurcation of the small cap Health Care sector, with demonstrative changes in its makeup and resultant behavior in its risk and return characteristics. This observation prompted us to probe further to quantify additional aspects of this shift, such as the constituent number, market value, performance and cash flow differences between the two groups.
Dissecting Beta – A Time Series Analysis
While the beta of the market, by definition, will always be 1.0, we have witnessed pronounced changes within its constituent base that are worth dissecting, particularly at the sector level. More specifically, we have seen that certain sectors with historically high betas have moderated over the near term while others are seeing parallel swings in the other direction.
Lease Accounting: How the New Standard Impacts Financial Statement Optics
Accounting changes rarely cause one to take notice, yet the Financial Accounting Standards Board’s (FASB) Accounting Standards Update 2016-02, Leases (Topic 842) has broad implications to the look and feel of the corporate balance sheets of lessees. We believe that these implications are rarely discussed by the financial press.
Leasing is utilized by many entities. It is a means of gaining access to assets, of obtaining financing, and/or of reducing an entity’s exposure to the full risks of asset ownership. Previous lease accounting was criticized for failing to meet the needs of the users of financial statements. While Topic 842 has formalized the accounting treatment of operating leases, we have been incorporating these adjustments into our work for some time. Analysis of the Balance Sheet is crucial to determining the financial well-being of any potential investment, and our adjustments to include leases finds their way in a variety of places throughout our investment process.
The Disconnection of Style-Based Investing
Style-based investing has increasingly dominated active management ever since Russell Investments began tracking Growth and Value characteristics in developing style-based indices in 1987. In an attempt to answer the question, "As styles go in and out of favor, is this nothing more than sector rotation or sectors going in and out of favor?" we sought to determine the level of performance alignment between the conventionally defined and alternative style-based indices. What we discovered may call into question the validity of style-based investing.
The Diverging Effect of Beats and Misses on Stock Prices
Our experience and intuition has led us to theorize that the reward for a good earnings release has been tempered while the penalty for a poor release has been magnified over time. In an attempt to further quantify and test our intuition on the magnitude of the impact of earnings releases on share prices, we parse the data that underpins the reactions to these announcements.
Executive Compensation - Revisited
In keeping with our efforts to convey unique insights on matters beyond excess returns, you may recall from our Summer 2016 whitepaper we measured the magnitude of executive compensation against the level of economic value generated by various corporations. We concluded at the time that firms that link compensation with economic value creation were still in the minority and that we emphasize those that do so in our research process. In our most recent whitepaper, Executive Compensation - Revisited, we extended our original analysis and aimed to quantify the density with which firms are using economic value creation (or similar measures) and how its usage has changed over time.
The Quantity Theory of Money
Much has been debated about the relationship between the money supply and inflation. Applying a well-documented economic principle, the Quantity Theory of Money, we attempt to quantify the risk of a rising money supply and inflation by looking at what might happen to inflation if velocity were to revert to its mean in the years to come. While our analysis is not a prediction or our estimate of future rates of inflation, it will hopefully provide some food for thought.
The thought of tracking the levels of executive compensation with economic value creation has always intrigued us. Using publicly available data and with the benefit of being able to access standardized disclosures, we formalized our analysis in an attempt to provide a perspective on an alternative way to view executive compensation.
Use of Cash: Dividends and Share Repurchases
With “Use of Cash: Dividend and Share Repurchases,” we examine the magnitude of how dividends and share repurchases have been broken down and have been covered by excess cash flow and how these have trended over time.
The Isthmus Partners institutional team is composed of highly experienced and credentialed professionals.
David A. HackworthyFounding Partner
Chief Investment Officer
& Portfolio Manager Read More
Frank J. Gambino, CFAFounding Partner
Chief Equity Strategist
& Portfolio Manager Read More
Jeremy R. Baier, CFAPartner,
Senior Equity Analyst &
Portfolio Manager Read More
Joseph S. Edelstein, CFAEquity Research Analyst Read More
Sara S. TrachteDirector of Marketing & Strategic Initiatives Read More