On October 31, 2018, Vaughan Nelson Value Opportunity Fund celebrated the tenth anniversary of its launch. Senior Portfolio Manager and Research Specialist Dennis Alff, CFA® reflects on this milestone.

What is Vaughan Nelson’s investment approach?
Every client of ours, whether it is an individual investor or a large endowment, invests because they have a future liability to offset. Vaughan Nelson recognizes this responsibility and we structure our team, approach, and philosophy around this idea.

We believe that offsetting future obligations is about more than just market exposure. We focus on a targeted return and seek investments that we believe have the ability to generate a significant return over a three-year period. Companies we invest in need to fall into one of the following three categories during the research process: Undervalued Growth, Undervalued Asset or Undervalued Dividend.

  • The Undervalued Growth category is focused on growing return on invested capital businesses. We place an emphasis on those companies demonstrating the ability to earn and grow above and beyond their incremental cost of capital.
  • The Undervalued Asset category is a business appraisal. We identify companies trading at a substantial discount to what we believe is their asset value, coupled with an identifiable catalyst to close this valuation gap.
  • Names in the Undervalued Dividend category usually generate the majority of their return from a high dividend yield, combined with minimal basis risk.
How does the approach fit into this strategy?
The focus on discovering mispriced assets forms the philosophy driving Vaughan Nelson Value Opportunity. We run a high active share,1 concentrated portfolio that invests in small and mid-cap companies. The portfolio is built bottom-up, implementing fundamental analysis with security selection acting as the primary alpha2 source. The ability to rotate amongst investment categories during a full market cycle can result in a dynamic portfolio intent on avoiding mean reversion3 and delivering excess performance.

Disciplined investment process

What do you look for when investing in a stock?
During the research process, a name being considered must fall within one of the three investment categories. Fundamental analysis is used to determine return drivers (earnings/cash flow, dividends, stock buybacks and debt paydown) and to identify whether the specific stock is likely to meet the targeted return objective.

What have been some learning experiences over the past ten years?
While the process and philosophy have remained consistent for the past ten years, there are always learning opportunities. The first came in 2008, when having a macro outlook became a necessity. This fund remains bottom-up, built on fundamental analysis, but it is important to be macro informed to help identify systemic, big picture items or discern whether capital markets could be benign or hostile.

We have found the three-year investment horizon is a strength, allowing the team the opportunity to trade time for value and benefit from improving situations in a short-term focused market. On occasion, the longer runway can open a name to volatility,4 as it is easy to overlook the potentially uneven path when focused on a multi-year thesis. In the fund’s first ten years, we have become more cognizant of this and continue to look to smooth and enhance the investor experience when possible.

How does Vaughan Nelson think about risk management?
Robust portfolio monitoring is a necessity when running a concentrated portfolio. Furthermore, we believe sector diversification alone is not adequate diversification. We benefit from a proprietary risk model that measures diversification and sensitivities to risk factors that move independently from one another. In a concentrated portfolio, it is imperative to try and avoid unintended factor bets being introduced.

How can the fund fit into an investor’s portfolio?
We believe investors do not benefit from a fund that makes all its money in one market and loses it in another. The goal for Vaughan Nelson Value Opportunity has been to build a dynamic portfolio that will produce a targeted return throughout a full market cycle. This fund could be used in several ways:

  • For investors seeking a high active share, concentrated US equity portfolio in the mid-cap universe where diversification is measured by granular risk factor exposures
  • For investors seeking a portfolio that targets companies with better earnings growth, high quality of returns and lower earnings variability
  • For investors seeking to source returns from multiple investment categories, allowing for the potential to generate alpha in different market environments
1 Active share indicates the proportion of portfolio's holdings that are different from the benchmark. A higher active share indicates a larger difference between the benchmark and the portfolio.

2 A measure of the difference between a portfolio's actual returns and its expected performance, given its level of systematic market risk. A positive alpha indicates outperformance and negative alpha indicates underperformance relative to the portfolio's level of systematic risk.

3 Financial theory suggesting that asset prices and returns eventually return to the long-run mean or average of the entire dataset.

4 The range of variation in the value of a security.

RISKS: Equity securities are volatile and can decline significantly in response to broad market and economic conditions. Investments in small and midsize companies can be more volatile than those of larger companies. Value investing carries the risk that a security can continue to be undervalued by the market for long periods of time.

Diversification does not guarantee a profit or protect against a loss.

CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions and are as of October 2018. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

Before investing, consider the fund’s investment objectives, risks, charges, and expenses. You may obtain a prospectus or a summary prospectus on our website containing this and other information. Read it carefully.