Blog

The 3 Fs of Portfolio Construction


July 16, 2014

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By Eric Hewitt

Portfolio Manager


My wife and I are both runners and enjoy the annual ‘fun runs’ we’ve built into our schedules. The Nisswa Firecracker on the 4th of July, the Bolder Boulder on Memorial Day, and even the occasional ½ marathon gives us motivation to train. Participating is fun, but nothing is more satisfying than crossing the finish line. Working on a stock idea has a similar feel, however, the finish line is not nearly as clear as the starting line. So what guides us as we move down the path from idea generation to ownership in a portfolio?

Here on the OppenheimerFunds Value Equity team we use a stock analysis method we call the 3 F’s: Free Cash Flow,* Fundamental Forecast, and Factor Exposure. By defining what we’re looking for in order to take a position in a stock, we’re better able to understand exactly where that finish line is and whether we’re willing to carry that stock across or leave it on the race course.

First, we take a history lesson to understand exactly how the company generates Free Cash Flow. Cash flow is the fuel for any company, enabling management to reinvest back into the business, make acquisitions, or potentially return the cash to shareholders via dividends or share buybacks. Our goal is to thoroughly understand the industry the company participates in, the products the company sells, and any change factors which could impact cash flow generation in the future.

Second, after we understand Free Cash Flow generation, we build off of that knowledge to develop a Forecast about the future. Success in investing is largely about seeing what others do not. This is the stage where we ask questions about what might happen and to what degree of confidence we believe something may actually come to pass. This is also the stage where we compare our forecast to what the market forecast thinks will happen. Where there’s a difference, there may be an opportunity.

Finally, we analyze the Factor Exposures embedded in the stock, such as active share, tracking error, foreign currency exposure, interest rate risk, Beta, and commodity exposure. This helps us determine whether a stock fits into our portfolio construction and what the position size should be. Sometimes there are very good stock ideas that have risks we’re not willing to take, and that’s ok too.

By following the 3F’s when analyzing a stock idea, our team has a clear idea of the finish line and whether the idea is worthy of carrying across or leaving behind. And yes, it feels good crossing the finish line!

* Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.

Active share measures the percentage of an active portfolio that is different from its respective benchmark. Tracking error is a common risk metric that measures the volatility of relative returns an active manager has realized compared to his/her fund’s benchmark. Beta is a measure of the risk of a security or portfolio in relation to an independent variable (i.e., the general market or other specified benchmark).

Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and geopolitical risks. Value investing involves the risk that undervalued securities may not appreciate as anticipated. Small and mid-sized company stock is typically more volatile than that of larger, more established businesses, as these stocks tend to be more sensitive to changes in earnings expectations. It may take a substantial period of time to realize a gain on an investment in a small or mid-sized company, if any gain is realized at all. There is no guarantee that the issuers of stocks held by mutual funds will declare dividends in the future, or that dividends will remain at their current levels or increase over time. Diversification does not guarantee profit or protect against loss.

A Daily net asset value and dollar change of the fund is as of the previous business day's closing. Fund net asset values are updated at approximately 7 p.m. ET daily.

Fund Footnotes

1 Special Risks: Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and geopolitical risks. Value investing involves the risk that undervalued securities may not appreciate as anticipated. Small and mid-sized company stock is typically more volatile than that of larger, more established businesses, as these stocks tend to be more sensitive to changes in earnings expectations. It may take a substantial period of time to realize a gain on an investment in a small or mid-sized company, if any gain is realized at all. Diversification does not guarantee profit or protect against loss.