Deep Value Equity Investing with PIMCO Pathfinder Strategy Introduction to Deep Value Equity Investing Deep value equity investing is an approach that seeks attractive risk-adjusted returns by investing in stocks trading at significant discounts to their intrinsic value. Deep value investing utilizes fundamental bottom-up security analysis to identify businesses available at steeply discounted prices with a margin of safety built into the price of the stock. This disciplined investment approach seeks to deliver attractive long-term returns with relatively low volatility. Deep value offers long-term equity investors the potential for attractive returns even in periods of slow growth and may therefore be especially attractive in the current environment. Over the next three to five years, PIMCO expects subdued growth in the developed markets, higher growth in emerging economies, and increasing regulation and government intervention an economic environment we call the New Normal. These shifting growth dynamics are expected to create notable gaps between short-term trends and longer-term structural realities, which, in turn, may obscure the underlying value of many securities. Deep value investing has the potential to discover these mispriced securities and seeks to outperform the broad global equity markets while exhibiting lower volatility over a full market cycle. It aims to provide consistent added value across market cycles with meaningful downside risk mitigation. Philosophy and Process: Deep Value Equity Investing at PIMCO Deep value investing at PIMCO emphasizes a diversified portfolio of stocks that we believe are significantly undervalued relative to what we have determined to be their intrinsic worth that is, undervalued based on either an asset-based valuation or a cash flow based valuation of their business and the gains they may be reasonably expected to offer over time. A company s stock can be undervalued because of a disappointing earnings report, a restructuring, a lawsuit, management that failed to deliver results, an adverse short-term cyclical trend, or some other perceived negative. Value investors in general seek to profit from investors tendency to overreact to this negative information and to punish the shares of even those companies with long-term potential. As companies that fall out of favor can sometimes stay out of favor for an extended period of time, PIMCO Pathfinder Strategy anticipates a threeto five-year investment horizon for typical deep value equity holdings. Determining a security s intrinsic value entails rigorous evaluation of the company s fundamentals, industry trends, competitors and the global economic environment for its goods and services. The initial step is to locate securities that are candidates for this thorough evaluation process. Seeking stocks primarily in developed economies around the world, portfolio managers and analysts study annual reports and company filings, and sift through information on corporate actions, restructurings, spin-offs, mergers and acquisitions, and also consult extensive networks of industry contacts, including high-level company management. In addition, the team visits companies worldwide to engage face-to-face with senior management and to get a first hand view of operations. The fundamental bottom-up analysis that underpins deep value investing seeks securities with compelling ratios of upside potential relative to downside risk: steeply discounted stocks of strong businesses. The steep discount coupled with solid company fundamental analysis is intended to help ensure each investment has an appropriate margin of safety the difference between a stock s market price and its intrinsic value.
Deep Value Equity Investing with PIMCO Pathfinder Strategy Companies sought are likely to display one or more of these favorable characteristics: solid earnings power and free cash flow generation; sustainable business models and competitive advantages that translate into assets overlooked by the markets; the flexibility to restructure inefficiencies; and capable, steady, shareholder-friendly management. In addition, the securities will typically have identifiable triggers either within a company s operations or its capital structure, or in the market environment itself, that can be used to help unlock its underlying value. The value in deep value investing means more than just evaluating a bargain it speaks to the real worth inherent in many of these companies, and the potential shareholder benefit should the stocks appreciate from what may very well be deeply mispriced levels. Analysts use several methods to search for mispriced stocks. Multiples-based fundamentals (ratios of price-toearnings, price-to-cash-flow, price-to-book, price-to-sales) can help to pinpoint stocks whose market price is well below the determined intrinsic value of the businesses. Free cash flow yields can be assessed against the averages across industry peers and a high free cash flow yield may indicate an attractive company. Ultimately, however, either an asset-based valuation or a cash flow based valuation tends to drive our estimate of a stock s intrinsic value. Understanding the equity as a business thinking like an owner is a critical component of the deep value approach. It entails ongoing contact with top-level management to understand their current thoughts on the operation of the business and at times can also mean advising them on how they may be able to create value for their shareholders as PIMCO Pathfinder Strategy actively pursues the activation of triggers that may help to realize intrinsic value. Assuring profit potential in a deep value strategy involves adhering to a discipline of knowing when to buy and when to sell: endeavoring to buy at a specific discount (for example, 60% or 70% of intrinsic value) and selling when the securities are trading at prices approaching what we have determined to be their intrinsic value. The strategy anticipates three- to five-year investment horizons for typical deep value equity holdings. However, it may liquidate holdings that don t meet its investment objectives when it is appropriate to do so. An active deep value investment strategy will likely involve significant deviations from benchmark exposures and is not managed with the objective of limiting tracking error. Supplemental Strategies for Deep Value: Merger Arbitrage and Distressed Credit In addition to undervalued securities from a broad range of global markets, deep value investing at PIMCO also incorporates alternative strategies in merger arbitrage and distressed debt, and may also include other tactical opportunities. Merger arbitrage has the potential to generate equity-like returns with low volatility and relatively low correlation to the overall market. Merger arbitrage looks to capture the spread between the current price of the target company and the ultimate takeover price upon acquisition. In merger arbitrage, PIMCO Pathfinder Strategy s focus is on announced actions, which then undergo thorough due diligence, helping to ensure a higher probability of success and a reasonable margin of safety. In line with a conservative approach, PIMCO Pathfinder Strategy does not use leverage for these investments. 2 Distressed credit investing targets equity-like returns via purchases of bonds and bank debt at notable discounts to par with meaningful collateral backing. The focus is on firms in distressed situations (e.g., bankruptcies, reorganizations, coercive tenders) and, in order to reduce downside potential, seniority in the capital structure. If and when a distressed company is reorganized and regains health, the debt purchased at discount may reach par value or even be swapped into equities.
Managing Risk in Deep Value Investing The deep value investment process strives to identify and mitigate downside risks in all market environments. Sources of risk in equity selection can include security overvaluation (overestimating the intrinsic value), excessive leverage, flawed business models and inadequate company management. Sources of risk in portfolio construction can include individual company risk, sector or industry risk, overall equity market risk, and/or currency risk. Risk management techniques include thorough fundamental research, a disciplined buy strategy focused on purchasing at a significant discount to intrinsic value with an attractive margin of safety, a disciplined sell strategy as the security approaches its intrinsic value or the investment thesis changes, and selective hedging strategies with currency forwards and derivatives. Constructing a diversified portfolio of stocks we have determined to be deeply discounted, with investments in alternative strategies such as merger arbitrage and distressed debt which have low to moderate correlations to the market, should also help lower the overall volatility of the portfolio. At the portfolio level, the strategy will tactically hedge currency, equity market and other risk exposures as appropriate. In addition, the willingness of the managers to hold a relatively elevated level of cash if the managers think it is appropriate to do so, can help mitigate systemic downside risk. Integrating Bottom-Up Security Analysis with PIMCO s Research Inputs to Maximize Value Deep value investing at PIMCO draws on the PIMCO Pathfinder Strategy team s disciplined and tested investment process, combining thorough fundamental security analysis with PIMCO s expertise in credit research and global economic analysis. Economic views can be a very helpful input into the analytical process, as companies don t exist in a vacuum. Economic variables such as one s outlook on interest rates or inflation can be critical in assessing the value of a security. Deep value investors with access to highly developed secular and cyclical economic outlook analysis have a potential advantage in evaluating the full spectrum of global economies, industries, firms and individual securities. The deep value portfolio management team can also tap into other benefits of the PIMCO platform, including deep resources in cash and currency management, policy research and operational execution. In addition, PIMCO s size and reach in the marketplace may offer unique insights into and opportunities with top-level company management. Given these combined resources, PIMCO s deep value portfolio managers can focus their efforts on uncovering fundamentally attractive, yet potentially out-of-favor and undervalued companies, at a price which they believe includes a reasonable margin of safety, in their attempt to produce attractive risk-managed returns for investors. 3
Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investments in value securities involve the risk the market s value assessment may differ from the manager and the performance of the securities may decline. Investing in distressed companies (both debt and equity) is speculative and may be subject to greater levels of credit, issuer and liquidity risks, and the repayment of default obligations contains significant uncertainties; such companies may be engaged in restructurings or bankruptcy proceedings. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investments in companies engaged in mergers, reorganizations or liquidations may involve special risks as pending deals may not be completed on time or on favorable terms. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Registered trademarks or trademarks contained herein are the property of Pacific Investment Management Company LLC and/or Allianz Global Investors of America L.P. in the United States and/or other countries. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Amsterdam Hong Kong London Munich Newport Beach New York Singapore Sydney Tokyo Toronto Zurich
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