Nakoma Capital's investment philosophy is based upon a fundamental view of how stock prices are set that begins with the proposition that stock prices reflect consensus expectations of company business performance. For every stock transaction there is a buyer anticipating the company will perform well (the bull) and a seller anticipating the company will perform less well (the bear). Subsequent changes in investor expectations of company performance drive stock prices. Stock prices rise when companies perform better than expected and the bears are forced to revise their forecasts higher or stock prices fall when companies perform worse than expected and the bulls revise their forecasts lower. Therefore, more accurate forecasts than the consensus forecast are required to produce positive absolute returns through stock investing.
This expectations-oriented investment approach is implemented through three integrated processes: dynamic asset allocation (to determine net equity exposure), fundamental stock selection and risk management.
The dynamic asset allocation process is designed to increase net equity exposure when it is the firm's view that the equity market environment is favorable and decrease net equity exposure when it believes the equity market environment is less favorable. The actual net exposure results from the flow of long and short ideas as well as an analysis of macro factors affecting investor expectations for market returns. The firm surveys economists and strategists to determine the expectations distribution for a number of drivers of growth, interest rates and investor sentiment. When trends in the leading indictors of these drivers are consistent with the more optimistic forecasts, the net exposure is increased. Conversely, when the firm believes trends are consistent with more pessimistic forecasts, the net exposure is decreased.
The fundamental stock selection process is designed to identify companies with the potential for positively or negatively surprising business results over a six to eighteen month time horizon. For each stock, the firm monitors key business drivers (macroeconomic, secular trends, industry dynamics and company specific events) that will affect the underlying company’s business over the investment time horizon. The firm believes that when a company’s key drivers exceed expectations, the company’s share price can be expected to follow a positive price trend until investor expectations and actual company performance converge. Conversely, if a company’s results fall short of investors’ expectations, its securities will usually under perform until those expectations are lowered to the level at which the company is actually performing. Analysis of each opportunity (long or short) considers the level of investor expectations in assessing the potential reward for a correct call versus the penalty for an error.
The firm’s risk management process analyzes the sources of volatility in the portfolio (e.g. capitalization, style, interest rate sensitivity, etc) in an effort to match risk exposures with the firm's overall market view and avoid unintended risk exposures. Additional risk management techniques (e.g. maintaining a well diversified portfolio with maximum position sizes) are employed in a further effort to minimize volatility.