This chapter pulls together the theory and practice of markets and investors, and discusses, at a high level, Epoch’s process for selecting individual stocks for investment. To sum up the foundation of the past several chapters: first, we respectfully depart from the theoretical arguments of Modern Portfolio Theory, and substitute the observations of behavioral finance—that real-world investor behavior is complex and leads to inefficiencies in stock prices, creating mispricing in securities and opportunities for active managers. Second, we believe that the reliance by corporate managements, as well as by many investors, on backward-looking financial measures derived from generally accepted accounting principles (GAAP) financial statements distorts the financial picture many companies present. Moreover, accounting-based investment decisions can give rise to their own category of mispricings and inefficiencies. Accordingly, we believe that cash flow is the origin of value in stocks, and that forecasts of cash flows should be the basis for security selection.
In the next few pages we discuss Epoch’s framework for evaluating the cash flows of individual companies. We emphasize the importance of managements’ decisions in allocating their available cash flow—either by adding value to their businesses through capital reinvestment, or returning capital to the owners through share repurchases and dividends.