Capital allocation matters because decisions on how to allocate cash flows—whether to reinvest in order to grow a company, or to return capital to shareholders—can create or destroy long-term shareholder value.

The U.S. Quality Capital Reinvestment strategy seeks to invest in companies that earn a superior ROIC relative to their weighted average cost of capital (WACC), are expected to be able to maintain that return premium and have the opportunity to grow their business. The portfolio generally holds between 75 and 100 stocks from the U.S. equity market and employs risk controls to diversify the sources of growth and reduce volatility.

The strategy first uses a quantitative screen to identify potential investments. TD Epoch seeks to identify companies that have ROIC greater than WACC, growth in cash flow from operations over the last five years, expected revenue growth greater than 5%, and high or expanding margins. The proprietary Epoch Core Model (ECM) is then used to rank every name that passes the screen against its peers on 22 different factors, many of which are based on TD Epoch’s free-cash-flow investment philosophy.

On a quarterly basis, the investment team runs a portfolio optimization on the names that pass the Capital Reinvestment screen. The optimizer seeks to maximize the portfolio’s information ratio—i.e., expected alpha relative to expected tracking error—with the ECM score serving as a proxy for expected alpha. Simultaneously, the optimizer seeks to maximize the screening metrics that make up the Capital Reinvestment screen described above. Risk constraints are in place to limit the contribution of any one stock to the portfolio’s aggregate ROIC - WACC premium. The optimization results in a suggested portfolio of 75 to 100 stocks, which typically includes 10 to 12 suggested new buys and 10 to 12 suggested sells.

The investment team performs rigorous fundamental research on each of the suggested names to determine whether the characteristics that allowed a company to pass the screen are likely to be maintained. The investment team performs financial statement analysis to understand the dynamics of how a company has generated a high level of ROIC. Once the source of ROIC is understood, the team looks for factors that increase the likelihood of sustaining that high ROIC. The team also looks for risks to that sustainability. Finally, they check a company’s proxy statement to see what kind of long-term incentive plan management has in place. Ideally, company management should be rewarded for generating good returns on capital, rather than simply for growth in sales, earnings, or market share.

Once the team understands the source of a company’s high ROIC, judges it to be sustainable, is comfortable with the risks to the ROIC, and thinks that management’s incentives are reasonably aligned with the interests of the shareholders, they will approve the stock for inclusion in the portfolio. The investment team typically implements roughly one-third of the buys and sells suggested by the optimizer. The team may also purchase companies that have not been suggested by the optimizer; however, these stocks must pass the Capital Reinvestment screen and be highly ranked by the ECM.

The investment team performs a quarterly portfolio rebalance that incorporates the results of the quantitative screen, optimization analysis, and fundamental research. Positions can also be added or removed at any time based on information from fundamental analysis or in reaction to new information. Stocks are generally held in the portfolio if they continue to demonstrate the sustainable growth characteristics sought by the strategy and may be sold or reduced if a company’s fundamentals change, there are alternatives with a better risk-reward outcome, or if there is deterioration in the investment criteria.

Risk management is integrated throughout the process with a focus on avoiding unintended risks. Portfolio risk exposures are monitored and formally communicated to portfolio managers on a regular basis and are discussed at investment meetings. The optimization process utilizes constraints to limit the contribution of any one stock to certain portfolio aggregate measures (ROIC - WACC, growth in cash flow, expected revenue growth, operating profit margin). The minimum position size is generally 0.25%, and the maximum is 2.0% (except for stocks which are greater than 2.0% of the benchmark, in which case the maximum is the benchmark weight plus 1.0%). There are no explicit limits on country, region, or sector weights, because the portfolio optimization process tends to prevent extreme overweights or underweights.