Rafael Resendes Interview: Investing in Large-Cap Stocks

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An Interview with Rafael Resendes, Managing Director at Toreador Research and Trading LLC and co-Founder of The Applied Finance Group (AFG) - Wall Street Transcript

Rafael Resendes, Portfolio Manager of the Toreador Large Cap Fund: TORLX

TWST: Would you start with an overview of Toreador and your investment philosophy there?

Mr. Resendes: The first concept that drives our thinking is that we are a sector-neutral fund; we’re not looking to make sector bets and so we stay invested in proportion to each major sector’s weight in the S&P 500. We are a large cap fund, so we purchase predominantly stocks that are in the S&P 500 or Russell 1000. We will drop down to stocks with market caps as low as $5 billion sometimes, if there are some large stocks that are falling that we believe are attractive, but predominantly, we are in the upper mega-cap range with our stock selection process. Therefore what we believe sets us apart from other fund managers is our stock selection process.

We really try to focus on four major drivers behind any stock that we look at. The first is understanding a firm’s earnings quality; in other words, GAAP accounting metrics and procedures result in a fair amount of latitude in the way companies can report their earnings and prepare their books, and we want to understand the quality of those earnings before we buy them. For example, companies may push their product out to their end customers and “book” a sale, without collecting any cash from the transaction. If this happens enough, we will see accounts receivables rise faster than collected cash, and indicate a potential problem in the future. Therefore, we rank all the companies we follow on a metric we created that determines the quality of a company’s reported earnings. We do not consider firms with low earnings quality unless we understand the reason and believe it is short term in nature.

The second factor we evaluate is a firm’s economic earnings,rather than its GAAP accounting earnings. There are a number of issues that prevent reported earnings from being a true proxy for a firm’s economic performance, so we take the time to fix those issues and put all firms on a level playing field to evaluate their performance. There are examples, such as the use of R&D for instance — in the technology sector, technology companies according to GAAP must immediately expense their R&D investments. equipment. We don’t expect manufacturing firms to recoup the cost of a new machine in the year they make the purchase, and companies investing in R&D do not expect to recoup the entire investment the year they make the expenditure. Therefore the R&D expenditure needs to be reversed from the income statement, capitalized on the balance sheet, and depreciated over time — similar to physical piece of equipment. As the knowledge economy continues to grow such adjustments become more and more important. We make this adjustment for every firm in our investable universe.

Another adjustment we make is looking at off balance sheet assets and liabilities, such as the use of operating leases, which is particularly important when analyzing retail companies. For these firms,

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