The Orchard Fund Investment Process

We invest in mature dividend-paying companies where we are able to directly manage the risks of those investments. The Orchard Strategy focuses on selecting companies that pay a dividend, have a history of growing that dividend and are likely to do so in the future.

Our process is based on fusing what we believe to be the best parts of all available information. Our approach uses quantitative, fundamental and technical disciplines, acting on the weight of all available information. We are process driven but retain flexibility.

We are able to invest in mid and large-cap companies that pay dividends (approx. 2000 companies globally). Within that universe, our ’portfolio contenders’ are companies which have a cushion of safety in their valuation but are exhibiting the early stages of an earnings upgrade cycle which is accompanied by improving analyst sentiment. In particular, we look to identify durable upgrade cycles which allow for significant re-rating of that company’s valuation as investors forecast a continuation of these new trends and start discounting future growth expectations in today’s price.

Our approach is to use quantitative, fundamental, technical disciplines. Our thematic and fundamental research helps to determine the persistence of these trends and the sustainability of the free cash flow yield supporting the company’s dividend.

Portfolio Construction

Although much of our analysis is similar to many of our peers, how we construct the portfolio is materially different from the majority, if not all, of our competitors. As we outline further in the section entitled, avoiding losses, we believe that the mitigation of losses is an absolutely fundamental characteristic of long-term capital appreciation. As such, once we have decided on a stock that we believe offers value, we analyse where would be the best level to buy that stock. If we believe that there is no possibility of that share price falling from the current price, then clearly we buy it straight away. However, in the majority of circumstances, that is not the case because of either company specific issues or the wider economic situation, in which case, we agree to buy the stock below the current market level. The distance below the current market at which we are willing to buy the stock significantly affects how much we are paid for that commitment, and as such we weigh up the benefit of a higher income against a smaller margin of safety. When we have decided which stock we are comfortable investing in, we analyse the different time periods for which we are able to make commitments to buy, balancing the higher annualised yields offered by shorter commitments against the greater income received for making longer commitments.

Once the commitment is made, we receive the premium immediately. After that, we can be forced to buy the stock on any business day at the price at which we have agreed but generally will only be forced to do so close to the expiry of that commitment. Our job during this period is to continue to monitor the stock and ensure it still meets the criteria for being in our portfolio. If at the expiry of the option we have to buy the stock, we do so and start the work of analysing where we would be willing to sell the stock. Once we have calculated this, we make a commitment to sell at a price above the current price and once again receive a premium up-front for doing so.

Assessment Process
If at any time during this process, we decide that the stock no longer meets our criteria, we can close our commitments out and realise a profit or loss, depending on where the share price is at that time.

Options Overlay

Whilst the options overlay is a vital part of the Orchard Strategy it is very much the tail, rather than the dog. Once we have done all of the work to choose the stocks which we intend to invest in, the options overlay allows us to make that decision better, or more importantly, has the ability to make a decision which wasn’t perfect, profitable. For those of our investors who are not immediately comfortable with the concept of options, this is a point worth dwelling on. When we have analysed a stock, we then agree to buy that stock approximately 10% below the current market price, our margin of safety, in return for receiving a premium of 8%. This has the benefit that we make our 8% return in a year, so long as the stock does not close the year more than 10% below the current market price. Even if we have to buy the stock, so long as it is not below the combination of our margin of safety and the premium received, 18% in this case, we are still profitable. Even if the stock has fallen more than 18%, we have bought a stock that we are comfortable with at a price at which we found it attractive.

Greater downside protection

To fully understand the benefit of this strategy it is worth comparing those outcomes against an investor who simply buys the stock. The table below clearly shows that, whilst the upside of the outright buyer is greater if the stock rises more than 8%, his downside is greater at every point below his purchase price. We believe that this asymmetry gives the Orchard strategy a real edge. In the example below, while the upside is limited to 8%, the stock has to fall from $100 to $82 before we start to lose money at which point the long-only manager is already losing 18%.

Once we own a stock, the options overlay again helps us to add value and reduce risk. By determining the level at which we are willing to sell a holding, and writing a commitment to sell it there, we are again paid a premium. This has a major impact on the on-going yield of the portfolio which, when combined with the stock’s dividend yield, ensures that the stocks we hold are producing an income in excess of 6% per annum. The risk associated with writing a call option is that we have to sell the stock at the price at which we have agreed to. The benefit is that the premium received increases the yield on our holdings to a level where we are very comfortable holding that stock.

Trade Details

Profit Profile

Risk Exposure

The use of options to enter and exit positions has a material effect on our ability to manage the risk of the Fund. Ideally, most investors want higher returns and lower risks. Over more than a decade, the Orchard Strategy has been able to deliver that through using the options overlay instead of simply buying and selling stocks. The importance of this cannot be underestimated for most investors. If we put up a chart of any major stock market over the last 100 years, a rational investor would have bought on day 1 and still be holding the investment, as the gains over an extended period have been exceptional. However, our ability to hold on to our investments is severely tested when we suffer setbacks and it is only human when markets correct to become concerned and wish to retain those profits which you still have, by exiting the market. The more vicious the correction, the more likely we are to wish to take money off the table. Regrettably, that generally leaves investors selling near the bottom of market corrections and missing out on the next move higher. By mitigating the worst of these losses and recovering any losses more quickly than a traditional equity investment, it makes it possible for investors to ride out the storm and remain true to their investment goal.

Risk Exposure Chart
As the chart highlights, although the Orchard Strategy cannot prevent drawdowns, those drawdowns are materially less than the wider market and the time taken to recover from those drawdowns is much shorter than traditional equity investing.

Avoiding Losses

As we get older we sometimes forget some of the lessons that we learn as children. This is often a mistake and never more so than when we forget basic mathematics. As the table below shows, the amount of return required to recover from a drawdown is significantly greater than the drawdown and the bigger the drawdown the greater the disparity. It is almost inconceivable that if the index draws down by 50% as it did in 2008, then it needs to make 100% to simply return to its original level. If you are able to restrict those losses to 20% during the same period, then a return of 25% will move the account back to break even.

However mundane it may sound, the best way to increase wealth is by ensuring that we do not destroy it first. Making money is exceptionally important, but in many ways, not losing it when markets fall is even more important in the long run.

MSCI 1 Table
MSCI 2 Chart

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MitonOptimal Portfolio Management (CI) Limited
PO Box 354,
St Peter Port,


+44 (0)1481 740044

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MitonOptimal Portfolio Management (CI) Limited (Registration No. 36763) is licensed and regulated by the Guernsey Financial Services Commission under the Protection of Investors (Bailiwick of Guernsey) Law 1987, as amended.

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