The Three-Basket Approach to Equity Portfolio Construction

Introduction

At Thornburg Investment Management, equity portfolio managers employ a distinctive three-basket approach to portfolio construction. This framework categorizes holdings into three groups: Basic Value, Consistent Earners, and Emerging Franchises, each representing a different earnings profile and risk-return characteristic. The approach serves as a cornerstone of our investment philosophy, enabling portfolio managers to achieve fundamental diversification that transcends traditional sector and geographic classifications.

The Three Baskets Defined

The three-basket framework reflects a fundamental insight: companies exhibit distinct earnings shapes that behave differently across market cycles. By intentionally diversifying across these earnings profiles, portfolio managers can construct portfolios designed to deliver attractive risk-adjusted returns through varying market environments.

Basic Value

Basic Value companies are typically financially sound businesses operating in cyclical industries. These companies exhibit greater economic sensitivity and higher volatility in earnings and cash flow, often selling at low valuations relative to their net assets or potential earning power. The earnings shape of Basic Value holdings tends to be cyclical, with amplitude tied to an external variable such as the price of oil and gas for an energy company. When purchased at attractive valuations, these holdings offer significant upside potential as conditions improve or as the market recognizes their intrinsic worth.

Consistent Earners

Consistent Earners are companies that exhibit predictable growth, profitability, cash flow, and often dividends. In general, the demand profile for the products and services for Consistent Earner businesses is steady. These businesses typically possess durable competitive advantages that allow them to generate steady returns regardless of economic conditions. The earnings shape is smoother and more predictable, providing ballast for the portfolio during periods of market stress. While some of these businesses may trade at above-average valuations reflecting their quality characteristics, disciplined portfolio managers seek entry points where valuations remain attractive relative to the companies’ long-term earnings power.

Emerging Franchises

Emerging Franchises are companies in the process of establishing leading positions in their markets, with potential to grow at above-average rates. These businesses may be creating new markets or taking share from existing participants through innovative products or services. The earnings shape is often characterized by an upward inflection, with higher growth potential but also greater uncertainty about the ultimate trajectory. Portfolio managers typically maintain a smaller allocation to this basket, reflecting both the higher risk profile and the need to identify clear paths to success before committing capital.

Basket Assignment in Practice: Meta Platforms

The classification of individual securities requires careful fundamental judgment, as many companies exhibit characteristics that could support multiple basket assignments. Meta Platforms Inc. provides an instructive example of how portfolio managers rationalize these decisions.

A case could be made for classifying Meta as a Consistent Earner. The company holds a dominant market position in social media and digital advertising, generates substantial and recurring cash flows, and has demonstrated durable profitability over many years. Its core advertising business across Facebook and Instagram exhibits predictable revenue patterns tied to user engagement and advertiser spend. The company maintains high margins and generates significant free cash flow, the hallmarks of the Consistent Earner profile.

Alternatively, one might argue for an Emerging Franchise classification. Meta is investing heavily in new growth vectors, including Reality Labs, artificial intelligence infrastructure, and its broader metaverse vision, which could represent transformational opportunities but remain unproven at scale. These investments introduce earnings volatility and uncertainty about the company’s future trajectory, characteristics more consistent with the Emerging Franchise basket.

In weighing these considerations, portfolio managers would likely favor Consistent Earner as the primary classification. The core advertising business is mature, highly profitable, and generates most of the revenue and earnings. The growth investments introduce some volatility but are funded by an exceptionally strong cash-generating engine. Meta’s earnings shape is fundamentally that of a durable, compounding business with growth optionality layered on top, not a company still establishing its market position. This example illustrates how the basket framework encourages disciplined thinking about the fundamental character of each holding.

Why the Basket Approach Matters

The three-basket approach serves multiple objectives that ultimately benefit client outcomes.

Style diversification: By maintaining exposure across all three baskets, portfolios avoid the style concentration that can lead to extended periods of index-relative underperformance. A portfolio tilted entirely toward cyclical Basic Value holdings would suffer disproportionately during economic downturns, while an overweight to high-multiple Consistent Earners might lag in value-led rallies. The basket framework provides an additional lens for maintaining balance.

Reduced volatility: The different earnings shapes represented by each basket tend to perform differently across market environments. When Basic Value holdings face headwinds from economic weakness, Consistent Earners often provide stability. This counterbalancing effect can reduce overall portfolio volatility without sacrificing return potential.

Opportunity capture: Market conditions continuously create opportunities across different company types. The basket framework ensures that portfolio managers maintain the flexibility to capitalize on attractive valuations wherever they appear, rather than being constrained to a single investment style.

Understanding earnings shape: Perhaps most importantly, the basket classification helps portfolio managers understand the aggregate earnings profile of their portfolios. By knowing how much exposure derives from cyclical earnings versus steady compounders versus growth inflections, managers can better anticipate how portfolio earnings will evolve through different economic scenarios.

The Role of Portfolio Analytics and Risk

At Thornburg, the Portfolio Analytics and Risk team works collaboratively with portfolio managers to ensure that quantitative insights inform and enable action. This collaborative model, detailed in our prior publications, extends naturally to supporting the three-basket framework through the development and maintenance of proprietary analytical tools.

The Basket Tool

While portfolio managers and analysts thoroughly research each holding and assign it to the appropriate basket based on fundamental analysis, the same meticulous process cannot be repeated for every name in the broader investible universe. To address this challenge, the Portfolio Analytics team developed a proprietary Basket Tool that systematically classifies securities across the equity universe into the three-basket framework.

The tool employs a scoring algorithm that leverages the same econometric factors used in our risk management process. By analyzing factor exposures related to value, earnings stability, growth characteristics, and other relevant metrics, the algorithm assigns each security to the basket that best reflects its fundamental profile. This automated classification serves several critical functions.

First, the tool provides portfolio managers with a view of how their benchmark’s basket composition changes over time. As market conditions evolve, the mix of Basic Value, Consistent Earners, and Emerging Franchises within an index shifts. Understanding these dynamics helps portfolio managers make informed decisions about their own basket allocations relative to the benchmark.

Second, the tool generates early warning signals when a portfolio holding may be drifting from one basket to another due to changes in valuation or company fundamentals. A Consistent Earner experiencing margin pressure might begin exhibiting characteristics more consistent with Basic Value. A successful Emerging Franchise might mature into a Consistent Earner as its market position solidifies. These transitions have implications for portfolio construction that the Basket Tool helps identify.

Ongoing Monitoring and Review

The Basket Tool is integrated into the broader suite of self-service analytics that Portfolio Analytics provides to the investment team. Portfolio managers can access basket composition and performance reports through interactive dashboards, enabling them to monitor basket exposures alongside traditional risk metrics.

During monthly risk reviews, basket positioning is examined in the context of market conditions and strategy objectives. These discussions bring together fundamental and quantitative perspectives, ensuring that basket allocations reflect intentional portfolio construction decisions rather than unmonitored drift.

Complementing Quantitative Risk Management

The three-basket framework operates alongside, not instead of, industry-standard quantitative risk management. At Thornburg, we employ sophisticated factor-based risk models that decompose portfolio risk into contributions from style, country, industry, currency, and security-specific factors. These models provide essential insights into ex-ante tracking error, value at risk, and stress test outcomes.

However, quantitative risk models have inherent limitations. They are backward-looking, relying on historical relationships that may not persist. They struggle to capture tail risks from unprecedented events. And their factor-based decomposition, while analytically powerful, may not align with how fundamental portfolio managers conceptualize their positions.

The basket framework addresses these limitations by providing a fundamentally grounded complement to quantitative analysis. Where factor models see exposures to value, momentum, or quality factors, the basket lens sees exposures to different earnings shapes and business cycle sensitivities. Both perspectives are valuable; together, they provide a more complete picture of portfolio risk than either offers alone.

Moreover, the quantitative tracking of basket assignments through the Basket Tool adds an additional layer of risk management. By monitoring how individual holdings and the broader market migrate across baskets over time, portfolio managers gain insight into fundamental changes that might not immediately appear in factor exposures. A company’s factor profile might remain stable even as its underlying business transitions from growth to maturity, a shift that the basket framework is designed to capture.  Risk management is multifaceted, and the three-basket approach offers a unique framework that has been utilized at Thornburg for decades.

Conclusion

The three-basket approach to equity portfolio construction reflects Thornburg’s commitment to fundamental investing with disciplined risk management. By categorizing holdings into Basic Value, Consistent Earners, and Emerging Franchises, portfolio managers achieve style diversification that can reduce volatility and enhance risk-adjusted returns across market cycles.

The Portfolio Analytics and Risk team supports this framework through the development of proprietary tools that extend basket analysis across the investible universe and monitor basket assignments over time. This quantitative support, delivered through collaborative engagement with the investment team, ensures that the basket framework remains actionable and integrated with broader risk management processes.

For clients, the result is equity portfolios constructed with attention to both fundamental quality and quantitative rigor: portfolios designed to participate in market opportunities while managing the risks inherent in equity investing.