Principles – Narrative

Fundamental value and risk is our focus when evaluating investments

Fundamental (intrinsic) value is the cash generated by an investment. Fundamental value is earned in the future as dividends, interest, and principal are paid or as retained earnings are successfully reinvested. Risk is the likelihood and potential magnitude of a decline in investment cash flows, or the payment of a market price at purchase which is higher than fundamental value.

When buying, we never confuse fundamental value with market price. Market price is what we pay. Fundamental value is what we get. Market price may be found quoted daily in the financial press. Fundamental value is determined by investment cash flows.

Market price, it follows, is not a barometer we would use to evaluate corporate performance. Our evaluation of corporate performance is based on items such as income, assets, and return on capital. We view the stock price of a publicly traded company simply as a record of what others – well informed or not – were willing to pay for it at various times in the past.

Fundamental value is such a critical concept because it is the only reference point for what an investment is actually worth, and therefore, whether or not the market price is fair, high, or low. Two facts support this view. First, the theoretical point that an investment is worth the present value of its future cash flows is self-evident and undisputed. Second, new era theories that have driven prices to speculative levels in the short run have always succumbed to the basic idea of fundamental value in the long run.

We insist on quality with a margin of safety

Investor portfolios must contain primarily quality investments. The portion which is not quality, by definition, is subject to unpredictable and material loss. Therefore, we recommend that risky investments represent a small portion of the investor’s overall portfolio.

We define quality at the investment level. The price of a quality investment is justified by a reliable stream of cash flows. Any other type of commitment is speculative.

A quantifiable margin of safety is the hallmark of a quality investment. For fixed income investments, (a) an issuer’s available resources must be significantly greater than the interest and principal due the investor, or (b) the assets backing an issue must be significantly greater than its price. The former applies to high-grade bonds, the latter to low-grade bonds.

For equity investments, (a) the fundamental value of a company must be significantly greater than its price, or (b) the probability of achieving a desired return must be very high. The latter provides a perspective on value which may be applied to high-grade equities.

We only invest in what we understand

True understanding is built upon high probability statements about businesses and values. It requires a dogged determination to get to the bottom of things and an equally dogged honesty about whether or not we did.

Understanding is also relative. Achieving better than average returns requires understanding security values better than average. The problem is most investment managers believe they are better than average.

Competence and honesty are the keys to assuring that we are not fooling ourselves. Competence means that we are capable of estimating business values and returns for both our portfolios and the markets in which we participate. Honesty means that we are candid about our relative return advantage or lack thereof.

Diversification and concentration are balanced with knowledge

Proper diversification is paramount to quality at the portfolio level. Proper diversification is achieved when the overall portfolio return is protected from unexpected adverse results in individual holdings, industries, or countries.

Proper concentration can be risk reducing as well as value enhancing. Concentration refers to making greater commitments to more attractive investments. The greater the difference between fundamental value and market price, the more robust our knowledge of an investment’s value, and the lower the risk of the investment, the more wealth we will concentrate in that investment.

Successfully executed, concentration has three benefits: (a) returns are enhanced by selecting investments with the highest probability of success, (b) risk is reduced by avoiding mediocre and poor commitments, and (c) knowledge is improved by concentrating the analytical effort.

A concentrated portfolio with fewer holdings is desirable when value-to-price, understanding, and quality are high. A low-cost, more widely diversified approach to a market is appropriate when there are no clear advantages in understanding, and therefore, in our ability to evaluate quality or estimate value-to-price.

Communication is essential for intelligent investor decision-making

One of the greatest risks investors face is selling low in a panic. Education and communication can greatly reduce this risk. We explain to clients the difference between fundamental and market value and openly share the rationale behind our investment decision-making. We believe this significantly reduces the risk of clients selling at market bottoms or buying at market tops.

Communication is also important for evaluating an investment manager’s abilities. Luck, risk, and a bull market can make an incompetent manager look brilliant. Conversely, every brilliant manager will under-perform at some time, and usually this is the best time to invest with them. Investors must look beyond performance to evaluate manager competence. To aid current and prospective clients in this endeavor, we regularly discuss the strategy and holdings behind our performance, and candidly address both our successes and errors.