Absolute Value is simply the application of pure value investing.  Valuation and Risk are the core principles. 

      Absolute Value can be thought of as the opposite of relative value.  Where a relative value practitioner would happily buy a stock that was expensive, but cheaper than its peers, we will not.  Where a relative value manager views risk as underperforming in the short term, being “left behind”, or standing apart from his peers, we do not.  We view risk as the potential for permanent capital loss.  Such risk can best be controlled by avoiding high-valuation stocks, and requiring the expected return on all potential investments to exceed the cash return.  It is attractive, sustainable, gains that we seek, not simply outperformance.   This approach is likely to lead to long term market outperformance, however, we believe that focusing on outperformance in the short term is likely to lead to underperformance in the long term.

      We determine value and risk in relation to historical norms, rather than in relation to other investments available at this moment.  A stock at say 8 times earnings is cheap, in an absolute sense, when history suggests that 8x has been a low level from which large future returns were made.  Conversely, a stock at 100x earnings might be considered a relative value if its peers are trading at 200x.  While it is true that the stock with a P/E of 100x is cheaper than, and may outperform, the one at 200x, neither are likely to be good investments as they are both expensive in an absolute, historical sense.

      Relative value investing will likely help a manager to grow assets, keep his job and earn his bonus, but we believe that Absolute Value investing is more likely to help the client achieve his/her goals of attractive, sustainable gains over long periods.

      More on Risk -  We believe that our risk management efforts are a key part of the value that we provide to the client.  We manage risk in two ways.  The first is the well known concept of 'margin of safety'.  When we purchase an investment we like to buy it cheap enough that if our calculations are a little off, we still will be getting a bargain.  Calculations of the fair value of an investment are by nature somewhat coarse.  We cannot calculate intrinsic value to the penny.  We know our calculations will be inaccurate to some degree so we build in a margin of error; a margin of safety.  For example, if we think it is worth $22 and it currently sells for $20, we will not buy it because there is no margin of safety.  If the stock sells for $11, then the calculated discount to fair value is great enough that even if our estimate is off by 20% we are still getting a bargain.  A healthy balance sheet and strong competitive position can also contribute to the margin of safety of an investment.

     The second way we manage risk is through the portfolio management process.  If we cannot find investments that are attractively priced, with reasonably low levels of risk, then we will allow the cash level to rise.  Similarly, we are willing to have no exposure to sectors of the market that offer no bargains.  We believe that this willingness to avoid stocks or sectors that are overpriced, or at least lack bargains, helps lower our risk of permanent capital loss.  After all, the most expensive investments are often the riskiest, and the cheapest investments are often (though not always) the safest, in our view. 

     Benchmarks and Risk -  Benchmarks are a thorny issue.   Benchmarks are indexes that are used to judge a manager's performance.  In our newsletters and performance reports we show the performance of the S&P 500 for comparison.  However, we usually ignore this index when we are making investment decisions.  In the money management business there is a widespread, and justifiable, fear of having your performance deviate too far from the benchmark.  If a manager underperforms the benchmark over even short periods, clients may leave.  Very often this will cause a manager to change the way he invests - all too often with poor results.  The thinking goes something like this:  The closer you stay to the benchmark, the less risk of a significant underperformance, the less risk of losing clients.  Do you see the slippery slope?  In this example, the reasonable desire to judge a manager's performance has negatively affected the manager's process and probably hurt returns.

      So what can be done?  The only solution we can see is that clients should have a thorough understanding of the manager's process; the investment discipline.  Only then will the client be able to make sense of the inevitable periods of underperformance and outperformance.  The manager should be able to explain, to the client's satisfaction, why the manager lagged the benchmark in one period and beat the benchmark in another period.  If the manager has a sound discipline and the willingness to stick with it over time, the long run results should be good.  If the client understands the discipline, and how it relates to the past/current/future market environment, the client is more likely to be able to stick with the manager through the inevitable periods of underperformance, to reap the attractive long term returns.  After all, even the best managers have periods of underperformance as we have discussed in our 6/30/2004 Newsletter.