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We are value investors. Value investing is an attempt to purchase assets for less than they are worth. Such mis-pricing occurs frequently as investors tend to overreact to bad news and sell good investments at bargain prices. The simplicity of buying healthy companies at bargain prices is easy to understand, although it requires serious effort to carry out effectively. The traditional value investing style originated in the mid 1930's, partly in response to the devastating bear market of the time. Clearly, it has withstood the test of time. Many famously successful investors have used some form of the value style to generate fantastic returns that often extend over many decades. We view the classic value style as a conservative, common sense, time-tested, approach to long term investing. More specifically, we are searching for stocks that are selling too cheaply relative to their 'earnings power'. Earnings power is our assessment of what the company could earn under 'normal' conditions. Typically the shares are cheap because conditions are not normal. We prefer to 'normalize' earnings for such factors as a company's business cycle, new product cycles, commodity price swings, recurring or non-recurring 'unusual' expenses, options expense, etc. Similarly, when a company whose assets have been poorly managed undergoes a management change, we may compare its 'earnings power' to its peer group to estimate what the company may earn under more capable guidance. Such a normalizing approach, in conjunction with a reason(s) to believe earnings will rebound, is a common theme in our investing. We are focused on absolute total return. We are concerned with capital preservation as much as we are with capital accumulation. We are strong believers in Benjamin Graham's three rules of investing: 1) Don't lose money; 2) Don't lose money; 3) Don't lose money. While it is inevitable that we will make some mistakes, the value of that extra amount of caution becomes self-evident in difficult markets. We are aware that you cannot eat relative performance and we do not consider losing money a success even if we do outperform our peers. We define risk as the possibility of permanent loss of capital, not as volatility (beta) or deviation from the benchmark. In fact, deviation from the benchmark is our goal. We cannot beat the market if we are afraid of deviating from it. We believe the risk is best managed through sound fundamental research and by allowing for a margin of safety in the original purchase price (i.e. buying dollar bills for $.50). Other types of risk you should be aware of are business risk and career risk. Business risk is the risk that an investment manager will lose clients if the investment style underperforms the market in the short term. Investors often chase performance, fleeing from a manger who had a bad couple of quarters and investing with whomever has the best performance of the moment. This is generally a mistake on the part of investors, but the fear of losing assets will sometimes cause managers to do things they wouldn't otherwise do. Such actions are taken for the benefit of the manager, not necessarily for the benefit of the client. Career risk is similar. The portfolio manager may be encouraged to do things in the short term that help his career, or increase his bonus, but could work against achieving superior long term performance for the client. The prevalence of managers worried about business risk and career risk seem to prove the point that it is better to fail conventionally than to succeed unconventionally. True risk is the chance that you don't achieve your investment goals. We expect to have very low turnover. We expect future turnover will likely be below 25% on average. In recent years our turnover has been closer to 10%. This means that we would expect to hold stocks for at least 3-5 years, and hopefully much longer. This is in stark contrast to the average mutual fund with turnover in excess of 100%! Mathematically, this means that every stock in the average mutual fund portfolio is sold out every year. Some mutual funds out there have much higher turnover. This certainly is not long term investing. Such high turnover is likely to be caused, at least partially, by the 'career risk' and 'business risk' described above. We are comfortable with these risks and believe that truly being long term investors in a world of short term investors gives us a competitive advantage. We expect to hold an average of 25 stocks in the portfolio. This should allow effective diversification while focusing our client's assets where our research indicates the best opportunity. Excessive diversification can dilute the impact of a few good ideas and lead to mediocre returns. The cash level is a result of the investment discipline. Ideally, we prefer to be fully invested, but only if we find 25 stocks that fit our discipline. We prefer to let the cash level rise rather than to lower our standards. We do not believe that we must be fully invested at all times. Rather, we think we should only invest when we have the opportunity to capture above average returns with below average risk. We have the patience to keep searching for the select few names that meet our strict investment criteria. Sector exposure is also a result of the process. While we are always aware of our sector exposure, we do not put arbitrary limits on how big or small a particular sector may be. Consequently, we will have large exposure to sectors where we find many attractive stocks, and we may have zero exposure to sectors where we find no appropriate investments.
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