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Investing

Summary of our Investment Approach

Philosophy

Our views on the equity markets combined with our specific skill set provide a framework for our investment methodology.

Nature of Insights

We believe the market often misprices stocks due to neglect, emotion, misinterpretation, and a short-term perspective. The best way to capitalize on these inefficiencies is through bottom-up company research. Stock selection is limited to those businesses we are able to confidently value and purchase at a significant discount. Our analyses of companies allow us to establish an informational edge with an emphasis on identifying how our insights about a company differ from the market’s as well as our degree of conviction in these insights.

Time Horizon

We think of our universe of companies not as a stock market but as a cross section of opportunities. We are owners of partial interests in businesses, and our investment time horizon reflects this mindset. Our holding period is conceptually varied as we are always looking for the valuation gap to narrow or close, and in many cases, companies are purchased based on a specific investment premise that we expect to unfold over time. We constantly assess the risk/reward relationships (more a function of discount to intrinsic value and the volatility of a company’s operating results than the volatility of its market price) associated with the stocks we own.

Concentration

We believe good ideas should be positioned to have a meaningful impact on client portfolio performance; our portfolios own the 25 to 35 best ideas we can find. Individual position sizes range from 2% to 10%, and weightings are directly correlated to our level of conviction. Our portfolio structure is not influenced by a given benchmark. We emphasize effective diversification, thinking in terms of investment opportunities instead of active exposures.

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Selection Criteria

In an early edition of Security Analysis by Graham and Dodd, the authors stated that nearly every stock could conceivably be a good investment at the right price. The foundation of our investment approach is built on several of the principles formulated by Graham and Dodd; however, price is not our only investment consideration. We often find and purchase businesses with more vibrant qualities. Our selection criteria include the following:

  • Businesses we understand that possess sound capital structures and maintain conservative accounting policies.
  • A current market price that is 35–50% below our estimate of intrinsic value.
  • A business model that provides strong potential for per share intrinsic value growth.
  • Management teams led by strong operators and proven capital allocators who have clearly aligned incentives in place to maximize shareholder value.

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Value Investing

We consider our investment style to have a clear value orientation, but our investments are not limited to low expectation and out of favor companies or industries. We tend to avoid very high growth businesses because they are often hard to value and therefore do not correspond with our risk-averse mindset and skeptical tendencies. We allocate client assets to companies that fall into three sub-categories of value:

  • Deep discount opportunities based on current earnings and asset values.
  • Companies where a recognized catalyst is in place to uncover value — spinoffs, restructurings, and turnarounds.
  • Discounted franchise businesses that possess durable competitive advantages and compete in markets with attractive long-term prospects.

We believe this “controlled flexibility” is integral to meeting our return objectives.

Valuation Methodology

In assessing the intrinsic value of our portfolio companies, we utilize the valuation technique that best reflects the true economic worth of a company’s assets. Our superseding goal is to determine what we would pay to own the whole enterprise based on the cash flow we believe the business will produce over the long haul (discounted at an appropriate rate). Accordingly, we primarily rely on discounted cash flow analysis and comparable private market transactions. However, we also often employ other methodologies such as liquidation analysis or replacement cost when appropriate.

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Risk Management

Our approach to risk management focuses on controlling against permanent capital loss.

Our risk control efforts emphasize:

  • Diligence and know-how in developing accurate insights about the companies we own.
  • Avoiding companies we cannot effectively value or business models that we do not understand.
  • Requiring a significant “margin of safety” between price and intrinsic value when we purchase businesses.
  • Effectively diversifying exposure to stock-specific risks and macroeconomic factor variables and maintaining adequate industry and sector diversification.
  • Partnering with competent management teams whose interests are aligned with those of their shareholders.
  • Maintaining objectivity in evaluating winning and losing positions.

Also worth mentioning are the risk control methods which are common to our industry that we do not emphasize. We do not manage portfolios to a low tracking error target; we do not consider traditional beta or price volatility metrics as a proxy for risk; and we do not own low-conviction stocks solely for diversification purposes.

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Conviction

Among the various labels that are used to describe investment managers, “having high conviction” is one that we embrace. We believe investing is about knowledge and interpretation, and the term suggests that clients are receiving a good value for their active fees. Our decisions regarding purchase, sale, and portfolio weighting of individual companies within our portfolios are directly correlated to our assessment of these variables:

  • The size of the discount.
  • The potential for intrinsic value growth.
  • Identification of and confidence in a variant view.
  • Identification of a meaningful catalyst.
  • A positive impact on portfolio diversification.
  • Liquidity.

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