“We prefer a lumpy 15% return to a smooth 12% return.”
Investment Philosophy
Similar to investing legends – Benjamin Graham, Philip Fisher, Peter Lynch and Warren Buffett – we believe that stocks represent an ownership stake in a company, whose value is based on the value of present and future cash flows. This concept of a company having an intrinsic value is central to everything that we do.
As Benjamin Graham said, "In the short term, the stock market is a voting machine, but in the long run the stock market is a weighing machine." Over short periods of time, the price of a stock can fluctuate wildly, but the weight that stocks prices are inexorably drawn to in the long run is their intrinsic value.
We do not attempt to time the market or make predictions about what exchange rates, commodity prices or interest rates will be. Instead, we spend our time and energy focusing on a business, analyzing the company, assessing their competitive advantage and learning as much as we can about the industry so that we can make an educated estimate of the company's intrinsic value.
While the current trend with Wall Street has been to make ever quicker trading, holding positions for days or even minutes, we use a different strategy by taking a long term view. They are hoping to take advantage of short term price swings with little regard to which companies they are buying or selling. This arms race of automated computer algorithms and “flash” trading is myopic and counter to value investing. Instead, we take the opposite approach by focusing on the long term when analyzing and investing in companies. One of the factors we look at is whether or not the company is meeting our environmental, social, and governance criteria. We care more about where a company will be five years from now than where the stock will trade in the next five minutes.
“Know what you own, and know why you own it.”
Investment Selection Process
We begin with the 4000+ publicly traded companies and filter through them using industry research and qualitative screens. The factors we analyze include revenue, earnings, margins, cash flow generation and returns on capital.
We then apply a deeper level of analysis including a review of the company management;we look for an ownership stake, compensation structure that aligns their incentives with shareholders and a history of making rational capital allocation decisions. Additionally, we review the company’s competitive advantage to ensure that we truly understand what is driving the current and future results of the business.
We then calculate our estimate of intrinsic value for these high quality companies, incorporating a range of possible outcomes and focusing on companies that are growing their intrinsic value over time. We then apply a discount to account for any possible faults in our understanding of the company or their competitive advantage.
From this select group of high quality companies we build a portfolio of approximately 30-40 companies that are trading at a discount to our intrinsic value. The final step in the investment selection process is determining the appropriate type of investment to make. Based on the characteristics of the company, we will either make an equity investment or an investment using options. Like having different tools in a toolbox, having the ability to choose different ways to invest in our best ideas allows us to maximize the chances of a successful investment while limiting our losses. We then use a modified Kelly criterion where we give higher portfolio weightings to companies we believe have the highest risk-adjusted return.
When using options we typically use one of three strategies:
When buying call options, we focus on companies that we feel are not only undervalued but that also have a catalyst for a high level of upside potential. We usually buy long-dated contracts and attempt to minimize the time value we have to buy. As the option buyer, we buy the longest-dated contract we can so that we have as much time as possible for our thesis to play out.
We initiate a covered call and diagonal spreads on positions we feel are undervalued but whose stock will rise more slowly and that we have a high level of conviction around the future prospects of the company. We typically write the call with an expiration date one to three months in the future and aim to repeat the process multiple times over our holding period, allowing us to earn income on the position while benefiting from a slowly rising stock price. We never sell a call that is not covered (i.e. a naked call).
When we are writing put options, we look for companies with strong defensive characteristics that we feel are undervalued. We usually write contracts that expire in two to four months and aim to write the option at a discount to the current stock price, providing us with an added margin of safety. As the writer, we want to maximize the amount of time value sold, and we want the flexibility to restart our strategy with new contracts every few months.
We also periodically buy puts on the market index for hedging purposes, seeking to limit the amount we pay to set up the hedge while still providing a level of protection against a broad market downturn.
Our investment process is rigorous, but adaptable. We regularly review and modify our positions in order to maintain a portfolio of high quality companies trading at attractive valuations.
Risk Management
“Wide diversification is only required when investors do not understand what they are doing.”
Our goal is to invest in businesses that we understand well, and which we have a high level of conviction about their future, that generate substantial amounts of cash, and whose management teams we trust. In such cases, we use strategies designed to take advantage of our belief of the company’s intrinsic value and make investment decisions to invest in companies providing the best risk/reward opportunity. As a result, our returns have been positive and outperformed the S&P 500 for nineteen out of the twenty four quarters we have operated. We typically hold positions in 30-40 companies but we do not diversify for the sake of diversification. We do not believe that diluting our best ideas and adding an inferior investment to the portfolio simply for the sake of diversification is a prudent investment strategy. However, typically limit any single investment to 10% and any industry to 30% of the portfolio. We define risk as the permanent loss of capital not by fluctuations in value.