October 22, 2014 Published by Zachary Shrier

We’re always delighted when clients ask us about our investment approach. We find the process of investing and the challenge of studying businesses more appealing every year; we love talking about the craft and teaching others about it. Part of this pleasure has been continually discovering new strategies for helping our clients build their assets. The opportunity to meet with clients and add to their lives with our accumulated insight and experience is something we look forward to every day.

The development of our investment approach is many decades in the making. Like many other competitive activities, successful investing demands rigorous self-knowledge – especially an understanding of one’s strengths and weaknesses. While there are thousands of different market strategies, individual asset managers and investors are likely to succeed only once they have found the approach that takes best advantage of their unique strengths. Inexperienced managers, not yet acquainted with their strengths and weaknesses as investors, often experiment with scores of different strategies – usually to the detriment of their clients. The formulation of a successful investment approach takes time.

As we have written about many times, our overall investment goal is to balance asset growth with capital preservation. Put simply, we use quality investments to help grow client wealth over time. In good times, we strive to deliver appreciable returns on your investment. In lean times, when markets and indices are showing losses, we aim to protect capital from excessive downside. Because of our emphasis on preservation, our clients are unlikely to see returns equaling those of the best-performing stock, investment, or asset class that year. This is a natural – and healthy – consequence of diversification. Like a physician, we strongly believe that a financial advisor’s first responsibility is to “do no harm” to the client’s long-term financial goals. Too many managers, chasing the performance of the hottest stocks and sectors, severely compromised capital preservation in the past decade. Their zeal came back to haunt them, though, when the music stopped.

We have made an attempt here to explain our investment approach to our clients in writing. What follows is a very concise clarification of the major principles that we use to select investments and steward client assets. Along with our business standards of outstanding client service, objectivity, and accessibility, we hope that this discussion of our investment approach will provide some additional insight into our value proposition to you.

 Asset Allocation. There are a number of categories of quality financial assets with which investors can help preserve and grow their wealth; examples include U.S. and foreign stocks, stocks of large and small companies, government, corporate, foreign, and high-yield bonds, and money markets. Each year investment returns vary significantly by asset class. The “winning” asset classes in 2014 won’t necessarily perform well in 2015. Asset allocation means aiming to own a diverse array of financial assets – not simply relying on the continual out-performance of one type of asset. We build our clients’ wealth by investing in a variety of financial assets. This strategy helps us balance performance with the unique risk tolerance level of the client.

Diversification in Stocks. In both our own experience and that of most other money managers, clients are most successful over time when invested in at least 20 stocks. Generally, constructing stock portfolios with 3-5% in each investment yields the best results. When combined with asset allocation, our clients should not see extensive capital losses simply because any one stock or asset class underperforms.

Crisis Investing. John Templeton, one of the greatest investors of the 20th century, formulated the “principle of maximum pessimism.” He exhorted investors to avoid becoming discouraged during times of negativity or fear when good companies are largely undervalued and misunderstood. “The time to buy,” he wrote, “is when everyone is scared and you are a bit scared yourself.”1 The market’s volatility during crises, while unsettling, is not truly equivalent to risk. In fact, volatility and sharp sell-offs in the market are actually to the advantage of investors focused on value. We want to use crises to buy strong companies at bargain prices. Above all, we do not sell into panics. Instead, we want to hold our positions and often commit new funds to our investments.

Independence from Wall Street research. We don’t put too much stock in the forecasts of brokerages. Relying on sell-side research has burned countless investors in the past few years. Recent congressional hearings, and the admission of many insiders, have highlighted what some professional investors have known for years: the numerous conflicts of interest that analysts face in recommending investments. We feel that our objectivity is a precious asset. Far from blindly following analyst advice, we will typically be buying companies when earnings are projected to be poor, in anticipation of better times and robust profits. Warren Buffett famously said, “You pay a very high price in the stock market for a cheery consensus.”2 We know that a consensus of cheery analysts doesn’t necessarily make for a good investment.

Contrarian Investments. The theory behind this investment approach is simple: buy the stocks of good companies when nobody else wants them. Then, as conditions improve and the companies return to grace, the share prices should rise and likely offer the “contrarian” investor an attractive return. The difficulty in this approach is successful execution. Financial writer and money manager Anthony Spare attributes this difficulty to “noise” that distracts investors from finding value. There’s certainly tons of “noise” – predictions of the future of the stock market, the Federal Reserve’s actions, the direction of the world economy, and the direction of interest rates. But while these prognostications of the stock market and the economy are interesting, they don’t hold sway with us when it comes to buying stocks.

We try to ask ourselves, “Is there an excellent business under all this noise?” We have found that that our clients have been most successful when we focused on buying great businesses and tuned out the chorus of forecasts and predictions from experts.

We consider this style of investing to be a core competency. We love to buy solid companies out of market favor as measured by low price-to-value measurements, such as high dividend yields. Subsequently, our research has determined that the greatest investors and money managers have used a similar approach.

Please understand that a contrarian’s mentality does not stop us from investing in “growth stocks” or other fast-growing businesses, when appropriate. We are always scouting for companies that have the potential to grow faster than the economy as a whole. We are simply going to be selective about when we commit to ownership of such businesses, and what price we’re willing to pay for them.

Avoiding “Hot” Stocks and Investment Fads. We assiduously avoid very popular stocks, “hot” stocks, and concept stocks of speculative companies that are unlikely to make money. The hopes, dreams, and longings of investors have overshot reality in every market bubble. Anthony Spare is fond of mentioning that “people will do anything to justify buying in expensive markets,”3 and we agree.

We’ve seen overvalued asset classes bid up to extreme levels many times; precious metals and oil in the late 1970’s and early ‘80’s, real estate and high-yield bonds in the late 80’s, and internet stocks in the late 90’s. It’s typical to watch expectations create high levels of optimism and concurrent overvaluation. We want to be sellers – never buyers – of these overpriced asset classes; in every case, the bubble has broken and prices have collapsed in a disillusioning rush for the doors.

When times are good, professional forecasters have always tended to see the positive trend as continuing indefinitely. And similarly, during the tough times, those forecasters project unending negativity. But the world is too dynamic for such thinking to be profitable in the long term.

Remember, when a company’s fortunes look wonderful and its stock is selling at high prices, it will be basking in the praise of Wall Street analysts, professional investors, and the financial media. This aura of incredible optimism and positive energy always makes it very difficult for investors to part with the stock – though the time may be ripe to do so. On the flipside, when quality companies are trading at their “lows,” below their fair value, they will find themselves the frequent targets of research analysts, critical news stories, and often pervasive scorn from the general public. In this environment of disparagement and pessimism, it takes a strong, experienced investor to buck the crowd and accumulate stock.

Our experience is that many of our most successful investments were made when investors felt least comfortable. It is for this reason that intelligent investing is often a challenging, counter-intuitive process.

Sensitivity to Major Trends. We find it helpful to watch and learn from the “money masters” – world-class investors who have proven themselves over the course of many decades. We are also particularly sensitive to stock purchases and sales made by company insiders. When we see out-of-favor issues being accumulated by outstanding money managers who share our emphasis on value, or by multiple top executives at the company itself, we consider these as additional pieces of evidence in support of our investment thesis.

Selectivity. We have long felt that fussiness was a characteristic of excellent investors. Consequently, if something doesn’t quite meet our criteria for a good investment, we don’t pursue it. Unlike in baseball, investments never penalize you for keeping the bat on your shoulder and letting a ‘pitch’ go by. It’s quite common for us to patiently follow a company for several years before taking a position in its stock.

Sell Discipline. It’s only human to love a winner, and investors are notorious for holding out for ever-higher stock prices even if they’ve told themselves they should sell. We work against this tendency by keeping to a sell discipline – a plan to sell stocks when they reach various goals we’ve set at the time of purchase. Most often, the sell discipline we’ve set instructs us to sell out of a position in stages, taking “money off of the table” as stocks appreciate in value. Again, this works to balance asset growth with preservation of capital – and it’s only in achieving that balance that we feel successful as money managers. On the downside, we protect client assets by staying on top of underperforming positions, eliminating them when our investment thesis fails to materialize within our time-frame.

Eating Our Own Cooking. With very few exceptions, investments that we buy and recommend for clients are the same ones that we’re buying for ourselves and our families.

If you have any questions or thoughts about what we’ve written here, please feel free to contact us. We appreciate your candid feedback.

1 Forbes, January 16, 1995

2 Fortune, August 6, 1979.

3 Last Chance Financial Planning Guide


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