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As investors, not speculators, we view stocks as businesses. We want to benefit from the cash it distributes and its ultimate value. Conversely, if we were speculators, we would view stocks as scraps of paper to be traded.
We look for a strong competitive position in its market, attractive economics, such as high margins and high returns on equity, a strong balance sheet and a management team that thinks and performs like owners. High quality businesses are attractive because their intrinsic value tends to grow with low volatility through time, and they’re not dependent on the capital markets to fund their businesses.
Warren Buffett calls this his “circle of competence.” Our portfolio tends to favor companies in the consumer, energy, financial, and service industries — areas we understand thoroughly. Because we do not possess scientific expertise, we shy away from companies that make a heavy investment in research and development. As we gain experience or bring analysts on board in these areas, this may change. Currently, we limit ourselves to reduce risk.
Growing businesses have more strategic options; the market places a high discount rate on expected growth beyond the next calendar year, and the after-tax return potential of a growth stock is higher because you can hold a growth stock for multiple years, resulting in a low turnover strategy and lower taxes. However, the risk with growing businesses is other investors prefer growth as well and can drive valuations too high.
The intrinsic value of the business is the sum of all its future cash flows. Ultimately, stock prices converge to the intrinsic value of the business. Our team considers most stocks are either fairly priced or slightly overvalued compared to their intrinsic value. Recognizing our assessment of intrinsic value could be incorrect or may decline, we buy stocks with a “margin of safety” or at a “discount to intrinsic value” to protect ourselves.
We find our best ideas in small cap stocks because they suffer from a lack of research coverage by Wall Street, and a lack of liquidity, keeping some large investors away. We believe we can continue to find many high quality businesses at attractive valuations in the small cap area.
We see regular opportunities in stocks related to corporate events such as spin-offs, initial public offerings, bankruptcy exits, rights offerings, and buyback programs. We believe these opportunities exist because institutional factors cause large investors to ignore these opportunities.
A portfolio approaching a 100-plus holdings loses the benefit of active management.
Often, the market adjusts to changes in a company’s business before we do. When stocks experience negative moves, it is often better to exit the position and reassess our investment thesis.
For most investors, multi-year after-tax returns are more important than single year pre-tax returns. We prefer to hold investments in our portfolio companies for a period of years to allow the management teams to compound the strong economics of the business.