Stock Portfolio Management

Investment Process & Philosophy

No investment strategy, style, sector, etc. can always outperform. Therefore, the highest probability of long-term investment success comes from taking a flexible, pragmatic approach. As prices and fundamentals change over time, our tilts to market segments will adjust based on where we see the most value at the time.

We can put together a highly diversified stock portfolio with just a few line items of low-cost index funds. However, we do not view ourselves as "passive" investors regarding our index fund positions as we can use these positions to over or underweight different geographies (i.e., U.S., Developed Markets ex. U.S. and Emerging Markets), investment styles (i.e., Value vs. Growth) or industries. In addition to core holdings of index funds, we are also willing to invest in individual stocks when we perceive a wide margin of safety.

The method of operation within equities described herein is consistent with two big things we believe to be true: (1) If you put together a diversified portfolio of profitable companies, so long as you avoid paying far too high of a valuation at the outset, you are likely to earn a decent rate of return over the long-term. (2) Markets are efficient much of the time, but not all the time. As a result, large mispricing will sometimes occur in the market, providing select opportunities in individual stocks which we can effectively evaluate.

It is prudent to have cash on hand as dry powder to take advantage of opportunities as they arise. The question then becomes; how much cash is too much to have in an equity allocation? It is rational to hold cash if you cannot find attractive stocks to buy. However, as cash builds, you eventually pass over into the imprudent game of trying to time the market. There is no rule for how much cash is too much, and some simply think you should stay fully invested all the time. However, our experience has led us to believe that 20% is an acceptable maximum cash balance.

Not coincidentally, we typically dedicate 80% of an equity allocation to index funds. The remaining 20% is earmarked for individual stocks, and if we cannot find enough individual stocks to own in sensible size to fill out 20% of the portfolio, we will hold cash. Therefore, in an extreme scenario where there is not a single stock we feel compelled to own, the maximum cash position would be 20%. Essentially, within the 80% allocation to index funds we are concerned with relative value, and with the 20% allocation to individual stocks we are concerned with absolute value. We prefer to have any cash balance driven by the availability of bargain purchases in individual names. To us, this seems a more objective process than it being driven by more macro-oriented observations.

Individual Stocks

There is no specific prescription for the proper margin of safety (i.e., price versus estimated value dislocation), so the ultimate margin of safety applied to a given situation is dependent upon qualitative factors such as the risk tolerance of the investor in question, the level of confidence the investor has in his estimate of per share value and the quality of the business being analyzed.

In analyzing businesses, we think of companies as existing on quality spectrum with 4 primary nodes: (1) Super-Prime, (2) High-Quality (3) Mediocre and (4) Sub-Prime. It is important to emphasize that these are points on a spectrum. Super-Prime companies are large enterprises exhibiting characteristics including extraordinary management, high barriers to entry and pricing power with excellent cash flow generation as a result. An example of a High-Quality business might be one that is well run, exhibits above average profitability and is conservatively financed, but it operates in a commoditized industry where there is no real pricing power. A company exhibiting stagnant earning power over a long period would most likely be categorized as Mediocre. Finally, a Sub-Prime company is likely to share many business characteristics with a Mediocre one, but with more than an easily manageable amount of debt involved.

When quantitatively ascertaining a value estimate for an individual company we typically compare the current valuation to that of the company’s own history, its historical relative valuation relationship with a peer group, and its historical relative valuation relationship with businesses generally. When practicable, valuation metrics used utilize all three major financial statements (i.e., income statement, balance sheet and statement of cash flow). The valuation metrics used and the weights assigned to them vary on a case-by-case basis.

We are typically willing to pay 75 cents, 67 cents, 50 cents and 25 cents per $1 of estimated intrinsic business value in the case of Super-Prime, High-Quality, Mediocre and Sub-Prime companies, respectively. These margin of safety figures are somewhat draconian, which leads to us typically owning a limited number of individual stocks under normal market conditions. Further, these parameters are also designed to preclude us from investing in Sub-Prime Companies outside of very special circumstances that would likely only come about under extraordinarily depressed market conditions. This is a feature, not a bug. We can achieve a high level of diversification in client portfolios and make meaningful portfolio tilts to relatively attractive geographies, market cap groups, investment styles and sectors via a small number of low-cost index funds. With individual stocks, we are waiting for instances where we perceive large price versus value dislocations.

The preceding paragraph speaks to our discipline regarding the initial decision to buy. Once holders of a company, we monitor its fundamental progress, update our estimate of intrinsic business value and adjust the margin of safety we would require to commit new client capital. Regarding our sell discipline, we become willing to part ways with holdings upon the margin of safety being meaningfully reduced. If all goes as planned, the margin of safety will be entirely reduced by price gains, with returns augmented by a coincident increase in estimated value. However, margins of safety can also be reduced by deterioration in intrinsic business value, and in those hopefully seldom instances, we will be willing to sell at a loss.

Specifically, a price 67% higher than where we would then be willing to commit new client capital (which could be higher or lower than the original price paid for existing clients if there has been a quantitative change in the estimate of intrinsic business value or a qualitative change in the required margin of safety) is a level where a sale is strongly considered and usually executed. Importantly, the implication is that we are willing to sell at a price that is lower than our estimate of intrinsic business value for Mediocre and Sub-Prime businesses. For High-Quality businesses, a 67% increase from 67 cents is $1.12, so we are willing to hold a High-Quality business until we can exchange $1 of conservatively estimated intrinsic business value for a moderate amount more than $1 of cash. In the case of a Super-Prime business, a 67% increase from 75 cents results in an exit price of $1.25 per $1 of estimated intrinsic business value. Yes, we need to be induced by a meaningful overvaluation to sell a Super-Prime company. The reason for this sale method - Higher quality companies, by their nature, tend to increase intrinsic business value at higher-than-normal rates over the long-term.

My "Super-Primes" are probably best described as very large, dominant companies with higher-than-average earnings growth potential and where risks to that growth potential are intrinsically less than average. My thinking is that 12.5% is a reasonable estimate of the average annual clip at which Super-Prime companies can be expected to increase in value. Therefore, a 25% overvaluation implies that the market has pulled forward roughly two normal years’ worth of value appreciation into the share price. We view selling in such an instance as prudent as overextensions of this sort often tend to be followed by pull backs that themselves often become overdone, perhaps bringing the specific company back into the bargain purchase zone. More broadly though, an overvaluation of the sort described in a Super-Prime company tends to occur during frothy market conditions where raising some cash may allow one to recycle the capital in other companies on better terms in the future when market conditions are less enthusiastic.

There may be happy times when price gains occur quickly. We will be willing to sell at such times even if our holding period is extraordinarily short. This may give the impression that we are short-term "traders" rather than long-term "investors." We disagree, as our estimate of intrinsic business value is based on an assessment of the company through a long-term lens. While this position may not be conventional, we do believe it is conservative and rational.

In practice, these assessments are much less dogmatic than they may appear here. However, I hope presenting it this way furthers your understanding of our philosophy and process.