We mean a lot by this statement. We firmly believe that a long-term perspective is required to consistently and reliably achieve superior returns in the equity markets. Thus, we are not traders and will not jump in and out of positions to attempt to eke out short-term profits. In fact, we believe that attempts to make such profits from short-term movements in the overall market are speculative in nature and fraught with risk. Instead, our preference is to invest in sound, quality businesses selling at prices well below intrinsic value.
We subscribe to the Benjamin Graham notion that in the short run the stock market is a voting machine, and in the long run the stock market is a weighing machine. That is, in the short term stock prices are determined by people's votes on what they think the correct stock price should be. These votes can often be irrational and produce stock prices that are greatly distorted relative to their underlying business values. However, in the long run, business fundamentals will overwhelm this short-term noise, and stock prices will approximate the underlying intrinsic values of the businesses they represent. Accordingly, we will generally make individual investments according to a long-term perspective and with a long-term horizon in mind. We will not attempt to make short term profits by "timing the market", i.e., profiting from short term movements in the overall market. Note that while a long-term perspective can produce outsized results, it often comes at the cost of short term volatility. In value investing, there are often periods of time when there is no perceptible difference between "being early" and "being wrong".
We may have investments which we hold for a lengthy period, possibly indefinitely, as long as certain fundamental attributes of the underlying business remain unchanged. For example, we have identified companies that have such strong underlying fundamentals and structures that we believe they can compound intrinsic value at an attractive rate for the foreseeable future. As a result, we likely will not sell these investments unless there is a fundamental shift in the company or industry or the prices become truly speculative in nature. Additionally, we may have other investments that typically have a holding period in the 2-5 year range, as we wait for their prices to reach intrinsic value. We will purchase these positions when the stock price is well below our calculation of intrinsic value, and we may exit these positions once the disparity between price and value disappears. The above-identified investments, as well as cash, will typically represent the large majority of our positions. However, from time to time, we may also invest in special situations, such as spinoffs, whose rate of appreciation may be very fast, and accordingly the holding period in these investments may be very short, possibly less than a year. Thus, while we generally invest for the long-term, we will also be flexible and opportunistic, taking maximum advantage of the opportunities presented to us.
As a corollary to our long-term investment perspective, our goal is not merely to attempt to garner quick personal gains. Instead, we intend to patiently compound money over a time period measured in decades, not years (and certainly not months). We have a strong passion for value investing and intend to continue to invest for a long time.
We view stocks as fractional ownership of a business, not merely numbers that wiggle around on a chart or pieces of paper that are bought and sold based on macroeconomic events. Accordingly, we strongly believe that to determine appropriate equity investments we must value the fundamentals of the underlying business. To that end, for each individual investment, we study financial statements of the individual business and assess quantitative and qualitative aspects of the business to determine the intrinsic value of the company. We believe in the Benjamin Graham notion that the underlying value of a business and the stock market's quoted price for that business are two very different constructs that may deviate significantly from each other (as Graham famously taught "Price is what you pay, value is what you get."). Accordingly, we attempt to estimate an intrinsic value for a business separate from its market price quotation. We will consider purchasing securities of a business when we determine that the intrinsic value of the business is far greater than the market's quoted stock price. We will not use any short term trading strategies, and further we will not use any form of technical analysis in our investment decisions.
We are mindful of Warren Buffett's two rules for investing: Rule 1: Do not lose money; Rule 2: Never forget Rule #1. Thus, risk management will always be front and center in our minds. We address risk in a number of ways, but perhaps the most important risk management strategy is our insistence on a large margin of safety in our investments. We define the term "margin of safety" as the difference between our estimate of the intrinsic value for an investment and the current market price of that investment. Our insistence on a large gap between value and price allows us to have a buffer in case: 1) our estimate of value was incorrect; 2) an unexpected event or circumstance causes the intrinsic value of the investment to change for the worse; and/or 3) an overall market decline occurs. In cases where we are right, this margin of safety allows for greater returns, and in cases where we are wrong, the margin of safety will often let us exit the investment without substantial capital loss.
Classical investment dogma teaches that risk and return are directly related - to achieve greater returns one must assume greater risk. While this is true for many investments, we believe the margin of safety principle works to our advantage to produce investments where risk and return are inversely related, i.e., where we achieve greater returns while simultaneously reducing our risk. As our margin of safety (the difference between the price we are paying and the value we are getting) increases, the amount of return we can expect to achieve increases while our risk (due to the increased margin of safety buffer) decreases.
We will attempt to identify and invest in a relatively small number of great opportunities that we have researched and understand, and which we believe provide the potential for outsized returns. Many people have gotten rich by investing in their best idea; very few, if any, have gotten rich by investing in their 20th or 50th best idea. We believe it makes sense to focus our portfolio on the ideas that we feel have the best potential for large returns with the least risk.
Conventional wisdom in investing preaches that wide diversification is necessary to reduce risk. However, conventional wisdom is often long on convention and short on wisdom. More recent research has shown that owning 10 - 15 stocks in different industries provides sufficient diversification, and additional stock purchases beyond this number adds very little in terms of risk reduction. Peter Lynch coined the term "diworsification" to refer to additional stock diversification that provided very little additional risk reduction, but necessarily drove potential returns to (or below) the market average. Adding to this point, we subscribe to the views of Philip Fisher, who wrote in his book "Common Stocks and Uncommon Profits" that: "investors have been so oversold on diversification that the fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing at all". Strangely, those who argue for wide diversification fail to consider the risk involved in investing in companies about which one knows very little.
Having said the above, there may be times when we choose to invest in a diversified number of opportunities to take advantage of market inefficiencies. For example, sometimes an entire sector becomes out of favor, with a number of companies within that sector being very underpriced (e.g., financial stocks in 2009 - 2011). In this case, it may make sense to buy a "basket" of such stocks, where such diversification provides some real benefit without being a drag upon returns.
We live in an ever-changing world--market opportunities change, industry sectors fall in and out of favor, globalization continues marching onward, and the legislative and regulatory environment is constantly in flux. However, perhaps the one constant in our ever-changing world is human nature. The way people think and behave, especially in markets, has not changed for close to 400 years since the first recorded market bubble in 1637, and we can fairly safely predict that it will not change in the next 400 years. We welcome the short term volatility caused by fear and panic in the marketplace, noting that periods of fear and macroeconomic distress (e.g., March 2009) are generally the best time to invest. We believe in the classic advice offered by Sir John Templeton: "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."
Therefore, we will often "go against the herd", making investments in out of favor sectors and out of favor companies. We are often net buyers in an uncertain or fearful environment and net sellers in an optimistic or bullish environment. We will often take positions in such pessimistic environments, not because we like pessimism, but because we like the prices such an environment produces. We believe that optimism is the enemy of the rational buyer. As Warren Buffett famously said, "You pay a very high price in the stock market for a cheery consensus." We prefer low prices. As an example, we believe that market participants tend to overreact to bad news in a herd-like manner, and these overreactions often result in prices that are compelling. Thus, we will often invest in companies that are strongly disliked (e.g., banks or AIG after the financial crisis).
However, we are not contrarian for its own sake -- we are neither right nor wrong because our actions are different than others. Instead, we rely on our data and reasoning to make decisions, without deference to the current consensus. Above all, we are opportunistic. Our goal is to invest in the most rational and thoughtful manner possible based upon the opportunities presented to us.
We are not active traders, and thus our level of trading activity may be much less than might be expected. In fact, 99% of our time is spent reading, thinking, and analyzing individual businesses rather than focusing on the minutiae of stock movements or actively moving in and out of multiple stocks. However, do not confuse our lack of trading activity with lack of effort. By continuously reading and analyzing, we are poised to take action when the right opportunity presents itself, and usually with size.