A Good Investment Strategy is One Rooted in Process and Framework
In order for active management to make sense we have to understand where we have an edge and only invest in those areas or circumstances.
Focus on companies that the big boys can't
Most multi-billion dollar funds are limited by their size to only invest in the largest 1,000 companies. With over 19,000 publicly traded securities in the U.S. alone, this leaves a plethora of companies that the best and brightest fund managers can't touch. Where the big money isn't looking, there are bound to be larger discrepancies between price and value. We use our smaller size to our advantage by focusing our time and energy evaluating companies that most institutional investors are ignoring.
TAKE ADVANTAGE OF FORCED SELLING
Investment mandates at many funds don't allow the funds to hold certain types of securities. For example, a debt fund usually does not hold equities. A S&P500 index tracking fund cannot hold stocks that are not in the S&P500. There are a number of situations where funds will sell securities because of these rules, not because of the underlying economics. We specifically look for these situations because we can take advantage of the forced selling to buy a position at a cheaper price if we believe in the value of the underlying business. Our favorite situations to track for forced selling are:
- Spinoffs: these are smaller companies that have "spun off" from larger companies and the larger company shareholders either don't want the spinoff shares or they can't own them. For example, a dividend paying stock from the S&P500 spins off a small subsidiary. The holders of the larger company will get shares in the smaller company as part of the spinoff. Many of those shareholders are funds or investors that only own dividend paying stocks, or only own stocks within the S&P500. These investors will sell the spinoff shares indiscriminately, creating a lower entry price for us.
- Orphan Stocks: these are companies that have emerged from bankruptcy. If there is a good underlying business, but the business became too leveraged with debt (usually because a private equity company loaded it with debt and then sold it into the public market) and it went into bankruptcy, when it emerges the previous debt holders are now equity holders in the new business. But because these new equity holders are frequently debt funds, they are forced to sell the stock and it creates a lower entry price for us.
DIVE INTO COMPLEX ACCOUNTING
We are Big 4 trained auditors. We understand complex accounting better than most out there. There are many situations in the market that will get ignored by investors because the accounting is simply too hard to figure out. This is where we can use our backgrounds to get an edge. We can dive into that accounting and potentially uncover an excellent opportunity that is being ignored by others.
HOLD CASH FOR OPPORTUNITIES
We don't have rules that say we have to be fully invested like many funds do. This means that when we don't see opportunities in the market that fit our criteria, we can hold cash and wait for those opportunities to emerge. It never feels good to be holding cash if the market takes off to the upside. However, many of the best long-term investors have proven that holding cash is the only way to take advantage of the extraordinary opportunities that come along when the market has significant corrections.
UTILIZE OUR STRUCTURAL ADVANTAGES
We have the following guidelines for managing risk:
- Only invest in companies we understand
- Demand a margin of safety before investing
- Be comfortable holding cash when nothing meets our criteria
- If a stock drops more than 10% from where we bought, we re-evaluate our thesis to make sure there is nothing we missed
Note: Risk = permanent loss of capital due to incorrect analysis. We DO NOT view volatility as risk. Volatility creates opportunity.
We run a highly concentrated portfolio of 10-20 stocks that we have high conviction in. We don't believe in putting money into our 50th best idea when we could put more into our best idea. Our portfolio is made up of the following types of investments:
- Generals: Extremely cheap stocks from a quantitative perspective, such as "net-nets"
- Compounders: Excellent businesses with consistently high returns on equity, run by management teams with outstanding track records.
- Specials: Catalyst driven situations often that give us entry points as a result of "forced" or irrational selling. Examples include spin-offs and post-bankruptcy stocks.
- Controls: Investments where we buy enough of the company to influence the management and operations of the business.
We believe that portfolio concentration actually decreases risk because it increases the intensity of our due diligence and depth with which we need to understand the risks and opportunities before buying that position.