Fundamental (or intrinsic) value is the cash generated by an enterprise over its useful life. Fundamental value is earned in the future as dividends, interest, and principal are paid or as retained earnings are successfully reinvested.

Risk is the likelihood and potential magnitude of a permanent decline in the earning power of an enterprise, or the payment of a market price at purchase which is higher than fundamental value. Our objective is to mitigate risk through integrity with our investment principles and investment process excellence.

We never confuse fundamental value with market price. Market price is what we pay. Fundamental value is what we get. Market price is reported daily on securities exchanges or ascertained from past transaction records. Fundamental value is determined by enterprise cash flows.

Market price is not a barometer we would use to evaluate corporate performance. Our evaluation of corporate performance is based on fundamental metrics such as income, assets, and return on capital. We view the price of a security simply as a record of what others – well informed or not – were willing to pay for it in the past.

Fundamental value is such a critical concept because it is the only reference point for what an investment is worth, and therefore, whether the market price is fair, high, or low. Two facts support this view. First, the theoretical point that an investment is worth the present value of its future cash flows is self-evident and undisputed. Second, fundamental value is ultimately monetized in the form of future cash flows.

The quality of a security is defined by the durability of the cash flows which produce its fundamental value. The quality of an investment is defined by the attractiveness of the price paid in relation to the fundamental value received.

A quantifiable margin of safety is the hallmark of a quality investment. For higher rated fixed income investments, an issuer’s available resources must be significantly greater than the interest and principal due the investor. For lower rated fixed income investments selling below their principal value, the assets backing an issue must be significantly greater than its price. For equity investments, the fundamental value of a company must be significantly greater than its price.

For other types of investments and as a rule, the probability of achieving a return commensurate with the risk taken must be very high.

True understanding is built upon high probability statements about security values. It requires a dogged determination to understand the economic drivers of each investment and an equally dogged intellectual honesty about whether we did.

Understanding is also relative. Achieving better than average returns requires understanding security values better than average. The challenge is judging whether we understand security values better than average. Competence and clarity are essential. Competence means that we are capable of estimating security values and returns for both our portfolios and the markets in which we participate. Clarity means that we are explicit about our relative return advantage or lack thereof, and only actively commit capital when we have a clear advantage.

Proper diversification is paramount to quality at the portfolio level. Proper diversification is achieved when the overall portfolio return is protected from unexpected adverse results in individual holdings, industries, countries, or other risk factors.

Proper concentration can be risk reducing as well as value enhancing. Concentration refers to making greater commitments to more attractive investments. Successfully executed, concentration has three benefits: (a) returns are enhanced by selecting investments with the highest probability of success, (b) risk is reduced by avoiding mediocre and poor commitments, and (c) knowledge is improved by concentrating the analytical effort.

A concentrated portfolio with fewer holdings is desirable when quality, understanding, and value-to-price are high. A low-cost, more widely diversified approach is appropriate when there are no clear advantages in understanding, and therefore, in our ability to evaluate quality or estimate value-to-price.

One of the greatest risks investors face is selling low in a panic. Thorough and timely communication can greatly reduce this risk. We issue regular commentaries which distinguish between fundamental values and market prices and support our conclusions with detailed valuation statistics. We believe this significantly reduces the risk of investors selling near market bottoms or becoming overly aggressive when prices are elevated.

Communication is also important for evaluating an investment manager’s abilities. Luck, risk, and a bull market can make an incompetent manager look brilliant. Conversely, every brilliant manager will under-perform at some time, and usually this is the best time to invest with them. Investors must look beyond market performance to evaluate manager competence. To aid current and prospective investors in this endeavor, we regularly discuss the strategy and holdings behind our performance, and candidly address both our successful and unsuccessful investments.