Q: What is the goal of the fund?

The goal has always been to compound our and our investors’ money as fast as we can, without taking undue risk. Our goal is not tied to a specific index, because we believe that directing your efforts to beat a specific benchmark can be value destructive. We aim to earn the best returns within the given opportunity set and without taking unnecessary risk.

We’ve always done that by owning a concentrated portfolio of 10 to 25 securities. Due to the concentration itself, we look very different from the broadly diversified indexes, but we believe that this approach is highly relevant today. 

In the last several years value investing has been a difficult field as a tide of money has flowed into index funds or similar products. We have seen a transfer of $2.5 trillion out of active management and into passive vehicles. It has become accepted wisdom that an index is the best place for investors, irrespective of valuation. Any time that that an investment philosophy is proclaimed to work independent of valuation, we are usually on the brink of a significant trend change.

Q: What core beliefs guide your investment philosophy?

We believe in behaving sensibly and investing for the long term in good, growing businesses, which we aim to buy at a discount to their real worth. Our analysis aims to find companies with clever managements that are growing intrinsic value, and who treat shareholders honorably. 

In a nutshell, we are the antithesis of the momentum investor. Being contrarian and value-oriented means finding investments that are misunderstood or under a cloud. These are high-quality companies that are perceived differently by the market for some reason. Negativity or disinterest in a company or an industry is not a sufficient condition to invest, but is often a good starting point.

We prefer to invest in businesses that can grow. Once in a while, we may find a company with an end market that isn’t growing, but with a stock that is so inexpensive that it is worth exploring. So, starting points matter, price matters, and sometimes a good business can be cheap.

For example, in 2011 and 2012 Microsoft was trading close to 10 times earnings, even though the company had net cash on its balance sheet. In 2000, it was trading at 56 times earnings and the stock then did nothing for a decade. During that period revenues tripled and net income almost quadrupled. The business did wonderfully well, but the valuation was depressed, because the market paid too high price as a starting point. Investors started to give up after a long period with no stock price appreciation.

Another great historical example is Johnson & Johnson. Investors were paying an excessively high price in 1972, because the company was growing and running great consumer franchises and pharmaceuticals. Over the next decade, revenues quadrupled and net profits quintupled, but in 1982 the stock price was lower than in 1972. In 1982 Johnson & Johnson was a great buy again, in the same way that Microsoft became a great buy in 2012. 

Q: Could you explain your investment process?

Our process is based on good old-fashioned fundamental analysis. We go through every piece of public document available and we talk to many people to develop a deep understanding of the dynamics of any particular industry we invest in. 

We need an attractive entry price and an edge at understanding something that the market is getting wrong. At the end of the day, if we are right in our good old-fashioned analysis, if we develop a thesis different from that of the market, and if we pay an attractive price, we will do well with that investment. We just cannot be sure exactly when. 

For example, we were buying Hewlett Packard all the way down, when many people expected earnings power to erode fast. However, it turned out that HP was able to stabilize and grow. It took quite a while for investors to understand the positive things that Meg Whitman was doing, but when market sentiment changed, we got significant returns over a relatively short period of time. That’s how it usually works.

The great advantage of the fundamental investor today is a long-term perspective and the understanding of the qualitative factors affecting an industry or a business over the next several years. That’s particularly important in light of the prevailing short-term focus of the market. 

Years ago, being able to get information was a real advantage. Information was very inefficient, while today everybody has access to much of the same information within microseconds. Now the process is not necessarily about getting information, but about being able to figure out what’s important. It is easy to drown in the ocean of available facts while underestimating the few important qualitative aspects of a business that should enable it to do well going forward.

Another key aspect is being able to evaluate people. To make a successful investment, we need to understand the management team, its experience, and its capital allocation ability. Such understanding is necessary for building confidence that the company will work out the challenges. The experience is crucial for being able to correctly evaluate and interpret information.

Q: Would you give some examples that illustrate your process?

Hewlett-Packard would be a good example. In October 2011, Hewlett-Packard made the mistake of acquiring Autonomy, the British big data software firm, without doing proper due diligence. In that period the stock price dropped from the mid $50s to $12; we got involved when the stock was in the low $20s.

In 2013 or 2014 all the headlines were about the potential bankruptcy of Hewlett-Packard. At the same time, the company was generating more cash than Walt Disney Productions or Coca-Cola; it had billions in cash generation. Yet, there was a temporary delusion in the market that the business wasn’t worth anything. 

All they needed was better management, which they got with Meg Whitman. Then they started to rationalize and streamline their operations. Eventually, they separated the personal computer and printer businesses from the enterprise business. We sold one of the pieces and kept the other and it has worked out well. Even in the PC and printing business, where end markets were stagnant or slightly declining, HP was able to grow because market share was consolidating. 

That’s also an example of how sometimes we find an industry, which doesn’t exhibit strong growth, but can provide opportunities for individual business. In the case of HP, the overhead could be reduced and there was no gigantic debt load. The company was generating enough cash quickly, so the debt from the Autonomy acquisition was paid off within two or three years. The thesis that customers were going to leave also wasn’t true. The big HP customers that we talked to said they were happy with the products and services. The key argument was that there weren’t many companies that could provide that scope of services on the enterprise level, so it wasn’t easy for customers to leave.

In the airline industry there is a similar situation. Until 15 years ago, there were a dozen major airlines that competed for decades. Today there are four or five main domestic carriers and all of them behave relatively rationally. Now these carriers have streams of income that aren’t just from flying planes; they also have baggage income, credit card, and other incomes. When everyone behaves rationally, the companies start to make a lot of money. 

Yet, the valuations in the airline industry are low because nobody believes that the trend will continue. If it does, at some point investors will wake up and there will be a fundamental revaluation of the business. In the meantime, these cash-generating companies are buying their own shares at low multiples, which is incredibly value creative for shareholders.

Q: How do you avoid value traps?

We always sleep with one eye open to look for fundamental degradation in a business. And we can change our mind if we don’t see progress. We like to remind ourselves that if the market has not figured out the thesis in a couple of years, the odds go up that we were wrong. In such cases we re-evaluate. The market is inefficient, but not that inefficient. When the market ignores the progress or the thesis, then we ask ourselves if our thesis is wrong.

In the past, value investors shied away from technology, because early stages tech businesses could be easily disrupted by someone who invented a better mousetrap. However, in the last 15 years, we have seen the rise of tech companies with strong market positions and cash flows. Companies like Microsoft, Google, and Facebook all have favorable business dynamics. 

On the other hand, Amazon has been an amazing stock, but the company has earned perhaps $10 billion in the 20 years of its existence, while having a valuation of $800 billion today. There’s definitely a disconnect. Netflix is a company that viewers love, but it has been a large consumer of cash as it’s been borrowing to fund its programming. Maybe it will turn into a cash-generating company at some point, but we should note some great cash-generating franchises like Microsoft or Google were cash positive on the day they went public. They’ve always generated cash and that attracts us. Another important feature is that they have dominant positions in certain areas. 

So, currently technology companies like Amazon and Netflix, which aren’t making a lot of money, have really big valuations. If such companies are a big part of the indexes, the situation becomes difficult for investors like us, who don’t typically buy expensive securities.  But this is not a permanent condition. 

We saw the same trend it in the period 1998 to 2000, when we refused to play the dot-com game, because the only special event of that time was that valuations became huge. When the technology market peaked in March 2000, suddenly our investments in Berkshire Hathaway and Mercury General Insurance, which were previously under tremendous pressure, started to go up. In the next decade we had wonderful financial results. So we’ve seen that movie before and we know how it ends; we just don’t know how long it will continue.

Q: Do you seek catalysts as part of your investment process?

Yes, we like seeing different catalysts. Our definition of a catalyst is something that will result in value coming out sooner rather than later. A catalyst could be a large shareholder that isn’t motivated by what the management wants and has a different interest. It could be a company that has consistently bought back shares over the years, a company that pays special dividends, or any marker that shows that the management is sensitive to shareholder return.

In the case of Microsoft, the market underappreciated the advantage of being a dominant, cash-generative business with a clean balance sheet. That allowed them to shift gears and to be able to devote resources to cloud computing. 

Q: In value investing there is usually a time lag or a period necessary for the thesis to materialize. What is your buy-and-sell discipline?

We actually prefer that a stock not go up right after we buy it. We need a period of depressed pricing or we would never own an amount that’s substantial enough. Although we manage a concentrated portfolio, we typically don’t start with big positions. We start with moderate-size positions and we keep buying if the stock gets weaker or our confidence really grows. When our thesis suddenly becomes obvious in the market, we get real appreciation and a much bigger holding.

When the investment thesis isn’t playing out, we have to redouble the efforts on the analysis and to look under every rock. In some cases, we have to change our mind and to admit that we have made a mistake. But if we are thorough in the analysis and confident in our thesis, we keep going until we reach the self-imposed limits on concentration. That means that our results differ from a broad index, but that’s how our investment style is supposed to work.

Q: In terms of portfolio construction, you hold 25% in cash. What is the rationale?

When you study the great capital allocators, there are similarities in their behavior. One of these similarities is that whenever a crisis came along, they all had cash in their balance sheet so they could step up and take advantage. They didn’t have cash all the time, but let it accumulate when most investors were optimistic. Then, they would deploy it when people were pessimistic. The process and the cycle would continue and after the recovery, they would sell something and generate cash off the investment. It’s a common factor that when people are optimistic, the good capital allocators all have a chunk of liquidity to be able to act opportunistically. 

Cash is an option on the future. Since we are big investors in our fund, we behave sensibly with our money and the money of our investors. Especially today, when valuations are historically high, we want to have optionality. We aim to construct the portfolio to perform best on a risk-adjusted basis for us and for our shareholders. There is enormous pressure when things go straight up, because cash becomes a drag and many managers avoid it. But we believe in a price-disciplined, patient approach to investing and that strategy has paid off.

Q: What is your view on the increasing liquidity as a result of the Federal Reserve’s policies? Does it create additional risks?

It is a difficult period, but conditions change and the Fed is clearly trying to withdraw liquidity today. We haven’t felt much change yet, because the Europeans and the Japanese continue to provide liquidity, but they also seem on the verge of slowing down or reversing. We don’t have much focus on the Fed, but there have been plenty of times, when people pointed to a macro factor as a justification for higher valuations.

For example, between 1966 and 1972 there was a fear of a shortage of stocks, because pension and endowment funds had decided that they could invest in equities. Billions of dollars were expected to come to the market and everybody was worried about valuations. Certainly, there is an aspect of that today, because of the cap-weighted indexes at the most popular index funds. When money is poured into them in increasing amounts, they are forced to buy the more expensively valued businesses at higher and higher prices. At some point, the trend will reverse and they will be forced sellers because they have no cash. That’s when differing from the broad indexes is going to be a huge advantage. We believe that we are not far away from that point.

But instead of philosophizing on the cycle, it is much more productive to stick to our discipline and to keep looking for the occasional pocket of inefficiency and to make sure that we have some liquidity. Over decades, we have found that this approach works well for us. The difficult periods are just part of the process. 

In the meantime, we look for the few investments that make sense and have nothing to do with the indexes. Such an opportunity could be a small natural gas company in Canada that’s not part of any big index, yet is selling at three times cash flow because of the depressed price of natural gas in Canada. 

There is a benefit in not managing a huge fund, because we have a bigger universe to choose from.  And there is almost always an investment with a cloud over it. Our job is to identify a few investments that are worth exploring due to some temporary fear. Since we are concentrated investors, we don’t need many stocks to get cheap; we just need a few.  If we are disciplined and patient, every few years there should be a good low-risk opportunity to commit capital at prices that should result in significant profits. That’s our goal.