We don’t voluntarily lock ourselves into the style, size, or geographic boxes. Investing today is difficult enough without self-imposed, baseless restrictions.
We patiently seek out stocks of any size and any growth profile in any country (where the law is on investor’s side) that meet our stringent Quality, Valuation and Growth criteria — these stocks just have to be significantly, if not ridiculously, undervalued.
If we cannot find stocks that meet our rigorous criteria in the US or internationally, we will not just buy second-rate stocks, we will simply hold more cash. We cannot time the market, but we can value individual stocks.
Our clients are our partners, and they are treated as such with complete transparency, honesty, and with direct access to our decision makers. In our quarterly letter we walk our clients through buy and sell decisions in their accounts.
We eat our own cooking. Our portfolio managers and their families own the same stocks as our clients.
We have no institutional pressure to do dumb things: We will not own a stock just because our competitors do (common practice in the mutual fund world). We will not hug benchmarks – we are not going to buy the best-looking horrible stock just to have exposure to an industry that is in an index.
Clients’ unique circumstances and wishes are taken into consideration. Some clients ask to avoid tobacco or defense stocks. Others want to take capital gains and losses for tax reasons.
We provide complete transparency: the client can see each position and cost basis in our quarterly report provided by IMA, or daily on the custodian’s website.
Decision makers are a phone call away. Clients pick up the phone and call us if they have questions or concerns or just to say thank you. Good luck reaching your mutual fund manager.
Unlike mutual funds, hedge funds, or ETFs, each of our portfolios is crafted for the individual client. Each client owns their cost basis, and they don’t pay taxes for gains enjoyed by previous investors (a common problem with mutual funds).
However, a stock we bought for clients six months ago when it was significantly undervalued may be only slightly mispriced now, and therefore we won’t buy it for a new client.
Unlike hedge funds or mutual funds (pooled investment vehicles), where on day one a client will own what other clients bought years ago, each account at IMA is invested as opportunities present themselves.
A sports car will not get us past the first potholes. What we need is a four-wheel-drive, all-terrain vehicle. This monster will not have the speed and the sex appeal of the shiny red sports convertible, but the heavy-duty all-terrain vehicle will complete the journey. Its position at the finish line will completely depend on one unknown – the road ahead.
If it is a smooth, unbroken surface, then our Land Cruiser will be left in the dust by the Ferraris and Maseratis in the race. It will finish the journey; it just won’t be the first to cross the finish line. But if our estimate of the road ahead is correct, you’re going to be mighty glad to be in the all-terrain vehicle … and you might even finish at the head of the pack.
On the surface the US and global economy appears to have been growing, and though the growth has been slow, it has been steady. Our concern, though, is that demand for goods globally has been highly inorganic, engendered by global QE and unsustainable budget deficits.
Investing is a forward-looking endeavor. We are not building a portfolio for the economy we see in the rear-view mirror but for the one that lies ahead. Unfortunately, the view of the road ahead is very murky at best. History is not very helpful either, as the global QE experiment has never been attempted at its current magnitude.
We are building a portfolio for Mojave Desert-like terrain. Paraphrasing Warren Buffett, “To finish first, first you need to finish.” Therefore, we want your portfolio to be filled with all-terrain vehicles (stocks).
Now that we have subjected you to our metaphor, let us explain what “all-terrain” means in practical terms. To do this we need to reintroduce you to our three-dimensional analytical view of stocks; Quality, Valuation, and Growth (QVG).
We’ll get to Quality in a minute. The Valuation (the worth of the business) and Growth (earnings growth and dividends) dimensions have a dual purpose: they serve as a source of returns and as a protector against losses. If you buy a company that is worth $1 for 50 cents (a 50% margin of safety) and the stock goes up from 50 cents to $1 that is the Valuation dimension working as a source of returns.
On the other hand, that 50-cent investment can tolerate a lot of bad news before you lose money on the investment – that is margin of safety working to protect you against losses.
The Growth dimension protects you against the clock – time. A company that is growing earnings and paying dividends is compensating you for your time. Dividends tangibly enrich your brokerage statement on a quarterly basis. Earnings growth increases the value of the firm with the flow of time – if earnings double, that aforementioned 50 cents turns not just into $1 but into $2.
Now, how about the Quality dimension? A traditional definition of a quality company checks off these boxes: has a significant competitive advantage and high return on capital (which usually accompanies a competitive advantage); has management that is both good at running the business and at allocating capital (arguably, more value has been destroyed by poor capital allocations than by poor business decisions); and, last but not least, has a solid balance sheet – we prefer companies that have net cash on their balance sheets.
However, there is a simpler test for what constitutes a quality company: it is one that we would be comfortable owning for five or ten years even if the stock market were closed.
In the environment where the true cost of money is unknown (thanks to central banks) and global growth has become a Frankenstein-like creation (thank your local central banker again), then for lower-quality companies, the Valuation and Growth dimensions have lost their tangibility. You thought you were buying a $1 for 40 cents, but in the absence of Quality, Valuation can degrade much faster than your margin of safety and $1 can turn into 20 cents in a New York minute.
Quality is an uncompromising filter in our analysis – we are obsessed and dogmatic about Quality. If the company doesn’t pass our Quality filter we simply stop our analysis – the company is dead to us, and we don’t go to the Valuation and Growth dimensions.
Passing the Quality test doesn’t make a company a buy, either, but it earns it the right for the Valuation and Growth dimensions to be examined.
Quality is the superstructure of the all-terrain company – it must survive anything thrown at it by the global economy.
For instance, a few years ago we found that stocks in the HMO industry were all cheap. There was no stock that clearly stood out as the one to buy; they all looked cheap. So rather than succumbing to decision paralysis we bought a basket: three 2% positions. Sometimes we buy a starter, a 2% position, hoping the stock declines further so we can increase to 4% or 6%, but hedging in case the stock doesn’t cooperate with us and goes up. Ideally we would like to be closer to 20 positions, but lately we’ve been closer to 30.
When choosing how many companies we should hold in our portfolios we strive to strike a balance between two extremes: over- and under-diversification. Under-diversification – when a portfolio consists of just a few names – is dangerous because it doesn’t allow room for error or randomness. We can perform a flawless analysis of a company and buy it extremely cheap, but it can get hit by a random (unpredictable) event. If that position were 20% or 30% of the portfolio, it would be hard to recover from it.
The other extreme is over-diversification – something we see all the time in mutual funds that hold hundreds of stocks. Though superficially over-diversification doesn’t send up any red flags, it is actually as dangerous to portfolio health as under-diversification.
In a 100-stock portfolio the average position will be 1%. If you are right on a stock and it goes up 50%, its additional contribution to the portfolio is only 0.5%; so all the hard work you did on research did not have a meaningful impact. But more importantly, if something goes wrong and the stock declines 50%, the impact on the portfolio will be only -0.5%. Now, on the surface this sounds like a great deal, an insignificant loss; but there’s a problem: the fact that being wrong on an individual stock in an over-diversified portfolio carries little penalty (pain) breeds indifference, not just to one position but to all of them (indifference times a hundred!).
So our approach in deciding the number of positions we own in our portfolios is very simple: we own stocks for which every decision matters, but not so few that we can’t afford to be wrong on a few of them.
In addition, every company in our portfolio receives a rating based on the quality of the business, its balance sheet, the predictability of its business, and our regard for management’s ability to manage the business and allocate capital (note, these are two different criteria).
A company that receives a perfect score on every measure will likely warrant close to a 6% position (if a lot of planets align we might even take it up to 8%). The lower the company’s score, the lower the weight it will have in our portfolios. This rating system, combined with expected returns, helps to maximize the probability of success and naturally tilts our portfolios toward quality stocks.
An investment process without a well-defined sell discipline is as functional as a highway with only on-ramps but no off-ramps. There are three reasons to sell a stock:
(1) Something has gone wrong. This will happen. We made certain assumptions about the company’s fundamentals when we bought the stock – we assumed cash flow would grow at a certain rate, return on capital would be “x”, or that management would make rational capital allocations. Then life happens, and we might discover that an assumption was wrong.
If so, we reexamine the stock as if we were analyzing it for the first time, asking ourselves this question: based on new information, what is the company worth? A lot of times we bought the company cheap enough that even the new bad news was already priced in, so we might do nothing (which is a decision). For every company in our portfolio we build a financial model. These models are helpful in helping understand the business not just when we buy the stock but as we continue to own it, and when things go wrong we can input the new information into our model and reassess the business.
However, if we find that, based on new information, the company isn’t cheap anymore, we’ll sell the stock without hesitation.
(2) We simply found another stock that offers better risk-adjusted returns. This often happens, especially when we find a company in the same industry that has a lower downside but higher upside. We may then swap one stock for another. But in general, stocks in our portfolios have to compete with an external opportunity set (stocks that we don’t own). Every stock in our portfolios is ranked based on the relationship of potential returns to downside risk.
(3) A stock reached its full potential. Valuing a stock is more an art than a science. Therefore, for every stock in the portfolio, we don’t just set a single sell price but set a price range. We continuously reassess those ranges as new information comes in.
Selling stocks that have done well for us is very difficult psychologically, as there is significant attachment that develops with such companies. To overcome this psychological attachment, we put our sell process almost on autopilot: once a stock price crosses the low point of our sell range we sell half, and then when it crosses the top of the range we sell the other half.
Instead of trying to time the market, we value individual stocks (call it timing if you like). As simplistic as it sounds, we buy stocks when they are undervalued and sell them when they are fairly valued.
As a market timer your cash balance is a function of what you think the market is about to do. Our cash balance is a by-product of investment opportunities we see in the market. If we cannot find enough stocks that meet our Quality, Valuation, and Growth criteria, we’ll have more cash.
We have owned many companies for longer than five years, and some we owned for less than a year (though this happens less often). When we analyze companies we look at them not as pieces of paper but as businesses we intend to own for a long period of time.
If you know what the company is worth, then change in intrinsic value is all that is going to matter. The price quoted on the exchange will be your friend, allowing you to take advantage of the difference between intrinsic value and quoted stock price. If the quoted stock price is significantly cheaper than your estimated intrinsic value, you buy it or buy more of it if you already own it. If the opposite is true, you sell it.
What is a company worth? Determining the intrinsic value is a combination of art and science (in that order) – it is not quoted on the exchanges. We go about this the same way a businessman would figure how much he’d want to pay for a gas station or McDonalds franchise.
Analysis of each company is different, but at the core we estimate the cash flows the business will produce for shareholders in the long run (at least ten years), and what the business will be worth then (based on our estimate of its earnings power at the time). The combination of the two provides us an approximation of what the business is worth now. But this is just a start. Then we look at known risks and try to imagine unknown ones. We try to quantify their impact on cash flows – we try to kill the business.
This “killing” helps to us understand how much of a discount to what this business is worth we should demand. This discount is also called “margin of safety.” By applying this discount to fair value we arrive at a buy price. For every stock we buy we probably look at twenty and do very serious analysis of ten or fifteen. In this analysis, what happens this month, this quarter, or even this year is only important in the context of the long run. Unless the company’s good or bad earnings report in any quarter changes our assumptions of the company’s long-term cash flows, it is just noise, which is just another word for … volatility!
One significant but often unappreciated benefit of a separately managed account is that, unlike owning a mutual fund or ETF, you can see the stocks you own. A discussion of mutual funds or ETF performance is somewhat nebulous (we are generalizing) because it very quickly turns into a discussion about the market. But when you can see every stock in your portfolio, you don’t have to think about the market; you can look at each stock as partial ownership of a real business and discuss how this or that risk will impact it.
When you own the market you are not sure how lower oil prices will hurt or benefit your portfolio, but when you own just a dozen stocks, this discussion becomes very straightforward.
We spend a significant amount of time trying to be as clear and transparent as we can about our thoughts on the market and individual stocks. Whenever clients get concerned about the market, they just call us. We will probably not be very helpful with the overall market discussion, but we’ll walk them through each stock in the portfolio and try to shed as much light as we can on what we believe each is worth.
For this reason macro forecasting was disapproved of by value investors, and for 20 years this attitude paid off. The economic climate was favorable, the stock market was in overdrive, price-earnings ratios were expanding. Macro did not matter — until the housing bubble and financial crisis. Value investors who had had their heads in the sand got annihilated.
Things in life often swing pendulumlike, from one extreme to another. Right after a crisis every investor is a macro expert. Investors who just a few years earlier didn’t even know the names of most economic indicators are now spitting them out in conversations as though they had absorbed them with their mother’s milk. So what should investors do — become macro experts or be economic ignoramuses?
Believe it or not, there is a logical and, more important, a practical answer to this question. As an investor you want to spend very little time on forecasting the weather (that is, what the Fed will do with interest rates next month or the rate of growth of the economy). Weather forecasting, first of all, is not always accurate, but it will certainly consume a lot of time and energy, and the forecasts have a very finite shelf life. Yesterday’s weather is irrelevant today. As long as you own companies that can survive rain without catching pneumonia — even a few weeks of rain — weather forecasting is a waste of time. This is what Buffett was implying by saying he didn’t want to be a macro forecaster.
There is a significant difference between being a meteorologist and a climatologist, but unfortunately in investing, both activities fall under the rubric of macro analysis, and little distinction is made between the two.
Instead of being a weatherman, we pay serious attention to “climate change” — significant shifts in the global economy that can impact your portfolio.
Often, just from a cursory look we know that the stock is not cheap enough, but if we really (really!) like the business we’ll invest the time to model it so we can understand it better and set a price at which we want to buy it (and then wait).
We build a lot of models. We built over a hundred models last year (we bought only a handful of stocks). Building models is important for us. Models help us to understand businesses better. They provide insights as to which metrics matter and which don’t. They allow us to stress test the business: we don’t just look at the upside but spend a lot of time looking at the downside – we try to “kill” the business.
We usually try to drill down to essential operating metrics. If it is a convenience store retailer, we’ll look into gallons of gas sold and profit per gallon. If it is a driller, we look at utilization rates, rigs in service, average revenue per rig per day, etc.
We looked at American Express before the crisis, which gave us insight into inflated profit margins of the financial sector, and thus we avoided for the most part the carnage in the financials. We thought American Express stock was not cheap enough at the time, but we learned that Amex’s high swipe-fee revenue provided an important buffer to help the company absorb significant loan losses.
Amex could have withstood over 10% loan losses on its credit card portfolio and still have remained profitable. This insight gave us the confidence to buy Amex during the crisis.
Models are important because they help us remain rational. It is only a matter of time before a stock we own will “blow up” (or, in layman’s terms, decline). We can go back to our model and assess whether the decline is warranted. The model then gives us the confidence to make a rational (very key word) decision: buy more, do nothing, or sell.
Models are frameworks that help us think about the businesses we analyze. We are always aware of John Maynard Keynes’ expression, “I’d rather be vaguely right than precisely wrong.” Models are not a panacea, but they are an important and often invaluable tool. However, models are only as good as their builders and the inputs to them.
We also employ three to four interns (apprentices) from local universities (usually finance students) that under Vitaliy’s direction build models and help us with research. In addition, we have a network of five dozen investors globally with whom we share ideas: they provide feedback on our ideas and are a great source of new investment ideas for us.
You’re ready to go…