We seek to invest in shares of businesses that are priced at substantial discounts to our estimate of intrinsic value. We view every stock purchase as if we are buying a piece of a business and seek to invest with management teams that are well-aligned with shareholders. We believe our clients should demand the same from their investment managers.
We are long-term, goal-focused, plan-driven stock investors. We believe that the key to lifetime investing is to act continuously on a specific, written plan. Likewise, we believe substandard returns and even investment failure inevitably come from reacting to let alone trying to anticipate, current economic and stock market events.
We understand that the economy cannot be consistently forecast, nor the markets consistently timed. Therefore, we believe that the only reliable way to capture the full long-term return of stocks of great companies is to ride out their frequent but historically always temporary declines.
A massive transfer of wealth from debt investors to stock investors is well underway and will continue into the foreseeable future. Shares of great companies are the only way to beat inflation and taxes. Even at anything close to today's interest rates you probably will not accumulate enough money to live in dignity and comfort in retirement.
In retirement, a fixed income strategy, like an annuity, bond mutual funds, or bank certificates of deposit (“CD”) at historically low-interest rates will never be able to fight off three decades of inflation. We believe if you stay relentlessly focused on your retirement plan as opposed to the short-term interruptions of the permanent uptrend, shares of great companies are your only hope.
Alignment of Manager and Shareholder Interests
Smart investors have noticed that fundamental problems arise where ownership and control of the modern corporation are separated. Managers control the firm and can make decisions that benefit themselves at the expense of the firm's owners.
David learned with his work at Stern Stewart and Co. that EVA ® and value-based management systems (VBM) are valuable answers to this problem. The value of a company is determined by its discounted future cash flows. Value is created only when companies spend money at returns that exceed the cost of that money. VBM extends these concepts by focusing on how companies use them to make both major strategic and everyday operating decisions. It is an approach to the management of companies that aligns a company's overall aspirations, analytical techniques, and management processes to focus management decision-making on the key drivers of value.
Our investment method avoids stocks in companies whose managers' interests are not aligned with the interests of investors. We measure this. We understand that these companies often do not lead to long-term value for investors. The long-term VAP investment process focuses on shareowner- aligned companies.
(1) Screen for ValueAligned Companies:
We find potential shares of great companies through proprietary stock screens, other investors we follow, or in one of our “fishing streams”, like private equity companies in the public market and companies using EVA or VBM. We measure whether it is a quality business by looking at whether it consistently earned returns on capital greater than the cost of that capital.
(2) Transform accounting into economic information:
We transform accounting information into EVA ®. EVA ® systematically corrects traditional accounting distortions by applying standardized, rules-based adjustments to better match revenues and expenses. For instance, in traditional accounting, Research & Development (R&D) expenses are treated as expenses. We add back those expenses to the income statement, raising economic earnings. R&D expenses are really “investments” on the income statement. We treat them as investments by adding them back to the income statement and putting them on the balance sheet.
(3) Estimate intrinsic value:
The intrinsic value of a company is the present value of all expected future cash flows. Using our proprietary tools, and advice from industry specialists we build a thorough model of the businesses that pass our screen tests. Using our models, we estimate the intrinsic value of the business. We estimate this the same way a businessman would figure how much he’d want to pay for a bowling alley or a Dunkin’ Donuts franchise. We estimate the cash flows the business will produce for shareowners and what the business is worth. To incorporate risk analysis into our investment process, we build financial models. Models help to understand businesses better and provide insights as to which metrics matter the most.
(4) Leave room for error in our buy price:
Unexpected things happen. That’s why our valuation model includes a margin of safety in case we’re wrong. We only purchase shares of great companies when the stock market price is sufficiently below our estimation of value. Considering a margin of safety when investing provides a cushion against errors in judgment or calculation.
(5) Expect stocks to revert to fair value:
If a stock is undervalued for a long time, the share price in the market eventually catches up to intrinsic value. If we do a reasonable job at estimating what the business is worth, then, at some point, the stock market will price it accordingly. At the time of valuing the shares of great companies, we set a Buy Below price at a business risk-adjusted margin of safety and a Sell Above price at a risk-adjusted price above our constantly updated estimate of intrinsic value.
(6) Monitor and manage the portfolio:
We are not traditional buy-and-forget-to-sell investors. We have strict sell criteria to remain “active” buy-and-sell investors. We value stocks based on what they’re worth, not what they used to trade at in the past. We don’t time the market, but we measure stock market risk and market trend. When the market risk is higher, we require lower Sell Above prices. We will hold cash if we cannot find stocks of sufficient quality at prices that offer our required margin of safety or if the stock market’s risk is too high.