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Building Our Portfolio

Establishing and Sizing Positions

We typically build concentrated positions in equity securities as we prefer to invest more capital in our best ideas, recognizing that bigger stakes can be taken when information is adequate and outcomes are more certain.  Our assessment of the attractiveness of each potential investment is informed by our deep research, shaped by our requirement of a ‘margin of safety,’ and driven by the strict application of our core criteria, among other considerations.  This approach reflects our desire to make investments only when we feel that risk is low and potential returns are high.  Consistent with our long-range investment horizon, we define risk as the probability that a business performs materially worse than we predict, leading to a permanent loss of capital rather than a temporary decrease in the quoted price of a stock.  We specifically reject the concept that price volatility is a form of risk, and instead consider it our friend – an opportunity to either buy a business cheaply or sell it dearly.  In fact, because we anticipate being a large net purchaser of companies for the foreseeable future, we welcome low and declining prices to build positions – even in positions we currently hold.  We are only concerned with the intrinsic value of the businesses in which we invest.  Stagnant or declining prices in the face of solid business performance are simply an opportunity to own a greater proportion of the future profits of a business.

The position size of and concentration in each of our ideas are influenced by the Kelly Criterion.  Our main takeaway from Kelly is that a position’s size should be a function of both the security’s expected return and its potential range of outcomes, such that:

Although the math cannot be done explicitly in investing, it implies two critical points when thinking about how big a position should be in a portfolio (with the first point being more obvious than the second):

(i)     the larger the expected return, the bigger the position should be, and

(ii)    the larger the possible range of outcomes, the smaller the position should be.

As absolute value investors, we are comfortable holding cash and equivalents in the absence of compelling opportunities that meet our minimum hurdle rate requirements.  It is our obligation to not put our partners’ capital in harm’s way without the prospect of an adequate return, and cash allows us to act quickly in volatile and/or falling markets.  We are staunch adherents to the belief that the avenue to superior returns is being “fearful when others are greedy and greedy when others are fearful.”  This investment strategy may not be the best way to earn high returns in any given year, but we believe it yields a portfolio that avoids the permanent capital losses endemic to short-term strategies, and earns the highest cumulative returns over a 20+ year time horizon.

Selling Positions

While our long-term approach typically produces low turnover and extended holding periods, we will generally sell a security under the following conditions:

»  We will begin to liquidate an investment when it appreciates to the point that it approaches or moves beyond our estimate of its intrinsic value.  An investment reaching our appraisal may have further upside potential, but it will no longer offer an appropriate margin of safety for putting capital at risk.

»  We will also sell any investment that has a material adverse change in business, management, or return prospects since we invested.  Negative developments by themselves do not necessarily trigger the selling of a position, but should an event lower our appraisal enough or prevent us from reliably appraising the intrinsic value of the investment, we will sell it.  Positive events may cause us to adjust our appraisal of value upwards.  We appraise our positions on an ongoing basis throughout the life of the investment.

»  Based on opportunity cost considerations, we will generally sell relatively overpriced securities to buy relatively underpriced securities as these specific opportunities arise.  This situation happens most often in times of market dislocations or disruptions.