Building Our Portfolio

Avoiding Permanent Impairments of Capital

Investing is an exercise in repeated decision making over time. So, the goal of investing is to maximize the geometric mean of investment outcomes, not the arithmetic mean.  As a result, our approach to underwriting and — by extension — risk management is focused on reducing the likelihood that we experience permanent impairments of capital for each investment. We consider our primary risk to be a business materially underperforming our long-term earnings expectations.  In other words and in total, we are striving to take “bankruptcy” spaces off the board:

The Kelly Criterion

We use the Kelly Criterion as a framework for position sizing, which specifies that we should consider both expected returns and potential ranges of operational outcomes.  The key takeaways as we apply Kelly to portfolio construction:

• The higher the expected return for an investment, the larger the position size should be (and vice versa)
• The narrower the potential range of operational outcomes for a business, the larger the position size should be (and vice versa)
• For an investment where the expected return is high (larger numerator) and the underlying business is high quality (smaller denominator), Kelly recommends an investor concentrate capital in this superior idea
• “Zeroes,” which represent permanent capital loss, are important and should be carefully avoided

Great Opportunities Are Rare

• High quality businesses trading at a significant discount to intrinsic value are rare.
• These opportunities tend to have one of two characteristics (or both):
  • Undiscovered businesses are under-the-radar. For these investments we generate an informational advantage through in-depth research that others are unwilling or unable to do.
  • Unloved businesses are widely followed but out-of-favor, so they require a strong stomach, careful analysis, and willingness to go against then-prevailing sentiment.

Concentration and Patience Are Key Features of Our Approach

• We make concentrated investments when we feel that information is adequate, risks are low, and potential returns are high, recognizing that bigger stakes can be taken when outcomes are more certain.
• We are benchmark-agnostic—a differentiated portfolio is a prerequisite for long-term outperformance.
• In the absence of truly compelling opportunities, we will hold cash and wait patiently.
  • We will not put capital in harm’s way without an adequate prospective return.
  • The avenue to superior long-term returns is being “fearful when others are greedy and greedy when others are fearful.”

We are long-term investors, but we will consider selling an investment when…

• …the price of the security approaches or surpasses our appraised value of the business, such that it no longer offers an appropriate margin of safety.
• …a fundamental negative change in a business, its management team, or its return prospects occurs that lowers our appraisal of its intrinsic value.
• …the core business changes and is no longer within our circle of competence, preventing us from reliably estimating its intrinsic value.
• …we are fully invested and have an opportunity to re-allocate capital from relatively overpriced securities to relatively underpriced securities in an ongoing effort to concentrate our capital in our best ideas.