Investment Philosophy and Methodology

Our primary objectives are first to preserve capital and second to make it grow. The first and most important decision is asset allocation. What percentage of your portfolio should be in stocks, bonds, cash, etc., in light of your financial condition and your goals, and in view of current and anticipated market conditions? Once that decision is made, we select suitable investments within the selected asset classes.† For that portion of a portfolio that is allocated to equities (or for our clients who wish to invest only in equities) we strive to buy shares in excellent businesses at prices that make economic sense. We search for opportunities that offer the investor the highest predictable annual compounding rate of return possible, where the risk is reasonable in light of the potential reward. We buy only where we are able to do so at what we believe to be fair or bargain prices.

In short, we seek to buy value stocks in excellent companies. Ideally, we like to determine what we want to buy; buy it when it goes on sale; and then hold it to reap the benefits of compounding after-tax rates of return. We generally prefer to buy and hold for the long term but, as briefly discussed below, our approach to investing does include selling positions when appropriate regardless of duration. Our investment decision-making process involves the following, highly disciplined, three step approach:

• Search for undervalued, excellent companies
  
• Buy stock in excellent companies at reasonable prices
  
• Sell the stock when the stock or the company no longer meets our criteria

1. Has the company demonstrated a consistent history of growing its revenues and earnings? Is the predictability of future (3-5 years) revenues and earnings relatively high?
   
   
2. Do the company’s revenues and earnings show an upward trend? How do the numbers for the current fiscal year compare to last year’s numbers? What are the forward looking estimates? What do demographic studies indicate about future demand for the company’s products or services?
   
   
3. Price to Sales and Price to Earnings. As a valuation measure we prefer companies with comparatively low price/sales and price to earnings ratios. The key to this analysis is in understanding why a company is trading at a low multiple. Often companies trade here for good reason. We like historically sound companies that have recently experienced a recoverable calamity or temporary setback, but remain fundamentally and qualitatively solid, and are thus out of favor with Wall Street for no good reason.
   
   
4. Price Earnings Growth Ratio (“PEG”). Comparing a firm’s price-earnings ratio to its historical and/or 3-5 year earnings growth rate estimate gives us PEG. A PEG of less than 1 indicates that the firm may be undervalued. Historically PEG has been a useful tool to identify opportunities to buy value stocks in growth companies.
   
   
5. Return on equity. An excellent measure of management’s efficiency and ability to add value to a firm is the company’s return on equity. (Historically, approximately 12% has been about average for American businesses.) How does the company’s return on equity compare to that of its competitors? How does the company’s current return on equity compare to its historic returns?
   
   
6. Free Cash Flow. Is free cash flow positive? Free cash flow is the cash generated from operations less the capital expenditures and other investments that are necessary to sustain and grow the business, and dividend payments. (Companies that generate positive free cash flow can use money to retire debt, repurchase stock, pay dividends, and buy new businesses that enhance overall value and strategic strength of the company.)
   
   
7. Is the company conservatively financed? Is the company’s debt reasonable under the circumstances?
   
   
8. Current Ratio and Short-term Liquidity. Do the company’s current assets (cash and assets readily convertible to cash) exceed its current liabilities by a sufficient margin? If not, why not?
   
   
9. Does the company’s net profit margin compare favorably to that of its competitors?
   
   
10. Our valuation approach includes intrinsic value calculations. This concept is based on the premise that all investments have an intrinsic value about which their market price fluctuates. A stock generally trades above or below its intrinsic value due to a variety of reasons (e.g., current economic conditions, the cyclical nature of the sector or industry, or the impact of a near term recoverable calamity).
    
    The temporary nature of each of these events leads us to believe that, over time, a stock’s price should converge with its intrinsic value. We estimate intrinsic value using method(s) appropriate to the nature of the company, its dividend policy, and the industry in which it competes. As managers who seek to invest our clients’ money in undervalued stocks of excellent companies, our goal is to buy at a deep discount (typically 25% to 50%) to intrinsic value.
    
    
11. Does the company have managerial talent capable of growing, and efficiently utilizing, retained earnings and allocating capital profitably?
    
    
12. Is the company managed by people who appear honest and competent, and who seem to function with their shareholders best interests in mind?. Are the pecuniary interests of the people holding the key management positions aligned with those of the public shareholders? Do they own stock in the company? Is their compensation reasonable? Are the company’s reports and financial statements clear and readily understandable?
    
    
13. Is the company a leader in its industry, consistently offering new products, services and innovations?

The final step in our methodology is the exit strategy. When do we sell? As noted above, we generally prefer to buy and hold for the long term in order to reap the benefits of compounding after-tax rates of return. We will, however, generally sell a position when any of the following conditions occur.

1. There has been a material negative change in the fundamental or qualitative characteristics of the company.
   
2. The price of the stock has approached, met, or surpassed our estimate of its intrinsic value. (But, we don’t necessarily sell when a stock reaches its intrinsic value. Stocks commonly move through intrinsic value on the way to being overvalued. We will attempt to capture as much of this upside as we can without jeopardizing our profits.)
3. In a fully invested portfolio it may be necessary to sell a position in order to free up cash to invest in a more attractive position. We generally (but with exceptions we deem appropriate) make investment decisions based primarily on the criteria discussed above. We are confident that, over a three to five year time horizon (i.e., a complete business cycle), our disciplined, value oriented approach will lead to superior investment results.

† This paper describes the methodology we currently use regarding investments in the common stock of individual companies, and is subject to change from time-to-time without notice. Our managed accounts vary depending on the investment objectives of our clients. For clients who seek income, we invest in bonds, high yielding common stocks, and bond funds. Where appropriate, we also invest in no-load mutual funds, closed end funds, exchange traded funds, and index funds. Recognizing that some degree of risk is inherent in all investments, our primary objective is always to preserve capital by using our best efforts to avoid avoidable loss regardless of the nature of the account.