Market and Performance Summary

The Kovitz Investment Group (KIG) equity composite’s performance in the first quarter of 2011 was positive 4%. Over the last fourteen and one-quarter years (since January 1, 1997, the beginning date of our audited track record), KIG has achieved a rate of return of 10.3% compounded annually. In comparison, our stated benchmark, the S&P 500, increased 5.9% in the first quarter and has returned 6% annually since 1997.

Though good on an absolute basis, our quarterly return slightly trailed the S&P 500’s quarterly gain. As we will discuss later, we outpace our benchmark on a three month basis barely half of the time (54%, not much better than a coin flip). However, as we will also illustrate, we progressively increase the percentage of times we outperform as the period length increases until we have a perfect record of outperformance (100% of the time) when you extend the measurement period to ten years. This serves as further confirmation that our focus on time horizons longer than most of our peers continues to be a strategy worth pursuing.

 The Large Cap Conundrum

Over the past several years, we have often written about our penchant for owning high quality, large capitalization stocks. Our affinity is not due to a belief in an inherent investment superiority of large companies versus their smaller brethren; a company’s stock can make a good investment regardless of its size as long as the price paid is substantially lower than what it may be worth. Rather, our collection of large companies is solely based on the discrepancies between price and value we are currently witnessing in the marketplace. Price is paramount in our investment world. It has been said that at one price an investment is a buy, at another it’s a hold, and at still another, a sell. Skipping to the punch line, we believe that at current prices large-caps (not all, of course, but those that meet our investment criteria) are a buy while small-caps are generally a sell.

It seems to us that for the past year, perhaps longer, price does not seem to have been a primary consideration as investors repeatedly made their investments in lower quality, richly priced small-cap companies as opposed to attractively priced, higher quality, large-cap companies. Because of this, the divergence between valuations of small- and large-cap stocks has never been greater. At current levels, the Russell 2000, a small-cap index, trades at 31 times reported income for the trailing four quarters while the large-cap dominated S&P 500 trades at 15 times.

This differential in the prices investors are willing to pay to acquire assets that are (apparently) viewed as faster growing and more economically sensitive could make sense if the starting valuations were reasonable and robust economic growth seemed highly likely. Of course, right now is an unusual time. The Fed is flooding the market with liquidity while interest rates remain near record lows. Despite this, banks are not lending aggressively. Sovereign debt levels throughout the developed world are approaching, or have reached, unsustainable levels. Municipalities are struggling with falling tax revenues and ever-growing budget gaps. China, the presumed growth engine of the world, is trying to cool its housing market, tame inflation, and ensure its banking system can withstand questionable loans made through local government off-balance sheet entities.

 With all of this going on, it seems odd for the strongest businesses in the world to be trading at such discounts. These companies enjoy very strong balance sheets that limit downside risk. Also, while we acknowledge that small companies can grow quickly, the larger companies in our portfolio are not by any stretch of the imagination done growing as most possess much greater exposure to global growth as compared to their small-cap peers. Notwithstanding all of this, we can buy these larger companies at valuations more than 50% lower than their smaller counterparts. The price at which the market is offering the highest quality companies suggests respectable stockholder returns can be obtained even with mediocre cash flow growth from this point forward, and exceptional returns can be expected if growth surpasses that. On the other hand, smaller, and many times lesser quality, equities are only available today at prices that require better than mediocre growth just to breakeven on a return basis with their large cap counterparts. For accepting these worse odds, an investor in lower quality assets is also assuming greater risk of a permanent loss of capital if earnings fall short of expectations. As is our inclination, we like the better odds with less risk.

Why Short-Term Results Don’t Matter – The Data

It’s no secret that we strive to invest your money based upon the principles put forth by Benjamin Graham. The purpose of subscribing to Graham’s techniques is to minimize risk of permanent loss of capital by selecting investments on the basis of value. This method precludes speculation and shuns the timing of purchases and sales based on an expectation of where the market is heading. In other words, our opinions are tied to the long-term prospects for specific companies and are not based on guessing short-term movements in the equity markets or reliance on another buyer to save us by paying a higher price.

When we buy a stock, the timing as to its expected appreciation is uncertain, yet we believe that it is selling substantially below its conservatively estimated intrinsic worth. The excess of that value over our purchase price creates a margin of safety. Having a portfolio full of stocks with ample margins of safety creates a package of attractively valued stocks with potential for appreciation. The often overlooked effect of this investment strategy is that it provides a natural hedge against the risk of permanent loss of capital. Heads we win, tails we don’t lose much.

We have put together the chart below based on our complete (since 1/1/97) performance history. It looks at our audited results over various rolling periods, from three months to ten years, versus the S&P 500.

We have long professed that short-term results (3-months, 6-months, and even 1-year) are little more than noise in a sequence of longer-term, statistically relevant time series. During 3-month intervals, our percentage of outperformance over the S&P is at its lowest point (54% of the time) and steadily increases with each successive longer time period measured. When we reach our longest measured interval (10-year rolling periods) we attain 100% supremacy over our benchmark. We couldn’t have dreamed up (don’t worry, we didn’t) results like this that better illustrate the thesis that compounding wealth is a long-term endeavor and not a short-term game. We will continue to focus on delivering attractive long-term, risk-adjusted returns, even if that might be at the expense of short- and intermediate-term performance. The accuracy of our analysis will determine if we are right, but not when we are right.

Our decision-making process applied to how we allocate your investment capital is the primary driver of our historical outperformance. We will not deviate from past practices and are therefore confident future results, measured over long periods, will be equally rewarding. Fortunately, we have a partner base that shares our long-term value orientation, understands the power of compounding and grants us the flexibility and freedom to apportion capital with this in mind. Having clients that focus on long-term wealth creation as opposed to quarterly performance is a sustainable competitive advantage. It allows us to focus on quantifiable longer- term outcomes as opposed to imprecise and ambiguous short-term market fluctuations. We know the capital you have entrusted to us is significant to you and, because KIG employees and principals have almost their entire liquid net worth invested along side, our incentives are aligned. We want to protect it first and grow it second. We are all extremely fortunate to benefit from an institutional paradigm and organizational structure which ensures rationality and prudence in the management of wealth.

Unknown Unknowns and the Margin of Safety

Our job is to evaluate facts and to apply logical reasoning based on what we know and, almost as importantly, what we don’t know. Donald Rumsfeld’s famous “known unknowns” and “unknown unknowns,” are useful constructs to heed in the investment business. (Regardless of what you think of him, he did have some fabulous quotes.)

To us, the battle to address “known unknowns,” defined by Mr. Rumsfeld as things “we know that we don’t know,” is relatively straightforward. We simply stay away from businesses outside of our circle of competence. If we don’t understand the intricacies of a business or industry and find it difficult to look out multiple years and decipher a sustainable competitive advantage that would make the cash flows somewhat predictable, we willingly pass. Put another way, it goes in our too hard pile. Some of these missed opportunities may work out fabulously well, but our “hit” rate will likely be lower than our preferred batting average. Also, our experience has shown that the investment returns on these complicated businesses that do work out are prone to be ephemeral. If we aren’t quick to sell, the gains tend to evaporate quickly and with minimal warning. To us, being right for the wrong reasons is no better than being wrong. We search for opportunities that are within our circle- where the long-term economic characteristics of the business can be evaluated. We want to be right for the right reasons. We may end up being wrong, but it will not be because we ventured into something we didn’t understand.

 For businesses that we understand well, there are still multiple pit-falls embedded in scenarios that are not forecastable. Future business developments are notoriously fuzzy. In investing, whenever you act, you are effectively saying you know more than the market: you are buying when someone else is selling and selling when someone else is buying. This is an inherently arrogant act and we need to temper it with the humility of appreciating that we could be wrong or that the surrounding circumstances could change. Additionally, and we must always acknowledge we have a lot of smart competitors. Unlike known unknowns, we believe that Mr. Rumsfeld’s “unknown unknowns,” or things “we don’t even know that we don’t know,” are, by definition, difficult to assess. Investing involves a high degree of uncertainty, which we are willing to accept assuming it’s roughly quantifiable. We spend a great deal of time trying to figure out what may severely hinder a company’s future cash flows or even doom it completely. These are factored into our mathematical expectancies (the range of all possible outcomes, adjusted for the probability of each), but in the end, paying a low price (i.e. demanding a margin of safety) is the best way we know to deal with these potentialities. After all, even with rigorous analysis, any estimate of fair value is just that: an estimate, not a precise calculation. The unknowns are always lurking, keeping us cautious and humble. A margin of safety provides a much needed cushion.

The Mathematics of Share Repurchases

Just as we embark on the strategy of purchasing undervalued securities (defined as selling below our estimate of intrinsic value), companies themselves pursuing this policy can increase shareholder value as it applies to purchasing their own stock. In our view, management’s primary goal is to increase intrinsic value per share, and intelligent capital allocation is crucial in influencing this metric. There are a number of strategies a management team can pursue to increase intrinsic value, such as acquisitions or internal growth investments, but these are not without risk. However, if management believes its stock is undervalued, share repurchases probably represent the highest return and lowest risk investment it can make. We prefer seeing a certain return over an uncertain one.

For the mathematically inclined, we’d like to share with you the arithmetic behind our assertion. (No need to suffer through it however- you can just take our word on it.) While it’s ideal for a company to buy back its own stock with internally generated cash, even if the company chooses to take on debt (assuming there is capacity to do so) to fund the buyback, the repurchase can still lead to gains in intrinsic value per share. The first column below illustrates the buyback as done without the use of debt, while the second column details a similar situation using debt to fund the buyback.

 

The capital allocation “default option” for most management teams is to grow its empire. Unfortunately, massive amounts of shareholder wealth have been destroyed using this type of thinking. The act of buying back shares may be unnatural for most management teams because, in effect, they are shrinking their company. Yet management teams that not only understand the link between price and value but also appreciate that they are merely stewards of the shareholders’ capital (it’s not theirs!) will channel the rewards back to the rightful owners through a repurchase plan.

 Many of our portfolio companies are pursuing this buyback strategy and we applaud these management teams for thinking like true owners. There is never any guarantee a particular company will follow through on the whole authorized buyback plan (and they shouldn’t if, for instance, the stock price rises and it’s no longer a great value), but the intention is typically sincere. Often times, the signal of their willingness to do so is just as important as the buyback itself. Below is a sample of recently announced buyback plans by many of our top holdings.

Portfolio Activity

Generally, in order for us to add a new position to the portfolio, we must believe its risk and return characteristics are preferable to one currently owned. While we have been searching as hard as ever, new opportunities remain scarce. This can be interpreted in one of two ways. The market could be valued relatively fairly, thus making new investments meeting our strict price and quality characteristics difficult to find. Alternatively, we are already holding so many significantly undervalued investments that it’s extremely difficult for a new prospect to qualify as materially better. While we actually find some truth in the first explanation - many stocks are indeed fully valued - this is a somewhat normal state for equity markets (extreme periods of overvaluation (January 2000) or undervaluation (March 2009) are more the exception) which we have navigated many times before and still found ample new opportunities to replace current holdings that neared our target prices. What’s different this time is that many (perhaps most) stocks are trading in a very narrow valuation band, meaning discounts to our estimates of intrinsic value are fairly uniform. While somewhat counterintuitive, the implication of this is that finding few new positions does not undermine our view that our current holdings are indeed cheap.

Keeping with this theme, we did add two new positions during the quarter; however, we did not sell an existing holding in order to make room for them. These positions were specifically targeted for newer clients who were not yet fully invested or longer-term clients who may have added additional funds but were not fully allocated to equities. Target (TGT) and Kohl’s (KSS) are two national retailers with excellent histories of store-level execution, solid financial profiles, and generating high economic returns while continually growing their business values. Current conventional wisdom posits that consumer related stocks will continue to struggle due to high unemployment and a continued overhang from the housing crisis. However, a consensus opinion is neither what we ascribe to nor seek. Each of these company’s current market values reflects that its inherent strengths and future growth in cash flows is likely being underestimated. Unorthodoxy does not make us right, however. That only comes if our knowledge is sound and our reasoning, grounded in logic, leads to superior analysis. We feel confident that this will be the case.

We increased our position in CVS Caremark (CVS) by selling down a commensurate amount of Walgreen. Our investment case for Walgreen Company (WAG) remains intact (even after a substantial run-up in the share price) as evidenced by the fact that it remains our largest position even after the swap. However, our affinity for CVS Caremark has grown as the share price trades at substantial discount to our very conservative estimate of value. Created by the merger of the CVS pharmacy business and the Caremark pharmacy benefit management (PBM) business, the combined entity’s innovative plan to become an integrated pharmacy services provider with tremendous purchasing benefits has not gone smoothly. While the CVS business is performing well due to the boost in store traffic from the merger, Caremark has lost some significant contracts and has struggled to win as much new business as had been anticipated. While we are somewhat disappointed, we believe that practically no value is being ascribed to the PBM business at the stock’s current price. While we think the current steps management is taking to fix the PBM’s marketing message are sound, we can win on this investment in two ways. Either they repair the business and the market attributes an appropriate value to the PBM, or they admit the merger was a mistake and sell or spin off the PBM, unleashing its inherent value. This is a good example where buying right mitigates the risk of loss, as the current price is above our purchase price even with these company specific negative issues.

Quotes

“Most victories come from exploiting your enemy’s stupid mistakes and not from any particular brilliance in your own plan.”

- Scott Orson Card “More money has been lost reaching for yield than at the point of a gun” - Warren Buffett, 2010 Berkshire Hathaway Annual Letter

 

 

 

(c) Kovitz Investment Group

www.kovitzinvestment.com