Investment Bedrock

By Kurt Hoefer, C.F.A.

Golub Group

Those of us who live near earthquake faults know that pressures build and are periodically released. The stock market behaves similarly, and excesses are corrected. In the market, we are willing to live with uncertainty, as we do in life. But because we are risk averse, we try to build our homes on bedrock, and do the same with our investment portfolios.

What is the investment equivalent of bedrock? We favor large, multinational, “Blue-Chip” companies because of their solid balance sheets, seasoned managements, durable competitive advantages, consistency of earnings and propensity to pay dividends. By investing in the shares of these companies, we dramatically reduce the risks that come from shifting business models, economic recession, liquidity crises, etc. – all of which can have cataclysmic results on smaller, poorly-financed companies. But as important, we firmly believe that we hit bedrock only when the shares we hold are cheap relative to their intrinsic value. This is a condition that presently prevails with Blue-Chip, large capitalization companies, such as the ones we hold in our clients’ accounts.

Our Core Investment Philosophy

We describe our investment philosophy as being simple, but not easy. Much of our thinking derives from the teachings of the late Benjamin Graham, who was an influential economist and professional investor, and often referred to as the “Father of Value Investing.”

Benjamin Graham is perhaps best known today due to frequent references made to him by billionaire investor Warren Buffett. In fact, Buffett describes Graham’s book, The Intelligent Investor, as “the best book ever written on investing.” We agree and have based our investment philosophy on the following three core principles described in Graham’s book:

• Business Perspective Investing: As stated by Graham, “Investment is most intelligent when it is most businesslike.” In other words, an investor should think of stocks as partial ownership interests in a business and not be overly concerned with the daily fluctuations of the stock market. This perspective helps the investor to eliminate any irrational reasons for purchasing a stock, and focus on understanding the merits, risks, and long-term potential of the company as well as the ability, integrity, and determination of the company’s management team.
• Margin of Safety: When a company trades in the market at a significant discount to a conservative estimate of its intrinsic value, a "margin of safety" exists, making it suitable for investment. Investments with a wide margin of safety have minimal risk and high return potential. Investments that lack a margin of safety are not investments at all, but are merely speculative gambles that have high risk and most often low long-term return potential.
• Mr. Market: The market is not there to guide you in determining the value of a business but, rather, is there to serve you and to be exploited. To explain this concept Graham used an analogy he named “Mr. Market.” Mr. Market is an obliging fellow who appears every day willing to buy and sell shares to you. Often Mr. Market is depressed and quotes you a very low price for a very good business. Other times Mr. Market is euphoric and quotes you a very high price for the same business. Under the former circumstances you should buy shares and under the latter circumstances you should sell your holdings to Mr. Market. The point of the analogy is that the market price of a security does not necessarily reflect the true underlying value of the business. It is through patience and discipline that investors can take advantage of the “ups and downs” of Mr. Market.

These principles are simple. The challenge lies not in the ability to grasp the meaning of the principles, but rather lies in the ability to adhere to them when speculative market trends temporarily outperform. During periods when stocks are overvalued and speculation is rampant it is important to remember another of Graham’s important lessons, which he so succinctly stated, “In the short-run the stock market is a voting machine. In the long-run the stock market is a weighing machine.” By this, Graham means that short-term security performance is primarily driven, not by business fundamentals but, instead, by the emotional “votes” of Wall Street. In contrast, long-term security performance is driven by Wall Street’s “weighing” of a business’ performance. We hold Graham’s words as gospel. For this reason, we are willing to forgo short-term performance based on speculative market trends and, instead, invest in securities only when it is intelligent to do so.

The Value of Dividends

We know Advisor Perspectives readers are well versed on the virtues of dividends when investing in stocks. No argument here. Dividends and dividend growth are a significant part of the long-term total return of a stock. Dividends provide a buffer should an economic slowdown translate into lower capital returns. Dividends reduce portfolio volatility, because they tend to be fairly stable – management teams are loathe to cut their dividend. Finally, a dividend payment is a signal that management believes its earnings will be strong and persistent over time – a sign it has confidence in the long-term growth of its business despite changes in the economic environment.

On the surface, it seems straightforward to find and invest in dividend-paying companies. However, in this environment, where there have been 975 negative dividend declarations over the past 12 months as companies have chosen or been forced to conserve cash, blind faith in the current payout is not enough. The investor must evaluate a company’s ability to pay and increase its dividend by analyzing its sources and uses of cash flow. Some companies that are in decline pay large dividends because they cannot find good growth opportunities in which to invest. The ones we’re attracted to, on the other hand, are growing companies led by experts at allocating shareholder capital. These management teams invest their profits back into their businesses but also return some of these profits to you, the owner. Having a clear understanding of a firm’s underlying cash flow makes it much easier to predict the sustainability and growth of its dividends.

Companies with Sustainable Dividends

A Wonderful Opportunity

The Golub Group believes that we are on the verge of the greatest migration toward dividend-paying stocks in stock market history. We believe that those of us who invest in the biggest, strongest, Blue Chip businesses in the world, which have the ability to sustain and raise those dividends for years to come enjoy a rare opportunity. Trillions in investor dollars are currently caught between a rock and a hard place, too fearful to venture at this moment into stocks but highly dissatisfied with the meager income received from savings accounts and money market funds. We believe this tension, brought on by dividend yields at the highest rates in decades, will cause an enormous movement over the next few years into the kind of stocks held in Golub Group’s portfolio.

Kurt Hoefer, CFA

Golub Group, LLC
www.golubgroup.com
2929 Campus Dr, Ste 145
San Mateo, CA 94403
(650) 212-2240 Phone
(650) 212-2249 Fax

(c) The Golub Group, LLC

www.golubgroup.com