In the tradition of Benjamin Graham, we believe that a share of common stock is a piece of a business. Analysis must begin with determining a fair price for the entire enterprise, then dividing that price by the outstanding shares, with an appropriate adjustement made for expected dilution from convertible securities, employee stock options, and secondary equity offerings.
Our job as managers is to put together a portfolio with the highest risk-adjusted look-through earnings yield five years from now, and structure it to avoid correlation and wipeout risk. This philosophy leads us to grow more enthusiastic as stock prices fall and more cautious as they rise.
In addition, we do not automatically sell shares of stock once they have reached fair value. Instead, we determine the unrealized capital gain on the investment and calculate the taxes that would due were we to sell. This deferred tax liability, in effect, represents an interest-free loan from the United States Government. By trading out of the stock, we are forced to pay the tax and have less overall capital at work. Thus, the new investment must generate high enough returns to compensate for the loss of capital. We are cognizant that many mistakes are made in an effort to minimize tax bills so if we believe shares of a company have been overvalued we will not hesitate to remove them from our books and transfer the proceeds into high grade cash equivalents.
Our stock activities include the following strategies:
Core Long-Term Holdings (The “Blue Chip Reserve” Portfolio)
These are businesses that we expect to compound at 8% to 11% on our cost basis, with dividends fully reinvested. Often, they are characterized as boring corporations with steady cash flows, established brands, conservative management, and demonstrated ability to act as prudent stewards of shareholder capital. The blue chip reserve portfolio includes companies such as Johnson & Johnson, Berkshire Hathaway, Procter & Gamble, General Mills, Kellogg’s, J.M. Smucker’s, General Electric, Wal-Mart Stores, Target, and Markel. We have no plans to sell or reduce these stakes. When prices are attractive, we actively add to our positions, often funded by redeploying earnings from the operating businesses.
Valuation Based Holdings
Historical evidence has shown that companies trading at deep discounts on financial ratios such as price to earnings, price to cash flow, price to sales, price to book value, or that boast high dividend yields, often provide market beating returns if they are purchased on a widely diversified base and companies with unusually high debt to equity ratios are removed from consideration. This portfolio is run very much in the style of the great value investors such as Tweedy, Browne & Company or Walter Schloss, seeking to identify cheap, unloved, unattractive businesses, and selling them when they reach our conservatively calculated estimate of private market value to a rational buyer. In some cases, we buy baskets of stocks such as a sector ETF to get exposure to an entire industry if we believe that it is being temporarily depressed due to market conditions.
Proprietary Trading
We employ several trading strategies to profit from temporary market conditions. These can involve the purchase of large blocks of heavily traded stocks, held for small incremental gains per share. In many cases, these are companies we would be willing to hold for a longer timeframe, if necessary. This technique, sometimes referred to as range-bound trading or channel trading, has been highly profitable for the capital division of Chenille Appeal, LLC since the beginning of the credit crisis. These positions are sometimes offset by full or partial hedges to reduce our aggregate exposure. This is a very small part of our overall portfolio and depends entirely upon the opportunities, pricing, and irrationalities available at any given time in the market.
Another activity that falls under our proprietary trading operations includes the purchase of deep-in-the-money options, including long term equity anticipation securities, that we believe are undervalued. Small fluctuations in the underlying stock price result in much larger changes in the option. Sometimes referred to as swing-trading, this structure allows us to amplify the returns from our range-bound and channel-trading activities.
Corporate Restructuring
Although we typically avoid turnaround situations, we are very interested in spin-offs and other corporate restructurings because it is often possible to get far more value for your money as shareholders of the parent company sell their newly received stock en masse, artificially (and temporarily) depressing the price. This type of activity has a long history with our firm when our Chairman and CEO placed a large portion of his net worth into Goodrich during his freshman year of college. The subsequent spin-off of EnPro Industries, which generated more than 1,000% gains and are still held on the books, resulted in a long, multi-year study of the economics of corporate distributions, leading us to dedicate a portion of the overall capital markets activity to the discipline.
Global Equity Holdings
Great values can be found not just in the United States, but anywhere in the world. Our equity investments include companies in the Netherlands, Switzerland, Great Britain, Ireland, France, Germany, Italy, Hong Kong, Japan, Mexico, Canada, Belgium, Sweden, Norway, and Brazil. We apply the same strict value based criteria for selecting appropriate holdings, making adjustments for international accounting standards.