We insist on owning quality companies characterized by their financial strength and proven ability to create high returns on invested capital. Protecting capital also requires building in a margin of safety, which we do by buying below our estimate of each company’s true value. Our knowledge is used to determine both the quality and value of each company. Our discipline is used to focus on owning our best and most reasoned ideas.
To us, quality businesses are those that can substantially increase in value over time. A common attribute of quality companies are those that consistently generate significant cash flow as a result of the following:
We only invest in a company after calculating our best estimate of its fair (intrinsic) value and only when there is a significant discount between a stock’s actual price and our estimate of its value. The discount between a company’s stock price and our estimation of its intrinsic value is the ‘margin of safety’. This is an essential element for capital preservation as we pay significantly less than what the company is worth and returns are enhanced as the margin of safety gap closes.
Portfolio diversification is essential to reducing risk, but only up to a point. As the chart below1 demonstrates, 95% of non-market risk (deviation from the index) is eliminated by a portfolio holding approximately 20 companies, spread amongst multiple industry groups. Adding substantially more companies increases frictional costs and ultimately dilutes the benefits of allocating capital to our best and most reasoned ideas.