We recently completed and sent to our investors the 2011 Annual Letter. Below are three excerpts from the letter that discuss key philosophical underpinnings of how we run the Partnership and think about investing.
Excerpt 1: Thoughts on Cash
In July, we sent you an e-mail entitled “Mid-Year Update.” We now follow up on three main points that were discussed in that e-mail: our return, cash, and our thoughts on managing your portfolio.
The second item from the Mid-Year Update was cash, which comprised 33% of our portfolio as of June 30th. Below is what we wrote:
“The overall market right now is highly priced, so finding inexpensive investments in which to place your money has become more difficult. We are actually comfortable with the cash balance right now. We are ready to invest in new opportunities as they arise but will also be ready to pick up cheap stocks if the bottom falls out of this market. We are currently invested in over 10 stocks. There are another 20 companies that we have fully analyzed and love the businesses but have either not been able to get for a price we like or previously owned the stock and sold it when it reached our valuation. If the prices of any of these companies drops enough along with the rest of the market, we will be ready to pounce. It is not likely that we will be invested in over 30 companies, just to be clear. After all, our 30th best idea is probably not as good as our #1 best idea, so we will be judicious about which companies to put your money into based on how much we like the business and how cheap the stock is compared to its value.”
The S&P 500 dropped 17% over a course of two weeks beginning roughly eleven days after we sent the Mid-Year Update. We quickly began putting cash to use, buying more of the Partnership’s existing holdings and buying new investments that finally reached an entry point with a reasonable margin of safety. In addition, over the last six months of the year, the size of the Partnership doubled due to new investors and positive returns. As we received additional funds, we continued to put that cash to use, resulting in a materially lower cash position at year-end despite the large influx of investor contributions. Being patient and ready to strike certainly paid off over the latter half of the year.
Excerpt 2: Focus of our Investment Approach
We would like to reiterate our approach to investing, if for no other reason than because we thoroughly enjoy talking about it. We have always sought out companies with durable competitive advantages, in industries that we understand, with management we trust, and selling at a significant discount to our internally-developed valuation. As you might imagine, companies meeting the first three criteria rarely meet the fourth. Those companies can be found in abundance when the overall market is down significantly as it was in 2008 and 2009, but what about when the market is at a normal or excessive level?
The answer is to seek out companies with stock prices that are suppressed for reasons inconsequential to the long-term operations of the company. So, with increasing frequency, we have sought out companies with suppressed stock prices due to fear, uncertainty, or relative obscurity. We then conduct our thorough due diligence to determine if those obstacles can be overcome. We invest in the company if the price is materially less than our valuation, which is always conservative in our view and accounts for the risks the market fears.
One of the more common market fears concerns a normal industry business cycle. Typically when times are booming, more competitors emerge, capacity increases, and eventually supply exceeds demand, leading to a downturn. Conversely, when times are bad, the poor performers disappear, capacity is reduced, and eventually demand exceeds supply, leading to improved business prospects and the inevitable upswing in the business cycle. However, the market has a short memory and is focused on the here and now. As a result, when an industry is at its low point in the natural business cycle, the market appears to believe it will stay there forever despite years of evidence to the contrary. We are happy to take advantage of this situation by loading up on best-in-class businesses with insurmountable durable competitive advantages while still relatively inexpensive. It may take a few years for these stocks to reach our valuation as the market slowly overcomes its fear and as the industry steadily improves, but the annualized return certainly will make it worthwhile if we require a large enough discount to valuation. For example, if we buy a company at a 33% discount to value, indicating a 50% potential upside from the purchase price, and the stock reaches our valuation in 2 years, then we have realized a 22% annualized return. Even if it takes 3 years, we still would have realized an annualized return of 14%. Further, the downside risk is very low since worst case scenarios have already been priced in, and the stock will improve substantially at the first signs of sustainable industry turnaround due entirely to the strength of the company’s operations. These investments simply require patience and conviction.
Another type of suppressed stock that usually has a faster payoff is affectionately called a “work-out.” These stocks have specific negative issues hanging over their heads and thus keeping the price down. Examples include the potential for debt covenant violations in the near-term, the loss or potential loss of a major contract, companies emerging from bankruptcy, the fear of new laws impacting business, or potential litigation. All of these fears usually quickly become fully priced into the stock, resulting in a rather large and rapid increase in the stock price if the specific issue works out positively for the company. The key is to make very certain that the issue has a high probability of working out favorably for the company while also ensuring that worst case scenarios already are priced into the stock by the time of our investment to protect our downside.
Finally, we pounce on the opportunity in obscurity. Obscure companies are followed only by few major analysts, if any, and are almost always small cap stocks. If we can find a very well-run company with a durable competitive advantage in an industry we like and understand, and determine that it is relatively unknown, we become very excited. To us, this sort of company is the Holy Grail of investments because we likely can look forward to years of large returns as the company grows and the market slowly learns about its existence.
What makes these investments successful, whether it be turnaround of an industry, favorable work out, or transition from obscurity, is called the catalyst. We seek to understand what the potential catalyst is for every investment and when we expect that catalyst to occur. In this, as with all things, we are conservative in our assumptions. As a result, we are often met with pleasant surprises.
We strive diligently to find as many as these types of investments as we can, but we only want to invest in the 10-20 that represent the absolute best opportunities after taking into account potential upside, possible downside, and the probability of the catalyst occurring.
Excerpt 3: How to Analyze a Certain Type of Work-Out
Another “work-out” we are proud of is Gentiva (GTIV). Most of you are familiar with Amedisys (AMED), a publicly-traded home health and hospice company headquartered in Baton Rouge. GTIV is one of AMED’s primary competitors. We do not come across this type of situation often, but when we do, the results can be spectacular. You may recall that in late 2010 we bought Dean Foods when the market bid down the price drastically over debt covenant fears only to see the debt agreements get amended to avoid a debt covenant violation. We made over 40% in a matter of months on that investment. GTIV presented the same situation.
Around the time AMED lowered its guidance during the fourth quarter and new cuts in Medicare rates for home health were announced, GTIV saw its stock price drop farther and faster than its peers due to potential debt covenant violations in the near-term. We immediately went to work analyzing the company to determine the probability of the covenants violations being avoided either through better than expected results or debt agreement amendments.
When assessing these types of situations, we have a few criteria that must be met. First, the company must be free cash flow positive. It is important to understand that banks do not want their borrowers to default, especially on a technicality, if it can be avoided. Further, those debt covenants exist to ensure that the company has the wherewithal to pay its debts. Therefore, if a company can continue to pay its debts despite violating a covenant, then the bank is all too happy to amend the agreement and to continue receiving its normal debt payments. Second, we check to see when the next major principal payment is due since most corporate bank debt is structured to pay only interest for a while and then pay off the principal all at once. If the principal payments are not due for a number of years, then the risk of not having the cash available to make debt payments in the near-term is very low, particularly if the company is free cash flow positive. Finally, we make sure the company has a good relationship with its bankers, which can be evidenced by a history of favorable and amicable debt agreement amendments or simply no issues at all in the past.
GTIV met all three criteria with flying colors. The company is a cash cow that generates more than enough free cash flow to make regular debt payments, the next major principle payment is not due for 4 years, and GTIV had already amended its debt agreement earlier in the year to more favorable interest rates. So we happily invested. Within a month of our investment, a debt agreement was reached, and we finally sold in early January after realizing a return of 58%.