Methods of Operations
Our avenues of investment break down into particular categories, each of which we expect will generate absolute returns north of 15% over 3-5 year intervals. We expect this approach, will lead to lower volatility, lower losses in down markets, and positive returns in flat/up markets. Our operations, are divided into 5 major parts, consisting of Generals (i.e., great businesses bought at bargain prices), Special Situations, Options, Shorts, and Macro Hedges. The way our capital is divided amongst them will have an important effect on our results in any given year (both on an absolute basis as well as relative to the S&P 500). Also, the actual percentage division amongst the categories at any given time is to a degree planned, but to a great extent accidental, and based upon availability factors and current market conditions
We feel that our unique, certainly unconventional, approach – which is modeled on Warren Buffett’s original private partnership from the 1950’s – offers investors a truly prudent and risk-averse strategy for both preserving principal and achieving consistent and above average capital appreciation for years to come. We believe (like Buffett believed), that the various areas of our investment operations are considerably more powerful taken together than any one of them is alone in producing consistently attractive absolute returns over an extended time frame.
In our opinion, those who focus only on one category at the exclusion of the others are at a meaningful disadvantage. By having a multifaceted and adaptable tool kit at their disposal, risk-averse, bargain hunting investors have a chance to do well in both good times and bad – and generate attractive absolute and relative returns with limited risk over 3-5 year intervals.
A Value-centric Philosophy:
The heart of our strategy is built upon the foundation of value investing originally developed by Ben Graham, and successfully applied (and further developed) by Warren Buffett, Joel Greenblatt, Seth Klarman, and others. Simply stated, we believe in concentrated value investing, which basically translates into buying assets for significantly less than their true value and selling them at or close to that value. There is simply no other investment strategy that comes close to offering the potential for extraordinary investment results over time, let alone in conjunction with limited downside risk.
Again, history has shown that the value approach has offered investors not only the best approach to protect against substantial economic loss, but the surest and best means available to achieve long-term, above-average profits in the stock market.
An Emphasis on Investing In Less Efficient Areas of the Market:
Our experience has shown that attractive opportunities to purchase grossly undervalued securities arise with a surprising frequency in a number of areas that not only can be identified, but consistently exploited by the bargain hunting investor. Legendary investor Joel Greenblatt dubbed these areas of opportunity as, “the secret hiding places of stock market profits.” Indeed!
Anyhow, it should be no surprise to novice and professional investors alike, that mistakes in pricing are not distributed uniformly over all areas of the capital markets. At AAO, we focus our search for opportunity on only those areas that tend to misprice assets on a relatively consistent basis. This should continue to be a successful approach for us.
For those who are unfamiliar with this dynamic, consider the following example. A small publicly traded firm without any analyst coverage will tend to get mispriced much more often than say a multi-billion dollar blue chip that is covered by every firm on Wall Street. The market is simply more prone to error – and therefore more prone to misprice – a business when there are very few securities analysts scrutinizing its public financial statements (and vice versa).
Superior Portfolio Construction and Risk Management:
The portfolio’s strategy is modeled after the original Buffett partnership from the 1950’s. Taking our cue from Buffett, we use overall portfolio structuring as a defensive tool by focusing on how each of our investments will work together in the context of the portfolio as a whole. The aim of this integrated approach is two-fold. First, it creates a portfolio that will minimize the volatility of our returns as well as the correlation of the portfolio’s performance with that of the broader equity and debt markets. Second, it provides a multifaceted and adaptable tool-kit that positions our portfolio to profit in any market environment, and better yet under a wider range of outcomes.
Our belief is that if investors hope to truly build a portfolio for all seasons, only a portfolio with significantly undervalued securities in combination with intelligent portfolio management can get the job done. Simply buying cheap stocks isn’t enough (as 2008 and early 2009 have shown). Notably, those who utilized a portfolio structure and risk management approach modeled on Buffett’s (at least loosely) managed to escape the recent meltdown relatively in-tact. Again, what is so brilliant, unique, and powerful about Buffett’s model is that it provides the blueprint for a portfolio structure that not only is (1) designed to generate above average investment returns on a consistent basis, but (2) specifically built to promote survival in a catastrophic scenario.
Within each area of our investment operations our goal is to make money, or at least preserve capital, on every investment. This means that securities within our portfolio should be sufficiently mispriced, so that if we are right, we will do well, but if we are mostly wrong, we should get our money back (or at least most of it). To put a little differently, with every investment we make, our fundamental analysis will always indicate not only an attractive expected return but also limited downside. For us, this means that it is difficult to envision a scenario or environment where we would suffer a significant and permanent loss of capital (i.e. the real definition of risk). Because we have a healthy respect that the future is inherently uncertain, we search for investment opportunities where we expect to make money under any reasonable outcome.
To reiterate, our investments will nearly always possess significant downside protection (i.e., limited downside risk). A security is deemed to possess downside protection if it was purchased at a large discount to our estimate of intrinsic value. Our appraisal is based either on the value of the company’s assets (such as cash, accounts receivable and real estate) or the present value of estimated future cash flows, or both. Every situation is different — how we arrive at an estimate of fair value will reflect the peculiarities of the particular situation. Once we estimate fair value, we ask a number of questions that help us build conviction that the current value will be safeguarded and, in fact, increased over time.
An Emphasis on Catalyst’s:
A primary focus of our research process is to identify event-driven situations (or value investments with a catalyst) in which a potential event could lead to a significant revaluation, up or down, in a company’s securities. Positive potential events (i.e., catalysts) could include operational restructurings, recapitalizations, turn-arounds, spin-offs of a business or division, change in management or the outright sale of the company. Negative potential events could include a liquidity crisis, adverse litigation outcome, or the exposure of accounting or other irregularities.
We believe that the presence of a catalyst serves to meaningfully reduce risk, as it partially eliminates our dependence on market forces for investment profits (and therefore further augments the margin of safety we have already achieved by investing at a discount from underlying value). In other words, if the gap between price and underlying value is likely to be closed quickly (as is the case with catalyst driven investments), the probability of losing money due to market fluctuations or adverse business developments is reduced.