Intrinsic value is the cash generated by an investment. Fundamental value is earned in the future as dividends, interest, and principal are paid or as retained earnings are successfully reinvested. Risk is the likelihood and potential magnitude of a decline in investment cash flows or the payment of a market price at purchase which, is higher than the fundamental value.

When buying, we never confuse fundamental value with market price. Market price is what we pay. Fundamental value is what we get. Market price may be found quoted daily in the financial press. Investment cash flows determine fundamental value.

Market price, it follows, is not a barometer we would use to evaluate corporate performance. Our corporate performance evaluation is based on income, assets, and return on capital. We view the stock price of a publicly traded company simply as a record of what others – well – informed or not – were willing to pay for it at various times in the past.

Fundamental value is a critical concept because it is the only reference point for what an investment is worth and, therefore, whether or not the market price is fair, high, or low. Two facts support this view. First, the theoretical point that an investment is worth the present value of its future cash flows is self-evident and undisputed. Second, new-era theories that have driven prices to speculative levels in the short run have always succumbed to the basic idea of fundamental value in the long run.

Investor portfolios must contain primarily quality investments. By definition, the portion that is not quality is subject to unpredictable and material loss. Therefore, we recommend that risky investments represent a small portion of the investor’s portfolio.

We define quality at the investment level. A reliable stream of cash flows justifies the price of a quality investment. Any other type of commitment is speculative.

A quantifiable margin of safety is the hallmark of a quality investment. For fixed-income investments, (a) an issuer’s available resources must be significantly greater than the interest and principal due the investor, or (b) the assets backing an issue must be significantly greater than its price. The former applies to high-grade bonds, the latter to low-grade bonds.

For equity investments, (a) the intrinsic value of a company must be significantly greater than its price, or (b) the probability of achieving a desired return must be very high. The latter provides a perspective on value, which may be applied to high-grade equities.

True understanding is built upon high-probability statements about businesses and values. It requires a dogged determination to get to the bottom of things and an equally resolute honesty about whether or not we did.

Understanding is also relative. Achieving better-than-average returns requires understanding security values better than average. The problem is most investment managers believe they are better than average.

Competence and honesty are the keys to ensuring we are not fooling ourselves. Competence means we can estimate business values and returns for our portfolios and the markets in which we participate. Honesty means we are candid about our relative return advantage or lack thereof.

Proper diversification is paramount to quality at the portfolio level. Proper diversification is achieved when the overall portfolio return is protected from unexpected adverse results in individual holdings, industries, or countries.

Proper concentration can be risk-reducing as well as value-enhancing. Concentration refers to making more significant commitments to more attractive investments. The greater the difference between intrinsic value and market price, the more robust our knowledge of an investment’s value, and the lower the risk of the investment, the more wealth we will concentrate in that investment.

Successfully executed, concentration has three benefits: (a) returns are enhanced by selecting investments with the highest probability of success, (b) risk is reduced by avoiding mediocre and poor commitments, and (c) knowledge is improved by concentrating the analytical effort.

A concentrated portfolio with fewer holdings is desirable when value-to-price, understanding, and quality are high. A low-cost, more widely diversified approach to a market is appropriate when there are no clear advantages in knowledge and, therefore, in our ability to evaluate quality or estimate value-to-price.

One of the greatest risks investors face is selling low in a panic. Education and communication can significantly reduce this risk. We explain to clients the difference between intrinsic and market value and openly share the rationale behind our investment decision-making. We believe this significantly reduces the risk of clients selling at market bottoms or buying at market tops.

Communication is also essential for evaluating an investment manager’s abilities. Luck, risk, and a bull market can make an incompetent manager look brilliant. Conversely, every brilliant manager will underperform at some time, which is usually the best time to invest with them. Investors must look beyond performance to evaluate manager competence. To aid current and prospective clients in this endeavor, we regularly discuss the strategy and holdings behind our performance, and candidly address both our successes and errors.