Market and Performance Summary

The Kovitz Investment Group^® (KIG^®) Equity Composite increased in value by 13.4% (net of fees) during the first quarter, surpassing our primary benchmark, the S&P 500, which rose 12.6% for the quarter. 

The chart below summarizes annualized performance results through March 31, 2012 for the KIG Equity Composite compared with the S&P 500 Index. Our goal is to outperform this index over the long term as we have done in every ten-year rolling period since the beginning of our audited track record on January 1, 1997 (64 such periods). Since inception, our results have exceeded the benchmark on an annualized basis by 4.2% per year after all fees and expenses. Consequently, a hypothetical $1,000,000 invested with us fifteen and one-quarter years ago would now be worth approximately $4,528,000, while the same $1,000,000 invested in the S&P 500 would now be worth $2,495,000. These results are further confirmation that our focus on time horizons longer than most of our peers continues to be a strategy worth pursuing.

 

KIG vs. S&P 500

Annualized Equity Performance (Net of Fees)

 

	1-Year	3-Year	5-Year	10-Year	Since Inception
KIG	10.7%	23.9%	2.7%	5.1%	10.4%
S&P 500	8.5%	23.4%	2.0%	4.1%	6.2%

 

 

Portfolio Outlook

Business headlines continue to bemoan the uncertain global economic environment. European sovereign debt issues remain even in the face of a “fixed” Greece. A slowdown in China looms while Iran threatens with potential nuclear capabilities. However, based on the strength of the market throughout the quarter, investors appeared to look through these issues. Were equity investors blithely ignoring these risks? Were these events already discounted in stock prices? We don’t necessarily have an answer and fortunately it’s of little relevance to us and the way we invest. The heart of our approach is to recognize, and take advantage of, the difference between a company’s intrinsic value and its stock price. Our estimate of intrinsic value is a function of how much cash we believe a company will generate over the next few decades while its stock price is largely a function of investor emotions and expectations of what the company or the economy may do over the next several weeks or months. At times, stock prices can be schizophrenic, but they consistently revert to reasonable assessments of fair value in the end. The above, and other macro issues, may cause momentary dislocations in prices, but they will likely have little to no impact on intrinsic values. 

To that end, our portfolio, in aggregate, is currently made up of the highest quality companies we have ever owned. Fundamentals at the individual company level are generally robust. Balance sheets are sturdy with high levels of cash and minimal debt. Cash flow generation is healthy due to a combination of revenue growth and increasingly efficient cost structures. Competitive positioning remains durable and is even improving in certain cases. Overall, the quality of our portfolio of businesses far surpasses that of the random collection of hundreds of companies that make up our benchmark. Given these facts, it would be reasonable to expect valuations of the individual securities to be high relative to their conservatively estimated fundamental worth. Fortunately, we don’t believe that to be the case.  In fact, market valuations appear to be discounting these companies as mediocre as many of our largest holdings sport free cash flow yields that are high on both an absolute basis and relative to the aggregate yields of our benchmark’s individual constituents.

Last quarter we introduced the concept of the Price-to-Value (P-V) ratio, a metric we use to track the market valuation of our portfolio relative to our assessment of fair value. The P-V ratio of the portfolio as of March 31, 2012 stood at 79% versus 74% at December 31, 2011.  All else being equal, a 13.4% rise in the market value of the portfolio since the end of last quarter should have caused an equal rise in the P-V ratio to approximately 84%. The fact that the current P-V ratio remains less than that implies that the intrinsic value of our holdings continues to grow at a reasonable pace, albeit a pace less than the 13.4% rate prices experienced in the quarter.

What all this means is we own companies whose stock prices are selling at large enough discounts to their intrinsic values that we are comfortable holding through potential market turbulence. If macro-economic issues, political headwinds, or the short-term gyrations of the stock market force us to wait a little longer for the ultimate payoff . . . well, we can think of worse things.

 

Portfolio Activity

Activity during the quarter was benign. We did not initiate any new positions, nor did we completely exit any.  Other than choosing to remain fully committed to our high quality collection of individual equities, the only decision of note was to increase our position in Biglari Holdings (BH) in conjunction with reducing our exposure to Red Robin Gourmet Burgers (RRGB). Red Robin has seen its stock price rise over 70% since our initial purchases at the end of 2010 (in comparison, the S&P 500 has increased approximately 15% since that time). Our investment thesis at that time was predicated on the fact that Red Robin had a solid franchise with an underperforming store base, yet the company still generated abundant amounts of cash. We believed the company’s shareholders would be better served by ceasing company-owned store expansion and concentrated on improving the customer experience, reducing costs, focusing new unit growth on franchise opportunities, and using excess cash to buy back stock. Together with another Chicago-based investment group, we bought a significant stake in the company, sought board representation, and secured one seat. The company implemented many of our suggestions, and the stock price rose as store-level performance improved. As we assess the situation today, we believe the company has navigated a successful turnaround and we look for unit-level economics to continue to improve as same-store sales increases are coupled with further cost reductions. However, the company has begun to recommit capital to new restaurant openings, reducing free cash flow commensurately. While these investments should provide adequate returns, we felt it prudent to take some money off the table given the size our position had grown to and reinvest the proceeds into another restaurant company, Biglari Holdings. Biglari’s Steak ‘n Shake subsidiary has been a top performer in the restaurant industry over the last three years as its high quality value offering has led to hefty gains in customer traffic. Yet, the shares trade at less than ten times our estimate of operating free cash flow, a large disparity to what we believe this company is conservatively worth. Sardar Biglari, the Chairman and CEO, is also continuing to implement his holding company concept where he utilizes cash flow from the company’s restaurant subsidiaries to make investments, in whole or in part, in outside companies. When we include this portfolio of cash and investments (net of debt) in our fair value estimate, we believe the stock is among the least expensive we own. 

 

Investing Scared

Every time we commit capital to an investment, we worry. We worry about the possibility of a permanent loss. We worry that there is something we don’t know or that we may have failed to properly analyze pertinent information (e.g. competitive position within an industry or industry growth rates). We worry about being blindsided by bad luck or a surprise event even if our analysis is accurate. We worry that maybe we could have gotten it a little cheaper. Yet we couldn’t imagine thinking any differently. Investing scared prevents hubris and forces us to make sure we’re as diligent as possible on each and every decision. Most importantly, it compels us to insist on an adequate margin of safety - to not pay a price so high that it presupposes things going right (i.e. that there is nothing to worry about).

Investing scared does not mean that we lack confidence in our decisions. It’s more an admission that, as much as we’d like to believe we control our own destiny, the future is unknowable. To think that we have all the answers or that we can predict how multi-variate investment paths will precisely play out is not only foolhardy, but reckless. It’s not just intellectually reckless, but it could lead to permanent losses of capital, which it is our goal to avoid above all else. 

Concerning the future, Nassim Nicholas Taleb, in his book Fooled by Randomness, meticulously points out how easily random events can make good decisions look wrong and bad decisions look right. In other words, the randomness of future events is, well, random, and the necessity of incorporating that into an investment approach of paramount importance. What confidence we lack in foretelling the future is replaced by the confidence we do have in our process. Based on years of developing and refining our methodology, we have learned to trust it. Spending our time focusing on understanding business models, assessing competitive positions, and scrutinizing financial statements with the ultimate goal of ascertaining the intrinsic value of businesses works well for us. Patiently waiting for particular valuation metrics to appear keeps us disciplined. Continually updating our assessment of the expected risk-adjusted returns on our current portfolio holdings keeps us unemotional in the face of the “panic du jour.” While not foolproof, the overall results have proven satisfactory based on our long term performance record.

One tactic we use to stress test our ideas in order to lower the odds of a mistake is the pre-mortem. Instead of analyzing a mistake in hindsight (your typical post-mortem), we attempt to prospectively analyze what went wrong with an investment we have yet to make. As a particular idea makes its way through our research process, we will take a step back and conceptually look ahead one year assuming that we made the investment and it did not work out as intended (i.e. we lost money and don’t see a chance of recovery). We then attempt to conjure up all the possible factors that made it a poor investment and place a probability on the likelihood of each. In essence, we try to kill the idea before we even execute the buy order. The ideas that have a relatively short list of potential death knells, or those with a longer list but of extremely low probability events, are moved through for final vetting. 

Along similar lines, the investment team will often square off in devil’s advocate discussions. In these debates, we pit an idea’s champion against another team member who, for the sake of argument, takes the opposite viewpoint in order to test the quality of the original argument and identify weaknesses in its structure. This process leads to either the solidification of the original position, its abandonment, or, typically, it brings to light areas where more detailed work is required.

These types of analyses serve to enhance and improve the rigorousness of our thinking. We likely would not go through exercises like this if we weren’t scared by the thought of losing your hard-earned capital. As always, we will continue to be diligent, objective, and patient in managing your money. However, regardless of the level of vigilance we take, we are always cognizant of Taleb’s warning: good analysis can prudently anticipate the range of things that might happen, but the one thing that actually happens may not have been one that reasonably could have been considered highly likely, or even possible.

 

Corollary to Investing Scared: Avoiding the Bad Years

There’s an old adage about a six-foot tall man who drowned crossing a stream that was five feet deep on average. While we have an almost habitual tendency to relate most anything back to investing, we believe the lesson here is well worth heeding. In investing, it’s not enough to survive on average. Investment survival depends not on how well one performs during periods of market euphoria, but how well you navigate through the rocky episodes. One of the byproducts and, indeed, one of the most important aspects of investing scared is that it obliges us to make sure the downside risk of our portfolios is limited in bad times.

In our view, it is essential for us to outperform the market during bad times. Simple mathematics proves the case: go down less and you don’t have to go back up as much to make up your losses. For an extreme, but illustrative example, let’s examine the year 2008 when the S&P 500 was down 37%. Over the same time period, the equity portion of our portfolios was down 29%. For the S&P to recoup its 2008 losses, it would need a subsequent gain of almost 59%. In comparison, although we hated being down 29% in that year, we “only” needed our portfolios to gain 41% to recapture our losses. In deference to the math, one of our stated investment goals is to generate average performance in good times, but far better than average performance in bad times. The tailwind of going down less coupled with only average performance on the way up will lead to returns more than sufficient to outperform our benchmark over a reasonable long time horizon.

 

 

The best way we know of to prepare for bad times and protect our clients’ capital is to do the following:

 

• Invest with a long-term horizon,
• Remain unemotional through the inevitable economic cycles,
• Focus on high quality, financially strong, and competitively entrenched businesses,
• Use conservative assumptions in determining intrinsic values, and
• Pay a price that is a substantial discount to our estimate of intrinsic value.

 

So, how has our philosophy translated into results? To answer this question, we first defined a “bad time” in the market as a year-long period where the market’s return was negative. Then, of the 169 rolling 12-month periods between our performance inception date of January 1, 1997 and December 31, 2011, we isolated the 51 periods where the return of the S&P 500 was negative and compared them to our returns during the same periods. We present the results in table form below.

KIG vs. S&P 500 Down Years

12-Month Rolling Returns: 1997 – 2011

 

	No. of Negative Return Periods	Average Return in Period	KIG Average Return in Period	Difference
S&P 500	51	-18.9%	-10.5%	+8.4%

 

What this says in words is that for all the 12-month periods where the S&P was negative, its average annual loss was 18.9%, while the average annual loss our portfolios experienced during the same periods was 10.5%. Intuitively, this is a good result and one we thought (hoped) would materialize. The reality of digging out of the average hole created by a “bad time” paints an even clearer picture as an 18.9% decline requires a 23% increase to get back even, while a 10.5% drop necessitates only an 11% rise. The upshot? Assuming a comparable return between KIG portfolios and the S&P in the ensuing periods, it would take the S&P roughly twice as long to recover its losses as KIG. Conversely, KIG would recover in less than half the time of the S&P.

The other aspect of our performance goal is to deliver only average performance in good times. Of course, we would accept more, but as a practical matter we have learned that attempting to outperform a rising market almost always leads to the opposite result in the long run. The analysis was similar to that performed above except that we compared the KIG equity returns to the S&P 500 returns during 12-month rolling periods where the S&P return was positive. Of the 169 rolling periods measured, the S&P 500 was positive in 118 of them (70%).

 

 

KIG vs. S&P 500 Up Years

12-Month Rolling Returns: 1997 – 2011

 

	No. of Positive Return Periods	Average Return in Period	KIG Average Return in Period	Difference
S&P 500	118	+17.0%	+19.3%	+2.3%

 

We have to admit that these results surprised us somewhat. Whenever the market is rising, it usually feels to us as if we’re not keeping pace. While counter-intuitive, the rationale for our outperformance in the “good times” may actually be due to our conservative investment posture. Buying only stocks selling at significant discounts to intrinsic value (i.e. with a margin of safety) not only provides downside protection, but leaves plenty of room to the upside. The upside is typically garnered through multiple expansion, which can prove more enduring and easier to obtain, than gains achieved through earnings growth. Intuitively, a stock that gets re-priced from 12 to 15 times earnings, even with no growth in earnings, advances 25% while a stock that grows its earnings 25% with no increase in its multiple will also go up by 25%. However, based on our experience, one tends to find companies growing at 25% sell at valuations already so high that any hiccup in growth can see a massive contraction of their multiple, which can more than offset the actual growth experienced. On the other hand, low multiple companies typically have meager expectations built into their share prices and often times anything short of a lousy earnings report can result in an expanding multiple. Maybe it has more to do with our personalities (we don’t like losing money), but we feel it is much easier to handicap the latter. Like any self-respecting horse-bettor, we like the odds to be on our side.

It’s satisfying that we have done well on an absolute and relative basis in periods when the market has done well, but we know that’s it’s the large relative outperformance in bad years that has produced the greatest impact on our historical performance record. You can be sure that we will be eternally mindful of these consequences.

 

Quotes of the Quarter

 

“The greatest enemy of knowledge is not ignorance; it is the illusion of knowledge.” – Stephen Hawking

 

"The function of economic forecasting is to make astrology look respectable." – John Kenneth Galbraith

               

This newsletter has been prepared by Kovitz Investment Group, LLC® (KIG), an investment adviser registered under the Investment Advisers Act of 1940, and is a quarterly newsletter for our clients and other interested persons. Within this newsletter, we express opinions about direction of the market, investment sectors and other trends. The opinions should not be considered predictions of future results.  Discussion in this newsletter relating to a particular company is not intended to represent, and should not be interpreted to imply, a past or current specific recommendation to purchase or sell a security, and the companies discussed do not include all the purchases and sales by KIG for clients during the quarter. A list of specific recommendations made by KIG over the past year can be made available upon request. In addition, please note that any performance discussed in this newsletter should be viewed in conjunction with complete performance presentations that we update on a periodic basis. Such presentations are available at www.kovitzinvestment.com, or by calling us at 312-334-7300. Information contained in this newsletter which is based on outside sources is believed to be reliable, but is not guaranteed or not necessarily complete.

 

Past performance does not guarantee future returns.

 

(c) Kovitz Investment Group

www.kovitzinvestment.com