One of our core business principles is that we believe our existence is only justified if we can achieve a return on invested capital which exceeds mutual funds, major indices and alternative investments. There would be no purpose in going through all of this effort if our returns do not exceed what we would otherwise make passively investing in an index fund, for example.
What we are trying to achieve is something most investors want, which is to earn above-average returns on their investments.
In an article written in the National Post, a financial advisor of a well-known firm explained that an investor should look to earn 6% as a benchmark return based on the following supporting information from analysts:
- Inflation will be about 2.25% in the future
- Bond yields will average 1.25% over the next 25 years
- Stocks and equities (internationally) will rise between 5% and 7% over the next 25 years
- An investor would invest in a basket of these items for an average return of 6% including management fees of 1%
Notwithstanding the forecast above (if you can forecast the future it seems easier to just buy a lottery ticket), I question what needs to be done so we are not limited to the average of all of the stock and bond returns over the next 25 years.
The article goes on to make a common claim, with which I strongly disagree: “Can you do better than 6%? It will be very difficult in a low inflation environment; to have any real chance you would have to take on more risk.”
How above-average returns can be achieved is subject for legitimate debate, but we feel strongly that they cannot be achieved simply by taking on more risk. Our experience has taught us that taking on more and more risk in the search for higher returns is a strategy which will result in very high returns or very large losses. Whether the high return or large loss will occur will be unknown at the time of the investment. In other words, bold performance and excessive risk taking will create years where you are “wrong” and years when you are “right.” History has proven that over an extended period, these large swings in portfolio gains and losses result in the bad years mostly washing away the returns created in the good years. The returns become average when taken as a whole.
More importantly, the investor will have to live through the market swings. The common idea of taking on more risk in search of above-average rewards is therefore mostly a volatile exercise ending in simply ordinary returns.
What so many great investors who I look up to figured out long before me was that we should not be chasing better than average returns as much as we should be protecting against losses. As Howard Marks, chairman of Oaktree Capital said in one of his early memos, “The best foundation for above-average long-term performance is an absence of disasters.”
It has always seemed more plausible to me that one can more easily avoid losses than chase large gains, because the latter essentially deals more with future outcomes that can never be known.
Therefore, we do not expect to outperform the market in years where it advances greatly, but do when it declines.
For instance, if the S&P/TSX Composite advances significantly, we would be happy to even perform below average that year. For example, if it advances 30% and our return on investor capital is 15%, we are happy to be making 15% (a return which in most years would probably be above average).
When the index declines, however, we would consider a year successful only if we performed better, since this is where the bulk of our efforts will be.
Our road to performance will therefore not be found in having one or two really great years, but by consistently maintaining principles that are focused on protecting against downside.
Here is how we try to do this:
- We ensure that the purchase price of our investment is covered by a discounted value of the assets of the business.
- We invest in businesses which employ very little to no debt.
- We buy control positions, or significantly impact the day-to-day financial operations of the business.
- We do not rely in any way on a future price increase of the asset to recover our principal.
- Our partners and managers understand that they are, in effect, co-managers of our capital.
One final note: Under no circumstances do I want to give the impression that we are bargain hunters. In fact, we approach business owners just as much as we are approached. Loss-avoidance, to me, is a mentality which can be applied to any industry or asset class.
In our case, though we are primarily buying private companies, our investment structures do not factor in any upside. This is not to be conservative for its own sake, but we are just genuinely not concerned with relying on an asset increasing drastically in value in order to recover our principal. If we have done our job, in the event of an asset sale, even a mediocre price will result in a relatively good return.