Kovitz Investment Management 2014 LetterVW Staff
Market and Performance Summary
The Kovitz Investment Group® (KIG®) Equity Composite (the “Composite”) increased in value by 4.3% (net of fees) for the quarter ending December 31, 2014. For all of 2014, the Composite returned 6.4%.
Many other money managers typically leave their discussion of performance right there. Positive returns should equal happy clients. However, as we’ve articulated over the years, investment results cannot be analyzed on a stand-alone basis; they are only meaningful in the context of how they measure up relative to a benchmark. On this score, we had a poor year as the Composite performance significantly lagged behind the S&P 500’s return of 13.7% during 2014. It is relatively easy to write these letters when we have outperformed our peers and benchmark. Fortunately, we have been in that position an overwhelming majority of the time. We now find ourselves in the opposite position with the need to explain the degree of underperformance that we have experienced over the past year. While uncomfortable, we will not shy away from our responsibilities in communicating to our client partners. We have always attempted to undertake a critical diagnosis of ourselves, including mistakes we have made, what we have learned from them, and how we plan to avoid repeating them.
As much as we’d like performance to come in smooth consistent arcs, it generally does not work that way. We accept the fact that there is a certain amount of randomness, particularly in the nearterm results of businesses and the market’s perception of such, and that returns are likely to be lumpy. It’s not an indictment of our process as no successful investment strategy exists that can consistently generate market-beating returns. Just as last year’s strong performance didn’t lead us to believe we got smarter, this year’s underperformance does not make us believe our process is broken. As investors running a fairly concentrated portfolio, you have to be able to psychologically
accept there are going to be times when you’re completely out of sync with the rest of the world. At the end of the day, our performance is the result of the success or failure of our strategy of identifying financially strong businesses with durable competitive advantages selling at significant discounts to our estimates of intrinsic value. We believe the framework of this strategy is sound and has worked well historically, not just for us, but for many other successful, like-minded investors.
The single most important thing we can do is to have the necessary resolve to stick with the process regardless of what the market is doing or how well or poorly our short-term results appear. That sounds simple, but the crux of our value proposition is being comfortable disagreeing with the market consensus. When the market tests us, as it has done recently, we feel comfortable relying on our disciplined process, which allows us to make rational, thoughtful decisions. Our process plus having the patience necessary to wait for opportunities to come to us (i.e. not to try and force it) are the primary ways we will reverse the recent underperformance.
For now, we remain focused on the careful and patient application of our investment criteria and valuation requirements. We are more concerned with the risk of suffering a permanent loss of capital than about the risk of missing opportunities, especially those that are short-term in nature. Our bottom-up research emphasizes business quality, industry structures, growth opportunities, management skill and corporate culture. It is further augmented by our assessment of the company’s ability to sustain earnings power over the long haul through an understanding of its competitive advantages, business model and management’s skill in the allocation of capital. We use absolute, rather than relative, methods to estimate companies’ intrinsic values and we use the movement of market prices around these intrinsic value estimates to construct and manage a portfolio of highquality businesses that have the potential to create sustained shareholder value over many years. One of the challenges we have faced over the last twelve months is that there has been very little stress, very little fear and very little volatility in the markets as a whole. Losing the opportunity to take advantage of large price swings doesn’t play to our strengths and has most likely attributed to at least some of the recent poor relative performance.
Short-term periods of underperformance are expected to happen somewhat regularly when we choose to invest using the methodology we do. Fundamental, value-based investing is predicated on a long-term time horizon. We have had similarly miserable periods before (the third quarter of 2002 and the second half of 2007 immediately come to mind) and we have always recovered from these dips. As our long-term results demonstrate, our process generally works well over long periods of time. Since the inception of tracking our equity performance (January 1, 1997) our Composite has returned 572%, or 11.3% per year, versus a gain of 287%, or 7.9% per year, for the S&P 500. One of the main reasons we have been successful is because, emotionally, it is very difficult to pull off. Enduring short periods of underperformance, even if it is a necessary ingredient in generating longterm outperformance, is no easy thing. To that end, we are very grateful for a client base that shares our focus on the long-term, thus allowing us to deviate from a benchmark over short time periods. It is a very meaningful advantage.
Below is our standard performance report for the KIG Equity Composite, which now encompasses 18 full calendar years. The chart summarizes both annualized and cumulative performance results from January 1, 1997 through December 31, 2014 for the Composite and the S&P 500. We manage your portfolio for long-term results, and we encourage you to evaluate its performance over a multiyear timeframe.
We appreciate the faith that our clients have placed in us. This faith in part helps us do our job, and gives us an advantage as we go about our investment decision making. Managing other people’s money is an enormous responsibility and we hope you take comfort in the fact that we are doing the exact same thing with our own money as we do with yours.
Kovitz Investment Management: Portfolio Activity
For the past several quarters we have lamented the stark lack of opportunities for us to put money to work in new names. Just about every sector of the market had elevated valuations and very few companies were trading at significant discounts to fair value. This latest bull market has seen almost no meaningful corrections and had not delivered any industry or sector declines that are normal even in a market that is rising overall. This set of circumstances had made it difficult for investors like us who tend to be opportunistic in building portfolios.
During the quarter, however, the price of crude oil swooned, and shares of companies in the energy sector and those in the industrial sector with energy-related businesses underwent a major correction. Historically, we have had very low exposure to these names. In recent years, with the price of crude trading near $100 per barrel and market sentiment that it would remain there, our feeling was that most stocks in the energy group provided little margin of safety. Our preference was to wait until valuations were more favorable, and, with oil prices having collapsed approximately 50% since mid-June, we believe that day is here.
To be clear, we are not making a call on where we believe oil will trade over the next several months or quarters. In the short run, we don’t know if the current plunge in the price of a barrel of oil will continue, stabilize, or even trend upward. Looking out over the next several years, however, our feeling is that oil prices will likely be higher. We say this not out of any sense of clairvoyance but from an understanding about how commodity markets generally work and our comprehension of how marginal cost economics typically play out. In a sense, commodity prices are self-correcting – the interaction between supply and demand in setting prices at the margin makes this so.
Commodity prices will decline if demand decreases or if there is too much supply. Conversely, prices will rise if demand increases or supply falls. In the current case of oil, the drop has largely stemmed from oversupplied conditions caused by increased production in Northern Iraq and Libya coinciding with huge gains in production in the United States due to the “shale revolution.” Even more fuel was added to fire on Thanksgiving Day when OPEC announced they would not cut current production levels. The most common interpretation of this decision was that it was meant as a shot across the bow warning U.S. shale producers that the Saudis are determined to not be the first to blink in the face of falling oil prices.
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