For a fixed percentage fee relative to account size and asset allocation, we select corporate and government-backed investments for clients consisting primarily of equities and bonds. A thorough discussion of long-term objectives, risk tolerance, and investment experiences of the client leads to an understanding between the client and this advisor that forms the basis of portfolio composition, which often include both domestic and foreign investments. Sensitivity towards client concerns is emphasized so that client comfort is included in the investment program. We are willing to spend time educating clients about the difference between speculation and serious investing. We exercise trading discretion over managed accounts.
We hold no client’s account assets. All clients’ assets are held by a custodian, typically a bank or brokerage firm, such as Charles Schwab & Co., Inc. Clients choose their own custodian. Our management fees are paid on a percentage of account assets and are charged quarterly to client accounts. The custodian of your account will not determine whether management fees have been accurately calculated; it is the client’s responsibility to verify the accuracy of the fee calculation. Since we are paid as a percentage of the account value, we get a raise if we perform well and the account increases in value and a pay cut if we fail to perform. We receive no transaction fees or brokerage commissions from managed accounts.
Client accounts are reviewed on a monthly basis. Companies in which we invest are reviewed continually. We do not prepare regular monthly reports for clients — the broker/dealers and trust companies that serve as custodians handle this responsibility. We do prepare quarterly summaries, including cost basis information, for our clients.
Unless otherwise directed by the client, we have discretion to direct client trades to brokerage firms of our choosing, even if a different brokerage firm serves as custodian of the account. For instance, we may direct a trade to Merrill Lynch Institutional, even though Charles Schwab and Co., Inc. serves as the custodian. The trade may cost more per share in commission than the custodian would charge, but may benefit from superior execution. Custodians usually charge a service fee of $25.00 for a “trade away.” We have no soft dollar relationships. Our portfolio management software is purchased from Schwab Performance Technologies, a division of Charles Schwab & Co., Inc. The annual maintenance fee we pay to Schwab Performance Technologies is discounted in some years.
Clients who direct where their account shall trade may forgo savings we can negotiate elsewhere, in particular by participating in block trades that benefit from volume discounts. Commission disparities can be substantial between client-directed and advisor-negotiated brokerage. Also, in cases in which we are buying or selling a security for all of our accounts, it may be necessary to trade at numerous different custodians. It is not possible to submit all orders at the exact same time. Directed brokerage accounts may be traded last. There could be a conflict of interest between our interest in receiving client referrals from brokerage firms as opposed to our clients’ interest in receiving discounted commissions and the best executions. Other registered investment advisors may share fees with us in return for referring accounts, and registered representatives may be paid referral fees for referring clients to us.
We will sometimes aggregate many small orders into one large block order. If the entire large order is executed in one day at different execution prices at any one particular brokerage firm, we will ask that brokerage firm to average the execution prices. Then, the order is allocated out to our clients at the averaged price, so that all clients get the same price. If the entire order is not executed in one day, we fill suborders randomly so that over the long term all clients are treated equally.
It is typical that we buy or sell the same securities for ourselves as for our clients. To paraphrase Warren Buffett, we eat our own cooking. The potential conflict of interest is limited because the securities are widely held and publicly traded and we typically hold issues for years, as opposed to speculatively trading them. Sometimes we will execute trades for the accounts of our firm, its employees, and employee families in the same trading session as client orders. When this occurs, these trades will either participate in the same block as client trades or will be executed after client trades are completed.
In special situations, our clients may choose a “performance-based” fee arrangement with our company. Any such arrangement shall be established in conformance with Rule 205-3 of the Investment Advisor’s Act, and shall be based on periods of at least twelve months in duration. This arrangement could provide an incentive for the management style applied to the special arrangment to be more aggressive in instances where this is the desire of our clients.
CASH ALLOCATION
We are very patient investors. It is not prudent to overpay for a company, even a very good company, and we will wait for the price to come down to an acceptable level. Accordingly, client accounts may hold a relatively high level of cash for periods of time. It is important to note that we do not time the market and the cash allocation is not a strategic decision. Rather, cash is a by-product of our disciplined purchase strategy. We do consider the cash as funds available for investment and part of the overall portfolio. Therefore, cash balances are included in the fee calculation. If cash were not included in the fee calculation, it would create a conflict of interest where our fee would increase simply by purchasing more securities, even if those purchases were not in clients’ best interest. We have noted this in our Discretionary Investment Management Agreement.
EQUITY INVESTMENT POLICY
We approach stock investing as the long-term ownership of part interests in businesses that we think will have materially higher cash earnings three to ten years from the purchase date. We attempt to establish ownership at a price discounted from our estimate of the business’ intrinsic value.
We are concentrated investors, the antithesis of a broadly diversified approach. It requires investors to patiently hold their portfolio even when other strategies appear to be winning. As a rule, the aim is a turnover rate of between 20% and 10%, which means holding positions for between five and ten years. Evidence, both academic and empirical, indicates that such a strategy can generate above-average returns if the stock selection reflects diligent and high-quality analysis.
The policy of portfolio concentration may well decrease risk, as it requires increasing both the intensity with which an investor researches and analyzes a business, and the comfort level he must achieve before buying into it. By focusing on a few select companies, an investor is better able to study them closely and understand their value. And, the more an investor knows about a company, the less risk he is likely to take. This approach to risk is directly opposite to the diversification technique recommended by typical investment professionals. The general assumption of a diversified portfolio is that the investor is unable to identify or predict all the risks associated with an investment. The objective of the concentrated investor, however, is to be able to clearly identify and predict potential risks in particular investments. Having a focus on individual investments and their intrinsic value allows the rational investor to take advantage of market fluctuations, which can create unusual opportunities to acquire companies at compelling prices. Short-term fluctuations in the price of a stock do not necessarily reflect intrinsic value, nor do they indicate the prospects of long-term investment success.
The road to these rewards may be bumpy, because price volatility is a necessary by-product of the concentrated approach. When a portfolio focuses on just a few companies, a price change in any one of them is all the more noticeable and has greater overall impact. The ability to withstand that volatility, without undue second-guessing, is crucial to the investor’s peace of mind and ultimately to financial success. This approach to portfolio management might appear odd to investors used to actively buying and selling stock on a regular basis, but it has two important economic benefits in addition to growing capital at an above-average rate: it dramatically reduces transaction costs and increases after-tax returns.
