In search of steady and proven performers

Author: Sherman Lee, Prudent Value

Covestor model: Prudent Value

In the first quarter of 2012, Prudent Value’s model portfolio returned 0.96% while the S&P 500 Index (S&P 500) and MSCI All Country World Index ETF (ACWI) returned 12.54% and 11.93%, respectively. Prudent Value’s underperformance relative to the broad indexes is attributable to our large cash position (91.78% as of 3/31/2012).

We ask investors to judge us over the long-term and when our portfolio is more fully invested. Also in the short-term market prices may or may not reflect the intrinsic value of the companies in our portfolio. In Benjamin Graham’s words, “In the short run, the market is a voting machine. In the long-run, it’s a weighing machine.”

With the benefit of 20/20 hindsight, our large overweight position in cash is not working out as expected. In tennis parlance, this was an unforced error because we started acquiring shares in August and September of 2011, but did not follow through in a meaningful way. That said, we were only active in the financial and technology sectors.

In the financial sector we initiated a position in insurance and holding company giant Berkshire Hathaway (BRK.A) run by the Warren E. Buffett and his partner Charlie T. Munger. The company has a record of outperforming the S&P 500 Index over the long term and to date has outperformed the S&P 500 in every five-year period since inception. Additionally, the shares are attractively priced as Buffett has recently made a public announcement that Berkshire is prepared to buy back its own stock.

In the technology space, we acquired shares in small and middle market payroll processor, Paychex, Inc. (PAYX). Despite high unemployment during this Great Recession, management was able to stabilize top line revenue and bottom line profits. Any recovery in jobs and/or short-term rates will be beneficial to Paychex. Additionally, we get paid a healthy 4.10% dividend to wait.

In the first quarter of 2012, the top three performing U.S. stock funds by category were science & technology (+20.26%), financial services (+17.56%), and healthcare/biotechnology (+13.75%). Coincidentally, all of our current holdings are in the top two performing categories. The worst three performing U.S. stock funds by category in the quarter were precious metals (-1.72%), utilities (+1.35%), and natural resources (4.24%).

While we do check the performance scorecard from time to time, our primary focus is to find great businesses run by shareholder-oriented management. Our favorite investments are undervalued wide economic moat businesses that typically sell products or services that have fairly predictable demand in both good and bad times. Wide economic moat is a type of sustainable competitive advantage that a business possesses that makes it difficult for rivals to wear down its market share and profits.

Welcome to all new investors who’ve joined us recently on the Covestor platform. Covestor allows you to compare and select the money managers, and private investors. If you choose to “covest” with Prudent Value, Covestor sets up a mirroring account for you that automatically re-creates our portfolio for our trades in “replicable securities.” Covestor is an SEC Registered Investment Advisor.

To learn more about Prudent Value, please read our 2001 Annual Letter (our first) which contains important information regarding our operations, principles, and investment strategy.  We invite you to read the sections entitled “Our Principles” and “Our Strategy” adapted below from our 2001 Annual Letter for your convenience. You might want to read them twice to make sure we’re the kind of company for you.

Our Principles

  • Seek high quality equity and debt investments that fall within our circle of competence.
  • The underlying assets of these investments should possess strong balance sheets and generate free cash flows.
  • View the purchase of these investments as fractional equity or debt owners of high quality organizations.
  • The owner mentality is important to us because market prices on assets are determined by supply and demand, often times referred to as fear and greed.  When the market is succumbed by fear and panic, market prices may fall below intrinsic values of underlying assets. This allows the enterprising investor the opportunity to purchase assets at a discount to its intrinsic values.
  • Purchasing assets at a large discount allows the patient investor several ways to benefit.

§  Higher share price to reflect asset’s intrinsic value.

§  Higher share price to reflect asset’s higher than expected earnings.

§  Higher share price on a buyout or takeover announcement.

§  Lower downside risk as price discount from value provides a margin of safety.

Our Strategy

Prudent Value concentrates assets in its best ideas (subject to reasonable diversification) and generally maintains its investment positions for an extended period of time. With regard to individual stocks, shares are generally added to a portfolio only when they (1) meet our criteria of a business comprising of favorable long-term economics, and (2) sell at a significant discount to our estimate of intrinsic business value. Companies are generally sold when their share prices reach intrinsic value or higher. If no opportunities are available with a significant margin of safety, Prudent Value may invest in cash equivalents and/or fixed income securities.