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June 30, 2010

The market went through significant turbulence this quarter, falling more than 15% from its April highs.  The fall started with a trading glitch, setting the mood for what became a fearful market.  That was followed by mixed, and often disappointing, economic news.  With the addition of European debt worries, the market found much to be pessimistic about.  Of course, none of this changes my approach to investing.  Market pessimism isn't always unfounded, but it's often mispriced.  I will continue with my value investing philosophy, keeping an eye on attractive stocks and buying them when prices reflect too much pessimism about the long-term future: or for any other reason that attenuates the relationship between underlying value and price.  

The economic recovery right now is moving very slowly, but it shows stability.  The chances of a double dip recession are low, but there is that possibility.  I cannot predict what will happen in the coming months, but I believe that the long-term direction of the U.S. economy is up, and that small-cap companies with a history of success, strong balance sheets, and competent management will outperform the market.

Rather than get caught up in all the noise swirling in the market right now, this is a perfect time to look back at some Warren Buffett wisdom.  In his 1977 letter to Berkshire Hathaway shareholders, Buffett outlined his company's investing focus as follows:

We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.

That seems simple enough.  Of course, running through the data to determine if a company meets all four requirements takes some expertise (and no one is more expert at this than Buffett himself).  This is the outline I follow as I work through the data for every company I buy for your portfolio.  And that is why I have high confidence in the long-term performance of your portfolio, as we move through this short-term turbulence.           

Speaking of short-term turbulence, Buffett followed up his comments by addressing his views on short-term price movements in the stock market:

We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.

Another Buffett attribution says that in the beginning, it's often tough to distinguish between being early and being wrong. Rather than waiting for the stars and moon to align, I would rather be a little early, and add shares to a position later if the price falls.  In other words, a 10% or 20% drop is a fair price to pay for a long-term gain of 50% or more.  Of course, not every company’s story works the way one thinks it will, and sometimes a company’s business experience will cease to satisfy.  That is why I advocate diversification of about 20 to 30 positions in strong value positions.  It is also why I’m so careful in choosing and following the companies in your portfolio.  

As always, I’m available to answer any questions you might have.  

Regards,

Aram Durphy