We view the market as a discounting mechanism. People buy and sell based on their expectations about the future. The key question in markets is always what is discounted. Investors earn excess returns when expectations are different from what occurs, driven by heterogeneous time horizons or diversity breakdowns.
The market generates prices every day, some of which present opportunities. Value investors recognize that markets are merely large auctions, with merchandise priced daily by the interactions of buyers and sellers. The best values in the market are represented by companies that trade at a discount relative to their underlying business value due to incorrect expectations.
Determining when expectations are disconnected with underlying business value requires processes that accurately assess true business value. The underlying business value, or what we refer to as ‘intrinsic value’, is the present value of the future free cash flows of the business. Undervaluation is not determined by a stock's valuation relative to existing or trailing earnings, book value or cash flow. Undervaluation is, rather, determined by the relationship between the stock price and the present value of the free cash that the underlying business will generate over one's forecast time horizon. Gaps between market value and intrinsic value require some kind of variant perception, or a way of analyzing the facts that differs fundamentally from a normative approach.
Beyond initial undervaluation, the key to earning superior returns in the future is to identify companies which are able to sustain high returns on capital; in particular, returns which exceed the company's cost of capital. Similarly important is the company’s management's ability to profitably allocate that capital as it is generated; furthermore, the longer the time horizon is, the more important the ability of management to skillfully allocate capital becomes. Long-term investors depend on company’s managers to be good stewards of their capital, and either invest it at rates above the cost of capital, or return it to shareholders in the form of dividends and/or share repurchases.
After identifying compelling opportunities in individual securities using the approach outlined above, we construct portfolios designed to generate the highest level of risk-adjusted returns. A successful portfolio must focus on the best investment ideas and not diversify so heavily that it fails to receive the long-term benefits of those ideas. We assess risk at the company level through careful and diligent analysis, and manage risk at the portfolio level through portfolio construction. While we do not expect to be right in every position, if we have invested in securities with a high probability of trading at discounts to intrinsic value, over time, we will outperform the market.