In 2008, a younger investment manager asked me to explain our approach to investing and to give him any additional advice that might be useful. In response to his request, I wrote the following letter.

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Dear Jack,

Thank you for your questions, which I will try to answer in this letter. I apologize for the length of the letter. It is difficult to do justice to a complex subject in a few paragraphs. Also, please be mindful that there is nothing sacred about the way I invest or about my ideas. As in so many things in life, there are many differing approaches to being a successful investor.

There is a saying that going to church does not make you a Christian any more than standing in a garage makes you a car. And it also is true that having specific strategies and approaches to investing does not make you a Warren Buffett. But it helps, and it has helped me to make reasoned investment decisions, especially during difficult times.

Our central strategy is to purchase deeply undervalued securities of strong and growing companies that likely will appreciate sharply as the result of positive developments. Our reasoning is that the undervaluation, growth, and strength should provide protection against permanent loss, while the undervaluation, growth, strength, and positive developments should present the opportunity to earn high returns.

I emphasize that our first goal is to control the risks of permanent loss. When we analyze a security, we first look for the attributes that will protect us against incurring a loss that cannot be recovered within a reasonable period of time. We will not commence analyzing the positive attributes of a security until we are convinced that the risks of permanent loss in the security are relatively low.

Our emphasis on controlling risks leads us to be value investors as opposed to growth-stock investors. We have observed that, over the years, many growth stocks have permanently lost value due to a slow-down in their growth rates, often caused by maturing markets or by increased competition (including competition from new destructive technologies—Kodak being just one example).

Over the past 50+ years, the stock market has provided annual average returns of 9 to 10 percent (appreciation plus dividends). If an investor purchases a portfolio of undervalued stocks and if the stocks merely perform in line with the market, the investor’s longer-term returns should average 9 to 10 percent. However, if the investor can find undervalued securities and can creatively project the occurrence of positive developments that already have not been discounted into the price of the securities, he can hope to earn outsized returns. Examples of positive developments include a cyclical upturn in the earnings of a company or industry, the solving of a problem that has been a drain of earnings, the introduction of an exciting new product or service, or the replacement of a weak management with a strong one. It sometimes takes a long time for a particular security to benefit from a positive development and to appreciate sharply. One has to be patient. But what happens if a predicted positive development fails to occur at all, which does happen? Then, the average stock still should provide average returns of 9 to 10 percent over time. This is not an unfavorable outcome. We are deprived of the icing, but we still get the cake.

Thus, in my opinion, an analytical, creative, and disciplined investor who uses sage judgment can achieve returns materially in excess of the market average. If such an investor succeeds in achieving average returns materially in excess of 9 to 10 percent, he eventually can become very wealthy through the power of compounding. Compounding is one of my favorite words. Compounding is powerful. Warren Buffett did not become one of the wealthiest men in the world by suddenly striking gold in a single highly successful investment, but rather by compounding the value of Berkshire Hathaway at a 20 percent or so rate for 45 years. If an investor can achieve an average annual return of 20 percent, then, after 45 years, an initial investment of $1 million will appreciate to $3.6 billion.¹ Wow!

However, while value investing sounds easy, one should remember that there are thousands of other investors trying to successfully do what you are trying to do, so value investing is a competitive (but fun and exciting) battle. To be a successful value investor, it helps to have a highly creative mind that is able to develop theses about the future, particularly about likely positive developments. I have given considerable thought to how an individual can increase his creativity, but the human mind is amorphous, and understanding the creative workings of the mind is like trying to get one’s hands around a cloud. However, I would say that it is helpful to let your mind wander, to be open to new ideas and change, and to free your mind from preconceived notions. Creative ideas rarely come in a flash, but rather usually from a combination or a reinterpretation of existing ideas.

Value investors also need experience. After graduating from a business school and after a few years working as an investment professional, an intelligent and diligent investor likely will become proficient at playing the notes, but it still can require several additional years before he can play the music. As in music and sports, the best professionals tend to develop a rhythm and feel that comes with long practice and that leads to optimum results. In my opinion, the intuitive feel (or sixth sense) that most good investors develop partially comes from an innate ability and partially from experience.

In addition to creativity and experience, a good value investor needs the self-confidence to be able to make decisions that are counter to the combined conventional wisdom of other investors. The price of a stock at any one moment reflects the conventional wisdom of the market. Conceptually, a stock that appears out of favor and materially undervalued to you does not appear undervalued to most other investors. Otherwise, a sufficient number of other investors already would have decided to purchase the stock, driving its price to its intrinsic value. Therefore, a good value investor must make decisions based on his own analysis and judgment and must ignore the mass of opinions from Wall Street analysts, newspaper journalists, TV commentators, and others. He must be a contrarian, and he must be willing and able to feel lonely and uncomfortable. When purchasing a stock, it is usually better to feel uncomfortable than comfortable.

Also, decisions seldom are clear. There always are uncertainties about the fundamentals of a company, and every company has present or potential problems as well as present or future strengths. However, an investor can try to assess the probabilities of certain outcomes occurring and then make his decisions based on the probabilities. Investing is probabilistic.

To successfully assess probabilities and make good investment decisions, an investor should hold considerable amounts of information about the companies and industries he is investing in. Having superior information (both quantity and quality) can give an investor a competitive edge. To obtain information, we spend a large percentage of our time researching the fundamentals of companies.

While investing is not formularistic, there do seem to be a number of reoccurring patterns and strategies that one should take advantage of or should guard against:

1. Be careful not to let your mind acclimate to a present circumstance, and then lose perspective. This is particularly true after a long period of prosperity. During “bull” markets, many investors tend to give themselves too much credit for favorable results and to give insufficient credit to the positive environment that played a large role in creating the results. This can lead to overconfidence on the part of the investor and resulting misassessments of risks.
2. Beware of projecting past or present trends into the future. The past often is an unreliable guide to the future. Steering an automobile by looking in the rearview mirror works as long as the road is straight, but is disaster when the road reaches a sharp curve. The same is true in investing.
3. Beware of seeking out information that reinforces your existing points of view or of screening out information that threatens to expose flaws in your existing beliefs. When you own a security, you are prone to be more accepting of good news about the security than bad news, and this can create a bias that leads to faulty decision making.
4. Intensively research stocks and industries, and pay attention to the quality of the information as well as the quantity. Quality information reduces uncertainty and risk. However, while it is dangerous to make decisions based on only a small amount of information, one should not miss investment opportunities due to overresearching an idea. You do not have to drink a whole bowl of soup to know how it tastes.
5. Be wary about basing investment decisions on predictions about the economy, interest rates, or stock market. There are so many variables that affect the direction of the economy, interest rates, or stock market that it is nearly impossible to identify, analyze, and weigh all the relevant variables, and even if this could be done, an investor would have difficulty estimating how much of the future already has been discounted into the price of individual securities. Experience has shown that investors are prone to overestimate how much they understand about the world, and underestimate the role of chance in events. Woody Allen once said: “I am astounded by people who want to know the universe when it is hard enough to know your way around Chinatown.”
6. Managements of companies possess more information about their companies than you ever will be able to possess. Pay more attention to what managements do than to what they say. Remember, managements, like most other people, tend to act in their self-interest. It often is a favorable sign when managements purchase shares of their companies for their own accounts, and vice versa. Favor managements who are highly incentivized to achieve higher prices for their shares.
7. Be particularly wary of projections made by managements and others who have vested interests in having their projections believed and acted upon.
8. Be wary of companies that largely have been “put together” through recent acquisitions. Normally, acquisitions are made through an auction process, with the acquiring company agreeing to pay the highest price. I agree with Warren Buffett that the smartest side to take in a bidding war is the losing side. After purchasing a painting at auction at Christie’s or Sotheby’s, I often am congratulated by my neighbors in the audience. My reaction is: why should anybody be congratulated for paying a price that no one else was willing to pay? When I value a company that has been acquisitive, I estimate that the parts of the businesses that recently were acquired are worth the price they were acquired at, plus some premium for subsequent growth or synergies, less a discount if I believe that the acquiring company overpaid. Thus, companies that largely have been put together in recent years normally are not worth a large premium to their stated book values.
9. Be aware of the laws of supply and demand. The balance between supply and demand normally is the main determinant of the market price of the item. Also, be aware that countervailing forces usually affect supply and demand. For example, when an item is selling at a high price because of a tight supply, the market tightness often is mitigated or erased by new supplies (attracted by the high prices), reduced demand (motivated by the high prices), or substitution into less expensive items.
10. Be wary of stock recommendations made by others, especially by those in the media who may sound articulate and authoritative, but who lack the resources to be successful professional investors. A horse that can count to 10 is a wonderful horse, but not a wonderful mathematician.
11. Do not be overly influenced by the media. Because bad news sells, the media has a pessimistic bias. Over many years, a large percentage of the severe problems predicted by the media never materialized, or proved to be far less severe than predicted. The cover story of the August 13, 1979, issue of BusinessWeek was titled “The Death of Equities.” The article’s gist was that investors were switching out of common stocks in favor of higher-yielding investments—and that it was likely that the stock market would not recover soon from the doldrums it had been in for many years. At the time the article was written, the S&P 500 Index was no higher than it had been 11 years earlier. Well, BusinessWeek was dead wrong. Soon after the publication of the article, the stock market entered a strong bull market. Between August 1979 and August 2000, the S&P 500 Index increased from about 100 to about 1,500. An investor who purchased an S&P 500 Index fund in August 1979 and sold the fund 21 years later, would have enjoyed a 16 percent average annual return on his investment (including dividends).
12. Avoid over-relying on numbers and models. Investors often feel comfortable with numbers and models because they appear definitive. However, they can be misleading because they often are based on historical data that may not be repeatable or are based on assumptions that may not prove valid. We need numbers and models, but their utility should be paired with judgment and common sense. There is the story of a statistician who drowned crossing a river that was only three feet deep on average. He obviously lacked both judgment and common sense.
13. Separate your analysis from your emotions. Especially during a difficult period, many investors become distraught, let their emotions dictate their investment decisions, and make decisions that are irrational and costly. By understanding your emotions and by understanding the nature of a difficult period, an investor can hope to organize and control his mind to think and act rationally.
14. Seek simplicity. An investor cannot be sure how an investment is going to turn out, but he can attempt to identify and analyze the key possibilities, then assess the odds of each possibility taking place, and finally make a reasoned decision based on the odds and estimated economics of the key possibilities. We live in a world of possibilities and probabilities, not certainties. It is logical that an investor can increase his chances of success if he can reduce the number of unknowns that he has to weigh. Thus, we are more confident when the outcomes of our investments are dependent on relatively few possibilities—few moving parts.
15. Realize that the trees do not grow to the heavens. Be cautious when the price of a security, or the market as a whole, sells at an inflated value relative to its historical norm. A material overvaluation can be dangerous, especially if it becomes accepted as a “new norm.” If there is an adverse change in sentiment, an overvaluation can correct swiftly and markedly.
16. A number of years ago, I adopted a methodology that is useful in determining whether the stock market is overvalued. I started by analyzing the “earnings” of the S&P 500 Index for the 40-year period 1960 to 2000. My conclusions (reached with the help of regression analysis) were that the earnings have grown at about a 6.8 percent compound annual growth rate (CAGR) and that the trend-line (i.e., normal) earnings on the S&P 500 in 2000 should have been about 46.75. I then calculated that, during the same 40-year period, the S&P 500 Index “sold” at an average price-to-earnings (PE) ratio of 15.8 times, which, I reasoned, is the normal PE ratio for the stock market. Thus, based on these historical metrics, I concluded that the normal level of the S&P 500 Index in 2000 should have been about 739 (46.75 × 15.8). Since earnings have grown at a 6.8 percent CAGR and since I know of no reason why this level of growth should not continue, I can then project future normal values for the S&P 500. In 2010, for example, the normal value of the S&P 500 should be about 1,427 (739 incremented at a 6.8 percent rate for 10 years). Thus, in 2010, if the S&P 500 happens to sell at 1,725, I would conclude that, based on historic metrics, the stock market is overvalued by roughly 21 percent. Because we wish to buy low and sell high, knowledge of where the market is selling relative to its historical metrics often is helpful, especially when the market is selling at an inflated level.
17. Conceptually, any investor can attempt to increase his² returns by accepting additional risks. Treasury bills are considered risk free but pay low interest rates. Investment-grade corporate bonds are riskier but pay higher interest rates than Treasury bills. “Junk bonds” generally are quite risky but normally pay quite high interest rates. Similarly, some common stocks are riskier than others. Every investor must analyze risks of permanent loss and must decide how much risk he is willing to assume. There is no correct answer to the proper level of risk avoidance. It depends on the nature of the investment and on the needs, desires, and personality of the investor.
18. While an investor should work hard to avoid permanent loss, he must guard against being so risk averse that he turns down too many promising opportunities for fear of making a mistake. Even the best investors occasionally will err. To err is human—and we should not let errors dull our confidence or spirits.
19. Be prepared and willing to change your mind if your initial decision was flawed or if circumstances change. Be readily willing to admit that you made a mistake.
20. Invest for the longer term (two years at a minimum) and deemphasize the significance of short-term results. Most hedge funds and mutual funds and many other investors are under pressure to achieve short-term performance. Thus, there is fierce competition for ideas that will appreciate sharply over the next quarter or so. There is much less competition for stocks that have less certain shorter-term prospects, even if they appear to have excellent intermediate-term prospects—and that is where we normally want to be.
21. Do not attempt to “time” the stock market. The near-term direction of the stock market is determined by so many forces that it is difficult for anybody to identify all the relevant ones, let alone understand and weigh them and then determine the extent that they already are discounted into the market. Furthermore, the forces are dynamic, leaving market timers at the mercy of future developments that are difficult (and many times impossible) to predict. For all these reasons, most market timers do not seem to enjoy acceptable batting averages. We agree with Warren Buffett, who, at the 1994 Annual Meeting of Berkshire Hathaway, said: “I never have an opinion on the market because it would not be any good and it might interfere with opinions that are good.”
22. Try to remain relatively fully invested as long as you can find a sufficient number of attractive securities. Because corporate earnings and the stock markets appreciate over time, if you are fully invested, you are swimming with the tide. However, when you cannot find a sufficient number of attractive securities to remain fully invested, be willing to hold cash. Do not stretch to remain fully invested. Further, if you perceive that there are excesses or other unacceptable risks in the economy, be willing to tighten your investment standards and sell stocks that had acceptable risk profiles in a lower-risk economy but unacceptable risk profiles in a higher-risk economy.
23. Try to generally think and act positively and optimistically. Because over the longer run the stock market appreciates at a mid-single-digit annual rate, it normally is advantageous to have an optimistic view of the world rather than a pessimistic one.
24. Structure a concentrated portfolio, yet a diverse portfolio. Conceptually, the first stock one selects for a portfolio has the most favorable risk-to-reward ratio, and each succeeding selected stock has a somewhat less favorable risk-to-reward ratio. Thus, a concentrated portfolio of 15 to 25 stocks should provide materially better risk-adjusted returns than a portfolio of 30 to 50 stocks. Yet one should seek sufficient diversity that a few permanent losses do not permanently impair the value of the portfolio or the confidence of the portfolio manager. It is important for a portfolio manager to sleep well at night. To achieve both concentration and diversity, a portfolio might consist of 15 to 25 holdings, with no individual security accounting for more than 12 percent of the value of the portfolio and no one industry accounting for more than 25 percent. The limits should be based on costs, not on market value, so that the portfolio manager is not forced to sell shares in a holding that has appreciated sharply, but that still remains attractive.
25. Be relaxed and invest with a passion.

Investing is exciting and intellectually challenging. It is fun. It also can be highly profitable, especially for someone like you who is bright and highly motivated. I hope that if you are a successful investor and if you become wealthy, you will use your wealth wisely. I believe that Pericles (who was an Athenian general and leader in the fifth century before Christ) had it right when he stated in his Funeral Oration: “Wealth to us is not mere material for vainglory, but rather an opportunity for achievement.” And Warren Buffett and Bill Gates have it right when they donate a large percentage of their wealth to charity—to help others who are far less fortunate in life than they.

I hope this letter is useful. Again, there are many approaches to investing successfully—many ways to skin a cat.

Best of luck with your investment career,

Ed Wachenheim