The below eleven points help us pursue our twin goals of superior long-term investment returns and below-average risk of permanent capital loss. We examine each one in turn:
Securities are ownership interests in businesses, and fundamental business analysis is the bedrock of the Crossroads Capital process.
Businesses have intrinsic value, which is nothing more and nothing less than the sum of expected future cash flows properly discounted for risk.
Even though intrinsic value is inherently unobservable, difficult to quantify, and constantly changing with new information, it is the fundamental building block of sound investment decisions; i.e., intrinsic business value is the “north star” of successful portfolio management.
Although markets are generally efficient, prices can and do differ significantly from intrinsic value. Active managers exist to exploit these inefficiencies.
The best way to maximize long-term, risk-adjusted returns is to patiently and methodically purchase securities at the largest possible discount to intrinsic value (and vice versa with respect to our short book).
Even though market prices tend to converge to intrinsic value over time, it is preferable to invest in businesses with relatively distinct catalysts capable of driving convergence over a definable timeframe.
Gaps between price and value tend to arise for many reasons. At Crossroads, it is critical to have a well-developed view of why a security is mispriced.
Common reasons for mispricing:
Buying/selling with little regard for price due to institutional constraints/segmentation.
Investors over-emphasizing next quarter due to career risk associated with short-term performance.
Over-reaction, herd mentality, difficulty reasoning about uncertainty, recency bias, etc...
Information not being priced in due to complexity and/or small size of business.
Marginal buyers/sellers are rational and are well-informed, yet they are still incorrectly assessing future business performance.
Certain types of securities are more likely to be mispriced than others. We focus on these types of securities, investing in catalyst-driven situations with large margins of safety and asymmetric risk/reward profiles.
Neglected/out of favor all-cap “compounders” where primary catalyst is the passage of time
Securities whose near-to medium-term performance is independent of market performance
Securities arising from corporate events that create complexity and/or forced buying/selling, e.g. spin-offs, rights offerings, recapitalizations, post-bankruptcy equities, distressed credit, de-mutualizations, merger securities, SPACs…
Ops undergoing or about to undergo significant internal change uncorrelated w/ market
Underfollowed small- to mid-cap growth equities with little to no institutional following
Stand-Alone Shorts with a Catalyst
Value traps, highly leveraged cyclicals, businesses in secular decline, frauds, …
The benefits of concentration outweigh its costs. Our 10th best idea is vastly superior to our 40th, and the marginal benefit of diversification is small after 10-15 positions.
Our concentrated approach will likely expose investors to volatility. For a small group of investors, however, volatility creates opportunity, not risk:
Exercise patience and discipline to invest in only exceptional opportunities.
Extraordinary ideas are rare, so rather than own a broadly diversified portfolio, Crossroads concentrates its time and effort on a small number of ideas. This approach makes it easy to be patient.
Also, concentration reinforces the selection of investments that have very certain prospects and a low likelihood of permanent loss, ensuring a portfolio that is less risky relative to more diversified alternatives.
Wealth preserving portfolio construction. Taking our cue from Buffett, we use overall portfolio structuring as a defensive tool by focusing on how each of our investments will work together in the context of the Fund as a whole.
Pre-tax returns are irrelevant. Our investors care about long-term, risk-adjusted, after-tax, net-of-fees returns.
We view as critical to the success of the partnership that we only admit Limited Partners who share our value-centric investment philosophy and long-term orientation.
Our long-term orientation and like-minded limited partners position the investment partnership for success.
Invest in businesses. Not stocks. Not markets.
Focus on gap between price and value. Invest with a large margin of safety.
Prefer ideas with clear catalysts.
Understand the “why” behind potential mispricings.
Emphasis on inefficient markets and asymmetries of returns.
Concentrate on best ideas.
Risk is permanent loss, not volatility. Let market volatility work to our advantage.
Exercise patience and discipline.
Survival investing ethos (superior risk management).
Evaluate ourselves on long-term, risk-adjusted, after-tax, net-of-fee returns.
Take long-term approach. Insist limited partners share long-term orientation.
In a world where performance comparisons are made not only annually and quarterly but even monthly and daily, it is more crucial than ever to take the long view. In order to avoid a mismatch between the time horizon of the investments and that of the investors, one's clients must share this orientation. Ours do. - Seth Klarman