STEWARDSHIP

Taken from Founders Capital Management 2010 Annual Report

The concept of investing, at its essence, is putting out $1 with the hope of receiving something greater than $1 in the future. How each individual achieves this result makes a simple concept more complicated. At one extreme, the chase for more dollars can become so consuming that individuals subject themselves to the greater fool theory—being sold a bill of goods that $1 is easily turned into more. All you need to do is put out $1 today and hope that a greater fool comes along to offer you more than $1 tomorrow. It is our firm opinion that the greater fool theory is grounded in speculation and is not the foundation of investing. To quote Mark Twain: “There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.”

The true art of investing is actually not as complex as speculating on which stocks to buy low and sell high. Intelligent investing involves choosing a few top-rate businesses that you understand, and purchasing an interest in these entities at a fair price. Although this sounds easy in theory, in practice the hard part of investing is identifying a few top-rate businesses and understanding them thoroughly enough to decipher a fair purchase price.

To figure out a fair purchase price, a top-rated business can be viewed as a goose that lays an ever-increasing number of golden eggs. The job of the intelligent investor is twofold—to evaluate the goose’s capability to continue producing golden eggs, and to have a predictable view of the number of eggs that goose will produce many years out. Very few businesses on the planet, of course, will fit the description of a rising golden-egg producer—so when an investor identifies one, it usually pays to purchase a meaningful amount of this goose. The objective to investing is correctly figuring out today’s value of the golden eggs produced over the life of the goose—and then acquiring the goose at a discounted price. Principally, an intelligent investor tries to pick up $1 of today’s value for the price of 65 cents.

From 2016 Annual Letter – Developing Insight
From 2016 Annual Letter – Art & Science: A Framework That Counts

Taken from Founders Capital Management 2015 Annual Report

The intrinsic value of a business is equal to the discounted value of the cash that can be taken out of a business over its remaining life—without affecting its need for capital to grow. There are various formulas and methods for figuring intrinsic business value; we will use a straightforward calculation to illustrate this concept. (It is necessary to interject some math at this point— please forgive us.)

Since we like the candy business due to its highly predictable nature, we will use this as an example: Suppose we own Candy Co., which is expected to earn $2.50 per share, of which $2 may be freely distributed to owners without impacting the company’s ability to grow into the future. In other words, 50¢ per share will be maintained by the company to reinvest in the business to support future growth opportunities. If our candy business is able to indefinitely earn 25% on each $1.00 it retains, then we can calculate a prospective growth rate of 5% between now and eternity for our business. The equation:

[ (50¢ kept within the business ÷ $2.50 earnings = 20% of earnings retained) x 25% return on the retained portion = 5% ]

We are not done yet. Conventional financial practice then applies a rate of interest to discount (called “discount rate”) our perpetual 5% growth on freely distributable Candy Co. earnings. A higher interest discount rate is used by the investor to compensate for the risk inherent in placing money in a more uncertain business, as opposed to purchasing a secure government bond. So, if an “average” 10-year U.S. Government Bond were to offer an investor a 6% return over time, then someone interested in purchasing shares of Candy Co. would want more than the 6% risk-free rate to place their money in a situation that carries greater inherent risk. Let’s say a purchaser wants a 4% premium to the 6% average 10-year government bond rate to compensate for their risk— they would then use a discount rate of 10% to figure a purchase price for each share.

Now, for the grand finale: After tumbling the previous numbers, a purchaser would likely offer to pay around $40 per share for Candy Co. The full calculation of intrinsic value would be as follows:

[ $2.00 distributable earnings ÷ (the 10% discount rate minus a 5% growth rate to perpetuity), or ($2 / 0.1-0.05 = $40) ]

The Art of Arbitrage

“Give a man a fish; feed him for a day. Teach a man to fish; feed him for a lifetime.” —Lao Tzu

Our discussion of risk management and asset allocation leads to another investment topic that we would like to highlight this year—arbitrage. The word “arbitrage” initially referred to an investor (arbitrageur) who profits from differences in price when the same security, currency, or commodity is traded on two or more markets. For example, an arbitrageur may simultaneously buy one contract for silver in the Chicago market and sell one contract for silver in the New York market, locking in a profit due to the fact that the selling price in the New York market is higher than the buying price in the Chicago market. Fundamentally, when practicing arbitrage, the arbitrageur takes advantage of disparities in the value of assets. His talent lies in the ability to recognize disparities and to profit from the ultimate convergence of price and value. Popular sporting events provide a clear illustration of arbitrage in action: When the University of Connecticut plays Villanova in basketball, you can usually count on someone selling tickets for $50 apiece on game day, even though he acquired the tickets for around $35 apiece a few months prior to the game. Clearly, the individual who initially purchased many tickets for $35 anticipated a sold-out game. When evaluating this potential opportunity, the person probably asked a few questions:  How probable is it that the basketball game will sell out?  What will be the value of the tickets on game day?  How far in advance should I purchase the $35 tickets?  What will the tickets be worth if the game is not sold out?  What will be the value of the tickets if the game is canceled? Founders Capital Management holds a large number of short-term and long-term investments that could be considered arbitrage by nature. For example, over the past few years, we have steadily purchased stock in ConocoPhillips and Kraft Foods. Although these two companies are very different, they have one thing in common: Both companies decided to break up their holding company and spin off into several businesses that would be traded on the stock exchange. During 2012, ConocoPhillips spun off its refining business (Phillips 66) into a separately traded company, while Kraft Foods split its company into two entities—Kraft Foods Group (North American grocery business) and Mondelēz International (global snacks business). When these companies initially announced their intentions to split their businesses, investors had the opportunity to value the separate entities and compare their “untraded value” to the whole company priced on the stock exchange. If the estimated value of the separate companies turned out to be higher than the “traded value” of the whole entity prior to the spin-off, then an arbitrage opportunity existed—basically, one could make an advance purchase of “tickets” with confidence that the tickets would likely be worth more on “game day” (the day the spin-off occurred). As capital managers, we seek a margin of safety on our investments by attempting to be good arbitrageurs. We discipline ourselves to look for discrepancies between the short-term and long-term “price” versus “value” of our investments. Given our desire to steer away from any speculative activity, the practice of arbitrage raises the probability that we will achieve a fair return on our investment activity over time.

Taken from Founders Capital Management 2015 Annual Report

“Tell me where I’m going to die, that is, so I don’t go there.” —Charlie Munger

Warren Buffett’s business partner, Charlie Munger, sums up the knowable vs. unknowable dilemma in the quote that leads off this section—if we were able to know where we were going to die, obviously we would avoid the destination. It is fascinating how many market participants knowingly choose to go to the investment graveyard by making baseless predictions about future prices of the market or specific stocks. We believe that investment success and failure do not stem from forecasting about the future, but rather from an ability to distinguish between what is knowable and what is unknowable.

Several times each year, we are asked to participate in a committee that evaluates investment presentations given by money managers. After each presentation, 100% of the time, the discussion focuses on the pricing activity of represented companies in the portfolio, as opposed to the intrinsic value of the underlying businesses. Everyone seems more interested in discussing the unknowable deviation of securities that went up (or down) significantly in price compared to the norm, instead of discussing the more knowable—i.e., the business prospects for each company. In one instance, a committee member stated that the managers’ portfolio should be invested “more aggressively,” as opposed to what he viewed as conservatively, where the price deviation of the purchased securities was “too much in the norm.” Our interpretation: This investor was seeking more uncertainty among the holdings because, in his view, a lot of unknowable price movement equates with potentially higher returns.

Our investment approach is to evaluate “comparative certainty” as opposed to “proportional uncertainty.” We place primary importance on evaluating what is more knowable and certain, as opposed to scattering portions of money around various unknowable and uncertain “opportunities,” hoping to achieve a better-than-average result.

From 2015 Annual Letter – The Knowable vs. Unknowable
From 2015 Annual Letter – Discerning Value from the Valuable and Invaluable

Taken From Founders Capital Management 2012 Annual Report

Risk:
People intuitively evaluate risk situations every day, and any potential investment presents various risk considerations. The discussion about risk focuses on three key principles to consider prior to allocating capital:

1. Speculation is the casualty of an investment portfolio. Take into account only those risks that can properly be evaluated, and once all significant issues associated with an investment have been appraised, including the possibility of loss, then (and only then) look at the expected profit, as well as the time frame of the holding.

2. The future is always uncertain and should be viewed with circumspection. Weigh each investment first as an income opportunity, and second as a growth opportunity, recognizing a “margin of safety” in each security.

3. Constantly investigate any probable connection among ostensibly unconnected risks. Limit investments to a group of securities that can be understood, and ensure that the investment portfolio is constructed to avoid the aggregation of losses from a particular event or from associated events that will precipitate permanent loss of principal.

Opportunity Cost:
The second factor that influences investment returns is opportunity cost. If an investor with XYZ Company stock, which is yielding a 10% annual return, believes ABC Company will offer an opportunity to earn 12%, he will likely sell XYZ Company to take advantage of the extra opportunity presented by ABC. Conversely, if there is a high demand for money, and banks can lend equally secured money that earns 10% as opposed to 9% interest, they will naturally take advantage of this opportunity.

Inflation:
The final factor that influences investment returns is inflation. Inflation has the largest impact on the long-term return of all types of capital. To an investor, the important earnings are the “real earnings” a business produces for owners. “Real earnings” are determined by the extra purchasing power an investor achieves having placed his money at risk. If inflation reaches a high enough rate, it can make the purchase of various assets unappealing. At a minimum, to produce “real earnings,” a business must achieve a “return on its invested capital” that exceeds its “cost of capital”, which is largely determined by the rate of inflation.

From 2005 Annual Letter – Factors that Influence Investments
From 2006 Annual Letter – Risk vs. Uncertainty
From 2012 Annual Letter – Measuring True Risk

Taken From Founders Capital Management 2012 Annual Report

“When investing, it is more important to own the right hens than to place lots of eggs in different baskets.”

Asset allocation is based on the principle that diverse assets perform differently in changing markets and economic conditions. By allocating money to various asset classes, the temporary underperformance of one asset will be offset by the over performance of another asset. Put another way: If you have one hand in the freezer and the other in the oven, on average you should feel fine. Following this principle, advisors typically spread investors’ money among asset classes such as equities (large cap, small cap, growth, etc), fixed-income (core and high-yield), real estate, and alternative investments such as hedge funds.

For the vast majority of individuals, allocating money among many asset classes, as well as index investing, is far more profitable than picking individual stocks, bonds, or real estate investments. This statement deserves some qualification, however. Much of this has to do with an individual’s ability to pick the “right securities” (or the right assets) at the “right prices” and having the “discipline” to hold on for the long term. Many investors fail to adhere to one of these three legs of the investment stool and would be much better off holding on to the general market or asset class.

At Founders, we choose not to index-invest. Why? For example, if we were to attempt to mirror a stock market index, we would first look at the index and decide which businesses we would discard based on criteria such as low returns on capital, the competitive warfare nature of their industry, and/or dying entities.

Using these criteria, we would quickly throw out several airline and automobile companies, retailers that are no longer relevant, and poorly run financial institutions. It makes little economic sense to us to own even a small sliver of any bad business. Once we discarded these poor businesses from the stock market index, we would then purchase a small slice of the rest. Of course, we would choose to distill this down further and invest in what we think are great businesses that have a true long-term competitive advantage that are positioned to grow for many years into the future. We would follow the same strategy with any asset class we invest in—we would first discard the issues that offered a low return for the risk we were taking, and then review the rest. Then we would take the few best.

From 2012 Annual Letter – Asset Allocation and Portfolio Management—Theory vs. Reality

Taken From Founders Capital Management 2012 Annual Report

Our Focus—Price vs. Value Movement

“The definition of stock market insanity: Watching prices move every minute—up, down, and nowhere –while expecting a different result.”

Most individuals keep their eyes peeled on the price movement of any asset they own, including stocks, bonds, mutual funds, ETFs, and even property. But they fail to keep in mind an important question: Does the price movement of the asset owned reflect true change in value? If you asked an individual, “Would you rather own an asset that went up in price and down in value, or an asset that went up in value and down in price?” most would choose the former. This says a lot about our human nature. Of course, doing the opposite of our natural human inclination would actually lead to long-term investment success. Good investors are constantly working against human nature, reminding themselves to stay focused on the asset’s value creation or destruction as opposed to its price movement.

Let’s expand on this thought with an example: Suppose that you were contemplating giving up a $125,000 annual salary you have enjoyed over the past few years to pursue an MBA at a great business school—let’s say, Yale. An outsider valuing you as an asset may initially place a lower “price” on you as you decide to leave your job and pursue your dream. In fact, the price could be significantly lower because you would no longer be earning any money, but instead looking to spend $175,000 over the next few years on continuing education. Adding insult to injury, your starting salary after obtaining your MBA will be in the same range as what you were earning when you entered school. If this is the case, why would anyone decide to pursue advanced education? The answer lies in the long-term value that can be created through the $425,000 investment (the education investment plus a loss of two years income). It is likely that today’s value of the future incremental earning power of our hypothetical MBA student would more than offset the initial outlay. Given this knowledge, should the MBA student pay attention to the lower asset price placed on him by outsiders, or emphasize the long-term value he is creating by advancing his education?

The answer to this question is obvious, and investors should consider the assets in their portfolios in a similar manner. The important question to ask when investing is: How does the increase or decrease in price of our holdings correlate with the increase or decrease in their value?

From 2012 Annual Letter – Our Focus – The Art of Arbitrage

Taken From Founders Capital Management 2015 Annual Report

Since we emphasized the importance of intrinsic value throughout this letter, an expansion on this thought is probably a good way to finish. According to the Stanford Encyclopedia of Philosophy:

Intrinsic value has traditionally been thought to lie at the heart of ethics. Philosophers use a number of terms to refer to such value. The intrinsic value of something is said to be the value that that thing has “in itself,” or “for its own sake,” or “as such,” or “in its own right.” Extrinsic value is value that is not intrinsic.

Many philosophers take intrinsic value to be crucial to a variety of moral judgments. For example, according to a fundamental form of consequentialism, whether an action is morally right or wrong has exclusively to do with whether its consequences are intrinsically better than those of any other action one can perform under the circumstances. Many other theories also hold that what is right or wrong to do has at least in part to do with the intrinsic value of the consequences of the actions one can perform. Moreover, if, as is commonly believed, what one is morally responsible for doing is some function of the rightness or wrongness of what one does, then intrinsic value would seem relevant to judgments about responsibility, too.

At Founders, we feel a great responsibility—both morally and ethically—to our clients. We understand that each of you has placed your money in our trust, and we want to ensure that you understand how much we value this faith. Our ethos is to value your money as if it is our own, and this is why we philosophically invest alongside our clients. This ensures that we are all in the same boat and that the intrinsic value of our businesses, our clients’ well-being, and our own well-being are interdependent. In our opinion, this is not only morally right, but a moral obligation.

Each of us at Founders is grateful for your business and, more important, your faith in us. Without your invaluable dedication and commitment to us, we would not be where we are today— this is certain. We thank you for the opportunity to serve you and for your continued trust.

From 2014 Annual Letter – Striving for “True Investment Intelligence”

Taken From Founders Capital Management 2015 Annual Report

Believe it or not, there is scientific proof that our ability to both detect and avoid risk lies in the emotional as well as the rational part of our brain. It may sound counterintuitive, but to assess risk, one must allow one’s emotion to participate in the decision making process. This concept is compelling, since rational and/or logical thinking alone does not help one to avoid risk. Now, couple this thought of allowing certain emotion to influence our evaluation of risk along with the sensation we experience when we lose money—any money after we have perceived making it. On a rational level, we understand that every day, and during both so-called bull and bear markets, the market goes up 50% of the time and down 50% of the time. And we know that over the long term, the market has increased in value beyond inflation. However, we feel as if the market is in freefall during a bear market, and on a permanent upswing during a bull market. The roller coaster ride of a volatile market causes even the most dogged among us to experience some level of stress—especially if our portfolio is temporarily down. The daily random movement of our portfolio causes us to focus on short-term volatility versus long-term returns.

Countless individuals have had the experience of selling all their securities at the bottom of the market, only to buy them back when “things got better”—and securities were much higher. Why do individuals practice this irrational behavior?

The answer lies in our emotional response to loss. Psychologically, the “feeling” of a loss is magnified by much more than the feeling of a gain, and we are naturally wired to avoid this emotional freefall. Successful investing involves developing a logical and disciplined structure to manage this part of human nature.

We don’t know what will happen in the market, but we do recognize the signs of difficulty. Leverage, overtrading, and complexity are signs of trouble when individuals are not viewing the markets as investment vehicles, but rather as casinos in which to gain some quick profits.

From 2007 Annual Letter – Randomness and its Influence on Human Behavior
From 2014 Annual Letter – The Continued Chase for Ever-Greater Returns
From 2014 Annual Letter – Natural Investment Psychology

Taken From Founders Capital Management 2012 Annual Report

Wall Street has attempted to provide an opportunity for individuals to choose portions of the stock market indices through the introduction of Exchange Traded Funds (ETFs).  Of course, what starts as a good idea on Wall Street often becomes a not-so-good idea. Since all investors possess a human desire to look for an edge, a plethora of ETFs have emerged to meet the investor’s appetite for diversification within a particular asset class. Initially, ETFs held assets such as stocks and bonds; today, investors can purchase just about any ETF imaginable, including leveraged ETFs, currency ETFs, commodity ETFs, etc. What investors don’t understand is that in several cases, the underlying asset representing these ETFs is not the actual securities, but derivatives—possibly because, in the case of commodity ETFs, the fund does not wish to take delivery of and store agricultural products such as corn and wheat; or perhaps because it may be difficult for the fund to purchase the basic securities that make up the ETF. What does this mean? In essence, individuals are wagering on the movement of certain assets without ever owning them.

Many ETFs are now trading in the stock market with the same velocity as stocks —nobody wants to hold on to an ETF for the long term. And with the overabundance of ETFs on the market representing just about every asset class, abuse of these funds is not readily understood by investors. The authorized participants that generate ETFs make a lot of money managing the rolling derivative contracts embedded within the ETF—at the expense of investors. We have to ask what financial value is created by this activity that is unconnected to any economic reality inherent in the assets these ETFs represent. Wall Street and investors have officially “moved beyond the boundaries” from the original intention of a normal ETF investment.