Kovitz Investment Group – Q3 Letter: Fundamentals vs. Expectations

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Kovitz Investment Group - Fall 2014 Commentary

Kovitz Investment Group: Market and Performance Summary

The Kovitz Investment Group® (KIG®) Equity Composite (the “Composite”) decreased in value by 0.4% (net of fees) for the quarter ending September 30, 2014. For the first nine months of 2014, the Composite returned 1.9%, while our primary benchmark, the S&P 500, returned 8.3% over the same period.

Performance so far this year, at least on a relative basis, continues to be lackluster. This is nothing out of the ordinary. There have been many times over our nearly two decade-long history where short-term underperformance has given way to longer-term outperformance. In fact, we believe that not obsessing about our performance relative to our benchmark over short periods is the cornerstone of how we have outperformed over longer time periods. Short-term stock gains and losses are fleeting while long-term price appreciation is driven by company fundamentals and the multiple applied to those fundamentals. We feel very strongly that our portfolio companies share strong fundamentals and are content to wait patiently for the market to place more appropriate multiples on their strong and growing free cash flows.

Keep in mind that we are in the business of chasing value, not performance, and to do as well as our benchmark has this year would have required us to take on more risk than we think is prudent. We will not chase returns by buying shares of highly priced social media stocks, early-stage biotechnology companies, utilities (yes, even utilities are expensive!), or other hot growth stories with poor fundamentals and uncertain prospects. “Fear of Missing Out” is not an emotion we possess. We are more concerned with the risk of suffering a permanent loss of capital than about the risk of missing opportunities, especially those that are short-term in nature. We are very grateful for a client base that shares our focus on the long-term, thus allowing us to deviate from a benchmark over short time periods. It is a very meaningful advantage.

Below is the standard performance report of the KIG Equity Composite which now covers more than 17 years. The chart summarizes both annualized and cumulative performance results from January 1, 1997 through September 30, 2014 for the Composite and the S&P 500.

Kovitz Investment

Kovitz Investment

Kovitz Investment Group: Fundamentals vs. Expectations

“The stock market is filled with individuals who know the price of everything, but the value of nothing.” - Phil Fisher

Suppose there’s a horse race between two horses and 100 bettors wagering on the outcome by each buying a $2 betting ticket. Ignoring the house’s take, the total pot is $200.

Horse A is a relative newcomer, but has performed strongly in warm-ups, while Horse B is an established horse who has run well for a long period of time and shows few signs of slowing down. Rational bettors could easily disagree over which horse is the better bet to win, so the field splits evenly. If 50 bet on Horse A and 50 bet on Horse B, the 50 winners will pocket the whole $200, or $4 per person. Each winner will have doubled their $2 bet.

Now assume a similar race except this time a report is released by Horse A’s promoter stating that Horse A has the potential, untested as it may be, to run much faster than Horse B. Based on this report, the consensus view becomes that Horse A is such an overwhelming favorite that 80 of the 100 bettors wager on her. The house being no fool, as anyone familiar with horseracing knows, will adjust the odds on Horse A. In this case, the odds will change from 2-to-1 down to 5-to-4. If Horse A wins, the 80 bettors with winning tickets will share the $200 pot, but will only take home a paltry $2.50 despite putting $2 at risk. If Horse B wins, the 20 bettors who stood by their original analysis will be rewarded with a significantly larger payday, returning home with $10 in exchange for the $2 they put at risk.

See full Kovitz Investment Group Letter here.

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The post above is drafted by the collaboration of the Hedge Fund Alpha Team.

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