Newsletter fall 2004.pmd

Fall 2004
Volume II, Issue 1
In this issue.
Market and performance summary
Mitchell A. Kovitz, CFA, CPA
So then.What about margin of safety?
Recent portfolio activity—Our sells
Robert C. Piton, CFA
What’s new?
Give me an alpha.
Jonathan A. Shapiro, CFA, MBA
[email protected]
Client alert
Marc S. Brenner, JD, CPA
[email protected]
312.334.7302
Bruce A. Weininger, CFP, CPA
[email protected]
312.334.7334
Richard Salerno
[email protected]
312.334.7304
This newsletter has been prepared by Kovitz InvestmentGroup, LLC, an investment adviser registered under the John Conway
Investment Advisers Act of 1940. This Investment Com- mentary is a quarterly newsletter for our clients and other interested persons. Within this newsletter, we Mark Rosland
express opinions about the direction of the market, investment sector and other trends. The opinions should not be considered predictions of future results. Discussionin this newsletter relating to a particular company is not Christopher Recker
intended to represent, and should not be interpreted to imply, a past or current specific recommendation to purchase or sell a security. The information contained in this newsletter, which is based on outside sources, is believed to be reliable, but is not guaranteed and not necessarily complete. Past performance does not guaranteefuture returns.
Market and performance
summary
The equity portion of the accounts managed by KIG, in its next generation product Arcoxia and taking into aggregate, declined in value by 3.8% in the third quarter, consideration the potential legal liability associated with lowering the calendar year gain to 6.9% (net of fees and patient lawsuits (where culpability and causation may be transaction costs). Year-to-date, the KIG composite has difficult to prove), we felt the stock was too cheap to outperformed the 1.5% return of the S&P 500, our sell. While it’s certainly possible the company may cut standard performance benchmark. So while the quarter its dividend, cash flow remains healthy even excluding was a forgettable one, we are not unhappy with our lost sales from Vioxx, and should continue to support a results so far this year as we continue to outperform by a healthy dividend yield that’s currently in excess of 5%.
And even after suffering a couple of recent clinical trial The quarter was rather volatile and there was a setbacks, the pipeline of potential new drugs is not bare.
great deal of variability in the performances of the However, given the known risks we did not feel comfort- individual stocks in the portfolio. Strong gains by Kohls
able adding to our position or buying for new clients.
(NYSE: KSS), Motorola (NYSE: MOT), Home Depot
Our analysis is ongoing and the situation remains fluid.
(NYSE: HD), McDonalds (NYSE: MCD), Laboratory Corp
Many of our portfolios were adversely affected (NYSE: LH) and BJs Wholesale (NYSE: BJ) were offset by
during the quarter when Cardinal Health, a leading losses in Cardinal Health (NYSE: CAH), Merck (NYSE:
pharmaceutical distributor, revealed that an informal MRK), IAC/InterActive (NASDAQ: IACI), and St. Paul
SEC investigation into the company’s accounting had Travelers (NYSE: STA).
been expanded beyond its initial scope. The company Speaking of Merck, on September 30th, it gave also disclosed that its negotiations with the pharmaceuti- the market a nasty surprise when management said the cal manufacturers regarding the transition of their drug company would stop selling Vioxx, its $2.5 billion-a-year distribution business from a buy-and-hold to a fee-for- arthritis and pain relief drug. Merck pulled the drug service business model were proceeding more slowly after a recent study revealed that long-term use of the than anticipated. While certainly not welcome news, we drug could increase the risk of heart attack and stroke.
believe the accounting irregularities were fairly minor Data accumulated prior to this study did appear to and will result only in a reclassification of certain rev- indicate a slightly higher incidence of cardiovascular enues and will not affect the company’s cash flow, which events for patients taking Vioxx, but this information was remains robust. We also believe Cardinal will ultimately well known throughout the medical community and be successful in its business transition and the risks indicated on the drug’s label. While we will never make inherent in this evolution are priced into the stock at excuses for our mistakes, the company’s action for a current levels. Its business is also well diversified which voluntary recall did catch us by surprise (and apparently should buffer the potentially uneven results coming from most other investors as evidenced by the one day 10 the distribution business. But again, owing to the innate risks, we have not yet increased our position for existing After thoroughly analyzing the situation (though client accounts or made a purchase for new clients. We admittedly, some of the issues and exposures are not will however, harvest the loss for tax purposes as an readily analyzable) we made the decision to hold the offset to the realized capital gains we have taken so far stock. Excluding all earnings contribution from Vioxx and So then.
What about margin of safety?
this year. As of the writing of this letter, the Company’s Our margin of safety principle, which we have referred stock recovered significantly after it released its delayed to many times in these pages as one of our core invest- 10-K (annual report) with no major surprises.
ment tenets does not guarantee against losses in stocks While we feel all of the stocks we make the we own. Instead, if a stock passes our screening criteria decision to purchase are undervalued to some degree, for business quality and our valuation models suggest it’s we fully realize that the odds are stacked against us that significantly undervalued, we believe only that the we will be proved right on every decision. It is for this probability of large loss is severely diminished, not that reason that our investment philosophy’s primary focus is it absolutely can’t or won’t happen. In the aggregate, on minimizing our mistakes (through strict selection we feel that if we assemble a portfolio that includes 25- criteria and being extremely price conscious), and have 35 names that meet our margin of safety criteria, overall confidence that our good decisions will greatly outnum- portfolio risk will be properly managed. We further ber the poor ones enabling us to garner a strong overall manage risk in the portfolio management process by portfolio return relative to our benchmark. As much as scaling into positions and closely monitoring position we would like to, we cannot invest in equities without sizes to make sure no one position becomes too large a subjecting our portfolios to some financial risk: the percentage of the overall equity portion of the account.
uncertainties of business (and the economy to some In other words, properly managing the overall book will extent) do not allow for this. We can only trust that our deaden the impact of losses, even significant losses in a ability to differentiate a good business from a poor one small percentage of the holdings. The key is to keep the and to recognize a fair price to pay for that business will mishaps small in relation to our collective decisions.
lead us to make a preponderance of good decisions.
Short-term performance may very well largely be Importantly, having a few stocks with current yet unreal- a matter of luck anyway. In order to evaluate the skill ized losses does not cause our confidence to waiver nor and diligence of an investment manager and to seperate stop us from making that next decision.
the element of luck you need to examine results over a There was some good news in the quarter.
long period of time. Looking at the five year period since Oxford Health (NYSE: OHP), often the subject of take-
September 30, 1999, a period encompassing various over rumors, realized that fate when UnitedHealth
market cycles, KIG equity portfolios have increased a Group (NYSE: UNH) swooped in to buy the managed care
cumulative 51% (8.5% on an annualized basis) net of fees company only days after talks ended with another and costs. For the same time period, the S&P 500 has potential suitor. We spend the majority of our time declined in excess of 6% (negative 1.3% per year). We thinking about what companies are worth, looking at the don’t believe that these types of results could have been economics and the competitive positioning of the busi- generated by maintaining a short-term focus. In fact, ness and determining what an intelligent private owner our decisions are never geared toward outperforming on would pay to buy that business and hold it forever.
a quarterly basis but rather are focused on increasing Based on Oxford’s strong brand image and its unique wealth over long stretches of time. Also, these results competitive niche on the East Coast, we had long be- have been produced despite the fact that from time to lieved that its private market value was greater than its time we may suffer some setbacks in individual names.
Recent portfolio activity—
Our sells
While we primarily sat on our hands in terms of portfolio
becomes obvious (or at least becomes a higher probabil- maneuvers in the second quarter, this quarter proved to ity event). Instead of merely postponing the day of be in stark contrast as we were active on both the buy reckoning and hoping things can turn around, we take and sell side; such will be the case when you are guided swift action to remove the offender from the portfolio.
by valuations and not the calendar. All of our sell actions Hope is not one of our investment strategies.
except for one were for our favorite reason- the stock In the case of St. Paul we were confronted with prices increased to what we believe represented fair two new pieces of information. The first involved the value for the businesses. These companies, with holding adequacy of the loss reserve levels of the combined periods of one to three years and gains ranging from 26% entity. We had believed that the merger made sense for to 82% (based on aggregate average purchase prices for strategic reasons of increasing scale and capital base, the KIG composite and including dividends), were Jack-
two hugely important characteristics of successful in-the-Box (NYSE: JBX), Allstate (NYSE: ALL), Lafarge
insurance companies. Soon after their first quarter (NYSE: LAF) and Oxford Health.
reporting results as a combined entity it became evident The exception was St. Paul Travelers, which was that this may not be the case and instead of the whole sold at a loss of approximately 15% on average. It was being greater than the sum of the parts, the opposite only last quarter that we extolled the virtues of the St.
may be a more likely outcome- the small problems of Paul and Travelers merger and our confidence in the two companies can mushroom when combined.
future of the combined entity. But our analysis and The second issue revolved around their exposure intelligence gathering does not stop once we purchase a to asbestos litigation, and a new unanticipated (per- company for the portfolio, in fact our efforts are in a verted?) use of the bankruptcy system to exploit gaps in sense stepped up in order to make sure what we bought the typical insurance contract. Quantifying asbestos is really what we thought we bought. Most times, the litigation exposure, even prior to this new development, information gleaned post purchase confirms our original had been a controversial subject for some time in the investment thesis. However, there are times we uncover insurance industry where logic, reason and even ethical new information or reassess risks that put our original decency has been turned on its head by claimants with investment thesis to the test. When this happens, no current signs of illness (except a clear bout of greed) portfolio changes need to be made regardless of whether who have been securing settlement awards with former that action is contrary to what we believed (and publicly employers and their insurance companies. Being as absurd as it was, it was long assumed that the govern- Some investment advisors tend to sweep new ment would eventually be able to step in and put the pertinent information opposing their initial beliefs under perverse process back on its correct track- to pay out the rug, hoping to be bailed out of their investment at a awards to only those who were truly harmed by asbestos later date by an acquisition or perhaps a bull market.
exposure. While it’s possible that some type of reform We, on the other hand, realize that we are going to make could be forthcoming, with a sharply divided House and mistakes (that’s about the only thing we can really be Senate we place low odds on anything meaningful coming sure of) and try to be intellectually honest with ourselves to pass. The latest bankruptcy-related development (and our clients) at the point and time the mistake tipped the balance of our opinion against continuing tohold the shares.
What’s new?
Turning to the new purchases, it was just last quarter we WellPoint is a managed care provider serving lamented the fact that we were finding it difficult to approximately 15 million members primarily in Califor- identify investment ideas that met our criteria for nia. WellPoint markets its products and services using purchase. We were firm in our conviction, however, that the exclusive Blue Cross Blue Shield (BCBS) names. With we would not commit client capital just for the sake of its planned merger with Anthem (NYSE: ATH) (another
appearing active, and were rather content to wait for holding of ours) being objected to by the California situations where we believed we were receiving more in insurance commissioner, the price of the stock declined value than we were paying. Our patience paid off to levels we felt did not incorporate the value of the somewhat as we added three new positions and in- franchise as a stand-alone entity. The BCBS name is an creased our stake in an existing holding. We also used extremely valuable brand, which we believe will enable what we believed to be temporary declines in prices of the company to continue to garner enrollment growth several existing holdings to initiate positions in accounts higher than the overall industry and drive premium growth. As important is its continuing investment in Still, the cupboard of new purchase opportunities technology and infrastructure and its disciplined under- remains largely bare. Our business owner/private writing focus that should enable the company to con- market value methodology is just not turning up that tinue keeping a firm control over its medical cost trends.
many attractive prospects. Most of the businesses that We believe this top line growth coupled with tight cost we find appealing (those in our “Universe” which was controls will continue to spur margin expansion and described in detail last quarter) seem to be selling at earnings growth. We considered the completion of the prices we believe represent fair value (i.e. little upside merger with Anthem (something we’re not counting on) as potential). In every case, however, we think only about a free call option as we believe that the opportunity was what the business is likely to do, not what the market, For longer term clients, Furniture Brands is not a new name. In fact this is the third separate time in the WellPoint Health Network (NYSE: WLP) and Furniture
past four years we have purchased shares in this furni- Brands (NYSE: FBN). Motorola, a global provider of
ture maker whose primary brands include Thomasville, wireless handsets and telecom infrastructure, is going Drexel Heritage, Broyhill and Lane. We did well with through a rebirth of sorts. A new management team has each of our prior two experiences with Furniture Brands refocused the company on its core strength of innovation and the price has once again fallen to levels where the and has radically reengineered its processes, cutting a tremendous amount of fat out of the cost structure. We We added to our stake in Home Depot, making it believe Motorola will benefit from a superior product our largest current holding. Fears over rising interest portfolio and increased operating leverage through its rates, a slow-down in housing and competitive pressure restructuring and consolidated sourcing. The company from rival Lowes has served to depress the valuation of also recently spun off its capital intensive semiconductor the home improvement retailer to levels that we feel do business, which should increase free cash flow and future not fully recognize the value of the franchise or its long term prospects. We believe new management led by Bob Alpha measures the difference between a fund’s Nardelli, a former General Electric (NYSE: GE) executive, actual returns and its expected performance, given its continues to improve the company operationally (distri- level of risk (as measured by beta). A positive alpha bution logistics, centralized purchasing, inventory figure indicates the fund has performed better than its management) while store remodels and renewed focus beta (i.e. its risk) would predict. In contrast, a negative on customer service have aided same store sales and alpha indicates a fund has underperformed, given the increased the average customer purchase amount. We expectations established by the fund’s beta. Some believe the market continues to be overly pessimistic investors view alpha as a measurement of the value concerning future earnings growth, but pessimism has added or subtracted by a fund’s manager.
always been one of our strongest allies (not because For the mathematically inclined we include the we’re necessarily negative people, mind you, but be- cause it seems to produce such good prices).
Other existing positions we added for many new accounts included Abercrombie & Fitch (NYSE: ANF),
Anthem, IAC/InterActive and Medco Health Solutions
(NYSE: MHS). Each of these was discussed in prior
letters. Also, for new accounts with no exposure to the
pharmaceutical industry we took a small position in
Pfizer (NYSE: PFE).
For example, a portfolio that rises while the market is Give me an Alpha.
rising, but by an amount greater than by what would beexpected based on the portfolio’s beta (or risk profile), To continue our effort to explain various financial statis- has a positive alpha. In this case, the portfolio manager tics often used to evaluate investment managers, we is earning excess returns or is “beating the market” with present the following brief discussion on alpha. In the first quarter, in what is probably looking like a romp Running through some numbers, let’s assume a through the Greek alphabet, we described beta, the portfolio returned 12% over some time period and has a sensitivity of a stock’s or portfolio’s returns to the beta of 1.0, while the market returned 10% over the returns of some market index. Or put another way, same time period. We will assume that the interest rate volatility or the systematic risk due to general market on a 90-day treasury bill (an estimate of the annual risk conditions that cannot be diversified away. Now we will discuss alpha, a counterpart of beta. The term is some- times referred to as “Jensen’s alpha” (named afterMichael Jensen, a Harvard Business School professor and University of Chicago graduate) and is used to determinethe risk-adjusted performance of an investment manager.
In this case, the portfolio manager out-performed the “It’s not solely the capacity to make
market on a risk-adjusted basis by 2%.
great shots that makes champions,
In the case of KIG, we have been tracking our but the essential quality of making
equity performance on a composite basis since January1, 1997 (7 ¾ years). Over that period, our composite has very few bad shots.”
returned an annualized 14.6% with a beta of 0.96, indicating that these results were obtained with acomposite portfolio that had a slightly lower volatilityrelative to the overall market. Over the same time “We try to price, rather than time,
period, the S&P 500 has had an annualized return of purchases. In our view it is folly to
7.03%. Based on these figures, assuming a risk free rate forego buying shares in an
of 2%, and using the formula for alpha set forth above,KIG has generated an annualized positive alpha of outstanding business whose long-
approximately 7.8% over this period.
term future is predictable, because
of short-term worries about an
economy or a stock market that we
Client alert
know to be unpredictable. Why
As we transition to our new broker-dealer, Kovitz Securi- scrap an informed decision because
ties, as a matter of regulatory compliance and clientprotection, we can no longer accept checks made pay- of an uninformed guess?”
able to Kovitz Investment Group or Kovitz Securities.
Warren Buffett, 1994 Berkshire Hathaway Share- Instead, please make checks payable to Pershing, LLC
(our clearing firm), and if possible please try to remem-ber to put your new account number (it starts with theletters ADV) on the check in the memo section. In theevent you want to forward a check made out to youpersonally (or to the name of the account), please writeon the back of the check, “Pay to the order of PershingLLC”, and then sign it. Thank you in advance for yourcooperation.
About KIG
Kovitz Investment Group, LLC is comprised of a diverse group of developed and modified by Warren Buffett and Charlie Munger investment professionals who combine experience in asset of Berkshire Hathaway. We consider investments in common management with a thorough understanding of financial stocks as units of ownership in a business. We don’t, therefore, markets. The KIG team consists of portfolio managers, equity regard ourselves as just traders of stocks, but rather as part- analysts, bond specialists, and financial advisers. The portfolio owners of a tangible business. Our primary interest lies in managers/analysts possess vast and varied educational and acquiring and holding securities of exceptional businesses at professional backgrounds. As a group they hold advanced suitable prices. As such, we seek to allocate investment capital degrees in Business Administration (MBA), Taxation, Law (Juris on the basis of justifiable premises, valid logic and hard doctorate) and Public Policy (MPP), and professional evidence, not popularity or emotion.
designations, including Chartered Financial Analyst (CFA), While we strive to maximize return, we believe that Certified Public Accountant (CPA), and Certified Financial the primary and overriding investment criterion should be Planner (CFP). Each portfolio manager is responsible for equity safety of principal with a focus on minimizing permanent loss of research, strategy and implementation.
capital. Our approach is focused on maximizing long-term net KIG’s approach to investing in equities is based on the worth and not necessarily on generating short-term methodology pioneered by Benjamin Graham, and as further 222 West Adams StreetSuite 2160Chicago, IL 60606

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