4 pillars of investing

S I M P L Y

Sarbit advisory services inc.100-1 Evergreen Place Winnipeg, Manitoba, Canada r3l 0e9sarbit.com

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This publication has been a long time in the making, after the many years I have been in the fi nancial services business. In the following pages, I have tried to encapsulate my investment philosophy in a succinct fashion. My hope is that all who read it will understand what we stand for here at Sarbit Advisory Services.

Our investment principles are being presented to you in a simple, understandable format. The reason? The basics of investing are really very common sense. Yet I have discovered over time that few Investors grasp these basic, easy-to-understand ideas.

Intelligent investing, as you will see, is based on a simple but fundamental idealowering your risk of loss. Nothing is more essential to a successful investment plan. We base this on the concepts and practices of successful business Owners/Investors, who follow this key concept everyday in their businesses. Not losing money is the cornerstone approach to the creation of wealth. Remember, a simple business concept followed by successful entrepreneurs.

At Sarbit, we are responsible to you, the Investor. We earn your trust by protecting your hard earned assets and

know that if they are secured, we believe we cant help but enhance the value of your investment. We take this commitment very seriously and place it as one of our primary goals. In everything we do, we intend to consider how our discipline will impact you. These principles are what successful investing is all about! We hope you will appreciate what we have come to refer to as Simply Sarbit.

Our company can be summed up in the three words we have chosen as our tagline:Probity. Discipline. Independence.

Lawrence A. Sarbit C H I E F I N V E S T M E N T O F F I C E R

S A R B I T A D V I S O R Y S E R V I C E S

S U B A D V I S O R T O I A C L A R I N G T O N

The power of this idea!

Welcome


Probity is possibly a word you havent encountered before. Well, not to worryneither had I! Not until a learned friend showed me this word and pointed out how it had fallen into the waste bin of the English language. Nevertheless, the meaning and power of this word is overwhelming. Some of its defi nitions include: integrity, honesty, honour, fi delity, loyalty and loftiness of purposeeverything

good and decent and everything we, at Sarbit aim to attain in all that we want to be. Sarbit will put the simple issue of behaviour forward. We always want to hold our head up high and proud; that must be our highest priority. As Warren Buffett, the American investment master has suggested: Act in a way today while assuming that all your behaviour will be reported in detail on the front page of the

local newspaper tomorrow for all to read, including members of your family, friends, business associates and general public. With such a perspective, youve got a better chance of doing it right.

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5The Original Sarbit General Store in Selkirk, Manitoba, 1917.The beginning of 50 successful years in business.


6 Larry Sarbit (age 4) cutting the grass in Selkirk.


Discipline is a word that has been part of my vocabulary in this industry ever since I was lucky enough to discover the writings and teachings of Ben Graham, Warren Buffett and other great thinkers. Without it,

investing, indeed the outcome of life, is reduced to random occurrences. Of course, no one knows the future. However, a disciplined approach gives you at least some measured way to deal

with your environment and ways to deal with events that occurpredictable or not. Well spend the majority of this publication describing our investment discipline, why it makes sense and the logic behind it.

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Finally, weve adopted the word independence. First, and most importantly, we at Sarbit apply this to our thought patterns. We dont think successful investing is achieved by

following the crowd or the herd where little or no thoughtful consideration is given. Successful investing is achieved by thinking independently and letting the facts and rational thought guide your

choices. Our mandate at Sarbit is that we continue to think and act in the best interests of the client. This means we will continue to follow our independent investment discipline.

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9Goldie SarbitLarrys Grandmothera very strong individual and leader of the family.


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As you proceed through this booklet, you will learn about a unique approach to investing that we believe offers a rarely used, common sense discipline that is rational, logical and successful.

At Sarbit Advisory Services, we put the client fi rst! If we do

what is right for the client, the marketing efforts will emphasize

that and both client and company will succeeda welcome

combination. We will act for the benefi t of clients. We are paid

to do what is appropriatenot what is popular. And we will

think independently. Independence of thoughtrational thought

and cold, hard business logicwill guide our decisions.

We rely on the intelligence and guidance of fi nancial advisors across Canada to carry our message to you, the client through IA CLARINGTON. Our objective as a fi rm is to manage the assets of people who understand and accept our philosophy as an intelligent approach to capital preservation and growth. We want to do something special for those clients and their advisors. In so doing, we think we cant help but be successful.

We believe there continues to be a need in Canada to have specialty investment companies and products that offer clients something not available anywhere else.


01.We cant accurately and consistently predict the future or short-term moves in interest rates. Interest rates are important to business in general, the real estate markets, trade, defi cits and the economy as a whole. But we dont know where they will be in six months or a year from now. As a result, we certainly wouldnt want to invest your money on such a forecast coming from either us or anyone else, for that matter.

02.We are unsure where the economy is going in the short or mid-term. However, it is our belief that if we, as a species are able to avoid blowing ourselves into orbit, a decade or two from now, we will look back on the extraordinary creation of wealth that took place over that time. The risks between now and then are huge. As Einstein said: There are only two things that he was aware of that were infi nitethe Universe and human stupidity. And he wasnt entirely sure of the fi rst! At any rate, we wont be making any bets with your money with this as a priority.

03.We arent able to accurately predict what will happen to currency fl uctuations in the future. We arent clairvoyant enough to know where the Canadian dollar will trade against the U.S. currency tomorrow, much less in a year from now. Our response is to hedge the two currencies and remove this unpredictable variable from the equation for Canadian Investors. Our advice to holders of foreign investments: avoid investments that have exposure to foreign currencies.

04.We cannot predict where the stock markets or individual stock prices will be tomorrow, the next day or fi ve years from now. We think the markets over the long term will be higher but we dont think our clients pay us to predict the unpredictable. In a word, we think this would be a waste of our precious time and would not lead to an incremental return to you, our clients.

The above points are where a great deal of energy is expended in the area of professional money managementIve seen it fi rst hand. Its a practice that produces a lot of heat but no light.

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WHAT IS DEFINITELY OUTSIDE OUR CIRCLE OF COMPETENCE

Our investment discipline is a simple one. It is modelled after the behaviour of successful business Owners/Investors. Our approach starts with an admission: we cant do everything well; most things in investing are out of our circle of competence. This Warren Buffett term refers to that circle within which the Investor has a high degree of knowledge and understanding. Outside of that circle, great danger exists and, most importantly of all, the potential to make a mistake and lose capital increases dramatically.

The Discipline:The Successful Business Methodology


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To answer that question, we looked for who makes money and creates wealth on a long-term basis and who does not. The result is that we have crudely divided the world into two broad categoriesMutual Fund/Stock Market Speculators (Speculators) and Successful Business Owners/Investors (Investor/Owners)and have found that most people either fi t into one grouping or another (please refer to the following table).

Another incredible revelation: these two categories of people are completely opposite in terms of their views and their actions. In the end, these two diametrically opposing approaches are also like night and day. One leads to successthe creation of wealth, while

the other is the road to sub-par results at best and losses, in the worst case. But what separates these two groups and their very different outcomes? Is it just luck or are there deep seated differences which culminate in opposite outcomes?

So, What Works in Investing?


Speculators and Investor/Owners T W O S E P A R A T E W O R L D S

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In our opinion, it is anything but chance that produces these different outcomes. When we observe these two groups from the standpoint of their business views

and behaviour, we see that they respond differentlyopposite, in fact. The table above displays just how different these two groups of participants in business

and investing are. From the beginning, they ask a fundamentally different questionwe call it the Big Question.

How much can I make? The Big Question How much can I lose?

Vast Majority % of Investors Tiny Minority

Emotion Key Factor in Decisions Logic, Rational Business Thought

Macro Economics Economic Viewpoint Micro Economics

Average / Sub par Quality of Business High

Overpriced Price / Value Reasonable / Bargain

Buy as Price Buying Behaviour Buy as Price

Sell as Price Selling Behaviour Sell as Price

High (They think its low!) Risk Tolerance Low

Relative Returns Investment Absolute Returns Measurement Metric

Months Less than a Year Time Frame Years / Decades / Generations Length of Ownership

Mutual Funds: Concentration of Holdings One or a Few Businesses Dozens / Hundreds of Stocks Clients usually own several funds

Imitate Index Performance Creation of Real Wealth Then, subtract Friction costs:

1. Management Expenses (MERs)2. Turnover Trading Costs

3. Capital Gains Taxes = Mediocre Results

Mutual Fund/ Successful Business Stock Market Speculators Business Concepts Owners / Investors


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S P E C U L AT O R S F I R S T A S K :

How much can I make? Implicit in this question is the lack of concern for risk. Upside is all they see. They dont look down at the perils below.

I N V E S T O R S / O W N E R S F I R S T A S K :

How much can I lose?


First and foremost in an accomplished business persons mind is the element of risk. They naturally want to know about what can go wrong, what hidden mine fi elds exist on their investment landscape. They instinctively know that taking care of risk will mean the greater potential for investment success, whether investing in their own private business, buying another private business or buying shares in publicly traded securities.

The answer to this question leads these two participants in completely different directions from this point. The opposite answer to the Big Question inevitably leads to completely different thought, behaviour and results.

Investor/Owners make up a very small minority in our society. Relative to the population, there are very few successful business people. The Speculator category makes up by and large most of the investing public. (While the membership of Investors in each category is mutually exclusive, it is amazing how many successful business owners can behave so rationally with their own business and yet so foolishly when it comes to publicly traded securities. Many are unable to make the transfer of logic from one to the other, even though the themes and entities are the same.)

The key factor involved in the decision-making process again is completely different. Investor/Owners use cold, hard logic and rational business thinking to decide what to do in their business. Emotion usually plays little role in their decisions and behaviour. Speculators, on the other hand, are largely ruled by emotion. Logic often has no place whatsoever in their fi nal decisions.

How else can one understand why they would sell their shares at ridiculously cheap prices or pay outrageously expensive prices for partial ownership?

Their economic viewpoint, likewise, is very different. The Speculators are more concerned with big picture itemswhats happening with oil prices, debt levels, the shift of jobs from the U.S. to China, terrorism and on and on. Investor/Owners are concerned with the micro-economics of their business. Practical, successful business people generally dont worry about the state of the economy when they buy a business or invest in their own company. Instead, they focus on the business fundamentals themselves and whether incremental returns can be derived from an investment. As noted above, we believe time spent on big economic questions that are largely unanswerable is a waste of our time.

What about the quality of businesses owned and/or bought? By defi nition, the small group of Investor/Owners possess a high quality business, either through their own efforts to create or fi nd a terrifi c operation or because the business fortunately came with great economic fundamentals. Speculators most often own average quality companies at best and sub par businesses at worst. And its usually not even an issue to them. They typically dont own the business for very long so quality isnt a concern. And, if you own the average mutual fund which typically holds dozens of stocks, the net result is that some companies are of high quality, some will be of inferior quality and most somewhere in the middle. The net result? An average group of businesses overall is what you cant help but end up with.

How about the issue of price and value? Successful Investor/Owners are extremely conscious of what they pay for everything in their business, from the carpet in their offi ces to other capital requirements in their business. Naturally, they are critical of what they pay for any business they might buy. They dont overpay for anything in business and are always on the watch for wasteful expenditures. The Speculators dont really worry or care about what they spend on a business. Witness what investors have been paying for publicly traded businesses, on average, for most of the fi rst decade of the new millennium. Price-to-earnings ratios of the s&p 500 have been double digit numbers for practically the whole period; at times reaching stratospheric levels of 30 and 40 times + earnings. That means paying 30 or 40 years of current earnings to get your initial investment back. What rational business person would be willing or able, for that matter, to wait all that time before the returns even begin to accrue? Private businesses change hands at substantially lower prices. Another characteristic of private transactions: rarely does either buyer or seller walk away with an extraordinary deal. Not so in the world of public companies where emotion (mentioned above) can offer extremes (prices so high, youre compelled to sell and prices so down and out that your mouth waters at the opportunity) to owners and potential buyers of part ownerships of businesses.

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Another enormous contrast between these two people is when they buy and sell businesses. Opposite againSpeculators buy as the price goes higher. The stocks taking off! Buy now before I miss it! Investor/Owners often stop buying for their business when prices rise too high. In the extreme, high prices are viewed as an opportunity to liquidate. On the fl ip side, Speculators sell on the way down. The stocks fallingget me out! The Investor/Owners like lower prices to add to the inputs to their own operations.

Investor/Owners have a low tolerance for riskthe successful ones know that the road to success is to avoid the downside and losses whenever possible. Speculators, on the other hand, think they have reduced risk by diversifying and holding a large number of stocks. The sad irony is that they are actually assuming higher potential danger. What other conclusion can be reached when you own a mutual fund full of mediocre companies at extremely high prices?


on performance and for the most part, derives returns close to the indices. But if they instead own actively managed funds, the friction costs are substantially higher and amount to a huge drag on performance. After deducting the management fees (mers) which can be in excess of 3%, after subtracting the turnover (as discussed above, with stocks held for less than a year in the average mutual fund, this translates into another burden of brokerage fees borne by the mutual fund owner), and resulting capital gains taxes if the sales are fortunate enough to produce gains, the net result is a return less than the index. This appears to be the main reason why most funds (8090% over any given period of time) underperform simple indices. In other words, the funds produce mediocre results for the hapless owners of these funds. Only the mutual fund company does wellthey earn fees

fund owns dozens, sometimes hundreds of stocks. Effectively, that means these funds become transformed into indexesthey become the s&p 500.

We come to the last, great test: that of performance. Are the hoards of speculators deriving a different result from the small group of business owners at the end of the game? The outcomes couldnt be much different. Lets take a look at the Speculators fi rst. Holding many dozens of different shares of many businesses invariably leads to a market average rate of return. As noted above, if an individual owns several funds of such an ilk, their overall holdings have become what Warren Buffett would call, de WORSE ifi ed. If one owns true index funds which generally have very low turnover in the portfolios and low fees, at least the owner suffers limited drag

of time. How can you call a fund or person, who measures their holding period in months, days, and minutes, Investors? As weve defi ned them from the begin-ning of this discussion, they are Specula-torsthey never really own anything they buy in the stock market.

How many companies do these two groups ownwhat is the difference in the concentration or number of holdings held by each group? Almost exclusively, if you identify winners and fortunes made in business, most of us can name the one business in which they have succeeded. For any famous, nationally known business owners, most people can name their reason for success in one or a few words. Thomson? Newspapers. Asper? Broadcasting. Demarais? Financials. On the other side, the average mutual

no matter how poorly the unfortunate owner performs. Investor/Owners, on the other hand, do something oppositethey create real wealth for themselves and their shareholders. Each business is different and returns will naturally vary. But the act of wealth creation is usually present.

So, here we have two very different groups of people involved in ownership of businesses. But as we found out, they think differently, and act in opposite ways with the net result being that one group, that small group of successful business Owners/Investors, are almost exclusively the ones who make out with the riches.

Which path to follow? The contrast outlined above leads to an obvious conclusionInvesting results are best achieved by following a successful business approach. Investing, after all, is a form of business. Any other way to behave and expect to

succeed is, in our opinion, pure folly. Einstein said; Insanity is doing the same thing over and over again but expecting different results. Unfortunately, this is how the vast majority of Investors behave. The results are usually disappointing, sometimes tragic. Investing is not a game and peoples retirement assets are not to be played with. The assets entrusted to us by our partners/clients, are serious business.

Studying successful business owners behaviour and thinking has resulted in us coming up with a few basic rules to guide us in our quest for low risk/loss reduction while creating wealth. We call this our 4 Pillars of Successful Business Investing.

Another area of extreme contrast between these two fi nancial participants is how long they own businesses. Successful Investor/Owners own their businesses for years, decades and often will hand the business down from generation to generation. Why would you sell a successful business? Further, Investor/Owners dont dump their company at the fi rst sign of trouble. If things arent going well after 6 months or a year, they dont abandon ship. They stay, they work hard, they take actions that must be taken but they dont leave. Most times, they fi ght to survive. The successful ones do. They know it requires determination, intestinal fortitude and a great deal of patience. Stock market speculators get out at the fi rst sign of trouble. The proof? Many mutual funds in Canada own a business/stock for a relatively short period

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the 4 pillars of successful business investing

T H R E EConcentration: Own a few

terrifi c companies.

O N EBuy wonderful

businesses.

T W OPay a bargain price.

F O U RHave patience.


First, what is a wonderful business and what characteristics identify it? Every professional money manager naturally says they own such businesses. But how do we know this is true? What have they done to demarcate and identify such businesses? What checklist do they use to show that a company they own is wonderful? Heres our list of qualities that we think best exemplify such a company.

O N E

1. A Huge Sustainable Competitive AdvantageA Franchise2. A Growing Stream of Free Cash Flow3. Simple, Understandable4. StableThe Basic Business Changes Little Over Time5. Predictable Earnings6. Consistent, Repeated Purchases of Product or Service7. Not Natural Targets of Regulation8. Disaster ProofMost Mistakes are Forgiven9. A Royalty on the Growth of Others, Requiring Little Capital Itself10. Good Management

Most of these ideas have been borrowed from the pre-eminent business investor of our time, Warren Buffett. They have stood the test of time. Lets review them systematically:

1 The competitive advantagenon existent in most businessesis a barrier to entry,

natural or regulated into existence. Such companies have the ability to pass on price increases to their customers without attracting a host of new entrants. This franchise comes in many forms. Coca-Cola has a trademark that is known around the world. There are lots of colas available to be consumed, but there is only one Coke. It can be size and regulation that gives a company its barrier and protection. The chartered Canadian banks are few in number and its hard to imagine any government in this country allowing any of them to go out of business. They have grown to immense sizes and are in so many businesses and reach into every aspect of life in this country that their demise has become impossible. Car dealerships are given geographic areas of operation. Youll never see two Ford dealerships side by side. Commodity businesses are the opposite. If they are successful, they attract a host of new competitors very soon. If they produce the same product or service as others, prices that can be charged are driven down for all participants.

A Wonderful Business: The Defi ning Characteristics

Buy Wonderful Businesses.

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Successful investing isnt about precisionit is more about knowing the trend and direction. Again, to refer to Mr. Buffett, successful investing is about being approximately right instead of exactly wrong.

6 A repeatable sales stream, consistent and predictable is another trait of a great business. A constant need for the product or service often means the business is less dependent upon general economic trends. Great businesses usually have a different economic playing fi eld than most companies. Their products/services are needed, regardless of whats happening in the bigger world. The need can often be postponed, but not forever. Cutback, maybebut not eliminated. Some car repairs can be delayed but not if its your vehicles transmission, wiring or steering. You will get them fi xed, regardless of the trade defi cit. The product sale must occur and will continue into the future.

change. Take the newspaper business where the advent of other forms of informationtelevision, radio and of course, the internethave transformed newspapers from an indispensable source of information to just another source of news. The good news is that this shift took a very long time to occur. For decades or even longer, newspapers ruled as the information source. Back to technology, where stability is almost totally nonexistent. This industry is all about change, rapid and revolutionary at times. And, most frightening to Investorsunpredictable.

5 Predictability of future earnings is an essential ingredient to making a business wonderful. And this doesnt mean knowing what a business will earn in the next quarter. Its about having a high degree of certainty that a company will have earnings a year from now and the year after that. And, its having a high degree of certainty that earnings will be higher in the future.

3 A simple business is what successful business investors lovea business model where one can quickly and easily understand how the company earns a living. Unfortunately, this leaves most companies out in the cold. For example, look at the airline businessso many factors (fuel costs, union diffi culties, mechanical repair costs combined with a vicious competitive environment) that can hurt you. Commodity businesses, where you make products that are made by so many others. You have no control over the price you can charge and, as Mr. Buffett says, youre only as smart as your dumbest competitor. A dangerous place to be.

4 Stability is a treasured characteristic of a great business. To know that the business you run isnt going to change a great deal in the short or medium term is worth a great deal. Over long periods of time, even the most stable of company models

Successful investing isnt about precisionit is more about knowing the trend and direction.

2 Free cash fl ow is the real earnings of a company, cash the owner can walk out of the business at the end of the day that has nowhere to go but into the owners pocket. By defi nition, such a

business requires little in the way of ongoing additional capital outlays or research and development costs in order to stay in business. The perfect business is one with little or no hard assets and a

huge barrier to recreate the business. What you have is the Canadian Mintthe ability to produce prodigious amounts of cash.

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10 Finally, high quality management is a fundamental requirement to make any company work. Again, we borrow a page from Mr. Buffett, who when he discusses some new business he has purchased, rarely talks about the business. Instead, he talks about the people, about how terrifi c and decent they are honest individuals that he is able to put complete faith in to continue to manage the acquired business. Mr. Buffett has talked about what the characteristics of great management are:they are smart, they have an obsession with the business, they are visionary and, as noted above, they are ethical. Our word is Probity. Without this last item, you have nothing but trouble. A smart, obsessed visionary crook running your business means you have a very dangerous virus in your company body that can destroy everything good that has been created. Having a bad person running your company makes all the other qualities listed identifying a wonderful business irrelevant. But if you have quality people in your business, you possess an extraordinary companya powerhouse of a business that has a high probability of creating wealth for the owners in the future.

We need businesses of such magnitude to be successful for you, the client.

advantage, the continued outpouring of free cash fl ows from the operations mean that the business will survive and prosper in the future. The chances that the underlying power of the business will overcome temporary diffi culties and mistakes are high, if the company has the right fundamental business characteristics.

9 Great companies enjoy the possession of a toll bridge or gross royalty on the growth of other businesses. Yet, these compa-nies require little capital themselves to sustain their operations. For example, the company, Stamps.com provides postage via the internet. You install their software and print out any type of postage from in-dividual stamps to shipping labels without leaving your offi ce. This service is available at a fraction of the price of having a postage meter. Postage is an essential service but Stamps.com has virtually no capital expenditures or property, plant and equipment. Businesses use postage and Stamps.com is a gross royalty on the growth of other companies.

7 Businesses that are not natural targets of regulation translate into businesses that do not have their rate of return determined by government appointed boards which are usually more worried about the cost to the public than to the success of the business under scrutiny. It means the prices levied for the companys products and services are determined by the market, which is a more effi cient process. Prices wont be held down artifi cially and instead will refl ect the true cost and realistic profi ts made.

8 A wonderful business can encounter the occasional disaster or mistake, either self-induced or externally based. Its going to happen sooner or later to practically every business. The problem is that companies arent run by machines; they are managed by fl esh and blood humans. And, for better or worse, people make mistakes, regardless of how smart or insightful they may be. They occur in the smallest enterprise; they happen in the worlds largest companies. Blunders occur because management doesnt have perfect insight into the future outcomes of their behaviour or that of others. Thats why you want to own a great business that can overcome such mishaps. The power of the franchise and sustainable competitive

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Now that we know what a wonderful business looks like, we want to buy this business at a bargain or cheap price. We dont ask for much.

For guidance in this, we go back to the sourceBenjamin Grahamwhose concept of the margin of safety is the fundamental bedrock of investing. It was his work and writings that led many great Investorsincluding Mr. Buffett in the right direction. The whole purpose of Grahams big idea was to protect capital. This concept is found in the dna of practically every successful Investor or business operator. To not lose money is fundamental to them. They know that protecting ones capital is the fi rst step in creating capital. You cant make money if you keep stepping backwards by suffering losses. Its just common sense that if you dont lose capital, the growth of capital becomes infi nitely easier.

T W O

Pay a bargain price.

Ben Grahams Margin of Safety is one of the most powerful yet elegant, simple investing ideas of all time. It says that you will have a margin of safety if you can buy $1.00 of business for $0.70, $0.60, $0.50, $0.40 and so on. Further, your margin improves correspondingly as your price declines. The bigger the margin, the greater the protection you have. Dont try to buy a dollars worth of business for 95 cents because you dont have a level of protection or safety. The closer the price you pay to your estimation of value, the lower the margin of safety. Trying to pay a dollar for a dollar means you have no margin and, in fact, you could fi nd yourself in trouble. Trying to be that exact in a world where precision is not possible is skating on thin ice. There is no room for error when you think you are smart enough to determine the exact value of a business. In reality, people disagree all the time about the value of everything from

a business to the value of homes, cars, precious metals, and baseball cards. Thats why the margin of safety principle is so important. By paying $0.50 for an estimate of what we believe is a dollars worth of value we dont have to be exact about the value. What if the true value is $0.85 instead of $1.00? By paying $0.50, we are still protected from loss. Furthermore, in order to actually lose money, your estimate of the business value would have to be off by 50%possible, but highly unlikely.

At the other end, when the market offers you a price well in excess of your estimate of the business value, be rational and thankfultake the money. Continuing to hold the stock is to hope that someone else shows up to pay an even more outrageous price. This is not investing, in our estimation.

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A Wonderful Business at a

Margin of Safety Price

statistical criteria. He knew that many of them would not turn out well. But, by owning many dozens of companies meeting his criteria, he would be playing the odds of enough successful investments to more than cover the disastrous companies that would invariably be bought over time. It works, but even Mr. Buffett does not follow a pure Grahamite approach to investing, adding that if he had continued to invest like Mr. Graham, he would not have been able to achieve the extraordinary success that he has. Mr. Buffetts experience in the world of textiles is a good example. He purchased Berkshire Hathaway, a New England textile manufacturer in 1965 at what he thought was a bargain price. In 1985, he closed the business after years

If we are fortunate enough to fi nd the above combination something magical happens. One or the other isnt going to get us to the Promised Land. What weve learned is that we require both. If all you care about is the quality of the business, trouble awaits if you overpay for the business. You can lose money by paying too high a price, even for the best company. On the other hand, ignoring the quality of the business in the true Ben Graham approach is also a place of danger. Often, you think you are paying a cheap price but you may be paying something for a business which at the end of the day has little or no true value. Mr. Grahams defence against this was to own many companies meeting his

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of losses. He discovered painfully that the business was, in fact, worthless. Any price paid would have been too much. The only thing he kept from the business was the name. Im just speculating that he kept the name on purpose, as a constant reminder of a big mistake. When we see the name, Berkshire Hathaway, we think of one of the most successful businesses of all timeone of the worlds extraordinary thriving insurance companies along with a host of great businesses that Mr. Buffett has pieced together, one at a time. When he sees the name, I suspect he fi rst just thinks, Textiles and Losses and Mistakea constant reminder of our frailty.


The Double-Dip ReturnHaving both a wonderful business and a cheap price is an unbeatable combination. Mr. Buffett calls such events, No-Brainers. With both of these qualities in your business, the odds are stacked heavily in your favour of a

1. High rates of return & 2. Low risk

successful and profi table outcome. In fact, the two together deliver what we call the Holy Grail of Investing, what every fi nancial school and educational program teaches is not possible to have:

This is best expressed in the following graph we have created from the double-dip concept described by Mr. Buffett in his 1989 Berkshire Hathaway Annual Report: our performance to date has benefi ted from a double-dip: (1) the exceptional gains in intrinsic value that our portfolio companies have achieved; (2) the additional bonus we realized as the market appropriately corrected the prices of these companies; raising their valuations in relation to those of the average business (3).

Y E A R 1 Y E A R 2 0T I M E

VA

LU

E O

F B

US

INE

SS

1. Increase of business value2. Return to rational business value3. High rate of return plus low risk

Every school of fi nance teaches its students the idea that if you want high returns, you must assume high risk. Conversely, low risk is accompanied by low rates of return. This has remained an unquestioned dictum. Mr. Buffett and a few others have proven otherwise.

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There are a lot of lines on this graph that need defi ning. The wavy line is the value of the underlying intrinsic value of the company. This is a wonderful business because its true value is increasing over the long-term. Weve tried to make the picture realistic by showing the occasional dip or fl attening in its history as businesses will truly act. The two straight parallel lines on either side of the business value represent the bounds of what rational business people will pay/sell the business for. As you can see, the buyers dont overpay, even for this great company. To pay a price well in excess of this line is not a rational business move. On the other side, the seller doesnt accept prices below the lower limit, either. Whats interesting here is that both buyer and seller have a pretty good idea of the value of the business in question. This is usually a private transaction and the participants are rational, logical business people. No one makes off with a big bargain; no one gets a windfall bonus price.

The game changes radically when we transform this private business into a publicly traded vehicle (jagged line). Now, weve introduced hundreds, perhaps thousands of owners into this company. As a group, their behaviour is different than the private business owners/buyers described above. Sometimes, they will pay a price not out of range of its true intrinsic value. At other times, however,

the emotional element takes over, characterized brilliantly as a strange, emotionally challenged fellow named Mr. Market by Ben Graham. Mr. Market has manic depressive tendencies, and occasionally, will be so elated with the business prospects, that he is willing to pay prices far beyond any rational price for the business. Note the line stretching well above both the intrinsic business value and the upper range of what a rational business buyer would be willing to pay. There are moments, however, when Mr. Market is so depressed or panicked by some negative events happening in the short-term to the business, that he is driven to give his shares away at irra-tionally cheap prices. Both pricesthe ridiculously high and lowcreated by poor Mr. Market, offer rational business Investors huge opportunities, especially when the business has terrifi c economic structures and we have a pretty good idea of the business value. Were particularly interested in those exceedingly discounted prices. This is where we get our double-dip opportunities.

The fi rst dip is the return derived from the growth in the business value. The second is where the business can be acquired at the 50 cents on the dollar discount price. This second return is achieved when the companys stock rises over some undetermined time frame back to a rational price as refl ected by Line 2.

The combination of Line 1the underlying growth of business value and Line 2a return from an extreme discount price to a rational price results in Line 3. The happy outcome is a case of the business value return being enhanced dramatically by the cheap price paid for the business. And we get the Holy Grail of Investinglow risk, high rates of return as described previously. Weve paid a discount price for the underlying business value. The risk of losing money, as weve discussed above is lower when youre paying a hugely discounted price for a dollars worth of business. And were set up to derive a high rate of return because the low price paid increases your compound rate of return over time. Few people understand this powerful strategy. I am uncertain as to what will happen in the fi eld of investing in the future, but after understanding these concepts so long and seeing so few grasp them and put them into practice, Im not worried about a greater percentage understanding the concept in the future. The speculative crowd is wary about buying businesses that have declined a great deal in price, especially if something has gone wrong.

U N I Q U E R E S E A R C HThats why we have Harvey Berkal working with us. Harvey adds a totally different dimension to the investment process. We are proud to say we are the only investment fi rm in Canada to employ the full-time skills of a lawyer and investigative journalist with more than 20 years experience and an eye towards protecting and enhancing your investment. He offers a perspective into a business that weve just simply never had before. Most investments in public companies are made mainly from studying the fi nancial statementsa one dimensional view which only accounts for a sliver of the knowledge of the business. Harveys work digs down deep, answering questions like: Who are the people running the company? What do the former employees have to say about their old employer? What do competitors, suppliers, or customers think? What are the hidden land mines waiting to blow? Harvey fi lls a lot of these holesconcerns that we would certainly need answered if we were going to buy the entire business. His work is important because it helps lower our risk of losing money. His efforts and all our work is fi rst and foremost about limiting risk and losses. Is there anything more important in investing?


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Concentration: Own a Few Terrifi c Companies.

As we discussed earlier in contrasting speculators and owners, we want to concentrate in a few wonderful businesses, as real successful entrepreneurs have done. In so doing, we can get to know our

businesses very well, and understand the fi ner details of its operations. Its impossible to do this with 100 or more companies.

T H R E E


F O U R

Have Patience.

Finally, we require patience for the investment to bear fruit. We consider ourselves partners in the businesses purchased on the stock exchanges. Real owners, as noted above, stay with the business for long periods, sometimes for a lifetime. As well, when we buy businesses at bargain prices, it is usually because of a problem related to the business or industry they are in. When other Investors will recognize the

underlying value is unknownwill it be three weeks or three years? Sometimes, a great deal of patience is required to have this true value recognized. In fact, as Mr. Buffett has pointed out, a continued undervalued stock price gives us a greater chance to purchase more of a great business at a bargain price, which ultimately leads to potentially greater returns. We have learned that patience usually pays off.

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Many people have labelled us as Contrarian Investors or Value Investors. Contrary implies being the opposite or completely different. We dont think in those terms and our goals are not to be the opposite. There has to be a good rational reason for such behaviour. Often, being contrary to the crowd for its own sake is a bad idea. But in that sub-section of life known as investing, joining the crowd in most instances is not a good strategy unless there is a rational, well-thought out reason.

As for the value label, we most defi nitely identify with that brand. We like to pay bargain prices for our businesses. But the word value doesnt describe fully what we are all about and only represents half of how we would portray ourselves. The second part is the word quality or business-oriented. Put together, these two separate tags equal how successful business people behave. We want to emulate the best habits of successful business owners. They practice both of these ideas mentioned above and do what most professional and amateur investors fail to dothey buy great businesses at bargain prices.

They are, more often than not, independent thinkers. Independence of thought as opposed to behaving as if you are wearing blinders is ultimately a better way to go. Benjamin Graham summed up very well a course of successful behaviour many years ago: Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgement is sound, act on iteven though others may hesitate or differ. (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgement are at hand. The Intelligent Investor.

If we, as a company can follow Mr. Grahams advice and possess not just the knowledge and experience but further, the courage to act upon our judgement, we cant help but succeed.

Lawrence A. Sarbit C H I E F I N V E S T M E N T O F F I C E R

S A R B I T A D V I S O R Y S E R V I C E S

S U B A D V I S O R T O I A C L A R I N G T O N

What powerful ideas!

Independent, Not Contrarian

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S I M P L Y

Sarbit advisory services inc.100-1 Evergreen Place Winnipeg, Manitoba, Canada r3l 0e9sarbit.com


4 pillars of investing

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