Broad Run Investment Management separate account client letter for the fourth quarter ended December 31, 2015.
For the year ended December 31, 2015, the Focus Equity Composite returned 3.4% net of fees1 compared to 0.5% for the Russell 3000 Index. For the fourth quarter, the Composite returned 3.6% net of fees compared to 6.3% for the Russell 3000 Index. The returns for your individual account will differ somewhat from the Composite due to variations in account holdings and other client-specific circumstances. Your account’s actual performance is presented in an attachment. We remind you that your portfolio’s composition is significantly different from the broad market indices, so your performance will inevitably deviate from these indices, especially over shorter time periods. We manage your portfolio for long-term results, and we encourage you to evaluate its performance over a multi-year time frame. Long-term Composite returns are presented at the end of this letter.
Broad Run Investment Management – Defensive Playbook
We are long-term investors in publicly traded businesses. We expect to own many of these businesses five, and even ten years from now. We believe that given a reasonable starting valuation our investment returns in these businesses will track their long-term growth in earnings per share. But, as recent market volatility reminds us, stocks, and for that matter businesses, face bumps in the road even if on a pathway to long-term value creation.
Our approach to navigating volatile markets is unchanged, which means Broad Run Investment Management don’t tweak and reposition the portfolio in an attempt to side-step short-term stock price volatility. Trying to time the market is largely ineffective and a distraction from what we consider the most important risk to the long-term investor: the potential for a “permanent capital loss.”
A permanent capital loss is a sustained setback in investment value for long-term fundamental reasons. For us, a reasonable measure of permanent capital loss would be if an investment were worth less five years from now than it is worth today. We believe (1) negative business developments – new competition, adverse technological change, liquidity shortages, bad capital allocation, etc. – and (2) excessive valuation are the key sources of permanent capital loss, so our research process and portfolio construction methodologies are designed to help us to identify and mitigate these threats.
At the company level, our five investment criteria, in-depth business-focused research, and collaborative team-based approach provide a first line of defense. Typically, when we talk about the five criteria (high-quality business, large growth opportunity, excellent management, low “tail risk,” and discount valuation) it is in the context of trying to identify long-term compounders, but the criteria also serve a loss avoidance purpose. Consider, for example:
- High-quality business – Broad Run Investment Management seek to invest in businesses that have sustainable competitive advantages. Possessing such advantages should translate into higher-than-average-returns on equity, allowing for higher sustainable growth rates. In addition, we believe that those higher returns should be less subject to disruption by competition; market share, pricing, margins, and cash flow all tend to be more defensible for a business with high customer switching costs or barriers to entry.
- Large growth opportunity – We seek to invest in businesses that have large growth potential due to competitive market share gains or industry-wide secular growth trends. These businesses tend to have more control over their own destiny so that value creation can continue – albeit at a reduced pace – during challenging economic times.
- Excellent management – We seek to invest in businesses run by management teams that have a track record of value creation and personal economic incentives aligned with shareholders. Not only do we believe these executives are more likely to achieve continued success, but we also believe they are less likely to make short-sighted decisions that destroy value and jeopardize the sustainability of the business franchise.
- Low tail risk – We try to be ever watchful for businesses with rising competitive threats, excess financial leverage, unsustainable levels of demand, fad or obsolescence risk, etc. Additionally, we try to avoid businesses where rapid change or complexity make it too difficult for us to have a confident opinion about what the company, and its profitability, will look like in ten years. If we can be confident our portfolio companies are relatively well insulated from catastrophic events, we are more likely to view short-term volatility as an opportunity.
- Discount valuation – We seek to invest in businesses trading at a discount to intrinsic value, and at modest multiples of earnings and cash flow. We believe this approach provides additional upside potential if we are right about the long-term business performance, and helps reduce the downside if we are wrong in our assessment.
In evaluating an investment prospect against our criteria, Broad Run Investment Management conduct in-depth fundamental research seeking a thorough knowledge of the business, its competition, and its industry. Our investment team conducts all research activities and makes all portfolio decisions. This team-based approach provides a combination of different experiences and perspectives we believe can lead to unique insights and more robust vetting of ideas. In our experience, an individual analyst – no matter how diligent – can miss an important business risk that will often be identified by the broader team.
Our second line of defense is at the portfolio level. Despite our best efforts, Broad Run Investment Management have had and will continue to have individual investments go wrong. So we spread positions across a variety of industries and try to limit aggregate exposure to any single business factor so that a setback is contained and can be absorbed by progress in the rest of the portfolio. A new position to the Focus Equity Strategy will typically be sized between 1% and 4% of assets. Allocations to that position will change over time as our experience with the business grows and the strength of our conviction in the investment opportunity evolves. Large positions are reserved for businesses in which we have a very high level of confidence. Regardless of our enthusiasm for an investment, we typically limit the weight of our top position to about 10% of assets.
Broad Run Investment Management – Notable Portfolio Changes
During the quarter, we added to several separate account positions on stock price weakness. Broad Run Investment Management increased Ashtead Group from about 2.5% to about 3.0% of assets, Hexcel Corporation from about 1.8% to about 4.0% of assets, and CarMax from about 5.5% to about 6.4% of assets. We discuss CarMax in detail below. For your reference, we discussed why we believe Ashtead and Hexcel have the opportunity to be long-term compounders in the second quarter 2015 letter.
CarMax (KMX) – CarMax is the largest used-car retailer in the U.S. It has grown into its leadership position by offering a consumer friendly car buying experience, in contrast to the adversarial experience at traditional auto dealers. CarMax stores offer a wide selection of late-model used cars (5 to 10x the typical dealer inventory) meeting high quality standards, with no-haggle pricing, and a generous return policy. The company provides a transparent vehicle financing process, attractive extended warranty options, and will buy your car from you even if they do not sell you a car.
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