Tuesday, January 20, 2009

Oak Value Fund: Investment Adviser’s Review – Q4 2008

“All armies prefer high ground to low and sunny places to dark.” - Sun Tzu, The Art of War

Quoting history’s most widely taught treatise of wartime engagement seems appropriate as we reflect upon the recent quarter, and for that matter, the year that was 2008. There is certainly no doubt that 2008 was a battleground for most investors. The events of the last year challenged numerous fundamental assumptions and theories on investing. In investment parlance, correlation across asset classes turned out to be much higher than imagined, volatility reached levels never seen before, governments responded in unexpected ways, and assumptions regarding expected returns were severely challenged. In everyday parlance, everybody got scared at the same time.

Of course, the paradox is that what would appear to make most investors feel better in the short-term (e.g. safety, cash) is not what drives investment performance over time. To the extent that emotion should be allowed to influence investment decisions, it should be in the context of taking advantage of someone else’s emotions. When Mr. Market wants in, he wants in. When he wants out, he wants out. Of late, he has really wanted out!

At Oak Value, we do not invest in a way that just makes us feel better today. We try to minimize the influence of emotions on our investment decisions by always seeking the high ground. After more than two decades in the business of investing, experience has provided us with a good definition of our “high ground.” This recent experience has only served to reinforce our longstanding belief that the Oak Value Fund (the “Fund”) and its shareholders are best served by focusing our time, resources and capital on advantaged businesses. From this vantage point, we have found that it is much easier to keep emotion out of the decision making.

When asked for our market forecasts, we invariably disappoint. We simply do not attempt to predict the market. Although we know from past experience that when markets change direction, the action can be swift. We do not invest in a way that contemplates catching updrafts or avoiding downdrafts. We focus on businesses. We seek to manage risk the same way that the management teams that run the businesses in the Fund’s portfolio manage risk – through a thorough understanding of the underlying businesses. We do not put our faith in a statistical model that shows we have a 95 percent chance of not getting blown up. We do not ignore the economy; we incorporate what we believe ought to happen over the long term, based on highly conservative assumptions. Within this framework, we look for businesses built on the high ground – those with durable competitive advantages. We place ourselves alongside what we consider to be competent management teams whose objectives mirror our own long-term horizons. Once we conclude that we have an attractive margin of safety, we buy.

Berkshire Hathaway – Simply put, insurance companies make their money by being paid to take on others’ risk and then investing what they are paid (float) until claims are made or the exposure expires. This is a business where the “high ground” is defined by only taking risk when the price is right and only investing capital when the potential returns are attractive. Success in these activities is highly dependent on having more capital than others when capital is in high demand. Broadly speaking, insurance company valuations were negatively impacted during the quarter by investor concerns over impact of the decline in market value of their investments on their capital adequacy and liquidity. Though shares of Berkshire Hathaway outperformed the overall financial sector, they declined meaningfully during the quarter. The uncharacteristically high volatility of Berkshire shares was due at least in part to concerns regarding a series of long-term insurance contracts (puts) the company has written on various global stock market indexes. As long as global equity markets remain under pressure, there will be headline risk associated with this issue, but we are confident in the long-term value of these contracts. In our opinion, Berkshire remains disciplined in its pricing of risk, opportunistic in its investing and conservative in its capital positioning.

“One who, fully prepared, awaits the unprepared will be victorious” - Sun-Tzu, The Art of War
Great quote from Oak Value's letter that is worth remembering: “…we are well aware of the potential trap of assuming that the old knowledge is the most relevant knowledge. Just as we attempt to resist the inclination to overreact to short term or most recent information, we must also guard against the risk of being blinded from the present by the shadow of the past.”