Quality stock investments have a significant margin-of-safety between intrinsic value and price. Quality businesses have an intrinsic value which is sound and reliable. The Equity Policy is to buy quality stock investments and quality businesses.

Quality stock investments have a single characteristic – low price relative to intrinsic value. Elaboration would require a discussion of how to calculate intrinsic value, which is beyond the scope of this policy. Quality businesses have several key characteristics, a discussion of which comprises the remainder of this section.

Net cash income is the substance of intrinsic value. Therefore, business quality is contingent upon the nature, protection, and use of corporate net income. The following are required business quality characteristics:

Two additional behind-the-financials quality characteristics bear attention: (a) management is forthright and competent, and (b) the company possesses a strong and persistent competitive advantage. The former is required; the latter is desired.




Diversification is spreading small investment commitments among a wide variety of selections. The object is to protect against a poor overall result due to poor results from one or several selections. Selectivity is concentrating investment commitments in a limited number of securities. The object is to two-fold: (a) protect against a poor overall result due to poor returns from low-quality businesses and over-valued securities, and (b) increase returns by focusing on the best opportunities.

Policy regarding diversification and selectivity is to strike a balance between the two which seeks protection first and increased return second. The optimal balance depends on market conditions. In over-valued markets with limited opportunities, a sufficient number of holdings must be balanced with a sufficient margin-of-safety in each holding. In under-valued markets with numerous opportunities, a sufficient number of holdings must be balanced with a limited number of the best opportunities.

The following portfolio holding guidelines were designed to achieve the balance described above. Expected holdings during normal periods are twenty to twenty-five stocks. Maximum security position size at purchase is 10%. Maximum security position size at market is 20%. Maximum industry position size at cost is 15%. Maximum industry position size at market is 30%. Maximum levels are rarely expected to be reached. Requirements at the maximum purchase level are exceptional quality and extreme under-valuation.




There are no restrictions based on company size. Size generally adds an element of safety. However, there are large companies which are riskier than some smaller companies. Risk includes many more elements than size.

Larger companies are more likely to be purchased because of the safety and competitive advantage their market standing sometimes confers. However, business quality and valuation remain the primary selection determinants.

The portfolio will typically contain a mix of large, mid-sized, and small companies.




Businesses are purchased for long run earnings accumulation rather than short run price appreciation. Many years are required for an appreciable portion of earnings to accumulate, even relative to a reasonable purchase price or rapid growth rate. Therefore, the anticipated holding period at purchase is at least 10 years.

Sales occur under three general conditions: (1) an unanticipated change at the company (2) an error in the analysis of the company, (3) a significant price increase coupled with the opportunity to buy an under-valued security. Regarding the first two conditions, businesses and industries change and analytical errors occur. Quick action is taken after coming to conclusions in these cases. Regarding the third condition, while long run earnings accumulation is the reason for stock purchases, the opportunity to profit from unexpected price increases will be acted upon.

The margin-of-safety principle applies on all sales. Price must be significantly higher than value to assure that selling is more profitable than holding. The expense of selling is certain; the outcome is not. The margin-of-safety requirement on both sales and purchases generally slows purchase and sale activity, since significant margins on both sides are typically infrequent. For taxable accounts, a significantly higher margin-of-safety is required to cover the capital gain tax (see the section “Taxes”).




The difference between dividend income and capital appreciation is primarily an issue of timing. Dividends are paid at management’s discretion; capital appreciation is realized at sale. Both are the direct result of the company’s net income. Cash dividends are paid directly from the company’s net income. Capital appreciation results from the company successfully reinvesting its net income.

Neither dividend paying nor capital growth companies are preferred. Rather, companies are selected because they possess strong operating characteristics and managers who deploy net income effectively. Managers should reinvest net income only at satisfactory rates of return. Otherwise, dividends should be paid or shares repurchased (when at low or fair prices).

The best stock portfolio will have some stocks that pay high dividends and others that pay low or no dividends. The bottom-line is total return from both dividends and capital appreciation.




Taxes are explicitly considered in taxable accounts. The income and capital gains rates of tax paying owners or beneficiaries are recorded. Securities are then evaluated for purchase or sale based on expected after-tax returns.

Regarding stock sales, a stock that is purchased to replace a stock that is sold must perform well enough to cover the capital gains taxes on the stock sold. The difference must be significant and clear, since taxes are certain and expected returns are estimates.

The objective is to maximize after-tax returns. It is accomplished by directly incorporating investor tax rates into stock valuations.




The performance objective is to provide satisfactory results in the long run, and to preserve capital from permanent loss during periods of economic decline.

“Satisfactory” is earning a return which is fair when considering the risk taken. Each stock is assigned a “required return” which reflects its risk. This is also the return (or discount rate) which equates its present value with its future dividends or free cash flows. The portfolio’s average required return is therefore a good proxy for its expected return – since stock price, discount rate, and corporate performance (dividend payments and business growth) are mathematically interdependent. It is also a conservative proxy, since purchases are made with a significant margin of safety and valuation inputs are estimated conservatively.

The level at which the required return is set, in addition to being effected by the risk of each individual stock, is effected by general price levels and interest rates. For example, when interest rates are low and stock prices are high, the portfolio expected return may be 10%. Conversely, when stock prices are unusually depressed, the portfolio expected return may be 15%. In summary, clients are given a specific expected return. This expected return is the primary benchmark for the portfolio.

“Long run” is a period of at least ten years. The long run objective is appropriate given the nature of fundamental operating performance and the potential for its separation from stock price performance. Fundamental operating performance consists of business growth and dividend payments. Stock price performance is based on the collective opinions of market participants. A long time is necessary for intrinsic value to accumulate via business growth and dividend payments, and a long time may be necessary for stock price to adjust accordingly.

The expected return will usually be higher or near the expected return for the overall market averages, since discipline regarding market valuation and required-return-setting is rigorous. The market averages are defined by three indexes: the S&P 500 Index, the S&P 400 Mid-Cap Index, and the Russell 2000 Index. These three indexes are of large, medium, and small companies, respectively. They represent the entire public company marketplace and the universe from which selections are made. They serve as a secondary portfolio benchmark.

Returns may vary widely, either positively or negatively, from one or all of these indexes over ten year periods or less. Stock portfolios are not constructed to minimize short-term return differences from certain indexes. The focus is on selecting the highest returning individual issues for the long run rather than focusing on short-term fluctuations among groups of stocks.

The evaluation of returns, in effect, presents only half the picture. Risk must also be evaluated. While return data can be generated rather easily, the quantification of risk is difficult at best. The provision of fundamental information – such as business descriptions, debt, profitability, and valuation ratios – is the most effective method for assessing the risk of this strategy.

“To preserve capital from permanent loss during periods of economic decline” means selecting companies that can withstand practically any economic scenario. Permanent loss occurs when a large portion of a company’s assets or earnings becomes permanently impaired or when an unexpected bankruptcy or liquidation occurs. The nature of a company’s business and its financial strength are carefully evaluated to determine its ability to weather adverse economic conditions.