Burgundy’s Investment Team researches numerous companies but invests in only a handful. To help us narrow down our potential investment universe, we use decision rules that point us toward the viable investment ideas and away from companies that are unlikely to be portfolio-worthy. In this pursuit, we have found a valuable screening question is, “Would I consider investing if I was a private investor buying 100% of this company?”
Applying this private investor litmus test to the public markets reinforces important disciplines. For example, private investors face limited liquidity and, as a result, should have long-term investment horizons. Private investors cannot easily sell an entire company after a short-term business disappointment. While we monitor quarterly earnings for changes in our companies’ long-term earnings power, we are generally not concerned about transient “beats” or “misses” relative to Wall Street estimates. Similar to private investors, we invest as though we face limited liquidity, generally intending to hold investments for many years. In some of our funds we face real liquidity issues, so this is more than an academic exercise.
Our long-term investment horizon manifests itself in low portfolio turnover rates, mirroring the turnover rate of a hypothetical private investor’s portfolio. Private investors do not sell entire companies frequently, nor does Burgundy sell entire positions frequently. Besides the benefit of raising the confidence threshold for the long-term staying power of a business, investing with a long time horizon has the added benefit of reducing unnecessary transaction costs.
Another discipline demanded by the private investor is concentrated investing. Private investors have concentrated portfolios for several reasons. Buying 100% of a private company involves extensive diligence, legal and transaction structuring work. More importantly, good private deals are rare. A private investor is unlikely to make an investment that will not earn a compelling absolute rate of return, narrowing the opportunity set and necessitating a portfolio with relatively few holdings. A private investor would never buy a host of mediocre companies simply to diversify or to more closely resemble an index.
Similarly, Burgundy employs concentrated portfolios because it is both rare and time consuming to find truly outstanding companies at attractive valuations. The average Burgundy strategy (organized by geography) holds roughly 35 companies;1 the average U.S. mutual fund has between 100-160 positions.2 The discipline of concentrated investing raises our standard of analytical rigour because our average investment is three to four times larger in relative terms.
In short, investing in public equities like a private investor improves absolute returns because it naturally leads to lower transaction costs and portfolios of strictly outstanding investment ideas. The third reason Burgundy invests like a private investor is to garner the courage to depart from the consensus.
Private investors typically buy businesses in auctions. Good private investors study the business, determine the return they seek on a potential investment in that business, and formulate a bid to achieve their desired return. Thus, private investors make bids based on their independent business judgment. If too few buyers show up to an auction, or other buyers do not do the right homework, a private investor can win the auction at a good price.
Likewise, the public markets sometimes offer great companies at cheap prices. Benjamin Graham wrote about this idea in The Intelligent Investor. He likened the market to a man named Mr. Market, a manic-depressive who offers to buy and sell companies at prices that often bear no relation to the underlying value of the business.
Skeptics may argue that Mr. Market contradicts the notion that the markets produce fair prices, which academics call market efficiency, and thus investing in public markets with a private investor mindset is futile. To address this argument, it is important to divide market efficiency into two parts: markets are efficient insofar as they reflect the consensus, and markets are efficient insofar as the consensus is right. It is debatable whether the former is true, but the latter is often untrue.
When the consensus is wrong, and it appears in stock prices, the private investor mindset is very useful. Like a private investor at an auction, we buy or abstain based on an objective appraisal of a business’ intrinsic value; we make a judgment independent of the consensus view.
To illustrate how the consensus opinion can be incorrect, consider two examples. In mid-2000, Nortel Networks ballooned to comprise 34% of the S&P/TSX Composite Index. The consensus view behind this valuation was the idea that Nortel would lead the world into a “new economy.” The consensus clearly turned out to be wrong. A more recent and lesser-known example is automotive dealership stocks during the financial crisis. Auto dealership stocks traded at extraordinarily cheap prices because the consensus view was that consumers would be unable to access vehicle financing and that the auto manufacturers would go out of business. In other words, the markets thought the auto industry was going extinct. One auto dealership stock that Burgundy owned in the Canadian small-cap portfolio traded at one-fiftieth of its current per-share valuation during the crisis. Whether the result of herd mentality or the fear of missing out, these examples demonstrate that the consensus opinion reflected in stock prices can be far from reality.
In closing, the private investor perspective reveals itself in our portfolios in the form of concentrated holdings within each geography and low turnover. Underlying these characteristics are high standards for analytical rigour, business quality and valuation, which mirror those of private investors. These standards compel us to act when market consensus diverges from our long-term view of reality. Thinking like a private investor gives us the conviction to make reasoned departures from the consensus, which are, by definition, unpopular.
- Average of the American Equity Fund, Asian Equity Fund, Canadian Equity Fund, Canadian Small Cap Fund, Emerging Markets Fund, European Equity Fund, U.S. Small / Mid Cap Fund and U.S. Smaller Companies Fund.
- Source: Value Investing, chapter 4, by James Montier.