Investment Philosophy

What is Value Investing?

"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
-Benjamin Graham, "The Intelligent Investor"

The "value investing" model, developed by Benjamin Graham in his texts, Security Analysis and The Intelligent Investor, is highly dependent on price. Security selection is therefore a process of identifying situations where companies trade at a significant discount to their liquidation or long-term going-concern value. This discount, defined as the "margin of safety," is critical in two respects. A large margin of safety component not only reduces the risk of a permanent loss of capital but also serves as the platform for significant future gain. Superior returns on investment often result when the marketplace ultimately recognizes the true value of the enterprise.

Value investing incorporates principles that have produced extraordinary returns for money managers through several market cycles over many decades. Kahn Brothers has the experience required to successfully apply these principles to the selection of securities. We do not attempt to time broad directional swings in market levels, interest rates or exchange rates. We are not interested in annual benchmark comparisons. A study of the performance of successful value-oriented investment managers over long periods of time found they under-performed market indices 30% - 40% of the time. In other words, out-performing an index 60% - 70% of the time produced highly satisfactory risk-adjusted rates of returns for these successful managers. Furthermore, investors appreciate that value investing generates tax efficient returns resulting from both long holding periods and favorable tax rates.

Kahn Brothers employs a bottom-up stock selection approach, and invests in undervalued equity securities that are usually out-of-favor in the market. We select securities, one at a time, based on asset valuations, operating performance metrics and long-term fundamental business prospects. Unlike many investment managers, we spend a considerable amount of effort evaluating the downside risk of every investment.

If there are very few values to be found in a given period, we are comfortable holding cash, rather than placing money in speculative, overpriced issues. We will not invest in an overpriced market simply to become “fully invested” but will patiently wait for attractive situations to present themselves.

Kahn Brothers thinks of a portfolio as an orchard of fruit trees. One cannot expect fruit every year from each species of tree. Investments can and often do have varied and unpredictable timetables to maturity. We believe a suitable time horizon for investment fruit to ripen for harvest can be three to five years or longer. Indeed, a key factor in realizing outstanding performance is having the discipline and patience to maintain time-tested principles and not abandon the orchard before the fruit has ripened.

Kahn Brothers views the investment process as a combination of art and science. Each investment decision has both quantitative and qualitative aspects. While a novice can readily duplicate the former, the latter can only be acquired after decades of analyzing investment opportunities. A key element to outstanding investment performance is bringing these two factors together.

Value investing incorporates only one methodology for securities selection. While many consider it to entail less risk than some other approaches, it can produce returns below popular indices for multiple annual intervals. Value investing may result in concentrated portfolios and will not produce portfolios diversified by investment style. These potential risks must be considered by any investor utilizing the services of Kahn Brothers Advisors LLC.

The following views summarize our methodology for evaluating each specific equity investment:

"We study companies and try to find undervalued securities... We're absolute value investors focusing on asset values, book value discounts and low price to earnings ratios to normalized earnings. And we aren't interested in so-called relative values -- you know, something selling at 20 times earnings in an industry group with a 35 multiple."
-Thomas Graham Kahn, "Outstanding Investor Digest"

I. Broad Investment Criteria

INDUSTRY - We invest in industries and businesses that we understand, focusing on depressed economic sectors, rather than the popular industries of the day. Significant capital gains can be achieved through investment in well-established industries. We therefore prefer seasoned businesses less likely to experience major structural change.

COMPANY SIZE - We often concentrate on small and medium capitalization stocks. Such securities may be traded in the less liquid over-the counter market. These companies frequently have a lesser following among security analysts and institutional investors. Small institutional ownership increases the likelihood of inefficient pricing, which helps create bargain opportunities.

MANAGEMENT - We prefer a company whose management holds a meaningful stake in the growth of the business and will protect their own, as well as the shareholders’ interests. We are less comfortable with situations in which management has aggressive compensation packages, little financial risk and nominal ownership interest.

FINANCIAL PERFORMANCE - We search for companies with solid balance sheets, strong working capital positions and minimal leverage. We analyze the balance sheet, not the income statement, first. Consequently, many of our investments have strong financial positions and weak short-term earnings. Companies with depressed earnings are more likely to be under-priced in the market.

II. Typical Investment Metrics

NET WORKING CAPITAL DISCOUNTS are stocks selling below net working capital per share after subtracting all long-term liabilities. In other words, if you subtract all current liabilities from all current assets, then further subtract all long-term liabilities and, finally, divide the remaining figure by the number of shares outstanding, you derive the net working capital per share. If a stock sells for less than this figure, you have an attractive price that always warrants a thorough investigation.

BOOK VALUE DISCOUNTS are securities that sell for less than the adjusted per share book value (stated net worth) on their balance sheet. Book value per share is calculated by subtracting total liabilities from total assets and then dividing the remaining balance by the number of outstanding shares. Intangible assets are typically excluded from our definition of book value, and assets and liabilities often require some fair market value adjustments.

LOW P/E RATIO STOCKS are securities that sell at low price to normalized earnings multiples or price to normalized cash flow. They may sell at high multiples of current earnings or cash flow.

SPECIAL SITUATIONS include companies potentially impacted by catalysts that are likely to trigger the unlocking of value that will result in significant capital gains.

FALLEN ANGELS are quality companies with strong market and financial positions that suffer from short-term but resolvable issues, while still possessing the capacity for materially improved long-term earnings. These are rarely book value discounts.