Investment Philosophy
Chapman Investment Management, LLC’s objective is to preserve and grow invested capital by seeking high-quality, proven growth companies whose securities are undervalued by the market. These companies typically have free cash flow and sustainable competitive advantages that produce superior returns, and they are led by a trusted and shareholder-oriented management team.
Our investment philosophy is grounded in seven guiding principles (click items below for detail):
Capital Preservation
Capital Preservation
“We understand that in order to break even after a 50% loss, an investor has the daunting task of doubling their return, which could take years.”
Our first investment priority is to preserve your capital. The first step in making money is to not lose it. We understand that in order to break even after a 50% loss, an investor has the daunting task of doubling their return, which could take years. Warren Buffett famously stated his basic rules for investing: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”
We preserve capital by managing risk – and two risks in particular: business risk and price risk. Business risk is the risk that a company’s competitive advantage will erode or be lost altogether, causing a permanent loss of capital and intrinsic value. Recent examples include the loss in pricing power of branded products due to private-label competition, the decline in subscription of newspapers, magazines and cable due to online content, the substitution of email for postal service, and the threat to physical retailers from cheaper warehouse clubs and online retailers such as Amazon. A company’s competitive landscape demands constant vigilance.
Price risk is the risk that an investor overpays even for a sound company. We minimize price risk by conservatively estimating a company’s intrinsic value and buying stock when the price is at an adequate discount to its value. This is our margin of safety. When we buy each stock with a margin of safety, downside risk protection is built into the overall portfolio.
Additionally, we prudently diversify with 15-25 companies, with no more than two companies in the same industry and no more than double S&P 500 sector weights in the portfolio.
Our first investment priority is to preserve your capital. The first step in making money is to not lose it. We understand that in order to break even after a 50% loss, an investor has the daunting task of doubling their return, which could take years. Warren Buffett famously stated his basic rules for investing: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”
We preserve capital by managing risk – and two risks in particular: business risk and price risk. Business risk is the risk that a company’s competitive advantage will erode or be lost altogether, causing a permanent loss of capital and intrinsic value. Recent examples include the loss in pricing power of branded products due to private-label competition, the decline in subscription of newspapers, magazines and cable due to online content, the substitution of email for postal service, and the threat to physical retailers from cheaper warehouse clubs and online retailers such as Amazon. A company’s competitive landscape demands constant vigilance.
Price risk is the risk that an investor overpays even for a sound company. We minimize price risk by conservatively estimating a company’s intrinsic value and buying stock when the price is at an adequate discount to its value. This is our margin of safety. When we buy each stock with a margin of safety, downside risk protection is built into the overall portfolio.
Additionally, we prudently diversify with 15-25 companies, with no more than two companies in the same industry and no more than double S&P 500 sector weights in the portfolio.
Quality Holdings
Quality Holdings
“We look for companies that have achieved a unique market advantage. Quality businesses are those having sustainable competitive advantages that are difficult for a competitor to replicate.”
Quality can mean different things to different people; some say you know it when you see it. In art there is Rembrandt and Monet, in jewelry there is Tiffany and Cartier, in watches there is Rolex, and in automobiles there is Rolls Royce. These products and brands have achieved a unique market advantage that has enduring value. We look for similar enduring quality attributes in companies when we invest.
Quality businesses are those having sustainable competitive advantages that are difficult for a competitor to replicate. Competitive advantages include patent protection (pharmaceutical and biotech drugs), trusted brands with great customer goodwill (Disney), regulatory licenses (Moody’s), high switching costs (banks), cost advantages (Costco), scale/size advantage (Coca-Cola), and a network effect (Facebook). Companies that have earned a competitive advantage and can sustain that advantage over time typically generate high returns on invested capital (ROIC equals cash income divided by debt and shareholders equity) and prodigious cash flow. These companies can be wealth generating and compounding machines.
Many of our portfolio companies have a ROIC over 20%, which substantially exceeds the average cost of capital of 10%. Consequently, these companies generate free cash flow and shareholder value. The ideal quality business would have a durable competitive advantage, high ROIC and free cash flow with little to no debt, a shareholder-minded management team of high integrity, and a “tollgate/repeat purchase” predictability to its business.
We have a healthy skepticism about reported earnings, which can be manipulated with accrual accounting to appear higher than the actual cash generated by the business and is a red flag. In April 2001, I visited Enron management at their Houston headquarters to understand how the company could report years of positive income, but have a negative cumulative five-year free cash flow and pay almost no taxes. Enron was then a popular energy services company with a $70 billion market valuation. I left without an adequate explanation and thereby avoided a potential loss since the company filed for bankruptcy eight months later.
Quality can mean different things to different people; some say you know it when you see it. In art there is Rembrandt and Monet, in jewelry there is Tiffany and Cartier, in watches there is Rolex, and in automobiles there is Rolls Royce. These products and brands have achieved a unique market advantage that has enduring value. We look for similar enduring quality attributes in companies when we invest.
Quality businesses are those having sustainable competitive advantages that are difficult for a competitor to replicate. Competitive advantages include patent protection (pharmaceutical and biotech drugs), trusted brands with great customer goodwill (Disney), regulatory licenses (Moody’s), high switching costs (banks), cost advantages (Costco), scale/size advantage (Coca-Cola), and a network effect (Facebook). Companies that have earned a competitive advantage and can sustain that advantage over time typically generate high returns on invested capital (ROIC equals cash income divided by debt and shareholders equity) and prodigious cash flow. These companies can be wealth generating and compounding machines.
Many of our portfolio companies have a ROIC over 20%, which substantially exceeds the average cost of capital of 10%. Consequently, these companies generate free cash flow and shareholder value. The ideal quality business would have a durable competitive advantage, high ROIC and free cash flow with little to no debt, a shareholder-minded management team of high integrity, and a “tollgate/repeat purchase” predictability to its business.
We have a healthy skepticism about reported earnings, which can be manipulated with accrual accounting to appear higher than the actual cash generated by the business and is a red flag. In April 2001, I visited Enron management at their Houston headquarters to understand how the company could report years of positive income, but have a negative cumulative five-year free cash flow and pay almost no taxes. Enron was then a popular energy services company with a $70 billion market valuation. I left without an adequate explanation and thereby avoided a potential loss since the company filed for bankruptcy eight months later.
LONG-TERM PERSPECTIVE
LONG-TERM PERSPECTIVE
“In the long-term, stock prices correlate closely with a company’s earnings and cash flow. Our goal is to outperform the market average over time.”
In the short-term, stock prices may react to current events, such as world political news, currency devaluations, central bank changes in monetary policy, rumors, changes in sell-side analyst recommendations, forced selling by mutual funds experiencing redemptions, trading by momentum-driven speculators, short covering, option expirations, quarter-end window dressing, and computer-driven block trades. These factors may have little to do with a company’s intrinsic value, but may present opportunities to take advantage of temporary differences between market valuation and inherent value. In the long-term, stock prices correlate closely with a company’s earnings and cash flow. For instance, in the ten-years ending August 2014, Walt Disney’s earnings grew 15% annually on average and the stock returned 15% annually.
Our focus is on a company’s long-term earnings prospects, and we prefer that our investment performance be measured over at least a five-year period. The heart of Sir John Templeton’s stock picking method was to favor stocks that had the lowest stock price relative to his five-year earnings forecast. Warren Buffett prefers to be measured over a rolling-five year period and has said that he wants to have a reasonably good idea of what a company will earn in ten years. Peter Lynch said that you might as well flip a coin to decide if stocks will be higher or lower in two to three years, but that stocks are relatively predictable over twenty years. While one cannot forecast five-year forward earnings with 100% accuracy, the earnings-based analytical process focuses on the right variables, such as the durability of a company’s competitive advantage and the predictability of the business.
The long-term earnings forecast process also distinguishes us from many sell-side analysts, who seldom forecast beyond two years, and from many investors who simply bet on whether a company will beat consensus earnings estimates for the next quarter. Our goal is to outperform the market average over time.
In the short-term, stock prices may react to current events, such as world political news, currency devaluations, central bank changes in monetary policy, rumors, changes in sell-side analyst recommendations, forced selling by mutual funds experiencing redemptions, trading by momentum-driven speculators, short covering, option expirations, quarter-end window dressing, and computer-driven block trades. These factors may have little to do with a company’s intrinsic value, but may present opportunities to take advantage of temporary differences between market valuation and inherent value. In the long-term, stock prices correlate closely with a company’s earnings and cash flow. For instance, in the ten-years ending August 2014, Walt Disney’s earnings grew 15% annually on average and the stock returned 15% annually.
Our focus is on a company’s long-term earnings prospects, and we prefer that our investment performance be measured over at least a five-year period. The heart of Sir John Templeton’s stock picking method was to favor stocks that had the lowest stock price relative to his five-year earnings forecast. Warren Buffett prefers to be measured over a rolling-five year period and has said that he wants to have a reasonably good idea of what a company will earn in ten years. Peter Lynch said that you might as well flip a coin to decide if stocks will be higher or lower in two to three years, but that stocks are relatively predictable over twenty years. While one cannot forecast five-year forward earnings with 100% accuracy, the earnings-based analytical process focuses on the right variables, such as the durability of a company’s competitive advantage and the predictability of the business.
The long-term earnings forecast process also distinguishes us from many sell-side analysts, who seldom forecast beyond two years, and from many investors who simply bet on whether a company will beat consensus earnings estimates for the next quarter. Our goal is to outperform the market average over time.
EMBRACE STOCKS AS BUSINESS OWNERS
EMBRACE STOCKS AS BUSINESS OWNERS
“We view owning a stock as a partnership with management. Our focus is on the business fundamentals and ensuring that our investment rationale and intrinsic value analysis remain sound.”
The barriers to owning a stock are low, but the barriers to understanding a business, its competitive advantages, risks, and value, are high. With a few online clicks and adequate funds, one can buy a stock in a fraction of a second. But becoming a long-term investor, as opposed to a short-term market trader, one must know the company and the reasons for owning the company. Without this hard-won knowledge, one cannot withstand the inevitable headwinds that tempt the uninformed to sell with the crowd. Fear-induced selling based on misinformation locks in poor results.
A long-term investor understands the difference between a company’s intrinsic value and the market price of the stock. It is not uncommon for a stock price to vary by as much as 50% from its high and low during a year, and we try to capitalize on the disconnect between the relatively stable intrinsic value and the more volatile stock price. We view owning a stock as a partnership with management and expect management to communicate and behave accordingly. While we monitor stock prices daily, once we purchase a stock, our focus is on the business fundamentals and ensuring that our investment rationale and intrinsic value analysis remain sound.
The barriers to owning a stock are low, but the barriers to understanding a business, its competitive advantages, risks, and value, are high. With a few online clicks and adequate funds, one can buy a stock in a fraction of a second. But becoming a long-term investor, as opposed to a short-term market trader, one must know the company and the reasons for owning the company. Without this hard-won knowledge, one cannot withstand the inevitable headwinds that tempt the uninformed to sell with the crowd. Fear-induced selling based on misinformation locks in poor results.
A long-term investor understands the difference between a company’s intrinsic value and the market price of the stock. It is not uncommon for a stock price to vary by as much as 50% from its high and low during a year, and we try to capitalize on the disconnect between the relatively stable intrinsic value and the more volatile stock price. We view owning a stock as a partnership with management and expect management to communicate and behave accordingly. While we monitor stock prices daily, once we purchase a stock, our focus is on the business fundamentals and ensuring that our investment rationale and intrinsic value analysis remain sound.
Concentrated portfolios
Concentrated Portfolios
“Superior quality businesses are not commonplace. We concentrate on owning only the best.”
Our portfolios typically own between 15-25 companies, with no more than two companies in the same industry. This selective approach has several advantages.
First, our winners can make a significant contribution to performance. Our experience has been that first-class businesses bought at compelling price discounts to intrinsic value can generate superior portfolio returns with less risk. Truly outstanding business gems are not usually on sale, but when they are, we want them to impact performance. Imagine Babe Ruth’s impact to a Yankees game if he had to wait his turn to bat once all the other starters and benchwarmers had their turn at the plate.
Second, we can leverage our research with our best ideas and avoid diluting our time following companies that merely occupy space in a portfolio. Lastly, our concentrated positions and longer holding periods lead to a more constructive dialogue with management as they can see by our strategic questions and actions that we really are business partners.
Our portfolios typically own between 15-25 companies, with no more than two companies in the same industry. This selective approach has several advantages.
First, our winners can make a significant contribution to performance. Our experience has been that first-class businesses bought at compelling price discounts to intrinsic value can generate superior portfolio returns with less risk. Truly outstanding business gems are not usually on sale, but when they are, we want them to impact performance. Imagine Babe Ruth’s impact to a Yankees game if he had to wait his turn to bat once all the other starters and benchwarmers had their turn at the plate.
Second, we can leverage our research with our best ideas and avoid diluting our time following companies that merely occupy space in a portfolio. Lastly, our concentrated positions and longer holding periods lead to a more constructive dialogue with management as they can see by our strategic questions and actions that we really are business partners.
Low Turnover
Low Turnover
“Buying a business that is undervalued for temporary reasons requires time and patience to realize its full investment potential.”
Our turnover is low, and our emphasis on the long-term leads to holding periods of several years. A 20-25% turnover rate in a portfolio means that we hold stocks on average about 4-5 years. This means that we only require about 4-5 new ideas each year. We can be patient and wait for Mr. Market to throw the fat pitch in the middle of the strike zone before swinging.
This is in contrast to the average mutual fund portfolio that has 100% turnover, often with at least 100 stocks. This means that the portfolio manager each year faces the daunting responsibility of analyzing 400 quarterly earnings reports and conference calls, monitoring the competitive advantages of 100 companies and their competitors, and finding 100 replacement ideas.
The “buy and hold” strategy allows us to enjoy the compounding benefits of superior growth companies, while minimizing the commissions and taxes that are obstacles to growing capital. We note that the majority of the Forbes 400 wealthiest individuals have earned their place on the list by owning outstanding businesses held for many years.
Our turnover is low, and our emphasis on the long-term leads to holding periods of several years. A 20-25% turnover rate in a portfolio means that we hold stocks on average about 4-5 years. This means that we only require about 4-5 new ideas each year. We can be patient and wait for Mr. Market to throw the fat pitch in the middle of the strike zone before swinging.
This is in contrast to the average mutual fund portfolio that has 100% turnover, often with at least 100 stocks. This means that the portfolio manager each year faces the daunting responsibility of analyzing 400 quarterly earnings reports and conference calls, monitoring the competitive advantages of 100 companies and their competitors, and finding 100 replacement ideas.
The “buy and hold” strategy allows us to enjoy the compounding benefits of superior growth companies, while minimizing the commissions and taxes that are obstacles to growing capital. We note that the majority of the Forbes 400 wealthiest individuals have earned their place on the list by owning outstanding businesses held for many years.
All Cap Flexibility
All Cap Flexibility
“Our portfolios are not defined by company size and market capitalization. We value the flexibility to select first-tier businesses led by all-star managers at attractive prices, regardless of the size of the company.”
We are not encumbered by the amount of our assets under management or by an arbitrary “style-box.” Many money managers have a mandate to stay within their defined style-box of, for instance, large-cap growth, even if large-cap growth stocks are overpriced. This is a by-product of the desire of the money management company with multiple style-boxes to be able to market whichever style-box happens to be in vogue. We manage your portfolio as though all of our own capital were similarly invested to capitalize on maximum opportunities.
We are not encumbered by the amount of our assets under management or by an arbitrary “style-box.” Many money managers have a mandate to stay within their defined style-box of, for instance, large-cap growth, even if large-cap growth stocks are overpriced. This is a by-product of the desire of the money management company with multiple style-boxes to be able to market whichever style-box happens to be in vogue. We manage your portfolio as though all of our own capital were similarly invested to capitalize on maximum opportunities.