We define risk as the probability of permanently losing capital over our five-year time horizon. Market volatility is not risk. Market volatility creates opportunity for long term investors who understand that price and value are not always equal. The greater the margin of safety in terms of value over price the lower the risk of losing permanent capital. A wonderful business purchased at an attractive price has very little risk in the long run even though its price might fluctuate significantly in the short run. Good businesses do not require leverage to produce high returns on shareholder’s capital and free cash flow. Leverage increases risk as well as the potential for return. Good businesses can enhance their returns to shareholders with an efficient capital structure and prudent leverage but we view leveraged businesses with skepticism.
We limit our search for qualifying investments to good businesses. Good businesses have identifiable, sustainable competitive advantages. We prefer great businesses but will invest in a business that is only good if its price is sufficiently discounted to intrinsic worth. We have no interest in business enterprises with inferior economics that are statistically cheap. By our definition good businesses produce free cash flow. Rapidly growing GAAP net income or earnings per share is of no interest to us unless it is accompanied by robust production of free cash flow. Businesses that are competitively entrenched produce free cash flow and those that are not competitively entrenched do not produce free cash flow. It is that simple. We want to invest in businesses that have sustainable competitive advantages that are becoming more competitively entrenched. As Warren Buffett would say, we want to invest in businesses with deep moats that are getting deeper.
Vulcan Value Partners’ goal is to lower risk by constantly reducing the weighted average price to value ratio of its portfolios. We will invest greater amounts of capital in companies with lower price to value ratios and reduce capital committed to companies with higher price to value ratios. We seek to be fully invested at all times but will hold cash when we cannot find enough qualifying investments. While maintaining an adequately diversified portfolio we will concentrate into fewer names when attractive discounts are available. We will own a greater number of names when price to value ratios are less attractive.
Vulcan Value Partners’ primary return goal is to compound capital at real rates of return significantly in excess of inflation over our five year time horizon. We believe that by focusing on the fundamental building blocks of absolute returns we will also deliver attractive returns relative to benchmarks over the long term.