Investment Commentary

Spring 2015

Market and Performance Summary

For the quarter ended March 31, 2015, the Kovitz Investment Group (KIG) Equity Composite
(the Composite) returned 1.4%* net of fees compared to 1.0% for the S&P 500 Index.
As long-term investors, our research process emphasizes the appraisal of factors that we believe
matter most to a businesss long-term success. These include the quality of the business, the strength
of the balance sheet, the predictability of the cash flows, and the ability of the management team to
allocate capital intelligently and judiciously. We believe these attributes are the most reliable
predictors of a companys ability to maximize intrinsic value on a per share basis.
Business quality may mean different things to different investors. When we think about a high
quality business, we are referring to a company that not only earns high returns on capital today, but
is likely to sustain high returns on capital long into the future due to a strong competitive position.
Warren Buffett notably refers to such businesses as possessing a competitive moat. Buffett asserts,
A truly great business must have an enduring moat that protects excellent returns on invested capital. The
dynamics of capitalism guarantee that competitors will repeatedly assault any business castle that is earning high
returns.
Buffetts symbolic moat is formed when a business possesses one or more sustainable competitive
advantages. The primary competitive advantages that we focus on include a low cost position, strong
brand loyalty, high customer switching costs, and network effects.
As taught in introductory business classes, the value of any financial asset (e.g., stocks) should equal
the present value of all of its future cash flows. Therefore, to effectively value a business we have to
make a reasonably accurate forecast of that businesss future. Accurately predicting the future cash
flow of a business is difficult. Without a moat, it becomes even more difficult because competition
can quickly disrupt a businesss sales and margins resulting in diminished cash flow. On the other
hand, predictability of cash flow increases if a business has a moat. The wider and more enduring we
perceive a businesss moat to be, the more conviction we can have in our intrinsic value estimates.
*The returns for your individual account will differ somewhat from the Composite due to slight variations in account holdings, cash position,
and other client-specific circumstances.
T 312.334.7300 F 312.334.7308

115 South LaSalle Street, 27th Floor, Chicago, IL 60603

www.kovitz.com

Assessing and appraising the strength and endurance of competitive advantages is the most difficult
task in investing. Most of our mistakes can be traced back to an incorrect assessment of a companys
moat. Given the foundational nature of this exercise in our research process and its critical role in
our future success, continual improvement in this area will always be our main focus.
While it is mandatory for a company to possess a defensible moat before the possibility of an
investment is considered, the overriding factor for inclusion in our portfolio is price. Regardless of
positive qualitative attributes, quantitatively, the companys stock must trade at a significant discount
to our determination of its private market value (intrinsic value) before we will make an investment.
This margin of safety provides further insurance against a permanent loss of capital should our
assessment of a companys moat prove overly optimistic.
Below is our standard performance report for the KIG Equity Composite, which now encompasses
18 years and 3 months. The chart summarizes both annualized and cumulative performance results
from January 1, 1997 through March 31, 2015 for the Composite and the S&P 500. We remind you
that your portfolios composition is significantly different from the broad market indices, so your
performance will inevitably deviate from these indices, especially over shorter time periods. We
manage your portfolio for long-term results, and we encourage you to evaluate its performance over
a multi-year time frame.
Note that we have added a new metric to the first chart: The percentage of the time we outperform
the S&P 500 on a rolling period basis. For example, there have been 208 one-year rolling periods
from January 1, 1997 through March 31, 2015 in which we have outperformed our benchmark 60%
of the time. Or, that there has been 100 10-year rolling periods in which the Composite has
outperformed 93% of the time. The point of detailing this is to remove the vagaries that the
selection of any arbitrary end date has on the numbers, and to provide a truer reflection of our longterm performance. As illustrated, the percentage of outperformance increases as the measured time
period lengthens, which corroborates our thesis that compounding wealth is a long-term endeavor
and not a short-term game.
KIG vs. S&P 500
Annualized Equity Performance (Net of Fees)
1-Year

3-Year

5-Year

10-Year

15-Year

Since
Inception
(18.25 Years)

KIG*

7.8%

14.6%

13.0%

7.9%

6.6%

11.1%

S&P 500

12.7%

16.1%

14.5%

8.0%

4.1%

7.8%

60%

75%

80%

93%

100%

NA

Rolling Period
Outperform Percentage

Page | 2

KIG vs. S&P 500

Cumulative Equity Performance (Net of Fees)
1-Year

3-Year

5-Year

10-Year

15-Year

Since
Inception
(18.25 Years)

KIG*

7.8%

50.5%

84.3%

114.1%

160.0%

581.6%

S&P 500

12.7%

56.5%

96.5%

116.0%

84.0%

290.6%

Please refer to the disclosure on the last page of this newsletter for additional discussion regarding the performance of the
Composite.

KIG Difference
Growth of $1,000,000 Investment
$7,000,000

KIG
$6,816,000

$6,000,000
$5,000,000
$4,000,000
$3,000,000

KIG
DIFFERENCE

$2,000,000

S&P 500
$3,906,000

$1,000,000
$0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
KIG TOTAL RETURN (WITH DIVIDENDS)
S&P 500 TOTAL RETURN (WITH DIVIDENDS)

Please refer to the disclosure on the last page of this newsletter for additional discussion regarding the performance of the
Composite.
We appreciate the faith that you, our partners, have placed in us to manage your capital on a longterm basis. The extended time frame you allow us provides a tremendous advantage as we go about
our investment decision making. Managing other peoples money is an enormous responsibility and
we hope you take comfort in the fact that we are doing the exact same thing with our own money as
we do with yours.

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Bear Markets are Inevitable

An extended period of strong market performance, similar to what we have experienced since the
historic lows of March 9, 2009, brings many investor worries and concerns to the surface. One of
the biggest concerns weighing on investors is whether or not the market is overdue for a pullback or
correction. It has been more than six years since the last bear market ended. When will the next rout
come? We dont know and, despite the endless pontificating in the financial press, no one else does
either. The only two certainties are that a correction will eventually occur, and the best way to
manage through it is to avoid any attempt to pinpoint the top of the market ahead of time. More
likely than not, endeavoring to pick a market top and a coinciding bottom will leave you worse off
than if you just stayed the course. Instead, be accepting of its inevitability and emotionally prepared
to ride it out.
The reason stocks have historically returned more than cash or bonds is not necessarily because they
are more risky but that they are inherently more volatile. Accepting volatility is the price of
admission investors must be willing to pay to achieve returns greater than those offered in lessvolatile assets.
Stock markets always willindeed, mustcrash from time to time. To understand why, consider
the work of the late economist Hyman Minsky. In the 1970s, most theories held that modern
economies were fundamentally stable. Deep recessions and financial crises were anomalies, caused
by outside shocks such as bad policy, war, or a spike in oil prices. Mr. Minsky thought differently.
In his view, crises were neither accidents nor the results of policy errors but were the result of
the normal functioning of our particular economy, as he wrote in a 1976 paper titled A Theory of
Systemic Fragility. In short, Mr. Minsky believed that a stable economy leads to optimism, optimism
leads to excessive risk-taking, and excessive risk-taking leads to instability. Success breeds a
disregard for the possibility of failure, he wrote. Booming business (and/or booming markets) and
the absence of serious financial difficulties over a substantial period leads to euphoria where
consumers, businesses, and investors grow increasingly comfortable taking on debt in pursuit of
financial gain and believe that stocks have nowhere to go but up. That is when the next crisis begins.
The core of Mr. Minskys work is that a period without crises plants the seeds of the next crisis.
Stability itself can be destabilizing. The paradox of investing is that if markets never crashedor if
investors perceived that they would never crashstock prices would rise so high that a new crash
would become inevitable. Stability in the stock market, like we have had for the last six years,
becomes destabilizing. Ultimately, jubilation must turn to tears.
Said another way, market crashes every now and then are simply whats needed in order for investors
to earn satisfying long-term returns; theyre not something to be feared. With this as backdrop, we
believe the worry about a correction (or crash) is given too much weight by investors and, as a
consequence, blurs their long-term thinking. Instead of fretting about when it will come, we take
ownership of excellent businesses with strong balance sheets at undemanding valuations. In a
market downturn, these businesses will of course experience some degree of pain along with the
general market, but they will likely weather the storm better than many of the average, or belowPage | 4

average, businesses. They will also provide ample upside when the cycle turns, particularly if we use
the market sell-off as an opportunity to buy more.
While we need to be wary of long-term risk (i.e. permanent capital loss, not the volatility of the
markets daily movements), we also believe that, instead of making equity investment decisions
based on predicted market sentiment, we must focus on individual companies, their long-term
fundamentals, and whether or not the current prices offer the opportunity to buy mispriced
securities that could provide potential for meaningful long-term capital appreciation. In this regard,
based on past experience, we continue to believe that periods of market volatility, marked by shortterm drops in equity prices, should continue to provide compelling opportunities to buy financially
strong, well-managed companies at very favorable prices. As value investors, we believe that having
a long-term horizon in an environment that is maniacally focused on short-term events provides us
with a strategic advantage. We believe that our long-term horizon, in conjunction with our emphasis
on an in-depth analysis of financial statements and a relentless focus on the quantity and quality of a
companys cash flow, should provide a big advantage to purchase outstanding companies at bargain
prices.
While there are always forecasters predicting the next market downturn, downturns have always
been part of the investment landscape. Although downturns tend to make investors nervous as
prices decline, we believe our future returns are determined by our strategy leading up to and during
these declines, not in attempting to avoid them.

Portfolio Activity
In contrast to the last quarter where we added seven new names to the portfolio (six as part of our
energy-related basket), no new names were added during the first quarter of 2015. We did increase
the position size in one portfolio name, Valmont Industries (VMI), as we felt investor fears about
its decline in utility project orders appeared overdone. Our feeling is that this segment is undergoing
a temporary cyclical decline as opposed to a more worrisome secular one. As is often the case, at
current prices, the market is ignoring Valmonts long-term earnings power and has focused instead
on short-term disruptions.
We strategically decreased holdings in three names, Kohls (KSS), Target (TGT) and Walgreens
Boots Alliance (WBA), as appreciation in each companys stock price pushed shares closer to our
intrinsic value estimates. Kohls efforts in building out its omni-channel offering along with targeted
marketing reforms have resulted in recent sales momentum that appears sustainable. We have long
felt Kohls business possessed unique advantages that, if harnessed properly, would ultimately lead
to same-store sales growth. Target benefitted primarily from addition by subtraction as it announced
that it was discontinuing its foray into Canada. The ill-conceived venture has been a drag on
company profits since inception and new management made the bold decision to stop deploying
capital into what was likely a money losing effort for the foreseeable future. Walgreens is benefitting
from strong sales in its U.S. stores and earnings accretion from its two-stage acquisition of Alliance
Boots, which was completed in 2014. All three of these actions Kohls decision to invest in its
Page | 5

omni-channel offering, Targets decision to stop throwing good money after bad in Canada, and
Walgreens acquisition of Alliance Boots are excellent examples of how capital allocation by
management is one of the primary determinants of shareholder value.
We eliminated our holdings in two companies. Abbott Laboratories (ABT) reached our fair value
estimate set at the time of our original purchase, with no new material developments that would
cause us to reevaluate our estimate of intrinsic value. Coach (COH), on the other hand, reached
our recently downgraded assessment of intrinsic value. While sales have likely stabilized at Coach,
todays price could prove low only if sales improve dramatically from here over the next couple of
years, which we view as a low probability. We still believe the brand has value and managements
turnaround plan is credible, but execution risk remains high. We also think that there may be too
much competitive pressure for sales to grow, even from todays dramatically lower base, at rates that
would make our exit price seem too pessimistic. In hindsight, we should have been more skeptical
before initially purchasing the stock because the genesis for this mistake can be traced back to a
poor assessment of Coachs moat. We initially believed Coachs brand possessed wide moat
characteristics, but increased competition and the fact that the company needed to make large
investments as a result demonstrated that the moat was actually much narrower than we believed.
We cant promise this will be our last mistake. They say mistakes are the portal to discovery and we
will make sure we learn something from each one. On the other hand, we can promise to treat your
money as if it were our own and to remain fully transparent in the decisions we make.

The Case Against Indexing

The debate over how investment capital should be managed has raged for years. Should funds
marked for investment be placed, as they have typically been for many decades, with active
managers (that is, the practice of using human judgment to select securities based on the merits of
business quality, valuation, and risk) who attempt to construct portfolios using individual securities
in an attempt to outperform a market index? Or should they be entrusted to passive managers
who merely try to match a market index and can therefore charge a much lower fee for their
services? Passive investors sacrifice the opportunity to earn more than the applicable index, knowing
that they also forgo the risk of earning substantially less.
One of the accelerating trends of the post-crisis investing landscape is the marginalization of
active management in preference for passive management in the form of index funds. For
active managers, 2014 was an awful year in which they failed to match their market benchmarks on a
scale not seen in decades. Some estimates suggest that as many as 90% of active managers in the
U.S. underperformed their benchmark in 2014 (including us). In fact, sentiment toward stock
pickers has gotten so bad that searching for active management on Google displays results like
Can Anything Save Active Management? and Is Active Management Dying?
Meanwhile, inflows into actively managed funds have collapsed, particularly in the huge market for
U.S. funds investing in equities, as investors have expressed their displeasure by moving money to
Page | 6

low-cost funds that mimic indexes. In 2014, actively run U.S. stock funds suffered $98 billion in net
redemptions, while index funds took in $167 billion. According to recent data, actively managed
funds still held a majority of all stock fund assets, or roughly 63% of the $8.7 trillion stock fund
business, but the numbers are changing quickly as more than 98% of inflows to stock funds in the
first nine months of 2014 were directed to index funds. Passive managers 37% share has more than
doubled from 10 years earlier, Morningstar data show.
The stream of money from institutions and retail investors that was already flowing instead to rival
passive funds has turned into a flood. Fidelity Investments, once the worlds largest fund manager,
saw $25 billion flow out of its active funds this year. Vanguard, its successor as the largest US
mutual fund group, took $189 billion into its passive funds. As these flows indicate, the outcry for
passive over active and that active management is a waste of time are louder today than they have
ever been.
Before delving further, it is important to understand the logic that sparked the invention of index
funds in the first place. Theoretically, an index fund benefits from the free rider concept, in which
daily market prices are established via the fierce competition amongst active managers, each of
whom is diligently working to uncover and exploit pricing inefficiencies through fundamental
research and nuanced judgment. Over time, greater assets accrue to the most capable at this game,
thereby constantly increasing the influence of the most successful active managers at the expense of
those less successful. The index buyer benefits from this competitive price discovery without the
effort of being an active participant, and achieves the fair market return with lower costs and easy
diversification.
Naturally, any free rider benefit is best exploited when the rider is as close to invisible as possible. If
the market share of the free rider becomes too large relative to the active players, the index begins to
distort the pricing mechanism by its own participation. It is a matter of debate where the line might
be drawn, but when 37% of all investments are managed to an index and when 98% of new money
that enters into a market is ultimately funneled into the securities represented by those indices, it
seems clear that popular indices have gone from reflecting competitive market prices to actively
driving them.
Stocks have moved in lockstep to an unusual degree since the 2008 financial crisis. Indeed, monthly
dispersion among S&P 500 members, a measure of how much individual stock prices move relative
to the market, narrowed for the fifth year in a row during 2014 and reached the lowest level since
1979 in August, according to data compiled by JPMorgan Chase & Co. and Bloomberg. Its not a
stretch of the imagination to conclude that this increased correlation is due to the massive inflows
into passive products, such as index-linked mutual funds and Exchange Traded Funds (ETFs). (An
ETF is a marketable security that generally tracks an index composed of equities, bonds,
commodities, etc., and, unlike mutual funds, an ETF trades like a common stock on a stock
exchange.) ETFs, in particular, have encouraged rapid, mass movements of stocks, and caused them
to trade more closely together.
Page | 7

These higher correlations, by definition, make it more difficult for active managers to generate alpha,
or outperformance, at least in the short term. A vicious cycle may well be underway. Active
managers could be lagging the index by virtue of underweighting the low-quality tail of the
indexes, while passive flows may be bidding up this very segment. If investments with active
managers are then redeemed in favor of ETFs and index funds, it could result in more selling
pressure for higher-quality names, more buying pressure for lower-quality names, more relative
underperformance by active managersand around we go.
In addition to the plethora of index-related mutual funds, there are currently 1,700 different ETFs
where you can express a market view. Based on availability and ease of use, many investors are
forgoing choosing individual stocks in order to choose sectors, countries, risks, or mixing and
matching all of the above. A typical commercial for an ETF goes something like this: Thinking of
buying Apple, Google, or Microsoft? Why own a single technology stock when you can own them all. With the
technology sector ETF, take the risk out of owning individual stocks.
The ETF industry would love to see the asset management industry continue to move from an
emphasis on security selection to ETF selection. The rationale for creating more and more of these
products designed to slice and dice the market every which way is that investment managers need
them. The industrys rapid growth has been interpreted as proof that, in fact, they are needed and
managers just didnt realize how much until they had them. Well, kids dont need matches, but, if
they are given a pack, they sure as shootin will use them. And they will likely burn down the house.
Will the new wave of index/ETF investors burn down house? The no hands index approach
works well when there is momentum in the market and its moving primarily in one direction, which
is exactly the environment weve been in for roughly the last six years. The problem is that feedback
loops go in both directions. When a positive feedback loop turns into a negative feedback loop,
what should be a modest sell-off or correction can quickly turn into a crash. As history has shown,
when a large number of price-insensitive investors whose primary attraction to an index was that it
was going up wish to hit the exit door at the same time, there may not be enough natural buyers to
fill the need for liquidity in an orderly fashion. This creates a vacuum that only much lower prices
can fill.
Much like today, in the late 1990s, after widespread underperformance by active managers in a
market run that failed to distinguish companies with good fundamentals from those with bad
fundamentals, many investors moved into what had done well, including passive strategies in
technology (NASDAQ 100 ETF) and U.S. large cap equities (S&P 500 index funds/ETFs). The
momentum of more money flowing into the largest and most expensive stocks forced the
capitalization weighted indexes to add more to those stocks, driving prices well beyond the values of
the underlying businesses. For those who believe that investing in vehicles that mirror index
performance is always sensible regardless of valuation, what happened next is part of investment
lore: From the peak in March 2000, the NASDAQ 100 and the S&P 500 lost approximately 80%
and 45%, respectively, over the next two and one-half years. In the multi-year period that followed,
individual company qualities and valuations mattered, and the relative performance of proven active
Page | 8

managers versus passive indices reversed itself, as we believe it will again. As our long-term clients
would expect, at this moment of weak relative performance and active management in disrepute, our
optimism about future relative performance is exceptionally high.
We have a basic view of the investing world that price matters, independent research matters, and
that there are opportunities in the marketplace because share prices regularly move more than
company values do. ETFs do not distinguish between good and bad companies or undervalued and
overvalued stocksbut that does not mean there are no such differences, or that they will not have
ramifications for investors. With so many stocks trading together and with valuations that fail to
reflect striking differences among them, we believe that active investors should see the current
environment as a major opportunity. The key, in our view, is to have patience enough to avoid
short-term speculative choices in favor of focusing on a long-term time horizon tied to underlying
fundamentals.
One argument for indexing revolves around the fact that information is so widely and readily
available that no one can get an edge because all available information is immediately factored into
stock prices. On the contrary, the challenge to investing is and always will be to filter out relevant
information from the massive quantity available. Of the hundreds of factors or variables in any
investment, typically its only a small handful that are truly important. Deciphering what those
important factors are and how they may impact a companys future business and economic results
takes judgment, acumen, and a dose of common sense. Indexing assumes this away.
At the end of any long-trending market, people would not be people if they had not imbibed the
idea that stocks are more alike than not, along with the corollary that they are not so much fractional
interests in individual businesses as they are disembodied ticker symbols. During a great bull market,
the difference between companies is likely to matter a great deal less than the fact that the market is
going up. Why bother to read the 10-K and the associated footnotes if one stock is essentially as
good as another?
The case against indexing is ultimately straightforward as this simple thought experiment
demonstrates. Take the S&P 500 with its 500 large capitalization companies. Assume 499 are solid,
reasonably valued companies, but there is one predictably inferior company (e.g., outmoded business
model, wild overvaluation, weak management, etc.) whose future price performance will surely be
worse than the overall index over a reasonably long period of time. A passive investor in this index
assumes ownership of all 500 companies, including the inferior one. An active manager, on the other
hand, could choose to own just the 499 good ones and will therefore outperform the index. If two
clearly inferior companies can be identified, then the active manager will be that much better off. If
three inferior companies can be identified . . . well, you get the idea. While this example is contrived,
the basic concept of a competent active manager attempting to weed out inferior companies while
owning better ones seems to validate that active management has an important role to play. Believe
us when we say that the fine art of security analysis is not dead.

Page | 9

Best Regards,

Kovitz Investment Group

Kovitz Investment Group, LLC

Page | 10

This newsletter has been prepared by Kovitz Investment Group, LLC (KIG), an investment
adviser registered under the Investment Advisers Act of 1940, and is a quarterly newsletter for our
clients and other interested persons. Within this newsletter, we express opinions about direction of
the market, investment sectors and other trends. The opinions should not be considered predictions
of future results. Discussion in this newsletter relating to a particular company is not intended to
represent, and should not be interpreted to imply, a past or current specific recommendation to
purchase or sell a security, and the companies discussed do not include all the purchases and sales by
KIG for clients during the quarter. A list of specific recommendations made by KIG over the past
year can be made available upon request. In addition, please note that any performance discussed in
this newsletter should be viewed in conjunction with complete performance presentations that we
update on a periodic basis. Such presentations are available at www.kovitz.com, or by calling us at
312-334-7300. Information contained in this newsletter which is based on outside sources is
believed to be reliable, but is not guaranteed or not necessarily complete.
Past performance does not guarantee future returns.

Page | 11

Mitchell Kovitz, CFA, CPA

312.334.7301
[email protected]

Andrea Cohen, CFP

312.334.7312
[email protected]

Sanford Kovitz, JD, MBA

312.334.7352
[email protected]

Marc Brenner, JD, CPA

312.334.7302
[email protected]

Mary Anderson, MBA

312.334.7355
[email protected]

William Lee
312.334.7335
[email protected]

Skip Gianopulos, JD, LLM, CFP

312.334.7303
[email protected]

Jenny Boyke, MAS, CPA, CFP

312.334.7316
[email protected]

Christopher Nicholson, CFP

312.334.7319
[email protected]

Jonathan Shapiro, CFA, MBA

312.334.7324
[email protected]

John Conway, CRPC

312.334.7343
[email protected]

Jack Nicholson, MBA, CFP

312.334.7323
[email protected]

Bruce Weininger, CPA, CFP

312.334.7334
[email protected]

Ed Edens, MBA, CFP

312.334.7333
[email protected]

Jason Petitte, CFA

312.334.7311
[email protected]

Ted Rupp, MBA

312.334.7317
[email protected]

Amanda Falkum, CFP

312.334.7351
[email protected]

Mark Rosland
312.334.7322
[email protected]

Joel Hirsh, CFA

312.334.7307
[email protected]

Debbie Hopkins, MBA, CFP

312.334.7325
[email protected]

Peter Rudman
312.334.7327
[email protected]

Leonard Gryn, CPA

312.334.7360
[email protected]

Kate Jonynas, CFP

312.334.7309
[email protected]

Rich Salerno
312.334.7304
[email protected]

*The returns for your individual account will differ somewhat from the Composite due to slight variations in account holdings, cash position,
and other client-specific circumstances.
T 312.334.7300 F 312.334.7308

115 South LaSalle Street, 27th Floor, Chicago, IL 60603

www.kovitz.com