Value Philosophy

The Fund's value philosophy is based on the premise that all stocks have a certain inherent value which is derived from the value of the companies they represent. With careful analysis the value of individual stocks can be estimated with a reasonable degree of certainty. This is in value investors' terms known as a stock's 'intrinsic value' (note; however, that this is not, as it is sometimes called, a company's book value). In a perfect world stock prices would always accurately reflect intrinsic value. However, in reality they often do not, or at least not always. The Citadel Value Fund focuses on finding and investing in those shares that our analysis shows are selling for far less than their estimated intrinsic value.

In implementing its value philosophy the Fund is committed to maintaining a clear, consistent, and disciplined methodology. This means not wavering in strategy, or watering-down the investment criteria to suit the wisdom of the day. A basic principle is not to speculate on how and when stock markets will perform, which sectors will out- or underperform, or which themes will drive stock prices. Few if any investors have ever succeeded in the long-term by practising those approaches. We are firm believers that stock prices are always, (although sometimes it takes a while), driven by the values of the underlying businesses. Solid businesses acquired at very low prices are the best recipe for achieving superior long-term returns, and preserving investors' capital.

Citadel Value Fund's strategy for investing in value

Fundamental company research to find undervalued stocks

The key to identifying undervalued stocks is to thoroughly research and analyse companies, and carefully estimate their intrinsic value. We continuously search for stocks which appear to be very undervalued based on quantitative measures such as Enterprise Value to Sales, EBITDA, or Free Cash Flow, Price-to-Book, etc., and then research them in-depth. Researching a company is highly time consuming, and involves analysing the financial statements, researching markets and competitors, interviewing management, etc., but it is crucial to reducing potential risks. Companies with very weak balance sheets, a poor track record of spending shareholders' money, or where we simply find it impossible to draw a reasoned conclusion are filtered out. The next important element of our work involves putting a price tag on a company. We do this by constructing detailed company and discounted cash flow models. We also use a variety of valuation yardsticks (often sector specific), and pay keen attention to the prices paid by the most knowledgeable buyers of companies - other companies in comparable businesses. We attempt to err on the side of cautiousness in this process. The end result is our estimate of a company's intrinsic value, and therefore our target price.

Purchase shares at a big discount to their estimated intrinsic value

While research often throws up undervalued stocks, the vast majority are not sufficiently undervalued enough to invest in. A select few do make the grade though. Buying at a large discount - as a rule we look for a price of 50% or less of estimated intrinsic value - offers two advantages. It provides a "margin of safety" to protect against unforeseeable risks, while simultaneously offering the potential for substantial share price appreciation.

Seek a balance between diversification and focus

Generally, the Fund will hold positions in between 20 and 40 individual stocks. This provides it with a sensible level of diversification to protect against potential disappointments in individual holdings. However, it also allows the Fund to build meaningful positions when our analysis turns up an undervalued gem. Furthermore, were the number of holdings to be much higher, it would be virtually impossible to carry-out the painstaking research which is crucial to the Fund's investment process.

Invest for the long-term

We cannot predict when undervalued shares will rise to their intrinsic value, nor do we believe that others can, at least consistently and with any degree of reliability. Consequently, we invest with a view to holding stocks for the long-term - generally 2 ½ years or longer. Short-term investment success is usually more a question of good luck than good judgement. However, in a portfolio of deeply undervalued stocks, held for the long-term, there is a reasonable probability that several will rise to their estimated intrinsic value on a regular basis thereby generating attractive returns.

Sell holdings when they reach our estimate of intrinsic value

Just as we look to buy based on a careful appraisal of a stock's value, we sell based on the same hard analysis, and replace it with another undervalued stock. Speculating that a stock will move above our estimate of instrinsic value is not part of this strategy.

Some myths surrounding value investing

Value investing is often characterised, unfairly we believe, as a bear market strategy. One of the persistant myths surrounding value investing is that while it may offer protection in down markets, returns will lag in good markets. A reason for this may be the perception that to invest in 'value', is to invest in weak, downtrodden, somewhat boring companies who were long-ago abandoned by investors. And while the share prices of these companies may be cheap, they could remain cheap for years. However, value is far more multi-faceted than this thinking suggests.

Value is about identifying a favourable relationship between price and future cash flows. While a steel mill selling at half the value of its assets might seem a good value stock, this is not necessarily the case. The best values are actually often found in the highest quality businesses which, for one reason or another, have seen their share prices fall. In the case of the steel mill, a sale or break-up could result in the hidden value in its assets emerging to the benefit of shareholders. However, barring that and assuming that its future results were weak (steel being a difficult business at the best of times), the share price would likely remain low. The quality business in contrast might well undergo a difficult year or two, but is still far likelier to see an improvement in its fortunes. With time, and growing cash flows, the value of such a company increases quickly. And markets usually don't take long to mark-up share prices when business improves. For a value investor bull markets are not a bad time. In fact, with the benefit of low prices paid when companies were undergoing setbacks, they can be very profitable as these stakes are suddenly re-valued.

Value investing is a much more all-weather philosophy than many credit it for. Where value investors cringe, is from the 'momentum'-driven market, such as we experienced in the late 1990's. This is the market where the traditional warning "past performance provides no guarantee for the future", seemingly becomes "past performance is a guide to future performance". Stocks rise for no apparent reason other than that they rose the day before. In such an environment, the value investor's focus on company fundamentals and low prices can be unrewarding. Luckily, however, these periods usually end with a bang!

How Citadel defines value

The approach that the Citadel Value Fund employs is two-fold; make concentrated investments in the quality businesses available at cheap prices, and diversify in the 'classic' value businesses. The overwhelming preference is for investing in the quality business, but at a low price. These will most often be companies whose current problems we judge to be temporary, not structural. The average stake in such companies will tend to be relatively large. This reflects the fact that the intrinsic values of these firms grow over time making them increasingly valuable. However, when market prices make it more difficult to find these companies at value prices, the portfolio will shift somewhat towards more 'classic' value stocks.

With 'classic' value stocks diversification is more important, and the positions will be much smaller. This is to protect both against the risk that a cheap stock remains cheap, as well as against firm-specific risks. Generally the 'classic' value stock is more controversial than its quality brethren, otherwise its valuation wouldn't be what it was. Results are sometimes weak, the business is often dull, and balance sheets can be stretched. Beyond spreading risk through diversification, we are prudent in avoiding weak balance sheets. This is to avoid the risk that a company is tipped into serious problems (i.e. liquidity problems or worse) if results deteriorate. We are also careful to select only those companies where cash flows are positive or close to it, and which our analysis indicates will improve. When prices get too far out of line, split-ups and acquisitions at far higher prices can occur. However, while nice if it happens, we don't build this into the investment case. Still, our thinking is that in a portfolio of deeply undervalued 'classic' value stocks - even if held for several years - the Fund will earn a good return if only a couple of these holdings adjust to our estimate of intrinsic value or close to it.

Value can appear in numerous guises. What is important is to recognise what form it is, and to invest accordingly. The Citadel Value Fund is all about stock-picking - irrespective of index or sector composition. However, while preferring the cheap quality business to the 'classic' value stock, both sorts can be excellent 'value' picks. The portfolio at any point in time is therefore apt to be a balance between both sorts of value. This should allow the Fund to perform well through most market cycles, while remaining true to its goal of preserving investors capital and earning attractive long-term returns.

More about value investing?

Prospective investors can read more about the Citadel Value Fund's Investment Philosophy in its brochure. This can be viewed or downloaded with Adobe Acrobat Reader, and is located in the Prospectuses & forms section of the website. More detail about the value philosophy of investment, and the Citadel Value Fund's specific approach to value investing can be found in the various letters and updates to shareholders in the Shareholders news section.

For those interested in reading more about value investing in general we would recommend the following literature, although there are numerous other worthwhile books and periodicals:

Warren Buffett's letters to shareholders - These highly readable letters, stretching back decades, give an excellent overview on value investing. They can be found at the Berkshire Hathaway website.

Security Analysis, by Benjamin Graham & David Dodd - Available in several editions this is the 'bible' for value investors, but not an easy read.

The Intelligent Investor, by Benjamin Graham - This is a smaller and more readable book than Security Analysis, and contains several of the most ground-breaking ideas in investing.

Buffett: the making of an American capitalist, by Roger Lowenstein - A superb, well written biography of Buffett which also sheds considerable light on Buffett's approach to value investing.

Common stocks and uncommon profits, by Philip Fisher - A good companion work to Benjamin Graham which stresses a less mechanistic approach to value investing through its emphasis on growth and company quality.