“Even a great business purchased at a high price is a poor investment.” -- Brian Yacktman
For Illustrative Purposes Only
* "Margin of Safety" is defined as the discount from the adviser's intrinsic value calculation that is desired in order to purchase a stock. By saying "safety," investors should not interpret this to be a safe or risk free strategy. Investing in common stocks involves risk and principal loss is possible.
** YCG defines "Intrinsic Value" to be the present value of a company's expected future free cash flows discounted at a rate equal to the risk-free rate plus YCG's assessment of an appropriate risk premium.
At YCG, we seek to identify companies trading at prices that we believe will produce high, risk-adjusted, forward rates of return. When evaluating any investment, the returns will be based upon the future cash flows generated. Thus, we place a strong emphasis on analyzing cash flow* and seek to answer four basic questions: How much normalized cash flow (cash flow adjusted for cyclicality in sales and margins) will the investment produce, after adjusting for often-overlooked items such as option issuance, pensions, and capital expenditures that will reabsorb the cash generated? When will that estimated cash flow arrive? How predictable or risky is that estimated cash flow? What is the price to receive that estimated cash flow?
Based on these estimates, we calculate an implied expected return and then look at the yield spread between stocks of varying quality levels. This method turns on its head the common, mechanical practice of estimating distant future cash flows, valuing those cash flows at an arbitrary discount rate, and then purchasing those cash flows at some predetermined discount to intrinsic value. We find our approach allows us to compare investment opportunities and objectively prioritize and focus in on our best ideas.
We believe patience is a virtue and that attractive opportunities will eventually arise, regardless of the overall market valuation. We believe that by doing thorough research and by placing a strong emphasis on price paid, we can help manage risk for our clients.
* The definition of free 'cash flow' is the cash flow from operations that is left over after spending on maintenance capital expenditures and acquisitions that are required to protect the business. In other words, it's the cash flow from operations that is free and clear to be distributed to shareholders in the form of dividends and share repurchases, and/or to be allocated towards ways to grow the existing business through means such as “growth” acquisitions or new capital expenditures, or simply pay down debt. Typically, we calculate this by looking at a normalized view of net income plus depreciation and amortization minus the maintenance capital expenditures and acquisitions that are required to protect the business, adjusted for often overlooked items such as pensions, stock option expenses, and leases.