RLI Investment Philosophy

The Principals of Successful Investment

www.roadlessinvested.com

2012

What is an Investment Philosophy?

An investment philosophy is a set of guiding principals that help an investor avoid common mistakes.

RLI believes an investment philosophy is critical to long-term success in investing Helps investors make decisions and avoid mistakes Protects us from our own worse enemy ourselves How does a philosophy help us? Provides a framework for making investment decisions such as buying or selling securities Helps us avoid the madness of crowds through disciplined, independent thought Helps us avoid situations where we are at a disadvantage, such as situations that we do not fully understand The RLI Investment Philosophy is based on a value investing tradition emphasizing discipline, long-term investment and a margin of safety Discipline Stick with the investment philosophy Do your homework Each and every time Know your limitations Stay within your circle of competence Insist on a margin of safety Be a long-term holder Know when to sell

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2012

Principle I: Discipline
Discipline is the cornerstone of successful, long-term investment.

Regardless of the mood of Mr. Market, the investor must approach each investment decision with the same level of thought, diligence and skepticism This means refraining during market euphoria if prices are not attractive and buying during market panics when the world seems most uncertain Having the discipline to approach each decision the same way helps the investor avoid following the crowd Remain committed to investment programs such as dollar cost averaging So what approach provides this disciplined? Its our remaining investment philosophy principles: Do your homework Each and every time Know your limitations Stay within your circle of competence Insist on a margin of safety Be a long-term holder Know when to sell

The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them.
Peter Lynch, One Up on Wall Street (New York: Simon & Schuster Paperbacks, 2000), 83

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2012

Thought Experiment
You do not need outsized returns to be successful as a long-term investor. Exercising discipline and avoiding mistakes may be the most important thing an investor can do to ensure success.

Is investment math cruel? If you experience a 50% loss, you need to a 100% gain to get back to even

Or is investment math overly generous?

Every $1.00 invested at a 8.0% compounded annual growth rate over 30 years grows to over $10.00

An investor needs to do very few things right as long as he or she avoids big mistakes.
Warren Buffett, Chairmans Letter to the Shareholders of Berkshire Hathaway Inc., 1992

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2012

Principle II: Do Your Homework Each and Every Time

Invest at least as much time buying a stock as you would invest making other major purchases.

Probably the single most common mistake investors make is not doing their homework They learn about some hot stock from a pundit on CNBC, an article in Forbes or a favorite uncle Worried they might miss it, they run out to buy it only to watch it fall Remember, you never really miss out by not investing There is never just one great opportunity there will be thousands over your investing lifetime For every great company there is never just one buying opportunity either you could have purchased Apple at any point between 2000 and 2010 and done fantastic Put simply, never buy a stock without first learning about the companys business model and competitive dynamics, reading its financials and estimating its intrinsic value at a minimum

Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.
Peter Lynch, One Up on Wall Street (New York: Simon & Schuster Paperbacks, 2000), 233

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2012

Thought Experiment
The average person spends considerable time comparison shopping common household items, but when it comes to investments, this approach is often out the door.

Did you spend more time researching your TV or your last stock purchase?

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2012

Principle III: Know Your Limitations

Knowing your own limitations is critical to avoiding costly mistakes.

To be a successful investor, you must recognize your strengths and limitations and then stay within your circle of competence Investor limitations come in many different forms Time limitations Temperament as an investor (i.e. risk tolerance) Understanding of an industry or business The first two determine whether a particular investor should venture into individual common stocks often the right answer is no If you do not have the time to research companies, then investing in individual companies is not for you If you know you do not have the stomach for price fluctuations or loss, you should avoid putting yourself in situations where you are likely to make mistakes like investing in common stocks The final dimension is about avoiding investing situations which you do not fully understand For example, Warren Buffet famously avoids investment in technology stocks for just this reason

Invest within your circle of competence. It's not how big the circle is that counts, it's how well you define the parameters.
Warren Buffett, Fortune Magazine, November 11, 1993., 11. Quoted in Robert G. Hagstrom, The Essential Buffett (New York : John Wiley & Sons, 2001), 81

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2012

Thought Experiment
Only you can judge whether you have the time, ability and temperament to be a successful investor.

A stop-loss position in which an investor automatically sells a position if the stock price drops by 10%

protects the investor from a bigger loss.

or

is the losing strategy of selling a stock because its price goes down.

When you put in a stop, you're admitting that you're going to sell the stock for less than it's worth today.
Peter Lynch, One Up on Wall Street (New York: Simon & Schuster Paperbacks, 2000), 244

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2012

Principle IV: Insist on a Margin of Safety

A margin of safety is the foundation of sound investment. It is the difference between investment and speculation.

When an investor acquires a stock at a price that is less than its estimated intrinsic value, then he is said to have a margin of safety This difference, or margin of safety, between the price and fundamental value protects the investor from: Mistakes in evaluating the company Deterioration of the fundamentals or business environment Unforeseen occurrences such as new competition or regulatory changes By insisting on investing only when you have a margin of safety, you help ensure that odds are in your favor If an investor buys a dollar for fifty cents, that dollar can lose half its value without the investor being harmed Investor benefits from double play stock price increasing to fundamental value, plus investor benefits as the company increases its fundamental value over time Remember, no one can predict the future! By insisting on an appropriate margin of safety, you protect yourself against costly losses

Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.
Benjamin Graham, The Intelligent Investor (New York: HarperCollins Publishers Inc., 2003), 512

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2012

Principle V: Invest for the Long-Term

Recognize that you cannot predict short-term movements. Lower your transaction costs and take advantage of lower tax rates by investing for the long term. Spend your extra time with your family and friends.

Short-term movements in the market are inherently unpredictable no one can tell you what the market or a stock will do over the next week, next two months or even over the next five years The good news, however, is that stock market returns have been remarkably consistent over longer periods of time, say 20 or more years Take advantage of that fact by investing for the long-term Control the factors that you do have control over, namely transaction costs and taxes Let the long-term forces of the economy and market do their work Transaction costs and taxes have a truly staggering impact when viewed over a long-term period Difference between short-term and long-term capital gains tax Impact of not letting your investment compound for as long as possible before reducing your base by paying transaction fees and taxes If you earn 10.0% return in the market each year and your transaction costs equate to 2.0% of your portfolio, you have expensed away 20% of your potential return In addition, the time and effort to find new investments is significant. Invest for long-term and enjoy more time with your family and friends!
My favorite holding period is forever.
Warren Buffett (widely quoted)

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2012

Thought Experiment
The economic case for long-term investment is compelling. Not to mention it is a heck of a lot less work.

Two investors both achieve 10% returns each year for 30 years One is a long-term holder, only selling his portfolio at the end of 30 years paying one time, long-term capital gains tax of 15% and transaction costs of 1.0% The other turns over his portfolio once per year, paying short-term capital gains tax of 35% and reasonable transaction costs of 1.0%
Value of Each Dollar Invested
$20.00 $18.00 $16.00 $14.00 $12.00 $10.00

$8.00 $6.00 $4.00

$2.00 $0.00

11

14

17

18

21

24

27

10

12

13

15

16

19

20

22

23

25

26

28

29

30

Long-term Holder
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Short-term Holder

Final

Thought Experiment
The impact of transaction costs and taxes is significant.

Consider this:
Every stock is held by someone. When someone buys, someone else must sell. The aggregate change in value of all stocks is the same as the gross aggregate change in investor wealth in the stock market. Therefore, while some investors might do better than the market in a given year, by definition someone else had to do worse as the sum of all investor gross returns must equate to the market return. However, each time an investor buys this security and sells that security, he or she incurs a transaction costs. The more an investor buys and sells, the more transaction costs he or she incurs. In addition, the investor may also pay advisors and portfolio managers to help manage their money.

The result?
While aggregate gross returns of investors equate to the aggregate market return, investors as a whole do significantly worse than the market. If you do nothing other than buy and hold a low cost index fund that tracks the entire market, you will have done better than the aggregate of all other investors. In fact, studies show you would likely do better than 70% of all actively managed mutual funds by utilizing this buy and hold strategy.

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2012

Principle VI: Know When to Sell

Considering our long-term focus, it is important to understand when we should consider selling. We believe there are only four reasons to sell a stock. None of these four reasons should be taken lightly.

We believe there are only four reasons to sell a stock, and selling should never be undertaken without a full analysis of the situation 1. Mistake in judgment or analysis
If the logic underlying the investment was based on faulty data or judgment, the investor should consider selling the position

2.

Fundamentals deteriorate
If the competitive landscape or economic fundamentals of the company change, or management quality deteriorates, this may be an appropriate time to sell

3.

Company becomes significantly over valued

Valuation involves significant judgment and is far from precise, and selling a stock involves paying transaction fees and taxes You should only sell a stock based on valuation if the over valuation outweighs costs incurred to sell

4.

Better opportunity to allocate your investment capital

Occasionally you may find a very attractive investment opportunity but have no available capital In this case, you may consider selling an investment you own that is less compelling and replacing it with the new opportunity

Remember, dont forget to consider transaction costs and taxes in your analysis

If the job has been correctly done when a common stock is purchased, the time to sell it isalmost never.
Philip Fisher , Common Stock and Uncommon Profits (New Jersey: Wiley & Sons, Inc., 2003), 113

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2012