Peridot Capital's Contrarian Investment Approach

"The most common error in investing is confusing business fundamentals with investment merit. A company that is doing terrifically well, that has great management and returns on capital, and great products and prospects, may be a terrible investment if the expectations embedded in the current valuation are in excess of those fundamentals. A company with poor business fundamentals, a mediocre management, and indifferent prospects may be a great investment if the market is even more pessimistic about the business than is warranted. The most important question in investing is what is discounted, or put slightly differently, what are the expectations embedded in the valuation?"

"Systematic outperformance requires variant perception; one must believe something different from what the market believes, and one must be right. This usually involves weighting publicly available information differently from the market, either as to its magnitude or its duration. More simply, the market is either wrong about how important something is, or wrong about when that something occurs, or both."

The pair of quotes above are not from anyone related to Peridot Capital. They are the words of Bill Miller, portfolio manager of Legg Mason Value Trust, the only mutual fund to ever beat the S&P 500 index for 15 consecutive years (1991-2005). The founder of Peridot Capital is a Baltimore native, has been a close follower of Miller for years, and shares many of Miller's investment philosophies. Miller does an excellent job of explaining some of the important concepts that value investors such as Peridot Capital rely on while managing client portfolios, hence he is being quoted on this site.

Now you may be asking why we are quoting a mutual fund manager when, in general, we advise that investors avoid mutual funds. A logical question would be, "Why not just buy shares of Bill Miller's fund rather than invest through Peridot Capital?" This is a valid question and there are a couple of reasons that stand out.

First, Miller's unprecedented streak has led to a huge influx of new money to his fund. As a result, he is becoming more and more limited in the stocks he can buy. Since Miller maintains a relatively concentrated portfolio (his top 10 holdings represent nearly 50% of total assets), a bigger fund means that he can only focus on large companies. Bigger companies have fewer growth opportunities (for Wal-Mart to grow by 10 percent, they need to add a whopping $30 billion in incremental sales), and as a result, their investment returns tend to be limited.

We believe it is reasonable to expect Bill Miller's investment returns will suffer as more investors hear of the streak and he receives more investment dollars. In fact, the numbers bear this thesis out. As shown below, Miller has beaten the S&P 500 by less and less with each passing year. This trend should continue, which is why we do not suggest buying Miller's fund after 15 years of stellar, but diminishing, outperformance. Peridot Capital, on the other hand, can focus on companies of any size, whereever excellent opportunities present themselves.

Legg Mason Value Trust Fund (LMVTX)
Average Annual Returns as of 12/31/05

While Bill Miller’s fund may have seen its best days already (Update: In 2006 Miller's fund trailed the S&P 500 index for the first time since 1990), we still share many of his investment principles when implemented on a smaller scale. The quotes from Miller listed at the outset of this discussion go a long way to describe how Peridot Capital employs its contrarian investment philosophy.

When we purchase a stock, we believe the general consensus is wrong in a meaningful way. In other words, investors are underestimating the prospects for a particular company. This negative sentiment can be present in the marketplace for several reasons. For example, investors might be too pessimistic about a company's prospects, due to unreasonably extrapolating recent negative events too far into the future. The company's future outlook could be much brighter than current market values would suggest.

When faced with these situations, we often will buy stocks that are either being completely ignored or stocks that have recently been met with selling pressure. Buying stocks that are on the way down can be a tough task psychologically.  After all, the short term momentum is downward, and so the stock could very easily continue falling after we make our initial purchase. This is where buying more shares at lower prices comes in handy. We can lower our average cost per share while others are worrying. If our contrarian thinking turns out to be right over the long-term, such purchases will prove very profitable.

Waiting for investors to change their minds can take time, so a long term investment horizon is crucial. Wall Street may have concern for a stock, causing it to go nowhere for weeks or even months.  Value investors, however, are willing to wait for the story to unfold and prove the naysayers wrong. This might not translate into huge profits right away, but if our variant perception is correct, eventually we will be rewarded with handsome profits.

Peridot Capital rarely tries to predict a stock's movement in any given day or a week. However,  we are typically extremely confident that our investment thesis will be proved accurate within a three to five year period. Such a long term investment time horizon is essential when purhasing stocks that others have shunned. It will take time for other's opinions to change, but when they do, the result can be superior investment returns over the long term for investors who are willing to demonstrate the patience necessary to both act on and wait out the market's short-term ups and downs.

A third quote from Bill Miller does an excellent job explaining Peridot's investment time horizon and thought process regarding investment holding periods. Since it would be difficult to phrase it both differently and more accurately, we'll let his words speak on our behalf:

"If your expectation is that we will outperform the market every year, you can expect to be disappointed. We would love nothing better than to beat the market every day, every month, every quarter, and every year. Unfortunately, when we purchase companies we believe are mispriced, it is often difficult to determine when the market will agree with us and close the discount to intrinsic value. Our goal is to construct portfolios that have the potential to outperform the market over an investment time horizon of 3-5 years without assuming undue risk. If we achive that goal, we believe we will doing our job, whether we beat the market each and every year or not."