Another example is Knight Transportation, which we’ve owned for a number of years. It’s in the trucking business where there is plenty of competition. The company was founded by four men all named Knight, who brought with them their work experience at Swift, a big trucking carrier in Phoenix, Arizona, where they had risen to senior positions. They were able to judiciously apply their experience and fresh ideas to run their own business and, we believe, they have done an outstanding job over time. They have adopted a different approach from the usual business that tends to be centralized in authority, by pushing responsibility away from headquarters down to operating people, giving them incentives and motivating them.

Now, in trucking, the operating ratio is a measure of efficiency, which is basically the inverse of operating margins. Hence, if a company has $1 worth of revenue and 90 cents worth of costs then they have an operating ratio of 90 or an operating margin of 10%. A typical truckload carrier probably has an operating ratio of 95, or around 5% operating margin, while a good carrier might have an operating ratio of 90. Knight, however, has achieved a ratio of 80 over time, which makes them far more efficient than almost all their competitors.

Q:  How do you organize your portfolio from the diversification and benchmark perspectives?

A: Historically, we have had a reasonably concentrated portfolio of between 30 to 40 stocks. Currently, the number is 30. We have a very low turnover as we do not have a lot of turnover in names. Our turnover numbers run in the mid to high teens. We are thus looking at long holding periods of five to even seven years.

In terms of portfolio construction we consider the Russell 2500 as our benchmark as it is the closest to our market-cap range. Currently, our median market cap is about $3 billion. From a benchmark standpoint we tend to ignore sector weightings completely as we do not take a sector approach to decision-making. We do not know what the Russell sector holdings or weightings are and do not care if there are sectors where we own nothing at all, especially if we think they are bad industries or businesses. We thus do not track index returns well.

Our portfolio is well diversified because, historically, we have found sustainable high return businesses over a wide range of industries. Therefore, even though the portfolio may not have any financials, chemicals, or other commodity-related stocks, and has relatively low weighting in high growth areas, we have acquired many names from different industries in our portfolio.

Again, as mainly individual companies form our portfolio, we may often select companies that are in identical businesses. However, if retailers suddenly become cheap and if we liked five names and added them to the list of retailers we have in the portfolio we could have a large exposure to the industry. We do not let this happen. Since we know what we’re buying and what we’re selling, if suddenly the weighting is tilting too far in some direction we just stop it. Moreover, we do not consciously look to add companies from a sector just because it is underweighted in our portfolio even if it is not as good as we normally like.

Q:  What is your buy-sell discipline?

A: Generally speaking, we prefer to buy stocks that are going down in price and tend to sell those that are going up in price.

Selling is harder as it is mainly based on valuations. Higher valuation would certainly be a reason to either reduce the position size or eliminate it completely and replace it with another of equal quality that is much lower priced. But we are not always sure whether our view of their comparable quality is really justified. This is because we are replacing companies we had bought at a reasonable price, owned for many years and know quite well, with less familiar companies.

Therefore, high valuations can sometimes be misleading, especially if the company continues to perform in an outstanding manner. Then maybe it will maintain that high price-to-earnings ratio.

The other reason for selling is because the stock is not as good as it used to be in terms of company quality and business dynamics. This may be due to competitive changes in the market or management changes, or because we just made a mistake and bought something that is not as good as we thought, or that it never was any good and it is just that we had only recently figured that out.

Q:  How do you control risk?

A: We try to be fully invested and we are not particularly concerned about market risk. Like in the case of sectors, we also do not make macro-driven decisions. We just take into account the macro view of stock markets and look for individual companies with superior operating financials and reasonable valuations.

Our key view on risk is that we own businesses that earn superior returns with leading market shares, high operating margins, good cash flow and relatively un-leveraged balance sheets. Therefore, such businesses ought to be less risky over time, assuming their valuations are not particularly higher than stocks as a whole.

Furthermore, in case of an adverse economic environment, we believe such businesses with lots of cash flow and strong balance sheets will actually be in a better position than their competitors. They can continue to invest in new product development and in marketing, perhaps making acquisitions of weakened competitors and, even if in such an adverse environment, their profits or stock price is down, when the situation improves, they are better off than when they went in. Such companies that benefit from adversity too are common members of our portfolio.

In terms of portfolio risk, since we research each stock individually, we end up with a considerably diversified portfolio that takes care of any risk that arises on that end. We are also debt averse and avoid companies whose balance sheets or income statements show big debt numbers and huge interest expense numbers.