Capitalism without risk is like religion without sin.
— Allan Meltzer, Carnegie Mellon

Several months ago, I had the privilege of being interviewed by The Wall Street Transcript. In mulling over this quarter's issue, I revisited the interview and decided to "update" it, and to address some questions and topics about which we are frequently asked.

The firm has a new name and a new look. Has anything else changed in the last few years?

There is an old saying which runs, "if it ain't broke, don't fix it." We have provided our clients with solid long-term investment returns for a very long period of time. The Business Valuation Approach, with its emphasis on private-market value, has enabled us to capitalize on opportunities in different types of markets and in a wide variety of industries and companies. So our dispassionate application of our investment discipline and style has remained constant.

However, we have changed a few things. First, we have made a major investment in developing a well-educated and dedicated group of support personnel. Second, we have continued to upgrade our technology and to increase our research budget significantly to improve our client-servicing and investment-research capabilities. For the accounts of individual clients, we are focusing on the tax ramifications of our investment activity. Finally, we have expanded our services to continue to meet the needs of our clients.

In the area of services, in January 1997 we launched an equity mutual fund, the Fountainhead Special Value Fund. We began the Fund after many requests by clients and others to manage sums smaller than our minimum account size. We also began offering customized portfolios for mid-cap and small-cap stocks in addition to what we call our traditional all-capitalization portfolio, which we think is most appropriate for most clients.

Could you share with us some more background on the firm?

The Houston-based firm is in its eighteenth year, and has approximately $940 million under management (80% in equities and 20% in fixed income). We manage both equity portfolios and balanced accounts. Our clientele ranges from private individuals to institutional accounts like pension funds, foundations, and endowments. Our managed assets are not a large sum in the world of such investment giants as Fidelity and Vanguard, but we recognize that each dollar is dear to our clients, and so it is to our firm as well.

We have a very experienced investment team of six who range from the late twenties to sixty-something. They comprise our Investment Advisory Group, which develops our investment strategy and ideas for selection, purchase, and sale. Any member of the Investment Advisory Group may present an idea for inclusion in or removal from our client portfolios. We encourage an open atmosphere, and we strive to develop a consensus of what actions are taken for our client portfolios. Our process brings out the best in terms of individual achievement, yet provides a forum for the strength of collective effort, wisdom, and teamwork.

How would you define your investment approach?

We call it the Business Valuation Approach. You could call us a value manager, but one who is also willing to buy growth at the right price. We identify attractive investment opportunities using a broad definition of value, uncovering securities often overlooked by other investors. We believe value can be found in different types of securities at different points in the economic cycle.

Most consultants who hire money managers for their clients want to pigeonhole managers in different style boxes (for example, small-cap, mid-cap, growth, and so on). We certainly have a distinctive style, but we resist narrow categorization. Our approach results in finding bargains among a wide variety of companies—large and small, growth and value. Our primary focus is on the company's worth as a business, and whether the public price reflects that worth. To those who say that a value manager should never buy growth, we counter, "Would you prefer we buy non-growth?" Everyone wants growth; they just may not be willing to admit it. The secret of success is to buy at an inexpensive price.

We use a "bottom-up" stock-selection process based on fundamental financial analysis, focusing on individual companies rather than using a broad macroeconomic, top-down approach. The latter attempts to identify industry groups and stocks based on an overall economic outlook. We do not place much confidence in the accuracy of broad economic forecasts. Ask five economists for their outlook, and you get ten opinions.

The Business Valuation Approach comprises three distinct disciplines: private-market valuation, historical valuation, and superior earnings growth. A company in which we invest will meet at least one of these three criteria.

Would you comment briefly on these three disciplines?

Private-market (or intrinsic) value can be calculated in one of two ways. One is what the company will be worth if liquidated, although this rarely happens. The other is what the company might be worth if acquired in an all-cash or arm's-length-negotiated transaction. Thus, we value the company as a going concern. We ask one basic question: would we be willing to buy the entire company at the current market price?

Historical valuation focuses on identifying stocks selling at the lower end of their fundamental benchmarks, like price/cash flow, price/earnings, price/book value, and price/sales. Stocks selling at the low end of their multiple ranges may often prove to be potential purchase candidates.

We research prospective stock purchases extensively, and we emphasize fundamental analysis for all three disciplines, as well as other factors like insider buying or ownership and hidden balance-sheet assets. That a company is a potential takeover candidate is an added plus for a stock which we would buy primarily on the basis of either historical value or growth at a reduced price.

Regarding our historical-valuation approach, it is significant that most value managers' methodology limits them to buying only low-multiple stocks. But we think value managers who focus primarily on this measure of value needlessly exclude their clients from opportunities utilizing private-market value or growth at a reduced price—both of which can often provide great values.

With regard to our willingness to buy growth, I have never met a value manager who did not really care about earnings growth. We are talking about buying growth at a reduced price (GARP), so indeed it does fit in quite well with our value philosophy. The simplest measure would be to unearth stocks whose P/E ratio is well below their expected five-year EPS growth rate.

Our fundamental research for GARP stocks includes many of the same measures and factors just described for the low-historical-valuation approach, but with more emphasis on such factors as a company's competition, the impact of technology, franchise value, the company's position in its markets, and demographic trends.

In the last several months, your clients have benefited from takeovers and mergers. To what do you attribute such good luck?

As they say, it is better to be lucky than smart. However, in the investment business, you make your own luck. This is a highly competitive industry in which only a handful of managers outperform their benchmarks over long time periods.

But takeovers are hardly a recent development for our clients; they are a by-product of our investment process. Takeovers have characterized our firm since its inception. In fact, we are rarely surprised when one of our holdings is bought by another company at a premium above the market, because we buy companies valued at fifty cents on the dollar. It is only logical that if you buy companies at public prices below their enterprise value, others may eventually recognize this value as well. A corporation whose public stock price is at a significant discount to its private-market value will not remain on the bargain counter forever. Any number of catalysts will cause the stock price to increase, in some cases dramatically. This focus on private-market value has contributed to our success over long periods through different types of markets. It is also what makes us unique from most managers.

You have told us how you decide what to buy. How do you decide when to sell, and what is your typical holding period?

Since two-thirds of our holdings are in about twenty stocks, we monitor them very closely. Our primary reasons for selling a stock are when price objectives are met and further upside is limited, when there is a change in the company's fundamentals, or when more attractive alternatives are found. Our holding period is typically one to three years.

There are thousands of investment-advisory firms and almost 9,000 mutual funds today, most of which do not have the outstanding long-term track record of your firm. What traits characterize a successful money manager?

That question has no perfect answer, and any answer will reflect certain professional biases, but I will take a stab at it. There are numerous factors, and no one person has them all. Among the essentials are a keen intellect, a natural curiosity, and a healthy skepticism. Good analysts and money managers are certainly born with talent, but it takes twelve to fifteen years to become a truly good money manager. Some of today's younger heroes who are in their twenties and early thirties running and gunning money at many mutual funds would disagree, but I would not entrust many of them with my own money.

Many intelligent people simply do not have the knack for making good investments. Perhaps even more important than intelligence is a willingness to be a contrarian and to swim against the tide of conventional wisdom. A truly successful money manager must have intestinal fortitude (i.e., guts) leavened with a great degree of humility born out of experience and wisdom. Numerous studies have demonstrated that most investors' aversion to loss is greater than their desire for gain. Such a mindset results in the tendency for investors to do what is (in their minds) seemingly safe, or to invest in that with which they are comfortable. Invariably, this proclivity results in foregone opportunities and below-average long-term investment payoffs.

You do not have to take foolish risks to achieve good investment returns, but you do need to recognize opportunity where others do not, and equally important, to seize the opportunity through action. How many times have we heard the familiar, "I can't believe I didn't realize how much things had changed"? Or more pointedly, as it relates to frustrated investors, we have empathy for the remorse expressed in "I can't believe I didn't buy (or sell) that stock. I just knew I was right."

Most investors fail to recognize investment value because their frame of reference requires a near-perfect convergence of the ideal circumstances for economic success, and they are uncomfortable with standing alone against the tide of conventional wisdom. Accompanying the desire for perfection and the propensity to be comfortable with consensus thinking is the fear of losing. However, in the real world, the ideal set of circumstances and a good price rarely converge.

Thus, an outstanding money manager is intuitive as well as thoroughly grounded in basic security analysis conducted within a framework of a solid understanding of economic rates of return. With regard to the intuitive and qualitative aspects, you should almost view the world upside-down. Far too many security analysts and investors make their decisions as if they were looking in a rear-view mirror to predict the future. Admittedly, historical analysis is key to developing a framework for evaluating the absolute and relative value of investments. However, more often than not, when recent poor economic or bad corporate news has affected a company, usually the stock price already reflects most of the known negatives. Likewise, when recent corporate news has been positive, in most cases the stocks of affected companies reflect the attendant high levels of confidence, comfort, and complacency.

A money manager, as opposed to the sometimes narrowly focused securities analyst, must have the insight to recognize a good (and hopefully great) investment from among the thousands of choices available. One of the keys to investment success is the ability to grasp the potential impact on stock prices of two types of changes: a change in operating fundamentals and a change in the perception which investors have of a particular investment. Savvy investors conceptualize the impact of these changes earlier than most. And, although seemingly swimming upstream at the time, the successful investor is more willing to buy when others are selling, and to sell when others are buying.

Another asset is patience. It takes time for fundamentals and perceptions to change. The patient investor, acting out of conviction, will allow events to unfold. If he has purchased intrinsic value at a significantly discounted price, he is less apt to worry about "the market" and its incessant ups and downs. The impatient, convictionless seller or buyer, vainly attempting to time the market, can be a value investor's best friend.

Could you give some examples to illustrate your observations on investor psychology?

During the summer of 1996 and on into early 1997, the stocks of cable-TV companies such as Tele-Communications Inc., Comcast, and US WEST Media were the pariahs of Wall Street. The industry was under regulatory pressure, making major and costly investments in upgrading its systems (for the future), and facing the threat of competition from satellite TV. The analyst community, while grudgingly positive long-term, was nevertheless reserved, urging caution and a "wait-and-see" approach. The stocks suffered because the industry was ill-informed, overly bearish, and short-sighted. As 1997 progressed, it became obvious that the infrastructure investment was paying off in terms of higher cash flows; satellite TV was not really the threat which had been feared; and the industry was offering promises of an interactive Internet vehicle. When Microsoft's Bill Gates signaled his intention to invest a few billion dollars in the industry, all was well. Today, Wall Street loves the prospects for cable, and investors do too. They must, as they are paying approximately 100% more for their stocks than they could have only twelve to eighteen months ago, when we were buying them. True, now that Wall Street is more comfortable, and the consensus has turned positive, investors may make positive future returns on cable-TV stocks bought at today's prices. But in most cases, they will probably not provide the great bonanza envisioned by current buyers.

Examples of the old adage "a fool and his money are soon parted" are provided by many Internet-related stocks. Netscape Communications, an Internet software provider, went public in August 1995 at $28 per share, and rose to $87 later that year; it was the darling of Wall Street. Today, the stock languishes at $17. And while Netscape may survive (and may even be bought out), it is reminiscent of a long list of companies over the last quarter of a century whose stocks have faded into obscurity or vanished through sputtering fortunes, bankruptcy, or a series of corporate restructuring whodunits. The investing landscape is littered with such names as Telex, Memorex, Wang Labs, Levitz Furniture, Discovery Zone, Hard Rock Café, and Planet Hollywood (to name but a few). The hype, euphoria, and embracing of an economic house of cards which fuels the parabolic movement in stock prices of such past (and undoubtedly future) disasters is all too often followed by an intensity of a reverse nature of anguish, despair, and often financial ruin. The Schedule Ds of thousands of unsuccessful investors are bitter testimony to their seeming inability to avoid the pitfalls of consensus thinking.

Are there other intangibles for which you would look in a money-management firm?

Another trait of successful money managers is that they have passion. They must be possessed of a passion to excel. The investment world is populated with thousands of very bright people, and those who excel seem almost consumed with the desire to win. They relentlessly devour information. Their adrenaline surges when finding another great investment. They are galvanized by the challenge of the race to win in a business in which victory can be measured daily, weekly, monthly, yearly, and longer. And they are certainly not complacent, but vigilant, aware of the daily potential for both disaster and success. Sure, good money managers are motivated by money, but most are equally (or even more strongly) motivated by the sheer challenge of the game. Numerous outstanding managers make and have huge sums of money personally, but continue the race because they simply love it.

So do great managers care more for the race or for their clients?

In addition to the passion for investment success is an equally important passion which marks outstanding money managers: a passion for bringing wealth to their clients. In the investment industry, client success, while sought after, is often subordinate to industry success or asset growth. Without exception, managers who hold client interests paramount will, in the long run, stand a better chance of achieving success as measured by investment returns than organizations which revere asset growth as the barometer of success. Certainly, size and a satisfied clientele are not mutually exclusive, and some element of organizational strength and resources can be important ingredients of successful firms. But a super-charged marketing operation whose primary (if unstated) goal is asset growth is less likely to excel from an investment standpoint than the organization where client success is the benchmark for achievement.

Morningstar, which monitors the mutual-fund industry, recently made some salient observations on firm size and marketing strategy. In reviewing some successful and "forgotten" funds and their managers, Morningstar stated:

. . . small asset bases can be especially advantageous for [managers] that pursue flexible strategies . . . or those that focus on less-liquid securities, such as small-caps or convertibles. . . . These [managers] have the added advantage of being run by small shops. Such firms seem less marketing-oriented and more investment-driven than big . . . companies. Moreover, their managers tend to be principals in the firms—a factor in their lengthy tenures—and to have significant ownership stakes, which ties their interests more closely to those of [clients]. Thus, our forgotten [managers] not only demonstrate that quality doesn't have to come in big recognizable packages, but that small can sometimes also be an intrinsic advantage.

Undoubtedly, we cannot be accused of being a marketing powerhouse, but our long-term record hopefully makes us huge in the eyes of our clients.

A corollary to a passion for client success is a manager's willingness to eat his own cooking. It never ceases to amaze us how often professional money managers are willing to invest in securities in which they would not invest their own money given comparable investment objectives. Frankly, we like to buy what our clients own—although our code of ethics precludes us from buying or selling before our clients' interests are served. We want our clients to benefit from our passion. As mentioned, our firm has an equity mutual fund, the Fountainhead Special Value Fund. Every employee who has been here a year owns shares in the Fund, and we watch it like hawks. We also manage our own company-funded profit-sharing trust, which, in addition to owning shares in our Fund, owns a large number of the equity securities held by our clients. The alliance of our interests with our clients' interests helps us in feeling both their joy and their pain.

So if you guys are so smart, why do you occasionally make a wrong turn?

It is always interesting to have client meetings in which a good part or the discussion centers on the "losers." While a good manager hates to lose, he will not brood, agonize endlessly, or consider it a personal failure. He will learn from the experience of a loss and go on.

Ironically, with good money managers, investments which do not pan out are typically a sign of good management. Aside from the fact that losing investments may be few in number, they signal a willingness to take well-thought-out risks. The more fearful you are to take a well-thought-out risk, the less likely you are to make those investments which will become the home runs of a portfolio. By attempting to avoid losing at all costs, you also forego winning. Again, this issue revolves around the psyche of investing. Too much emphasis on playing it safe yields mediocre results. On the other hand, injudicious speculation or "playing the market" will result in consistently bad decisions with predictably poor returns.

If you cannot stand to incur a loss in individual stock investing, as opposed to recognizing that occasionally it is inevitable, then you do not really possess the disposition to invest. And if you are more inclined to be comfortable, then you should be willing to accept average results. Unspectacular decisions usually yield unspectacular results.

But is it really possible to achieve outstanding returns without inordinate risk?

We think so, and we would argue that undue risk is not worth whatever extra return might be achieved. The scope of this interview cannot presently deal with the many discussions revolving around the issue of risk. Intuitively, most would concede that an investment in a newly formed company runs a far greater risk of the loss of capital than would an investment in a ninety-day US Treasury Bill. And most investors, for example, would agree that semiconductor maker Intel is a financially stronger company than, say, 360° Communications, a cellular-telecommunications operator. On August 5, 1997, Intel traded at $100 per share, riding a wave of analyst and investor euphoria and optimism, and at a high multiple of estimated earnings (which subsequently failed to "meet expectations"—the Wall Street kiss of death). At the same time, 360° was $19 per share, suffering from myopic concerns about cellular competition and trading at a significant discount to its enterprise value. Eight months later, Intel closed at $74—a 26% decline—and 360° increased 68% to $32 per share. Intel's fundamental outlook has deteriorated dramatically from its halcyon summer, while 360° recently agreed to be acquired by Alltel, which itself would be a juicy morsel for a larger competitor. Was it David or Goliath which had the greater market risk last summer?

Investors too often confuse business risk with stock-market risk. There is very little business risk with long-established corporations whose finances are strong, whose products and services are in demand, and who have a history of sound management. But investors will often pay too much for historical success and perceived safety while paying too little attention to their market-valuation risk. Value investing, which focuses on the intrinsic (as opposed to market) value of an economic enterprise, is aimed at evaluating business risk and valuation risk.

Investors also tend to confuse volatility with risk. A narrow focus on individual stock-price fluctuation and quarter-to-quarter (or year-to-year) variability in portfolio returns can lead investors to conclude that they own risky stocks, or a risky portfolio. Stocks are volatile, but unless you must sell, the inherent volatility of stock prices or of a portfolio's return can be a very misleading measure of valuation risk. Investors who focus on business value and the long term know from experience that stock-price and portfolio volatility are inevitable, but it can present numerous opportunities, and it is a questionable barometer of long-term investment risk.

The Business Valuation Approach should yield opportunities regardless of what "the market" is doing. We do not waste much time on market timing or on worrying about the market, because our clients do not own the market. In looking at corporate history, industries which have experienced bear markets or their own depressions in the face of a long-term secular upturn in stock prices are the rule, not the exception. Over the last 25 years, disastrous operating environments have plagued (at different times) such industries as automobiles, aluminum, forestry, energy, technology, tobacco, insurance, building, ad nauseam. You can count on both hands the companies which have escaped unscathed in terms of a disappointing and gut-wrenching stock-price decline. Yet, correspondingly, out of turmoil opportunity arises. The recent phoenix-like resurrection and restructuring of such industries as banking, cable TV, brokerage, and telecommunications illustrates the benefits of a well-disciplined approach focused on individual stock values.

So you really haven't changed your style?

The answer is an emphatic no. This question seems to arise when analyzing the size or market capitalization of the stocks we buy. Our Business Valuation Approach will take what the markets offer, regardless of the size of the company. Based on the criteria we use to determine value today, there are simply far more potentially rewarding investments available in the United States which have total market values of between $100 million and $5 billion. In years past, we have owned the stocks of some very large companies. Today, so much money has chased the large, top-quality companies to such high price levels that there is little compelling value among the widely followed companies in the upper tiers of such indices as the S&P 500 and the Dow Jones Industrial Average. Should that change, we will consider buying them—not because our style will change, but because the prices (and possibly the fundamentals) of the target companies will have undergone major change. Our discipline will remain constant. It is, after all, our clients' money with which we are concerned, not a consultant's magic style box.

Any final thoughts?

The last several years have been nothing short of spectacular for a large number of investors in the United States. Probably we have all become a little spoiled. Investors, including our clients, should not expect recurring miracles. Realistic expectations about long-term investment returns may help to avoid unnecessary frustration.

As we move into the spring of our eighteenth year as a firm, and for some of our principals the second quarter of a century in investment management, we look forward to continuing the pursuit of investment success for our clients. We have witnessed many different types of markets. In all, we have found that our Business Valuation Approach has served our clients well, and it should continue to do so.

Yet beyond the disciplines of this approach, those ingredients of success which have served us well will be fostered and encouraged: namely, the enlisting and embracing of colleagues who embrace high ethical standards, who are highly intelligent, and who have a passion for their clients and their profession. We will continue to practice independent thinking based on solid analysis; we will draw judiciously on our collective experience; and and we will maintain a healthy skepticism of consensus thinking which is based on illusory concepts of safety and risk. Finally, we hope we can exercise not only judgement and wisdom born out of years of successful experience, but that we will cultivate a never-ending enthusiasm for positive change and opportunity from that which is new.