Hortz: What about the top level design?   

Hoffman: This is not something that we impose on our portfolio but something that happens organically as an output of our process. I analogize it to building structures in earthquake zones. Just as buildings along fault lines need to be resistant to both standard vertical forces as well as the lateral forces produced by quakes, our portfolios need to be constructed to withstand both the pressures on individual holdings as well as the kinds of exogenous shocks that can affect the portfolio more broadly. It’s here where the real strength of our price discipline comes to the fore. Due to the fact that we’re buying what’s cheap and selling what’s expensive, we’re continuously layering different economic and cyclical scenarios into the portfolio—and rotating out of them over time as well. Since our holding periods tend to be pretty lengthy—7-9 years, on average—we typically have a series of such cyclical stories built into the portfolio, resulting in a group of holdings that are likely to be favored in some economic circumstances but not others. 

Hortz:  How do you determine companies that add to the architectural design of the portfolio, that have as you say a certain ‘give‘ built into them?

Hoffman: The ultimate architecture of the portfolio is determined by the brick-by-brick investment decisions we make. It’s our goal to invest in good, resilient companies at bargain prices and to own them until high price or a degradation in quality dictates their sale. At the individual company level, we look for firms with strong value creation opportunities that they are well-positioned to exploit, that have the ability to extract economic rents over time, and that have an excellent management team and a strong culture that is well suited to the industry.

Hortz:  Can you further explain your concept of resilience and give us some examples of companies that exhibit this?

 Hoffman:  Sure. Resilience is an important through-line for our companies, the attribute that more than any other allows the portfolio as a whole to retain some stability during turbulent times while also maintaining the ability to take advantage of opportunities to grow and thrive. We believe that resilience exists independent of what one might think of as a good business. While its building blocks are similar: strategy, management and culture, it represents a fusing of those attributes specifically in the service of addressing crises (or even just hiccups) of both internal and external origin.  It invokes flexibility, the capacity to adjust course midstream, as well as a certain toughness of spirit. Most critically, it means that a company is built not only to survive disruptions but ideally to affirmatively succeed when circumstances are less than perfect.

I’ll give you a few examples. NVR is a homebuilder that is not in the business of speculating on the price of land; in fact, it foregoes the opportunity to benefit from appreciation in land prices in favor of the flexibility conferred by owning options on land rather than the land itself. Since a predecessor company went into bankruptcy in the early 1990s due to excessive land holdings, NVR clearly prepares for a world in which periodic financial and housing crises can arise, even if that means leaving some return on the table during the good times. The case is much the same in property casualty insurance, where resilience means strong and effective cycle management, a practice that allows an insurer to move capital from one line of business to another depending on the point in the insurance cycle. Arch Capital, for example, pursues a strategy of shifting capital to those areas where fear predominates and away from those where complacency has set in. One of its current cash cows, mortgage insurance, benefitted from dislocations in the marketplace following the housing crash; yet Arch foresees a day, perhaps not too far down the road, when market conditions are too benign to justify continuing to write that business as enthusiastically.

The real common denominator for companies like this is the pulled punch: namely, the willingness to forego that last dollar of revenue or margin. Much as we at Marshfield look to sell a stock before—sometimes frustratingly long before—a stock reaches its pinnacle price, these kinds of companies understand that designing a strategy for the full cycle (and in anticipation of potential threats) means leaving some money on the table in the form of lost revenue or seemingly non-optimized operations.

Hortz: How does looking at investment risk from so many levels, from both the individual company level and at the portfolio level as well, best serve the portfolio and investors?

Hoffman: Portfolio design for us is less about following a detailed blueprint and more about an organic process of analyzing individual companies and deciding whether we should buy (or sell) them and if so, when. While, in theory, these independent decisions could result in a portfolio overly beholden to a particular economic environment or to the success of a particular industry or sector, in practice, this has rarely if ever proved to be the case for us. The interaction of our company quality requirements with our price discipline has over time tended to yield a portfolio embodying a balanced series of economic scenarios, where periodic shocks are not equally borne by every holding.