The Tao of Turtle Creek

The Tao of the Turtle September 2009
How Do You Feel About Risk Now?
The past two years in the financial markets have been remarkable. The turmoil that began in August 2007
intensified during the fall of 2008 and, at the time of this writing, has abated with a return to some
semblance of normality. This period has caused many investors to challenge a number of long held
convictions and beliefs – particularly on the nature of risk: what exactly is it, and how should it best be dealt
with?
Over the past few market cycles, there has been an increasing obsession with finding ‘uncorrelated assets’
in order to build a portfolio that exhibits as little measured price volatility as possible. The problem with this
Does a decline in the price of approach is two-fold. First, it presumes that shorter term price volatility equates to risk and, second, it
an asset represent a loss, or presumes that historical relationships between different asset classes will hold in the future. Time and
an opportunity? The only again, the second presumption is refuted as historical relationships between assets go haywire (often at
just the wrong time) and never has this been more evident than in the past year. But more importantly, the
way to know is to understand first presumption is simply wrong.
the value of what you own . . .
and then to measure your A better view of risk is one that any common sense investor would provide: “Risk is the chance that I lose
my money”. That seems pretty straightforward and is a great starting point. But what does one mean by
investment performance over
losing money? If you own shares of a quoted company and the share price declined by 5% yesterday as a
a reasonable period. result of general market fluctuations, does that mean that you have lost the money? Of course not, as this
is a temporary change rather than a permanent one. The legal and accounting professions have tackled
this issue since the early days of capitalism by classifying asset price declines as either a temporary or
permanent impairment. With a temporary impairment, the quoted price has declined but there is no
fundamental change in the true value of the asset and it is expected that, with time, the price will recover;
whereas with a permanent impairment, there has been a true loss that will never be recovered. In other
words, one has to understand the true value of the asset and one has to introduce the concept of time.
An investor’s time horizon is important to understanding his capacity to handle risk. If he absolutely needs
to have access to all of his money instantaneously, then he has a very low time-risk tolerance and should
have all of his money in treasury bills. The longer an investor’s time horizon, the more investment
alternatives available to him. Note that we are not talking about his personal risk tolerance but rather, his
time horizon. Having a long time horizon deals with a lot of the problems and perceptions of the risk of
losing one’s money.
Many institutional investors attempt to assess risk by estimating the maximum price decline over a one year
period. But implicit in this approach is the view that “the maximum price decline” over a 12 month period
represents the amount of the loss. The idea that a decline in the price of the common shares of a company
over a one year period equates to a ‘loss of money’ is wrong. It may have been the case that there was a
permanent loss: for example, the company may have borrowed too much money and defaulted on its debt
or it may have made fundamental strategic errors over many years which are now coming home to roost
through a loss of competitive position. However, it is also quite possible that the share price decline
resulted from a general market decline, or from company specific events that are interpreted as negative by
the market when they are immaterial, or even positive, to the fundamental value of the company. Often,
key strategic decisions are not immediately appreciated by investors and frequently such decisions can
cause share price declines in the short term.
Perhaps the best way to illustrate the dilemma of a short time horizon versus a long one is to look at Turtle
Creek’s overall experience. In Turtle Creek’s 11 years, we have owned 65 different companies. Most of
these have been small or moderate holdings of the fund but 21 have been large holdings, which we define
4 King Street West, Suite 1300, Toronto, Ontario, M5H 1B6 T 416.363.7400 F 416.363.7511 www.turtlecreek.ca
as a holding that was 1/12 (approximately 8%) or more of the fund at some point in time. So essentially,
over the years, we have stepped up and made a significant overweighting in 21 companies. And there are
two key observations to make. The first is: in every case we initially “lost money” in that the share price of
the position declined. Indeed, we do not move to an 8% position in the fund at once; most often we begin
to buy with a target that is well below 8%, and it is further share price declines that causes us to increase
the size of the position.
The second observation from our significant investments is that in every case we ultimately made money,
realizing a significant gain. In every instance, a decline in the share price did not mean a loss of money –
as long as the time horizon was measured over a few years rather than instantaneously. Instead, the share
price decline represented an opportunity to increase the size of the holding and to make money from the
temporary drop in price.
So here is the conundrum: does a decline in the price of an asset represent an opportunity – the value
hasn’t changed but the price is cheaper – or does it represent a loss and a signal of increased risk (i.e.,
something bad has happened)? The only way to know is to understand the value of what you own . . . and
then to measure your investment performance over a reasonable period.
We spend the great majority of our time working to understand the value of each of our investments. We
cannot describe this process in a single paragraph – it will be the subject of numerous future articles – but
we can say that, while it requires a great deal of effort, it prepares us for the events that inevitably occur
(either market related or specific to the company) that cause meaningful changes in share prices. The
grounding that we have from the extensive work we have done to arrive at a view of fundamental value
allows us to react during these events. Buying more of a company when its share price has fallen isn’t that
difficult to do if you truly understand the company’s value. The truth is that most investors do not
understand value and so are not comfortable ‘stepping-up’ at the times they should.
If short term price volatility is irrelevant, over what time period should investment performance be
measured? We use three years as the minimum period over which to evaluate an investment fund since
any shorter period can give very misleading results – a fund may be brilliantly building positions in
undervalued companies or it may be stubbornly pouring good money after bad in overvalued companies.
The only way to assess investment performance is over a long enough period of time. Three years is the
point at which one starts to cross over from the ‘voting’ to the ‘weighing’ characteristics of the market;
although five to ten years is required for the real shift to occur. We believe the results over our first 11
years are evidence that, with us, short term price declines represent opportunities with lower – not higher –
risk. Since our inception in 1998, we have had positive three year returns 87% of the time whereas the
market has had positive three year returns only 38% of the time (and we have outperformed the market in
over 89% of the three year periods).
Risk is not short term price volatility but rather is the chance of permanently losing money. We deal with
the fundamental conundrum of investing by working to understand the value of the companies that we
invest in and by acting accordingly when prices decline. We focus on increasing the intrinsic value of Turtle
Creek since this is what will determine share prices over the long term.
Page 2
The Tao of the Turtle November 2009
Can You Be “Right” But Forever “Wrong”?
Anyone who knows us or reads our literature will understand that the core of our approach involves first
determining the intrinsic value of each of our investments and then building a portfolio with a heavy bias
towards the companies trading at the biggest discount to their value. Sometimes, in discussions with
clients, we are asked what happens if the market never recognizes intrinsic value. In other words, can you
be ‘right’ but forever ‘wrong’?
There are two parts to our answer. First, it actually doesn’t matter whether the market ever recognizes
intrinsic value for our approach to generate strong returns. Second, despite the first part of our answer, the
market does in fact recognize value – so long as you give it a reasonable amount of time to come to its
senses. Indeed, while the stock market may be quite inefficient in the short term, it does a better job in the
longer term.
Part 1: It doesn’t matter if the market stays inefficient.
In the longer term, virtually all of the investment returns from the stock market come from dividends, not
appreciation of share prices. This is a fact that is well documented and best explained by Professor Jeremy
Siegel, particularly in his book The Future for Investors. If you stop and think about it, this of course has to
be the case. Companies, as a group, generate much more cash than is needed to profitably grow their
businesses and, sooner or later, good companies return that cash to their shareholders. When we at Turtle
Creek buy common shares, we are buying a piece of a company and investing with a long term horizon; we
are not buying a piece of paper on the premise of selling it to someone else in a year or two. Our focus is
We don’t need the market determining the net surplus cash that will be generated by each of our companies. We have no expectation
to recognize intrinsic or need for the share price to rise. We are content to invest solely for the future free cash flows.
value in order for us to Perhaps the best way to explain this is by looking specifically at Turtle Creek Equity Fund. In 2008 the fund
earn strong returns, had look-through cash earnings that resulted in a cash earnings yield of about 30%. And now we are going
to make a provocative statement: assuming a static portfolio (ie, no reweighting), over the next five years
particularly in the current the cash flow from our portfolio would increase our unit price threefold. These returns would come solely
environment. from the cash earnings of our holdings and not from any narrowing of the gap between intrinsic value and
price. Of course, a key caveat for the tripling of the unit price is that our cash flow forecasts must, on
balance, be accurate. We may not always be correct in our forecasts, but the point is that the returns in this
scenario have nothing to do with the market price of our companies – the returns come from the cash flows.
Part 2: The market doesn’t stay mispriced forever.
At the end of 2008 the intrinsic value of the fund was $40 versus a unit price of $8.70, resulting in a
discount to intrinsic of 78%. This is an historically (and stunningly) high discount that we do not believe is
sustainable. As a reminder, intrinsic value is calculated based on our best estimate of a company’s future
cash flows, discounted back to the present at about 10% per annum. Aside from factors relating to short
term market sentiment, we recognize that a company’s stock price will diverge from our view of intrinsic
value for two primary reasons: i) the market may be using a different discount rate; and, ii) the market may
have a different view on the future cash flows. With respect to the discount rate, we believe that it is
important to apply a consistent rate and that there is a great deal of empirical evidence supporting a rate in
the range of 10% (more on this in a future thought piece). With respect to cash flows, while the market
often reacts powerfully to short term events with our companies, it ultimately focuses on the longer term
fundamentals. Both with respect to discount rates and cash flow forecasts, we believe in a reversion to
the mean.
4 King Street West, Suite 1300, Toronto, ON M5H 1B6 T+1.416.363.7400 F+1.416.363.7511 www.turtlecreek.ca
This reversion works in both directions: in 2000 when there was widespread optimism as to the future
earnings powers of companies and the market appeared to be applying a much lower than normal discount
rate or had overoptimistic views of the future growth rates. In that environment, our portfolio traded above
its intrinsic value and, as a consequence, over 30% of our fund was in net cash. The log graph below
shows intrinsic value and unit price for Turtle Creek since inception. Over time, we expect the unit price will
revert toward a 20% to 30% discount to intrinsic value. We don’t have much control over this discount
(other than having our companies taken over at intrinsic value) and we don’t worry about it; we focus on
Reversion to the mean is a
what we can control: growing the intrinsic value of our fund.
powerful force. It will,
over time, drive the Unit Price & Intrinsic Value
spread between intrinsic $64

value and our unit price 37% CAGR
Intrinsic Value per Unit
$32
toward more normal
levels. 31% CAGR
$16
Turtle Creek Unit Price

C$ (log scale) $8
$4
$2
$1
Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09
If you will permit us a Turtle ‘Creek’ metaphor: sometimes investors in the public markets are paddling into
a strong current (witness the past decade where total returns in the stock market have been negative); and
other times they are paddling downstream where returns seem easy and, frankly, they don’t paddle that
hard (witness the bull market from 1984 to 2000 where annualized returns were 19%). At Turtle Creek we
are always paddling as hard as we can, regardless of the market environment. In a declining market – such
as we are experiencing – we continue to strive to increase the intrinsic value of what we own, although any
increase is not immediately apparent to our unitholders in the unit price. What we can say with confidence
is that, since our inception 11 years ago, the market current has been strongly against all investors,
including us, such that our traded prices are at historically large discounts to value. We make no prediction
as to when this discount will revert toward more normal levels but we do believe that the reversion is
inevitable.
Since the beginning of the year, our unit price has increased by over 100% such that we have surpassed
our all time high unit price that was reached two years ago, before the market turmoil began. This is
gratifying in such a difficult market, but we are more proud of the fact that, by paddling hard, we have been
able to increase our intrinsic value over the past two years by approximately 65%. In other words, we have
recovered primarily because of our efforts and not because of a rising market (the year to date Russell
2000 and S&P 500 Canadian dollar total returns are 0.4% and 3.0%, respectively). When the current finally
flows with us, rather than against us, and stock prices recover to more normal levels, our unitholders will
see our efforts further revealed in our unit price.
Page 2
The Tao of the Turtle July 2010
Why We Own Equities
Turtle Creek is where we, the Partners, have been managing our personal wealth for over a decade. While
we have had investors other than ourselves from the outset, it has been, by and large, people we know – they
invested with us because they knew us, personally and professionally, and were confident we would earn
them strong returns. Over the past year, we have spoken to many new investors as we have broadened
Turtle Creek’s investor base and this has required that we more clearly articulate our history, approach and
philosophy.
And what we have come to realize through this process is that, in giving the history of Turtle Creek, we didn’t
go back far enough in describing our evolution. We recognize that it is easy to have the perspective that
Turtle Creek is simply a manager of a Canadian public equity fund when, in fact, we are wealth managers
who have chosen equities as the most appropriate asset class to grow wealth. How we invest and what we
own today is simply the outcome of a journey that began over 25 years ago.
From the early years of our professional careers, we undertook the challenge of determining how one could
Turtle Creek is, at its core, both preserve capital and generate wealth over the longer term. We are obsessed with generating superior
returns while not jeopardizing our existing wealth. To that end, we embarked on a process of evaluating all
about preserving capital manner of investment strategies and different asset classes. Fortunately, there is today a rich amount of
while generating wealth. historical data as well as a body of intellectual thought that pretty clearly ranks asset classes from ‘best’ to
‘worst’. The historical record is unequivocal: equities outperform all other major asset classes – bonds,
treasury bills, gold – by astonishing margins over the longer term. See the table below which summarizes the
real (inflation adjusted) value of one dollar invested in each asset class over the past 200+ years (1802 –
2010).
Value of $1 invested in 1802 (inflation adjusted)1 Annualized real return

Gold $4 0.6%
Treasury bills $296 2.8%
Treasury bonds $1,166 3.5%
Common equities $549,000 6.6%
Take a moment to reflect on this table. The results are stunning. One dollar invested in fixed income would
now be worth somewhere between $300 and $1,200 whereas one dollar invested in equities would now be
worth $549,000 – a thousand fold outperformance in real wealth as compared to bills/bonds. One dollar
Equities have vastly invested in gold, in fact, is merely worth four dollars, over 200 years later. You can see why we determined
outperformed every other many years ago that we wish to have our money invested in equities; not bonds, not bills and especially not
gold. Even over shorter periods (20 years, for example) equities almost always (95% of the time) outperform
asset class. bonds.
Looking at the historical record, one could wonder why investors would ever want to own bonds. In fact, most
buyers of bonds are not looking to earn an appropriate risk adjusted return but have other objectives. Think
of China, a huge buyer of U.S. treasuries, who is simply trying to sterilize its enormous trade surplus; or
pension plans and insurance companies, who offer defined pensions or annuities based on the currently
prevailing interest rate – they are simply repackaging and passing on interest rates. As well, from a
behavioural finance perspective, our observation is that investors often overpay for the regular nature of
interest payments and are put off by the short term price fluctuations of common shares.
1. Siegel, Jeremy J. Stocks for the Long Run, 4th Edition. New York: McGraw-Hill, 2007.
The Tao of the Turtle July 2010
Not only have equities outperformed bonds by stunning margins, they also have proven to be a much better
hedge against inflation. Many investors today do not appreciate this. They are anchored in the historically
anomalous strong performance of bonds over the past 25 years without appreciating that the good returns
arose from a uniquely ideal starting point in the early 80s when 10 year bond yields were almost 16%. The
prior 40 years were devastating to bond holders with total real returns of negative 2.7% per annum. In other
words, between 1940 and 1980, bond holders lost 67% of their wealth. Even holders of corporate bonds lost
50% of their wealth. During the same period equities increased almost nine fold in real terms; about 18 times
that of corporate bonds.
In the short term, the stock market is confusing and volatile but in the long term it is boringly reliable and
predictable. Time transforms certain asset classes from least attractive to most attractive – and vice versa.
Drawing from the world of pensions and endowments, a five year time horizon leads most institutions to the
familiar 60:40 ratio of equities to debt; while a 10 year horizon leads to an 80:20 mix of equities to debt and a
15 year horizon leads to a 90:10 ratio. Given our long term focus, it is not surprising that we have selected a
100:0 ratio.
Almost everyone has a much longer time frame than they recognize. This is partly because their investing
Most investors have a horizon is far longer than their remaining working life or even their expected lifespan. Many people confuse
longer time frame than when they will “start” needing to draw upon their investment assets in retirement with their investing time
horizon. In reality, while someone might want to start consuming some of their accumulated investment
they recognize. assets when they turn 65, their actual investing time horizon based on the expected average life of their pool
of assets certainly extends decades into the future. As such, one quickly gets to our allocation of 100%
equities and 0% debt. Indeed, most people wish to leave some of their wealth to their children and
grandchildren and once a multi-generational time horizon is assumed, the investing horizon extends much
further.
When we started Turtle Creek 12 years ago, we were faced with exactly this issue – not for ourselves but for
a select few unitholders who were investing all of their wealth in Turtle Creek and who were older than us.
Conventional wisdom argued that they should have a substantial allocation to fixed income securities but we
recognized that, so long as one has a ten year plus investing horizon, a 100% allocation to equities makes
the most sense. Today, those same unitholders have seen their wealth increase over ten fold, and now, as
they begin to withdraw small amounts of their assets, they are in a remarkably stronger position than if they
had been invested in bonds.
So all of this clearly leads to being owners of well-managed businesses (as opposed to lenders to the
companies or buyers of commodities), but why mainly Canadian companies? To be clear, we have always
owned some non-Canadian businesses, here is an excerpt from our first annual letter, written many years
ago: “[An] implication of this policy [investing all of our own money in Turtle Creek] is the necessary broad
nature of the investment mandate. Once a manager agrees to invest all of his financial assets in units of the
fund, the mandate must encompass all of the investments that appear attractive to the manager. Currently,
for Turtle Creek, this overwhelmingly means equity or equity-linked securities of Canadian based companies.
It is our expectation that this will remain the case, but if it ever changes, you will be given plenty of warning”.
To date, our focus on Canadian companies stems from our geographic location. But as we near the end of
the process of thoroughly evaluating all of the Canadian based companies in our home market, we will
naturally begin to look at owning more companies whose head office is outside of Canada; but we will make
such investments only when our context and knowledge of those companies matches that of our Canadian
companies.
As you can see, the case for equities as the means by which to grow our wealth and yours is overwhelming.
Owning the equity of well-managed companies, at attractive valuations, is the best way to generate strong
real returns over the long term. Turtle Creek is not simply a Canadian equity fund; Turtle Creek is a wealth
management firm. Our focus on Canadian equities is simply a description of how we, today, are striving to
preserve capital and maximize wealth.
Page 2
How We Own Equities
A few months ago, we wrote an article entitled “Why We Own Equities”. The article put forward the strong
case that equities should be the overwhelming portion of one's financial assets. This thought piece builds
on that article by explaining how we own equities and how we improve upon the approach of passively
‘owning the entire market’.
Owning the entire stock market is a great beginning point and for most people it isn’t a bad place to stop.
Much has been written on the benefits of taking a passive approach to owning equities (i.e. low cost index
Unlike the majority of active
funds) – and rightly so. The truth is, beating the market is not that easy to do and the great majority of
managers, we have active investment managers and individual investors fail to do so. Indeed, the underperformance of active
significantly improved upon managers is nothing short of remarkable. For example, in the past five years, only 7% of active managers
the approach of passively in Canada and 9% of active managers in the United States have beaten the market1. It’s not impossible to
outperform the market; but it isn’t easy to do and few investors consistently accomplish it.
owning the entire market.
In our first 12 years, we have substantially outperformed the broader market indices. We have a compound
annual return of 29% versus the S&P 500 total return of negative 1% and the Russell 2000 total return of
3% per annum. Clearly, unlike the majority of active managers, we have improved upon the passive
ownership of index funds. How have we done this? By doing three things. First, only owning companies
that are well managed and that are honestly run in the best interests of the shareholders. In other words:
own good companies. Second, owning more of the good companies that are priced cheaply and owning
less of the good companies that are priced dearly. Third, responding to changes in the relative share prices
of the companies that we follow.
But how do we find the good companies? Through lots of hard work and using the experience and scar
tissue we have gained over 25 years. To appreciate how we find them, it is helpful to understand our
backgrounds. Over our careers, we have met privately with thousands of management teams, from pre-
revenue start-ups to global corporations, in sessions that have ranged from hours to many days. From
those thousands of preliminary meetings we have had intensive follow up due diligence with hundreds of
Our experience brings a companies. We have not only looked at companies from the outside – but from the inside as well – as
perspective to investing that directors, as shareholders and as advisors. This extensive experience brings a unique perspective to
investing that traditional money managers and analysts do not have. And it is this perspective that we bring
traditional money managers
to bear in separating the good from the bad.
do not have.
When we first meet with companies, we don’t concern ourselves with whether or not it is ‘a good buy’ at
that moment. We know that over time every company will be, at times, a good buy (cheap) and a good sell
(expensive). We concern ourselves with the quality of the business, the nature of the industry in which the
company operates and the integrity and caliber of the management team and board of directors. We are
looking for ‘highly intelligent organizations’ that are constantly searching for ways to develop an edge on
their competition and earn superior returns for their shareholders. We have watched companies that had
ideal environments generate poor results and we have observed companies create enormous shareholder
value from a starting point that afforded them no easily discernible advantages.
The truth is, many companies are not run in the best interests of shareholders, and of those that are, the
further truth is that many of those companies really aren't that well run. We are constantly looking for public
companies that are both honest and well run. The good news is that we have found a large number that fit
1. SPIVA (Standard and Poor’s Indices vs. Active Funds) Report, 2010.
these criteria. Then, we target to own about 25 companies - the best among the many that qualify. When
we say 'best', we mean companies that are trading at the lowest price compared to their intrinsic value.
There are many great companies on our qualified list that are priced today as great companies; we prefer to
own great companies that are priced as mediocre companies.
We arrive at a view of intrinsic value for each of our companies through a lot of hard work. We are not
trying to figure out at what price a company's shares will trade - we are trying to determine the fundamental
value of the business; the value that comes from all of its future profits (and dividends). Our observation is
that the vast majority of public money managers spend most of their time and effort trying to guess which
direction stock prices are going to move and very little, if any, time thinking about the true value of the
companies in their portfolio. We do not purchase shares of a company with the short term hope that its
As long term owners, we traded price rises and so are not troubled by fluctuations in the share price. Leave aside the question of
care about the performance whether or not it is possible to forecast share price movements (we think not), we believe our time is much
better spent determining the fundamental value of our companies. As long term owners, we only care
of the business; not the
about the performance of the business.
current share price.
So, identifying the 25 companies we wish to own is a critical step in our investment process and if we
stopped at that point we would be much better off than owning a broad index. Putting 4% of the Fund in
each of the 25 companies would be fine and the investment returns over time should exceed that of the
broader markets. But we don’t own equal amounts because it is never the case that all 25 of our
companies are trading at the same discount to their intrinsic value. Owning more of the companies that are
trading at the cheapest prices will increase returns and, at the same time, lower risk.
Which brings us to the third step of how we own equities. We view fluctuating share prices only as an
opportunity: an opportunity to own more of a good business at a lower price or to own somewhat less of a
good business because the price is higher. This approach turns mainstream thinking on its head. As John
Maynard Keynes so acutely observed "it is largely the fluctuations which throw up bargains and the
“it is largely the fluctuations uncertainty due to the fluctuations which prevents other people from taking advantage of them". We
which throw up bargains actually find it pretty easy to take advantage of the fluctuations because we spend so much of our time
understanding the true value of the companies we own. For example, in the past couple of years, during
and the uncertainty due to
the extreme market gyrations resulting from the credit crisis, we continued to own our companies with the
the fluctuations which pre- same long term view and we were simply able to take advantage of the bargains that were thrown up. For
vents other people from tak- us, this third step of taking advantage of fluctuating share prices is a bonus above and beyond our core
ing advantage of them” - John approach of owning good businesses for the long term. If there are no fluctuations, then we will continue to
Maynard Keynes own the best companies we can find in the same proportions. But we suspect J.P. Morgan's observation
that "markets will fluctuate" will continue to be true as long as humans (and their emotions) drive markets.
In summary, we believe we ‘add value’ as an investment manager in a number of ways: sorting through the
thousands of companies to find a select group of well and honestly run companies; owning the ones that
are most cheaply priced relative to their intrinsic value; and, finally, reacting rationally to changes in the
relative pricing of the companies.
Page 2
The Tao of the Turtle May 2011
Income vs. Capital
Well-run endowments, such as Yale University’s, have long recognized that it does not make sense to
differentiate between income and capital – they exclusively focus on the total return of their portfolio.1 For
most people however, there is nothing more confusing about investing than differentiating between income
and capital. On the surface it seems pretty straightforward: whatever is paid out (in the form of either
interest or dividends) is income whereas any gain (or loss) resulting from a change in the investment’s price
is capital. While definitionally correct, it misses the fundamental point that both sources of investment
return ultimately flow from the same source: the underlying earnings or cash flow of the corporation.
But how should a corporation’s earnings be returned to shareholders? While there is a right way and a
Nothing confuses investors wrong way to deploy shareholders’ capital in a business, there is no right way or wrong way to return to
more than income versus shareholders the surplus capital that has been generated by the business. Companies can choose from a
capital. variety of alternatives to return capital, such as a regular dividend that may range from a trivial payout ratio
to a very high one; a policy of special dividends; a regular program of buying back stock; or, periodic
significant buybacks. While these alternatives are all perfectly acceptable policies for returning capital to
the shareholders, they produce dramatically different ‘yield’ characteristics.
Instead of focusing on yield, we care about how a company operates its business and how it thinks about
and deploys its capital. This is what matters and, in that regard, there are right and wrong answers. In
contrast, there are many correct answers when it comes to how and over what time period one returns
profits to the shareholders and, in fact, we own companies that take very different approaches.
A couple of examples from our portfolio demonstrate how varied (and each correct in their own way) such
policies can be. One of our companies until recently paid out a very high portion of its earnings – it was a
classic yield stock. That was until a recent merger occurred which saw a new CEO step in. Rather than
paying out dividends, the new CEO prefers to return surplus capital to shareholders by way of share
buybacks. His philosophy is perfectly fine; and the philosophy of the previous management team was also
perfectly fine, so long as neither philosophy causes the company to sub-optimize its business operations.
The company’s stock went from being high yield to no yield, yet no change to value occurred.
Companies run into trouble Another of our companies pays out a high portion of its free cash flow. It was formerly an income fund and
upon its conversion back to a corporation it decided that it could and would maintain its dividend. (For our
when they let corporate yield
non-Canadian investors, income funds were a relatively short lived phenomenon that allowed companies in
policies affect business Canada to turn themselves into something akin to a REIT. They were tax efficient, high dividend payout
decisions. entities.) Again, there was nothing wrong with deciding to maintain a high payout just as there was nothing
wrong with another of our investments that converted back to a corporation and decided to reduce its
payout. As long as, in each case, the shareholder distribution policy does not negatively impact the
underlying business, any of these approaches is fine.
Companies run into trouble when they follow a policy of regular dividends that are unsustainable and/or
where they would be better off if they retained some of the funds for reinvestment. There are a lot of
companies like this out there and we have no interest in owning them. To take one example, we recently
spent a bit of time looking at Yellow Media. The share price had declined sharply and some stock analysts
had suggested that we should have a look. Our conclusion, after a cursory review, was that the company
was overly focused on maintaining a specific dividend payout to the point of recently selling a key business
unit at a price that was two-thirds of the price they paid only a few years ago, in part, so they could stay
1. Swensen, David F. Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. New York: The Free Press, 2009.
The Tao of the Turtle May 2011
within a debt covenant that allows them to maintain the current dividend. We do not wish to own
companies that appear to be burning the furniture, one piece at a time*.
What one really has to do is ‘look under the hood’ to understand the underlying cash earnings power of an
investment. It doesn’t really matter to us how much of the cash earnings are being paid out in a regular
way. Indeed, we are quite happy to see our companies retain cash earnings for acquisitions if those
acquisitions are accretive to shareholder value. When we think about yield, we focus on the underlying
cash earnings of our portfolio. The table below shows the cash earnings of our portfolio (as at December
31st each year) over the life of Turtle Creek.
Cash Earnings per Unit2

One must ‘look under the
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
hood’ to the underlying cash
$0.10 $0.11 $0.48 $0.94 $1.11 $1.34 $1.43 $1.95 $1.79 $1.72 $2.06 $1.88
earnings of one’s
investments.
Over Turtle Creek’s twelve year life, we have grown the cash earnings 20-fold from $0.10 per unit in 1999
to about $2 per unit. We have achieved this partly by focusing on what is 'under the hood' – the cash
earnings power of each investment. This is the 'yield' that matters, not the portion of cash earnings that our
companies decide they will pay out in the form of regular dividends every month or quarter. However, our
investors can’t see this yield – all they can see is a quoted unit price. Accordingly, we recently introduced
a class of units that pays a fixed amount per month: a distribution class.
There are four reasons we are introducing a distribution class of units for TCEF. First, many of our
investors have the need for a conservative investment with a current cash flow; a distribution class allows
them to meet this need through Turtle Creek. Second, we are concerned about many of the ‘yield’ products
out there in the marketplace – structured product that is being created to satisfy investors’ demand for
income. Much of this product is inferior, confusing and laced with multiple layers of fees and costs. By
providing an ‘income’ product ourselves, we hope to prevent our investors from going off and hurting
themselves. Third, by introducing a class of units that distributes a monthly amount, we are able to drive
home the message contained on these two pages: that income and capital combined are what truly
matters – and that (other than government debt) the source of both is identical – the earnings power of
corporations.
“How much income can I
derive from my investment The fourth, and most important, reason for introducing a distribution class for TCEF is to answer a question
portfolio without depleting we are often asked, “How much income can I derive from my investment portfolio without depleting my
capital?” Having the right answer to this question is critical for our investors. We think very carefully about
my capital?” this and will always pick a distribution amount that, in our estimation, is sustainable and, as such, will not
deplete an investor’s capital. At the time of the launch of the distribution class, we chose an initial
distribution of $1.00 per unit. While we chose this amount based upon our portfolio’s cash earnings, a
survey of endowed institutions (which by their very nature, are focused on targeting permanently
sustainable spending amounts) found that more than 90% of them employed target withdrawal rates of
between 4% and 6% of the portfolio’s net asset value.3 Interestingly, our initial distribution equated to
roughly a 4.5% rate, comfortably at the low end of this range. We are confident that our distribution amount
is sustainable and, indeed, we expect that it will grow over time.
* 5 months after we wrote this Yellow Media announced it was eliminating future dividends on its common shares and the common shares had fallen 96%
from $4.42 to $0.16. On December 20, 2012 the company implemented a recapitalization, prior to this recapitalization the common shares had traded at
$0.06.
2. Cash Earnings are the true “look through” cash earnings of our portfolio companies; i.e., the amount that could be distributed by our companies
without impacting their earnings power. The Cash Earnings are for Turtle Creek Investment Fund to 2007 and Turtle Creek Equity Fund thereafter.
3. Swensen.
Page 2
What Kind of Return Can You Expect? Part I
One of the most common, and important, questions investors ask is “What kind of investment return can I
expect from my portfolio?”. The answer to this question informs much of what they subsequently do with
their capital. As is the case in most important questions, the answer is not simple – but unlike in many
other cases, there is a clear answer.
It is most meaningful to think in terms of ‘real’ or inflation-adjusted returns. As we have written in the past,
equity investments win hands down. The table below tells the story.
Value of $1 invested in 1802 (inflation adjusted)1 Annualized real return

Over the longer term,
equities have outperformed Gold $5 0.7%
other asset classes by a Treasury bills $284 2.7%
shockingly large margin. Treasury bonds $1,177 3.4%
Common equities $655,000 6.6%
Owning equities protects wealth and generates more over time. Real returns of 6-7% (and nominal returns
of about 9%) is the best starting assumption when thinking about long term returns.
However, this comes with one big caveat: the valuation of the stock market – the multiple that the market
places on company earnings at any point in time – has an enormous impact on all but the longest term
investment returns. Expanding multiples were the key driver of the long term bull market that ran from 1984
to 2000. The compound annual investment return during this period was 18.3% per annum, while the
growth in earnings was 5.9% per annum. As you can see in the graph below, the multiple increased from
around 10X in 1984 to over 40X in 2000! Clearly, the majority of the returns came from expanding P/E
multiples, contributing about 10% a year over 14 years resulting in a quadrupling of P/E multiples.
Obviously, this couldn’t continue forever and, in fact, had to revert back to more normal historical multiples
at some point. This key fact seems to escape most investors. So many of them became spoiled from the
strong returns in the 80’s and 90’s – returns that had never previously been earned throughout the 200
years of modern financial markets.
Bull and bear markets come
from earnings multiple Cyclically Adjusted Price-Earnings Multiple2
changes, not changes in the 45
40
growth of earnings
35
themselves. 30
25
P/E Ratio
average (16.4)
20
15
10
5
0
1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
All figures based on US dollar data.

1. Siegel, Jeremy J. Stocks for the Long Run, 4th Edition. New York: McGraw-Hill, 2007. Returns updated to October 31, 2011 by Turtle Creek.
2. Shiller, Robert. Irrational Exuberance. Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005. Updated: www.econ.yale.edu/~shiller/
data.htm. Shiller defines Cyclically Adjusted Earnings as a rolling 10 year average. Price and Earnings figures are adjusted to October 2011 dollars.
Earnings and price data are taken from the S&P 500 since 1926 and from Cowles and Associates (Common Stock Indexes, 2nd ed. [Bloomington,
Ind.: Principia Press, 1939]) before 1926.
Similarly, compressing multiples have been the key driver of the long term bear market that we have been
in since 2000. Just ask anyone who invested in the stock market in early 2000. Their return, including
dividends, has been zero. It isn’t often that investors earn no return over such a long period and this is why
so many have ‘given up’ on equities. And yet, during this period earnings have grown by 5.2% per annum.
The problem is, this growth in earnings has been more than offset by a greater than 50% contraction in P/E
multiples.
Think of it this way: during the 16 year ‘bull market’ earnings grew at a rate of 5.9% per annum and during
the 11 year (and counting) ‘bear market’ earnings grew at a rate of 5.2% per annum. Essentially, all of the
‘bull’ and the ‘bear’ came from earnings multiple expansion and then contraction.
But let’s look at what happens if you adjust for this – if you hold the earnings multiple constant3. Looking
over the past 200 years, it is possible to identify about 60 different periods where the beginning and ending
price earnings multiples were roughly the same. The average length of time for these periods was 35 years
– well within the period of time most people should consider when thinking about their family’s wealth.
Essentially, this analysis adjusts for the fact that, in the shorter term, the majority of stock market returns
come from revaluations of companies and, instead, focuses on the longer term reality where the vast
majority of returns come from the earnings and dividends of companies.
Long term returns are highly The results of this analysis are instructive. The average nominal (including inflation) return was 9.6%, in
predictable for equities, line with the overall 200 year returns; but what is noteworthy is the consistency of the returns – the standard
deviation was only 1.6%. Essentially, long term returns are highly predictable for equities, once you adjust
once you adjust for earnings for earnings multiple changes. As an aside, the same cannot be said for other asset classes such as
multiple changes. bonds where the standard deviation was almost as high as the nominal returns. Time transforms the short
term ‘volatility’ of equity returns – the volatility that comes because public investors are constantly changing
the multiple they place on company earnings – into remarkably ‘stable’ returns over a longer but
manageable time period.
The obvious question that this raises is: is now a good time to be invested? Where are we today in terms
of stock market valuation levels? Take another look at the graph on the prior page. The price earnings
multiple has averaged 16 times – and today the multiple is 19 times. While the current multiple is much
lower than ten years ago, it is still above the long term average and we could still face further multiple
contraction to something below the long term averages over the coming years. The good news is that, at
some point, growing earnings offset further multiple contractions and returns have to improve. And, at
some point, the earnings multiple might actually expand, which, as we have seen, can contribute mightily to
investment returns. Interestingly, the earnings yield of equities is becoming very attractive relative to long
term bond rates. The earnings yield is 5% whereas the (10 year) bond yield is 2%. This ratio of 2.6:1
compares with the long term average of 1.8:1.
The reality is that no one knows which direction the markets will head in the next year or two (or five). But it
has rarely been the case that equities have not been the right place to be. Indeed, it was only at two points
during the 20th century when you were probabilistically better off not being in the stock market – 1929 and
1999. Otherwise, you were better to be invested in equities, and that is definitely the case today.
So after all of this, what kind of return can you reasonably expect? Well, if you own bonds or gold it hasn’t
Equities today are at the
been very pretty over the long term, and odds are it could be particularly ugly in the next decade or two for
long term average valuation those asset classes. For equities, we are now very close to the long term average for stock valuations and,
multiples. with that as your starting point, you can expect to do much better than other asset classes and earn high
single digit returns – about 9% per annum (or 6 to 7% in real terms).
We will turn to Turtle Creek and our own return expectations in the second part of this series; but, to give
you a sneak peak of our views, we believe that Turtle Creek can improve upon these broad equity market
returns by at least a few hundred basis points and get our investors into double digit annual investment
returns. Outperforming the stock market by a few percentage points a year over the long term can have a
powerful impact on one’s savings, as we will discuss in What Kind of Returns Can You Expect? Part II.
3. Peter L. Bernstein. Financial Analyst Journal, March/April 1997.

Page 2
The Tao of the Turtle January 2012
What Kind of Return Can You Expect? Part II
A couple of months ago, in Part I, we highlighted the long term, consistent outperformance of equities
relative to other investment asset classes. In Part II we turn to Turtle Creek and discuss how we think we
will do relative to the broad market.
We believe that over reasonably long periods of time we can consistently earn investment returns that are
superior to the broad equity markets. Why do we think that we can continue to do this? Because we own
above average companies at below average valuations.
The results so far have been pretty good, as shown in the table below.
We have outperformed
because we own above Compound annual returns1
average companies at below 3 Years 5 Years 10 Years Inception
average valuations. Turtle Creek1 26% 1% 14% 24%
S&P 500 in C$2 7% (3)% (2)% 0%
Outperformance 19% 4% 16% 24%
Such outperformance presents its own obstacles for us. Existing and new investors often perceive that with
such high returns we must somehow be a risky proposition. This is not the case. We own companies that
generate substantial cash earnings, have little to no debt and trade at modest valuations. And the
investments in the portfolio do not really change that often; once we find a great company we tend to own it
for a long time. With about 25 holdings, the average turnover has been 3 companies a year.
Outperforming the broad market in the long term is not that common among investment managers. Our
outperformance arises from a number of factors that we have ‘working in our favour’ and we’ll mention a
few of them here. First, we have an investment strategy that is internally logical and repeatable, which we
have described previously in some detail. Second, we are an experienced, tightly integrated team that has
worked together for many years: the three partners of Turtle Creek have been together for close to 20
years. The best investment decisions are made by a manageable group of people who have worked
We never set out to earn closely together for a long time. Third, we allow ourselves to spend our time on the right things (i.e., getting
such substantial returns; to know our investments very well). Fourth, we don’t let the fluctuations of the marketplace distract us from
our expectations are our investment strategy. Having all of these things working in our favour has helped generate superior
investment outperformance to date. We have every reason to think this will continue.
modest.
Which brings us to an important point. We never set out to earn the types of returns that we have earned in
our first 13 years. We have very modest expectations. After all, Turtle Creek is where we are investing all
of our money. We remind our investors all the time how boring our approach is. Our mindset is that of an
owner of companies – not of stocks.
Despite such strong relative performance, we stress to our investors that they should have reasonable
expectations. It is not reasonable to expect outperformance of 19% per annum over 3 years and definitely
not reasonable to expect 16% per annum outperformance over 10 years. Frankly, if we are able to achieve
4% to 5% per annum outperformance, as we have in the past 5 years, we will be very happy.
So let’s look at what long term investment outperformance can do for your net worth. The following table
calculates future real (inflation adjusted) profits for various asset classes over 10 year and 25 year periods,
assuming that the asset class earns its long term historical return. The table also shows the impact of
annual outperformance of 2%, 4% and 6% over the historical return for equities.
1. Net returns to investors. For more details see www.turtlecreek.ca
2. All return data is in a common currency (Canadian dollars).
The Tao of the Turtle January 2012
Inflation Adjusted Profits From $1,000 Investment3

Gold Cash Bonds Equities 2% 4% 6%
(T-bills) better better better
After 10 years $80 $310 $400 $900 $1,290 $1,740 $2,280
The magic of compounding After 25 years $200 $970 $1,330 $3,970 $6,900 $11,470 $18,520
means even modest After 25 years (after tax) $0 $90 $200 $2,030 $3,370 $5,270 $7,940
outperformance can have a Long term historical average 0.7% 2.7% 3.4% 6.6% 8.6% 10.6% 12.6%
annual real return4
powerful impact on your
net worth. After 25 years you would have approximately two and half times your money if it was invested in bonds
compared to five times your money if it was invested in equities. That’s not bad, but look at what happens
if, in addition to investing in equities, you outperform. Take, for example, the ‘4% better’ column. After 25
years you would have more than 12 times your money. While all of this is after the effects of inflation, it is
before taxes – which makes the relative comparison of equities versus bonds even stronger as you can see
in the third row of the table. Essentially, bonds and T-bills barely maintain their value (all of the real profit is
taxed away) and the relative attractiveness of equities is even greater because of the lower tax treatment
on dividends and capital gains.
These results are based on the average for the past 209 years and, if we had to guess how the next 25
years might diverge from the very long term, our bet is that bonds and gold will underperform their longer
term results whereas equities are more likely to meet their long term average returns. Indeed, we would
not be surprised to see bonds earn negative real returns for investors, just as happened the last time bond
yields were so low (in the 1940’s). As such, the relative outperformance of equities could be significantly
higher than shown in the table.
There has been only one other time in the life of Turtle Creek when our portfolio offered such good value:
at the end of 2008 when the world was in the midst of a good old fashioned financial panic. When we step
back and look at what we own, we are frankly astonished at the low trading multiples of some of our
holdings. Which isn’t to say the trading multiples couldn’t go lower – but at these levels there is much more
‘upside risk’ than ‘downside risk’. Even if traded multiples don't expand, our unit price will rise as a result of
the cash earnings generated at our companies.
Rarely has Turtle Creek been With real returns on equities averaging 6.6% over the long term and inflation averaging 2.5% to 3% (which
at such attractive valuation is also a good assumption for the future), nominal equity returns have averaged approximately 9% to 9.5%.
From where we sit today, we believe that Turtle Creek, over the long term, can outperform this by 4% to 5%
levels.
resulting in total nominal returns in the low to mid-teens. This return expectation arises solely from our
ability to identify good companies and own them at low valuations.
Our past performance has exceeded this mid-teens level as a result of the market occasionally getting the
value of some of our investments stunningly wrong (in both directions). While our investment approach
does not depend on this happening, if the market repeats this sort of extreme behaviour in the future, we
will take advantage of it for the benefit of our investors.
The choice of time frame in the table above was not arbitrary. We intend to still be managing all of our
money at Turtle Creek in 25 years. We are playing a Long Game. We understand the profound impact on
one’s wealth of even modest investment outperformance over a long period. By owning above average
companies at below average valuations, we believe we can continue to outperform and generate wealth for
our investors.
3. Profit figures are calculated assuming that the asset class earns its long term historical average annual inflation adjusted (real) rate of return. After tax
figures have been calculated assuming top marginal tax rates.
4. Siegel, Jeremy J. Stocks for the Long Run, 4th Edition. New York: McGraw-Hill, 2007. Returns updated to October 31, 2011 by TCAM.
Page 2
Risk, A Further Discussion
A few years ago, in the midst of the Credit Crisis, we wrote our first ‘Tao of the Turtle’. It was on the topic of
risk, entitled “How Do You Feel About Risk Now?”. In it, we explained that risk is not a short term price
decline but is the prospect of truly losing money – that if you understand the value of what you own, a price
decline is most often simply an opportunity. In this article, we pick up the thread of our first Tao and
continue our discussion of risk.
The two elements of measuring investment performance are return (how much you make on your
investments) and risk (how dangerous was the way you made your returns). Return is easy to measure
Investment return is easy to after the fact. Risk, on the other hand, is not. It is in most cases impossible to know how much risk an
investor took to earn his returns. The future is unknowable and whatever actually happens wasn’t
measure, investment risk is
necessarily ordained to. As we like to say, you would need to run the universe through at least a few
not. thousand times to really understand the likelihood of things happening.
The only way to deal with the inevitably uncertain future (risk) is to think properly in terms of probabilities. It
is important to recognize that, just because an outcome happened, it was not inevitable. Many times
events have occurred that were better or worse than our ‘most likely’ prediction. We are always asking
ourselves the question: “are we properly handicapping the range of possible outcomes regardless of what
the actual outcome turned out to be?”. Our forecasts encompass a range of possible outcomes – although
only one will occur. This is what we mean when we say we think probabilistically, and such a mindset is
critical to superior long term investing. But before we explain further about how we think of risk, we would
like to make two points.
First, using price volatility as a proxy for risk is wrong. Academics took to using volatility as a risk measure
because no one had a better idea – and its use has exploded. It’s understandable why this happened –
determining actual risk levels is devilishly difficult (and sometimes impossible) and price volatility is readily
measurable. But it isn’t really a proper measure of risk; and its use has resulted in a number of distortions
in the capital market such as investors plumping for rarely priced investments (think private investments)
since they don’t exhibit price volatility. The idea that private investments are less risky than public ones is
absurd, yet this is one of the many confusions caused by a mistaken focus on short term price volatility.
Price volatility is a terrible
proxy for risk. Second, since you really can’t know the true risk investment managers are taking, the best way to mitigate
risk is to ensure you are aligned. The ancient Romans understood this well: the engineer who oversaw the
building of a new Roman arch had to, upon its completion, stand under it while the scaffolding was
removed. This severe consequence for failure tended to keep the builder’s focus on quality and risk
mitigation (as one can imagine). In a similar vein, the ideal alignment in investing is to ensure that all of a
manager’s investment assets are alongside his clients’. Most investors today under appreciate the
importance of such full alignment.
Okay, so you should ignore price volatility and pay attention to alignment. But then what?
To reiterate, the proper way to think about investments is probabilistically: there are a range of possible
outcomes but only one of those outcomes will occur. That means there are a large number of quite
reasonable outcomes that could have occurred but didn’t – at least this time around. We think of
investments in this manner – as a range of outcomes as pictured on the following page. In this stylized
example of a company, using a discount rate (investment return) of 10%, the distribution shows the present
value of the future cash flows, or what we call intrinsic value. In this example, $10 is the most likely value
(the largest area under the curve) but there are many better scenarios where the intrinsic value turns out to
be higher than $10 and a similar number of worse scenarios where the intrinsic value turns out to be lower
than $10.
Stylized Probability Distribution of Intrinsic Value for a Company
Probability
Risk primarily comes from
paying too high a price for
an investment.
$0 $3 $5 $8 $10 $15 $20 $25

Intrinsic Value
Assuming a $10 purchase price, if the intrinsic value turns out to be higher than $10 (i.e. the future cash
flows are more than expected), you would earn more than 10%. Similarly, if the intrinsic value turns out to
be less than $10 (i.e. the future cash flows are less than expected) you would earn less than 10%.
But, having determined the range of intrinsic values, what if the same investment is available at $8? There
are still a great number of outcomes that would see a lower than 10% return – but fewer than when one
pays $10. And there are many more ‘better than expected’ outcomes. And what if one is able to pay only
$5? Now, there are fewer ‘bad outcomes’ (outcomes where the return is lower than 10%) and many more
‘good outcomes’ (outcomes where the return is well above 10% – sometimes significantly so). And what if
one is able to buy the investment for only $3? Now, there are extremely few ‘bad outcomes’ – almost all
are good outcomes and many of them are fantastic outcomes. And remember, even in the rare event that
the investment was only worth $3, a positive return of 10% would still be earned over a multi-year period.
Our focus is on minimizing We are constantly trying to buy as “far to the left on the curve as possible”, not to enhance our returns
risk. Our superior returns but to reduce our risk.
are simply a byproduct of The price one pays for an investment is the biggest risk factor. How risky is the above investment if one
risk mitigation. pays $15, or $25? Very, because in the great majority of scenarios your return is well below 10% including
many scenarios where the returns would be negative.
This is the key point: if you spend your efforts trying to find the lowest risk investments (within an asset
class) the collateral benefit is that you increase your likely return. Reducing risk means owning the
cheapest investments – the ones with very few scenarios that result in bad outcomes and many scenarios
that result in good to very good outcomes. This is not about trying to enhance returns; it is about trying to
avoid the loss of money. This turns the risk/return paradigm that we have all been taught on its head: the
lower the risk (cheaper) the investment, the higher the expected returns whereas the more expensive the
investment (the higher the risk) the lower the expected returns. This is so counter to what we have all been
taught that it takes a while to register. But think about it: low risk and high expected returns coexist when
you pay $3 for the above investment and high risk and low expected returns coexist when you pay $25.
This has been our approach since we began 14 years ago. At Turtle Creek we have always endeavoured
to reduce our investment risk as much as possible by buying stocks that are trading at the greatest discount
to their intrinsic value (buying as far to the left on the graph above). The greater the discount the greater
the number of very good outcomes and the fewer the number of inferior outcomes. We have earned very
strong returns over the life of Turtle Creek, but we haven’t been trying to – we’ve been focused on
minimizing risk by buying the least expensive investments. The superior returns are simply a byproduct.
Page 2
Investment Edge 1: Security Selection
When speaking with investors we are often asked about the reasons for our long term investment
performance. We explain that our results come primarily from three sources of investment ‘edge’: Security
Selection, Valuation and Portfolio Construction. This article is the first of a four part series, with each of the
first three dealing with one of the sources of our investment edge and the final article providing a case
study. Our first edge is, in the nomenclature of the investment industry, security selection or, more simply,
picking good companies.
The world is complicated.
We start with the premise that the world is a very complicated place and getting more complicated all the
Investing only in superior,
time. We believe that finding very well run corporations, who themselves share this appreciation of
intelligent companies is a complexity, and entrusting our capital to them is a very wise use of our and our investors’ money. While we
great advantage. do our level best to understand each of the companies we invest in, we recognize the impossibility of
having a complete understanding of any corporation. Accordingly, we believe it is critical to invest only in
honestly and well run organizations who deal intelligently with the opportunities and risks they face and who
strive to earn superior returns on behalf of their shareholders.
Of course the trick is finding the good ones. After all, everyone claims to be looking for great companies.
But we have a couple of advantages that puts us in a unique position to genuinely be able to separate the
wheat from the chaff. The first advantage is our professional backgrounds and the second is our approach.
We have professional backgrounds that differ in some material ways from traditional investment managers.
Prior to Turtle Creek we (the three Partners) spent a combined 30 years, first advising major corporations
and then taking controlling ownership positions in a dozen companies in a broad variety of industries. Over
those years we met with thousands of management teams, in sessions that have ranged from hours to
many days. From those thousands of preliminary meetings we went on to have intensive follow up due
diligence with hundreds of companies. We have not only looked at companies from the outside – but from
the inside as well – as directors, as large shareholders and as advisors. This extensive experience has
provided us with plenty of ‘scar tissue’ and brings a unique perspective to investing that many traditional
Our professional money managers and analysts often lack. And it is this perspective that we bring to bear in separating the
backgrounds and approach good companies from the bad.
enable us to find superior The second advantage in finding great companies is our approach. When we first meet with companies,
companies. we don’t concern ourselves with whether or not it is ‘a good buy’ at that moment – we know that every
company, at times, will be cheap (a good buy). We concern ourselves with the quality of the business, the
nature of the industry in which the company operates and the integrity and caliber of the management
team. We are looking for ‘highly intelligent organizations’ that are constantly searching for ways to develop
an edge on their competition and earn superior investment returns for their shareholders. We have
watched companies that had ideal environments generate poor results and we have observed other
companies create enormous shareholder value from a starting point that afforded them no easily
discernible advantages. We allow ourselves the time to really assess how management thinks. We don’t
force this process – sometimes it takes a long time to get comfortable that a company is exceptional.
In order to find superior companies we meet with everyone, talk to everyone and read as much as we can.
Initial meetings are, of course, just a first step in a process of determining which companies belong on our
‘list’. And we don’t just meet with management teams; we talk to research analysts, other investors,
industry specialists, corporate directors, all with a view to identifying superior companies.
We are agnostic as to the growth rate of the industry in which a company operates. We own companies
that are in high growth sectors, companies in mature industries and even a couple of companies in
declining industries. We are looking for highly intelligent companies that understand the environment in
which they operate, that out-think and out-maneuver their competitors, and that focus on maximizing
shareholder value even if that means (in a declining industry) harvesting capital from their business and
returning it to their shareholders.
Once we have found an exceptional company we do a lot of additional things (more on this in our next two
Taos) but it is much easier to earn superior investment returns if you restrict your portfolio construction to
companies that are endeavouring to create shareholder value and are building great businesses. It’s nice
to have the wind at your back.
We are recalibrating our view all the time: after meetings, after calls with management, after facility tours,
after earnings reports – we refine our view of the company. Are they as good as we thought? Are they
better? Are they worse? These changes are most often incremental in nature, but inevitably, over time,
Finding and owning excep- some of our companies decline in our estimation and others rise. It is a never ending process. Year in and
tional companies is one of year out we add new companies to our holdings and remove others – at the rate of about three per annum.
the reasons for our strong Sometimes a removal occurs because the price has risen toward our view of intrinsic value and we find
other more attractive value propositions, but most of the time the removal occurs simply because we have
investment results.
found a stronger, better run company. This process will never end.
However, having said all of this, we also recognize that one could spend all of one’s time and energy trying
to find the next ‘diamond in the rough’. While we allocate some of our time to Investment Edge 1 we spend
the majority of our time ensuring that we have a superior view of our existing companies. It is more
important to take the time to have a quality view as to the value of what you own than to spend too much
time and energy looking for something better – but not really understanding what it is worth.
Joseph Schumpeter famously described the process of capitalism as one of ‘creative destruction’. As you
read this, there are companies you have never heard of that will become household names in the future
and there are companies that today are household names that will be defunct in a decade or two. Think of
this: in the past 50 years over 900 companies have been added to the S&P 500 index, an almost 200%
turnover. There is no reason to think this pace of change will be less in the future. We have set many
tasks for ourselves, but one is to find the few exceptional companies among the many ordinary ones. In
the life of Turtle Creek we have found a number and it is one of the reasons for our strong investment
returns. Today, more than ever, our portfolio has many superior companies, but we know there are
exceptional companies that we have not yet identified. It is a never ending activity: meet everyone, talk to
everyone and read as much as we can.
Page 2
The Tao of the Turtle December 2012
Investment Edge 2: Valuation
There is a well known adage in investing that goes something like this: “Why do people get excited when
they see tuna on sale at the grocery store but not when stocks go on sale?” Beyond the fact that it is a little
unfair to compare a staple good (which is relatively easy to value) with a financial asset (which is much
tougher), the truth is most investors don’t spend much time thinking about the underlying value of stocks
and so don’t know when they are on sale.
Pick up any finance textbook or quality book on investing and you will find a fulsome explanation of how the
value of any financial asset is its future cash flows discounted back to today at an interest rate that
compensates for time and riskiness. Every investor will nod in agreement while reading this: an
investment is worth the present value of all future cash flows. But then something seems to happen to
investors when they are faced with the reality of constantly changing asset prices – they forget this basic
A Founding Principle of truth and spend their energy trying to predict where traded prices are headed. By the way, it’s not just in
public markets where this distraction occurs - we have seen the same phenomenon in our days in private
Turtle Creek is "The Only equity where investors sometimes based the price they would pay for a company on what they thought they
Value is the Present Value could flip it for in a public offering.
of Future Cash Flows".
Turtle Creek was founded in 1998 on six investment principles. The fifth of these investment principles
addresses the distraction described above and is at the core of our investment approach: The Only Value
is the Present Value of Future Cash Flows. This statement declares our long-held belief that all other
valuation methodologies are inferior. Many of the other methodologies are simply crude, shorthand
versions of net present value. For example, multiples of earnings, book value or cash flow are 'back-of-the
envelope' valuation techniques that only capture a small component of a proper discounted cash flow
analysis. Even worse are relative value methodologies that simply look to what ‘comparable’ companies
are priced at. But worst of all are pure price-driven methodologies such as charting or technical analysis
that confuse price with value.
We devote a great deal of effort determining the present value of the future cash flows (intrinsic value) of
each of our investments. And, just as importantly, we have a very long time horizon (another one of our
founding principles). Determining the intrinsic value of an investment would be somewhat irrelevant if we
Our financial models are
were planning to sell it in the next year or two. In that event, we would have to spend our energy trying to
invaluable repositories of guess what others will pay for it in the next year or two. But we are investing for the long haul which allows
information and testing us to focus on how much cash each investment will generate over the long term.
grounds for our views on For each of our investments, we build a unique, very detailed financial model from scratch. The ultimate
the future of our objective is to provide a window into the future but it also serves the purpose of collecting, in a manageable
businesses. form, a great deal of relevant historical information. The model becomes a repository for our thinking on the
investment. As well, it forces us to make all of our assumptions explicit and it is a basis for us to debate
among ourselves the relative merits of each holding. The model is a guard against untested speculation
since it forces us to think long and hard about all of the factors that will affect the future, including the risks
the business may face that are currently unexpected and unforeseen. Our investors will point out that our
intrinsic values are only as good as our assumptions. Of course this is true, but it is important to
understand that we are not trying to forecast the cash flows of pre-revenue companies where all of the
value comes from earnings many years in the future. All of our companies are making money now. In
each case, a meaningful portion of the intrinsic value of our holdings comes from the cash flow over the
next five years or so rather than in the distant future.
The current version of each financial model reflects our best estimate of the intrinsic value of the
investment. We recognize the actual outcome will be different – sometimes higher and sometimes lower
than our best estimate. In one of our recent Taos (Risk, A Further Discussion), we described in detail how
The Tao of the Turtle December 2012
important a probabilistic mindset is. In the language of statistics, our best estimate is really the 'expected
value' of many different scenarios.
Over time the financial model for each company evolves to reflect new information. We archive older
versions (in some instances we are well past version 100!) and it’s interesting to sometimes look back.
Over the years we have had many more upward revisions than downward ones. We’re delighted to be
wrong when reality turns out better than our forecast. We aren’t trying to be overly conservative but we
also avoid ‘drinking the Kool-Aid’. We didn’t drink the Kool-Aid in 1999 and we didn’t throw in the towel in
Having a consistent despair in late 2008. Having a view of the intrinsic value of companies and understanding how stable those
discount rate helps to values really are (as opposed to daily share price gyrations) is a powerful foundation from which to build
immunize us against and maintain an investment portfolio.
excessive market Beyond getting the cash flows right, the other key factor in our valuation approach is the discount rate. We
pessimism (as in 2008) have always used a discount rate of about 10% per annum. The “always” in the previous sentence is
or optimism (as in 2000). important. Contrary to standard financial theory, we don’t believe in changing the discount rate based on
prevailing interest rates. The intrinsic value of a well-run company doesn’t really change every time interest
rates change. The long term nominal returns on equities have been remarkably stable at about 9% to 10%
and so using a discount rate in that range is as good a choice as any. We are well versed in the financial
theory that would have us use a lower discount rate today since long term interest rates are at historic lows.
But we want to avoid getting whipsawed or being carried along by the crowd. In the late 1990’s, when
stocks traded at all-time high valuations, we maintained our discount rate (and our forecasts) and, as a
consequence, sold portions of our holdings over time as their prices rose, such that we had during that time
as much as one third of the fund in cash.
In any event, getting the precisely correct discount rate isn’t really that important. We simply want to
recognize that $1 today is worth more than $1 in a year, and much more than $1 in ten years. There are
lots of great arguments that the discount rate should be 8% (or 12%) which would result in higher (or lower)
intrinsic values for our companies. But either of those alternative rates wouldn’t much change the relative
attractiveness of our holdings and therefore wouldn’t have caused a meaningful change to the portfolio
composition over time. Our companies are all similar in one regard: they are making money today. We
don’t own investments that are premised on no cash flow for the next ten years but then a big ‘payday’. If
we did make such investments, we would have to worry more about the discount rate because we would be
choosing between companies that are generating cash today versus far in the future. Even worse, if we
invested in risky early stage biotechnology companies or startup mining operations in the Congo, then we
would have to use a higher discount rate to reflect the higher risk. But we don’t invest in such ventures.
We are focused on the cash The modest differences in risk across our companies are dealt with partly through using a narrow range of
discount rates, partly through the forecast of the cash flows, and partly in our process of portfolio
flows that will be earned by construction (more on this last point in our next Tao). Some of our companies are mature and we are
our investments and paid forecasting minimal growth while others have a higher growth profile, so the discount rates we use matter –
out to shareholders. but only to a small degree. The key is that we have reasonable ‘apples to apples’ intrinsic valuations
among our holdings so that we know how much of each to own.
The most important point is not the accuracy of our financial models (although they’ve been pretty good
through the years) or the precision of our discount rates (although they’re not bad). The most important
point is our focus on the underlying investments and the cash flows that will be earned at those companies
and eventually paid out to us, the owners. Nowhere in this valuation process do we consider the current
share price. This mindset is an important differentiator for Turtle Creek. It is only when we take the intrinsic
values of all of our investments and turn to the question “How much of each should we own?” that price
enters the discussion. But this is getting into portfolio construction which will have to wait until our next
Tao.
Page 2
The Tao of the Turtle April 2013
Investment Edge 3: Portfolio Construction
This is the third article in a series on our investment ‘edges’. Our third investment edge is Portfolio
Construction: how many holdings we have in the portfolio; how much of each holding we own; and how the
composition changes over time.
Turtle Creek was founded in 1998 on six investment principles and the third and fourth of these address
portfolio construction. The third principle is “Abhor Lazy Money” and the fourth is “Abhor Over-
Diversification” (and were tongue-in-cheek references to Aristotle’s adage, repeated by Galileo, that ‘nature
abhors a vacuum’). In one of our earlier (2004) annual letters, with respect to lazy money, we explained:
“Our goal is to ensure that Turtle Creek is always ‘smart’ money inasmuch as it is striving to achieve a
We abhor lazy money and we constantly optimal portfolio. Often investors may make an excellent investment selection, but they do not
abhor over-diversification. appreciate that the investment process is dynamic and never-ending. Over time, the price and
fundamentals of their investment will undoubtedly change as well as that of their other investments. Unless
rigorous and persistent analysis is brought to bear on these changing factors, then it is ‘lazy money’.” In the
same letter, with respect to over-diversification, we said: “One of the consequences of modern portfolio
theory has been an obsessive pursuit of greater and greater diversification to the point where some
investors attempt to have their financial assets spread over an exceptionally large base. Simply put, it is
impossible to outperform the market when you are diversified to such an extent that you become the
market”.
The best way to explain how our portfolio construction works is to start with a stylized, simplified example.
Imagine a portfolio comprised of two investments, Company A and Company B. Both companies have an
intrinsic value of $20 per share and both companies trade at $10 per share on the stock market. To further
simplify, assume that everything else about them is the same – they are of similar risk, financial leverage,
management quality and alignment, growth opportunities, etc. In that case, an optimal portfolio might be
comprised of 50% in Company A and 50% in Company B. Now imagine that the share price of Company A
rises to $12 and the share price of Company B declines to $8. (Share price movements of this magnitude
occur often in the public market). Now, Company A comprises 60% of the portfolio and Company B
comprises 40%, and yet Company A is now relatively less attractive since its price has risen closer to
intrinsic value and Company B has become more attractive since its price is further below intrinsic value.
The way to fix this is to sell some of Company A and buy more of Company B. How much to sell and buy is
subject to a number of factors beyond the spread between value and price, but common sense would
suggest that one would prefer to own more of Company B than of Company A.
Now take this simple example and add an additional 23 companies, so that the portfolio is comprised of a
Building an optimal portfolio total of 25 investments. And rather than assuming the companies are all similar, introduce the reality that
is complex and difficult, but each one has its unique risk profile (its own unique probability distribution of likely intrinsic values), and its
own quality and alignment of the management team, growth opportunities, financial leverage, etc. You can
the principles are clear and
see that the relatively straightforward portfolio construction described in the prior paragraph quickly
straightforward. becomes substantially more complex. However, the principles remain the same: in building an optimal
portfolio it is better to own more of companies that are cheaper and less of companies that are more
expensive and there should be a bias toward companies that rate higher on a host of other factors.
This brings us to a key point about portfolio construction: without our Edge 2 – Valuation, it would be
impossible to construct an optimal portfolio, or even any logical sort of portfolio. You have to understand
the value of each of your investments (how much free cash each investment will generate over time) – and
most importantly, the relative value among your investments – before you can go about the process of
portfolio construction. It is worth reiterating that we think about valuation probabilistically. In our recent Tao
(on valuation), we provided the visual of a bell curve to show how we think about our intrinsic value
estimates – while we use the ‘best estimate’ midpoint for each valuation we recognize that, in an uncertain
world, value exists over a range.
The Tao of the Turtle April 2013
We wish we could come up with an appropriate visual representation of how these intrinsic value ranges for
all of our companies (which are then adjusted by a variety of other factors) interact to create our optimal
portfolio, but we haven’t been able to. Even with an understanding of relative valuation, portfolio
We have developed a construction is not a simple matter. Sometimes, when we are asked by investors how we construct our
proprietary, multi-factor optimal portfolio, we joke that “we have a secret algorithm”; but there is some truth in this. At the outset of
Turtle Creek we devised a highly complex, multi-factor model that guides us in determining the portfolio
model to assist our portfolio
weightings. We have enhanced and improved this multi-factor model over time but its essence hasn’t
construction. changed since 1998. The most important factor in determining the portfolio weightings is the difference
between each investment’s intrinsic value and the current price, but there are many other factors that go
into determining the weightings and, in aggregate, these other factors have a substantial impact on the
ultimate weights.
All of the above process results in the creation of our ‘optimal portfolio’. This portfolio has a number of
interesting characteristics and we note some of them here.
1. Despite the fact that all of our companies have a North American head office (with the great majority
having their head office in Canada), only a third of the cash flow comes from Canada, a third from the
United States and a third from overseas. We like being exposed to growing markets around the world
– but we believe the best way to gain that exposure is through North American based global
businesses where we can have meaningful ongoing interaction with management teams.
2. Our portfolio is well diversified across industries. This is not an initial objective in our portfolio
construction, it is simply an outcome of our investment process.
The portfolio is well diversi-
3. Our portfolio makes a lot of money. In 2012, the cash earnings were $2.65, which is roughly an 8.5
fied across industries and times price earnings multiple.
geographies. The holdings 4. Our portfolio companies pay out a lot of the money they earn. In 2012, the cash distributed by our
are highly profitable with companies to their shareholders (primarily through regular and special dividends) was equal to $1.62
very low debt levels. Most per Turtle Creek unit. That is a yield of over 7%.
5. A disproportionate number of our companies have had their existing executive management team in
of the management teams
place for a long time, and many of them are still run by the founders of the company.
have long incumbency and 6. Our portfolio companies have lower debt levels than the average public company. Indeed, none of our
are good at acquisitions. companies have high yield debt.
7. An unusually large number of our holdings are very good at creating shareholder value through
acquisitions. Most companies are bad at acquisitions – it’s not easy to do them successfully. Our
background as M&A specialists and then private equity investors where we made control investments
helps us identify the management teams who are good at it.
In constructing our portfolio we aim to have approximately 25 holdings. That number is determined by two
factors: i) how many companies we are able to develop and maintain a deep understanding of, given our
current investment team format; and, ii) a belief that 25 holdings strikes an ideal balance between
minimizing risk and maintaining the benefits of a focused portfolio. To take one last quote from our 2004
annual letter: “Our general objective is to have at a minimum 50% of the fund’s assets invested in no more
than ten companies at any point in time”. Nine years later, the objective is unchanged and fits nicely with
about 25 holdings that flex in their portfolio weightings such that it is always the case that ten holdings
represent more than half of the fund.
We are long term owners of companies and once we construct our optimal portfolio – the correct weighting
for each of our holdings – we have no intention of making changes unless our relative view of our
companies change. However, the public market is constantly re-pricing our companies’ share prices and
so to maintain our optimal portfolio we simply must react to the price changes by adjusting the size of each
holding. This often results in significant changes to the size of each holding but it is all within the context of
optimal portfolio construction. We will shortly be releasing a fourth and concluding Tao in this series that
will profile a long time holding of Turtle Creek which will serve as an excellent demonstration of all three
investment edges, and in particular, portfolio construction and ongoing reweighting.
Page 2
The Tao of the Turtle June 2013
Investment Edges – A Case Study
This is the fourth and concluding article in our series on our investment ‘edges’. The prior articles in the
series explained our three investment edges: Security Selection; Valuation; and Portfolio Construction.
This Tao describes how we have applied these three edges to one of our holdings.
Open Text Corporation is a company that we have owned since the early days of Turtle Creek. The chart
below shows three things: Open Text’s share price (the squiggly black line); our estimate of the company’s
intrinsic value per share (the step-function green line); and the size of the holding as a percentage of our
portfolio (shown as the grey background).
Intrinsic Value Per Share
Price & Intrinsic Value (log scale)

$70
Open Text is an excellent
Portfolio Weighting (%)
company that is run in the

best interest of shareholders. Share Price
Portfolio
Weighting
$20
Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12
Before we turn to the chart, let’s discuss Open Text in regards to our first edge, Security Selection. We
endeavour to identify superior companies – highly intelligent organizations that earn superior returns for
their investors. Open Text is a software company that has become a global leader in the large and growing
Enterprise Information Management market. When we first invested in the company, revenue was $50
million. Today, revenue is over $1.4 billion and margins have strengthened, resulting in profitability
increasing at an even faster rate than revenue. This profitable growth has been accomplished both
organically and through acquisitions. Open Text has created substantial shareholder value – since 1999,
the share price has increased from $20 to $70, an annualized return of 9.3%.
We don’t care about cursory The green line on the chart is our estimate of the company’s intrinsic value per share and reflects our
valuation metrics – we care second edge: our ability to arrive at a reasonably accurate estimate of value. We define intrinsic value as
the present value of all future net free cash flows, using a reasonable and consistent discount rate. Since
about cash flow. we first began to follow Open Text, we have maintained a detailed financial model that has been modified
and refined, as appropriate, over the years. Our unwavering focus is on the cash flow that the company will
generate, not its P/E ratio, its GARP ratio, its book value multiple, its share price momentum, etc. We
ignore all such cursory valuation metrics. We care, instead, about the free cash flow that the company will
generate and ultimately pay out to shareholders.
The upward intrinsic revaluations of Open Text over the past 14 years (we have increased intrinsic value 16
times and never reduced it) harkens back to our first edge, Security Selection. It will do wonders for our
long term returns if we build our portfolio only from a pool of superior companies.
The Tao of the Turtle June 2013
Our third edge, Portfolio Construction, is evident in the chart through the grey background which shows the
percentage size that Open Text has been, over the years, of our portfolio. We are continuously striving to
own the right amount of Open Text. Indeed, we are constantly striving to own the right amount of all of the
companies in our portfolio. In late 1999, when Open Text was trading at a very low price relative to its
We are constantly striving to value, we made it the largest holding in the fund with a weighting of over 10%. As the share price
recovered sharply in the ensuing months (a four-fold rise over a four month period), we sold most of the
own the right amount of all
holding and ultimately took the position to zero by late 2000. The adjustments to the position’s weighting
of our portfolio companies. have been significant over the years, as you can see in the graph, but they are simply a logical reaction to
the relative price changes of our holdings.
Generally, we own less Open Text when the gap between intrinsic value and share price narrows and more
Open Text when the gap between intrinsic and price widens, (although, as we described in our most recent
Tao on Portfolio Construction, there are many additional factors that go into our determination of how
attractive Open Text is at any point in time). But the biggest determinant of how much we want to own can’t
be shown on the graph: the attractiveness of Open Text relative to the other holdings in the portfolio. A
great example of this ‘relative attractiveness’ occurred in late 2008. You can see on the chart how stable
Open Text’s share price was in 2008 – particularly compared to the falling share prices of almost all other
public companies. As a consequence, the relative attractiveness of Open Text lessened substantially since
its share price didn’t fall, while the share prices of most of our other holdings did. So we did the rational
thing: we sold Open Text and invested the proceeds into other, more attractive, positions. When those
other positions began to recover in early 2009, we sold bits of those and invested the proceeds back into
Open Text. This process has been repeated many times over the life of Turtle Creek, not only with Open
Text but with our other holdings as well.
We will continue to be a We continue to believe that Open Text is an excellent company that is run in the best interest of
shareholders and we expect to be a shareholder of the company for years to come – barring it being taken
shareholder of Open Text
over. But the amount we own at any time will likely continue to vary widely. Two times we have not owned
but the amount we own will any Open Text (in 2000 when the company was grossly overvalued by the stock market and in late 2008
vary widely – more when it is when other companies we owned were grossly undervalued by the stock market), but we think of ourselves
hated; less when it is loved. as having been a shareholder continuously for 14 years. We simply let our shareholdings temporarily fall to
zero a couple of times because of market gyrations that caused us to re-weight towards other holdings.
The confluence of properly executing on all three of our investment edges results in a happy outcome.
Open Text definitely falls into the category of an above average company. In the past 14 years its share
price has increased at an annualized rate of 9.3%, and our intrinsic value estimate has increased at a
somewhat higher rate. But because of our process of relentlessly trying to have an optimal portfolio, we
have owned more Open Text when the stock market hates it and less Open Text when the stock market
Our approach has increased loves it, and we have been able to increase a ‘buy and hold’ return of 9% per annum to 70% per annum.
Not all of our holdings have presented us with such beautiful volatility, but our returns have exceeded a
a ‘buy and hold’ return of 9% ‘buy and hold’ return for every one of our longer term holdings.
a year to 70% a year.
While all of this may look obvious in hindsight, it is worth keeping in mind that all of these adjustments are
made in real time without the benefit of foresight. Today, Open Text represents about 6% of the fund. We
have a plan (we always have one) as to how much more of the fund Open Text will be if the share price
declines to $60 or $50 or $40 (hint: the percentage increases as the price falls), and we have a plan as to
how much less of the fund it will be if the share price increases to $80 or $100. We don’t take a view on
where the share price is likely to go – we simply know what we will do at every price point, and we have
such a plan for every one of our holdings.
Page 2
Why the Market Gets it So Wrong, So Often
This Tao will be a bit of a departure for us. Typically, we write about Turtle Creek’s investing approach
rather than pontificate on the market. To long time followers of Turtle Creek, it will come as no surprise that
we believe that markets are terribly imperfect. Yet, many of our investors are told by others that the market
is efficient and rational. Our experiences suggest just the opposite and so we thought we would take the
time to explain some of the reasons the stock market gets it so wrong, so often.
The market is comprised of both investors and speculators (with many more of the latter). Let’s define the
two terms. Investing is focusing on the quantity, quality and timing of the cash that will be returned to you
from your holdings. Speculating is worrying about what other people will pay you for your holdings.
Investing is focusing on the Investors treat stocks as fractional ownerships of underlying businesses. Speculators don’t think about the
cash you will receive from fundamentals of a business but rather focus on how they believe others are going to next act; they partake
in a ‘greater fool’ world, viewing stocks as pieces of paper to be swapped back and forth. Investors take a
your holdings. Speculating
long term view and don’t spend any time or energy trying to predict price movements. Speculators, on the
is trying to predict what other hand, are wholly consumed with predicting the direction of share prices. In reality, no one knows
others will pay you for your what the market will do and trying to predict it is a waste of time and pure speculation. With so many
holdings. market participants trying to predict the unpredictable (i.e. speculating) it’s not surprising that security prices
often become so disconnected from fundamentals.
As well, there are elements of human psychology that work against one’s ability to act as a rational
investor. For example, people over-anchor on some information they might have, despite the fact that there
are many more important factors affecting the value of a business, or they grab onto evidence that their
own preconceived views are correct and ignore evidence to the contrary. As an example, someone
convinced that markets are poised for sharp declines will seek out the views of market doomsayers rather
than the views of more balanced commentators. As well, most people exhibit hindsight bias where a
person believes (after the fact) that the onset of some past event was predictable and completely obvious,
whereas in fact, the event could not have been reasonably predicted.
Oftentimes, participants in the stock market overreact to new information, creating a larger-than-appropriate
effect on a security's price which typically reverses over time. This overreaction occurs because people
tend to heavily weight their decisions toward more recent information, making any opinion biased toward
the latest news. They also exhibit an asymmetric aversion to losses. In other words, for these investors,
the heartache of a decline in stock prices is significantly stronger than the joy of an increase in stock prices.
The consequence of this is that people don’t optimize their investments.
Perhaps the most famous market related human bias is herd behaviour, which is the tendency for
individuals to mimic the actions of a larger group even when the individual would not make the same choice
alone. Part of the reason for herd behaviour is the social pressure to conform; however, the stronger factor
is the rationale that it's unlikely such a large group could be wrong. After all, even if you are convinced that
a particular idea or course of action is irrational or incorrect, you might still follow the herd, believing they
There are many human know something that you don't.
behavioural biases that These are but a few of many biases, and so it would be bad enough if these were the only things polluting
pollute an 'investor' mindset. an investor mindset, but there are other powerful forces, of more recent development, at work as well.
Over the past 60 years, there has been a remarkable shift in the stock market from individuals investing
directly to handing over the management of their investments to others. In 1950, individual investors held
92% of U.S. stocks and institutional investors held 8%. Today, individuals hold less than 30% of stocks and
institutions more than 70%. This represents a fundamental shift in the markets, from that of principals
managing their own money to that of agents managing money for others.
Much has been written about the ‘institutionalization’ of investing, and not much of it positive. Institutional
The institutionalization of mindsets result when the decision makers pay attention to things other than trying to optimize the portfolio.
Not surprisingly, being an agent instead of a principal, these professional money managers have to defend
money management has
their ‘performance’ to their clients. As such, decisions are often taken that are more in the interest of their
introduced ‘agency’ issues business of money management than in the interest of the client. For instance, since many clients are
that have made the market terrified of price volatility, institutional money managers may attempt to minimize volatility so as to hold on
less patient and rational. to their clients, with the result being that investment returns are sub-optimized due to this volatility
management.
This relatively recent professionalization of money management and its attendant ’agency’ effects introduce
levels of short-termism and speculation that are not yet fully appreciated by most people. Perversely, the
institutionalization of the market may, in aggregate, have made it less patient and rational. We aren’t aware
of any individuals who have fired themselves from the job of overseeing the management of their own
money, and yet every day we see professionals who are fired by their clients for poor ‘performance’.
Regardless of whose fault it is (the client for being short term focused or the manager for succumbing to the
pressures to think short term), this agency effect forces most managers into chasing short term
performance since otherwise they may lose their job. A number of institutional managers have commented
to us – “I’d love to do what you guys do, but I can’t. My clients would fire me because they wouldn’t give
me enough time”. Leaving aside the question of whether or not they could do what we do, it’s worth noting
the institutional pressures they face.
Markets are becoming more If anything, the level of speculation in the market is increasing, not declining. There is so much immediacy
in our modern lives and this translates into an increasing inability for investors (professional or amateur) to
speculative, not less. take a longer term view. Modern information and communications technologies make it increasingly easy
for people to engage in frequent and rapid movement of their investment assets. Arguably, a contributor to
the extremely high market valuations and gyrations in the late 1990’s was the advent of the internet which
enabled ‘day traders’ to buy and sell their investments at the click of a mouse.
In an odd development, the main reaction to the difficulty in dealing with all of these factors is to adopt a
completely passive strategy of owning index funds. We understand the argument and have ourselves
expressed the view in a prior Tao that it is a good starting point for many investors and where some should
stop. But it is the classic case where what may make sense for one investor makes no sense for everyone.
If everyone invested in passive index funds there would be no one left to think rationally and independently
about allocating capital.
When you add it all up: (1) the fact that most market participants are speculating; (2) the numerous human
biases that drive most people away from an investment mindset; (3) the increasing ‘agency’ nature of the
markets and its attendant short-termism and lack of alignment; (4) the immediacy of information in the
modern world combined with the human need for instant gratification; and, (5) the mindless, passive nature
of indexing as an increasing proportion of the market, it isn’t surprising that the market often gets it wrong
In the long run, (in the short term). Indeed, while the speculative instinct and human biases such as those described above
fundamental investing is have been around since the creation of markets, the other three influences are relatively new and are
the only thing that matters. undoubtedly causing markets to be less ‘efficient’ over time. Of course, all of this relates to the shorter term
– in the long run, fundamental investing is the only thing that matters. Frankly, for true investors, all of this
will simply mean even greater opportunities to outperform.
Page 2
The Endowment Approach – Thinking Very Long Term
Or, How you can eat your cake and have it too
Many people live in fear of running out of money as they age, positing some sort of worst case scenario.
This fear of catastrophe can cause them to be overly cautious in asset class allocations and investment
holdings which, perversely, can cost them dearly in the amount of savings they have in the longer term.
They end up in what they think are ‘conservative’ investments but then lose their savings to the combined
effects of low investment returns on the one hand and inflation and taxes on the other.
One of the most common questions we hear from our investors is “how much can I take out of Turtle Creek
Our distribution class was each year and not eat into my capital?” A number of years ago we created a distribution class in our fund
created to answer the that provides the answer to this question. Distribution class units provide an amount, set at the first of each
question: "How much can I year, paid monthly, that we are comfortable will not eat into an investor’s capital, after adjusting for inflation.
This amount we determine is ‘sustainable’, that is, the amount distributed will not eat into permanent
take out each year and not capital. It is based on both the underlying current earnings power of our portfolio and the market prices of
eat into my capital?” our holdings, smoothed over a period of time. The amount distributed is intended to strike a balance
between spending today while still maintaining, at a minimum, all of one’s capital, after inflation. It is not an
annuity – in other words, it is not structured to end at some point. Annuities return capital in addition to
earnings and are structured so that there is no value at the end of their term. In contrast, we return
amounts under an ‘endowment spending model’ – the principal, inflation adjusted, is intended to last
forever. Think of it as multi-generational wealth preservation.
Applying this spending or ‘disbursement’ model to Turtle Creek since it started produces striking results. At
the beginning of the fund, $1 million invested would have generated a disbursement of $44,000 in the first
full year of 1999. As you can see in the table below, the disbursement amount would then have grown
substantially to an annual level of $892,000 for 2015, a 20-fold increase. And even after all of the
disbursements, the $1 million would have grown to $27.9 million as of the start of 2015.
‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14 ‘15
Annual $ 44k 53k 77k 109k 147k 209k 284k 349k 420k 472k 472k 507k 595k 646k 674k 761k 892k
Over 16 years, the Distribution
disbursement amount
One could make the argument that this disbursement model is overly conservative. After all, cumulative
grows 20-fold, and the inflation since 1998 has been about 40% so to preserve the original $1 million the current principal would
remaining capital grows have to be only $1.4 million. Instead, the principal amount at the end of 2014 was $27.9 million. Clearly,
from $1 million to $27.9 our disbursement model could have allowed for much larger amounts over the years and still preserved the
original capital. However, the reality is that, for planning purposes, we don’t presume the returns we have
million. earned historically. In previous Taos we have pointed out that the very long term nominal return for equity
markets has been approximately 9% and we have indicated that we think we can, over the long term,
improve upon this and get our returns into the teens. But we have never presupposed the 25%
compounded returns we have so far earned since this is not a reasonable assumption over the very long
term. In other words, we want to bulletproof the capital amount to make it impervious to chronically weak
markets and we have done just that.
As well, while endowments don’t have to worry about taxes, the rest of us do. The good news is our
investment returns are largely taxed at the much lower capital gains rate (compared to income) and,
despite the active rebalancing aspect of our investment approach, there is reasonable tax deferral in Turtle
Creek. This compares with much lower investment returns of traditional fixed income securities that are
then taxed at higher rates with no deferral. The point is simply that one has to allow for some amount to
cover taxes as well as inflation when applying an ‘endowment spending model’ to taxable investors.
In any event, while our disbursement model may be overly conservative, it does recognize the actual
investment results of Turtle Creek, albeit on a lagged basis. Over the medium term, the disbursement
amounts ‘catch up’, to some extent, to the higher investment returns of Turtle Creek. Besides, we would
rather our investors be in the position where they can take additional amounts beyond our distributions, if
they wish, and still preserve their original capital rather than be faced with the opposite issue.
Now let’s look at what would have happened if we applied our disbursement model to market returns. If the
$1 million was invested in the TSX, the initial disbursement amount of $44,000 would have grown to
$81,000 by 2015, just barely keeping pace with inflation and the capital remaining would have grown to
$1.6 million; again just keeping pace with inflation. The results in the broad U.S. market are even worse:
the initial disbursement amount of $44,000 would have declined to an amount of $29,000 by 2015 and the
$1 million initial investment would have shrunk to $621,000. The results from applying the disbursement
model to the market indices and to Turtle Creek are summarized below:
1999 2015 Capital remaining at Capital remaining

disbursement disbursement the start of 2015 (inflation adjusted)
TSX $44,000 $81,000 $1,624,000 $1,191,000
S&P 500 (C$) $44,000 $29,000 $621,000 $455,000
Turtle Creek $44,000 $892,000 $27,886,000 $20,399,000
Clearly the disbursement amount was not sustainable if $1 million had been invested in the broad U.S.
market and barely sustainable in the broad Canadian market. At some point, in the case of the U.S. market
Our investors are better off the disbursement amount would have had to be cut and in the case of the Canadian market, one would be
to think in terms of the just holding on today.
annual disbursement amount Our distribution class serves a further important purpose. Our investors are better off to think in terms of
rather than worry about the annual disbursement amount rather than letting themselves be distracted by market fluctuations. A
market price fluctuations. focus on the disbursement amount, that has grown 20-fold over 16 years without ever declining, is much
better than worrying about the bull and bear markets that Turtle Creek has lived through so far. Through all
of these different markets our companies have continued to generate profits and return a portion to
shareholders.
We have often observed that investors seem to ‘over value’ fixed payment securities (bonds, annuities,
etc.). You can see this in the rates investors are currently willing to accept in the fixed income markets.
Our distribution class helps investors understand that the cash flows are from the same source: company
profits. And while the cash flows of our companies are more variable than investment grade debt, we
believe we are in a much better place to generate current income for our investors and also protect and
grow their remaining capital.
The alternative title to this Tao, ‘How you can eat your cake and have it too’, is an intentional reversal and
In investing, it is possible to challenge to the old proverb ‘you can’t have your cake and eat it too’. Because in fact, in the world of
eat a ‘slice’ every year and investing, it is possible to ‘eat’ a slice of your investments every year, so long as it is a reasonable portion
end up with a bigger cake. relative to the ability of what was left untouched to grow and make up for the amount consumed. This is
why it is critical to take a very long term perspective and to have the ability to earn strong investment
returns that will cover the portion you eat as well as deal with inflation and taxes.
Disclosures
All information on the disbursement model has been applied retroactively to Turtle Creek and the market indices. Turtle Creek’s
historical performance consists of Turtle Creek Investment Fund Class A Series 1 to November 1, 2008 and Turtle Creek Equity Fund
Class I Series 1 thereafter and is net of all fees, carried interest and fund expenses. Turtle Creek Equity Fund introduced its
distribution class in 2011.
Page 2

The Tao of Turtle Creek

Uploaded by

Copyright:

Available Formats

The Tao of Turtle Creek

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Tao of Turtle Creek

Uploaded by

Copyright:

Available Formats

The Tao of the Turtle September 2009

How Do You Feel About Risk Now?

Part 1: It doesn’t matter if the market stays inefficient.

Part 2: The market doesn’t stay mispriced forever.

spread between intrinsic $64

Turtle Creek Unit Price

Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09

Value of $1 invested in 1802 (inflation adjusted)1 Annualized real return

Cash Earnings per Unit2

Value of $1 invested in 1802 (inflation adjusted)1 Annualized real return

All figures based on US dollar data.

3. Peter L. Bernstein. Financial Analyst Journal, March/April 1997.

2. All return data is in a common currency (Canadian dollars).

Inflation Adjusted Profits From $1,000 Investment3

Stylized Probability Distribution of Intrinsic Value for a Company

$0 $3 $5 $8 $10 $15 $20 $25

Intrinsic Value Per Share

Price & Intrinsic Value (log scale)

company that is run in the

Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12

1999 2015 Capital remaining at Capital remaining

You might also like

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.