Our approach to selecting investment ideas is to seek high quality businesses, run by high quality people, at prices that offer an attractive return on investment. We discuss our thoughts on each of these components below. We also discuss how we think about our holdings as a group, how we think about risk, and what we and our clients should expect of each other.
Business Quality
We define the quality of a business by the value that is delivered to the customer, by the cash returns it generates on the capital invested, and by the characteristics that are in place to ensure that good value and high cash returns will continue to be delivered into the future. Our goal is to understand how the business really works and how it really makes money. This means understanding (1) the business model, (2) the durability of the business, (3) the financial strength of the company, (4) the capital allocation opportunities available to it, and (5) the characteristics of the industry in which it operates. We seek companies that deliver value to customers that is unique, and that can continue to do so. High quality businesses increase the likelihood of success and are more likely to avoid or survive adversity.
To understand the business model, we must understand pricing, cost structure and capital needs. These determine the returns that are possible, the cash requirements of the business, the opportunities for growth, and the amount of value that is added for customers or suppliers. We look carefully at the business’ competitive advantages, such as low cost operations, scale, reputation, company culture, special expertise and customer lock-in. Competitive advantages vary and are often subtle, which makes this our favorite investment topic. The durability of the business is the likelihood that its advantages will continue in the future: what keeps customers coming to the company, what keeps them from providing the service for themselves, what keeps suppliers from moving into the business, and what keeps rivals from replicating it. The financial strength of a company can be seen and evaluated by the existence and recurring nature of its free cash flow, its debt levels relative to its assets and cash flow, the maturity schedule of its debt and other sources of liquidity such as cash on hand. We examine past and planned capital allocation. We are looking to own companies that generate more cash than they consume, and to hold them for long periods, so understanding how that cash will be allocated is crucial. A changing capital allocation policy is usually a signal of something significant at a company, such as a change in the competitive landscape, the beginning or end of a period of internal investment or a management team that may be bored or seeking public recognition. Knowing that a company generates high levels of cash flow is not enough: we must also be confident management will use that cash flow in ways that will contribute to our long term return. Finally, the ideal company operates among weak competitors in an industry that is large, growing, and fragmented.
People
When evaluating the people involved, we are looking for people we would be proud to consider our business partners. We want managers of both high integrity and demonstrated ability. We believe this factor is often neglected by professional investment managers because it sharply reduces the range of eligible investments, and because the analysis is difficult: character can not be directly seen, but must be inferred from conduct.
There are a number of flags we look for that suggest the character of management and how they think about shareholders, the ultimate owners of the business. Executive compensation shows very clearly how the management team values its worth to the business, in absolute terms and relative to the profits of the company. Compensation should be tied to important performance measures like cash flow and returns on capital. Abuses like excessive issuance, lack of performance-indexing and re-pricing of stock options are red flags to us. We look for evidence of a corporate culture that has developed strong, shared values about the business and is cost-conscious. We like to see bench strength and promotion from within, widespread employee stock ownership (not options), a history of avoiding the faddish behaviors that periodically sweep through public companies (tracking stocks and REIT conversions, improbable business ventures, consultant or financial engineering cultures), demonstrated business and industry smarts, and intense awareness of the sources of the company’s competitive advantages and what is necessary to maintain them. Management’s character can be seen in “promotional” behavior and statements, private life behavior, transparency and clarity of disclosure, annual reports that inform rather than market, choices of accounting methods, whether and how management interfaces with Wall Street, how they respond to questions, the degree to which management is visibly concerned about the stock price as opposed to the nuts and bolts of their business, what their decisions in the past say about their priorities, management passion for the business, board composition and the identity and character of significant shareholders. Capital allocation is also a key element of the evaluation of management. It serves as evidence of their past investment decisions and as a guidepost to their future plans for the business. Have they successfully allocated capital in the past (expanding high or low return business, acquisitions, organic growth, buybacks, office buildings, etc.); what are their expressed plans for capital budgeting, and do they make sense; is capital allocation a “front and center” topic (driving large decisions and prominent in shareholder communications), or is it ignored?
We use a variety of methods in our evaluation such as direct meetings with management, investment conference interactions, networking, earnings releases and calls, trade journals, interviews, third parties, presentations, and public filings and reports. At the end of the day, we are looking for people who think and act like small private business owners, and who treat shareholders as partners. Identifying such people gives us the best assurance that good results will be fairly shared with owners, adds a significant measure of downside protection in the event of business adversity, and is a material part of the satisfaction we derive professionally from our work.
Price
Our goal is to understand the value, or potential value, of a company. Once we have found a good business run by good people, we must be careful to pay a price no higher than that which will give us a very good, long term, compounding rate of return. While we don’t attempt to predict a return for the portfolio as a whole, and individual investments will have widely varying results, we will be disciplined about the price we pay. We think in terms of a five year investment horizon, and seek to make new investments in companies that our analysis indicates will provide at least a 15% compounded return.
To determine value, we may take an asset valuation approach and/or use discounted cash flow analysis of the free cash flows of the business. We will look at valuation under a range of different scenarios and outcomes, attempting to be intellectually honest in our assumptions. We will look at comparables, but with caution, as what others have paid may or may not be what a business is worth to us. We are leery of simple, ‘one size fits all’ and ‘rules of thumb’ approaches to valuation, such as low p/e or p/e to growth ratios.
As part of our analysis, we try to understand why a company might be available at a bargain price. This can result from a variety of causes: great companies that disappoint lofty expectations, cloudy near-term outlooks, large, one time problems (such as specific litigation) and others. Attractive prices are often accompanied by poor current results and/or negative press. We view the market as a smart but imperfect mechanism, prone to occasional mispricing that presents opportunities for us to evaluate.
Portfolio Construction and Risk
We believe in owning a concentrated portfolio. We prefer concentration because it means our capital is invested in companies we have been able to evaluate more thoroughly. We will be diversified enough that a small number of mistakes will not wipe out our capital, but not so much that the performance of our best ideas is watered down. Diversification is not insurance against bad results, it is an attempt to trade-off the upside against the downside by accepting average results, whatever the average may turn out to be.
We typically own 10-20 companies when fully invested, with position sizes that average approximately 5 to 7.5% at purchase. However, at any given time, position sizes may vary widely depending on the quality of a given company, the business risks it confronts, whether we are in the process of buying or selling it, and its performance and resulting appreciation or depreciation.
At any given time, our cash levels are the byproduct of our other investment decisions, which we make one investment at a time. We do not manage to a particular cash level or net investment position, and do not adhere to a full investment mandate. We recognize that cash can not earn the kind of returns available to equities, and are anxious to find good investment ideas, but we will not commit your (and our) capital to investments simply to reduce the amount of cash we have on hand.
While we think about owning our investments in terms of years, the amount of time we will hold any given investment will vary widely. We will tend to sell: (1) when a great business becomes significantly overvalued, or an average business approaches full valuation; (2) when appreciation in price has made a single investment too large a position within the portfolio; (3) when the fundamentals of the business deteriorate; or (4) when we realize we have made a mistake.
While we are primarily focused on finding companies that fit our business, people and price tests, we will occasionally invest in special situations (typically in smaller weights) that do not meet all our criteria, but which present an unusual opportunity. This may include investing in a company’s debt rather than its equity.
In the Partnership (but not in separate accounts) we may short-sell stocks and use leverage (limited to 10% of Partnership net worth, each). This is consistent with our view that from time to time we will find an opportunity to do something intelligent with each of these, but also with our recognition of their inherent risks and our expectation that their use will be limited.
In separate accounts, our goal is to own a similar list of securities in each account, so results should generally be similar. However, the practical reality is that people contribute and withdraw money at different times. As a result of this, and the fact that securities valuations vary at different times, the weights in which we buy securities in different accounts could vary, and therefore performance among different accounts should be expected to vary somewhat. Performance in the separate accounts will also vary from the performance of the Partnership because the Partnership’s charter is a little broader and because its nature as a pooled fund should give it the opportunity to invest in some things that are not practical to buy in separate accounts.
We do not view risk as stock price volatility. To us, risk is the possibility of real, permanent loss of capital. We guard against this in our careful selection of good businesses and high quality people, in the price we pay, and in the amount of capital we commit. Our goal is to understand the range of potential risks and calibrate the size of our investment to reflect this. Where we believe that the range of outcomes includes a small possibility of a significant loss, but the expected outcome is sufficiently favorable, we will take small positions. Similarly, where a great company is at the edge of what we are comfortable paying, we may start with a small position, and hope for an opportunity to buy more at a lower price.
Finally, our investment research and decision making process is joint and collaborative. We concur on the vast majority of decisions. However, we do not agree about every decision. Where we are unable to agree, either of us can independently make a decision to make an investment; but the other acts as a governor on that decision by deciding how much to buy. Similarly, either of us can initiate the sale of a position, but the other can require that at least a small position be retained.
Our Role as Managers
What can you expect from us? Briefly, that we tell you what we are going to do, that we do it, that we report the results promptly and with candor, and that we share your results.
We report to you quarterly. We discuss changes in the portfolio, our thinking about the companies we have bought or sold, and any significant changes in companies we hold. We will be candid about our mistakes, and about the opportunities and risks our companies face.
We are as transparent as practical, and generally disclose all positions. The exceptions are stocks we have shorted, where we only disclose the size of the short position(s), and illiquid stocks we are in the process of buying. Both exceptions are to prevent disclosure from impeding our investment operations, in the first case our efforts to obtain further information and in the second case our efforts to accumulate a position in a hard-to-buy security. Both exceptions should be infrequent and apply to only a small percentage of the portfolio.
We will share your results. We have our entire investable net worths in the Partnership and in related separate accounts we manage. Many family members and close friends are also clients. You can be sure that our attentions are fully engaged, and our interests aligned with yours.
Finally, you should expect the highest fiduciary standard of behavior from us. In our dealings with you, you should expect us to be forthright and fair…not merely technically correct or legally defensible.
Your Role as Clients
It is important to us that, before you hire us (either through the Partnership or through a separate account), you “buy into” our principles, our practice of concentration, our willingness to invest in ‘out of favor’ situations and our time horizon.
All of these factors are likely to cause our results to be more volatile and perhaps significantly different than the markets generally, and we may own companies about which there is negative press regarding their business outlook. All of these things are going to require that you, as our client and partner, have a certain amount of courage about the convictions that cause you to invest with us. Our investment style is not for everyone.
We can not make investment a painless, upbeat and consistently rewarding process. What we can do is follow a time-tested philosophy, work hard at something we love and invest our money the same way we invest yours.
2020 Coda
We wrote the foregoing “Statement of Investment Philosophy” in 2004. We very much wanted to write something that would stand the passage of time. We’ve never had occasion to change the principles we set out there, and we wouldn’t change them today. In a way, they are our version of a Constitution, or a founding charter. Over many years of practice, our understanding of the principles has deepened, our judgment has been seasoned by successes and mistakes, and our skills have improved with long exercise.
To that end, we use our letters to expand on our philosophy, and how we practice it. All of these are available to you on our website. We encourage investors to read them all, or as many as possible. Given that they now run to hundreds of pages, we highlight a few for specific topics: re-visiting the main elements of this Statement (2Q16), concentration and quality (2Q14, 4Q16), sell discipline (3Q17, 2Q19), absolute and relative performance (2Q10, 2Q13), risk (1Q07, 3Q07, 3Q08, 4Q08), and inflation (1Q08, 1Q11, 3Q11). Future letters will discuss such topics again, and outside of our letters, we are always happy to discuss any aspect of our philosophy – it’s a topic we love, and it’s important to us that clients both understand and buy into it.
We believe deeply in investing our money the same way we invest yours. There can be no greater alignment of interests with our partners. So we want to call out two changes of wording in the Statement above, addressing how we share your results. We no longer disclose the amount we originally invested. And we added the word “virtually” to how much of our “entire investable net worth” is invested in the partnership and separate accounts.
Our goal in that sentence was, and is, to assure you that we eat our own cooking, not to risk one day parsing words with a lawyer. What constitutes one’s entire investable net worth is necessarily subjective, and our policy does not prohibit holding cash, or real or personal property that is owned for reasons that are not primarily investment related. Reasonable exceptions are allowed (for instance, for stocks purchased for children for education purposes, assets received by inheritance, trusts managed for relatives, and so on).
We eat our own cooking, and only our own cooking.