Our investment philosophy is to purchase stocks in the same way that a knowledgeable buyer would evaluate a business for acquisition in its entirety.  The business should be simple to understand, utilize conservative accounting methods, and should be led by individuals whose interests are aligned with shareholders, are ethical and competent leaders, and are able to articulate a sound growth strategy and value proposition.

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After a company passes our rigorous quantitative screens, we will conduct thorough due diligence process, which focuses on four core evaluations that we believe are critical drivers of long term stock out-performance.  These are:  competitive positioning, earnings quality, management integrity, and valuation or "margin of safety"

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Step 1.  Evaluation: Competitive Positioning

•We look for companies that have built competitive advantages that are difficult to replicate and who possess bargaining power relative customers and suppliers, have the ability to control pricing of their products or services, which, over the long run allows them to higher returns on their invested capital. 

•We also place considerable emphasis on business risks such as the threat of new entrants, the risk of substitute products or services, and the breadth or concentration of its customer base. earn higher returns on invested capital.  

Competitive Advantages

•Patents & Intellectual Property (Microsoft, Pfizer)

•Network “Multiplier” Effect (eBay, Cisco)

•Economies of Scale – Low cost producers (Honda/Toyota)

•Distribution Network (PepsiCo)

•High “startup” costs – Limiting entrants

Competitive Risks

•Concentrated customer base (auto-part suppliers)

•Concentration of supplier base (Intel/AMD)

•Threat of new entrants

•Substitutes (music industry)

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Step 2.  Evaluation: Earnings Quality

•We also place particular emphasis on earnings quality, evaluating not just a company’s margin trends, but its ability grow revenues faster than it must reinvest or acquire new assets, such as property, plant, equipment. 

•We demand that each company we own generates free cash flow and is able to support the growth of its business internally, rather than having to seek dilutive financing through the capital markets.  Additionally, we have found that historically, deteriorating cash flow trends coinciding with strong earnings trends, often signals either operational challenges (i.e. bloated inventories of products that can't be sold, or sharp increases in accounts receivable that allows customers to make purchases on credit as a way to drive sales growth) or even, more scrupulously, accounting manipulation.  We avoid these "earnings torpedo's" by analyzing both earnings and free cash flow trends.

•Our best ideas are typically those stocks that are growing free cash flows at faster rate than reported income, as we have found this fundamental characteristic is highly correlated with market outperformance. 

 

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Step 3.  Evaluation: Margin of Safety

Most importantly ,however is the margin of safety that we require for purchasing stocks.  We are value investors,  which means that we invest in companies that we believe trade at a substantial discount to what we consider to be their true business, or intrinsic value. We are patient investors, not market timers. We believe that, over time, the price of a stock will rise to reflect the value of the underlying company.

Valuation Points:  Value vs. Momentum?  While some proponents of momentum investing will disagree, we believe that the historic performance of value investing provides conclusive evidence that, all else equal, buying stocks during periods of low valuations and selling at peak valuations will generate superior results over the long term.   Valuation Points:  Our Methodology

Demand 25% discount to intrinsic value Discounted Cash Flow & Scenario Sensitivity: Using conservative assumptions, what is the businesses "intrinsic" value Private Market Value - Comparable  M&A Transactions:  What are industry "players" and private equity companies willing to pay for a similar company? Sum of the Parts & Asset Plays:  Are the assets, including cash, equipment, land worth more than the value of the stock? Multiple Analysis: See Below

Importantly, we spend considerable time understanding the appropriate valuation metrics that drive value in a particular industry.  For example,  looking at price to earnings estimates for an industrial company with enormous levels of depreciation, or a financial company whose earnings may be highly impacted  by market volatility, may be inappropriate gauges of the companies true worth.

 

Valuation Points:  Industry Specific Metrics

Industrials	Financials	Technology	Health/Consumer	Energy/Materials	Telecom/Util.	Hotels/REITS
Price to Cash Flow EV/EBITDA	Price/Book "Tier 1 Ratio"	Price/Growth Price/Sales	Price/Earnings Price/Cash Flow	Price/Reserves Price/Cash Flow	Price/Subscriber EV/EBITDA	Price/Room Comparable Sales