Investment Evaluation

In order to minimize the risk of permanent capital loss, we consider the following main criteria in our investment evaluation process:

Circle of Competence

Stay within our circle of competence

  • Only invest in businesses we can understand and predict.
  • Be disciplined about what we do and do not know.
  • Only compete when we feel we have a competitive advantage.
  • Always examine the psychological factors at work to avoid fooling ourselves.

Business – We are buying businesses, not pieces of paper

Use fundamental analysis to find good businesses

  • Only understandable and predictable businesses will be considered.
  • Insist on a conservative balance sheet and accounting.
  • Look for high returns on capital.
  • Look for businesses with high barriers to entry, i.e. “moats.”
  • Insist upon real owner-earnings – free cash generated after all interest payments, taxes, working capital requirements, and maintenance capital expenditures.
  • Talk to suppliers, competitors, customers, and management.

People – We cannot provide management

Evaluate management

  • Businesses must have trustworthy and capable management in place who think and act like owners.
  • Find management with whom we would want to be partners in a private endeavor.
  • Read management correspondence (shareholder letters, press releases, conference calls, etc.) to make sure management’s focus is on maximizing long-term shareholder returns rather than tangential issues like current stock price, public relations, market share, growing revenues, etc.
  • An important indicator of management integrity is conservative, easily understood accounting; read footnotes and ask questions.
  • Prefer management that invests a substantial portion of its own net worth in the company.

Evaluate management capital allocation

  • Study carefully what management does with marginal free cash flow (dividends, stock buybacks, or expansion) and estimate returns.
  • This is a critical and often overlooked skill; a lot of otherwise competent managers are poor capital allocators.

Price

Conservatively value businesses

  • Insist on a margin of safety by paying less than 60% of a conservative appraisal.
  • Account properly for all real costs including maintenance capital expenditures, interest, stock options, off-balance sheet liabilities, pension funds, etc.
  • Account properly for non-cash charges like depreciation and amortization.
  • Predict owner-earnings into the future.
  • Discount earnings to the present using a rational rate.

In the absence of compelling long-term equity investments, we are opportunistic when the market presents attractive risk/reward scenarios. At all times when making portfolio allocation decisions, we compare our best stock ideas against our best bond, risk arbitrage, and cash alternatives, and we feel very comfortable holding cash and cash equivalents in the absence of other attractive positions. This investment strategy may not be the best way to earn high returns in any given year, but we believe it will earn the highest cumulative returns over a twenty-year time horizon by hopefully avoiding the permanent capital loss endemic to short-term strategies.

Sell Decision Criteria

While we favor holding long-term investments, situations arise where investments must be sold. A sell decision is based on certain criteria, including the following:

  • We will begin to liquidate an investment when it reaches 90% of our appraised value. An investment reaching our appraisal may have further upside potential, but it will no longer offer an appropriate margin of safety for putting capital at risk.
  • We will also sell any investment that has a fundamental negative change in business, management, or return prospects since we invested. Negative developments by themselves do not necessarily trigger the selling of a position, but should a negative event lower our appraisal enough or prevent us from appraising the investment at all, we will sell. Positive events may cause us to adjust our appraisal of value upwards. We appraise our positions on an ongoing basis throughout the life of the investment.