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How We Think

This manager commentary provides insight into our philosophy and the key tenets that have consistently underpinned our investment approach, which have remained unchanged since our founding. These excerpts are not all-encompassing, though they should provide a clear sense of "how we think" and to our application of a value investing philosophy as pioneered by - among others - Ben Graham, Warren Buffett, and Charlie Munger.

Increasing Our Odds

As the new Lindley investment reflects, our mandate (i) is focused on finding attractive investments one-by-one and (ii) affords us the flexibility to invest capital only when we think an investment is truly compelling on an absolute basis. We assess individual investment opportunities based on our estimate of their expected returns and the likelihood that the underlying businesses will perform close to our expectations for them.

A New Investment In Latin America

Based in Lima, Corporación Lindley SA bottles, distributes, and markets soft drinks, fruit juices, water, sports drinks, and concentrate in Peru. The company has the exclusive rights to produce Coca-Cola products in the country, including Inca Kola, which is the top-selling carbonated drink with a 33% market share (Coca-Cola is a strong #2). We have followed the business for some time, and since the fall of 2014 we have visited Peru three times to meet management and to survey execution at the point of sale. This research suggested that execution could be improved and that certain parts of the business needed more investment.

Thoughts on Walmart & Our Trip to South Africa

We have been interested in investment opportunities in Africa for several years. While there are certainly many challenges, the potential to reach a large, young, and growing population should yield some attractive opportunities over time. As a starting point for better understanding consumers in Africa, Richard spent ten days in South Africa meeting with the management teams of several interesting companies as well as visiting a variety of stores. He returned very impressed with management at one company in particular, and we hope that we will get the chance to buy this business or one or two others that Richard visited when appropriate margins of safety are present.

Observations from South America & Western Europe

One of the main reasons to visit a country is to observe firsthand the facts on the ground. Another is to talk to people doing business there who are not primarily reading the English-language media, which means that they often have viewpoints that diverge from ours. Both practices broaden our perspective and give us a worldview that is closer to reality.

The Mystery of the Missing Goods

A number of recent news accounts have highlighted the increasing scarcity of basic foodstuffs and hygienic products in Venezuela . The situation, which will likely be worse by the time you receive this letter, is a direct result of a series of government policies that are having dire consequences for the country.

Recency Bias, Global Interest Rates, and Return Expectations

As we demonstrated in our last letter, the rate of return of an asset is inversely related to its price. That is, as the asset’s price goes up, its future rate of return falls. So inevitably, at the very time that recent positive returns trigger a feeling of safety because one’s expectation for future returns is growing, the opposite is actually happening. Risk rises as actual future long-term returns decline. The inverse is true, as well.

Incentive Misalignment in the Money Management Business

The benchmark index is by definition fully invested, so inherent in this incentive structure is also the pressure to be fully invested, particularly in a market that has recently risen. This pressure is greatest at precisely the wrong time. Expensive securities offer low expected returns and a high risk of permanent capital loss, but a manager’s perception of career risk – even if merely subconscious – can cloud his assessment of value and weaken his discipline.

Price Matters

The math of investing is not difficult and can be done with a little division and some basic algebra, but the math is essential. Buying and selling securities without a fluent understanding of how intrinsic value is calculated is mere speculation.

Determining Intrinsic Value

We have written extensively in the past about the centrality of intrinsic value in our investment process. A company’s stock price can sometimes diverge widely from its intrinsic value, which Ben Graham explained thusly, “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

What to Build (or Buy) in Today’s Opportunity Set

Based on the historic real rates of return of 3-4% and adding inflation expectations of 2-3%, long-term nominal rates of returns on assets are adequate in the 5-7% range. Historically, we have used those assumptions as a base and then insisted on a margin of safety by buying assets at a substantial discount to their intrinsic values. Our goal with this approach is to earn positive returns even when we make mistakes and achieve outsized returns (i.e. above 5-7%) when we are correct. An investment with a prospective return in the 10-14% range has been our minimum satisfactory expectation (i.e. a hurdle rate) before we will put capital at risk.

The Virtue of Inactivity

We have heard many variants on this theme from Munger and others over the years, and yet it remains one of the least appreciated aspects of investing. Really great investment opportunities are rare, and our job is to recognize them when they occur and to avoid putting capital in harm’s way in their absence.

Focus On The Customer’s Decision

Because the size and duration of cash flows are ultimately a function of a company’s competitive advantages our core emphasis as investors is on correctly assessing the sustainability of these advantages. We believe a critical aspect of this analysis is to understand why a company’s customer makes the decision he does, and whether he is likely to repeat that decision.

Research Trips in Eastern Europe, Greece & Turkey

We have been fortunate to cover a lot of ground in the last four months. We took trips to England in March and in May, spent three weeks driving through Central and Eastern Europe in late May and early June, and recently returned from a multi-week trip to Greece and Turkey during the first half of July...

The Mind of a Value Investor

The human condition is such that investors are rarely deficient in arrogance, but humility in decision making tends to be in short supply. We are relentlessly trying to impose a system of checks in an effort to resist this negative natural propensity, including constantly challenging the assumptions key to every current and potential holding...

Wal-Mart De Mexico Postmortem

We have seldom seen a company with competitive advantages as big as those Walmex enjoys – larger than even the advantages Wal-Mart (US) had over its domestic competitors in 1990. The combination of exceptional operations, the accumulated knowledge of best practices, a deeper management team, and superior access to capital makes Walmex truly an extraordinary business and, to us, perhaps the finest large company in the world. Nonetheless, at the current price we no longer feel that the company trades at an adequate discount to our appraisal of its intrinsic value, which regrettably leads us to sell the business.

Einstein, CERN and the Limitations of Models

Ultimately, our models are necessarily inadequate at describing reality, so we spend time thinking through their limitations to avoid mistakes. We continuously contemplate and discuss how the individual businesses that constitute the Fund’s portfolio are positioned for the unexpected. Following Einstein’s example, we hypothesize what would alter our expectations for a business, and we recognize that our valuations are just theories, not certainties.

Overpriced Markets

We do not think it is unreasonable to expect the Fund to underperform in runaway markets and make up for that underperformance in other types of markets. An overpriced market is a substantial risk to a long-term investor, as deploying capital at high price-to-value ensures mediocre long-term performance...

Arca: Dissecting an Investment

As a way of further elucidating our investment approach, we wanted to illustrate the research and investment process for one of our major holdings, Embotelladoras Arca, S.A.B. de C.V...

Commitment Bias

Any honest post-mortem of the investment decisions we have made at Cook & Bynum over the past nearly ten years will reveal plenty of mistakes. We have made mistakes because we lacked perfect information. We have made mistakes because we improperly processed the information we did have...

Avoiding the Loser and the “Too Hard” Pile

Short-term quotational changes in the value of a business do not concern us. We do, however, spend a significant amount of time thinking about how we might suffer permanent capital loss in a holding, as this type of loss is a major obstacle to long-term investment success...

The Importance of Price

One of our four guiding principles of investing is to be disciplined about the price we pay for any security. Our circle of competence includes many businesses that possess attractive durable competitive advantages and that are run by capable management. However, unless the market offers bargain prices, we cannot build in the appropriate margin of safety your capital deserves when deployed.

2009 Post Mortem

When we think about our goals at Cook & Bynum, we are not trying to earn a certain return or accumulate a certain amount of assets. Rather, we are trying simply to execute well a pure, concentrated value investing philosophy on whatever assets we have under management and given whatever opportunities the market presents at that point...

Expanding Our Geographic Circle of Competence

We can magnify our informational and decision-making edge in such places because a large percentage of Western managers and investment banks simply refuse to bother with such places. Many that do invest are not doing the type of on-the-ground work that we think gives us an advantage. The less sophisticated the market participants and the more difficult the research, the greater the likelihood that we can identify good businesses trading at irrationally low prices.

Pricing Power and the Potential Impact of Inflation

The recent shifts in monetary and fiscal policy in many of the world’s largest economies have made it timely to discuss the effects of inflation on intrinsic value. Pricing power is a key factor to predicting how a business will perform in an inflationary environment...

Greedy When Others Are Fearful

The first quarter of 2009 saw continued turmoil and fallout from the bursting of the housing bubble. The broad-based decline of virtually all equity markets around the world continues to present us with attractive buying opportunities...

Making Disciplined Allocation Decisions

We put little stock in our ability to predict when either the economy or the market will turn around, but our lack of leverage and stable of quality businesses give us the liberty to wait. And just as importantly, because we own quality businesses, we expect that the fund will both avoid permanent capital loss and earn an acceptable return when the market begins to recognize the intrinsic value of our holdings. We suspect the returns from holding equity securities in general will be more than satisfactory over the next 20 years from these levels.

“Invert, Always Invert”

The great 19th century mathematician Carl Jacobi was fond of saying that when you encounter a tough problem, “Invert, always invert.” This principle has applications in many fields, not the least of which is investing. The purpose of investing is to make money. Using Jacobi’s principle we ask the question, “How do we not lose money?”

The Danger of Leverage

As value investors, we make the assumption that the market is irrationally pricing a security now, and we expect the market to value the same security more rationally in the future...

What Does a “Moat” Look Like?

We often talk about a “moat” around a business. A moat is a sustainable competitive advantage that allows a business to earn outsized returns on capital over time and allows us to better predict the future prospects of a business. We could not buy businesses with conviction without a moat.

The Psychology of Errors

An important differentiator between our selection process and the processes of the value managers we respect is the time and effort we spend on analyzing how psychological factors affect decision making. A number of different factors cause people to systematically make mistakes in judgement...

Geometric Means, Kelly Criterion, etc.

We continuously have in-depth discussions surrounding the purchase or sale of a given security, but there exists another equally important problem for the investor – how to allocate capital between competing qualifying ideas. It is not good enough to simply say, “This is an undervalued business with a high margin of safety..."

“Real” Risk

We are often asked to discuss our investment philosophy as it relates to our expected long-term returns. Many people making investment decisions today at very large, sophisticated institutions believe that an investment is less risky if it has a smooth progression of returns month after month and year after year...

When “Mr. Market” Frets, Opportunity Knocks

Diligence when adding new capital is imperative to ensure that existing partners are not diluted out of sizable positions in businesses that we currently own. We have been quite fortunate to acquire new positions and to add to most of our previously-held positions during periods of growth...

Margin of Safety

We are actively looking for more investments that meet our qualitative criteria of good businesses with a sustainable competitive advantage and with talented, honest management. If these qualitative criteria were our only concern, we would have dozens of qualifying investment ideas. However, price is essential to our process.