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# January 26th, 2009 Newsletter - Investment Philosophy

Good companies have two major characteristics: (i) they earn high returns on capital and (ii) those returns are defensible over long periods of time
To illustrate why returns on invested capital are important, let me provide a simplified example. Two aspiring bakers, Susie and Alice, have approached you about opening separate bakeries in the same town. It will cost \$100k to open each bakery. Being a good sport, you invest all the capital necessary to start both. After the first year, Susie has generated \$20k of cash flow from her bakery and Alice has generated \$10k of cash flow from hers. In other words, Susie has generated a 20% return on your capital and Alice has generated a 10% return. Now, Susie takes the \$20k generated an opens a smaller branch in a neighboring town that generates another 20% return or an additional \$4k per year. Now, Susie is generating you the \$20k from the original bakery plus \$4k from the new branch, totaling \$24k per year or 24% on your original \$100k investment. Assuming Susie keeps investing in new branches and continues to earn these high returns, she will be generating \$103k per year after 10 years or over 100% on your original investment, whereas if Alice follows the same course, but only earns 10% returns, she will only be generating \$24k or 24% in 10 years.

This concept can be extended to public equities by carefully examining a company’s assets employed and its cash flows over long periods of time, and ensuring they earn high returns on that capital (15%+).

However, just knowing that a company historically earned above average returns on invested capital isn’t enough.  You need to know why, and if generated those returns will continue over time. For instance, if Susie’s returns are because everyone loves her personally and nobody likes Alice, then the returns will only be sustainable for as long as you can retain Susie (which will likely become expensive as Susie realizes her value). However, if Susie is successfully branding the bakery as the bakery with the best and most unique cupcakes in town, then maybe her returns are sustainable even after she is gone. Susie’s branding effort is an example of what Warren Buffett calls a “Moat”, as in a moat around a castle that protects it from invaders. A Company’s moat helps keep competitors, customers, suppliers, substitute products, new entrants, and/or inflation from reducing the Company’s returns on invested capital. As I present my ideas to you, I will point out what moat I believe each company has, the threats to its moat, and why I feel the Company will be able to maintain their historical returns on capital.

Investing with Management Teams Who Allocate Capital Wisely

Good businesses are relatively easy to manage from a day-to-day/operational perspective, however they require managers with a rare trait - wise capital allocation discipline. In the bakery example above, Alice should send all the cash flows generated from her business back to you (the Company’s owner), so that you can send that money to Susie and earn 20% returns with Susie, instead of 10% returns with Alice. However, given you will likely own only a small ownership stake in the public companies I recommend, you will not be able to direct management to take such actions. Therefore, the public market investor must assess management’s willingness to make tough decisions, like returning capital to shareholders who can put it to a more profitable use. When evaluating management teams, I analyze how they have made capital allocation decisions in the past, and also whether they have historically taken actions to increase the Company’s moat and its return on invested capital.  Perhaps most importantly, I also assess whether they are incented to do so in the future.

The Business Can Be Bougt at a Cheap Price

Occasionally, good businesses meeting the above criteria trade in the public markets for cheap prices. Perhaps this occurs because the business hasn’t been growing as fast as Wall Street expected, or is being sold as part of the market’s overall downturn. A company’s value can be unrecognized by the stock market for years, but if you invest in a business with the above traits, eventually the market will recognize the value of the business and the stock will rise to reflect that value. I am seeking to buy businesses with pre-tax equity free cash flow yields (pre-tax normalized cash flow to shareholders / market capitalization) of ~14% (Warren Buffett’s target) assuming no growth in earnings. Pre-tax equity free cash flow yields average ~7% for business with the above traits. In other words, buying at a 14% equity free cash flow yield, means that the stock’s price will double as it reaches its appropriate value.

A Few Notes on Portfolio Management

I aim to invest in 10 companies by the end of the year. Continuing to hold each investment will regularly be evaluated against purchasing other potential investments, the tax consequences of selling, and the benefits of diversification. I do not try to time the market or individual equities, as I am a long-term investor who doesn’t pay attention to the fluctuations of the market, but instead to the underlying values of the businesses I invest in. For instance, I am recommending McGraw Hill this month, which announces earnings on January 27th. While the stock price may move dramatically on that day, I don’t know if earnings will beat or miss Wall Street expectations, but I do believe that McGraw Hill is a great company trading at a cheap price, and if held over time will represent an attractive investment. Again, I neither encourage nor discourage you from investing in McGraw Hill today before the earnings announcement, but I will be purchasing it today for my own portfolio, and do not know whether or not after the earnings release you will be able to buy it at a cheaper or more expensive price. However, I do know that I am comfortable with the price I will be paying.