Philosophy & Process

Misty Mountains

Stringent Qualitative and Quantitative Selection Criteria

How do we select the companies whose stocks we want to own? For us to invest, we need to believe we have established some reliable truths about the opportunity through our research, analytical work, and valuation estimate.

We insist our companies meet the four following quality selection criteria, which we call the "F.A.C.T." of the investment case.

Fundamentals of the business
We look for high-quality businesses that have sustainable, superior fundamentals giving them long-term staying power and the capacity to build value over time. These include compelling products or services customers are willing to pay for, high barriers to entry, low threat of substitution, a favorably structured market place, competitive advantages, power over customers as well as suppliers, and ultimately, pricing power. Strong fundamentals may allow these businesses to expand their addressable markets and capture shares. We believe they have the potential to generate industry-leading margins, high levels of cash flows, and attractive returns on capital.
Agency reliability
We look for high quality managers, that is to say shareholder-aligned executives who can run operations well and be good stewards of capital. We expect them to make appropriate investment decisions by comparing the relative returns of various opportunities and, in the absence of attractive options, return capital to shareholders. Frequently these managers are owners themselves, and if not, are compensated as such based on their ability to build value over time.
Capital stability
We look for high quality balance sheets with limited amounts of financial gearing, conservatively managed debt structures, and good cash flow profiles. Well-run, high quality businesses do not need financial leverage. Financial strength enhances their ability to weather temporary disruptions or adverse economic circumstances and puts them in a position to grow stronger during difficult times.
Trading discount
Lastly, we look for high-quality prices, meaning low absolute valuations. We want to invest in a company when its stock trades at a significant discount to its intrinsic value. Buying at a discount protects the investment because we cannot always be right with our assessment of value. Investing in high-quality businesses coupled with a margin of safety, helps manage the potential negative impact of unforeseen factors and allows the passage of time to work in our favor. Lastly, we expect the discount to unwind over time thus allowing us to pursue excess returns.
There is no guarantee that this process will result in profit or protect against loss.

Key Steps and Inputs of the Process

In looking for suitable opportunities, our approach is akin to an R&D process. We need to come up with highly differentiated fundamental ideas, and quickly identify those than can become actual investments. This funnel-like process relies on a few key steps and inputs.

Necessary conditions: We eschew businesses that do not lend themselves to appraisal. We also limit ourselves to countries with established rules of law and political systems that allow for transparent and unbiased enforcement of those laws.

Proprietary research: In analyzing companies, we take a bottom-up, research-driven approach. We dedicate a lot of time traveling to visit companies and meet with management teams. We interview competitors, suppliers, customers, and other relevant third parties. We study how industries can evolve over time and how adept management is at responding to change.

Filings and publications: We also study a long history of annual reports, investor presentations, conference call transcripts, third party research and other relevant publicly available materials.

Financial Analysis: Through this process, we seek to gain an understanding of the fundamentals of the business. We use our research findings to assess a company’s normal economics, and to estimate the present value of its future cash flows. We also study its financial position and how its balance sheet would hold up in challenging conditions.

Phaecian Funnel Graphic