Aligned Investors Our four cornerstone approach
A long-term, bottom-up, fundamental approach The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective. Warren Buffett We have long admired the investment philosophy of Warren Buffett at Berkshire Hathaway, and one piece of wisdom we have gleaned from Buffett over the years is that boring can be beautiful. There is nothing flashy about our investment approach. We do not waste our time on the fruitless exercise of predicting what the market will do in the next month or year. Our process is simple: we find truly great businesses that are run by talented managers with aligned incentives, and then we remain focused on valuation and reducing risk. It is completely bottom up, one hundred percent fundamental, and implemented with a consistently long-term time horizon. That last point long-term time horizon underlies everything we do. It is the reason we only want businesses of the highest quality with sustainable competitive advantages. Mediocre businesses will occasionally shine, but time is not their friend. It is also why we care so much about management. For a trader it is irrelevant who is in charge of a company, and for someone with a three month holding period it hardly matters more. But for us, scanning the next five years, the decisions management teams make are crucial. This long-term horizon also guides our focus to the intrinsic value of a company. During smaller windows the market is a voting machine and momentum can carry the day, but over time the market functions as a weighing machine and intrinsic value is the ultimate guide. Finally, this horizon shapes our understanding of risk. Typical measures based on price volatility are meaningless to us. As longterm owners, we are not concerned if traders move a company s stock around day to day. We keep our concern on the real risk of permanent capital loss for example, from a poor acquisition, or an impaired business model. 1 Aligned Investors
These areas of focus high quality businesses, owner-operator management, valuation, and risk reduction make up our four cornerstone approach. High-quality businesses with a sustainable competitive advantage Businesses with owner-operator management or culture 1 Our four cornerstone approach 2 4 3 Focused on risk reduction throughout the entire process Valuation discipline builds in a margin of safety Aligned Investors 2
Competitive advantage High-quality businesses with a sustainable competitive advantage Our process starts with identifying a sustainable competitive advantage. There has to be something special, a moat that defends the business from competition. This advantage can come in many forms, depending on the nature of the business and industry. It could be a brand. There could be network effects, or switching costs. There could be scale or cost advantages. The important point is that there must be something we can identify. We do not have interest in businesses with average returns, nor do we have interest in businesses with high returns that cannot be defended. To identify this sustainable competitive advantage, we leverage the framework laid out in Michael Porter s now classic book Competitive Strategy. Porter describes the five forces that contribute to the dynamics of any industry (see image below). We seek companies that are positioned where competition is scarce, substitutes unavailable, barriers to entry high, and that have leverage in their relationships with buyers and suppliers. Porter s Analysis Competitive rivalry Substitutes Power of buyer Number of competitors Relative size of competitors Niche/quality differences Exit barriers Power of buyer Relative price of substitute Relative quality of substitute Switching cost to buyer Barriers to entry Competitive rivalry Power of suppliers Number of buyers Switching costs Brand Price elasticity Barriers to entry Economies of scale Switching costs of buyer Capital requirements Substitutes Power of suppliers Number of suppliers Ability to substitute Cost advantages Distribution advantages Switching costs Size of suppliers 3 Aligned Investors
Owner-operator Businesses with owner-operator management or culture We care a great deal about who is running a company, and we strongly prefer another owner. Every CEO has two basic jobs, managing the day-to-day (operations) and deciding what to do with the profits (capital allocation). On the operating side, owner-operators are passionate leaders, careful about monitoring expenses, and focused on the business s long-term health rather than short-term results. Even more important, however, is the perspective they bring to capital allocation decisions. Most CEOs have short-term pressures and perverse incentives that lead to poor decisions particularly acquisitions and share repurchases at peak prices. Owneroperators do not feel the same pressure to show immediate activity. They are focused on building long-term value. We classify every management team into one of three buckets. Bucket 1 includes true owneroperators, Bucket 2 companies have a culture of such, and Bucket 3 has everyone else. Our portfolios typically have 75% weight in the first two. Bucket 1 Bucket 2 Bucket 3 Owner-operator founder or co-founder; second generation family; meaningful stake Management team with an owner-operator culture; think and act like an owner Cash-paid CEO Aligned Investors 4
Valuation Valuation discipline builds in a margin of safety As owners, we believe a business is worth the present value of the cash it is able to distribute to us over its lifetime. We keep our focus on free cash flow. Using our knowledge of the business, we forecast each company s financial statements to come up with the free cash flows that, when discounted back to today, provide our estimate of intrinsic value. This intrinsic value estimate is then used as a guide. We want to own great businesses run by terrific managers, but we do not want to overpay. Our goal is to buy companies at 70 cents on the dollar, thereby building in a margin of safety. Our turnover is low 20% per year on average and the majority of this buying and selling is to refresh the discount to intrinsic value in the portfolio. Value discipline: Creating a margin of safety 70 cents on the $1 of intrinsic value Margin of safety $1 of intrinsic value 5 Aligned Investors
Risk reduction Focused on risk reduction throughout the entire process When we define risk, we are not talking about daily volatility, or a certain level of beta. We are talking about losing money. We do not care about measurements that serve as inputs to sophisticated academic models. We care about avoiding permanent capital loss. Because of this, reducing risk is a focus throughout the process. We avoid risk by pushing aside all but the highest quality of businesses. We refuse to invest with mediocre management teams that have poor incentives. And we are disciplined about valuation in order to build in a margin of safety. Risk reduction is also its own cornerstone. We are vigilant in monitoring the companies we own. Having turnover as low as ours, the bulk of our return over the next few years will come from the companies we own today, not the ones we will consider. So that is where we spend our time, building cumulative knowledge, understanding the business better, meeting with management teams, and always looking for early warning signals. It could be an uncharacteristic acquisition, or the emergence of a breakthrough competitor, or new technology that changes the whole competitive landscape. When a fundamental weakness is uncovered before it is apparent in the business results and eventually the stock price, we reduce real risk from the portfolio. Lower business risk Owner-operator management Margin of safety Portfolio monitoring Monitoring for early warning signals of fundamental change, such as: Eroding barriers to entry Emergence of new competitor Disruptive technology Regulatory change Questionable allocation of capital Change in accounting methodology Aligned Investors 6
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