Q: What is your investment philosophy?

A: We look for those rare durable growth businesses with a wide economic moat, or sustainable competitive advantage, and abundant opportunities to grow and reinvest capital at high rates of return. However, and just as importantly, we will only buy a business when we feel we are getting it at a reasonable discount to its true worth. I guess you could call us value-based growth managers. For us, growth and value are inseparable. Identifying those stocks with valuations representing a good margin of safety is just as important as identifying a business that can grow shareholder value well into the future.

Q: What do you think drives the stock prices over the long term?

A: In our minds, it’s the growth of shareholder value, not just earnings per share, that drives stock prices over the longterm. This definition of growth is different from most managers that just focus on earnings or revenue growth. A company creates value by generating a return on capital that is greater than its cost of capital. Over the long term that spread is what determines the value of a business, and ultimately, its stock price.

Just looking at EPS, in our opinion, misses half the story. How much capital is required to generate that earnings growth is just as important. Looking at the world with this more complete picture broadens our universe and gives us a truer perspective on the real durable growth franchises that are out there. Plus, we often uncover a lot of unique growth businesses that many growth managers would overlook.

Q: Who are the typical clients of your strategy?

A: We have a combination of high net worth individuals and institutions. Given our historically low turnover, the portfolio tends to be fairly tax-efficient, which is important to many clients.

Q: Do you have a minimum required investment?

A: We generally require at least $1 million for our separately managed accounts, though we sometimes lower this by special exception and through the sub-advisory platforms we are part of.

Q: Could you highlight your investment process?

A: We put each company through the same process, regardless of the business model or what sector it is in. Every time we look at a company, we ask a series of questions. What is the moat around this business? What are the future cash flows? How much are we willing to pay today for those cash flows? How are we different from the consensus? What is the downside if we are wrong about the future? How does this stock fit into the overall portfolio? If we are right on our projections a majority of the time, we will be providing a valuable service to clients.

There are basically four criteria for every stock that goes into our portfolio. First, it needs to be able to grow shareholder value over the long-term. As we discussed, that doesn’t mean it must grow EPS at some minimum rate, but rather it must expand profits relative to invested capital over time.

Second, we will only invest in businesses with wide-moats, or some protection around their franchise that should allow them to generate excess economic returns well into the future. This moat can take many forms, but it’s usually something structurally that gives the company a permanent cost advantage, requires a significant lock-in for customers, or represents some intellectual property that keeps the competition at bay.

Third, we will only invest in management teams that have proven to be good capital allocators. Many management teams are just focused on growing revenue or earnings at the cost of eroding returns on capital. We do extensive work in adjusting accounting statements to reflect economic reality. Ultimately, the historihistorical numbers don’t lie and are an excellent report card to see if management really does what they say they do.

These first three criteria whittle our universe down to 150 or so companies. These are those truly rare business models in which we have a high level of confidence that in five years or more they will still be generating excellent returns on capital. The next step in our process is to figure out what these businesses are worth. To do that, we employ various valuation metrics, with discounted cash flow metrics being the most important.

We run a lot of different scenarios and apply probabilities to those to come up with a probability-weighted value. We aren’t naïve to think we are going to know exactly what the future holds, so we look at various scenarios, both bullish and bearish, and determine what the likely upside and downside is. We want to stack the odds in our favor and maximize our payout while minimizing our potential losses.

Q: How is your research process organized?

A: Our research team is made up of seven people, each of whom has some industry specialization. We think that the cumulative knowledge built up by covering an industry for years, understanding the management teams, business models, and product cycles is a very important competitive advantage for us. Most of us have been covering our industries for a decade or more. We can use that deep fundamental understanding when the market is panicking about an issue we don’t consider to be that important to the long-term growth of the business.

Given the strict criteria we talked about, we are only looking for each team member to identify two or three really fat pitch ideas a year. Our objective is not to find just any stock that can go up over the next 3, 6 or 12 months. It is to uncover those rare durable growth franchises, figure out what they are worth, and then just wait, years in some cases, until we get a chance to buy the stock on sale.

Q: Can you give us some historical examples of this process in motion?