Q:  What is your investment philosophy?

A: We look to invest in superior businesses with a proven track record of superior and sustained earnings with high returns on capital in the industry. Moreover, we expect them to continue in this vein in the future. Our philosophy is that, by investing in companies that earn a high return on capital and reinvesting the cash flow to sustain growth, we will generate superior long-term investment returns.

We are core style investors that look at small and mid-size companies with market capitalization of as low as $500 million up to $10 billion in a universe of 3,000 companies.

Q:  Given this philosophy, what is your investment strategy?

A: Generally speaking, we believe that the historical performance is a good guide to the future and our strategy is to begin by looking at a company’s past track record when we look for evidence of superiority in a business. However, ours is not a blackbox approach where we buy all companies with high returns on investment. We actually analyze the business, the company, and the industry to convince ourselves that the specific company’s past superior performance is likely to continue into the future.

Our strategy is to find and own such companies for an extended period of time that will ensure sustained high returns. We do not want to make money by trading in stocks for short-term gains and miss a large portion of future gains.

Q:  What kind of screens do you employ to get a watch list of potential candidates from your vast universe of companies?

A: The fact that we are only looking for companies with high returns on capital as well as sustained returns in the past five years is in itself our quality test or key screen that gets us to a basic list. After that we do screening based on fundamental analysis to find out whether the businesses will continue to be attractive and whether the returns will be sustainable. Finally, we carry out valuation test to assess how much we are paying for these businesses.

Q:  How is your research process organized?

A: Again, we begin by looking for companies that have had superior returns in the past, and we also look at numbers such as returns and cash flows. We spend our resources and try to understand the business, the company, the industry, what the competitive environment is like and how it may be changing, and we try to be in a position to figure out whether things will continue to be favorable for the company.

Most importantly, we believe that over time the way a company invests its surplus cash is of great significance to the success of the enterprise. We are not interested in paying high multiples. Therefore, we tend to avoid the classic growth stocks even though these companies can reinvest all of their surplus cash flow in the core business, resulting in continuing high returns. These companies will not pass our valuation screen.

Consequently, we may have many companies in the portfolio that earn attractive returns but can take only a portion of the cash flow and reinvest it in their existing businesses leaving them with a lot of surplus cash on hand.

We believe that in the long run, asset allocation has a significant impact on the kind of returns shareholders get. Therefore, we are interested in seeing a track record of intelligent reinvestment of this surplus cash flow. This would typically entail making acquisitions. Again, there are certain criteria they must follow. These acquisitions should make strategic sense and be priced reasonably. Alternatively, the company might wish to give it back to the shareholders. That can obviously come as a share repurchase or dividend.

Finally, there might be a company that cannot find reinvestment opportunities and acquisitions at the moment because things that are relevant to them are overpriced or are simply not for sale, and they’re willing to be patient. They don’t feel the need to go out and do something every week or month or quarter and hence let the cash accumulate.

Q:  When looking at small cap stocks, how important do you think is interaction with management?

A: We’re not opposed to meeting management, as we believe such interaction can definitely benefit us. We believe it is a good way of getting to know and understand the business, as management will clearly be more knowledgeable about it. Moreover, with small companies there may be just two or three key individuals that are important to the running of the business and it therefore makes our task easier to know and assess their capabilities and efficiency if we interact with them. However, in the case of large companies, this exercise is not very useful, like at GE or IBM, where although managers are very important, there are usually too many of them.

Q:  Can you give us a few examples of holdings you have found to have sustainable high capital returns?

A: A company that we’ve owned for about ten years is O’Reilly Automotive, which is in the retail car parts business like Auto Zone and Advance. A fundamental difference between O’Reilly and its competitors is that they have evolved from being only wholesalers where they sold to mechanics, to retailing to do-it-yourself individuals. Currently, their business is about 50% commercial or wholesale and about 50% in the retail, do-it-yourself category. That balance gives them many advantages over the retail chains like Auto Zone or Advance Auto Parts, which have around 10% or 15% of their business in commercial or wholesale segment and the rest in do-it-yourself segment.

The first advantage is that they can operate in smaller markets because of their two sources of business. For instance, in a town of 5,000 people or 10,000 people, it may be the only store, giving the company competitive advantages and also allowing for bigger and better inventory levels. This model has proven to be quite successful for O’Reilly and permitted it to expand stores steadily over time. This is a business that can reinvest all of its cash flow internally, and has done so for many years and we expect that to be the case in the future as well.

Currently, O’Reilly is probably the third or fourth largest chain by stores in the country. It operates in the Midwest and to some extent in the Southeast, but is yet to penetrate the Northeast and the West. Therefore, there are lots of geographic expansion opportunities and it will soon be able to double its business on a store basis.