A: It is a bottom-up process where our assessment is driven by the competitive advantage and the 10-year outlook. We don’t try to come up with the next quarter’s estimate because everyone on Wall Street is doing that and their estimate’s just as good as ours. So we’re trying to assess the next 10 years and to not be distracted by the noise for the current quarter.

In the old days this business was driven by getting better information sooner than the rest of the Street. Investors would spend a lot of time trying to uncover some tidbit of information that no one else knew. But those days are gone and we don’t even structure our research process to gain an information advantage. Rather, it’s about seeking judgment advantage.

Today you win the investment game by making better judgments on the data that’s available to everyone. We believe that the 10-year outlook provides an advantage over the short-term outlook of most investors. Also, we are very thoughtful and we don’t make too many decisions. With 40 stocks on average and turnover of 25%, there are only 8 new stock ideas we can put to work in our portfolio every year, which is a manageable number. For comparison, many fund managers have to come up with 100 new ideas per year and don’t have the time to analyze the situation completely. Our approach enables us to be more thorough in our research and gives us the confidence to take bigger position sizes.

Q:  Could you give us some examples of stock picks that illustrate your process?

A: Corinthian Colleges is our most recent purchase and is a good example of what we look for. It is the third largest player in the for-profit segment of the post-secondary education market. The company has a very capital efficient business model. In fact, it has the rare advantage of negative working capital because tuitions are paid in advance. That means that the company is not constrained when it grows the business. The second point is that there are barriers to entry. It takes years to get accreditation and to qualify for government-backed student loans, which are very important in this business. This particular company also has a pristine balance sheet with more cash than debt. The business has a history of strong profitability and because of this combination, we like the business model for the long-term.

Currently the stock is cheap because there is a cloud of uncertainty hanging over it. The entire industry got a bit anxious to grow, including Corinthian. They over-expanded and built too many schools. At the same time, some of these companies lost their focus and got into regulatory trouble on a few issues. As a result of the negative publicity, enrollments slowed down right when new capacity was coming online. So the earnings got hurt and Corinthian’s operating margins tumbled down from more than 20% to about 6%.

But we’re buying the stock because our analysis suggests that they have turned the corner operationally. They have rationalized some of their capacity and their marketing costs have started to decrease. This is a good enough business and we have a high degree of confidence that if the problems are solved, the future of the company is bright. It has a debt-free balance sheet and solid cash flow, so we get paid while we wait.

Q:  What are the risk management techniques that you use?

A: First and foremost we insist on quality because if you’re only buying quality businesses, you’ve already gone a long way in managing your risk. We also manage risk by constantly reviewing the companies in the portfolio. It is a dynamic world and things do change. Once we have analyzed a company and made a 10-year forecast, we don’t want to forget about it for 10 years because sometimes forecasts are wrong, and sometimes businesses and environments change. So we re-evaluate and review every thesis quarterly.

We also have some risk control measures that we implement in the portfolio construction stage. We limit the position sizes in the portfolio to 5%. Our industry exposure is limited to 20%, while our sector exposure can be no more than one-third of the portfolio. That’s how we manage risk and we make sure that we are well diversified.

Another thing that differentiates us from other fund managers is the experience in managing money. The company has been doing this for 57 years and there aren’t many companies in this industry that have been around that long. The longevity by itself says something about our process because an approach that doesn’t work wouldn’t survive for more than 50 years.