So we cannot predict the timing of the inflection point, but when the market valuations don’t make sense, we are very confident that the inflection will occur. We have learned over the past couple of decades that market participants often follow emotions and overpay for currently rapid earnings growth. Inevitably, the environment changes, and when the change occurs, it is usually rapid and back into our favor.

For example, a lot of U.S. money right now is invested in the direction of the booming Chinese and Indian markets. Those economies are clearly doing well and that’s the major reason for the investments. Investments are made not because the companies are cheap, well positioned and undervalued, but because the market is booming and they feel that they must participate. As the market inevitably has cyclical downturns, the same investors pull the money out just as quickly, like in the Asian Tigers crisis in 1990s. They can’t stand the losses because they become cautious about their retirement.

Q:  How do you generate ideas?

A: Similarly to most investors, we watch the markets, follow the newspapers and the data services, and attend research conferences. But reading and watching the markets is our primary source of ideas. We also check the 52-week low screens not because we are looking for deep value, but because we would investigate further the high-quality stories that trade at a 52-week low. We like looking at fallen angels although, just because a stock goes down, it doesn’t mean it’s going to go back up. But it definitely can.

Q:  Would you highlight your research process?

A: We look for companies that generate consistently high returns on equity in good and bad times, and for companies with solid credit ratings and balance sheets. That approach tends to exclude most of the utilities, metal companies and mining companies. We don’t invest in the airlines, for example, because of the high capital intensity, the competitiveness, and the power of the unions.

Many highly-cyclical companies, like various coal and steel producers, were bankrupt 10 years ago. They are doing extremely well now because of the high price of commodities. We are not forecasters of commodity prices, however, we strongly believe in microeconomics. So we are confident that in a commodity industry, price will trend toward marginal cost. Unfortunately, for most commodities, the marginal cost is much lower than the current prices. We would rather stay out of these industries as, by definition, economic profit over a cycle should be close to zero.

So our first requirement for a company is being in the right industry. The valuation screens and the fundamental due diligence come second. Above all, we have to be convinced that the industry has sustainable trends and improving fundamentals. Then we identify the most attractive companies in that industry to research. In other words, we are looking for the leaders.

The next step in our research process is examining the quality and the consistency of the earnings. We look at the margins, if they are stable, growing, or over-earning. If the margins are depressed, is there a catalyst to accelerate them? Is the revenue growth steady? Are the earnings at least stable or, preferably, growing and about to accelerate?

We review the company financials thoroughly and once the companies pass the fundamental test, we move on to valuation. We look for companies trading significantly below their long-term average or where we think they’re worth. eBay traded at 5,000 times earnings in 1999; clearly we don’t expect that it will ever go back to that type of multiple.

Q:  Do you consider their competitive advantages in global perspective?

A: Yes, and Coca-Cola is a great example of that. It hasn’t done well lately in the U.S, but it has a 50% share of the worldwide soda market. We can argue whether soda is growing or not, but Coca-Cola is increasing its non-carbonated water business worldwide, either through acquisitions or through internal R&D.

The major power of Coca-Cola is its distribution network and the global brand name. You can get a cold Coca Cola even in a grass hut in Costa Rica. It is a remarkably powerful brand all over the world, including the big market of China, where the volumes are growing by over 20% a year. The stock market isn’t giving Coke much credit for that business as it is totally focused on the execution issues in the US, while we see Coke as expanding its lead or at least remaining strong. We also own Pepsi, and the two companies combined are very strong worldwide and I don’t see any signs of that leadership eroding.