Q: Would you describe your investment philosophy?

A : I don't place much emphasis on forecasting the direction of the stock market or the economy, because shortterm market gyrations do not affect the long-term prospect of an investment. At the core of my thought process is the belief that a stock is not a piece of paper to be traded but rather represents partial ownership in a business. I believe that there is a strong correlation between the growth of a company’s earnings and the appreciation of a company’s stock price over the long haul. I therefore look for specific business fundamentals that I believe result in aboveaverage profit growth. If we can find companies with better fundamentals than the average company, we can find companies that have the potential to outperform the market. Then it’s a question of price. Discipline and patience are important elements of our investment strategy.

I mentioned that we look for companies with strong fundamental characteristics. By this I mean companies that have high rates of return on equity and capital, strong free cash flow, above-average profit margins and dominant market share. We also focus on businesses that have rock solid franchises…those that have a competitive advantage and the flexibility to adjust to changing competitive conditions. Furthermore, we prefer companies that have predictable and sustainable growth prospects. You won’t find traditionally cyclical companies in our managed portfolios.

Q:  When managing money, are you looking primarily for growth, value, or preservation of capital?

A : Preservation and growth of capital are equally important. Our clients already tend to be wealthy and are not interested in winning the lottery. Rather, they want to grow their wealth over time at predictable and above-average rates, and they want to accomplish this with low volatility. That’s Tsai Capital’s focus.

One way we can reduce downside risk is by making an investment when we believe it represents value. I think we are disciplined. Valuation is very important to us. And I am not just referring to P/E ratios. They can be misleading. Microsoft and Wal-Mart had very high P/Es when they went public, but they clearly represented value. We focus more so on the future cash flows of a business. If there is a company we would like to own but the price is just not right, we will put it on our radar screen and wait for an appropriate entry point.

But to answer your question, we are looking for growth, value and preservation of capital. I don’t think there is a style box for that, but rating agencies place us in the large-cap growth category because our portfolio companies tend to have above-average growth rates and P/E ratios and our weighted average market capitalization is north of $60 billion.

Q:  How important is your benchmark in terms of diversification and portfolio construction?

A : The Russell 1000 Growth Index and the S&P 500 Index are the most appropriate benchmarks for our portfolios. I think benchmarks are important because they help one to judge results in all sorts of ways. But we don’t create portfolios around benchmarks. We buy what we think makes sense. Our goal is to create a portfolio of no more than 20 of our best ideas…20 high quality and undervalued growth stocks. We also want to control the risk or volatility of the portfolios. Today, the Tsai US Large Cap Equity Growth composite of separately managed accounts is about 60% less volatile than the S&P 500 Index.

Q:  Historically, most people have relied on Wall Street’s quarterly earnings estimates. How important are those numbers to you?

A : First of all, we rely on internal research to make our purchase and sale decisions. What a company reports in relation to our internal forecasts is relevant. What a company reports in relation to Wall Street’s estimate is relevant to us only to the extent that it results in an opportunity in the marketplace. Secondly, we don't place as much emphasis on one particular quarter as on the results of a company's operations for a year. Management, for example, has a lot of latitude with respect to their depreciation estimate, which can get revised throughout the year.

Q:  What are the key factors in making your earnings estimate and in understanding the capacity, volatility or predictability of the earnings?

A : I focus on companies and industries I believe I understand well. Tsai Capital is generally not involved in companies that have rapidly changing operations where it is difficult to predict the future. For example, there is not much technology in the portfolio because technology tends to change too quickly and that leads to unpredictability. We are looking for consistency and accuracy in our estimates.

It is also important to break down the business into its component parts. Looking at retail companies, for example, we want to understand how well each store is doing, the unit economics, returns per square foot, etc. In doing so, we believe that it is more instructive to speak with the competitors of a company than to the company itself.

Q:  How do you narrow down the potential investment candidates for the portfolio?

A : The universe that I start with consists of about 2000 companies. After applying various screening criteria, that list is narrowed down to no more than 50 to 75 companies. For example, we look for strong historical revenue and earnings growth because they can help to demonstrate the consistency, or lack thereof, of a company’s operations and the skill of a management team. We also seek out companies that can produce at least 10% earnings growth per year, above inflation, and businesses that have high return on equity and invested capital and little debt.

After the initial screening is completed, potential investment candidates get eliminated for other reasons. For example, housing stocks have performed very well over the past decade. Many have high return on equity and capital, strong top and bottom line growth rates and solid balance sheets. On the surface, these companies would appear to be investment candidates for the Tsai US Large Cap Equity Growth portfolio, but these are cyclical businesses and exactly the types of companies that we wouldn't want to own.

Additionally, we favor companies that have grown internally rather than through acquisition, companies that have small amounts of intangible assets and companies that do not have large amounts of one-time charges that often distort the true earning power of a business.

Q:  What sectors of the market do you find interesting today?

A : One area that I consider very interesting is the healthcare industry. America is getting older. By 2030, 20% of the population will be over the age of 65, compared with just 13% today. Pharmaceutical companies appear to be logical beneficiaries of an ageing population, but looming patent expirations and FDA concerns make investing in pharmaceutical stocks more difficult than immediately apparent. One way to profit from the aging of the American population, I think, is to invest in a company like Walgreens, which is the largest retail drug store chain. If drug XYZ looses its patent or is pulled from the marketplace, consumers will purchase a competing drug to treat the illness. Walgreens makes the sale anyway. This will be a growth story for a long time.