Moat - ValueWalk

Value-oriented Equity Investment Ideas for Sophisticated Investors A Monthly Publication of BeyondProxy LLC  Subscribe at manualofideas.com “If our efforts can further the goals of our members by giving them a discernible edge over other market participants, we have succeeded.”

Investing In The Tradition of Graham, Buffett, Klarman Year VI, Volume VII July 2013 When asked how he became so successful, Buffett answered: “We read hundreds and hundreds of annual reports every year.”

Top Ideas In This Report DirecTV (NYSE: DTV) …………………….. 34

Norfolk Southern (NYSE: NSC) ……………………. 66

Oracle (Nasdaq: ORCL) ………………… 70

Also Inside Editorial Commentary ……………… 3 MOI Members on Moats …………… 7 Interview with David Rolfe ……….. 14 20 Wide-Moat Companies ……….. 26 10 Essential Value Screens ……… 106

About The Manual of Ideas Our goal is to bring you investment ideas that are compelling on the basis of value versus price. In our quest for value, we analyze the top holdings of top fund managers. We also use a proprietary methodology to identify stocks that are not widely followed by institutional investors. Our research team has extensive experience in industry and security analysis, equity valuation, and investment management. We bring a “buy side” mindset to the idea generation process, cutting across industries and market capitalization ranges in our search for compelling equity investment opportunities.

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► MOI Members Share Their Insights into Moats ► Exclusive Interview with David Rolfe ► 20 Companies Profiled by The Manual of Ideas Research Team ► Proprietary Selection of Top Three Candidates for Investment ► 10 Essential Screens for Value Investors Companies profiled include Abbott Labs (ABT), Danaher (DHR), DIRECTV (DTV), Express Scripts (ESRX), Hershey (HSY), Intel (INTC), Jack Henry (JKHY), Johnson & Johnson (JNJ), McCormick (MKC), MSCI Inc. (MSCI), Norfolk Southern (NSC), Oracle (ORCL), Pfizer (PFE), Procter & Gamble (PG), Republic Services (RSG), Stratasys (SSYS), Tyco International (TYC), Union Pacific (UNP), Wal-Mart (WMT), and Walt Disney (DIS).

New Exclusive Videos in the MOI Members Area (log in at www.manualofideas.com or email [email protected])  Rupal Bhansali on contrarian investing strategies  Ken Shubin Stein on building a successful process  Ideas: Sealed Air, Haynes International, Berkshire Hathaway

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Copyright Warning: It is a violation of federal copyright law to reproduce all or part of this publication for any purpose without the prior written consent of BeyondProxy LLC. Email [email protected] if you wish to have multiple copies sent to you. © 2008-2013 by BeyondProxy LLC. All rights reserved.

Table of Contents EDITORIAL COMMENTARY ..........................................................................3 MEMBERS SHARE THEIR INSIGHTS INTO MOATS ...................................7 EXCLUSIVE INTERVIEW WITH DAVID ROLFE ......................................... 14 PROFILING 20 WIDE-MOAT INVESTMENT CANDIDATES ...................... 26 ABBOTT LABS (ABT) – GEODE, GMO, MFS, JENNISON, PRIMECAP, SOUTHEASTERN ................ 26 DANAHER (DHR) – T ROWE, MFS, WINSLOW , VIKING, CAP RE, NEUBERGER ............................ 30 DIRECTV (DTV) – AKRE, BAUPOST, BERKSHIRE, LANE FIVE, SOUTHEASTERN, WEITZ................ 34 EXPRESS SCRIPTS (ESRX) – CAP WORLD, DAVIS, GMO, T ROWE, WEDGEWOOD, W EITZ ......... 38 HERSHEY (HSY) – HERSHEY TRUST, CAP WORLD, FMR, JPM, PIONEER, RENTECH ................. 42 INTEL (INTC) – W ELLINGTON, HARRIS, FRANKLIN, GEODE, BLEICHROEDER, WALTER SCOTT...... 46 JACK HENRY (JKHY) – FINDLAY PARK, JPM, KAYNE ANDERSON, ROYCE, TIMESSQUARE .......... 50 JOHNSON & JOHNSON (JNJ) – FAIRFAX, FRANKLIN, MFS, WELLINGTON, WEST COAST ............. 54 MCCORMICK (MKC) – T ROWE, FRANKLIN, PARNASSUS, MS, NEUBERGER, GEODE .................. 58 MSCI (MSCI) – BAMCO, DELAWARE, GSAM, IFP, MSIM, T ROWE, VALUEACT ....................... 62 NORFOLK SOUTHERN (NSC) – CAP RE, CAP WORLD, CITADEL, DFA, GEODE, MS, T ROWE ...... 66 ORACLE (ORCL) – CAP RE, CAP WORLD, MFS, FMR, GMO, HARRIS, EAGLE, T ROWE ............ 70 PFIZER (PFE) – WELLINGTON, T ROWE, FMR, MFS, CAP WORLD, DODGE & COX, GMO .......... 74 PROCTER & GAMBLE (PG) – BERKSHIRE, CAP W ORLD, PERSHING SQUARE, YACKTMAN, GMO . 78 REPUBLIC SERVICES (RSG) – CASCADE, SENTRY, FRANKLIN, SASCO, CAP RE, ARTISAN........... 82 STRATASYS (SSYS) – KORNITZER, PRIMECAP, SAMSON, TIGER TECH, TURNER, WELLS ............ 86 TYCO (TYC) – CITADEL, CLEARBRIDGE, DODGE & COX, IRIDIAN, MFS, THREADNEEDLE ............ 90 UNION PACIFIC (UNP) – CAP W ORLD, CAP RE, T ROWE, WINSLOW , JPM, DFA, PRIMECAP ....... 94 WAL-MART (WMT) – BERKSHIRE, CAP WORLD, EAGLE, FRANKLIN, GMO, MARKEL ................... 98 WALT DISNEY (DIS) – CHILDREN’S, DAVIS, FMR, MARKEL, TIGER GLOBAL, T ROWE ............... 102

10 ESSENTIAL SCREENS FOR VALUE INVESTORS ............................ 106 “MAGIC FORMULA,” BASED ON TRAILING OPERATING INCOME ................................................. 106 “MAGIC FORMULA,” BASED ON THIS YEAR’S EPS ESTIMATES ................................................. 107 “MAGIC FORMULA,” BASED ON NEXT YEAR’S EPS ESTIMATES ................................................ 108 CONTRARIAN: BIGGEST LOSERS OVER PAST 52 WEEKS (DELEVERAGED & PROFITABLE) ........... 109 CONTRARIAN: CHEAP FREE CASH FLOW GUSHERS ................................................................ 110 VALUE WITH CATALYST: CHEAP REPURCHASERS OF STOCK ................................................... 111 PROFITABLE DIVIDEND PAYORS WITH DECENT BALANCE SHEETS............................................ 112 DEEP VALUE: LOTS OF REVENUE, LOW ENTERPRISE VALUE ................................................... 113 DEEP VALUE: NEGLECTED GROSS PROFITEERS .................................................................... 114 ACTIVIST TARGETS: POTENTIAL SALES, LIQUIDATIONS OR RECAPS ......................................... 115

Value-oriented Equity Investment Ideas for Sophisticated Investors

Editorial Commentary

T

he search for great businesses is both harder and easier than the search for cheap but mediocre businesses. It is harder because truly great businesses— those with sustainable competitive advantage—are rare.

Making matters worse, “imposters” abound, as CEOs are naturally inclined to portray their companies as great, and as many businesses manage to earn high returns on growing amounts of capital over multi-year periods. Try Green Mountain Coffee Roasters (GMCR), Lululemon (LULU), or Priceline (PCLN). Each company has had strong operating momentum, rightfully earning the label of “great business” at this time. Unfortunately, the market’s apparent judgment that each of these businesses is sustainably great—as deduced from the stocks’ aggressive market quotations—may prove incorrect. The likely imposters GMCR, LULU and PCLN have managed to “fool” the majority of investors, even as a handful of smart, value-oriented investors may have sold short shares of one or more of the companies. Perhaps GMCR, LULU and PCLN will prove to have been the real deal in terms of the prospective returns for shareholders, but we have our doubts. The search for great businesses may be easier than the search for cheap but mediocre equities, as great businesses tend to stay great for long periods of time. This makes knowledge more highly cumulative than is the case with mediocre businesses, which come and go or are forced to drastically reshape operations due to outside pressures. An investor looking chiefly for statistical bargains is constantly running screens and climbing the research curve on new equities, many of which will look materially different in just a few short years. On the other hand, Buffett-style investors can read about businesses over many years, building up a base of long-term knowledge and context in specific companies. Buffett had likely followed the business and culture of Goldman Sachs (GS) for decades prior to swooping in with an investment during the financial crisis. Similarly, when the call came to consider the acquisition of Heinz, Buffett could draw on decades of accumulated knowledge about the business. The likelihood of missing a major driver of value or a major risk is considerably lower in such a scenario than in the case of an investor who must quickly “get up to speed” on a mediocre business that may be available at a temporarily low price. Many fellow members of The Manual of Ideas who seek to invest in great businesses at reasonable prices have built up watch lists of such businesses, tracking the width of their competitive moats over time. This is not a quantitative process but rather a matter of ongoing judgment. Buffett must have felt the monopolistic pricing power of local newspapers start to erode quite a bit before their financials removed any doubt that major changes were afoot in the media landscape. Similarly, those who have followed cable operators for a long time must be growing ever more concerned about the evolution of their competitive position vis-à-vis Internet-based video. On the other hand, investors who have followed U.S. railroads for a long time probably started seeing major improvement in railway economics quite a bit before the rest of the investment community caught on. As such, an investment process that relies on knowledge accumulation over time can deliver an edge in judgment at key inflection points in the attractiveness of certain companies or industries. Such an edge may be less available to those who focus on screening-based deep value approaches. Inside, we bring you a variety of perspectives on wide-moat investing, including our recent in-depth interview with value investing thought leader David Rolfe, chief investment officer of Wedgewood Partners, a multi-billion dollar investment firm founded in 1988 and based in St. Louis, Missouri. David is also a keynote instructor © 2008-2013 by BeyondProxy LLC. All rights reserved.

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July 2013 – Page 3 of 117


at Wide-Moat Investing Summit 2013 (online at ValueConferences.com). We also bring you other MOI member perspectives on wide-moat investing. Even as a wealth of literature already exists on the topic of investing in great businesses, we hope you’ll uncover some new nuggets of wisdom on the following pages.  Before we delve into this month’s three highlighted ideas, I’d like to review the top selections from last year’s Wide-Moat Issue, published on July 1, 2012. Each of the three ideas went on to perform strongly over the subsequent twelve months, so the question is, why? We were quite simply lucky to some extent, and I’m not sure we would be reviewing the selections had they worked out poorly. So, take this exercise with a grain of salt. Nonetheless, it’s interesting to consider each of the three theses below. If you read them a year ago, what did you think of them? Why did you invest, or why not? (If you are a new member of The Manual of Ideas, perhaps you’ll enjoy considering what you might have done with the following three ideas last July.) A look back: Top three ideas highlighted in The Manual of Ideas on July 1, 2012: Abercrombie & Fitch (NYSE: ANF, $30 per share; MV $2.5 billion) Abercrombie & Fitch enjoys premium brand equity in the teen apparel market, propelling the company’s stores to industry-beating returns. ANF has achieved returns on capital in excess of 30% in “normal” years. This trend continues today outside the U.S., where the company generates EBIT margins in the mid-30s. We believe ANF retains significant growth opportunities internationally, as evidenced by both store growth and same-store-sales growth. While ANF’s large FQ1 share repurchases may have been badly timed, they reflect management’s judgment that the stock is undervalued. Continued repurchases and international expansion should create incremental value on a per-share basis. We view the equity as compelling at the recent price of $30 per share. Goldman Sachs (NYSE: GS, $91 per share; MV $46 billion) Goldman Sachs can legitimately claim to be one of few investment banks whose intrinsic value resides more in the franchise than in top-performing staff, though this is not necessarily evident in a lower comp ratio. Many GS partners would earn much less if they worked elsewhere, making GS their preferred place for building a long-term career. While some cracks have appeared in Goldman’s the-client-comesfirst façade, the firm’s franchise is not yet seriously threatened. We view the recent quotation of 8x 2012E EPS, 7x 2013E EPS and 0.7x tangible book as sufficiently compelling to consider an investment. Iconix (Nasdaq: ICON, $16 per share; MV $1.1 billion) Iconix makes for a difficult judgment call, but we have warmed up to the company over time. Management has assembled a portfolio of attractive lifestyle brands and operates a model with low capital intensity and high returns. While the company’s negotiating leverage and licensing opportunities would diminish in a weak economy, Iconix undeniably owns brands retailers want to have, including Joe Boxer, Danskin, Rocawear, Starter, Ecko Unltd, Peanuts, and Sharper Image. We are comforted by the fact that Iconix generates both strong GAAP earnings and FCF, enabling the company to reduce leverage. Recent stock repurchases also reflect positively on Iconix’ cash-generative model and could increase per-share intrinsic value.

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© 2008-2013 by BeyondProxy LLC. All rights reserved.




We found this year’s choice of the top three wide-moat ideas more difficult, as reasonable valuations seem harder to come by than only a year ago. Even as equities have declined in price in recent weeks, we find that the declines have been concentrated primarily in mediocre or commodity-based businesses. The 52-week low list is full of metals and mining companies. With that in mind, we highlight the following three wide-moat businesses as worthy of closer consideration. Of the three ideas, we believe Oracle (ORCL) offers the most compelling risk-reward. DirecTV (NYSE: DTV, $60 per share; MV $34 billion) $70

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At a 10% forward earnings yield, the market continues to treat DirecTV as if it had little to no growth prospects. This belies growth in Latin America where DirecTV is the largest pay-TV provider. With Latin America contributing ~25% of EBITDA, and DirecTV still growing in the U.S., the valuation is attractive. What makes the situation compelling are exemplary capital allocation and the ability to reinvest capital from the maturing U.S. market into Latin America and other markets for a long time to come. Despite concerns about competition and capital intensity, as well as increasing leverage, we like the risk-reward. Norfolk Southern (NYSE: NSC, $73 per share; MV $23 billion) $90 $80 $70 $60 $50 $40 $30 $20 $10 $0 Jun 04

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Norfolk Southern’s model has improved over the past decade, as higher gas prices and traffic congestion have made the highway system less competitive. While railroads are a capital-intensive business, barriers to entry are so high that existing players can enjoy improving economics for a long time as railroads become more appealing to shippers. Unfortunately, the fact that the business has gone from bad to good has not remained a secret, and railroads no longer trade at bargain prices. While we may be inclined to wait for a recession or another adverse event before considering a long-term investment in a railroad, we acknowledge that companies like Norfolk Southern are likely to create value for long-term shareholders even from recent elevated trading levels. © 2008-2013 by BeyondProxy LLC. All rights reserved.




Oracle (Nasdaq: ORCL, $30 per share; MV $142 billion) $40 $35 $30 $25 $20 $15 $10 $5 $0 Jun 04

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Oracle is rivaled by only a handful of companies as a long-term success story in software, thanks in large part to the execution skill of CEO Larry Ellison. The company has ably leveraged strength in relational databases into application software as well as hardware, both via acquisitions. The company benefits from some of the highest switching costs in the IT industry, as customers use complex Oracle solutions to power mission-critical applications. As a result, Oracle has become a predictable, modestly growing FCF machine, with per-share value creation helped by friendly capital allocation policies. The recent revenue growth disappointment provides an opportunity, as shares trade at an FCF yield, adjusted for net cash, of ~11%..  Fellow member Ciccio Azzollini has once put together a wonderful value investing conference to take place in Molfetta, Italy. The 10th Value Investing Seminar will be held on July 11-12, with quite a few members of The Manual of Ideas in attendance. Guy Spier, Francisco Parames, Robert Robotti, Joel Cohen, and David Poulet are just a few fellow members who will be speaking at the event. Be sure to say hello to them, and have a great time! Join us at Wide-Moat Investing Summit 2013 on July 9-10. The fully online Summit will feature the best investments among competitively advantaged companies. Speakers include Rupal Bhansali of Ariel Investments, Pat Dorsey of Sanibel Captiva Investment Advisers, Paul Lountzis of Lountzis Asset Management, David Rolfe of Wedgewood Partners, Dave Sather of Sather Financial Group, Jeff Stacey of Stacey Muirhead Capital Management, Don Yacktman of Yacktman Asset Management, and other leading investors. To register, visit ValueConferences.com Sincerely,

John Mihaljevic, CFA and The Manual of Ideas research team





Members Share Their Insights into Moats We invited our members to share their thoughts on identifying companies with sustainable competitive advantage. We present selected responses below. We polled members for their insights last year as well. The July 2012 WideMoat Issue included the wisdom of Pat Dorsey, Daniel Gladiš, Michael McKee, Guy Spier, Josh Tarasoff, and other MOI members. If you have not seen last year’s issue, we highly recommend downloading it from The Manual of Ideas online members area at http://www.manualofideas.com/protected

ETHAN BERG, CHIEF INVESTMENT OFFICER, G4 PARTNERSHIP While there are numerous potential sources of advantage, what strikes me is how genuinely rare it is to find sustainable competitive advantage. A company may have good products, a good reputation, significant market share, and high returns on capital, but each one of these is susceptible to erosion. By themselves, none of those factors indicates sustainable competitive advantage. The latter exists only when a firm clearly understands customer needs and uniquely and decisively configures their own assets and activities to deliver against those needs better than any other firm—an advantage so great that it is not replicable no matter how much a competitor spends. The advantage should almost seem unfair. Otherwise, if the opportunity is good enough, other firms will build the capabilities, and the advantage will not endure.

“We have in our living room a piano made by Steinway. One hundred years, ago, Steinway had strong market share amongst concert pianists. Today, it has strong market share amongst concert pianists. While they are still short of Buffett’s preferred holding period of forever, they remain a candidate.”

The three most important things to look at in searching for competitive advantage are 1) customer’s needs, 2) a company’s assets and activities, and 3) the fit between those two things relative to other firms. For commodity products, the need is almost always price. Low prices can only be maintained over time if the company in question has a lower cost structure. As Ken Peak correctly pointed out in his Contango [MCF] roadshow when he discussed their core beliefs since inception, “The only competitive advantage in the natural gas and oil business is to be among the lowest cost producers.” He configured the company to be a low-cost producer. Helpfully, he would detail the full costs of production for him and others in his industry. He was focused on the one thing that mattered in his business. In non-commodity businesses the needs vary, but the analysis is the same. Good strategy in non-commodity businesses begins with an understanding of who the customers are and what their needs are. I live a few minutes from Tanglewood, the summer home of the Boston Symphony Orchestra. My wife and I occasionally host chamber music concerts. We have in our living room a piano made by Steinway [LVB]. One hundred years, ago, Steinway had strong market share amongst concert pianists. Today, it has strong market share amongst concert pianists. While they are still short of Buffett’s preferred holding period of forever, they remain a candidate. There are quite explicit reasons their advantage has endured and will continue to endure. Generally speaking, within the piano market, there are four primary segments: professional/serious players, institutions, furniture buyers (!), and families. Each segment has specific needs. Focusing on the concert pianists, the need is what is called the “voice”, which is Steinway’s legendary sound. (For institutions, it is durability. For furniture buyers, it is type of wood and size. For





families, it is primarily price.) Regarding voice, the underlying assets and activities are technical excellence (more than 100 piano-related patents), 12,000 parts, craftsmen with 20+ years of experience, the “concert bank,” master piano technicians, know-how in wood selection, etc. There just isn’t any easy way for this system of assets and activities to be replicated for this part of the market. While there could be questions about size of the market, the collection of individual advantages results in sustainable advantage.

ANTHONY CAMBEIRO, PRESIDENT, ANTHOLOGY CAPITAL To find a firm with sustainable competitive advantage, you first have to find a firm that actually has a competitive advantage. One primary way of identifying a firm with competitive advantage is to look at the historical returns on invested capital. A long history of high ROIC is usually indicative of some kind of sustainable competitive advantage. There are many ways to measure this. Our preferred measure is [EBIT / (total assets - current liabilities + short term debt excess cash)]. Another favorite method is to ask a CEO a variation on these questions: Which one of your peers do you most admire and respect? If you could put a silver bullet in the head of one of your competitors, who would it be any why? If you could pick one other company in your industry to own/run, which would it be and why? If you ask enough players in the space these questions, you’ll end up with a pretty good view of the market.

“Carmax was once thought to be a terrible business. In the late 1990s and early 2000s, they found themselves in a land grab war with AutoNation. The company spent millions of dollars building huge superstores all across America, racking up huge losses. The stock fell nearly 90% from its IPO price. AutoNation eventually cried uncle and gave up. That day KMX shares hit an alltime low. However, this was the best possible news for KMX.”


Let’s say you find a company that has generated high ROIC. Start looking to see why they generate these returns and if the reasons are sustainable or temporary. A more difficult challenge is to find a company whose financials do not yet demonstrate competitive advantage. Finding a situation like that is every investors dream since the stock is likely to be mispriced by a wider margin. To determine the question of sustainability of returns and thus sustainability of competitive advantage, it requires a deeper understanding of the business model and the reasons those returns exist. This requires a lot of reading (SEC documents, transcripts, presentations, industry research) on the company in question and all the other companies in the ecosystem (competitors, customers, suppliers). Additionally, it can help to speak with industry participants to deepen your understanding of the advantages a company may have. A company with durable competitive advantage is Carmax [KMX]. I learned about Carmax KMX at my former firm. We were the largest shareholders in the KMX tracking stock in the early 2000s. I’m quite certain we were the first (in 2003) to figure out how to scrape the company’s website every night and estimate the number of cars sold to within 100 cars out of 70,000. Carmax was once thought to be a terrible business. In the late 1990s and early 2000s, they found themselves in a land grab war with AutoNation [AN]. The company spent millions of dollars building huge superstores all across America, racking up huge losses. The stock fell nearly 90% from its IPO price. AutoNation eventually cried uncle and gave up. That day KMX shares hit an alltime low. However, this was the best possible news for KMX. The primary competitor who had forced them into a land-grab strategy had decided to quit. This allowed KMX to stop expanding and focus on optimizing the business.




What they developed over the coming years was a differentiated and unique business. There are hundreds of little advantages which combine to create an enduring and significant advantage. KMX has created something that has never existed in the used car market—a brand associated with trust. The long-term value of that brand association in the used car market is and will continue to be incredibly high, and no other company is close to building something similar. Here are a handful of the advantages we see KMX possessing:

“My experience with investing in Carmax is that despite the long-term advantages, the stock market can still be overly concerned with near-term issues. KMX stock has been quite volatile, which is great for the longerterm investor since you can continue to buy stock during periods of weakness. Only by having conviction in the long-term advantages are you able to buy with both hands when the market is giving it to you.”

Economies of scale. KMX sells over 500 cars per location. The average for other dealerships is closer to 40. This huge volume advantage allows the employees to become more efficient and allows the company to leverage fixed overhead and spend more on advertising to build a national brand. Footprint of superstores in single-store markets. KMX has opened over 100 locations, and many are superstores in markets the company believes only support a single store of that size. This serves as a deterrent for a potential entrant since the prospective returns on capital would not look attractive. Appraisal lane and wholesale market. KMX will purchase any car a customer brings into their stores. They have huge economies of scale, buying over 400,000 cars per year from their customer base. The margins on cars purchased through this appraisal lane are better than cars bought at auction. KMX can only buy at scale if they have an outlet for the cars they don’t want. And so they run their own auctions for other dealers to come buy the cars KMX does not want to retail. You can only get dealers to come to your own auctions if you have enough volume to make it worth their while. Another benefit from this is that one of the first things a customer does before they buy a car is figure out how much they can get for their old car. Studies show that a large percentage of customers who purchase a car will do so from the first place they visit. Getting them to start at KMX thanks to the appraisal lane is a big advantage. Brand. KMX has built a brand consumers can trust. The company stands behind the quality of their cars and the consumer offer—no-haggle pricing, à la carte offering of finance and extended warranties, and fixed commissions for salesmen, incentivizing them to put you in the car best for you. Systems. Huge investment in systems has allowed KMX to know how to manage inventory and adjust quickly to changing market environments. History in ABS market. KMX has a 15-year history in the securitization market. The proven history of their paper allows them to continue to securitize at rates far better than a new participant. This allows them to earn a better margin and keep accessing the market in tighter environments. This is not easily replicated. There are other advantages as well, but this should give you a flavor of what makes the advantages of KMX durable. My experience with investing in KMX is that despite the long-term advantages, the stock market can still be overly concerned with near-term issues. KMX stock has been quite volatile, which is great for the longer-term investor since you can continue to buy stock during periods of weakness. Only by having conviction in the long-term advantages are you able to buy with both hands when the market is giving it to you.





JOHN GILBERT, CIO, GENERAL RE–NEW ENGLAND ASSET MANAGEMENT “Mead Johnson has all the things we like—an oligopolistic industry structure with high shares for the participants, a wellknown and longstanding brand name in Enfamil, and unusually large exposure to emerging market economies, where infant nutrition and safety can be even bigger issues than in developed markets. Beyond the industry structure issues, however, MJN has an advantage most businesses crave but do not possess—price-inelastic customers.”

Sustainable competitive advantage has become more appreciated, but not more persistent. The investing challenge of finding it at a discount has gotten harder. Occasionally it comes our way. Mead Johnson [MJN] was the infant formula spinoff from Bristol-Myers [BMY]. It has all the things we like—an oligopolistic industry structure with high shares for the participants, a wellknown and longstanding brand name in Enfamil, and unusually large exposure to emerging market economies, where infant nutrition and safety can be even bigger issues than in developed markets. Beyond the industry structure issues, however, MJN has an advantage most businesses crave but do not possess— price-inelastic customers. A baby is the most important thing in the world to young parents. What MJN is really marketing isn’t a liquid, it is trust. Price is never irrelevant, but in this product is secondary. MJN and its small cohort of competitors have pricing flexibility and the margins and ROIC that go with it. On lack of sustainable competitive advantage: Technological change has been poison for many legacy businesses that at one time appeared bulletproof. Newspapers are an obvious example. Another is Pitney Bowes [PBI], which had 80% share of the mailroom equipment market. A good business—until email became the dominant written form of communication. It was clear to us several years ago that attrition was inevitable in their client base. We eliminated any holdings and have not regretted that decision.

HEWITT HEISERMAN JR., AUTHOR, THE CHECKLIST INVESTOR In the book It’s Earnings That Count I describe a three-step test to find bargain growth companies: authentic earnings power, durable competitive advantage, and low price to intrinsic value. Morningstar says there are five types of durable competitive advantage: cost leadership, intangibles, switching costs, network effect, and efficient scale. I add a sixth criterion: ecosystem (e.g., Apple’s iOS platform). Companies with authentic earnings power, which I define as rising levels of GAAP net income, confirmed by steady increases in FCF and EVA, tend to enjoy competitive advantage. The more durable the moat, the more valuable the business. (Some firms enjoy multiple advantages, as Morningstar points out.) To estimate competitive advantage durability, I used to compare my target to other companies that offered a similar product—a “left-right” landscape analysis. When I bought video retailer Blockbuster because “entertainment” is a perpetual want, and because the stores have convenient locations, I identified other companies that also distributed movies via physical locations, like Coinstar [CSTR] and their Redbox vending machines. I preferred Blockbuster, which offered a broader selection. That was a competitive advantage, I thought. Due to the rise of the Internet, I have learned to consider non-traditional substitutes. With its mail-deliver distribution model, Netflix [NFLX] was even more convenient than Blockbuster. Lots of other consumers realized the same, to Blockbuster’s detriment. Selling for over $18 in 2002, Blockbuster declared bankruptcy in 2010, and shares last traded for $0.07. Lesson? When assessing the durability of a moat, think two-dimensionally. Don’t just look at traditional substitutes (left-right), also consider alternate substitutes (up-down). © 2008-2013 by BeyondProxy LLC. All rights reserved.


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ARKO KADAJANE, PORTFOLIO MANAGER, AMBIENT SOUND INVESTMENTS We don’t have any good quantitative metrics for finding companies with sustainable competitive advantage. It’s rather easy to find companies which currently have a wide-moat business. Return on equity or return on invested capital gives you some sort of a preliminary understanding that the company should enjoy some edge over competitors. The problem is that in most sectors it’s impossible to predict which companies have sustainable competitive advantage and high return on capital in the future. The main questions for me is how sticky the product or service is, and does the company have the ability to raise prices. If those two qualities aren’t met there should be a scale advantage or some other low-cost operator advantage. I always like to think about the service or product as a customer, although sometimes this approach has a bias risk.

DAVE SATHER, PRESIDENT, SATHER FINANCIAL GROUP “Having an oligopoly alone does not assure a good investment. However, an oligopoly with wise management can be fantastic. This will quickly show up in the numbers—high return on equity, high return on capital, high free cash flow.”

We are happy to find oligopolies. Monopolies are either governmental partners, or the government will break up the monopoly. Either way, this presents a risk to an investment thesis. As such, a few strong competitors will provide very good returns—while keeping new competitors at arm’s-length. Having an oligopoly alone does not assure a good investment. However, an oligopoly with wise management can be fantastic. This will quickly show up in the numbers—high return on equity, high return on capital, high free cash flow. If the return on capital is too high, it can show a vulnerability for new competitors to come in. Obviously, being a low-cost producer is always good. Wal-Mart [WMT] is a great example. They are certainly not an oligopoly—but it is extremely difficult to compete against them. Fannie Mae and Freddie Mac both were oligopolies that turned out to be bad investments because of a change in credit policy and poor management. These were also ones in which the negative influence of government or politics caused the management to do foolish things. In the end, the wide moat collapsed. Cemex [CX] is an example where the moat was challenged. In our assessment, the moat was still there since a geographical monopoly arises around a cement plant due to transportation costs. Unfortunately, the incurrence of too much debt—and the stacking of the debt in a few maturities—greatly hurt Cemex. Furniture Brands [FBN] appeared to have a moat. They had a great reputation and brand names. Unfortunately, once Asian markets decided to mass-market competitors, Furniture Brands could not compete due to their high labor costs.

FABIAN SCHILCHER, PRIVATE INVESTOR As to finding moats in general, I could only repeat what the great investors have put in writing. There is, however, one specific concept I found appealing and wanted to analyze/backtest further but have not gotten around to doing so yet. It is the concept Sanjay Bakshi describes in a presentation about floats and moats. To quote Bakshi: “My argument in the presentation is that float comes in many forms, and if there is a solid moat, it’s quite likely there will be a low or zero © 2008-2013 by BeyondProxy LLC. All rights reserved.


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cost float as well. If I am right, then there is a quantitative way to spot a moat— just measure the size of float and its trend over time…”

GREG SPEICHER, PRIVATE INVESTOR Finding wide-moat businesses begins with developing a clear idea of what you are looking for. To do this, you need, à la Munger, a latticework of mental models drawn from the master teachers on competition and competitive strategy: Buffett’s complete corpus, Porter’s five forces, Greenwald, Pat Dorsey, and classic microeconomics works such as Shapiro and Varian’s Information Rules. This needs to be complemented by a growing mental library of wide-moat companies to use as reference points when evaluating possible investments. Obvious examples include Coke (brand, scale, cost advantages), GEICO (lowcost provider), See’s (brand), BNSF (lack of substitutes, insurmountable barriers to entry); there are many others. An added plus is experience running a business, because there is no substitute for seeing these competitive forces from an operating perspective. This can be further complemented by reading the best books on industries, companies, and business leaders. Once you know what you are looking for—an ongoing, cumulative process— there is no subsitute for broad, sustained reading and thinking to find wide-moat business. There is no way to automate this process. Good places to look are industries with superior economics: high barriers to entry, high returns on capital, stable market share. Another place to look is the 13Fs of focused value investors who specialize in wide-moat businesses. Once you find a wide-moat candidate, you must research it like a journalist, looking for insights into the nature and durability of the moat. Many such businesses are hard to find, but some great ones are hiding in plain sight and simply require the patience to wait for the right opportunity and the courage to invest when the time arrives.

JEFFREY STACEY, FOUNDING PARTNER, STACEY MUIRHEAD CAPITAL MGMT “Does the business show a high return on shareholders’ equity over a long period of time? Does it have a pristine balance sheet? Does the business have pricing power or brand presence or the lowest-cost production? Does it have high margins and a track record of consistent free cash flow generation?”


Most investors intuitively understand the concept of investing in companies with enduring competitive advantages or what is referred to as a wide moat. But while the concept is simple, it is not easy to do. Judging whether a moat exists and the sustainability of that moat is difficult. Even Warren Buffett, who is clearly the greatest wide-moat investor of all time, misjudged the sustainability of the moat around newspapers when the Internet emerged as a disrupting force. As I search and sift and study companies in an attempt to assess the size and durability of the moat a business may possess, I try to keep things as simple as possible. Does the business show a high return on shareholders’ equity over a long period of time? Does it have a pristine balance sheet? If a business generates high returns through leverage and financial engineering, it probably doesn’t possess an enduring moat. Does the business have pricing power or brand presence or the lowest-cost production? Does it have high margins and a track record of consistent free cash flow generation? These are all pretty basic things and are easy to assess. While it won’t necessarily result in an investable moat, insisting on the basics will lead you to high-quality companies, which should result in an ample margin of safety if you don’t pay too much.


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The search is never easy and there are many potholes on the investment road. Several years ago we invested in Indigo Books and Music [Toronto: IDG]. Indigo is the largest book retailer in Canada with the largest market share by far. At the time we invested, it had best-in-class margins, net cash on the balance sheet, and high returns on equity. It was a destination stop with a great brand image with Canadian book lovers. The basics were all present. However, the moat wasn’t enduring, and the emergence of e-reading was a game changer. While management is very talented and continues to do all the right things, the simple fact remains that book retailing must reinvent itself to be successful. It seems so easy to conduct this public post mortem and reach the conclusion that Indigo didn’t have an enduring moat. But while the concept of investing in wide-moat companies is a simple one, our experience with Indigo all too convincingly demonstrates that it isn’t easy to do. The search continues…

GLENN SUROWIEC, PORTFOLIO MANAGER, GDS INVESTMENTS I probably have a non-traditional perspective on “wide-moat” investing. I largely accept that, if executed correctly, wide-moat investing is a relatively low-risk way to achieve market-beating returns. That said, in this pursuit one will likely find more “moat imposters” than not. Why?

“My advice is to be really honest about how durable the moat is. If you find a company that truly has a wide moat that’s materially discounted, then back up the truck because there are few easier ways to make money. A current example would be Apple.”

There are certain “laws” of capitalism and economics. One that routinely holds is that capital chases high returns and withdraws from low returns. The majority of high-return companies can’t withstand a flood of new supply. Industry pricing and returns come down; companies get re-priced from extraordinary to ordinary. It’s easier for me to invest in this high-probability scenario than the low probability that a high-moat company retains its position over the long term. The other issue with wide-moat investing is that most obvious moats are priced as such, e.g., Coca-Cola [KO] or Disney [DIS]. It’s rare to find a truly widemoat company, and even more so to find one that’s materially undervalued. I do track a list of wide-moat companies and do buy them when they occasionally fall out of favor. Specifically, I look for consistently high returns on capital and exceptional brand strength. You need both because many high-ROIC companies have the illusion of strength simply because there’s an absence of competitors. Microsoft [MSFT] stands out in this regard—high returns, with ambivalent customers just waiting for a new entrant. Cable/phone companies are other examples—we deal with them because we have to; this is a temporary condition. My advice is to be really honest about how durable the moat is. If you find a company that truly has a wide moat that’s materially discounted, then back up the truck because there are few easier ways to make money. A current example would be Apple [AAPL].

The views expressed above do not necessarily reflect the views of the firms with which the authors are affiliated. The authors may have positions in the companies mentioned and may transact in the securities of those companies at any time without further notice.



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Exclusive Interview with David Rolfe We recently had the pleasure of speaking with David Rolfe, chief investment officer at Wedgewood Partners. St. Louis-based Wedgewood Partners, founded in 1988, has approximately $3 billion of assets under management. David joined the firm in 1992 in his current role and has been instrumental in shaping Wedgewood’s investment philosophy and approach. By investing in growing, wide-moat companies, Wedgewood has managed to compound capital at 12% per year, net, from 1992 through March 2013, versus 9% for the S&P 500. (The following is a lightly edited interview transcript and may contain errors.) The Manual of Ideas: You’ve been in the business for decades as an investor. Before we discuss your investment approach and some of your favorite ideas, tell us a bit about your background and what got you interested in investing.

“…he put me in the direction of outside reading, nonacademic reading. That was my first exposure to the likes of Buffett and Graham, Templeton, and T. Rowe Price… He was also influential—if you really are interested in this topic, buy these books.”

David Rolfe: I was born and raised in St. Louis, Missouri and that’s where Wedgewood is located. I was very fortunate to become passionately interested in the investment business back in 1984, a long time ago. I had an investments professor at the University of Missouri, St. Louis, Dr. Ken Locke. I’ll never forget Investments 334. I didn’t have any expectations when I signed up for the class. The first day the professor dismissed the chapter at hand, and all he did was talk about the stock market. It turned out he was a market junkie. I imagine most of the class was rather bored but there were a few of us that were fascinated. We couldn’t get enough of it. He made it very interesting. In fact—myself and another student and the professor—we actually started the student investment club at the University of Missouri, St. Louis. It started out as a paper portfolio. It’s still there, still running. It’s $175,000 or $180,000 and well-organized, and they compete against other schools for monetary prizes. That was the initial bug, but how he really helped me was he put me in the direction of outside reading, non-academic reading. That was my first exposure to the likes of Buffett and Graham, Templeton, and T. Rowe Price… He was also influential—if you really are interested in this topic, buy these books. Buy the classic books, read them and reread them. I was hooked. Then when I finished school in late 1985, I joined on the sell side of the Street. I was a stockbroker. That was my easiest way to get into the business. The second planet that aligned for me in early 1988, after the crash of 1987— and I like to joke that after the crash of 1987 I couldn’t sell a brokered CD to my parents—but I was fortunate that I was able to go to the buy side of the Street as a portfolio manager at the old St. Louis Union Trust Company, and it was quickly bought out by Boatmen’s Trust. St. Louis is a big trust company town. What was key in my career development at that firm—all the portfolio managers had a discretionary book of business. They could do whatever they wanted in terms of philosophy and process. In addition, the combined entity had a huge custody business, so that was my first exposure to the likes of Mason Hawkins at Southeastern Asset Management and the early “growth gang” at Janus: [Tom] Marsico, [Jim] Craig and [Tom] Bailey. They were doing the focus thing. Out of that rich environment, I had become enamored with focus investing. After almost four years of being a portfolio manager at Boatmen’s Trust, luck would befall me again in that the founding chief investment officer of



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Wedgewood Partners—the firm was founded in 1988 so this is in the spring of 1992—the founding chief investment officer retired. At the ripe old age of thirty—and I knew all the mysteries in the investment world—with little track record at hand, I then met my partner Anthony Guerrerio, the president and founder of Wedgewood Partners, and he gave me a chance. He gave me a shot. In May 1992, I joined as chief investment officer with a blank slate to bring this developing philosophy with me to Wedgewood. And along the way, we vetted a couple folks on the investment team. First, Dana Webb in 2002; Michael Quigley in 2006; and so the four of us have been doing this single strategy beginning in 1992—21+ years. MOI: You’ve had a great track record since then. I’m curious to delve a little bit deeper into that investment philosophy of yours. You have three key tenets— focus, patience, and discipline. Let’s pick focus. What do you mean by it?

“We’re putting our twenty best ideas in the portfolio, and that’s where we stop. Given that we have very little turnover at Wedgewood, we hope to own these terrific growth companies for many years.”

Rolfe: One of the phrases we like to chat about when we describe our philosophy at Wedgewood Partners is this idea that focused investing has structural advantages over other strategies. At Wedgewood, we typically own about twenty stocks, that’s how focused we get. By being focused at the company level, we’re going to be picky. We’re putting our twenty best ideas in the portfolio, and that’s where we stop. Given that we have very little turnover at Wedgewood, we hope to own these terrific growth companies for many years. Our focus is on businesses we think are best in class, uniquely competitively advantaged, that we believe at a minimum can double over the next three to five years. It’s not growth for growth’s sake—hypergrowth, imprudent growth, risky balance sheet leverage growth. We’re looking for these terrific businesses, market share dominating leaders that don’t have to use financial leverage. Once we identify that small subset, we have to wait patiently for the value side of the equation. It’s just as important, critically so. We know if we’re buying companies at fair value, and if they compound at 15% over the next five years, the underlying growth is going to drive the out-years of the stock appreciation. However, we want to buy them at a discount to intrinsic value. And we know from experience, and it makes intuitive sense, that it’s the value side of the equation that’s going to be the biggest driver of your potential return on that company over the next week, month, quarter, year, even two years. If we’re right on these business models, they shouldn’t be changing that much. But as we know with Mr. Market, valuation changes constantly and it can get extreme. We’re picky on the types of companies we want to own. And we’re picky on the valuation in which we invest in them, or trim or sell them. MOI: You talked about Warren Buffett as an influence. The companies that you identify and would like to invest in at the right price are companies that exhibit strong growth. Tell us about the challenges of being a value investor and investing in these types of companies that some would say are growth stocks. Rolfe: It is a big challenge. Every investment style has its Achilles heel. I believe the big Achilles heel for far too many growth managers is the fact that they overpay or have to overpay for these companies. It’s really difficult. If you want to build a portfolio of fifty or sixty, even a hundred terrific growth companies—I don’t know if there are a hundred terrific growth companies—but to populate a portfolio that large, you have to suspend a lot of your valuation criteria just to get them in the portfolio. It’s great owning an industry darling when the stock price is rising and revenues and earnings are terrific. The



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company is doing what you expect it to do. But far too many growth managers pay too high a price for these companies. The biggest challenge is having the patience to wait for the company to get valued attractively. Said another way, there’s got to be some hair on the story. You look at the list of all the holdings in our portfolio and it’s very easy to identify—great company, but there’s an issue with it right now. That’s how you get the opportunity. Our work is to determine if it’s a short-term problem that’s fixable—company level, industry level. And if so, we’re getting the best of two worlds: a great franchise at a discount. The biggest challenge is to have this value orientation to growth. So many growth investors I would almost characterize as maybe closet momentum investors. You see the darlings of the day and you see them populate many portfolios. We’ve come to learn over our careers that if a company is truly a terrific company that has a great growth pass for the next ten, fifteen years, the market will deliver it up at a price that makes sense. You have to be patient, that’s the biggest thing. You’ve got to be patient. No company clicks along without bumps in the road forever. You look back at the great investments over time—Wal-Mart [WMT], Coca-Cola [KO], maybe even GEICO as an example here talking about Buffett. There have been plenty of times when those companies were out of favor—there’s something going on at the company level [so that] the valuation comes in. The trick is to discern if it’s a short-term phenomenon that’s fixable or not. Our biggest mistakes have been getting the company wrong, not the valuation wrong. We’re not chasing momentum stocks, paying 35x, 40x earnings for a 20% grower—if the stock turns out to be an 18% or 19% grower and the valuation comes down, there’s the mistake. It’s getting the business wrong. That’s where our focus is at Wedgewood, day in and day out—at the company level. Then again, we have to be patient on the valuation to come to levels where we believe the risk-reward is attractive enough that we swing the bat. MOI: Let’s stay with the business side of things. Help us understand how you identify these great businesses. What really differentiates a truly great business from a merely good one? Perhaps that’s where some investors make the mistake—how do you separate those truly outstanding businesses? We already heard from you that they are quite rare. There aren’t that many out there.

“…there’s got to be some hair on the story. You look at the list of all the holdings in our portfolio and it’s very easy to identify—great company, but there’s an issue with it right now. That’s how you get the opportunity.”

Rolfe: You do even a little cursory screening of companies of reasonable size, say $5 billion and above, large mid-cap to large-cap, that’s our universe. Depending on where you are in the business cycle—if you just go back over any period [of] five to six years, and you look for companies that have compounded their earnings consistently at 15% plus a year, the list is not that large. What we’re looking for to discern great from good is ultimately profitability. If a company has significant competitive advantages—the key metric is cash, return on invested capital. We want to own companies that generate buckets of cash. And for a company to consistently do that, they’re going to have to ward off all those competitive threats. Customers are a threat. Certainly, customers want more from a company and pay less. Same as suppliers, on and on it goes. When you find these businesses that have a long enough history of demonstrating that they can ward off the multitude of competitive pressures, and there’s this great business franchise that’s generating unlevered returns on invested capital of 20%, 30%, 40% or



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even higher, that’s when our antenna perks up and we just have to wait for the valuation to come in to pull the trigger. Also, going back to this idea of the structural advantage of focus investing, if we are truly dedicated to finding these top-rate, best-of-breed businesses, our prospective list of companies isn’t that large. There are only four of us at Wedgewood. Including the companies we have in our portfolio—right now it’s about twenty-two—and on our shortlist at any given time it’s maybe another ten to twenty companies. While we only have four people doing this, our watchlist is only about thirtyfive or forty companies, it’s not that many. That list doesn’t change that often. Related to that, while we currently own about twenty or so stocks in our portfolio, over the last twenty to twenty-five years we’ve only owned a little more than seventy-five or eighty others. That’s it. We swung the bat about a hundred times in twenty-five years. I’m linking my previous firm since over the course of Wedgewood we’ve owned most of those stocks that were in the portfolios at my predecessor firm. That’s it. We think that’s a market distinction and difference to so many firms. That’s really the root of our culture and how we think and act at Wedgewood. Again, classic Buffett, we wait for a fat pitch. MOI: What are your favorite sources of mispricing?

“We swung the bat about a hundred times in twenty-five years… That’s it. We think that’s a market distinction and difference to so many firms.”

Rolfe: Most of them come at the company level, and it can be a multitude of things. These companies have a terrific product or service. Many times there may be some competitive inroads, maybe their market share starts to level off, maybe they start to lose some market share. They have to adapt. Companies can’t become complacent. There are times when competition begins to take its toll, and that’s when you might see an earnings miss or two. If it has been a previous growth darling, chances are it had a pretty healthy multiple, so now the stock’s crutching quite a bit. That’s when we sharpen our pencils. If we can understand these business models well enough, understand the history of the management team, how they have dealt with problems in the past, nothing is steady-state at any business. That’s the mosaic that we put together in our heads. Then the four of us reach a conclusion if we think there are better days ahead for these great businesses and the near-term problem can be addressed. Then we have to try to get our heads around the valuation. Those are the day-in, day-out discussions I have with my three partners. MOI: One often hears this term “secular growth.” I never really understood what that means. How do you go about identifying growth that’s sustainable? It seems growth in a way is cyclical… Rolfe: How we try to differentiate between this idea of secular growth and cyclical growth—we’re reminded of T. Rowe Price’s definition of growth. Back in his day, the economy had bigger booms and bigger busts. The economy was much more cyclical. His definition was, through the course of a business cycle or successive business cycles, a company will [have] higher lows and higher highs in terms of revenues and earnings. As a company goes through the cycle in a secular way or over a longer period, that growth chugs along… Simplistically, too many cyclical companies are boom-bust, and they aren’t necessarily forging a long-term growth path that we would find attractive. The way we view secular growth is, all companies are cyclical and it’s just that over



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a three- to five-year period, the underlying growth rate of the company, the underlying size of the company will grow through business cycles. What we’re looking for at a minimum is a company that can double over three to five years. If we don’t think a company can double, it’s probably not a good enough growth opportunity. We’re only looking for twenty companies. MOI: We are in a low interest rate environment… When you invest in companies that are growing rapidly, that have prospects for sustained growth, how does the level of interest rates affect your thinking about value?

“This is a unique period. Consider how low interest rates have been for such a long period of time. It changes a lot of behavior. You have changes in your opportunity set. As an example, our largest holding is Apple [AAPL].”

Rolfe: This is a unique period. Consider how low interest rates have been for such a long period of time. It changes a lot of behavior. You have changes in your opportunity set. As an example, our largest holding is Apple [AAPL]. We’ve owned it in size since the end of 2005. The company has all this cash on its balance sheet… But now the stock has gotten so cheap that they’re going to start returning buckets of it back to shareholders, which we applaud. They don’t need $150 billion to stay relevant. Interest rates are so low that they can take advantage and borrow money, and it’s very accretive. It creates opportunities. Companies that maybe would not borrow money before [now] have that opportunity. On the flipside, we saw in 2006 and 2007 so many cyclical companies had cheap and easy credit, a credit bubble, and rising material prices. Return on asset was high because prices were high. Revenues were running at a nice rate so you had operational leverage. Combined with financial leverage, a lot of these cyclical companies were booming, and those were the market leaders back then. What we have now in terms of a change of behavior is, look at what the chase for yield has wrought. We see excesses in the fixed income market. We see excesses in the credit market, the levered credit market. We’re seeing it significantly in the stock market, the industry leaders over the last year certainly. Over the last six months or so, the classic blue chip companies that pay a big dividend, many of them are priced at a P/E of 20x, 21x, 22x. In the chase for yield, these companies have been bid up to what we believe are excessive levels. We actually like this environment. We would rather a company not pay a large dividend. By our definition of the growth, what we want is compounding of retained earnings. When companies don’t have those opportunities and they’re paying out a third to a half of their retained earnings in the form of a dividend, you have these companies with underlying growth of 4%, 5%, 6%, 7% are now priced at a P/E of 20x, 21x, 22x. The chase for dividend yield, this is classic Mr. Market. We get to extremes. As an investment manager, we have to have the courage of our conviction, trust our research, stay with our philosophy and process, and not chase, just like in 2006 and 2007 when we were lagging, you can’t chase that so-called leadership just because you’re behind. The markets can change on a dime. Leadership can change on a dime. Low interest rates change behavior on a number of fronts. We’re seeing extremes across the board here. MOI: Help us understand how the low interest rate environment can feed into valuation models. What are your favorite valuation methods for these types of companies? Some people may be enticed to take the low interest rates and feed them into their discount rates.



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“…the history of GEICO is ripe with examples for growth investors and value investors. The company was started in 1937 with about $100,000 in seed capital. In 1948, Benjamin Graham broke his rules and he put 25% of his investment partnership in a privately held company.”

Rolfe: That’s a classic problem with the so-called Fed model. You put in a silly discount rate and you’re going to get some obscene prices. When we do our valuation work, we always have to step back and say, what variable doesn’t makes sense here? What variable isn’t sustainable? If interest rates are too low, everything else being equal, in a low interest rate environment, a dollar of earnings is worth more. But common sense has to rule the day, and so you build in some scenarios. What would the numbers look like five years from now if rates went up 200 basis points? When it comes to valuation, when we’re looking at a technology company that had a huge valuation in 1998, 1999 and early 2000, averages are deceiving. You have to throw those numbers out because there was an extreme. Same thing when you had such a valuation compression in 2008 and early 2009, throw those [numbers] out unless you’re modeling another end of the world. A key aspect when we model businesses or model intrinsic value, a lot of common sense goes into those models. You have to step back and say, what really makes sense here? That’s part experience, part discipline. We don’t model to the second or third decimal point. They’re not that elegant. They can appear to be, but that can also be a trap for investors. MOI: The spectrum of value investing is quite wide. Give us some sense of how you fit in. How do you see the dilemma between value and growth? Rolfe: It’s the valuation that’s going to give us an opportunity, or an extreme valuation that’s going to turn a decent investment over the near term into a really good investment. So many people have said it over the years—Buffett and Munger included—value and growth are two sides of the same investment coin. The changes of valuation give us opportunity. Everything else being equal, I would much rather own a better business than a turnaround business, a secularly growing business rather than a deep cyclical business. There are too many people in the industry—for various institutional, imperativedriven reasons—they want to talk about growth or value and put managers in certain camps. We want to do both. And again, if we’re only looking at a twenty-stock portfolio, we think that we have more of an opportunity to execute on the classic tenants of both growth and value investing. We don’t have to lower our hurdle on either score to get something into the portfolio. On the one hand, it’s good that the industry is like this. It gives us opportunity. I’m glad that 98+% of money managers out there aren’t focused managers. It keeps us away from the traffic jam, if you will. MOI: You’ve studied the example of GEICO to illustrate this misnomer of growth versus value investing. Can you share with us some of the insights that you’ve got out of studying GEICO over the years? Rolfe: It’s a story we’ve liked to tell when we’ve met with clients and prospective clients because the history of GEICO is ripe with examples for growth investors and value investors. The company was started in 1937 with about $100,000 in seed capital. In 1948, Benjamin Graham broke his rules and he put 25% of his investment partnership in a privately held company. Fate would have it that the SEC ultimately ruled to allow that purchase—he was an advisor buying an insurance company. It allowed for the first publicly traded shares of GEICO, and GEICO soared, and it soared. Graham was quick to admit two things. He purchased half of GEICO in 1948 for about $712,000. Ultimately, it rose in value to over $400 million at its peak in



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1972. Graham was very upfront [about] admitting that the gain in GEICO was more than all of his other successes combined. If it wasn’t for GEICO, his reputation as a great investor wouldn’t have been such. What’s interesting is that a lot of the study of Benjamin Graham is classic deep value, honed out of the scars of the great depression. He broke the rules and he bought this company, and held it for all those years where his discipline would have said to sell it. As fate would have it, Buffett became involved when he was going to school at Columbia, studying under Graham. He found out about GEICO. It was a company he hawked when he was a stockbroker after he left Columbia. When GEICO stumbled in the early 1970s, it was Buffett who swooped in and started buying the shares when they had fallen. They reached a high of $61 in 1972, were about $40 in 1974, and they fell to a couple of dollars [by 1976]. Here was the opportunity, a classic value opportunity. Buffett knew that the underlying advantage of GEICO, their low-cost advantage versus their competitors, was still intact, and that would be the foundation for growth going forward. For those who have followed Buffett’s career, they know that GEICO was a huge win for him, a huge success. He bought about a third of the company in those dark days. His last investment was in 1980. Through share buybacks at GEICO, he ultimately got to about 50% of GEICO. He bought the other half in late 1995 for $2.3 billion. When you read the annual reports, even when he first invested in GEICO, and then particularly in the annual reports starting in 19951996, when the details were singing the praises of GEICO…

“There are plenty of times when a great growth company stumbles. [GEICO’s] was a significant stumble back then, but all along the way, there were times that GEICO was eminently investable in terms of a good valuation, and all the while, the growth was clicking along.”

He liked to joke that he wanted Tony Nicely to step on the accelerator to spend all this [money on] advertising, and then Buffett kept his foot on Nicely’s foot. When Buffett arrived on the scene, GEICO was spending about $33 million in advertising per year. They’re up to a billion now per year. It’s three times the advertising, roughly, of their three largest competitors combined. I’ve never heard Buffett talk about it in these terms, but it had to give him satisfaction that he played a significant role in saving GEICO. And Benjamin Graham still owned it. His wife, when he passed away in 1976, members of the Graham family, still had their GEICO investment, and that was a significant part of that rebirth—the impact of Buffett. It’s been sixty years, and Buffett still sings the praises of this great growth company, GEICO. It’s the story I like to tell to explain what we’re trying to do at Wedgewood. There are plenty of times when a great growth company stumbles. That was a significant stumble back then, but all along the way, there were times that GEICO was eminently investable in terms of a good valuation, and all the while, the growth was clicking along. MOI: Let’s talk about some of the “GEICOs” in your portfolio, some of the great businesses that you were able to acquire at a good price. You talked a little about Apple—how do you see the investment case here? Rolfe: In the fall of last year when it was $705 a share, it was a crowded trade. They have stumbled. Their product introductions haven’t had the same regular sequence, and there are many people who believe that Apple’s best growth days are well behind them. We also fall into that camp, just in terms of the raw growth numbers they were able to put up over the last couple of years, just before their recent stumble. But the stock got almost cut in half, and we actually believe it was more dramatic than that. All along while Apple’s earnings have disappointed, they were still generating buckets of cash.



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If you look at when the market value was $700 billion, and where it fell to a low of $380 [per share]—all along the way over those seven, eight months, they were generating a ton of cash. If you subtract the cash out and you look at the decline in Apple from an enterprise value [standpoint], it was almost cut by twothirds. At [recent] prices, the market-implied growth rate is flat. It’s assuming flat growth and a significant and permanent contraction in their margins, and we don’t think that’s the case. We [have] added more to our position. We believe that the long-term growth case of Apple is made through the prism of analyzing their ecosystem. That’s a significant distinction [versus] other technology companies, present and past. We live in a world of ecosystems. The average revenue from a customer within that ecosystem is a lot higher than a one-off purchase. You buy an iPod, you might buy an iPhone. You buy an iPhone, you might buy an iPad, and you might buy successive generations once you get locked into that ecosystem with software and services.

“The reason why Nokia is where it is right now is they haven’t had an ecosystem. Their products were one-off hits and misses if you will vis-à-vis the competition. As much as I say that these gadgets are peripheral to the ecosystem, make no mistake about it: If Apple starts to deliver me-too, low-quality products, the ecosystem growth is going to grind to a halt, and that ecosystem can shrink.”

The ecosystem growth is very healthy. 400+ million iOS users, hundreds of millions of active iTunes credit cards. We think the market’s obsession with individual products at current margins, prospective margins, one-off product introductions, one-off product growth rates clouds the judgment of this ecosystem growth. Ultimately, these various products and services are peripheral, important but peripheral, to the growth of the ecosystem. We don’t think ecosystem growth is over. We still think [Apple] is a true growth company, not at the rates it once was, but at current prices, it doesn’t take much to move the needle. In total, they are going to return about a hundred billion dollars—largely sixty billion in stock buybacks over the next 2.5 years. They’re still building cash. Depending on when they buy back stock, you could see a reduction of shares outstanding from 10% to 15%, and that balance sheet is going to be loaded up again in two or three years, and they can do the same. The valuation is extremely low, and when we look out three to five years, there’s going to be this growing franchise that prospectively can have anywhere from 20%, maybe one-third—that’s probably a little bit on the high side over the next five years—of their shares bought back. That’s a big driver of intrinsic value growth per share. We’ll see how it turns out; Apple is our largest holding. MOI: Some investors would say—and perhaps that is the key factor that makes some investors uncomfortable with Apple—is this comparison with Nokia [Helsinki: NOK1V], this comparison with other technology companies where you just don’t know the rapid change and the risks. Is that in your view the key insight here—this ecosystem that Apple has versus let’s say Nokia? Rolfe: That’s a great question. The reason why Nokia is where it is right now is they haven’t had an ecosystem. Their products were one-off hits and misses if you will vis-à-vis the competition. As much as I say that these gadgets are peripheral to the ecosystem, make no mistake about it: If Apple starts to deliver me-too, low-quality products, the ecosystem growth is going to grind to a halt, and that ecosystem can shrink. Every year the iPhone’s been out since 2007—and they just recently again won J.D. Power’s for consumer satisfaction—we see developers developing apps for their ecosystem, and we see the usage of iPhones, particularly iPads. They still deliver high user satisfaction that is keeping those ecosystem members interested in future products. Certainly, if something comes along with a better mousetrap, technological obsolescence is right there. There’s no question about



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it. It’s inherent in almost every company, particularly technology companies. We worry about that a lot and we think about that a lot. But we look at the totality of hardware and software, throw in iTunes. iTunes is growing so rapidly. They’re at a run right now. iTunes and accessories are surprisingly at a runway of $16-17 billion per annum. That’s starting to approach the size of Windows or Microsoft Office—that’s significant. That’s also part of the ecosystem. Apple has a number of avenues of growth that feeds that ecosystem. As long as they’re delivering high quality, best-in-class consumer satisfaction with their products, we’ll be happy to own the company. MOI: On the return-of-capital front, are you comfortable with how the current leadership of Apple has approached this?

“When I think about the tens of billions that Cisco [CSCO], Hewlett-Packard [HPQ], and Research in Motion, now BlackBerry [RIM], have spent, I’m sure a lot of the management would like to have that cash back. Apple is a difference [because] they’re still generating a ton of cash. That buyback shotgun is going to be loaded and recocked three or four years from now.”

Rolfe: Quite frankly, we were getting a little frustrated. Management talked about that they were thinking about this, they knew the stock was down, at the board level they were having active discussions, and we wanted them to swing the proverbial big bat when they made an announcement. And they did, and so they get it. I’m very pleased that the emphasis is going to be on buying back stock, it’s very accretive. We hope they exhaust that $60 billion now. They could buy back the stock at a billion a week for the next year, roughly speaking. Do it now and do it in size while the stock is down. Corporate America is littered with many examples of poor stewardship, of management buying back a bunch of stock at high prices. When I think about the tens of billions that Cisco [CSCO], Hewlett-Packard [HPQ], and Research in Motion, now BlackBerry [RIM], have spent, I’m sure a lot of the management would like to have that cash back. Apple is a difference [because] they’re still generating a ton of cash. That buyback shotgun is going to be loaded and recocked three or four years from now. They’re going to return $100 billion by the end of 2015. It’s not like, there goes the cash, now what? Apple’s business model and cash generation speak to ongoing share buybacks that can be very significant. It’s not out of the realm ten years from now that half the shares could be bought back. MOI: What are some of the other positions in the portfolio that perhaps could give us insight into how you generate ideas? What are some of the reasons why these great companies become cheap and what the investment case is? Rolfe: We’ve owned Berkshire Hathaway [BRK.A] nearly continuously since 1998. Just from a growth company perspective, there’s been debate, not so much of late, is Berkshire really a growth company in the traditional sense? Obviously, pre the purchase of General Re, it was the big stock positions— Coca-Cola, Gillette, ABC/CapCities, GEICO, the whole thing. As the company has morphed into more of a conglomerate, the growth has been outstanding. I still can’t believe what Buffett was able to pull off when he bought the rest of Burlington Northern. It’s been an outstanding investment, incredibly accretive. We just got word of buying the rest of Iscar—terrific. We’ve owned Visa [V] for a number of years. We’ve owned American Express [AXP] for a number of years. We’ve owned Google [GOOG] for a number of years. Again, these are just terrific businesses that the market served up at terrific prices and we swung. MOI: What about Qualcomm [QCOM]? It’s a big position of yours. What’s the investment case?



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Rolfe: In this mobile Internet world, they’re the arms merchant. They have an incredible intellectual portfolio of patents, and they are at the forefront of Moore’s law in terms of shrinking the size of semiconductors. Their multipurpose chipsets find their way into almost the least expensive phones all the way to the high end. If you want to be competitive in today’s mobile world in terms of a handset, a smartphone, even a non-smartphone, Qualcomm is on your speed dial. Their solutions and technology stand at the forefront of the mobile Internet. We’ve owned that company for quite a few years as well. MOI: What was the reason that you were able to acquire it at the right price, when you think at when you bought it?

“Another way to look at it is the old Charlie Munger ‘invert.’ We ask ourselves, what’s the market-implied growth rate? That’s where you get that big difference of where your numbers are, if they’re close to consensus or not. It could be below, the same or higher. Now you’ve got a pretty good debate. If you’re right, there’s your upside.”

Rolfe: They had a period of stalled growth, and that got Wall Street a little bit impatient. Also, Qualcomm had a lot of initiatives that were kind of hard to get your arms around. Ultimately, what’s the plan here? Are they ever going to move the needle? Again, what resuscitated Qualcomm was the smartphone. We have these sophisticated networks, different networks around the world. When you look at the totality of the silicon in the smartphone that Qualcomm can address, it has helped their average selling price stabilize, and in some cases even go up. That was the long term bear case on Qualcomm—that the average selling price of their components is going to go down every year forever. What has surprised folks over the last couple of years is just how steady the average selling price has been. As the company generated more revenue, through operational leverage, they generated a bunch of cash. They’ve been good stewards of shareholder capital, buybacks, and so a lot to like at Qualcomm. MOI: Some investors may not look at it the way you do and perhaps dismiss Qualcomm as just another tech company where it’s difficult to gain comfort. What is really the moat here with Qualcomm? Rolfe: It’s their intellectual capital. It’s their patents. They were the inventor of CDMA technology. Their intellectual footprint in terms of a moat is deep and wide. The scale and scope of what Qualcomm is doing are unmatched. Their ability not only to recognize market opportunity and get there before competitors, in size, but also drive innovation, it’s huge. But I understand, there are a lot of folks, Mr. Buffett included, who’ll say it’s a technology company and I’m just not going to try to get my head around it. That’s fine. But when you look at the totality of what Qualcomm has been able to build, it’s stunning, that franchise. It would take a lot to knock them out of the top spot. MOI: In the case of Qualcomm or any of the other businesses you mentioned, how do you think about valuation? How do you assess whether the market quotation of a business is attractive enough to remain in the portfolio? Rolfe: [Qualcomm] hasn’t done much of late, actually. We think the shares are pretty attractive. But it’s like with any other investment. At the company level, we’re trying to ascertain their total addressable market, their competitive position. Do we have confidence in a certain level of earnings power three to five years from now? What do we think would be an appropriate valuation, a significant discount from intrinsic value? Another way to look at it is the old Charlie Munger “invert.” We ask ourselves, what’s the market-implied growth rate? That’s where you get that big difference of where your numbers are, if they’re close to consensus or not. It could be below, the same or higher. Now you’ve got a pretty good debate. If you’re right,



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there’s your upside. If you’re wrong and the company is still growing, you’re not overpaying, there’s that buffer on the downside so your mistakes aren’t fatal. MOI: Do you apply in these models a similar discount rate across the board and then adjust the numbers of each company? Or do you apply different rates?

“We want these businesses to have minimal business model overlap. We don’t want businesses largely competing for the same profit dollar. That will eliminate a prospective candidate. As an example, we own Google. We won’t own Facebook at the same time.”

Rolfe: There’s a little bit of a variation depending on the companies. The ones where you have higher conviction—different numbers for those that have a little more risk in their business. Our head isn’t so much in those valuation models. If you have conviction in the company and the valuation makes sense—with that margin of safety that ought to hit you across the head… If it’s close and it’s, let’s kind of massage the numbers of the model to make sense, now you’ve lost the forest for the trees. It’s got to be that big margin of safety. We hope we can understand the Qualcomm business model well enough and their competitive aspects to have confidence in an earning power three to five years from now. There are other folks that would just stay away because it’s a technology company, but that’s okay. MOI: The companies you mentioned are all listed in the U.S. Have you looked at companies that are domiciled abroad? Is your approach global? Rolfe: No, it’s U.S.-based. From time to time, we may own a company that is domiciled out of the United States, but it’s rare. In a twenty-stock portfolio, if we can’t find twenty companies in the U.S., we’re not doing something right. MOI: Help us understand how you go about constructing this portfolio and how you think about position sizing? Rolfe: The three pillars of what we do are growth, valuation, and then portfolio. They all play a key role. Out of our list of thirty to forty companies we want to own, we are going to select about twenty that have the best risk-reward in terms of prospective growth and valuation. Portfolio management plays a key role. We want these businesses to have minimal business model overlap. We don’t want businesses largely competing for the same profit dollar. That will eliminate a prospective candidate. As an example, we own Google. We won’t own Facebook [FB] at the same time. No opinions on Facebook, it’s just that those two businesses have too much of their business model as an overlap. The maximum we’ll let a stock get to is 10%, the minimum we’ll do is 2.5%. What you see as the end result in our portfolio, out of our thirty to forty favorite businesses, these are the ones that we believe are priced right today. At the portfolio level, these business models are not overlapping or competing with other companies in the portfolio—and that’s it. We actually think that’s maybe a different yet thoughtful way of diversifying. We don’t think you need fifty companies to be prudently diversified. We’re not going to own three railroads—that defeats the purpose. If we’re wrong on one, we’re probably going to be wrong on the other one or two related businesses. It’s been our long history and understanding as investors of this idea of investing through the lens of a business owner, having the right temperament, having the right behavior set. Identify these businesses, wait for the valuation. When it makes sense, swing hard enough to make a difference. At the portfolio level, thoughtful, prudent diversification from a business model perspective, not just raw numbers, where it says we need fifty different stocks to be diversified. We think far too many people have to do it that way. We just choose not to.



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MOI: What is the single biggest mistake investors make, perhaps focusing specifically on investors who may be hesitant to invest in companies that are growing rapidly. What do you think they are missing?

“Most of the big [mistakes] are because of temperament and behavior, the psychological aspects of investing, not the IQ side of it.”

Rolfe: A couple of things. Depending on where we are at in the business cycle—we just entered the fifth year of a bull market—people start to chase things. When we were in 2008 and 2009, look at mutual fund flows, people couldn’t get out of stocks fast enough. It’s just that temperament, it’s huge. At the individual company level, people make the mistake of assuming a great growth company can grow, can compound at a large number for quite a few years and they bid up the valuation to what are extremes. There’s almost no way to make a fundamental case that valuation is reasonable. But we’ve learned over time, stocks can stay really high really long, and the opposite is you get into a company where the business doesn’t turn. It’s a permanently impaired growth company and it deserves to sell at a cheap multiple, or a cyclical company that just doesn’t turn. Most of the big [mistakes] are because of temperament and behavior, the psychological aspects of investing, not the IQ side of it. MOI: How do you keep improving as an investor in great businesses? What are some books or resources you could share? What’s your advice to investors? Rolfe: In this business, we are all very fortunate that we can sit on the shoulders of the giants. There is literature out there, non-academic, just go to Amazon. The best investment books, there’s plenty of them starting with Buffett and the partnership letters, his chairman letters, then the classic Phil Fisher, on and on. I’d be the first to admit [that] at Wedgewood we slavishly copy from the greats. Again, we’re not reinventing the wheel at all. There are certain aspects of investing—in this case growth, value and portfolio management—we decide to do in a very specific, differentiated way from most of our peers. A significant part of what we do at Wedgewood is a decision of what we choose not to do. As John Bogle of Vanguard has said over and over again, there’s power of simplicity, fewer ideas but more impactful ideas. What we love about indexation, it’s largely a buy and hold endeavor. Said another way, it’s let your winners run. That’s what we try to do at Wedgewood. Once you find that terrific business, unless the valuation gets extreme, we hold on to it like a junkyard dog because they’re too hard to find. That’s just how we think, and that’s part of the culture I’ve tried to embed with my three partners. Their contribution has been very significant in that they add to that culture. That’s the biggest thing the four of us do at Wedgewood—buy into this culture. Over the years, we’ve never had discussions of why don’t we get thirty stocks or why don’t we do another strategy. That’s huge. When you think about how low our turnover is, over the last two years or so we’ve only added five or six companies to the portfolio. This isn’t a team of twenty or thirty where everybody is coming up with great ideas and they want to see their work in the portfolio. It’s huge to buy into that culture. MOI: Back to focus, patience, and discipline… Rolfe: That’s it. Don’t overthink it. Each of those elements is very powerful— growth, concentrating on your best growth ideas, classic tenets of valuation, maybe a thoughtful but different application of diversification. Throw them all together and you’ve got something. MOI: On that note, David, thank you for your time and insights.



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Profiling 20 Wide-Moat Investment Candidates Abbott Labs (ABT) – Geode, GMO, MFS, Jennison, Primecap, Southeastern Health Care: Biotechnology & Drugs, Member of S&P 500

ABBOTT PARK IL

Trading Data Price: $35.58 (as of 6/21/13) 52-week range: $29.48–$38.77 Market value: $55.5 billion Enterprise value: $54.0 billion Shares outstanding: 1,558.9 million Ownership Data

www.abbott.com

Consensus EPS Estimates

Valuation

This quarter Next quarter FYE 12/31/13

Latest $0.44 0.53 2.01

Month Ago $0.44 0.53 2.01

# of Ests 21 20 25

P/E FYE 12/31/12 P/E FYE 12/31/13 P/E FYE 12/31/14 P/E FYE 12/31/15 EV/ LTM revenue

18x 18x 16x 14x 2.5x

FYE 12/31/14

2.25

2.25

24

EV/ LTM EBIT

24x

Insider ownership: