Owner’s Manual

Introduction

This document is inspired by the owner’s manuals published by investors we admire, including Warren Buffett and Terry Smith, who believed that the relationship between an investment manager and the people whose capital he manages should begin with candor. We agree. What follows is our attempt to tell you, as plainly as we can, how we think about investing, what we expect of ourselves, and what we hope for from you. If, at the end, you feel that our values and yours are well-matched, we suspect the partnership will be a productive one.

Mutual Expectations

We are not in the business of gathering assets. This may seem an odd thing for an investment firm to say, but it is worth saying because the incentives of our industry generally point in the opposite direction. Most firms grow because growth is profitable for the firm, even when it is not profitable for the investor. We have no interest in this trade. A larger investor base would dilute our focus, complicate our decision-making, and, over time, erode the very returns that justify our existence.

We would rather manage less capital well than more capital indifferently. For this reason, we seek to partner exclusively with investors who share our values, our time horizon, and our understanding of what wealth creation actually requires. Working with a small, steadfast group of patient people allows us to concentrate on the only things that matter: the quality of our investment process, the integrity of our decisions, and the long-term results we deliver. We will measure our success in three ways:

1. The long-term, compounded returns we deliver to the families and institutions who entrust us with their capital.
2. The caliber of our investment decisions – selecting and managing a portfolio of exceptional businesses.
3. The quality of our investors, marked by patience and shared vision.

Our Investment Philosophy

Our mandate is simple, if not easy: to invest in a small number of outstanding businesses that are built to compound shareholder value over decades rather than quarters. We provide periodic reporting because transparency demands it, but we do not steer our portfolio toward short-term metrics. Markets are noisy in the near term and roughly rational over the long term. Our job is to focus on the long term and tolerate the noise. In practice, this means we are drawn to businesses with a particular set of economic characteristics – those rare enterprises that consistently earn returns on their invested capital well in excess of their cost of capital, and that can reinvest those returns at similarly attractive rates for years to come.

Investment Principles

Our portfolio consists of high-quality businesses with durable growth potential, regardless of market capitalization or sector. We prioritize the management of risk – by which we mean the risk of permanent capital loss, not the temporary fluctuations that the financial industry mislabels as “risk” – and the durability of future earnings. Our approach rests on three principles:

1. Businesses create wealth by generating returns on capital that exceed their cost of capital. This is the only reliable engine of long-term value creation.
2. The paramount risk is permanent loss of capital, which we seek to avoid through rigorous selection rather than through diversification for its own sake.
3. The best results come from concentrated ownership of exceptional enterprises purchased at reasonable valuations. We would rather own a few wonderful businesses than many mediocre ones.

Why do we place such emphasis on returns on capital? Because it is the clearest measure of whether a company is creating wealth for its owners or merely rearranging it. Consider a company that earns an 8% return on its invested capital (calculated as Net Operating Profit After-Tax divided by Net Working Capital plus Net Fixed Assets) but whose cost of capital is also 8%. That company has worked hard, hired clever people, and generated revenue – but it has not made its shareholders any richer. If it earns only 7%, it has actively destroyed value. The arithmetic is unforgiving.

What We Look For

Our goal is to identify businesses that earn returns on capital well above average – typically in excess of 20%. But a high return on existing capital, while necessary, is not sufficient. We also need a high return on incremental capital. This distinction is everything, and it is where the magic of compounding either appears or doesn’t.

The Compounding Problem

Imagine a business that invests $100 and earns $20 – a solid 20% return. So far, so good. But suppose the business pays out that $20 as a dividend and reinvests only the original $100 the following year. And suppose it repeats this pattern indefinitely. The return on capital is excellent, and it never changes. But the business is not growing. Free cash flow per share is flat. The investor receives a nice income, but the value of the enterprise is standing still.

What We Actually Want

The companies we seek can reinvest all of their earnings – the original $100 plus the $20 earned – at the same 20% rate. In the second year the business earns $24. In the third, $28.80. The value of the business is compounding, and so is the investor’s wealth. This is the difference between a good business and a great one, and it is the difference we spend most of our time trying to identify.

Free cash flow – which we define simply as cash from operations minus capital expenditures – matters so much because it represents optionality. A business generating abundant free cash flow can reinvest in its own growth, acquire complementary businesses, pay down debt, repurchase its own shares, or pay dividends. Any of these, done intelligently, increases shareholder value. The key word in that sentence is intelligently, which brings us to the question of management.

Our Investment Process

Daniel Kahneman, the psychologist who won a Nobel Prize for his work on decision-making, concluded that in probabilistic endeavors like investing, the rewards flow to those who emphasize process over outcome. A good process, repeated consistently, will produce good outcomes over time – even if any single decision may go wrong. A bad process may produce good outcomes in the short run, but eventually the math catches up. We have tried to build a process that is robust, repeatable, and honest about its own limitations.

We spend most of our time on the qualitative characteristics of the businesses we study – those attributes that resist easy quantification but prove decisive over the long run. Competitive advantages. The quality and incentives of management. The culture of the organization. Whether the people running the business think like owners or like employees. These are the things that determine whether today’s high return on capital will persist for five years or twenty.

Our particular focus is on competitive advantages – the structural characteristics that allow a business to charge higher prices or operate at lower costs than its competitors, and to sustain this advantage over time. In Valuation: Measuring and Managing the Value of Companies (2015), Koller, Goedhart, and Wessels identify eight distinct sources of competitive advantage. They describe, in essence, the kinds of businesses we seek:

1. Difficult-to-replicate patents or proprietary processes
2. Brand or franchise quality that creates a perceived or real difference
3. Switching costs that make it expensive for customers to leave
4. A dominant or monopolistic position within an industry
5. Disruptive innovation or uniquely efficient processes
6. Unique resources – materials, geography, regulatory licenses, or other scarcities
7. Economies of scale
8. Structural low-cost production

This kind of research requires a deliberate environment – one that favors reflection over activity and depth over breadth. We try to build this by minimizing distractions and channeling our energy into reading, learning, and thinking, rather than into the ephemeral pursuits that consume much of our industry, such as marketing and the cultivation of media appearances.

We evaluate company leadership not by their quarterly presentations but by their long-term capital allocation. Do they reinvest in projects that earn above their cost of capital? Are they incentivized to build value over years, or to manage the stock price over months? Do they think like owners? The short-term direction of a stock price is unknowable. The long-term economics of a well-run business are not. We try to focus on the latter, and we look for management teams that do the same.

Long-Term Focus

In pursuit of exceptional long-term returns, we are willing to embrace unconventional ideas and tolerate periods of underperformance. During such periods, we stay the course, and we often add to our highest-conviction holdings when prices decline. Some managers spend their careers trying to match a benchmark or to avoid straying too far from their peers. We do not. If periodic underperformance is the toll for superior long-term compounding, we pay it willingly. Outperforming over a decade or more requires a willingness to look wrong over a quarter or a year, and this is an advantage that is available to anyone but exercised by almost no one.

Our ability to invest this way depends, in no small part, on you. The most important asset our investors bring us is not their capital. It is their temperament. Superior long-term compounding is only possible when investors can endure volatility without losing their nerve – when they can view a 20% decline as an inevitable feature of equity ownership rather than as evidence that something has gone wrong. This is why we are so particular about the partners we choose, and why your patience matters to us as much as your capital.

Our Sell Discipline

We will sell an investment when its fundamentals deteriorate in ways that impair our long-term thesis, or when its valuation rises to levels that can no longer be justified by even our most generous assumptions about its future. In either case, we may hold cash or short-term equivalents until more attractive opportunities present themselves. Our decisions to buy, sell, or hold are driven entirely by our bottom-up assessment of individual businesses. We do not attempt to time the market, because we do not believe it can be done reliably, and because the attempt tends to produce more harm than benefit.

Conclusion

What we are trying to do is simple to describe and difficult to execute: find a small number of exceptional businesses, buy them at sensible prices, and hold them for as long as the thesis remains intact. Along the way, we will make mistakes – every investor does. But we believe that a disciplined process, applied consistently over time, gives us the best chance of compounding your capital at rates that justify the trust you have placed in us.

We do not know what markets will do next quarter, and we do not spend much time speculating about it. What we do know is that the businesses we own are, in aggregate, well-managed, competitively advantaged, and capable of generating attractive returns on capital for years to come. That, we believe, is the foundation on which lasting wealth is built – not in the frenzy of daily trading, but in the quiet accumulation of compounding returns over decades. We are grateful for your partnership, and we look forward to the years ahead.