Value-Oriented Equity Investment Ideas for Sophisticated Investors

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Value-oriented Equity Investment Ideas for Sophisticated Investors

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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 investmentideas that are compelling on thebasis of value versus price. In ourquest for value, we analyze the topholdings of top fund managers. Wealso use a proprietary methodologyto identify stocks that are not widelyfollowed by institutional investors.

Our research team has extensiveexperience in industry and securityanalysis, equity valuation, andinvestment management. We bring abuy side mindset to the ideageneration process, cutting across

industries and market capitalizationranges in our search for compellingequity investment opportunities.

THEWIDE-MOATISSUE

MOI Members Share Their Insights in to 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 i nclude Abbott Labs (ABT), Danaher (DHR),

DIRECTV (DTV), Express Scr ipts (ESRX), Hershey (HSY), Intel (INTC),

Jack Henry (JKHY), Johnson & Johnson (JNJ), McCormick (MKC),

MSCI Inc. (MSCI), Norfo lk 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).

NewExclusive 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 Ai r, Haynes International, Berkshire Hathaway

Register at ValueConferences.com
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Table of Contents

EDITORIAL COMMENTARY ..........................................................................3MEMBERS SHARE THEIR INSIGHTS INTO MOATS ...................................7EXCLUSIVE INTERVIEW WITH DAVID ROLFE ......................................... 14PROFILING 20 WIDE-MOAT INVESTMENT CANDIDATES ...................... 26

ABBOTT LABS(ABT)GEODE,GMO,MFS,JENNISON,PRIMECAP,SOUTHEASTERN ................ 26DANAHER(DHR)TROWE,MFS,WINSLOW,VIKING,CAP RE,NEUBERGER............................ 30DIRECTV(DTV)AKRE,BAUPOST,BERKSHIRE,LANE FIVE,SOUTHEASTERN,WEITZ................ 34EXPRESS SCRIPTS(ESRX)CAP WORLD,DAVIS,GMO,TROWE,WEDGEWOOD,WEITZ......... 38HERSHEY (HSY)HERSHEY TRUST,CAP WORLD,FMR,JPM,PIONEER,RENTECH................. 42INTEL (INTC)WELLINGTON,HARRIS,FRANKLIN,GEODE,BLEICHROEDER,WALTER SCOTT...... 46JACK HENRY(JKHY)FINDLAY PARK,JPM,KAYNE ANDERSON,ROYCE,TIMESSQUARE.......... 50JOHNSON &JOHNSON(JNJ)FAIRFAX,FRANKLIN,MFS,WELLINGTON,WEST COAST............. 54MCCORMICK(MKC)TROWE,FRANKLIN,PARNASSUS,MS,NEUBERGER,GEODE.................. 58MSCI(MSCI)BAMCO,DELAWARE,GSAM,IFP,MSIM,TROWE,VALUEACT....................... 62NORFOLK SOUTHERN(NSC)CAP RE,CAP WORLD,CITADEL,DFA,GEODE,MS,TROWE...... 66ORACLE(ORCL)CAP RE,CAP WORLD,MFS,FMR,GMO,HARRIS,EAGLE,TROWE............ 70PFIZER(PFE)WELLINGTON,TROWE,FMR,MFS,CAP WORLD,DODGE &COX,GMO .......... 74PROCTER &GAMBL E(PG)BERKSHIRE,CAP WORLD,PERSHING SQUARE,YACKTMAN,GMO . 78REPUBLIC SERVICES(RSG)CASCADE,SENTRY,FRANKLIN,SASCO,CAP RE,ARTISAN........... 82STRATASYS(SSYS)KORNITZER,PRIMECAP,SAMSON,TIGER TECH,TURNER,WELLS............ 86TYCO(TYC)CITADEL,CLEARBRIDGE,DODGE &COX,IRIDIAN,MFS,THREADNEEDLE............ 90UNION PACIFIC(UNP)CAP WORLD,CAP RE,TROWE,WINSLOW,JPM,DFA,PRIMECAP....... 94WAL-MART(WMT)BERKSHIRE,CAP WORLD,EAGLE,FRANKLIN,GMO,MARKEL................... 98WALT DISNEY(DIS)CHILDRENS,DAVIS,FMR,MARKEL,TIGER GLOBAL,TROWE............... 102

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


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Editorial Commentary

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 sustainablecompetitive advantageare rare.

Making matters worse, imposters abound, as CEOs are naturally inclined to

portray their companies as great, and as many businesses manage to earn highreturns 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 markets apparent judgment that

each of these businesses is sustainably greatas deduced from the stocksaggressive market quotationsmay 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 mediocreequities, 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 considerablylower 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--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 ourrecent 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

T
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at Wide-Moat Investing Summit 2013 (online at ValueConferences.com). We alsobring 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

youll uncover some new nuggets of wisdom on the following pages.

Before we delve into this months three highlighted ideas, Id like to review the topselections from last years 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 Im not sure we

would be reviewing the selections had they worked out poorly. So, take this exercise

with a grain of salt. Nonetheless, its interesting to consider each of the three thesesbelow. 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 youll 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 companys 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 ANFs large FQ1 share repurchases may have been badly timed, they reflect

managements 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 Goldmans the-client-comes-

first faade, the firms 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 companysnegotiating 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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We found this years choice of the top three wide-moat ideas more difficult, asreasonable 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)

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 isthe 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 wellas increasing leverage, we like the risk-reward.

Norfolk Southern (NYSE: NSC, $73 per share; MV $23 billion)

Norfolk Southerns model has improved over the past decade, as higher gas pricesand 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.

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Oracle (Nasdaq: ORCL, $30 per share; MV $142 billion)

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. Thecompany 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 friendlycapital 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. The10thValue Investing Seminarwill 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 atWide-Moat Investing Summit 2013on 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 Lountzisof Lountzis Asset Management, David

Rolfeof Wedgewood Partners, Dave Satherof 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, CFAand The Manual of Ideasresearch team

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Members Share Their Insights into MoatsWe 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 Wide-

Moat Issue included the wisdom of Pat Dorsey, Daniel Gladi, Michael McKee,

Guy Spier, Josh Tarasoff, and other MOI members. If you have not seen lastyears issue, we highly recommend downloading it from The Manual of Ideas

online members area athttp://www.manualofideas.com/protected

ETHAN BERG,CHIEF INVESTMENT OFFICER,G4PARTNERSHIP

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 thoseneeds better than any other firman 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.

The three most important things to look at in searching for competitive

advantage are 1) customers needs, 2) a companys 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 hediscussed 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 strongmarket share amongst concert pianists. Today, it has strong market share

amongst concert pianists. While they are still short of Buffetts 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 Steinways legendary sound. (For

institutions, it is durability. For furniture buyers, it is type of wood and size. For

We have in our living rooma piano made by Steinway.One hundred years, ago,

Steinway had strong market

share amongst concertpianists. Today, it has strong

market share amongstconcert pianists. While they

are still short of Buffettspreferred holding period of

forever, they remain a

candidate.
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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 isnt 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 youcould 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, youll end up with a pretty good view of the market.

Lets 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 modeland 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. Im quite certain we were the first (in

2003) to figure out how to scrape the companys 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 all-

time 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.

Carmaxwas once thoughtto be a terrible business. In

the late 1990s and early2000s, they found themselves

in a land grab war withAutoNation. The companyspent millions of dollars

building huge superstores allacross America, racking uphuge losses. The stock fellnearly 90% from its IPO

price. AutoNation eventuallycried uncle and gave up. That

day KMX shares hit an all-time low. However, this was

the best possible news forKMX.


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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 marketa 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:

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 dont 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 offerno-haggle pricing, 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 whatmakes 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.

My experience withinvesting in Carmaxis that

despite the long-termadvantages, the stock marketcan still be overly concernedwith near-term issues. KMXstock has been quite volatile,which is great for the longer-term investor since you can

continue to buy stock duringperiods of weakness. Only by

having conviction in thelong-term advantages areyou able to buy with bothhands when the market is

giving it to you.


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JOHN GILBERT,CIO,GENERAL RENEW ENGLAND ASSET MANAGEMENT

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 likean

oligopolistic industry structure with high shares for the participants, a well-known 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 isnt 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 had80% share of the mailroom equipment market. A good businessuntil 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 bookIts Earnings That CountI 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: costleadership, intangibles, switching costs, network effect, and efficient scale. I add

a sixth criterion: ecosystem (e.g., Apples 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 producta left-right landscape

analysis. When I bought video retailer Blockbusterbecause 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 Blockbusters 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. Dont just look at traditional

substitutes (left-right), also consider alternate substitutes (up-down).

Mead Johnsonhas all thethings we likean

oligopolistic industrystructure with high shares for

the participants, a well-known and longstanding

brand name in Enfamil, andunusually large exposure toemerging market economies,where infant nutrition andsafety can be even biggerissues than in developed

markets. Beyond the industrystructure issues, however,

MJN has an advantage most

businesses crave but do notpossessprice-inelastic

customers.
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ARKO KADAJANE,PORTFOLIO MANAGER,AMBIENT SOUND INVESTMENTS

We dont have any good quantitative metrics for finding companies with

sustainable competitive advantage. Its 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

its 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 arent 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

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 returnswhile keeping new competitors at arms-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 numbershigh 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 oligopolybut

it is extremely difficult to compete against them.

Fannie Maeand Freddie Macboth 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

debtand the stacking of the debt in a few maturitiesgreatly 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, its quite likely there will be a low or zero

Having an oligopoly alonedoes not assure a good

investment. However, anoligopoly with wise

management can be fantastic.This will quickly show up inthe numbershigh return on

equity, high return on

capital, high free cash flow.


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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, la Munger, a latticework of mental

models drawn from the master teachers on competition and competitive strategy:

Buffetts complete corpus, Porters five forces, Greenwald, Pat Dorsey, and

classic microeconomics works such as Shapiro and VariansInformation 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 (low-

cost provider), Sees (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 foran 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

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 along period of time? Does it have a pristine balance sheet? If a business

generates high returns through leverage and financial engineering, it probably

doesnt 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 wont 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 dont pay too much.

Does the business show ahigh return on shareholdersequity over a long period oftime? Does it have a pristine

balance sheet? Does thebusiness have pricing power

or brand presence or thelowest-cost production? Doesit have high margins and atrack record of consistent

free cash flow generation?
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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 wasnt 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 mortemand reach the conclusion that

Indigo didnt 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 isnt easy to do. The search continues

GLENN SUROWIEC,PORTFOLIO MANAGER,GDSINVESTMENTS

I probably have a non-traditional perspective on wide-moat investing. I

largely accept that, if executed correctly, wide-moat investing is a relativelylow-risk way to achieve market-beating returns. That said, in this pursuit one

will likely find more moat imposters than not. Why?

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 cant withstand a flood of new supply. Industry pricing

and returns come down; companies get re-priced from extraordinary to ordinary.

Its 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]. Its rare to find a truly wide-

moat company, and even more so to find one thats materially undervalued. I dotrack 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 theres an absence of competitors.

Microsoft [MSFT] stands out in this regardhigh returns, with ambivalent

customers just waiting for a new entrant. Cable/phone companies are other

exampleswe 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 thats 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.

My advice is to be reallyhonest about how durable the

moat is. If you find acompany that truly has a

wide moat thats materiallydiscounted, then back up the

truck because there are feweasier ways to make money.

A current example would beApple.


14/117



Exclusive Interview with David RolfeWe 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

Wedgewoods 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: Youve 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.

David Rolfe: I was born and raised in St. Louis, Missouri and thats 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. Ill never forget Investments 334. I didnt 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 couldnt get enough of it. He made it very interesting.

In factmyself and another student and the professorwe actually started the

student investment club at the University of Missouri, St. Louis. It started out as

a paper portfolio. Its still there, still running. Its $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 exposureto the likes of Buffett and Graham, Templeton, and T. Rowe Price He was

also influentialif 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 couldnt sell a brokered CD to my

parentsbut 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 Boatmens Trust. St. Louis is a big trust company town.

What was key in my career development at that firmall the portfolio managershad 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 Boatmens Trust, luck

would befall me again in that the founding chief investment officer of

he put me in the direction

of outside reading, non-academic reading. That wasmy first exposure to the likes

of Buffett and Graham,Templeton, and T. Rowe

Price He was alsoinfluentialif you really areinterested in this topic, buy

these books.


15/117



Wedgewood Partnersthe firm was founded in 1988 so this is in the spring of

1992the founding chief investment officer retired.

At the ripe old age of thirtyand I knew all the mysteries in the investment

worldwith 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 199221+ years.

MOI:Youve had a great track record since then. Im curious to delve a little bit

deeper into that investment philosophy of yours. You have three key tenets

focus, patience, and discipline. Lets pick focus. What do you mean by it?

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, thats how focused we get. By being focused at the

company level, were going to be picky. Were putting our twenty best ideas in

the portfolio, and thats 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. Its not growth for growths sakehypergrowth, imprudent growth, risky

balance sheet leverage growth. Were looking for these terrific businesses,

market share dominating leaders that dont have to use financial leverage.

Once we identify that small subset, we have to wait patiently for the value side

of the equation. Its just as important, critically so. We know if were 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 its the value side of the

equation thats going to be the biggest driver of your potential return on that

company over the next week, month, quarter, year, even two years.

If were right on these business models, they shouldnt be changing that much.

But as we know with Mr. Market, valuation changes constantly and it can get

extreme. Were picky on the types of companies we want to own. And were

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 andinvesting 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. Its really difficult.

If you want to build a portfolio of fifty or sixty, even a hundred terrific growth

companiesI dont know if there are a hundred terrific growth companiesbut

to populate a portfolio that large, you have to suspend a lot of your valuation

criteria just to get them in the portfolio. Its great owning an industry darling

when the stock price is rising and revenues and earnings are terrific. The

Were putting our twentybest ideas in the portfolio,

and thats where we stop.Given that we have very littleturnover at Wedgewood, wehope to own these terrific

growth companies for many

years.


16/117



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, theres got to be some hair on the story. You look at the list of

all the holdings in our portfolio and its very easy to identifygreat company,

but theres an issue with it right now. Thats how you get the opportunity.

Our work is to determine if its a short-term problem thats fixablecompany

level, industry level. And if so, were 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. Weve 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,

thats the biggest thing. Youve got to be patient.

No company clicks along without bumps in the road forever. You look back at

the great investments over timeWal-Mart[WMT], Coca-Cola[KO], maybe

even GEICOas an example here talking about Buffett. There have been plenty

of times when those companies were out of favortheres something going on

at the company level [so that] the valuation comes in.

The trick is to discern if its a short-term phenomenon thats fixable or not. Our

biggest mistakes have been getting the company wrong, not the valuation

wrong. Were not chasing momentum stocks, paying 35x, 40x earnings for a

20% growerif the stock turns out to be an 18% or 19% grower and the

valuation comes down, theres the mistake. Its getting the business wrong.

Thats where our focus is at Wedgewood, day in and day outat 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:Lets 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 thats where some investors make the

mistakehow do you separate those truly outstanding businesses? We already

heard from you that they are quite rare. There arent that many out there.

Rolfe:You do even a little cursory screening of companies of reasonable size,

say $5 billion and above, large mid-cap to large-cap, thats our universe.

Depending on where you are in the business cycleif 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 were looking for to discern great from good is ultimately profitability. If a

company has significant competitive advantagesthe 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, theyre 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 theres this great business franchise

thats generating unlevered returns on invested capital of 20%, 30%, 40% or

theres got to be somehair on the story. You look atthe list of all the holdings inour portfolio and its very

easy to identifygreatcompany, but theres an issuewith it right now. Thats how

you get the opportunity.


17/117



even higher, thats 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 isnt that large. There are only four of us at

Wedgewood. Including the companies we have in our portfolioright now its

about twenty-twoand on our shortlist at any given time its maybe another ten

to twenty companies.

While we only have four people doing this, our watchlist is only about thirty-

five or forty companies, its not that many. That list doesnt 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 weve only owned a little

more than seventy-five or eighty others. Thats it.

We swung the bat about a hundred times in twenty-five years. Im linking my

previous firm since over the course of Wedgewood weve owned most of those

stocks that were in the portfolios at my predecessor firm. Thats it. We think

thats a market distinction and difference to so many firms. Thats 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?

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

cant become complacent. There are times when competition begins to take its

toll, and thats 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

stocks crutching quite a bit. Thats 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. Thats 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 thats sustainable? It

seems growth in a way is cyclical

Rolfe: How we try to differentiate between this idea of secular growth and

cyclical growthwere reminded of T. Rowe Prices 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 arent

necessarily forging a long-term growth path that we would find attractive. The

way we view secular growth is, all companies are cyclical and its just that over

We swung the bat about ahundred times in twenty-fiveyears Thats it. We thinkthats a market distinctionand difference to so many

firms.


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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 were looking for at a minimum is a company that can double over three

to five years. If we dont think a company can double, its probably not a good

enough growth opportunity. Were only looking for twenty companies.

MOI: We are in a low interest rate environment When you invest incompanies that are growing rapidly, that have prospects for sustained growth,

how does the level of interest rates affect your thinking about value?

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].

Weve 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 theyre going to

start returning buckets of it back to shareholders, which we applaud. They dont

need $150 billion to stay relevant. Interest rates are so low that they can take

advantage and borrow money, and its 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.

Were 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 dont have those opportunities and theyre

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, youcant chase that so-called leadership just because youre behind.

The markets can change on a dime. Leadership can change on a dime. Low

interest rates change behavior on a number of fronts. Were 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.

This is a unique period.Consider how low interestrates have been for such a

long period of time. Itchanges a lot of behavior.You have changes in your

opportunity set. As anexample, our largest holding

isApple[AAPL].


19/117



Rolfe:Thats a classic problem with the so-called Fed model. You put in a silly

discount rate and youre going to get some obscene prices. When we do our

valuation work, we always have to step back and say, what variable doesnt

makes sense here? What variable isnt 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 ifrates went up 200 basis points?

When it comes to valuation, when were 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 youre 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? Thats part experience, part discipline. We dont model

to the second or third decimal point. Theyre 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: Its the valuation thats going to give us an opportunity, or an extreme

valuation thats going to turn a decent investment over the near term into a really

good investment. So many people have said it over the yearsBuffett and

Munger includedvalue 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 industryfor various institutional, imperative-

driven reasonsthey want to talk about growth or value and put managers incertain camps. We want to do both. And again, if were 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 dont have to

lower our hurdle on either score to get something into the portfolio.

On the one hand, its good that the industry is like this. It gives us opportunity.

Im glad that 98+% of money managers out there arent focused managers. It

keeps us away from the traffic jam, if you will.

MOI: Youve studied the example of GEICO to illustrate this misnomer of

growth versus value investing. Can you share with us some of the insights that

youve got out of studying GEICO over the years?

Rolfe: Its a story weve liked to tell when weve 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 purchasehe 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

the history of GEICO isripe with examples for

growth investors and valueinvestors. The company was

started in 1937 with about$100,000 in seed capital. In

1948, Benjamin Grahambroke his rules and he put

25% of his investmentpartnership in a privately

held company.


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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 wasnt for GEICO, his

reputation as a great investor wouldnt have been such. Whats 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 Buffetts 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 atGEICO, 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 1995-

1996, when the details were singing the praises of GEICO

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 Nicelys foot.

When Buffett arrived on the scene, GEICO was spending about $33 million in

advertising per year. Theyre up to a billion now per year. Its three times the

advertising, roughly, of their three largest competitors combined.

Ive 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 BenjaminGraham 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 rebirththe impact of Buffett. Its been sixty years, and Buffett still

sings the praises of this great growth company, GEICO. Its the story I like to

tell to explain what were 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:Lets 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 littleabout Applehow 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 havent had the same regular

sequence, and there are many people who believe that Apples 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 Apples earnings have

disappointed, they were still generating buckets of cash.

There are plenty of timeswhen a great growthcompany stumbles.

[GEICOs] was a significant

stumble back then, but allalong the way, there weretimes that GEICO was

eminently investable in termsof a good valuation, and allthe while, the growth was

clicking along.


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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 two-

thirds. At [recent] prices, the market-implied growth rate is flat. Its assuming

flat growth and a significant and permanent contraction in their margins, and we

dont think thats 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. Thats 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 ecosystem growth is very healthy. 400+ million iOS users, hundreds of

millions of active iTunes credit cards. We think the markets obsession with

individual products at current margins, prospective margins, one-off product

introductions, one-off product growth rates clouds the judgment of thisecosystem growth. Ultimately, these various products and services are

peripheral, important but peripheral, to the growth of the ecosystem. We dont

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 doesnt take much

to move the needle. In total, they are going to return about a hundred billion

dollarslargely sixty billion in stock buybacks over the next 2.5 years.

Theyre 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,

theres going to be this growing franchise that prospectively can have anywherefrom 20%, maybe one-thirdthats probably a little bit on the high side over the

next five yearsof their shares bought back. Thats a big driver of intrinsic

value growth per share. Well see how it turns out; Apple is our largest holding.

MOI:Some investors would sayand perhaps that is the key factor that makes

some investors uncomfortable with Appleis this comparison with Nokia

[Helsinki: NOK1V], this comparison with other technology companies where

you just dont know the rapid change and the risks. Is that in your view the key

insight herethis ecosystem that Apple has versus lets say Nokia?

Rolfe:Thats a great question. The reason why Nokia is where it is right now is

they havent had an ecosystem. Their products were one-off hits and misses if

you will vis--vis the competition. As much as I say that these gadgets areperipheral 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 iPhones been out since 2007and they just recently again won

J.D. Powers for consumer satisfactionwe 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. Theres no question about

The reason whyNokiais

where it is right now is theyhavent had an ecosystem.

Their products were one-offhits and misses if you will

vis--vis the competition. Asmuch as I say that these

gadgets are peripheral to theecosystem, make no mistakeabout it: IfApplestarts todeliver me-too, low-qualityproducts, the ecosystem

growth is going to grind to ahalt, and that ecosystem can

shrink.


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it. Its 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.

Theyre at a run right now. iTunes and accessories are surprisingly at a runway

of $16-17 billion per annum. Thats starting to approach the size of Windows or

Microsoft Officethats significant. Thats also part of the ecosystem. Apple

has a number of avenues of growth that feeds that ecosystem. As long as theyredelivering high quality, best-in-class consumer satisfaction with their products,

well 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?

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. Im very pleased that the emphasis is going to be on buying back

stock, its 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, Im sure a

lot of the management would like to have that cash back.

Apple is a difference [because] theyre still generating a ton of cash. That

buyback shotgun is going to be loaded and recocked three or four years from

now. Theyre going to return $100 billion by the end of 2015. Its not like, there

goes the cash, now what? Apples business model and cash generation speak to

ongoing share buybacks that can be very significant. Its not out of the realm tenyears from now that half the shares could be bought back.

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Value-Oriented Equity Investment Ideas for Sophisticated Investors