Tuesday, August 26, 2008

Investing in Sustainably Advantaged Businesses - TWST Interview with Larry Coats of Oak Value

We define good businesses as those that we believe have the ability to produce predictable and growing excess cash. The predictability component is defined to a large extent by the company’s positioning relative to customers, suppliers, competitors and substitute products.

If you envision perhaps a diagram where you have a company in the middle and you have those forces — customers, suppliers, competitors and substitute products around it — you would recognize the notion that Buffett talks about in terms of a “moat and castle.” Our use of this framework is really founded somewhat in the teachings not only of Buffett and the “moat-and-castle” concept, but also Michael Porter who is a professor at Harvard and certainly a good strategic thinker. Porter also uses this competitive framework. I asked Mr. Buffett once if this competitive framework that Porter uses is essentially the same thing as his concept of “moat and castle,” and his response to me was, “Well, Porter writes books about it and I make billions, but they’re really the same concepts.”

As we look at good businesses, that’s what we’re asking. Do these businesses have sustainable advantages from an economic and a competitive standpoint so they have the ability to generate above average returns and then can they give us the predictability that we need as we look out into the future. When we get down to the valuation phase, we believe that the value of a business is defined by its future cash flows. We have to value companies looking forward as opposed to looking backwards, if you will. Good management we view as being shareholder-oriented, having demonstrated the ability to run the business and very importantly, having demonstrated the ability to reinvest the excess cash flows that the good business generates into higher-returning investments. If you can’t do that, obviously you need to return that capital to the shareholders.

Then the final piece from a philosophical standpoint is the valuation — good businesses with good management at attractive prices. We view the valuation piece in the framework of a discounted cash flow model using a five-year period and an 8% discount rate, and we’re attempting to buy businesses that we believe are trading at roughly $0.65 to $0.70 on the dollar.