Graham & Doddsville Spring 2017 Issue: Begg, Sosin, Krishna

Columbia Business School is out with its spring 2017 issue of Graham and Doddsville.  It features:

- Interview with A. Rama Krishna of ARGA Investment Management who talked about investing in international markets and in particular, Russia.

- Interview with Cliff Sosin of CAS Investment Partners talking Herbalife (HLF) and World Acceptance (WRLD).

- Interview with Chris Begg of East Coast Asset Management, who we've featured on the site numerous times in the past.  He shares his thesis on TransDigm Group (TDG) and thoughts on Sherwin Williams (SHW).

The new issue also includes student investment pitches such as long Yum China (YUMC), long Alaska Airlines (ALK), long Corning (GLW), and long Dollarama (DOL).


Embedded below is the spring 2017 issue of Graham & Doddsville:



You can download a .pdf copy here.

For more of their past issues, we've also posted up their interview with Kingstown Capital as well as their interview with Meritage Group and MSD Capital.

East Coast Asset Management on An Ownership Mindset: Q2 Letter

Christopher Begg's East Coast Asset Management is out with its Q2 letter.  In it, Begg outlines the "value of an ownership mindset and how it plays an integral part in a compounding triumvirate with a good business and an effective operator."

Comparing investing to horse racing, he highlights how it's important to ask certain questions:

"If we bought this business in its entirety, could we put blinders on for five or ten years and feel secure in our investment?  Our level of comfort is simplified by the three key factors of business (horse), operational excellence (jockey), and the timelessness of an owner mindset (owner/trainer)."


Embedded below is East Coast's full Q2 letter:



For more from this firm, check out their previous letter on understanding the mispricing of an investment.

East Coast's Q1 Letter on Business Adaptation & the Gas Evolution

Christopher Begg is out with East Coast Asset Management's Q1 letter entitled "The Economy of Evolution."  This time he touches on how businesses are constantly thwarted by change and can be forced to adapt.  Three specific forces they're focused on are: the Amazon effect hurting brick and mortar retail, climate change, and a shift to natural gas.

Since most businesses fail to adapt over time, East Coast looks at whether or not the business' terminal value will be better five or ten years from now.

In particular, the letter goes into depth on the 'gas evolution' and how one can play an impending shift in energy demand.  Instead of looking at the producers or consumers, they prefer to look in the middle, or the 'toll bridges' as the global gas supply chain gets built out.

East Coast then dives into a representative idea, a global terminal storage operator.  They started building a stake in Q4 2013 and have continued to add.  They see it as a transformation play as the company had average operating economics but an inflection point should change that with secular tailwinds.

While the letter does not specifically identify the company, the descriptions sound like it could be Koninklijke Vopak (AMS:VPK).

Embedded below is East Coast's Q1 letter:




We'll end with one last quote from the letter: "Proper temperament is one of the most important attributes of the investor - breathing in reason before instinct."

For more from this firm, head to East Coast's previous letter on understanding mispricings.

East Coast's Q4 Letter: Understanding the Mispricing of an Investment

Chris Begg's East Coast Asset Management is out with its 2013 year-end letter.  The Q4 missive walks further down their investment checklist.  Last quarter, we highlighted their letter on competitive advantage and this time they focus on understanding the mispricing of an investment

Through use of checklists, they categorize investment opportunities and identify the bull/bear cases, potential catalysts, long-term fundamentals, various sentiments, and more in order to understand what exactly is driving the mispricing.

This ties in with their concept of 'investment longitude' in that they want to understand the critical data points that truly drive the business (and the stock).  The letter below walks you through how to do so.

In terms of how East Coast has been positioning themselves, they've been shifting more of their portfolio toward 'transformation' plays, or companies benefiting from secular tailwinds.  Begg's letter also details how they purchased a European cable business in Q4.  While they don't specifically identify the position, it certainly sounds like John Malone's Liberty Global (LBTYA/LBTYK).

Embedded below is East Coast's Q4 letter: Navigating Beyond the Pillars:



For more on their investment checklists, head to East Coast's letter on competitive advantage.

East Coast's Q3 Letter: Checklists and Competitive Advantage

Christopher Begg is out with East Coast Asset Management's Q3 letter to investors entitled "Architecture of Reason."  In it, they outline some of their thoughts on the current market, as well as dive into aspects of their investment checklists. 

Begg writes,

"As many of the businesses we own now trade at higher valuations, we now find ourselves in a middling period of fair value.  We are not finding as many new businesses to purchase at a discount yet we remain content with the harmony of our portfolio in absolute terms and in proportion and perspective to other investment considerations, including the octave of cash and the extremely dissonant harmony of bonds."

In the letter, Begg also outlines their economics and competitive advantage checklists:

Economics - Owner Mindset

1. Owner Earnings - cash flow is the lifeblood of the business
2. Wealth creation engine - what is the number? the operating metric
3. Number vector - what is the vector of the number?
4. Economic 'goodwill' - the only goodwill that counts
5. Real vs. nominal profitability - the inflation test
6. Metrics - custom economic score card
7. Intangibles and the vanishing point - demystify all intangible assets
8. Non-economic accounting maneuvers - testing for disease
9. Debt - proportion: is debt proportional to operating income?
10. Statement of cashflows: management's "statement" - initial capital allocation test
11. Equitiy - proportionality: E=MC2 - is equity used in proportionality with its value?
12. Total other obligations: ideal city - harmony - company specific / community


Competitive Advantage

1. Novice test - explain what the business does to a novice
2. TAM - total addressable market by business unit
3. H4 industry - longitude/critical data points of the industry
4. ABC's - diagrams - an actual unit sold, the business model and competitive landscape
5. Degree of Timelessness - is it eternal?
6. Variant viewpoints - CEO parachute test - company and competitor
7. Advantaged moat - the give external senses
8. Nuthatch concept - test 1 - locality: are they a local champion?
9. Test 2 - inversion: can they do something their competitors cannot do?
10. Aggregation of owner earnings - ten years out: confidence of whole vs the parts
11. Gating factors: for industry and company success
12. Elasticity of demand and supply - pricing power - it (is) not but only a tiny knowledge of the eye


Embedded below is East Coast's Q3 letter:




For more investor letters from this quarter, head to:

- Dan Loeb's Q3 letter

- David Einhorn's Q3 letter

- Corsair Capital's Q3 letter

- Cobalt Capital's Q3 letter

Intangible Attributes That Lead to Intelligent Investment Decisions: East Coast's Q2 Letter

Christopher Begg is out with East Coast Asset Management's Q2 letter and in it he tackles the intangible attributes that they feel lead to intelligent investment decisions.

Here's a few of the intangibles they've identified:

- Ability to be receptive
- A curious nature
- Desire to seek continuous improvement

Expanding on investment process, Begg writes,

"Freedom from answers is not indecisiveness, it is an awareness of the biases that lead to false convictions where one roots oneself into a position that is immovable.  We are not always right, and humility has taught us to treat every capital allocation decision we make with the assumption that we are unaware of some unknowable piece of information.  Even after we decide to make an investment, we set a course to discover what we missed."

The full letter is below.  For those less interested in process and investment approach, East Coast also lays out their investment thesis for an agricultural equipment manufacturer at the end of the letter:

East Coast's Q2 letter:




For more from this firm, head to East Coast on transformation investments.

East Coast's Q1 Letter: How an Idea Goes Through Their Investment Process

Christopher Begg's East Coast Asset Management is out with their first quarter letter for 2012.  Entitled "The Art of Fugue," the letter details how an opportunity goes through their investment process and they also provide an update on their portfolio.

Investment process is always a work in progress, so it's interesting to hear how other investors refine this and what they incorporate into their approach.  On East Coast's process, Begg writes,

"Once an investment idea is sourced, the idea is put through an initial checklist and if it has merit it will ultimately be categorized as a compounder, a transformation, or a workout. Next, the investment idea will go through two stages of due diligence – two individual fugues, both in six parts. In each six-part stage we always begin and resolve with our subject, or royal theme, which is a perspective on compounding."

We've highlighted East Coast's investment process before, but their latest letter breaks down the six things they look at (in search of quality of the business):

- Competitive advantage
- Pricing power
- Market opportunity
- Capital itensity
- Economics
- Management

Then eventually they look to answer 4 questions:

1. Does the investment have an attractive expected rate of return? (IRR)
2. Does the investment have a sufficient margin of safety?
3. Do we understand the critical data points that will drive the success and intrinsic value of the business?
4. Do we understand first cause, or why the investment may be mispriced?

Begg then applies the above to a new holding they initiated in the quarter so you can follow along with their investment process to see how they think about everything.  It's certainly a useful exercise and some of you may be able to guess the position.  Embedded below is East Coast's Q1 letter:




For more on investment process, be sure to head to East Coast's letter on transformation investments.

East Coast on Transformation Investments: Union Pacific, Colfax & WABCO (Q4 Letter)

Christopher Begg's East Coast Asset Management is out with their Q4 letter.  Last time, we highlighted their letter on investment process and this time around, they focus on examples of 'transformations' that they invest in.

East Coast defines transformations as businesses that often have average or below-average economics and they are focused on seeking the cause that will produce a 'meaningful inflection point of change' on the economics of the business.

Begg writes,

"Our investment process becomes considerably more important when we try to ascertain if a business is truly transforming and emerging toward greatness.  Every business is either getting better or worse with change, and we feel the market tends to value businesses on a one-point perspective by inferring the status quo.  This can lead to mispricings for those transformations that we identify prior to change agents being reflected on businesses' financial statements."


3 Types of Transformations & Investment Examples

They've broken this down into 3 categories:

Secular:  Prolonged positive inflection point in a business' economics (often after industry consolidation).  Examples that East Coast owns include Union Pacific (UNP) and Burlington Northern Santa Fe (via Berkshire Hathaway ~ BRK.B)

Systemic: A business that adopts new companywide operational and cultural methods that drive change.  Ex: Colfax Corp (CFX), which East Coast purchased in the fourth quarter.

Separation: Often a result of spin-offs, these businesses weren't operating at full potential within the context of a larger organization.  Ex: WABCO (WBC), which they also purchased in Q4.


To read East Coast's thesis summary on each security, read their Q4 letter embedded below:

 


For more from this manager, head to East Coast's thoughts on what defines a great business and a look at IBM.

East Coast Asset Management on Investment Process: Q3 Letter

Christopher Begg is out with East Coast Asset Management's third quarter letter to investors.  Entitled "Inventing a Flying Machine," the letter discusses investment process, something we try to focus on in addition to tracking hedge funds.

On Investment Process

Market Folly is a big proponent of saying that "investing is a continual education" and so today we learn from Begg who writes that, "In order to produce superior compounded returns over time I believe one must not only have a differentiated view but more importantly a differentiated investment process."

East Coast uses checklists to 'invert' their thinking and how they see an investment.  While they will be drawn to something that has cheap valuation, they want to look at why it's priced cheaply.  This falls directly in line with what Charlie Munger likes to say: "invert, always invert."

East Coast looks for a margin of safety in each investment and try to drill down an investment to the critical data points that drive the company's underlying fundamentals.


3 Types of Investments They Focus On

East Coast categorizes their investments in three ways:

1. Compounders - These typically have the longest duration and highest return potential.

2. Transformations -  These benefit from tailwinds either due to secular dynamics or a business' competitive advantage.  They note that many investors often don't have the patience or investment timeframe for these to pay-off.  These could also be labeled 'time arbitrage' plays, a type of investment the likes of John Griffin at Blue Ridge Capital makes.  East Coast has more than two-thirds of their portfolio allocated to compounders and transformations.

3. Work-outs -  These are investments that trade at a discount for whatever reason and they look for this gap to close.  These types of names typically have catalysts and are often invested in by various hedge funds.  East Coast allocates less than a third of their portfolio to these ideas.


Where East Coast Looks For Ideas

Here's their list of places to start:

- Market sell-offs
- Post-bankruptcy reorganization
- Spin-offs
- Industry transformations
- Political and economic clouds

We'd also toss in that in addition to during proprietary research, it doesn't hurt to look at what other investors are doing as well.  Bruce Berkowitz of Fairholme Capital has recommended this as it's a great place to find ideas to do further due diligence on as well.  Tracking hedge funds is the main purpose of MarketFolly.

Lastly, East Coast emphasizes the importance of thorough research.  They recommend finding competitors of the company you're looking at and talking to people involved in each respective industry to gauge the dynamics and competitive landscape.


Embedded below is East Coast Asset Management's Q3 letter:




For more from this firm, we've also posted up East Coast on what defines a great business as well as their past letter on mispricings.

East Coast's Q2 Letter: What Defines A Great Business & A Look At IBM

Christopher Begg's is out with East Coast Asset Management's Q2 letter entitled, "The Beekeepers" where he makes an excellent analogy to investing.  In it, he also delves into what defines a great business and discusses IBM (IBM) as one of their new holdings in context of a larger theme.

Before diving into the IBM idea, we wanted to highlight a few of his salient points from the letter.  He makes a great analogy in the letter writing, "Bees also suffer from the biggest problem of most investors - the inability to sit in a room and do nothing."  Indeed, many great investors have extolled the virtues of patience in investing.

And on the topic of crowded trades, Begg writes,

"We observe that many investors appear to share similar behavior.  Too much demand chasing too little supply will eventually drive prices to extremes, diminishing the resources or future returns for a particular asset class.  We are witnessing this today with money markets and fixed-income securities where yields hover near all-time lows and the crowded hive has to swarm to find more resources."


Why East Coast Likes IBM

Begg highlights that Warren Buffett's Berkshire has become the largest shareholder of IBM (over $13 billion).  East Coast added the name to their books in the quarter and here's some of the rationale as to why:

- IBM has averaged unlevered returns on net tangible assets over the last five years of greater than 20%.

- Their durable competitive advantage exists in the sheer depth of their proprietary intellectual knowledge with which they can solve their customer's complex problems.

- They've targeted four key areas of market opportunity: developing markets, cloud and smarter computing, business analytics and optimization, and smarter planets/smarter cities.

- Perhaps one of the most important: pricing power.  As we all know, Buffett loves pricing power.

- Effective management.


Read their full thoughts in East Coast's Q2 letter embedded below:





For more from this firm, be sure to also check out their Q1 letter on mispricings as well as their thoughts on competitive advantage.

East Coast Asset Management on Mispricings: Q1 Letter

Christopher Begg's East Coast Asset Management is out with their first quarter letter and in it they focus on mispricings.  We like to highlight their letters due to the focus on investment process.  After all, investing is a profession that requires continual education.

Begg shares his wisdom by writing, "Mispricing discovery is intelligent investing. We want to clarify that mispriced does not mean cheap - mispriced investments are not partial to any particular asset class nor are they partial to style boxes and growth rates."

We've previously highlighted how Greenlight Capital's David Einhorn looks for mispricing when investing, seeking to better understand situations to generate returns.

Begg goes on to breakdown mispricings into two types:

Structural - These exist "when an event occurs that forces a large population of owners to sell without any change in the investment's intrinsic value.  Examples of structurally induced selling would include: when an investment is deselected from an index, when a company is spun off from a larger parent company, or perhaps when a company's credit rating is reduced."

Psychological - He says that these mispricings "are driven from collective investor psychology which induces broad selling or a lack of buying in an investment."

East Coast feels that "our greatest source of mispricings occurs when myopic investors have difficulty focusing on the distant compounding merit of a great business (compounder category) or the inflection point of a material change in an industry that is improving (transformation category)."

Begg then goes on to highlight their investment in Colgate-Palmolive (CL) as a prime example.


Current Market Commentary

East Coast also summarizes their views on the current market, writing

"In aggregate, the market is reasonably priced at below 14 times 2012 projected earnings; inverting the multiple means that we are getting a 7.5% earnings yield.  If we include an economic growth rate of 2-3% we arrive at expected equity returns in high single digits."

Their letter also goes on to examine Apple (AAPL), concluding that, "We don't disagree with the quality of the business nor do we doubt that the valuation looks attractive.  What we do struggle with is the ability to truly compound at an attractive rate based on size."  We've also posted up on the subject with our post: The Apple Conundrum.

Embedded below is East Coast's first quarter letter:



For more from this firm, head to East Coast on embracing uncertainty as well as their great piece on gaining an investment edge.

East Coast Asset Management's Q4 Letter: Embracing Uncertainty

Christopher Begg is out with East Coast Asset Management's Q4 2011 letter to investors. In it, he discusses the concept of embracing certain uncertainties. He writes,

"We observe a general misclassification between uncertainty and risk. Looking forward, we also anticipate the general perception of 'risk' versus 'risk-free' assets will change. Central bank intervention to mitigate the effects of the inevitable deleveraging cycle will raise the cost of capital and compromise the value of paper currency. We expect this could be a disappointing realization for those seeking long-term shelter in cash and bonds."

They've somewhat touched on this notion before when in a past letter they outlined why they see heightened and prolonged inflation ahead. This falls into one of their seven broad views in which they have constructed their portfolio currently:

1. Deleveraging
2. 'Fair Wind' for high quality equities
3. Inflation
4. Emerging market consumer
5. Eurozone consequences
6. Jobs and housing
7. Adaptation

We want to draw specific attention to their focus on the emerging market consumer because they aren't the only firm fixated on this phenomenon. Hedge fund Kleinheinz Capital has pointed to the power of the emerging market consumer, but also cautions that inflation is the biggest threat in emerging markets.

On the subject, Begg writes that, "This 'impression, sunrise' of the emerging market consumer is one of the most underappreciated change agents that will ultimately drive global economic growth over the decades to come, and help move the world economy beyond the deleveraging currently at hand."

Embedded below is East Coast's Q4 letter:




Given that East Coast's letters often serve as vehicles for passing along timeless educational aspects of investing, be sure to check out their pieces on competitive advantage and gaining an investment edge.

East Coast Asset Management on the Fear of Bubbles: Q3 Letter

Christopher Begg is out with East Coast Asset Management's third quarter letter to investors. In it, he tackles the latest global macro mess and how the fear of bubbles has captivated markets.

While many equity investors have begun to place a lot of focus on macro events (even betting on macro outcomes), he prefers to stick to his value investing focus. That's not to say that Begg disregards the global macro, though. Last time around, we highlighted how East Coast sees heightened and prolonged inflation ahead.

Instead of letting global macro events dominate their investment strategy, they've simply used macro analysis as a tool to reflect on how various scenarios effect businesses and investments.

Begg aptly describes the current status of financial markets by writing:

"There is a very large disconnect between the prevailing emotional sentiment and truth. The vast majority of investors are tightly huddled in a consensus of uncertainty and fear. Fundamentals and merit appear in solitude at the edge of chaos ... We sadistically love these environments for the bargains they produce."

And he also touches on some of his latest portfolio movement:

"Our new holding in our core portfolio has recently emerged from bankruptcy with a much improved balance sheet. It is in an industry which has been materially improved as capacity has been removed and a more rational shareholder mindset adopted. We bought this business at a free cash flow yield above 15% from current earnings."

As always, East Coast's letters are better read as a whole than summarized and it is embedded below (email readers click the link to read):



Since East Coast's past letters are often focused on timeless educational aspects of investing, we'd recommend checking out their pieces on competitive advantage and gaining an investment edge.

East Coast Asset Management Sees Heightened & Prolonged Inflation Ahead

Christopher Begg is out with East Coast Asset Management's second quarter letter and in it takes a look at markets from a top-down perspective. While East Coast's investment principles are guided by value, they, like many other value investors such as David Einhorn (Greenlight Capital) have incorporated a top-down view into their thought process.

At present, East Coast takes the following notes:

- Developed countries continue to print money.

- Developed world currencies depreciate against emerging currencies.

- "Inflation will be heightened globally and accumulated wealth is at risk of losing purchasing power, therefore we will limit intermediate and long-term fixed-dollar investments."

- As paper currencies lose value, global equities will provide the alternative.

- Businesses with pricing power will outshine those without. (In the past, Market Folly highlighted how Berkshire Hathaway bought Lubrizol due to pricing power.)


Begg has also spent this summer teaching security analysis at Columbia Business School. The letter embedded below introduces his concept of 'finding longitude' which focuses on refining each investment to specific datasets that gauge how a business is truly performing:

(Email readers come to the site to read the letter)



East Coast's letters are always packed with insight, theory, and practical applications of investing so if you haven't read them, we'd highly recommend viewing East Coast's thoughts on:

- Competitive advantage
- On the topic of compounding
- Gaining an investment edge
- Variant perception

East Coast Asset Management on Competitive Advantage: Quarterly Letter

East Coast Asset Management's quarterly letters have become one of our favorites for insight and timeless advice on the topic of compounding as well as variant perception. This time around, Christopher Begg focuses on competitive advantage and the ability of businesses to first become 'local champions'.

Begg writes that, "high quality businesses that can raise prices and whose products have localized advantages with a growing emerging market consumer will thrive." This point is exemplified by Warren Buffett & Berkshire Hathaway, whose latest purchase of Lubrizol was seemingly based on pricing power.

The main gist of the letter is that solid investments are found in businesses with solid competitive advantages that allow them to do something their competitors cannot.

East Coast's letter also goes on to quote Steve Mandel of Lone Pine Capital who said, "Our ability to identify businesses that have the market opportunity, product distinction, competitive advantage and management skill to grow earnings and cash flow for longer than is factored into consensus expectations has distinguished our investment effort over the years."

Lastly, Begg gives an example of misclassifying an investment in Cisco Systems (CSCO) and how he has learned from the mistake. Investors never stop learning and this is the perfect example of why many successful investors critically focus on competitive advantage.

Embedded below is East Coast Asset Management's latest letter:



You can download a .pdf copy here.

Begg has also accepted a position as an Adjunct Professor at Columbia Business School and will be teaching Security Analysis this summer. For more great insight from this firm, check out East Coast on gaining an investment edge.

A Unified Theory of Investing: East Coast Asset Management's Year-End Letter

Today we present the fourth quarter letter from Christopher Begg and East Coast Asset Management. Readers will be familiar with East Coast from their insightful past commentary on consensus versus variant perception in the markets. Their 2010 year-end letter begins with a macro assessment but the meat of the letter focuses on developing a definable edge in investing.

Unified Theory of Investing

Begg says that the Unified Theory of Investing, like Newton's law of gravity, appears self evident once identified. He writes, "in the case of investing, it is both the complexity of the market place and the emotions associated with allocating financial resources that serve to obscure this law."

In short, East Coast proposes that the Unified Theory of Investing is Internal Rate of Return (IRR). The firm then offers the equation that JoC = IRR, where JoC stands for "Joys of Compounding." We previously detailed East Coast's letter on the joys of compounding. They are merely using IRR as a metric for comparing and contrasting investment options. What is the potential IRR of the investment?

To illustrate this, Begg presents a simple analogy: "Just like a shopper walking the aisles of a grocery store, the investor shops for opportunities by the IRR that is intrinsic to the potential investment at the price quoted."

It should come as no surprise that David Einhorn's hedge fund Greenlight Capital evaluates their investments on an IRR basis. As you'll note in Greenlight's year-end letter, there is a section of closed positions where the fund identifies their IRR on each previous investment.

Gaining an Investment Edge

Begg's letter then goes on to discuss a conversation he had with Seth Klarman of the Baupost Group. They focused on how successful investors and firms need to have a definable edge. East Coast identifies a three-pronged approach in their investing edge:

1. Process of Infinite Refinement - Passing through knowledge to arrive at simplicity

2. Perspective - The lens with which you see the world

3. Synthesis - Aggregating, sorting, and curating the right information which can then be viewed critically

These concepts are all discussed in-depth and we highly recommend reading East Coast Asset Management's fourth quarter letter in its entirety, embedded below:



You can download a .pdf copy here.

Yet another great piece from East Coast illustrating a framework for investing. More great market commentary can be found in David Einhorn and Greenlight Capital's year-end letter that we posted yesterday as well as Dan Arbess and Xerion fund's 2011 strategy.

The Joys of Compounding: East Coast's Q3 Letter

Chief Investment Officer Christopher Begg is out with East Coast Asset Management's third quarter letter. Readers will recall that back in the second quarter, East Coast offered a prudent exercise in consensus versus variant perception in the markets. This time around, Begg focuses on the joys of compounding.

The Joys of Compounding According to Warren Buffett

Upon revisiting the early Partnership letters from Warren Buffett, Begg extracted two major observations: Buffett emphasized the importance of compound returns and he diligently assessed what types of investments would allow him to earn such returns.

Importance of Compound Returns

To illustrate the power of compound returns, Warren Buffett used investment examples of Isabella's $30,000 underwriting of Columbus's voyage to find the new world, Francis I of France's $20,000 purchase of Leonardo da Vinci's Mona Lisa, and Peter Minuit's $24 investment to buy the island of Manhattan.

Using Buffett's rate of a 6.5% compounded return, Queen Isabella would have earned $4.4 quintillion, Francis I would have earned $98 quadrillion, and Peter Minuit would have made $763 billion. Obviously compounding is quite a powerful force.

Buffett's Investment Categories

Perhaps the most useful information from Buffett's "Joys of Compounding" exercise is his categorization of investment ideas. He utilized three categories including: generals, workouts, and control.

Generals were undervalued securities where he had no timetable for when the undervaluation might turn into fair valuation. In 1965, Buffett wrote that, "over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories."

Workouts were companies dependent on corporate action for financial results rather than supply/demand factors in markets.

Control investments were obviously where Buffett sought control of a company to institute change. Just yesterday we discussed how Buffett's biggest mistake was actually buying Berkshire Hathaway, a company he took control of.


East Coast's Three Investment Categories

Expanding on Buffett's methodologies, East Coast Asset Management utilizes three investment categories of their own: compounders, transformations, and workouts. Compounders are "strong businesses whose intrinsic value is growing at a healthy rate." Transformations are loosely "businesses where the economics are improving." And lastly, workouts are "opportunistic situations where a structural, observable catalyst is in place to unlock value." To get further feel for their investment process, we've in the past highlighted equity specific research from East Coast with their bullish case on Becton Dickinson (BDX).

For an in-depth look at the categorization of investment ideas and the benefits of compounding, embedded below is East Coast Asset Management's third quarter letter:



You can download a .pdf copy here.

Be sure to also check out Begg's excellent previous insight that focused on consensus versus variant perception in the markets as well as their past look at the deflation-reflation continuum.

Consensus Versus Variant Perception in the Markets: East Coast's Q2 Letter

We're pleased to present the second quarter 2010 commentary from East Coast Asset Management. The letter, penned by Chief Investment Officer Christopher Begg, touches on a number of intriguing and hotly debated topics, including inflation. Some of you will recall that we featured some past commentary from East Coast where they examined the deflation-reflation continuum.

East Coast is decisively in the inflationist camp. They believe that central banks armed with printing presses can only lead to one outcome. Their portfolio is positioned to mitigate the effects of any tail risk events such as hyperinflation, a bond bubble, a spike in interest rates, paper currency debasement, and a double dip recession. You'll recall that Baupost Group's Seth Klarman has also protected his portfolio from tail risk events as a form of cheap insurance.

Summarizing East Coast's stance, Begg writes, "The greatest opportunities to compound capital come from periods where dislocations are being driven more by 'what ifs' than the 'what is'. Fundamentals trump hypotheticals and facts weigh heavier than emotions."

Maybe the most intriguing aspect of their commentary though is the list of consensus views they've compiled. They've outlined 10 areas where there are currently consensus views in the market; areas where East Coast has strafed away from the crowd and into an opportunity with a perceived edge. They see these variant opportunities as a means to mitigate risk away from the consensus. This is a topic we've very briefly touched on in our piece where we examined the hedge fund herd mentality.

Below is East Coast Asset Management's list of 10 consensus views and their corresponding variant perception:

1. Consensus: Everyone is a macro-economist. Variant Perception: Fundamental/value investing and focusing on micro themes is the key.

2. Consensus: Binary extreme outcomes of inflation/deflation. Variant Perception: Individual investment merits based on expected return.

3. Consensus: Flood to fixed income as individual investors chase yield. Variant Perception: Bond bubble. Attractive equity total return expectations.

4. Consensus: Inflation protection via TIPS. Variant Perception: Owning businesses with pricing power.

5. Consensus: Gold - speculators are weak holders. Variant Perception: Own gold for mid-long term as paper currencies are debased. John Paulson started his gold fund for the exact same reason: as a bet against the US dollar.

6. Consensus: Overly bearish. Variant Perception: Bullish on fundamentals.

7. Consensus: Short-term time horizons. Variant Perception: Mid-to-Long term time horizons.

8. Consensus: Low rates will be the norm. Variant Perception: Interest rates will dramatically rise across the curve. (Legendary hedge fund manager Julian Robertson had previously placed a bet on sharply rising interest rates).

9. Consensus: Inferior companies can thrive. Variant Perception: High quality companies have a competitive advantage. East Coast specifically highlights Nestle (NSRGY), Waste Management (WM), Colgate (CL), Coca Cola (KO), Novartis (NVS), and Express Scripts (ESRX). We've seen numerous hedge funds become bullish on high quality companies as well. In particular, Andreas Halvorsen's hedge fund Viking Global favors ESRX. Additionally, we earlier today highlighted East Coast's bullish stance on Beckton Dickinson (BDX).

10. Consensus: Complexity. Variant Perception: Simplicity.

Begg examines each of the ten above listed views in-depth in his most recent letter and ends his commentary by giving us a view of their most recent portfolio construction. We highly recommend reading the entire East Coast second quarter letter embedded below:



You can download a .pdf copy here.

For more from East Coast Asset Management, be sure to check out their recent bullish presentation on Becton Dickinson (BDX) that we posted earlier today. Additionally, those intrigued by the inflation/deflation debate should head to their past piece on the deflation-reflation continuum. For more great investment commentary we posted up Perry Capital's latest letter yesterday as well.

The Bullish Case on Becton Dickinson (BDX) From East Coast Asset Management

East Coast Asset Management is out with an in-depth presentation on Becton Dickinson (BDX). They lay out the bullish case for the company and assume that if you hold it for three years that an internal rate of return (IRR) on BDX if purchased now would be 17.6% annualized. This is not the first time we've covered commentary from this firm as we previously highlighted their deflation-reflation continuum debate. We're excited to bring you their latest market commentary as well as their presentation on Becton Dickinson. So, how do they come to this conclusion on BDX?

Let's first start with the thesis behind this play. Anant Ahuja, Christopher Begg, and Jack McManus have laid out the model for East Coast Asset Management and point out that Becton Dickinson is a niche business with a diverse set of products aimed at capitalizing on the increasing amount of aging baby boomers. Shares have been under pressure due to concerns over exposure to Europe, weak 2009 sales, and unfavorable foreign exchange trends.

The stock currently trades at 8x EV/EBITDA, well below the historical 5 year average of 10.1x EV/EBITDA. They argue that the business has an intrinsic value of $90-95 per share, representing 35-40% upside in the stock. East Coast highlights that Becton Dickinson has an impressive past of shareholder value creation. Over the past five years, BDX has seen 23.5% ROIC, 22.2% ROE, EPS CAGR of 15.8%, and 37 consecutive years of dividend increases. Not to mention, the company has repurchased a consistent amount of shares, with $450 million allocated this year. Given that these are attributes Warren Buffett often likes to see in a business, it should come as no surprise that his Berkshire Hathaway added to its BDX position in the first quarter.

East Coast says that, "the market, in its predictable myopia, has oversold BD out of concerns and speculation over matters that are not implicit in the underlying metrics of the core business." East Coast Asset Management argues that at current share prices, the company is being valued at a future free cash flow of only ~ $4.50 per share. Ahuja, Begg, and McManus wager that this is a floor in valuation as this assumption infers no capital expenditure being allocated toward growth. Their estimates fancy that the business is worth closer to $92 per share (compared to the $67 per share it's trading at currently).

As with any investment, there are also risks involved. They try to highlight these potential headwinds by outlining a possible rise in input costs, a medical device excise tax, as well as low cost manufacturers in other emerging markets thwarting business. Despite these reasons and others listed in their presentation, East Coast Asset Management is confident that the current share price is mainly a "result of macro fears and lack of granular clarity in the short term."

Embedded below is East Coast's twelve page presentation on Becton Dickinson (BDX):



You can download a .pdf copy here.

For more from East Coast, be sure to check out their previous market commentary on the deflation-reflation continuum. Stay tuned as later today we'll also be posting up their most recent market commentary. In the mean time, you can head to some of the recent hedge fund letters we've posted as well for investment insight.