10. Please elaborate on the investment process, with detailed emphasis on the most important parts of the process. In particular, please describe the criteria and/or parameters that are used in selecting issues for purchase. Which of these criteria are the most important? Has there been any change in your investment approach over the past ten years? Please explain.

We start with a bottom-up scan of domestic companies, typically looking at most U.S. companies at least four times per year.  We add to that an understanding of the sector dynamics in which companies are operating, an assessment of the business cycle, and a review of macroeconomic conditions. We are looking for companies with stable returns that can be purchased cheaply, or for companies with improving returns that have not yet been recognized by the market.

Our primary screening metric is return on shareholder equity (ROE).  Since World War II, the average return on corporate shareholder equity has been about 14%. And we like better-than-average companies, so we look for companies with ROE over 14%. In a climate of 2 1/2% inflation and 4-5% interest rates, we need to see a P/E less than or equal to the ROE. By contrast, in a climate of 9% inflation and 12% interest rates, we were screening for a P/E less than half the ROE. So, we are always looking for good companies, but the price we are willing to pay for those companies changes as inflation and interest rates change.

Once we have identified companies meeting our ROE and P/E criteria, we begin our fundamental analysis. We dig into their numbers to learn how they achieved that ROE, and whether it is sustainable. We look at growth, profits, financial strength, labor relations, and management teams.

Growth is an important consideration, especially the relationship between growth and ROE. If ROE is higher than the growth rate, the company is probably generating free cash flow. Cash flow puts a company in control of its own destiny. Growth rates higher than the ROE are not sustainable without additional debt or equity financing. We prefer companies with ROE that can comfortably fund growth. We like to see revenue-driven growth, not just cost-cutting or accounting sleights of hand. Revenue tells you if the public is buying the company’s product, and it should be near the level of earnings growth. Both earnings and revenue growth should exceed the industry medians.

Profits are another critical factor. The way to make profits is cost control, and we look for companies whose profit margins exceed the industry median.

Clean balance sheets are important, but can be more or less critical depending on the business and the stage of the economic cycle we are in at the time. Use of debt can help boost ROE when the company is performing strongly, but it can hurt the company when business slows down and the company still has to meet its interest payments. We look for companies with the percentage of liabilities to assets lower than industry medians and then look for free cash flow.

Labor relations and management teams are harder to quantify. In the final analysis, the quality of the management team is all you have, but we don’t know a better way of measuring them than by how well they have done the job historically. The quality of the management teams usually becomes clear in the fundamental analysis that we perform.

We don’t believe that a holding period of “forever” is appropriate in all cases, but are comfortable holding companies as long as they continue to meet expectations.

Finally, our approach has been the same for at least 30 years.