The Manual of Ideas Top Ten Interviews

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    Dear Reader,

    Since the inception of BeyondProxy in 2008, our goal has been tobring timeless investment wisdom and timely ideas to our membersworldwide. Through The Manual of Ideas and ValueConferences, wehave rallied intelligent investors around a shared mission of lifelonglearning.

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    Exclusive Interview with

    61

    Exclusive Interview with

    3

    Charles de VaulxExclusive Interview with

    26

    Pat Dorsey

    Exclusive Interview with

    37

    Tom GaynerExclusive Interview with

    43

    Joel Greenblatt

    Exclusive Interview with

    45

    Howard MarksExclusive Interview with

    55

    Michael Maubossin

    Allan Mecham

    Exclusive Interview with

    67

    James Montier

    Exclusive Interview with

    71

    Guy SpierExclusive Interview with

    83

    Amit Wadhwaney

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    Charles de Vaulx joined International Value Advisers, LLC (IVA) in May 2008 as a partner and portfolio manager, andserves as chief investment of cer, partner, and portfolio manager.

    Until March 2007, Charles was portfolio manager of the First Eagle Global, Overseas, U.S. Value, Gold and Variable Funds,together with a number of separately managed institutional accounts. He was solely responsible for management of theSo re Fund when it won an Absolute Return Award for “Fund of the Year” in the global equity category in 2005 and 2006.In addition to sharing Morningstar’s “International Stock Manager of the Year” Award in 2001 with his co-manager, Charleswas runner-up for the same award in 2006. From 2000 to 2004, Charles was co-portfolio manager of the First EagleFunds. He was named associate portfolio manager in 1996. In 1987, he joined the SoGen Funds, the predecessor to the

    First Eagle Funds, as a securities analyst. He began his career at Societe Generale Bank as a credit analyst in 1985.Charles graduated from the Ecole Superieure de Commerce de Rouen in France and holds the French equivalent of aMaster’s degree in nance.

    The Manual of Ideas: It’s a pleasureto have with us Charles de Vaulx,Chief Investment Of cer atInternational Value Advisers. Charles,welcome.

    Charles de Vaulx: Thank you.

    MOI: Charles, how did you becomeinterested in investing?

    de Vaulx: I became interested at anearly age. My rst investment wasa gold coin in late 1975 at the age

    of fourteen years old. My rst stockwas in 1976, after what had beentwo very dif cult years following the1973-’74 oil crisis and recession. Atthat time I was in Paris, but I had justbeen there for a few years.

    Prior to that, from age ve to twelve-and-a-half, I was living with myparents in Johannesburg, South

    Africa, and before that I was bornand spent ve years in Morocco.My father worked in the oil industrywith Total. I think that my time inSouth Africa and my exposure tobusiness through my father helpedme get interested as a child inunderstanding businesses. Evenbefore the oil crisis of ’73-’74, therewere major ideological challenges.Communism was still a major threatworldwide. We tend to forget.

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    Both of my grandfathershad been in the military. Itoccurred to me at an earlyage, perhaps at the age of9, that going forward thereal wars may no longer bemilitary, but more economicwars, ideological wars and,hence, I felt that I needed tounderstand money, industryand nance as opposed todoing what my grandfathershad done and go into themilitary.

    Exclusive Interview with Charles de Vaulx

    Both of my grandfathers had beenin the military. It occurred to me atan early age, perhaps at the age of9, that going forward the real wars

    may no longer be military, but moreeconomic wars, ideological warsand, hence, I felt that I needed tounderstand money, industry and

    nance as opposed to doing whatmy grandfathers had done and gointo the military.

    As a young child in Morocco andlater traveling with my familythrough Southern Africa, I wasexposed to poverty growing up,which scared me. It impressedupon me the importance of savingso that you can at least have theessentials — shelter, clothing, food.These experiences made me realizethat nothing is a given.

    After I bought my gold coin and myrst stock my interest only grew. I

    read the nancial newspapers eachday and during my lunch breaksat school I would sometimes takea quick subway ride to the ParisBourse. Much later, in 1983, as apart of my studies in France, I wasable to get a six-month internshipin New York City in 1983. I wastwenty-one years old at the time,and three out of the six months Ispent with Jean-Marie Eveillard,

    with whom I worked subsequentlyfor a long time. Jean Marie taughtme what I knew nothing of at thetime, which is value investing-

    the concept that investing is notnecessarily about nding growthstocks, and that markets can beinef cient enough sometimes thatsome stocks can trade at times ata 30% or 40% or 50% discount towhat the companies are actuallyworth.

    MOI: How did working with Jean-Marie Eveillard influence you? Canyou share with us perhaps thesingle biggest lesson from working

    with Jean-Marie?de Vaulx: There are several thingsI want to mention, but if therewas one overriding theme, it’s theclarity with which he conveyedto me the obvious if one ismathematically inclined: if youcan minimize drawdowns, andif you can minimize losses onestock at a time in your portfolio,that is mathematically one of thesurest and best ways to compoundwealth. This is opposed to shootingfor the moon, betting the farm andtrying to nd stocks that may go upten times – the ten baggers.

    Other related themes would bethat conventional wisdom amongmoney managers, back then andstill today, was that the only formof active money management wasa concentrated approach — havingonly ten, fteen, twenty stocks andtrying to do as much homework aspossible on those stocks. You’resupposed to have conviction, gofor it.

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    Jean-Marie [Eveillard]understood that therewas another way — hisway — which was to

    have a highly diversi ed portfolio, oftentimes ahundred, hundred and fty,two hundred names, bebenchmark agnostic, andbe willing to make largenegative bets by owninglittle or nothing of whatwould sometimes becomethe biggest part of thebenchmark.

    Jean-Marie understood that therewas another way — his way — whichwas to have a highly diversi ed

    portfolio, oftentimes a hundred,hundred and fty, two hundrednames, be benchmark agnostic, andbe willing to make large negativebets by owning little or nothing ofwhat would sometimes becomethe biggest part of the benchmark.Oftentimes, what becomes thebiggest part of the index is the stuffthat has gone up the most, whichcan be the least desirable whetherit’s Japan in the late ‘80s, or TMTstocks in the late ‘90s, or nancialstocks in ’06-’07. It’s important tonote that diversi cation is okay aslong as it has nothing to do with thebenchmark, as long as you’re willingto make big negative bets and aslong as you know your companieswell enough to have accurateintrinsic value estimates. Wede ne intrinsic value as the price aknowledgeable investor would payin cash to own the entire business.

    I think it’s Warren Buffett who manytimes said that diversi cation canbe an excuse for ignorance. Ifyou only have a forty basis pointposition in a stock you can getlazy and you don’t feel you need toknow everything. I think we showedover time that our estimates of the

    intrinsic values of the companieswe’ve owned have been quiteaccurate. The reason is that eventhough we’re not catalyst-driven,it just so happens that on averagemaybe 15% of the stocks we’ve heldfor many years have been takenover. Through all of these takeoverswe’ve been able to compare ourown internal estimates of intrinsic

    value worth versus the price thatwas paid and history shows thatour estimates have been fairly

    accurate. I believe that there’s noneed to know every detail, ratherthere’s a need to understand the keythree, four or ve factors affectingthe company.

    Another insight that Jean-Mariehad, which I guess I implicitlyshared – having told you my littlestory about my gold coin and mystock – is the idea that one couldbe eclectic. One did not have to becon ned to only large cap stocks.It’s okay to consider bonds - high-yield corporates and Treasuries(when they yield 15% and whenthey are labeled Certi cates ofCon scation – that was the termin 1982). It’s okay also to considerbonds to try and get equity-typereturns. It’s okay also to have cash– cash as a residual, not as a wayto time the market. If you cannot

    nd enough cheap securities, it’sokay to hold cash and just wait

    for those opportunities to presentthemselves. The main objective isnot losing money and compounding

    wealth over the long-term.

    Obviously, like the fathers of valueinvesting – Warren Buffett, WalterSchloss, Ben Graham – JeanMarie was very much a discipleof the notion that leverage hadto be avoided at the portfoliolevel. He also believed that onehad to avoid as much as possibleinvesting in companies that have

    too much leverage or banks orinsurance companies that areundercapitalized.

    Also, I think what was unique withhim, especially as a value investorback then – this was pre-2008 – isthat he was willing to pay someattention to the macroeconomicenvironment. Value investors aretypically very proud to say that theyare only stock pickers. “Only Godknows the future and He ain’t tellingus”, so why waste time trying toguess next year’s inflation, interestrate, GDP growth rate and so forth.I think that Jean-Marie, havingbeen a student of the Austrianeconomists as I had been myself inschool, was keenly aware of creditcycles.

    Being a reader of Jim Grant’s

    Interest Rate Observer and otherpublications, he was aware,especially after 1982, that therewere many countries in the worldwhere the use of debt became moreand more pervasive—debt at thecorporate level, at the householdlevel, at the government level. Ithink being mindful of those creditcycles made him understand that

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    We own a billboardadvertising company inSwitzerland called Af chage[Swiss: AFFN], and it’s quitesmall.

    …our portfolio today is trulyeclectic and multi-cap. Ofcourse, if you look at the topten holdings you’ll nd mid-cap or larger cap stocks. Butif you look at our holdingsin Asia, where statisticallytoday the small-cap stocksare much cheaper than thelarge-cap stocks, you will nda wide array of stocks

    sometimes stocks look cheap – asthey did in Mexico in 1994 – butthen again it was an optical illusion

    because those stocks were cheapbased on earnings that werearti cially inflated because of abig lending boom that had beenhappening in Latin America from’92 to ’94 or in Asia from ’95 to’98 and, more recently, a big creditboom in Europe and the U.S. from’03-’07.

    Then nally, I’ve appreciated that

    Jean-Marie understood that itwas wrong to forecast. You’redeluding yourself if you think youcan forecast. On the contrary, youhave to be aware of how manyunknowns there are as well as fattails and black swans. Also, froma marketing standpoint, Jean-Marie taught me to never promiseanything to clients and certainlynever to overpromise.

    MOI: You describe your investingapproach as cautious andopportunistic. How is that reflectedin security selection and overallportfolio construction?

    de Vaulx: Well, I think I’ll try toanswer your question in a sense ofhow that cautious and optimisticapproach is reflected today, aswe speak, in the overall portfolio

    construction of our funds and theway we pick stocks.

    I think that our portfolio today istruly eclectic and multi-cap. Ofcourse, if you look at the top tenholdings you’ll nd mid-cap orlarger cap stocks. But if you lookat our holdings in Asia, wherestatistically today the small cap

    stocks are much cheaper than thelarge cap stocks, you will nd awide array of stocks. We also hold

    some mega-cap stocks: Total [TOT],I don’t know if Berkshire Hathaway[BRK] quali es as one (probably) aswell as tiny, little stocks in Japan,Korea or Switzerland. We own abillboard advertising company inSwitzerland called Af chage [Swiss:AFFN], and it’s quite small.

    the next year or two or three or four.So it’s short-duration, high-yieldcorporates. The yield is not huge.

    Today, we’re talking about 4%, butthese are what we deem extremelysafe instruments and because theduration is short, there’s no interestrate risk there.

    You also will notice the eclecticnature by the fact that we havesome sovereign debt, and it’sapproximately 5.1% of the portfolio.It’s mostly short-dated government

    debt from Singapore. The coupons,the yields, are de minimis. Here theattempt on our part is to hopefullyget an equity-type return out ofthe underlying currency. The hopeis that the Singapore dollar willkeep appreciating over time and,of course, in two years from nowwhen those bonds mature the ideais to just roll them over and buy newsimilar short-dated bonds and to

    remain exposed to the Singaporedollar. Because that country doesn’thave much of a scal de cit,there’s not much of a long-datedgovernment bond market to beginwith.

    You’ll see the eclectic nature bythe fact that we hold some goldin the portfolio, both bullion andgold-mining shares. I am happyto have convinced Jean-MarieEveillard in late 2001 that gold-mining shares were so obscenelyexpensive, overpriced, that if wewanted exposure to gold we hadto modify our prospectus to giveourselves the right to hold goldbullion. It’s been a great move! Weown a few gold mining shares, butit’s really de minimis and only in our

    You also see our cautious andopportunistic approach reflected inthe fact that we own some bonds.In the IVA Worldwide Fund here inthe U.S., we have a little less than9% in high-yield corporate bonds,mostly a residual from a lot ofbonds we were buying late ’08-’09. So, as a result, many of thesebonds will be maturing shortly in

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    Another negative bet you’llnotice is that, other than afew stocks in South Korea,we have virtually no exposureto emerging markets. Wehave no direct exposure tothe BRICs – Brazil, Russia,India and China – becauseeven though these stockshave come down a lot last

    year and some of them this year, we believe that thesestocks are dead. We arecautious and worried aboutwhat’s going on in China.

    U.S. registered mutual funds. Ourpreference remains, by far, towardsholding gold bullion.

    You’ll notice that at the end of June[2012] we had 12.4% in cash. Insome ways you may want to viewthose short-dated, Singapore dollarbonds as quasi cash in Singaporedollars. The fact that we’re notfully invested tells you that we areworried that we think that, by andlarge, stocks are not dirt cheapenough to be fully invested.

    If you look at the kinds of names weown in stocks or at least if you lookat the top-ten holdings, you’ll noticethat the balance sheets of thecompanies we own are very strong.We are very fond of the expressionMarty Whitman coined a while back,which is that it’s not enough for astock to be cheap, it also has tobe safe – “safe and cheap”. Safetystarts with the balance sheet.

    The cautiousness of the portfoliois expressed by the fact that we aremaking some negative bets. Wehave virtually no nancials exceptfor a few insurance brokers, exceptfor – and we may talk about it later– some tiny positions in GoldmanSachs [GS], UBS [UBS]. Financialsin the U.S. are slightly tooexpensive and in Europe we think

    that most banks remain grosslyundercapitalized

    Another negative bet you’ll noticeis that, other than a few stocks inSouth Korea, we have virtually noexposure to emerging markets.We have no direct exposure to theBRICs – Brazil, Russia, India andChina – because even though these

    stocks have come down a lot lastyear and some of them this year,we believe that these stocks are

    dead. We are cautious and worriedabout what’s going on in China. Webelieve that a soft landing is in thecards, and hopefully that will notbecome a hard landing. Any sharpslowdown in China will have majorconsequences for commodityprices, which in turn will hurt manyemerging countries.

    Some speci c countries like India

    have obvious issues with inflationand current account de cits, notto mention problems with theirelectricity. We’ve seen in Brazilover the past year-and-a-half howgovernment intervention hashad the ability to hurt investors.Investors in Petrobras [SaoPaolo: PETR] have seen PresidentRousseff, basically ask thecompany to think more about

    what’s good for Brazil Inc. asopposed to doing what’s right forthe company’s shareholders.

    Also, we worry about what’s goingon in Europe. We’re not sure whatthe outcome will be. It’s a bigunknown and the way we expressour skepticism towards what’shappening in Europe is by being65% hedged on the euro. We arewilling to hold quite a few Europeanstocks because we believe thatmany of them are multinational andnot necessarily that Euro-centric.

    Conversely, let’s not forget thatquite a few American companieshave a lot of their revenues inEurope. Also, even in the instanceswhen some of our European stocks

    are quite Euro-centric in terms ofwhere their business is conducted,we think that some of these

    businesses may not be as cyclicalas others, or if they are, the price ofthe stock may already reflect thatit’s going to be a dif cult economicenvironment for a long time inEurope. So, in other words, there aremany stocks in Europe where wethink the bleakness of what’s goingon has already been priced in.

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    I’m obviously very familiarwith the expression “buy-and-hold” and that expression,

    frankly, makes me cringe. Idon’t think it belongs to thelingo that value investors use.Value investors know about price and value.

    MOI: In your Owner’s Manual,you state that in the short termyou try to preserve capital while

    in the longer term you attempt toperform better than equity indices.How much of a role does portfoliomanagement play in achieving thisversus a buy-and-hold strategy inessentially the same equities forthe long run?

    de Vaulx: Let me start with thesecond part of the question. I’mobviously very familiar with the

    expression “buy-and-hold” andthat expression, frankly, makes mecringe. I don’t think it belongs tothe lingo that value investors use.Value investors know about priceand value. “Price is what you pay,value is what you get.” Sometimesthe price is way below that value,sometimes the price is at or closeto that value and other times theprice is much above that value.

    The underlying premise for mostvalue investors is that it may taketwo, three, four or ve years for theprice to meet that value. Maybesome of the company’s problemshave to be sorted out. Maybesome of the good attributes ofthe company have to be betterrecognized over time by investors.So, yes, value investors areprepared to wait for awhile for thevalue to be recognized or realized.If for some reason that value getsrecognized sooner then so be it andit’s a bonus!

    Another reason why buy-and-holddoes not make sense is becausethe strength, the moat of manybusinesses, is often not permanent.Because of globalization or

    technological changes, the oddsare high that a business todaywill be very different fteen years

    from now. For instance, retailersthat were popular fty or sixtyyears ago—Montgomery Ward, J.C.Penney [JCP], Sears [SHLD]—noneof these names are truly relevanttoday. Nothing’s permanent.

    understanding correlations. Forinstance, if you are managing aglobal portfolio, you should be

    mindful that if you own stocks inChina along with stocks in Brazil,you need to understand that maybethey are a lot more correlated and joined at the hip than you wouldnormally think. If you are concernedabout the outlook for natural gas,it can be useful to know whatcompanies in your portfolio wouldbene t should prices of naturalgas go up in North America andconversely which companies wouldbe hurt.

    I think understanding correlationsis very important, especially in aglobal world where there’s a lotmore debt in the system than inthe past. We’ve seen the globalnature of banks. A good exampleof this is the paradox of what’sgoing on in Europe. In countries

    like Italy, France and Germany therehas been no residential lendingbubble to speak of, yet the banksin these countries still managedto misbehave, not by lending totheir own people, but by lending toGreece, Spain and Eastern Europeand buying subprime here inAmerica.

    Now, there are a few exceptions,obviously. Warren Buffett hastried to look for those – the CocaColas of the world, the AmericanExpresses of the world. I think asan investor it’s important, especiallyfrom a qualitative standpoint,to look at the past ten years’earnings, but it’s always importantto be mindful that businesses maychange and sometimes for theworse. Technology, the internet,has revolutionized what’s beengoing on in the media industry. Ithas destroyed, to a large extent,the economics of the newspaperindustry. So I think from thatstandpoint, buy-and-hold is — andI mean by that buy and hold for

    fteen or more years — a verybizarre concept.

    Now, the rst part of your question-I’m intrigued that very few valueinvestors ever comment onportfolio construction, in particular

    …understanding correlationsis very important, especiallyin a global world wherethere’s a lot more debt inthe system than in the past.We’ve seen the global natureof banks.

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    Another thing that’s not discussedenough is position sizing. I thinkI’ve made my point about us not

    being big fans at all of runningconcentrated portfolios. I don’tthink I could sleep well at night ifI had positions of 8%, 9%, 10% inindividual names. There is an art toposition sizing, whether this shouldbe a fty basis point position or 1%or 3% position. It may be temptingas a shortcut to believe that youshould always overweight stocksthat offer the highest discount tointrinsic value and vice versa.

    In reality, you have to size yourpositions to take into account fourvariables plus a fth one. The rstvariable is: Does the companyhave a good enough business thatthere’s scope for some intrinsicvalue growth, between the retentionof some of the free cash flow andmaybe some organic growth?

    Can that company see its intrinsicvalue grow by 7%, 8% or 9% perannum, which in itself would be anequity type return. Conversely, isit a mediocre business, a static ordeclining business, where intrinsicvalue at best will be static and atworse maybe declining over time.Obviously, the more scope forintrinsic value growth, the more youcan justify allowing for less of a

    discount, both when you own it andthen when it’s time to sell it.

    The second variable is leverage.The more leverage there is, becauseleverage magni es everything, youshould ask for a bigger discount.You may also, depending on theleverage, want to size your positionaccordingly.

    Something that should have abearing on the position size iscorporate governance and capital

    allocation; for example, if acompany operates in a country likeBrazil where shareholders may bemistreated by the government orthe regulators. Also, regulators mayask SK Telecom [SKM] or ChinaMobile [CHL] to be good corporatecitizens and help the population bynot raising their fees or keeping theprice of fuel low, but that’s at theexpense of the company.

    It’s important to considercorporate governance from agovernment standpoint andpolicymakers’ standpoint, but alsofrom a controlling shareholderstandpoint and/or management.Most companies in Japan andSouth Korea do an extraordinarilylousy job at paying dividends, andyou have to factor that into both

    the discount you should requirewhen you get in and the sizingof the position. And, of course,if the company has a history ofdi”wors”i cation, you should eithernot buy it altogether or, if youdo, make sure the position sizeremains modest to take that riskinto account.

    The fourth variable is liquidity. If asecurity is only somewhat liquid,it is often wiser to ask for a biggerdiscount when you buy it.

    The fth variable is comfort level.For us to be willing to have 3%,4% or 5% of the portfolio in onesecurity, our comfort level has to bevery high. It has to be high in termsof the discount to intrinsic value,our respect for management in

    terms of running the business froma capital allocation standpoint and,most importantly, our comfort level

    that we understand the businesswell enough. For instance, I cansleep like a little baby having 1.8%in Microsoft [MSFT], but the factis that I don’t know where thecompany will be ten years out and Iwould be unable to sleep at night ifit were an 8% position.

    I can sleep like a little babyhaving 1.8% in Microsoft[MSFT], but the fact is

    that I don’t know where thecompany will be ten yearsout and I would be unable tosleep at night if it were an 8% position.

    Obviously, part of portfolio

    management in our case is theidea that there’s no requirement tobe fully invested, which should beobvious if you’re a value investor.If many stocks in your portfolio goup and get closer to their intrinsicvalue estimate, your self-disciplinekicks in. You have to trim yourpositions, raise cash, and youshould hold onto that cash unlessyou nd new securities that offer

    discounts to intrinsic value that arewide enough, and just wait.

    There’s another concept that Ienjoy, which I’ve read in one of BenGraham’s books, where I think heargued that if at any given timeyou can put together a portfolio ofgenuinely cheap securities- whileat the same time Mr. Market as

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    a whole is quite expensive, youshould keep some cash and/orbonds on the side, maybe 20%-25%

    of the portfolio. You’re deludingyourself in believing that the stocksyou have — however factuallycheap they are — will not suffer atemporary unrealized loss as Mr.Market may go down.

    MOI: You state that you are tryingto deliver returns that are asabsolute as possible. Describe thechallenges of doing so in a low-

    return environment. How do youbest preserve purchasing powerover time?

    de Vaulx: That’s a great question.We wrote a piece, Volatility as aFriend in a Low-Return World, inwhich one of the points we makeis that an additional dif culty ofbeing in a low-return environmentis that there’s volatility. And,historically, times of high volatilityand low returns typically have beenassociated with dif cult economictimes. I obviously have in mindthe ‘30s after the crash and thefollowing depression, and theperiod from the ’73-’74 crisis andthen the stagflation that took placein the late ‘70s until stocks andbonds troughed in early August of’82.

    Today’s low-return environment isunique from these other low-returnperiods in history in that stockstoday are not cheap. For example, ifyou think about 1974 or 1982, whenthe S&P was trading at eight timesdepressed earnings, the averagedividend yield was 6.8%. Today theaverage yield is 1.9%. One of theobvious reasons why stocks were

    able to get so cheap in the pastis because we had high inflationand very high interest rates. When

    you have very low interest ratesas we have now, it becomes a lotharder for stocks to become dirtcheap. And even though stocks arein many cases, especially outsidethe U.S., as cheap now as in March2009, and much cheaper than2006-’07, the reality is that after thecrisis, stocks did not go down at allas much as they did throughout the‘70s.

    Because the economic outlook isdif cult, because stocks are notdirt cheap, because I believe thatcorporate pro t margins will godown in many instances, I believethat stocks may only deliver returnsof 4-6% for the next 4-6 years,which is less than the 7-9% equity-type return that one typically wouldexpect out of equities.

    bonds, these things yield close tozero and after inflation they yieldless than zero. If you look at the ten-

    year Treasuries today, in Americathey yield 1.84%. If you look at theten-year TIPS and subtract onefrom the other, the implied inflationexpected for the next ten years is2.6%. So anyone who buys a ten-year treasury implicitly is willing tolose, after inflation, 75 basis pointsper annum. If you compare that toa stock offering 7-10% or more FCFyield and if a portion of that FCF is

    paid out in dividends that represent4-7% or more of the stock price,that stock starts to look compelling.

    On the one hand, because stocksare not cheap enough to offer anequity-type return, you may notwant to be fully invested and, yet,if you decide to only be 60% or65% invested in stocks, which weare now, then you’re diluting yourreturns even more.

    This environment clearly makesit harder to always be up everycalendar year (last year the IVAWorldwide Fund I share class wasdown 1.96% while the MSCI ACWorldwide index was down 7.35%)and makes stock picking even moreessential, as mistakes that youmake carry with them much steeperpenalties. However, the underlying

    volatility makes it possible for agood stock picker to do better thanthe equity market over time. Forexample, if equity markets return anaverage of 5% over the next 5 years,it becomes a lot easier to do betterthan that if those returns come withvolatility (helping you buy low andsell high) than if markets achievethose low returns in a straight line.

    Because the economicoutlook is dif cult, becausestocks are not dirt cheap,because I believe thatcorporate pro t margins willgo down in many instances,I believe that stocks mayonly deliver returns of 4-6%for the next 4-6 years, which

    is less than the 7-9% equity-type return that one typicallywould expect…

    That in itself would argue for somecaution, but then again, the troubleis, if you’re not fully invested inequities, what do you do with therest of the portfolio? If it’s cash and

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    As I mentioned earlier, times ofhigh volatility and low returnstypically have been associated

    with dif cult economic times. Andin dif cult economic times, youhave the additional complicationof government intervention inmarkets. Policymakers tend to tryto make things better or be temptedto kick the can down the roadand postpone the problems. Wehave seen policymakers intervenethrough nancial repression, puttinga cap at very low levels on whatsavings accounts can pay whetherit’s here in the U.S. or in India orChina or if it’s through manipulatingforeign exchange rates. Right now,for example, we see the Swisstrying to make sure that the SwissFranc does not appreciate againstthe euro. In a low-return world, all ofthese interventions further increasevolatility and also increase thebinary nature of possible economicoutcomes. Whatever policies areput into place by governments maylead to deflation, as we saw in the‘30s, or it may lead to inflation andmaybe stagflation.

    When you’re in the business, as wetry to be, of preserving purchasingpower over the short and longterm, I think that you have to beall the more careful not to bet the

    farm if you don’t know whether thenal outcome will be inflation or

    deflation. For example, you shouldresist the temptation to go allout and only own twenty-year orthirty-year treasury bonds, or in ourcase you should not necessarilybe 100% in gold or stocks with thepremise that if there’s inflation orhyperinflation that’s the best way

    to be protected. At this time, wehave not made a call either way-deflation versus inflation- and have

    positioned the portfolio as such.

    If you look at our portfolio todayyou’ll notice that some of whatwe have would be good if thedeflationary forces were to gainstrength, for instance, which couldhappen if there’s a major slowdownin China or if things get worsein Europe. What would help ourportfolio is the cash, especially

    since we are invested in top-notch quality commercial paper.In addition, the majority of stocksthat we own have strong balancesheets, which should performbetter than lower quality stocks in adeflationary environment.

    Conversely, many of the stocks thatwe own share attributes that shouldhelp them do well in an inflationaryenvironment. These are the kindsof stocks that Buffett owned in thelate ‘70s when he worried aboutinflation – non-capital intensivebusinesses, businesses wherethe companies should be able toraise prices by at least as much asinflation. Importantly, with non-capital intensive businesses, allof the earnings are free cash flowthat can be paid to shareholdersas opposed to being reinvested athigher prices in the business.

    Gold, you could argue, is only ahedge against inflation. We’vealways believed that goldhistorically has been an equallygood hedge against deflation.Gold did very well in the ‘30s, notonly because there was a goldexchange status, not only because

    the U.S. devalued the dollar, whichled gold to go from $20.67 in 1932,’33 to $35 in ‘34, but because gold

    becomes very desirable when youhave deflation because there’sno counterparty risk associatedwith gold. Gold is not an IOU. Sowhen banks go bankrupt – 40% ofbanks went bankrupt in the U.S.in the ‘30s – any IOU is at risk dueto counterparty risk, even cashdeposited at the bank. Gold doesnot have that problem. So, inflationcan be good for gold. We saw it inthe’70s. Deflation can be good forgold. Conversely, what is typicallybad for gold is disinflation.

    …gold becomes verydesirable when you havedeflation because there’s nocounterparty risk associatedwith gold. Gold is not anIOU. So when banks gobankrupt – 40% of bankswent bankrupt in the U.S. inthe ‘30s – any IOU is at riskdue to counterparty risk, evencash deposited at the bank.Gold does not have that problem.

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    MOI: You state that you seekinvestments in companies of anysize that typically have one or more

    of the following characteristics– nancial strength, temporarilydepressed earnings, or entrenchedfranchises. What are someexamples of these temporarychallenges, temporary depressedearnings for otherwise nanciallystrong and entrenched businesses?

    de Vaulx: I’ll give you an examplefrom the past and a more recent

    example. I remember in the late‘90s we bought McDonald’s [MCD],the fast food company. Why?Because we were impressedby how global they were, muchmore global than some of theircompetitors. We also, early on,understood what Bill Ackman sawa few years later, which is the realestate angle, the fact that they ownso much real estate, a lot of it they

    rent out to franchisees. Addressingyour question of temporarychallenges, the reason why thatstock became so cheap back thenis that the company was sufferingbecause the food had becomevery bad — much worse than thecompetitors. And the service —there were many complaints aboutthe quality of the service.

    We felt that those two issues werexable. Once those issues were

    recognized by top management,they were eventually able to xthem and the stock over time hasgone up extensively.

    A more recent example wouldbe was last summer, News Corp.[NWSA], Murdoch’s media company.They had the scandal associated

    with their tabloids in the UK. Thestock came down and, yet, we werecomfortable building a decent-

    sized position. The company hada very strong balance sheet, sowe thought that they could sufferhaving to pay some nes. Withhindsight, the balance sheet wasso strong that, in fact, the companyhas been very aggressive buyingback their own shares since then.On a sum of the parts basis, a yearago, the stock fell as low as $15 or$16. We had, on a sum of the partsbasis, a value of around $30.

    News Corp. is a very differentcompany than it was 20 yearsago. News Corp. almost wentbankrupt in the early ‘90s and atthe time it was mostly newspapers,magazines, but today’s businesses,BSkyB, Fox, there’s very little print,in the sense of being threatenedby the Internet. These are very

    powerful businesses — one of thebusinesses is 20th Century Fox,which is a decent business, sopretty un-cyclical businesses withno major immediate sort of threatto their businesses – high marginbusinesses, a very strong balancesheet.

    The way we interpreted thescandal is, we thought it had asilver lining because via somesuper-voting structure, Murdochcontrols the company. We thoughtthat the scandal – because it’ssuch a public business– he wouldbe forced to improve corporategovernance, which I think he has.We felt the Chief Executive Of cer,Mr. Carey, was very competent aswas the predecessor, Mr. Chernin.

    We realized that the super-votingcontrol allowed him to make somemistakes in the past, but small

    mistakes.

    He lost a lot of money when heoverpaid for Dow Jones, thepublisher of The Wall StreetJournal. He overpaid for MySpace,but in the grand scheme of thingsthese were small deals and,conversely, to his credit as a mediaguy, he saw the changes thatwere happening in the newspaper

    industry and moved away from thatover the years. Today, the stock isat over $24. I think that was a goodexample of what we thought was atemporary challenge and one thatwas limited to just one part of theirempire.

    News Corp. is a verydifferent company than it

    was 20 years ago. NewsCorp. almost went bankruptin the early ‘90s and atthe time it was mostlynewspapers, magazines,but today’s businesses,BSkyB, Fox, there’s very little print, in the sense of beingthreatened by the Internet.

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    One stock we’ve boughtover the past six, ninemonths is a French companycalled Teleperformance[Paris: RCF].

    One stock we’ve bought over thepast six, nine months is a Frenchcompany called Teleperformance

    [Paris: RCF]. They run corporate callcenters, and that’s a case where allof the earnings pretty much comefrom the United States. They’re verypowerful in the U.S. In fact, for allpractical purposes, the companyshould be headquartered and listedhere. It’s sort of an accident thatit is listed in France. The Frenchfounder happens to live in Miami,and it’s an interesting case wherethe French operations are losing alot of money.

    It’s much harder in France than inthe U.S. to re people and so theyare not able to stop the bleedingright away in France, and I thinkwe feel that we can quantify whatthose losses will be. Worst case,the company can hopefully shutdown the business over time, and I

    think those losses in France maskthe quality of their earnings in theU.S. Historically, there have beenmany instances where we havedabbled a lot in what we call highquality, yet, cyclical businesses.

    If you think about temporarystaf ng companies – Randstad,Manpower; if you think about thefreight forwarding companies– Kuehne + Nagel, Panalpina,Expeditors International… Ifyou think about the advertisingcompanies, billboard advertising,they are good businesses in theWarren Buffett sense of returnon invested capital — servicebusinesses, high returns oncapital, high free cash flow. Theyare cyclical because, oftentimes,

    other investors have a shorter-termhorizon than we do. Whenever theeconomy goes south, in the world

    or in the country, these stocks godown, sometimes excessively so,so that the stocks implicitly forgetthat there’s a prospect that it’s justa cyclical downturn, not a secularchange in the business. So we’veoften been doing some of this inthe past.

    not global. It has operations mostlyin Switzerland and in a few otherEuropean countries, but to a large

    extent, the business model is thesame as similar companies in theU.S. or elsewhere.

    The way we are organized internallyat IVA is that the work has beendivided among analysts alongsector lines.

    Value investing is an Americaninvention. American value investorswere adamant against internationalinvesting for a long time. Even inthe late ‘90s Warren Buffett wasnot willing to invest internationallybecause there was this belief thatforeign accounting is dif cultto understand, disclosure is notas good. The notion was thatmanagers outside the U.S. don’tcare about shareholders and soforth. The other theme at the timewas that if all you want to do is playin economic growth in the rest ofthe world, you don’t need to investinternationally. Instead, you cando it through Coca-Cola [KO] orMcDonald’s or Microsoft [MSFT] orColgate [CL].

    In terms of understanding thecompanies, we think it’s a hugecompetitive advantage to look atthings on a global scale and by

    sector. At the same time, we remainmindful that there are still somerisks associated with internationalinvesting we have to factor in. Forexample, disclosure is not as goodas it is in the U.S. In the U.S., youhave 10-Ks where companies haveto give some description of someof the business segments they’rein. They typically will tell you if they

    MOI: How does your approach tointernational investing differ fromthat to investing in U.S. equities, ifat all?

    de Vaulx: For a long time, untilalmost in 2008 you typically had,especially in the institutional world,the distinction between domesticinvestors that invest in domesticU.S. stocks and internationalinvestors that invest outside theU.S. We’ve always felt that beinga global investor made moresense because many industries

    are global. If you look at theautomobile industry, it would beabsurd to look at GM [GM] and Ford[F] without being aware of TataMotors [TTM] and Volkswagen[Germany: VOW] and Hyundai andToyota [TM] and so forth. Or thatbillboard advertising company Imentioned earlier, Af chage inSwitzerland, that company itself is

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    We own a stock in Francecalled GDF Suez [Paris: GSZ].One of the businesses is thedistribution of gas to bothretail clients and corporateclients; and even thoughthere have been contractsgoing back a long timestipulating that if certaincosts escalate — contractswith the government — thecompany has the right to pass along those increasedcosts.

    own some of the real estate of theplants, the plant and the equipment.In general, international companies

    give less granular informationregarding the business segments.Also, although there have beenimprovements in corporategovernance and laws to protectminority shareholders, I think it’sfair to say that there are still risks ininternational stocks.

    I’ve talked about the risk ofgovernment interference. We own

    a stock in France called GDF Suez[Paris: GSZ]. One of the businessesis the distribution of gas to bothretail clients and corporate clients;and even though there have beencontracts going back a long timestipulating that if certain costsescalate — contracts with thegovernment — the company hasthe right to pass along thoseincreased costs. More recently,

    the government over a year agotold the company, no, they cannot.Even though a recent court – somesort of Supreme Court – hasargued in favor of the company,our understanding is that thegovernment is not bound to honorwhat that court has decided.

    With international investing, if youlook at companies in Europe andAsia compared to the U.S., moreof those companies, especiallythe small ones, are controlled by afamily or group. The risk associatedwith being a minority shareholderis all the more prevalent, relevant,and I think you have to be mindfulof it. Not necessarily in the senseof not buying any of the stocks,but maybe sometimes asking for

    bigger discounts to intrinsic valuewhen you get in and also makingsure that the position size, which

    we were discussing earlier, doesn’tget too big.

    the Procter & Gambles, the Coca-Colas go down.. Conversely, wehave to be mindful, when we invest

    in yen or in Malaysia, or if we wereto invest in Spain, we have to bemindful of the foreign exchangerisk. Either way, understand thatwe might want to control it throughhedging the currency assumingthat the risk of hedging is notprohibitive.

    MOI: How do you generateinvestments?

    de Vaulx: Compared to many ofour peers, it would be fair to saythat we may rely a lot less onscreens. It would be easy everyweek to run screens globally aboutstocks that trade at low price tobook, high dividend yield, lowenterprise value to sales, enterprisevalue to operating income, andso forth. Generally speaking, a lotof our value competitors beginthe investment process —by thatI mean the search for ideas—bytrying to identify cheap-lookingstocks.

    However cheap a stock such asSK Telecom [SKM] would become

    it would be hard for me to have an8% position in SK Telecom knowingthat it’s a Korean company. Koreais not known for the greatestcorporate governance, and it’s aregulated business where you areat the mercy of the regulator whomay want to favor the number twoplayer, the number three player inthe industry as opposed to let SKTelecom grow market share.

    Another obvious challenge — whichalso impacts U.S. companies —has to do with foreign exchange.Of course, U.S. companies — andwe’re seeing it now with the dollargoing up against many currencies,including the Indian rupee, theBrazil real — from a translationstandpoint, we see the earnings of

    However cheap a stock suchas SK Telecom [SKM] wouldbecome it would be hard forme to have an 8% position inSK Telecom knowing that it’s

    a Korean company. Korea isnot known for the greatestcorporate governance, and it’sa regulated business where you are at the mercy of theregulator…

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    Sometimes using screen devicesthey look for cheap-looking stocksand once they have identi ed a list

    of cheap-looking stocks, then theydecide to, one at a time, do thework and investigate each of thesecompanies. The pitfall with thatapproach is typically those cheaplooking stocks that you’ve identi edwill typically fall in two categories.Either stocks that are of companiesthat operate in overly competitiveindustries or overly regulatedindustries where the regulator maynot always be a friendly regulator.So you may nd steel companies,or some retail companies, or theinsurance industry in many partsof the world is notorious for itsovercapacity and lack of barriers toentry.

    So, either you’ll nd companiesin overly competitive businesseswhere it’s hard, or even worse, you’ll

    nd typically some of the lousiestcompetitors in their respectiveindustry. If you had run a screena day before a company wentbankrupt, the stock probably lookedcheap on maybe a practical basis orprobably enterprise value to salesbasis.

    The problem with these cheap-looking stocks of both categories isthat it’s going to be hard for thesestocks to see their intrinsic value goup over time. If anything, especiallyin the second category, the worstcompetitor type category, some ofthese companies may actually seeintrinsic value go down over time.

    Conversely, what piques ourcuriosity, what makes us want toinvestigate an investment idea is

    not that it looks cheap at rst sight.It’s rather that the business looksneat or that the company seems

    uniquely good and well positionedin what they do, and then we hopeand pray that, for one reason oranother, the stock happens to becheap. I’ll give you an examplewhich goes back many years.Maybe 15 years ago, I was readingbriefly about a company I had neverheard of – Thomas Nelson, a U.S.-based company.

    They were the leading publisherof bibles in America, maybe in theworld. They were also a leadingpublisher of inspirational books andI said, well, book publishing usedto be a great business. It changedfrom being a great business to agood business. Margins went frombeing obscenely high to just highbecause authors asked to be paidmore over time. I said, gee, a bible

    publisher… There’s not much in theway of author rights. That’s prettyneat. Next to that brief descriptionof the business was a P/E ratio thatdid not look low- it was15 timesearnings, a P/B that did not seemlow and a dividend yield that did notlook enticing. So the stock did notlook cheap, but I said maybe there’ssomething hidden. Maybe theearnings are temporarily depressed,

    and so maybe the stock is cheapeven though it does not look so at

    rst blush.

    I was intrigued by the business,and I took a look at it and realizedthat the company had, for the veyears just prior, started to comeup with ve new bibles – biblesfor children, bibles for the elderly

    and so forth – and they hadcapitalized the costs of creatingthese new products. Now that

    those bibles were available for salein bookstores, the company wasamortizing over ve years, or maybethree years, that cost. So now thecompany’s earnings per share wereafter a pretty big amortization ofcapitalized costs, which was nota cash charge. What looked like ahigh price to earnings ratio of 15times was only a 10 times priceto earnings before amortizationof capitalized costs. So the priceto cash earnings was much morereasonable.

    I was intrigued by the fact thatthe company, two years prior, hadmisbehaved. Since they had agood business, they had decidedto diversify and buy into a dif cultbusiness. They had bought aprinting business in the UK. They

    had borrowed money for that, butto their credit, a year later theyrealized their mistake and had soldthat business at a loss, but theyhad sold it and the proceeds werehigh enough to pay down debt.The bottom line is that for the fewpeople who knew that companyin the past, who owned it, theywere disappointed in managementbecause of that one time mistake.

    I felt that, hopefully, managementwould have learned from theirmistake.

    Oftentimes, we will study over theyears great businesses, whetherit’s a Google, an ExpeditorsInternational [EXPD], 3M [MMM],and we keep them in mind andwe have a tentative intrinsic

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    value estimate, and sometimesthere could be a crash. There canbe a crisis like ’08, something

    happens and sometimes thesestocks fall enough that we revisitthem. I talked about these greatbusinesses that are cyclical, thetemporary staf ng companies,most of the time they’re tooexpensive for us to catch, but oncein a while, especially during aneconomic downturn, we’re able tobuy them.

    Even L’Oreal [Paris: OR], theFrench-based yet global cosmeticscompany, a few times in the pastduring an economic downturn,sales slowed down and the growthguys that typically own the stockdon’t want to own it, because thegrowth rate is not there. So theydump it. It still optically looks tooexpensive for the deep value guys.In other words, instead of staying at

    six, seven, eight times EBIT, it maystill trade at nine, ten, eleven timesEBIT. So the growth guys don’t wantit, the deep value guys don’t wantit. It sits in limbo, and that’s whenwe’re able to get those things.

    So it’s not much in the way ofscreening. It’s just the analysts,based on the sector they follow,

    and because some of us have beenin this business for a long time –myself, over 25 years and Chuck [deLardemelle] and Simon [Fenwick]and Thibault [Pizenberg] for manyyears – and because we’ve lookedat tiny companies and huge ones,we have a pretty good idea of whatthe best businesses and companiesare out there in the world, and wekeep them in mind and try to revisitthem when there’s a crisis or a bigeconomic downturn.

    MOI: Where do you see the biggestinef ciencies currently?

    de Vaulx: Many bonds, especiallyU.S. Treasury bonds, Germanbunds, possibly Japanese JGBsstrike me as very expensive.Because of the fear of the unknown,because investors have not donewell for many years, the flight tosafety is so extreme that investorsare willing to buy those bonds thathave yields that, in all likelihood,will be less than what inflation willbe during the time period. In otherwords, owning a ten-year Treasurynote yielding 1.8% strikes me as agood way to grow poor, but I thinkyour question, really, is more onthe long side, what do we think ischeap?

    One of the biggest inef ciencieswould be Japan, where the markettrades at a level that’s lower thanin 1983 – 29 years ago. In Japan,the smaller the stock, the lessliquid a stock, the cheaper it isrelative to other stocks, so smallstocks in Japan are, by far, the

    cheapest. I think some peoplehave run screens, trying to identifyBen Graham’s net-nets around the

    world and an overwhelming numberof names that pop up throughthat screen are many small-capJapanese names. I think thesestocks are cheap for a reason.So maybe inef ciency is not aproper word. Investors have beenvery disappointed over the yearsin Japan by the fact that manyJapanese companies are wellmanaged. They run the businessproperly, many businesses have adecent and sometimes very highreturn on capital employed, but theflaw is the capital allocation.

    Dividend payout ratios are low inJapan and, oftentimes, companieswill pay out no more than 20%,25%, 30% of the earnings. At leastcompanies do not di”wors”ify theway they used to in the ‘80s leading

    up to the bursting of the Japanesebubble, but we’ve seen manyJapanese companies year afteryear keep most of the free cashflow that’s been generated by thebusiness and let the cash pile upon the balance sheets. So there aremany small-cap Japanese stocksthat are quite cheap. There’s onecalled Shingakukai [Tokyo: 9760].It trades below net cash and the

    business is pro table.

    Even L’Oreal [Paris: OR],the French-based yet globalcosmetics company, a few

    times in the past during aneconomic downturn, salesslowed down and the growthguys that typically own thestock don’t want to own it,because the growth rateis not there. So they dumpit. It still optically looks tooexpensive for the deep valueguys.

    …there are many small-cap Japanese stocks thatare quite cheap. There’s onecalled Shingakukai [Tokyo:9760]. It trades below netcash and the business is pro table.

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    The reason why there aren’t asmany inef ciencies today as wewould expect, especially in such

    a dif cult economic environment,is that equity markets aroundthe world over the past eighteenmonths have been quite ef cientin discriminating and establishinga differentiation between stocksof companies that are averageor mediocre from stocks ofcompanies that have greatbusinesses, especially thosebusinesses that are not veryvolatile. If you look at certainstocks such as Nestle [Swiss:NESN], Diageo [DEO], Colgate [CL],Bureau Veritas [Paris: BVI], manyof these stocks are close to theirall-time highs. They are perceivedas extremely high quality, verydefensive, generate a lot of freecash flow, and especially if they paysome sort of dividend, they havebeen bid up accordingly.

    I’m not suggesting that thesestocks are overpriced. I’m sayingthat they don’t offer much in a wayof a discount to intrinsic value.Even though emerging marketstocks have come down quite abit last year and in some countrieseven this year, we believe thatmany stocks look cheap basedon earnings and cash flows, but

    these earnings and cash flows areat risk of being sharply reduced ifthere’s too much of a soft landingin China. So even though emergingmarket stocks have come down, wedon’t deem them to be inef cientlypriced.

    MOI: When it comes to Japan,where do you see the biggestvalues?

    de Vaulx: Not so much todayamong some of the leadingexporters, global-type companies.If you look at the share price ofShimano [Osaka: 7309], whichmakes the bicycle parts, if you lookat Keyence [Tokyo: 6861], Fanuc[Tokyo: 6954], these stocks are notoutrageously expensive, but theyare not cheap. I think it’s smaller

    businesses, oftentimes, althoughthe example I’ll give you is not sosmall.

    Our largest holding in Japan isAstellas Pharma [Tokyo: 4503],which is Japan’s second-largestdrug maker. The market cap is inthe billions of dollars and what’sinteresting with Astellas is thatover the past seven years theybought back 19% of their sharesoutstanding, which is unusual, it’svery un-Japanese. Companiestypically don’t do buybacks, ornot that extreme, so even thoughthe company has bought back alot of their own shares over theyears, even though the dividendpayout ratio is close to 50%, whichis high by Japanese standards,the company’s net cash today stillaccounts for 18% of the marketcap. So the company still has somenet cash, and also the companyhas made a few acquisitions in thepast. The last one was a year anda half ago, a U.S. based companycalled OSI Pharma. Because ofthose acquisitions, there’s a prettylarge expense called amortizationof goodwill and, basically, our sense

    is that the local investors forget totake into account the amortizationof goodwill. They may look at

    enterprise value to EBIT.

    Most Japanese investors will onlylook at the price to earnings ratio.Some of the more daring investorswill look at enterprise value to EBITand that will help them factor in thefact that there’s all that cash, butEBIT, unfortunately, is 20% lowerthan EBITA, the amortization ofgoodwill of intangibles is quite high.

    Today, with the stock at 33,845yen, the stock trades at 6.2x EBITA,earnings before interest, tax andamortization, 6.2x EBITA of [theyear ending] March 2014. Yet, ifyou look at reported EBIT based onthe estimate for [the year ending]March 2014, the EV to reportedEBIT is 7.5x and that’s, at best, whatthe locals see.

    Our largest holding in Japanis Astellas Pharma [Tokyo:4503], which is Japan’s

    second-largest drug maker.The market cap is in thebillions of dollars and what’sinteresting with Astellas isthat over the past seven years they bought back 19%of their shares outstanding,which is unusual, it’s very un-Japanese.

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    The company has been very goodat their core business. They havea pipeline that’s among the best

    compared to other pharmaceuticalcompanies in the world. Becauseof the pretty high dividend payoutratio and the low stock price, thedividend yield is 3.4%. As you know,ten-year Japanese governmentbonds only yield seventy-six basispoints. For a local investor, to get3.4% dividend yield in yen is quiteremarkable. On an EV to EBITAbasis, the stock is very cheap at6.2x. It has net cash and somegreat growth prospects becauseof many drugs that are about to belaunched. That’s a good example ofa cheap stock in Japan.

    MOI: When it comes to Europe,most of your investments thereare in companies headquarteredin France and Switzerland. Whynot more in Germany or peripheral

    European countries?de Vaulx: Again, great question.Let me start with Germany. Inthe past, we have had quite afew investments in Germany. Weused to own in the early 2000s,late 1990s-2000s, Buderus[formerly Frankfurt: BUD]. It wasour largest holding. Buderus is aboiler manufacturer. We’ve ownedshares such as Vossloh [XETRA:VOS], Axel Springer [XETRA: SPR],Hornbach [XETRA: HBH3], the DIYretailer and so forth, but the realityis that most companies in Germanyare not listed. If you think aboutindustry, industrial companiesin Germany, they are not listedbecause they belong to what theGermans call the mittelstand. The

    mittelstand are those thousandsand thousands of basically smalland mid-size companies, many of

    which are family-owned, and thesecompanies are not listed. All thosegreat German industrial companiesbasically are not available in thestock market.

    Now, among the companies in thestock market, many have beenrecognized as good companiesand so the stocks are no longercheap — if you think about some

    of the auto manufacturers likeVolkswagen. So for the time being,we don’t have much in Germany,although we did buy, a month ago, alarge industrial German company.

    Switzerland is an interestingcountry where there are manyquality companies. Even thoughwe’re value-oriented, we start ourprocess with trying to identify notso much cheap-looking stocks, butquality businesses. We like qualityand then we hope and pray thatsomehow, one way or the other, wecan get it for cheap.

    Switzerland has so many greatbusinesses, whether it’s Kuehne& Nagel [Swiss: KNIN], which isan even better freight forwardingcompany than ExpeditorsInternational here in America.

    Nestle is a wonderful foodcompany, better in my mind thanKraft [KFT]. Geberit [Swiss: GEBN]makes great plumbing products.Lindt & Sprüngli [Swiss: LISN], asI’m sure you know, makes deliciouschocolates, and so it’s our bias toits quality that oftentimes has ledus to Switzerland. Adecco [Swiss:ADEN] is a leading temporary

    staf ng company, has much highermargins than Manpower [MAN],has higher margins than Randstad

    [Amsterdam: RAND]. They justhave top-notch companies inSwitzerland, and sometimes we arelucky to get them cheaply.

    France is an interesting countrybecause even though France hashad and today has those socialisttendencies, France has an amazingnumber of great businesses, whichoftentimes are global leaders.

    Think of Pernod-Ricard [Paris: RI].Pernod-Ricard started as a littlefamily-controlled business in thesouth of France and through astutemanagement and acquisitions theyhave become a leader in the sale ofliquor competing very well againstDiageo, which is best-in-class inthat industry. Think about L’Oreal —what a wonderful, global consumercompany. And of course everyone

    knows that France is the home ofstocks such as LVMH and Hermes,the luxury good companies.

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    In France, we own Sodexo [Paris:SW] a food catering company.They compete against Compass

    [London: CPG] in the UK. Sodexois a very well-run, global company.They have a huge subsidiary here inAmerica, Marriott Services, whichthey acquired a long time ago.

    There’s a stock we don’t own nowbut we’ve owned in the past. It’sbecome somewhat of a darling,Essilor [Paris: EI]. They are, by far,the leading company worldwide

    that manufacturers lenses forglasses.

    are family-controlled. We at IVAbelieve that more often than notfamily-controlled businesses do

    better than other types of businessand could not agree more withTom Russo from Gardner Russo& Gardner on that topic. One ofhis big themes is that he loves, forthe same reason we do, family-controlled companies because theyhave a long term vision and oftentimes do great things.

    The nal point I want to make about

    France, and it’s important from aprotection of minority shareholdersstandpoint, is that France is apretty good place to be a minorityshareholder. When there aretakeovers in places like Germanyor Switzerland, not to mention Italy,you often, as a minority shareholder,can be abused.

    In France, especially now,compared to 20 years ago, minorityshareholders are well treatedwhen there are squeeze-outsand takeovers. The protection ofminority shareholders is prettyhigh in France. That’s importantbecause it just so happens thatquite a few of our companies, notby design, get taken over, and whenthat happens we want to be wellprotected.

    If you look at places like Italy, therearen’t that many listed companies,sort of the same reason asGermany. All these companies,like industrial companies basedin northern Italy, most of them arefamily-owned and not listed. Sothere’s not that much available inthe stock market, and some of theother countries in Europe — Spain,

    In France, we own Sodexo[Paris: SW] a food cateringcompany. They competeagainst Compass [London:CPG] in the UK. Sodexois a very well-run, globalcompany. They have a hugesubsidiary here in America,Marriott Services, which theyacquired a long time ago.

    Portugal, Austria — oftentimesthe biggest stocks are just the bigbanks and insurance companies.

    Most of them are, especiallyon the banking side, grosslyundercapitalized. They may lookcheap, but they are certainly notsafe. Again, not a lot of qualitystocks are available in the Greekstock market, or the Portuguese orSpanish one.

    …France is a pretty good place to be a minorityshareholder. When thereare takeovers in places likeGermany or Switzerland, notto mention Italy, you often, asa minority shareholder, canbe abused.

    We’ve owned in the past BureauVeritas. It’s a little bit like ISS[Group] in Switzerland. It’s aninspection service company andthey have big market shares inmany speci c niches. It’s a servicebusiness, non-capital intensive.France has companies such asLegrand [Paris: LR]. Legrand isthe leader worldwide in electricalswitches.

    France does have those globalcompanies that are very good atwhat they do and, at the sametime, many of these companies

    MOI: You recently initiated a fewsmall positions among large globalbank stocks. What is the rationalefor this, and why now?

    de Vaulx: Let’s keep things inperspective. We’re just dipping ourtoes here. We have small positionsin UBS [UBS] and Goldman Sachs[GS] and had a small position inCredit Suisse [CS] that we arenow out of, as our con dencelevel was not high enough. In the

    case of UBS, their private wealthmanagement business does strikeus as having a lot of value. If youassign some value to the privatewealth management business,and if you add that value to theshareholders equity of the rm, thenyou’ll reach the conclusion thatthe bank is more than adequatelycapitalized.

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    The rating agencies, as a rule, don’tfactor in the value of the privatewealth management business,

    but we are willing to do that. Onthat basis UBS strikes us as wellcapitalized and somewhat cheap.Goldman Sachs we think has aunique culture. We think that beinga global leader, as they are, will givethem a competitive advantage. Wethink that Goldman Sachs will bewilling to cut costs further to makesure their return on equity, two orthree years from now, covers thecost of capital.

    Goldman Sachs will see many of itscompetitors exit certain businesseslike trading, market making, andinvestment banking. As capacityshrinks in the industry, with manyof Goldman Sachs’ competitorsabandoning certain businesses,Goldman Sachs will end up with alarger market share. They’ll be more

    dominant, and if they can reign inthose compensation costs, theywill end up with a decent return oncapital. We have a two- to ve-year horizon with Goldman Sachs,hopefully for them to do some goodthings.

    MOI: In the case of UBS, I guessyou own both equity as well asdebt; one of your largest positionsis debt in Wendel [Paris: MF]. I’mcurious if you could explain justwhy you hold certain of these debtsecurities, perhaps also explainingthe risk/reward versus holding theequity.

    de Vaulx: In the case of UBS, wedo own the equity and the debt. Infact, the UBS debt we own is a veryunusual bond, which in a few years,

    the xed coupon will be replaced bya floating-rate coupon. So, basically,even though these are long-dated

    bonds, we do not take interestrate risk because they will have avariable rate. In essence, we viewthose UBS bonds as quasi-cashin terms of the interest rate. Theyield is not huge, but it is still a verycompetitive yield that will be some200 points higher than what wecurrently get on our cash.

    In the case of Wendel, we have

    known the company for over adecade. We started buying thestock at my previous rm in theearly 2000s. We did very well withthe stock in the 2000s, but thecompany made a big mistake in2006, I think, they overpaid andover-borrowed to buy a stake inSaint-Gobain, a French company,and so they levered themselvesup just as the nancial crisis was

    about to hit. When the nancialcrisis hit, we started buying somebonds at IVA. We own severalbonds – some mature in 2016,others in 2017 and others in 2018.So it’s not too short and not toolong. It is a perfect duration andthose bonds, in late 2008, were sodepressed that we were gettingyields to maturity of 16%, 17%, 18%.

    Since then, the holding company,which is a family-controlled holdingcompany, has been able to shedassets. They’ve reduced their stakein Legrand. They’ve reduced theirstake in Bureau Veritas. They’veshed other assets, so the balancesheet has improved greatly andthese bonds are, in our mind, verysafe. I wouldn’t say extremely safe,

    but very safe and now the yieldshave come down tremendously, butthese bonds still yield in excess of

    5%. So it’s still a pretty reasonableyield in a zero return world, andso we’re very comfortable withWendel. Now, you may argue that5% is not exactly an equity-typereturn of the 7-9%, but it’s a prettysafe piece of paper, so we’re happyto hold onto it.

    MOI: How has your view on owninggold, cash and xed income

    changed recently, if at all, and therationale for each in terms of overallportfolio and risk management?

    de Vaulx: Our view on gold – whichis not only today, but in general –we think that gold is a nice tool tohave. Of course, it’s a tool where wegive ourselves the latitude to buyeither gold bullion or gold miningshares. Sometimes which of thetwo you buy makes a difference.Sometimes gold may do well, butgold mining shares not so well, orvice versa. Gold is misunderstood.Gold tends to be viewed, too often,strictly as a hedge against inflationbecause people remember whatgold did in the 1970s. I would argue

    …we think that gold is a nicetool to have. Of course, it’s atool where we give ourselvesthe latitude to buy either goldbullion or gold mining shares.Sometimes which of the two you buy makes a difference.Sometimes gold may do well,but gold mining shares notso well, or vice versa.

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    that gold also should be viewed asa hedge against deflation. Let’s notforget that in the 1930s when we

    had the depression and deflation,gold did well. Under the goldexchange standard, we saw goldgo from $20.67 in 1930 to $35 anounce in early 1935.

    Why can gold do well when there’sdeflation? Because when there’sdeflation, there’s counterpartyrisk. Companies default, banksdefault. In America, almost 40% of

    banks defaulted. Gold, not beingan “IOU”, is a very precious tool in adeflationary environment.

    What typically can hurt gold is anenvironment where real interestrates are high. The incentive tobe in gold when you could earn anice, fat, juicy, positive real returnis a high burden to want to owngold. Conversely, when real interestrates are negative, when the cashat the bank or on treasury billsyields less than inflation, when youhave a negative real interest rate,it’s in nitely more palatable andtempting to own gold, so negativereal rates are a tailwind while realinterest rates being positive wouldbe a headwind.

    Gold is not as cheap now as itwas in 2001 when gold crossed

    $255 an ounce. Gold today isaround $1750. At the same time,if you adjust all the inflation thathas taken place since the late1970s, inflation de ned as whatthe Consumer Price Index (CPI)has done or money supply growtharound the world, if you look at howmuch central bank balance sheetshave grown over the years, so if you

    adjust for that, you’ll notice thatthe price of gold today, in fact, isnot that high compared to the late

    1970s.

    Within the context of portfoliomanagement, the way we usegold is simple. The concept is asfollows: when stocks and bondsare dirt cheap — as in hindsightthey were in 1982, for instance —there’s no need for gold. What doesbeing cheap mean? Cheap meansthat something, a stock or bond,

    trades way below intrinsic value, sothe bigger the gap between priceand value, the bigger the so-called“margin of safety”. So you don’tneed gold. Conversely, when stocksand/or bonds are expensive, likemany stocks were in the late 1990sand early 2000s at the height ofthe tech bubble, this is when it canbe very handy in a portfolio to owngold. Of course, the beauty is that

    the market, in its all too unusualkindness, gave gold away foralmost nothing. Gold was around$260 an ounce in 1999, and it hit alow of $255 an ounce in 2001. It isnow over $1750 an ounce.

    Going forward, if stocks and bondsbecame dirt cheap — we don’t viewthem as dirt cheap today — say, ifstocks fell 20%, we would not needto own as much gold as we do. Weroughly have 5.5% of the portfolio ingold right now. Conversely, if stocksmove back up, and if some of theworld’s economic imbalances havenot been addressed yet, if all thepolicymakers do is kick the candown the road further, we probablywill decide to add a little bit to ourgold exposure. So we really view

    gold as a hedge. We also realizethat it does not always work as ahedge.

    If you think of 2008 or 2011, goldperformed as a hedge. When stockswere down in 2008, gold was up6% or 7% for the whole year. Lastsummer, July and August 2011,when stocks were falling worldwide,gold went from $1,200 an ouncein July to over $1,900 an ounce inearly September. Conversely, thereare other times when gold, instead

    of being inversely correlated tostocks or bonds becomes positivelycorrelated, and in those times golddoes not act as a hedge. In 2009-10, we saw gold go up insipidly withstocks and bonds and did not actas a hedge during those two years.

    Going forward, if stocks andbonds became dirt cheap —we don’t view them as dirtcheap today — say, if stocksfell 20%, we would not needto own as much gold as wedo.

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    intrinsic value, but that has nothingto do with buy and hold. If, for somereason, markets are so volatile that

    the price of the stock, within sixmonths, gets closer to the intrinsicvalue estimate, the value investorhas to sell. Self-discipline kicks in.There’s a mistake both from peoplethat overtrade on the one hand andthose who have too much of a buy-and-hold mentality.

    MOI: How have you improved yourinvestment process or investment

    judgment over time? Have youtweaked anything as a result of thecrisis in 2008-‘09?

    de Vaulx: Well, speci cally 2008-2009, the answer — and I don’t wantto sound arrogant is no. We havebeen mindful, starting in 2003-’04,that there was a big credit bubbletaking place in Western Europe,in the United States, in EasternEurope, and we also noticed thatmore and more companies aroundthe world were becoming more andmore levered nancially, includingbanks that were becoming moreand more undercapitalized, and sothe crisis that took place did nottake us by surprise at all. Frankly,we were surprised that it took solong for the crisis to hit. I wouldhave imagined that the crisis wouldhave happened in 2006, frankly.

    The fact that we, going back 20 to25 years or so, had paid enoughattention to the big picture – creditcycles, reading carefully Grant’sInterest Rate Observer or GaryShilling’s deflation pieces – andhaving paid attention to the macrohelped us identify that there was abig credit bubble happening and, as

    value investors, being insistent thatnot only must a stock be cheap,but that it also needs to be safe.

    The balance sheet has to be strong,and that also kept us out of trouble.So from 2008-’09, I do not thinkthere was a lesson to be learned.Marginally speaking, over time, interms of how do we improve theprocess and the judgment, I wouldmention two improvements.

    One, for many years, we typicallyonly calculated one core intrinsic

    value estimate for a company, andtypically we did not do discountedcash flow (DCF). We did not try toguess what the future earningsof a company would be. Wewould typically rely on mergerand acquisition multiples, privatemarket value, that sort of thing,but the one thing we started doinga few years ago is we computeda worst-case intrinsic value. We

    make much harsher assumptionsregarding revenues. We make muchharsher assumptions regardingoperating margins. We try to betterunderstand what costs are xed,what costs are variable, and whenwe run these worst-case scenarios,it gives us, of course, worst-caseintrinsic values that can help usidentify some good entry pointsinto stocks.

    Say a company has a core intrinsicvalue of 50, the stock’s trading at35, the worst-case intrinsic valueis 32 — the stock price is almost atthat worst-case intrinsic value, andthat typically creates a pretty solidfloor below which the stock will notgo. That’s the big improvement —to have worst-case intrinsic value

    We would typically relyon merger and acquisitionmultiples, private marketvalue, that sort of thing, but

    the one thing we starteddoing a few years ago iswe computed a worst-caseintrinsic value. We makemuch harsher assumptionsregarding revenues. We makemuch harsher assumptionsregarding operating margins.

    estimates because it forces ouranalysts, even more so than wehad ever done in the past, to worry

    about what can go wrong. Wealways have done it, but this takesthat worry to another level and alsoyou quantify it.

    The second improvement, if I may

    say, is that a long time ago — 10,15, 20 years ago — we had a strongbias towards quality within thevalue camp, away from the guyswho like to dabble in cigar buttsand mediocre businesses. We werewilling to pay up for quality, theway Warren Buffett learned to do atone point. Today, in a very dif culteconomic environment worldwidewith, at best, very modest economic

    growth and low returns goingforward, I think we are trying topay even more attention to thequalitative aspects of the businessand not relying on the rearviewmirror. More than ever, we try to askourselves more and more questionssuch as: are these high marginssustainable? What will Microsoftlook like 10 years from now? In a

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    low-return, low economic growthworld, quality deserves to be at apremium to lower quality stocks,

    and we need to focus even morethan ever on the qualitative aspectsof the businesses.

    MOI: I think you mentioned somebooks, but what resources ingeneral have you found helpfulto become a better investor? Youmentioned the bias toward qualityand quality businesses, qualitymanagement teams who have

    perhaps some of the businessmenthat one should study to learnabout how to operate a business,how to allocate capital effectively— anything you can share with usin terms of books or resources orpeople that we should study?

    de Vaulx: Besides the classics,Ben Graham, of course, BerkshireHathaway annual reports. One hasto not only read them, but re-readthem. I’m fond of Vladimir Nabokov,the writer of Lolita. He said, “a goodreader is a re-reader”.

    I think some of the books that area must would be Peter Bernstein’sbook about risk, Against the Gods:The Remarkable Story of Risk .

    I believe that awareness of history,in particular, economic history,

    nancial history, history of howtechnological improvements andtechnological breakthroughs haveimpacted the world, and historyof geography — are important, soI think some history books are amust. Financial history, there’s awonderful historian who passedaway a year or two ago, CharlesKindleberger, who many people

    There is a great book byDavid Kynaston called Cityof London. It goes back 300or 400 hundred years andbasically walks through the

    nancial history of the worldthrough what happened inthe city of London.

    know. One of his most famousbooks is Manias , Panics andCrashes, but he also wrote more

    in-depth books. One is called, TheFinancial History of Western Europe ,and there are other books that are acompilation of many of his essays,and I think these are very valuable.

    There is a great book by DavidKynaston called City of London.It goes back 300 or 400 hundredyears and basically walks throughthe nancial history of the world

    through what happened in the cityof London.

    Some reading that delves intobehavioral nance and psychologycan be very interesting. DanielKahneman’s books should be readalong with Poor Charlie’s Almanack ,which has transcripts of many ofthe speeches that Charlie Mungerhas made over the years.

    Otherwise, for anyone who beginsas an investor, I would recommendbooks by John Train. Some 20 or30 years ago he wrote, The MoneyMasters , where you have a chapteron Ben Graham, one on PhilipFisher, one on Warren Buffett andso forth ,and then ten years laterJohn Train wrote,

    The New Money Masters , with PeterLynch, Mario Gabelli, and so forth.The advantage of those books is

    that you have one chapter on onemoney manager, and that bookhelps the reader understand thatthere are many ways, many recipesto invest money, and each of theseways has its own internal logicand own set of rules. If someonewho starts as an investor readsthe book, he or she will appreciatethat there are many ways to do it,many ways to cook, and he or shewill probably be able to, based onhis or her temperament, identifyand nd some af nity with one ofthose investment styles, whetherit’s George Soros or Paul TudorJones or Ben Graham with the cigarbutts, or Philip Fisher. I think TheMoney Masters and The New MoneyMasters are great books to read tobegin in our business.

    MOI: On that note, Charles, thankyou for your time and all theinsights.

    de Vaulx: I really enjoyed it.

    The Manual of Ideas is indebted toChristopher Swasbrook, ManagingDirector of Elevation Capital

    Management, for making thisconversation possible.

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    Pat is President of Sanibel Captiva Investment Advisers, where he leads the investment team and helps guide capitalallocation. Pat was previously Director of Equity Research at Morningstar for over ten years, where he was responsible forthe direction of Morningstar’s equity research effort. He led the development of Morningstar’s economic moat ratings aswell as the methodology behind Morningstar’s framework for competitive analysis. Pat is the author of T he Five Rules forSuccessful Stock Investing and The Little Book that Builds Wealth.

    The Manual of Ideas: Please tell usabout your background and how youbecame interested in the topic of

    moats.Pat Dorsey: I was director of equityresearch at Morningstar for about10 years. I basically built the equityresearch team and process there,starting with about 10 analysts andbuilding it to about 100 analystswhen I left. I formed the intellectualframework that we use to evaluatecompanies. A big part of that is afocus on a competitive advantage,or an economic moat. I becameinterested in the topic becausesome companies essentially defyeconomic gravity and manage tomaintain high returns on capitaldespite competition.

    It’s a fascinating topic becauseeconomic theory suggests that allcompanies should just revert to

    Exclusive Interview

    with Pat Dorsey

    It’s a fascinating topicbecause economic theorysuggests that all companiesshould just revert to mean

    over time. Competitionshows up, capital seeksexcess pro ts, and you drivereturns down. But, bothempirically and intuitively, weall know that’s not the case.

    mean over time. Competition showsup, capital seeks excess pro ts, andyou drive returns down. But, both

    empirically and intuitively, we allknow that’s not the case. We can allname a dozen companies off thetops of our heads who have basicallyde ed the odds and maintained highreturns on capital for decades at astretch. What frustrated me when Igot into the topic is that most of theliterature on competitive advantageis written from a strategy standpoint.Most of your readers are familiar

    with Michael Porter’s Five Forcesmodel, which is very useful and agreat starting point, but it’s alwaysfrom the perspective of a manager ofa business. In other words, I managea company or a unit of a company,and what can I do to make that pieceof that company better? So, it’s allabout maximizing the assets thatyou have.

    As investors, we have a differentchallenge. We’re not stuck with aset of assets of which we need to

    maximize the value; we can choosefrom thousands of different setsof assets called companies. So weneed more objective characteristicsby which we can assess the qualityof competitive advantage andthen make some judgments aboutwhether a company is likely to havehigh returns on capital in the futureor not.

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    Exclusive Interview with Pat Dorsey

    The smartest manager inthe world will not make anairline have the economicsof a software company or anasset manager; it’s physicallyimpossible.

    MOI: Let’s start from the beginning.Can you defne what you mean bymoat?

    Dorsey: When you think of aneconomic moat—and let’s beclear I stole the term from WarrenBuffett; he’s the one who coined it.If you’re going to steal, steal fromthe smartest guy around—a moatis structural and sustainable. Ithink those are the two key thingsfor investors to think about. It’sstructural in that it’s inherent tothe business. The Tiffany brand isinherent to Tiffany [TIF]; you can’timagine Tiffany without it. Theswitching costs of an Oracle [ORCL]database are inherent to the waydatabases are used in business.Contrast that with a hot productor a piece of a hot technology thatmay come or go.

    Moats are also sustainable. Theyare likely to be there in the future.As investors, we are buying thefuture. Look at the investmentswe make today. How they turnout will depend largely on whathappens three years from now, veyears from now, or ten years fromnow. So, we need to think aboutsustainability of a competitiveadvantage. A company with a veryhot product and a cool brand right

    now may have very high returns oncapital, but the sustainability is inquestion. Whereas you can look ata railroad or a pipeline that would

    not have as high returns on capitalas an Abercrombie & Fitch [ANF],but it’s very sustainable becauseyou can predict the likelihood ofthat competitive advantage