Insider Monkey: So, in that first step are there any investment screens or value statistics? Just to give an example, a price to earnings multiple or a high net margin?
Tom Gayner: Well the price to earnings multiple is a valuation metric of the stock itself. That is not in and of itself anything for the profitability of the business, so that is not a metric we would look at in regards to that first point. I’ll get into that later but that is not from step one.
The net profit margins, return on capital, return on assets, return on equity, things of that nature, those are the sorts of things that would matter in that regard. Clearly, we would not look at anything unless it was in double digits in terms of return on equity and we don’t want to see a lot of leverage used to get there. So that is the first screen.
The second screen and the second thing we talk about and think about and we care a lot about is more the investment and management team with equal measures of talent and integrity. Because one without the other is worthless- people who have integrity but maybe are short talent may be very nice people and you may like them, you may be comfortable with them and enjoy their company and all that but in context of the business they can’t really get the job done. So that doesn’t do you any good.
In the alternative if you attract people who have talent but perhaps an integrity problem they may do well but we as their outside partners won’t so we try to discern that the management teams we’re investing with have equal measures of both.
The third thing we think about is the reinvestment dynamics of the business and that’s to say if they make money what do they do with it? If you have very good returns on capital and reinvest that at the same or better returns year after year after year, you become a compounding machine. The second best business in the world is one that makes very good returns on capital, can’t really reinvest that easily or well, but the management knows it and they’re intellectually honest about it. So either they’re good at acquisition, or they pay out dividends, or they repurchase shares or something like that to indicate that they are good managers and your capital is worth more than the business itself.
The worst business in the world is one that doesn’t earn very good returns on capital. So we stay as far away as possible. That’s what we think about our perspective there.
The fourth and final general area that we think about is valuation and that is where the P/E ratio and things of that nature come into play. If you have those first three attributes in place, what do you have to pay to get it? You can have great businesses that intrinsically do very well, but if you pay way too much for it, you as an investor will earn subpar returns. The business can’t live up to its valuation metrics.