Fortrea (FTRE) Intro | Market Inefficiency | Concerns

“We try to think about why the other guy is selling to us.”

— Seth Klarman

“Fish where the fish are.”

— Charlie Munger

“May the odds be ever in your favor.”

— Effie Trinket, The Hunger Games

(You get three free quotes today! Wow! What a deal!)

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~25 minute read

Today we’ll do an overview. I’m not done writing Fortrea up, but will introduce it. There will be very few charts and deep analyses, just a walk-through of key facts. We will also talk a bit about stock market dynamics, having an “edge”, a place to fish for ideas, and some concerns I have.

Although I love complexity and building a mosaic out of disparate facts, there are actually no points for difficulty when investing. If you can find simple ways to make money, do that. Intellectual masturbation might feel good to some people, but it doesn’t improve results. In this light, I believe this is a dirt-simple investment thesis in a dirt-simple business, with obvious reasons the market isn’t interested in it, where the risk/reward is outrageously good, and the bar to success is incredibly low.

(Note: on Friday 8th Nov, the stock ripped 30%+. Most of this post was written prior to then, and the stock was ~$18 per share, not $24. This content is based on my $18-19 cost basis and the information at the time. We took a 6% position that ripped to 7.5% of the portfolio now. At most I think I would take it to 8-10% after a bunch more thinking and learning, as this position has the most quantitative upside and low downside, but I have less conviction in the outcomes than say Brookfield. I haven’t finished going through the company’s Friday call and integrating new information into my report and notes; even then I still have 100+ pages I can still read near-term.

We also got very, very lucky recently. I sold half our position in Capital One and 10% of our KKR position the day after the US federal elections, when those stocks had ripped 14% and 10% respectively. Most of that funded more Fortrea purchases on the 7th. Then on the 8th, Fortrea ripped >30%. So… a lot of gains were made in only 3 days. In >10 years this has never happened to me and I would not expect it to happen again soon. This is all luck and there’s no skill behind it at all, but I will certainly take luck where it comes.

I have very few ideas in the pipeline and don’t expect making much change to the portfolio for a while. The bar for new purchases is also very high as the risk/reward on many of our positions is still exceptional. I also feel the evidence is good for every position and am excited about what we own. KKR’s and Brookfield’s asset managers are growing >15%/yr in the current environment and they’re reinvesting free cash flow into attractive investments, generating good returns on that capital. Brookfield still trades at only ~65% of base case value. DaVita’s taking advantage of the shift to value-based care and is leveraging margins in this and the international business, while its volume growth slowly recovers. General Motors pulled back from over-investing in lower-returning products, is scaling into electric vehicles more intelligently, and is taking all its free cash flow and buying back shares at what we think is half intrinsic value; the US economy also never went into recession and consumers continue to buy very profitable, big vehicles. Citi’s Jane Fraser is hacking away at the bank’s problems while the industry’s loan and deposit growth looks likely to return. And you’ll see, Fortrea’s CEO is fixing the company and likely to grow its profits significantly, and it traded at less than half intrinsic value. With the exception of KKR, most of these good things are still not fully priced into the stocks. Only Ally hit a speed bump, but the evidence says there’s still a clear pathway to $5-6/share in earnings and ~15% returns on the bank’s capital, certainly not priced in at $37/share. I am excited for this portfolio. I still think we got away like bandits with most — possibly all — of our stocks, and I don’t think the portfolio risk/reward has been this compelling since 2020; maybe in 2022/2023 when we first rotated into Brookfield and Ally.)

With that out of the way, on to the good stuff.

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Fortrea Holdings Inc. (NASDAQ: FTRE)

So far I think the stock is a 2-5x next few years.

Basically, this company is doing a lot worse than its peers because it was an irrelevant subsidiary of a much larger company. Now it is its own company. Just before it became that way, new management was put in place. They can control Fortrea’s destiny. They don’t answer to a parent company CEO. They don’t need to face a board of directors and justify increasing the capital/operating budget of a small, irrelevant subsidiary.

The new guys also want to fix Fortrea. And! The new CEO has a track record of doing this already, so he and the team of prior executive colleagues and contacts he brought with him just have to repeat what they’ve already done. The new CEO’s compensation is also such that he makes money if we make money, and he loses money if we lose money. He’s aligned with us. Nice.

The industry structure isn’t changing much and the company is already in a fine competitive position, with a competitive value proposition, and where the data indicate Fortrea’s value proposition and competitiveness are actually improving under the new CEO. The industry stability means the ground is unlikely to shift under this guy’s feet while he fixes the company’s margins. It also means he has a shot at reinvigorating the revenue growth and winning more contracts. Nice.

It’s a $1.6 billion company that does $120 million in free cash flow. Optically, a fair-looking price for a cash-generative, slow-growing business. But! If the management does the thing they have already done in the past, then it can go to $300-350 million in free cash flow. It’s in a structurally growing industry (4-9% annually, much more than GDP), and everybody in the industry earns extremely high returns on capital (~100% ROICs). When you do some DCF modeling and scenario analysis, you get an equity value of $4.5-7ish billion in the base case, or 3-5x your money. In the downside case, you paid a relatively fair price for $120 million in free cash flow and probably won’t lose a lot of money.

That’s it. That’s the thesis.

Great. Thanks for reading. Have a great weekend.

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Still here, huh? Fine, you get the two-pager instead of the one-paragrapher. BUT THAT’S IT! No more after that! Time is money and this is a free blog! We will talk more about Fortrea in the future, and there’ll be the full report soon enough.

First we’ll talk about spin-off situations and markets a bit, then the following section will go over the idea.

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What’s a Spin-off? Why check them out?

Fortrea is a spin-off. It was a subsidiary of a large company, Labcorp, and was spun out an independent, publicly traded company. It is ~10% Labcorp’s size.

Spin-offs are often a good place to fish.

Why?

Glad you asked. There are a several reasons. The main reason is that a small subsidiary is typically spun out of a big company, which usually results in the following situation. This situation is inconvenient for the shareholders, and inconvenience creates market inefficiency:

A bunch of institutional investors (mutual funds, pensions, etc.), own the parent company’s stock. It is 1-5% of most of their portfolios. Labcorp’s a member of a few indices too, so index ETFs own it (e.g., it’s 0.04% of the S&P 500).

When a company is “spun out”, the existing shareholders of the parent company receive a pro-rata share of the new company. If you owned 10% of Labcorp’s shares, you will get 10% of the shares in Fortrea. They own exactly what they owned before, except now it’s split into two different companies and two different stocks.

“So? What’s the problem?” you ask.

Another great question.

Say the spun-out company is one-tenth the size of the parent, like Fortrea is. What just happened? All these guys just got shares amounting to 0.1-0.5% of their portfolios, usually of a subsidiary so small the analyst (if there is one) doesn’t know the business as well as the parent company. It also usually doesn’t have the same economic drivers as the parent company and is in a different industry. That’s because after a “strategic review,” boards/managements/consultants usually decide to spin out a business that doesn’t fit the parent company’s core business. You don’t spin out a subsidiary that does the same thing as the other subsidiaries. You spin out the black sheep.

Now, nobody’s going put a new analyst (if they have one) on a 0.1% position where they have to learn a whole new industry just to cover it. Why? It doesn’t move the needle for the portfolio’s annual performance even if the stock triples.

Furthermore, most mutual and other funds have minimum market cap requirements, say $10 billion and up. So if a $20 billion company spins off a $2 billion subsidiary, the portfolio manager has to sell the stock whether or not they want to, because it breaks their investment mandate. Yes: Even though they literally own the same things they owned before, they now have to sell one simply because the things come in different packaging.¹ Lastly, spun-out companies by their nature are not included in major stock indices, so the index funds have no choice to sell it. It breaks their investment policy and their mandate, too.

See what’s happened?

Many of the new company’s shareholders are going to sell without doing any incremental due diligence, and without much thought as to what price they’re selling at.

I hope you can see it is an utterly fantastic situation when the guy selling to you is a forced seller who doesn’t care about the business or the price.

Look at it this way: if your goal is to win, the dumbest way to play tennis is against Roger Federer. The smartest way, by contrast, is to beat the crap out of a two-year-old who can’t hold a racket. In the investment business, the money doesn’t care how it is made. What is “fair” matters insofar as it is legal, ethical, and serves clients’ objectives responsibly. Making metaphorical 150km/h+ serves at two-year-olds is legal, ethical, and responsible, because both sides told everyone they are informed market participants acting under their own agency when they make trades over the stock exchange. Or as Jamie Dimon likes to say: “We’re all adults here.”

In life, most people only learn half the success equation: be really good at what you do. They think:

Your Skill = Your Success Chance.

Nope.

The other half is to ensure your competitors are not good at what they do. (Or that you don’t have any competitors at all!) So:

Your Skill — Opponent’s Skill = Your Success Chance

In sports, we divide competitors into weight classes and divisions and such, so rookies don’t get crushed by Olympians. In the market, not so. It is more like the poker table: we put all the sharks and the fish together in the same aquarium and say “ok good luck everyone” as if we are going to have a nice, clean, even match-up. Yeah, right.

Which is why, at the poker table and the stock market, it’s important to figure out who are the fish and who are the sharks. Because if you can’t figure it out, it means you are the fish.

Now that I’ve been doing this >10 years and have a bit of a track record behind me, it appears I have evolved away from fish and toward shark. However, that’s not an excuse to get competitively complacent! We have no intention of moving up in weight class!

Thus, one reason we avoid companies we don’t understand — and the reason we look for situations that seem to put the odds in our favor — is because we are trying not to get outplayed by the other sharks swimming around in the market. We want to have silly spin-offs like this one.

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Spin-offs have a second interesting feature that throws out an immediate green/red flag: they need a new CEO,² and a new compensation contract.

Incentives rule the world. So… put on your detective hat and look at where the executives go.

If not-so-great execs are going with the new company, maybe it’s a dud. Maybe they’re there because it’ll be a great “retirement home.” They’ll clip a fat paycheque and send the kids to private school while the business doesn’t really go anywhere. (I make jokes in my posts, but this one is not; you would not believe how common this is. Well, maybe some of you at sleepy, big companies know.) Other times, you might see the CEO of the large parent company go with the new spun-out entity even though they have a great track record at the larger parent and will make more money there. That should raise eyebrows! Why’s such a high-performing executive hanging their hat on the future of some no-name subsidiary when they’ve already got it made?

Something similar happened with Fortrea.

Before the spin-off, a really good industry CEO, Tom Pike, got recruited by Labcorp to run what would soon be called Fortrea. He brought a bunch of former colleagues with him. All he got was an up-front equity grant. He doesn’t get other bonuses for at least 3 years. He’s basically an operating shareholder. His upside/downside risks are the same as ours.

I did a little digging. More interesting, Pike had been semi-retired, and had a great operating record at the company he retired from: Quintiles (now part of IQVIA). There, he raised operating margins. Quintiles won industry accolades. Growth was strong. Etc.

Eyebrows raised!

Now not only did the numbers look compelling, the qualitative set-up looked great, too: we’ve got forced sellers in a business with crappy and deteriorating fundamentals, but a new CEO who kicks butt! Ok, drop everything! No time for Brookfield quarterly earnings reports! No time for drinks at the bar! No time for Tinder! We have research to do!

Now, on to the Fortrea idea.

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Fortrea: a good to great thesis

This is a “good to great” kind of idea.

Although the business is profitable, generating good free cash flow, growing, and earning good returns on capital, Fortrea’s margins, capital intensity, and performance consistency lag the industry. Given it was small, there was probably not a lot of incentive at Labcorp to make the best of this company.

Enter Mr. Pike.

Again, he was pulled out of semi-retirement to run this thing and brought former colleagues with him to execute the same old playbook and bring the company’s margins up to par with the industry. We’ve got a clear catalyst.

If they can fix margins and extract Fortrea’s potential, I think they can increase free cash flow from ~$120 million recently to >$300 million in a few years. Fortrea’s also a leader in a structurally growing industry, and can grow 4-9%/yr for years to come, all while earning very, very high ~100% returns on capital.

This is a $1.6 billion market cap company today. A company that makes >$300 million, earns ~100% on invested capital, and is growing >5% annually is not worth $1.6 billion. It is worth more like $4.5-8 billion.

Fortrea also lives in what many investors call “a good neighborhood.” This is an industry where all the major competitors earn very high returns on capital and can raise prices to pass on cost inflation. This is because — for any number of possible reasons which you have to figure out — the industry’s benign. It’s not very competitive. In Fortrea’s case, the industry also has structural tailwinds allowing all the major players to grow 4-9%+/yr, well above GDP.

What’s a Fortrea, anyway?

Super simple. It is a “knowledge renting” business.

It’s like a law firm, an engineering firm like Jacobs, an IT consulting firm like Accenture or Tata, a management consulting firm like BCG, an accounting firm like KPMG, or a marketing agency like Omnicom, etc. All are the same: they rent specialized knowledge and labour. Read some of their annual reports and put them side-by-side. You may be surprised how economically similar they are.

Many even have the same contract structures with their customers.

Usually they charge either a fixed price (with “change orders” whenever the contract scope changes), or they charge “time and materials”, a mark-up on the employees’ salaries. The main cost by far is labour. E.g., a first-year associate lawyer might make $50-100/hour, but the firm is billing the client $100-150/hour and the gross margin is $50/hour, which then covers all the advertising (wining and dining the clients), the overhead, the risk of cost over-runs and such, etc., plus profit. Many — but not all — of these businesses run on multi-year contracts with a few hundred customers at a time (think of IT consultant Accenture doing a 2-year ERP/cloud system implementation for a client like John Deere).

Which one’s Fortrea? Fortrea rents drug development knowledge and is called a “Contract Research Organization” or CRO.

Instead of engineers or management consultants, Fortrea is basically a bunch of M.D.’s (doctors) and Ph.D.’s (the other kind of doctors), data analysts & statisticians, clinical research staff and nurses, sales and business development executives, support people, the executive team, and a few specialized clinics around the world.

The customers are large pharmaceutical companies like AstraZeneca, GSK, Merck, etc., and small biotech firms like Novocure, etc. I’ll call these the drugmakers.

Drugs are heavily regulated and need to be approved by government regulators. Before drugmakers can market a drug and doctors can prescribe it, a candidate drug goes through clinical trials to prove its efficacy and that the benefits vastly outweigh the risks. Then it may be approved.

The drugmakers frequently outsource those clinical trials to CROs.

It’s a stable, non-cyclical business. Drugmakers’ profits from drug sales have nothing to do with the economy. So, they make steady investments back into R&D for new drugs

Drugmakers spend $250 billion on R&D worldwide, rising ~3%/yr. About 40% of this is the cost of clinical trials. About half of that is currently outsourced to the CRO industry, and is the industry’s $50 billion revenue (i.e., $250 * 0.4 * 0.5 = $50).

Trials take years, so Fortrea’s revenue is on multi-year — but cancellable — contracts. It does $2.7 billion in revenue, but has a $7.4 billion “backlog”, which is the scope of work in all the contracts they’ve already signed (and maybe started), but which they haven’t yet finished doing and been paid for. I.e., if they didn’t win any more business from today onward, and none of the customers cancelled, they would still generate $7.4 billion in future revenue on the clinical trials they have already contracted to carry out for customers.

The industry has 3 big players with 15% each, 4 mid-sized ones with 5-7% each (incl. Fortrea), and hundreds of small ones with <1% each. The companies benefit from scale, and the bigger guys usually have higher margins because they leverage the overhead costs (IT, etc.). Fortrea should earn margins close to the leaders. It should also do just fine growing with them, as it consistently wins industry awards, and third-party customer surveys show Fortrea ranks fine and already has years-long relationships with many established pharma companies.

The industry’s growing well above GDP because the drug industry is outsourcing more and more of its clinical trials to the CROs. There are many reasons we can’t detail fully in this post. For the last 20 years, drugmakers returns on R&D investment have been falling, for example from not discovering many very large “blockbuster” drugs (GLP1s have been the only really big ones recently). This trend is ongoing and the drugmakers earn only ~5% on R&D today. It’s really bad. Drugmakers’ executives are trying to increase their capital productivity: obviously, they want to keep bringing drugs to market, but it needs to make economic sense when they sink huge sums of money into the ground.

Good CROs do a bunch of things more efficiently than the drugmakers, so outsourcing is rising. And like we said, the market’s only 50% penetrated. Drugmakers still do half the dollar value of clinical trial spending themselves. And it’s clearly not optimal. So the CRO industry’s growing at a high-single-digit clip and has a ways to go. Since Fortrea’s got a good reputation, it should continue to capture a lot of this growth.

Tom Pike’s Two Levers

That’s the skinny on the industry. How do we make money, though?

Broadly, Tom Pike needs to do two things.

First, the easy one: fix capital productivity.

Most analysts are not very good at balance sheet analysis and focus on the income statement. If you have been looking at banks for years like I have, you get pretty good at balance sheet analysis. My prior firms also focused on understanding capital intensity and working capital, so, I know my way around a balance sheet and how capital productivity contributes to returns on capital and cash flow.

Many analysts are missing important stuff about Fortrea’s balance sheet. Many companies get saddled with debt when they are spun out, so that the old parent gets a bunch of extra cash. Part of the reason the market doesn’t like Fortrea is probably this debt load. It’s not good to have $1.2 billion in debt when you’re making only ~$120 million free cash flow, especially when your margins and revenue are currently going down, not up. This makes investors light-headed.

While Fortrea doesn’t have a lot of fixed capital (property, plant, and equipment), it does have a lot of working capital (accrued salary expenses, accounts receivable in the form of unpaid billings, etc.) to manage. Fortrea’s working capital position is… bad. The company’s cash conversion cycle is horrendous compared to peers.

The main issue is with receivables. When it wins business, its contracts don’t follow industry-standard payment and billing terms, and doesn’t follow through with promptly billing customers.

Tom Pike is fixing this.

New business is coming in under revised contracts. As the book of business turns over, I estimate a significant portion of Fortrea’s working capital — mainly from a few receivables line items — is going to unwind. It’s going to be able to pay down 30-40% of its debt just from this source alone. It doesn’t even need to pay debt with operating profit. It’s also selling an irrelevant subsidiary, and using the proceeds to pay another ~30% of its debt. From these two sources, debt will decline from $1.1 billion to ~$400 million, possibly less. At the same time, free cash flows are going to increase toward >$300 million/yr. So its debt ratios are going to decline from a very high 10x debt-to-free-cash-flow to a very conservative 1-2x debt-to-free-cash flow with very little effort. EDIT: I made a mistake here, most of the proceeds from the sale have already been received, and there’s only another ~$60 million or so coming from the asset sale. Debt is still going to decline to a much more conservative ratio in the next couple years. It may look like Fortrea has a debt problem, but there is, in fact, not much of a debt problem.

Second, the harder one: fix margins

There are accounting differences as to who expenses what where. Furthermore, differences in acquisitions result in some competitors having a lot of amortizable intangible assets while other competitors like Medpace don’t. So we are going to look at operating margins plus depreciation and amortization, or EBITDA margins, and we aren’t going to focus as much on what can be done to reduce the cost of sales and increase the gross margin bucket, vs. what can come out of SG&A (selling, general, and admin expenses). Stuff can come out of both.

On the overhead expense side (mainly SG&A), the main thing is that when a company gets spun out, they usually enter into a TSA (transition services agreement) with the parent company, wherein the old parent keeps providing them with things like IT hardware, software, and staff. That preserves business continuity. While that’s happening, the company starts investing into its own IT systems and staff. Right now, if you go read Labcorp filings, they’re charging Fortrea $23-27 million per quarter for these costs. On top of that, Fortrea’s running new systems and testing them, so there’s the expense of running two systems at once while one is being stood up. There’s also the cost of a bunch of IT consultants like Accenture doing all the implementation. Finally, Fortrea’s new systems cost less than Labcorp’s (~$15 million/yr). So, once that stuff’s all done being implemented, Fortrea’s going to save $25 * 4 + 15 = $115 million per year, plus consultant costs, pre-tax. Nice.

Second, there’s recently been a slowdown in the industry, the drivers of which we don’t have enough time to talk about today. Fortrea did not think there was going to be as bad of a slowdown as there was, and is now running over budget. Many staff are underutilized — meaning they are being paid but their 8 hours a day isn’t being billed out to clients and generating revenue. Underutilization is bad for all “knowledge rental” businesses — you’re paying people but not making revenue on them, so you’re just eating the cost. Fortrea’s said it’s deliberately not choosing to lay people off because the business development pipeline is still at a record. It would be stupid to lay off specialized doctors oncologists and nephrologists, and Ph.D.’s in biostatistics — all of whom are hard to find kind of workers — only to then need to hire a bunch of people in 3-9 months. So they’ve accepted margins are going to suffer for a bit instead. I have a view on this industry’s growth and a view that — for various reasons — Fortrea is in a good enough position that it will capture this growth, and so eventually they are going to get “operating leverage” on these costs and margins are going to increase as Fortrea wins new contracts and these people start billing their hours out to clients. I did some sneaky math and I think it will get us $75 million+ in incremental pre-tax income.

Those two things combine put margins back up to the kind of profits the rest of the industry makes.

Finally, Tom Pike and his team are used to things being their way. What they measure and how they measure it wasn’t the way the old executive team did it. As they finish implementing new IT systems, they’ll have visibility into the business. They’ve already done a bunch of cost benchmarking by function (how much HR cost per dollar of revenue, how many HR and other overhead staff per person, how many subordinates per middle manager, how many oncologists and related staff per dollar of oncology drug contract revenue, etc.) and have a good sense of what can be improved once they have the right stuff in place. For example, they don’t even have their preferred ERP systems running for their accounting and analytics, nor do they have the HCM system they want so that they can hire, train, re-train people, maintain the knowledge base, etc. They’re still running off Labcorp’s accounting systems. They’re hamstrung. Being free to optimize things is going to extract another layer of cost saves and productivity.

And that gets us to the sort of margins that will result in >$300 million annual free cash flow. In a few years, the business is also going to be larger since it’ll be growing mid-single-digit or more.

If we are right, these things will happen. If they happen, then it will work like all of our stocks have ever worked: eventually, the current market narrative won’t agree with what’s happening. So, people will see what’s happening and start touting and believing the new narrative based on the new results, see things our way, and re-price the stock.

And if we are wrong, then we paid 13x free cash flow for a high-returning 2-5% growth business, which is a fair price. Our downside analyses showed there wasn’t much to lose from that price if we were wrong.

So it’s like most of our investments lately: we paid a price that already implies that the bad things happen (or continue happening), and yet all the evidence says good things are coming instead. And if those good things come, none of them are priced into the stock, so there’s a lot of money to be made. In Fortrea’s case, all you have to believe is that Tom Pike — who has a history of doing a good job with exactly this kind of company — does a good job at the following:

1. Pike and his new team successfully implement new IT systems they already know how to use, using consultants who already do this well. They then cut the cord with Labcorp and save over $115 million annually.

2. They use those systems to get visibility into the business, and pull out further improvements, the benchmarking for which, and the function by function analysis, they’ve already done and have plans for.

3. Pike and team work on improving the sales process and value proposition, such that business wins go back to what they usually are. Pike already did this well when he ran Quintiles years ago. Quintiles is a nearly-identical CRO to Fortrea. Revenue growth lets them get gross margin leverage on the under-utilization.

4. At that point, the company would already be worth significantly more than what we paid. Beyond this, Pike has the opportunity to get to industry-leading levels of growth and is targeting 9% on the high end. He executed well at Quintiles. The firms in the industry who do this generally see further operating leverage on overhead costs, and EBITDA margins continue to push toward 20%, which isn’t even contemplated in our base or upside case.

Dude. Can you see how low the bar is here? This stuff is soooooo easy. And the people doing it are already good.

And all you need to believe is points #1-3. That’s it. If those happen, it’s worth $45-75 a share, or +150-300% from the $18-19 I paid. If they don’t happen, it’s worth $18-22.

I think we are likely to look like we got away like bandits with this one, having paid $18/share for a stock that can earn $3.50-4.50+/share in annual free cash flow in a few years, where the business is straightforward and stable, the industry’s core service hasn’t changed much for 40 years, it’s in a fine competitive position, and the CEO already has a good record preceding him.

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Let’s close out.

Homework

If are interested in similar case studies from the past, check out Lowe’s when Marvin Ellison took over. Check out Canadian Pacific Railway when Hunter Harrison took over, or Fiat Chrysler under Sergio Marchionne. I have a growing mental database of these, which is why I feel situations like Fortrea fall into my circle of competence. Many turnarounds don’t work, but there are ingredients I’ve identified where they do.)

Closing with concerns

I am afraid for the typical retail investor and many other institutional investors. Market participants — many new to investing — are very excited about stocks and other assets. Far too excited. I’ve started writing up a post on it.

The issue during these times is that people lose — or never had — discipline. When everything is generally rising, you look like a genius. That gets inside many heads.

The market fluctuates though. You have to be prepared for it going the other way.

I don’t think many people are sufficiently concerned with protecting their capital.

If you look at all our investments historically, we think a lot about the downside and the quality of the assets we are buying. We are always very concerned with protection of capital. If our businesses don’t turn out like we thought they would, fine, but at least we maintained our capital. This lets you get up to bat again quickly. But, if you lose all your capital, the game’s over. Our portfolio is always constructed in a way where I believe that on the whole, there is little potential for a huge, permanent impairment of capital. We focus hard on buying assets with low quantitative downside, and with very strong qualitative attributes that make them durable, well-managed businesses. We refuse to take on significant risks in the pursuit of growing our capital, as we don’t think huge risks are necessary for huge gains. Hopefully, as you’ve seen with some of our stock pitches, this holds true in practice. As I have seen with the numerical data, we have not had a big permanent loss for quite some time. Even some of the “mistakes” I sold, like Wells Fargo, continue to hit new highs and the underlying businesses remain strong, and we did not lose money.

Obviously, our stocks will temporarily go up and down, but if we have correctly called the businesses, their futures, and their risks, they will not stay down 50%.

This cycle of euphoria and despair is as old as the market itself. Many people will again lose their shirts, though I don’t know when or how. I just know that they will because there is no process discipline.

This game is a marathon and not a sprint, and people who haven’t trained with proper process discipline never make it to the end of the marathon.

Chris

1. This is why you don’t create restrictive mandates when you create an investment fund, because you put yourself into all kinds of nonsense situations that don’t serve the interests of your clients or yourself.

2. And usually a couple others to fill out the senior executive team.