This interview originally appeared on the Inside Value website in January 2007.
In the first half of our interview with David Carr and Larry Coats, investment managers at Oak Value Capital Management in Durham, N.C., they shared the influence Warren Buffett had on their thinking and reiterated the importance of understanding a business's model when evaluating it as an investment. That focus and dedication has helped them generate annual returns of 14.7% since September 1986, vs. 11.8% for the S&P 500.
In the second half, we'll learn about other managers they respect, find out how they stay patient when making investments, and see which one of the two is the real cheapskate!
In part 3, we learned more about the portfolio. Now we explore the art of determining the strength of a company's business model.
David Meier: Thanks for sharing your thoughts on the importance of the business model. At The Motley Fool, we work to help readers understand how businesses work when we give our thoughts and share our knowledge.
Who do you think does a good job of starting from analyzing the business model and going all the way to making good decisions?
David Carr: There are lots of managers, who we will loosely define as value investors who skin the cat different ways. For us, along a continuum, we would prefer to own a really great business and a good business if we can find the right margin of safety.
We have a lot of respect for the guys at Harris Associates, at Oakmark. We know Henry Berghoef well, and we know Bill Nygren and that crowd. They do good work, and they are ethical and honest and trying to do the same kind of thing. We know Tom Russo well. Tom is doing things a little bit differently and has a little bit of a different platform. He has some interest in some companies that are different from our group, but there is also some overlap. Certainly, we have a lot of respect for Mason Hawkins at Southeastern, although it is not likely we would ever buy General Motors
There is obviously the Sequoia Fund, although it is evolving some. But there are still good people there with Bob Goldfarb. So there are a number of people out there who we respect and who think the same way. We are always glad to look around the room and see people whom we can call brethren. They may approach investing differently, but we all insist on transparency in the accounting and honest management.
Larry Coats: In his article "The Superinvestors of Graham-and-Doddsville," Buffett said there are a lot of people out there who have taken a common set of principles and applied them through varying processes to all yield above-average or very attractive results, and he cites some examples there. So as David talks about some of these people, they are people who share a common set of principles, but the processes that all of us use are slightly different. We may come to the same conclusions or slightly different conclusions, and there are a lot of our "brethren," as he puts it, in this business whom we have a lot of respect for, we just disagree with the conclusions that they draw on individual companies and individual prices relative to our charge to the shareholders that we manage money for. So it is a large universe in many respects, but it is also a relatively small family that is focused on these principles.
DC: We like anybody who is rational. If somebody is rational, he may get to a different answer through a different mechanism. We have a disdain for irrationality; we love people who are rational.
LC: Rationality is a good place to start.
DM: This is a philosophical question about margin of safety. If a business is more predictable, should investors lower their margin of safety?
DC: On the area of predictability, after a lot of years in this business -- over 20 years -- and having seen thousands of companies and managements, I think we have a pretty good ability to understand predictability, and there are times where we will take a bit less of a margin of safety for that predictability. But it is not an absolute.
One thing, we don't monkey around with our discount rate. There are some who will tell you [that] you should have different discount rates for different businesses. In our mind, you either understand it and know how to value it or you don't. If we don't know how to value it, using a 40% discount rate won't help us.
For example, the margin of safety we demanded on eBay
LC: And the other issue is you may be getting a 25% discount on a more conservative case and a 40% discount on a most optimistic case, so the growth rate has some impact on that as well.
DC: That is a very good point. We don't believe there is one model. Years ago, we started to develop multiple models and multiple terminal values, because we go in and we have some idea in our minds of what we think will develop over time, but there are all these things in the outside world that are going to impact that development, including management itself and how it executes.
So we often find, in many cases, as we get into a company, especially a newer one, often we are forced to take that base case we used and move it up because what the company does and how it executes end up being at a better case and a higher case than what we originally used.
LC: The other side of the equation you have to be careful about in this business is one of your greatest enemies -- overconfidence. You have to be very, very careful not to allow your perceived predictability of the business to influence your perception of your ability to predict the business.
We have found that the most prudent thing for us to do is for us generally to try to get a 30% or greater margin of safety and to do that in a disciplined manner. Other people will tell you that you can pay $0.80 for one business and $0.60 for another business and have the same risk-reward profile. That is not typically the way we do it. You have to remember that margin of safety is there to protect you from your propensity to be wrong. We are human. We will make mistakes, and no one has a crystal ball and the ability to predict the future in all of the things that are likely to come into play.
In Part 5, we'll learn about the value of patience.
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Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. He's ranked 7,979 out of 30,725 rated investors in CAPS. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.
