Priced at or below intrinsic value
Owner-oriented management aligned with shareholders
Respected, candid, accessible, and communicative
Proven track record of financial success
CONSISTENTLY EARNS HIGH RETURNS ON CAPITAL
strong free cash flow; little or no debt
A business we understand, preferably a tollgate
Sustainable competitive advantage
High barrier to entry leader with strong brands
Consistent business with open-ended opportunity
PYRAMID OF GROWTH
The Pyramid of Growth process produced a top performing five-star ranking by Morningstar rating service for mutual funds that I managed. Well executed, The Pyramid of Growth is designed to provide financial peace of mind by participating in the success of companies with enduring quality and compounding growth.
Each block of the pyramid represents a criteria to determine if the business is high-quality and has a sustainable competitive advantage – click the blocks for additional explanation and click the items below for additional discussion about our investment process.
Priced at or Below Intrinsic Value
We look for opportunities to benefit from the inevitable decoupling between the intrinsic value of a business and its market price. Intrinsic value is the present value of a company's future stream of cash flow discounted by the rate that reflects the risk of future uncertainties and investors’ need to be compensated for postponing consumption. Intrinsic value for bonds is easy to calculate because the future cash flows are determined by the coupon rate. The challenge for equity investors is to estimate future “coupons” for stocks. The metrics we use to estimate intrinsic value may include discounted cash flow, free cash flow yield, enterprise value (debt and equity) to cash earnings, price earnings (P/E), P/E to ROIC, and price to book value for financial companies. In the long-run, intrinsic value tracks closely with the trends in cash flow generated by a business. In the short-run, market volatility, triggered by macro-worries or company-specific issues that are temporary, fixable, and non-structural, present opportunities to benefit from businesses “on sale.”
Owner-Oriented Management aligned with shareholders
We are looking for management whose compensation and actions indicate that their interests are aligned with shareholders as equitable partners. We assess management to determine that they are trustworthy, passionate, focused and cost conscious. We like to see management repurchase stock opportunistically when the price is below intrinsic value. This benefits us as remaining shareholders since future earnings are spread over fewer shares which increases value per share.
Respected, candid, accessible and communicative
We seek management that is admired and respected for their integrity and accomplishments, especially by their peers. We want management to be candid and transparent in their communications with shareholders.
Proven Track Record of Financial Success
We look for proven performers that have been tested by economic storms and competitive threats. An excellent track record is not a guarantee of future performance, but it is better than failed promises.
Consistently earns high returns on capital
All else equal, the most valuable businesses are those that deliver more cash flow and income with fewer assets. A company that generates $25 of cash income with $100 of invested capital in the form of debt or equity is more valuable, all else equal, than another company that only generates $10 of cash income with the same $100 of invested capital. Generating a ROIC substantially greater than a company’s cost of capital is a primary driver of creating shareholder value. A high ROIC is the best indicator of a company’s productivity and evidence of a competitive advantage. A business gem that we prize is one that can sustainably generate a ROIC that is materially higher than its cost of capital.
Strong free cash flow; Little or no Debt
Companies that generate free cash flow (cash flow from operations less capital spending) are self-funding businesses that are “masters” of their own financial destiny. As Warren Buffett says, they “don’t rely on the kindness of strangers” for the lifeblood of their operations, especially when lending and stock financing frequently vanish in a tough economy.
A Business We Understand, preferably a tollgate
Tollgate businesses have recurring revenues with repeat transactions that enhance earnings predictability and allow for more accurate intrinsic value estimates. Companies that have recurring revenues are “all-weather” companies that deliver consistent results despite weak economies.
Sustainable, competitive advantage
Competitive advantages that are long-lasting create enduring value. Examples include patent protection, trusted brands, regulatory licenses, high switching costs, cost advantages, scale/size advantage, and a network effect. Evidence of competitive advantages include a low threat of new entrants, little threat of substitution, strong bargaining power over customers and suppliers, and minimal rivalry among competitors.
High Barrier to Entry Leader with Strong Brands
Trusted brands can be a company’s most valuable asset and create customer loyalty. Customer loyalty generates repeat sales which are more profitable than the cost of attracting new customers. We prefer one-of-a-kind businesses with no close substitute.
Consistent Business with Open-Ended Opportunity
We are interested in companies that can benefit from an open-ended market opportunity with products and services that exploit secular trends.
Our investment process is clearly defined, consistently applied, rooted in proven and timeless investment principles, and is a process that has delivered excess returns with less risk.
Warren Buffett said, “If I have seen further than others, it is because I have stood on the shoulders of giants.” The giants he referred to were successful investors such as Ben Graham, Phil Fisher, Phil Carret and Charlie Munger.
In my quest over twenty years ago for adopting best practices from giants of the investing world, I chose three investors who demonstrated success over decades: Sir John Templeton, Peter Lynch and Warren Buffett. For each investor, I studied their investing process with a special emphasis on case studies of their winning stocks. The case studies blended the master’s rationale for buying specific stocks as described by them in subsequent interviews, with prevailing news and popular opinion at the time of their successful investments. Combining the historical context of company developments with their rationale formed lasting insights and interesting common threads. These common threads became the fabric of the Chapman Investment Management investment process, called The Pyramid of Growth.
The Pyramid concept was borrowed from the Pyramid of Success which was developed by the beloved former UCLA basketball coach John Wooden, whom ESPN named Coach of the Century. Coach Wooden’s Pyramid of Success is a format with which he illustrated the qualities necessary for individual and team success. Each block of the Pyramid represents a behavior, attitude, value and quality ingredient for success, including enthusiasm, industriousness, self-control, poise, confidence and competitive greatness. Ultimately he defined success as “peace of mind which is a direct result of self-satisfaction in knowing you made the effort to become the best you are capable of becoming.” Coach’s Pyramid and definition of success inspired me when I first discovered them by reading his book, They Call Me Coach,when I was a freshman in high school. They have guided me ever since, particularly as I had the honor of personally knowing Coach in the last eight years of his life. The Pyramid of Growth process produced a top performing five-star ranking by Morningstar rating service for mutual funds that I managed or co-managed at two of my predecessor firms. Well executed, The Pyramid of Growth is designed to provide financial peace of mind by participating in the success of companies with enduring quality and compounding growth.
Why We Sell or Trim Stocks
Why we Sell or Trim Stocks
We buy stocks with the intent to hold them indefinitely. Change is constant, however, and either differences in business fundamentals or market prices may warrant a portfolio change. There are five reasons why we would sell a stock.
We will sell a stock if the price is excessively overpriced relative to its intrinsic value. When a stock price is discounting earnings several years forward or if its valuation ratio is well above its historical range, we will sell. If a stock price is only modestly overvalued, for instance by 10-20%, we will hold the stock if we are confident it will grow into its valuation in the near future. Outstanding companies are not frequently on the bargain counter. Once we own one, we want to participate as fully as possible in their wealth creation. We are aware of many instances where an investor sells an exemplary company that is only modestly overvalued, fully expecting to buy it back cheaper, but the stock does not give the opportunity, and the cost to the investor of foregone profits is enormous.
BETTER IDEAS WITH MORE CONVICTION AND HIGHER UPSIDE RETURN
We are constantly evaluating new investment players to become starters in our portfolio lineup. If a starter becomes permanently injured or is too pricey, we will make the substitution. Also, if a stock appreciates from a beginning mid-single-digit percentage weight to a double-digit weight in the portfolio, we may trim the stock and reallocate the proceeds to more attractively priced investments.
DETERIORATING FUNDAMENTALS/ERODING COMPETITIVE ADVANTAGE
Companies that enjoy high returns on capital and superior operating profit margins attract competition. If the barriers to competition erode and violate our original expectations for owning the company, we will sell.
KEY MANAGEMENT DEPARTURE
Warren Buffett and Peter Lynch have said they try to buy stock in businesses that are so wonderful that an idiot can run them, because someday one will. The common reality is that management does matter. Companies once moribund have been resurrected to prosperity because of a change in leadership. Other companies have had wealth destruction due to weak, misguided or greedy management. When key management leaves a company, we will re-evaluate the new leadership to ensure we still like, trust and admire the new team, its incentive compensation structure, its communication and its strategy.
RECOGNIZING A MISTAKE
Despite our best effort to apply our due diligence process in assessing the sustainability of a company’s competitive advantage, the competence of management, and our estimate of intrinsic value, we occasionally make mistakes. These are mistakes of commission, where we buy a stock that does not meet our expectations, and we sell to limit our losses. We also seek to minimize our mistakes of omission where we don’t buy a stock that qualifies for purchase, which subsequently creates massive wealth. These don’t appear on our report card, but they are costly nevertheless.