The Manual of Ideas interview with James Thompson of Southeastern Asset Management

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James Thompson
Principal, Southeastern Asset Management
Transcript (lightly edited, may contain errors)
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Exclusive Transcript
Guest: James Thompson, Principal, Southeastern Asset Management
Host: Oliver Mihaljevic, The Manual of Ideas
June 2, 2014, New York City
The Manual of Ideas: Thanks so much for joining us. Such a pleasure to have with
us today Jim Thompson, Principal and Senior Analyst at Southeastern Asset
Management. Jim, welcome to the program.
James Thompson: Thank you, Oliver.
MOI: Really look forward to learning from you about valuation. Today, you’re
going to help us understand better how to tie in price and the business and thinking
about management into coherent investment strategy and focus intelligently on
valuing a business. Before we get into that, tell us a bit about your path as an
investor and who were some of the people, what were some of the events that
really influenced your investment thinking?
Thompson: When I graduated from UVA in ’86, I ended up working at Wachovia
Bank in the trust department and that was a fantastic learning place because there
were so many young people that were doing value-oriented work and we were all
focused on really trying to build these valuation models. In 1996, fortunately, I
went to go work for Southeastern Asset Management and that’s where I met
Mason Hawkins and Staley Cates, two of the best value investors I know of and it
was a fantastic learning experience, not just through those guys, but the entire team
of Southeastern. During that time period, I had a slight period where I left the firm
and I worked for two years with Peter Cundill in Canada. That was a great learning
experience, too. I’m back at Southeastern today and, again, we have a talented
team. We’re always pushing to do better work in valuation and it’s just a great
place to be.
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MOI: You mentioned some of the investment greats there and I’d be curious to
hear from you what it’s like to work with Mason Hawkins and perhaps you could
tell us a bit about some of the key lessons that you learned over the years working
with Mason.
Thompson: Mason is a very focused investor, so he hates diversification just for
the sake of diversification. He wants to concentrate our firm and our own personal
money into the best investment ideas we have, so that’s why we have about 20
names in a particular mandate. It’s really about getting the best ideas that meet our
businesspeople price criteria. We don’t want to diversify away and he’s never
wanted to put money into the 45th or 52nd best idea. I think it’s about
concentration of your best ideas. It’s about in-depth knowledge about what you’re
doing and this idea of are you willing to put all your money into this idea? Are you
willing to sink or swim with the analysis you’ve done?
MOI: You mentioned also the late Peter Cundill. What a great investor he was as
well and I’m curious, perhaps you could contrast a bit Peter’s approach to Mason’s
and what you learned from each one of them. Help us understand a bit how
perhaps Southeastern differs from some other value investors who are just as
successful.
Thompson: They’re not that divergent, but in some ways, Pete Cundill, his focus
was more like the early days of Buffett, so more a hard asset value, book value,
tangible assets. Mason is much more oriented towards franchises, discounted cash
flows, great businesses. There’s definitely an overlap, but that’s how I would
separate the two.
MOI: That really brings us to the topic for today, which is how to think
intelligently about valuation and there, of course, are many ways to think about it
as you’ve said here. Two people thinking a bit differently about it, but both very
successful in the way they approach it, so help us understand. Of course,
everybody would like to have a great business and great management at a great
price, but it doesn’t always work out that way, so help us understand how you

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think about those factors holistically when devising an investment process, a
framework for how to think about valuing businesses.
Thompson: Okay, that’d be great and do you mind if I use the whiteboard here?
What we talk about when we do our strategy is we look for, not unlike some other
people, this notion of the price, the business and the people, if you will. That’s not
unlike a lot of people and we want this middle ground where they all overlap.
The price part is chiefly at discounted cash flow and this kind of cash flow, a lot of
people will tell you they don’t like it, there’s a lot of reasons not to do discounted
cash flows. Often, the negative I hear is, “If you torture the numbers enough,
they’ll confess what you want them to. It’s too complex, it relies too much on too
many assumptions.” That’s somewhat true, but I think the opposite side of that, the
reason the [inaudible 0:05:15] on discounted cash flows, it’s very explicit. Your
assumptions are explicit, you can do sensitivity analysis on those assumptions. You
can monitor progress along the way, so as things change. If working capital levels
change in a company, if the organic sales drop, then in real time you can actually

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what the impact of that is. It really allows for in-depth discussions with
management because you’re really talking about the levers of value creation
instead of just saying EV to EBITDA. It’s getting in-depth to the valuation work.
Now within that, the trick of a discounted cash flow, what happens is you end up
with something like this. Here’s time and you buy the stock here and you assume
you get some sort of terminal value and you may get dividends along the way.
Now that’s how a stock looks. When you look at a company, it’s different than that
because what you have is a long-term set of cash flows like this.

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One thing we do is we DCF these cash flows and we look at what the value is to
us, if you will, and let’s just call that the public value. We also crosscheck that
against private market values because it’s a world of competitive capital allocation.
There are activists out there, there are people actively buying companies, so it’s not
just a theoretical exercise. It’s a real exercise of what the value is to somebody else
and what the value is to us. Once we get into those points about business and
people, there’s some real implications about what that means to discounted cash
flow. Let me just touch on those really quickly. We talk about bullet points. We
talk about within the business, we want to be understandable. That’s kind of also
what Buffett talks about with ‘circle of competence.’ Once you understand a
business, once it’s in your circle of competence, that allows you to have much
higher confidence, if you will, at your ability to actually do a discounted cash flow.
Complex companies, companies you don’t understand, you’re going to get DCFs.
We talk about debt. The important part about debt, there’s two things about debt
that are important. One is that if you have too much debt or too many liabilities,
this discounted cash flow could get stopped out. In a recession, you may go

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bankrupt. You may have assets taken away from you like in 2008 when certain
companies went bankrupt. You didn’t live to fight another day. The other thing
that’s important about the level of debt, depending on how you did the discounted
cash flow – growth or with interest included – is it makes it much more volatile.
Your answer becomes what we call the risk factor of the valuation. If you’re wrong
on the valuation and you have debt involved, then you’re going to be way wrong
on the underlying value of the stock.
We talk about moat and a moat is really important. That’s completive advantage
and so that’s Porter’s analysis largely, but the important thing there to think about
for us is duration and protection. If you have a business with a good moat, these
cash flows are more protected. You’re much more likely to get the projections
right if the business has a natural fighting ability against its competitors, but the
duration is something else people don’t talk about a lot. We’ve seen some people
that talk about it, but the sense is that if you have a great franchise, you’re likely to
underestimate how durable that franchise is over time. It’s a hidden source of

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undervaluation, if you will. An example I like to use is Coca-Cola. Buffett uses it
all the time, too. It was founded in the 1880s. I don’t know what people did on
DCFs, but I doubt anybody did a DCF long enough to truly estimate the value of
the moat of Coca-Cola. Debt, its understandability, its moat, those are the things
we’re looking for.
Now on the people side, we want some degree of trust and trust is also important
because when you’re talking to a company, they need to have credibility and
whether you actually believe what they’re saying about the future of the business
and their ability to execute. If you’re going to be invested with somebody for a
long period of time, then you need to have a working relationship where you
actually believe and enjoy working with them. We want skilled operators, so we
want to have a history of operations that, again, lead us to believe these cash flows
can improve. They’ll be built upon and, again, over time this will surprise us to the
positive because they’re good operators instead of letting the business fail.
Allocation of capital is key for us and I think that’s one the thing we’re very good
at. We spend a lot of time with the management understanding how they’ll take
this free cash flow and reallocate it into the business.
For us, that means we want to understand the list of projects that’s in front of them.
We want to understand how they think about returns and risk and how they’ll
allocate that cash flow, whether they’re going to allocate it into buying back shares
or acquisitions or organic growth. That’s where we spend a lot of time. There’s a
free cash flow part of the business we talk about and that’s important because
people will often tell you that a business with free cash flow is the best kind of
business and I’ll say I think it’s a business that can have free cash flow. The best
businesses may not have cash flow because they have special projects where they
can reinvest into and that’s key to understand. We owned Yum! Brands and they
had a really special project, which was building out Kentucky Fried Chicken in
China. That was a special project that only they had. We also want shareholder
orientation and, if you will, incentives that are aligned with that.

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I like to joke that there’s two types of people in the world – there’s pie makers and
there’s pie takers. We want somebody who’s involved in creating a larger pie that
they participate in, that all shareholders participate in, not try to allocate more of
the pie to themselves. That’s how this all integrates into this kind of cash flow. I
think it’s holistic and the more you get of this right, the more likely you are to get
the discounted cash flow correct. I guess I should finalize that we want to buy this
at a big discount, so that’s the final part.
MOI: There are certainly a lot of questions here and we’ll get to talking about
some of the finer parts and some of the dilemmas within each of these categories of
price, business and people, but perhaps to step back first and ask about with this
framework, how do you go about searching for ideas globally? How do you filter
down the opportunity set efficiently? Where do you say no quicker?
Thompson: That’s a good question. I would say there’s three things we do, sort of
in buckets. One of those buckets is an office-wide or company-wide search. What I
mean by that is we monitor spinoffs, we monitor stock buybacks, legal insider
trading for the corporate CEO and things like that. We monitor restructuring
events. We look at people we admire and we look at what they’re buying. We have
that list and that’s internally available to everybody. It’s dispersed to the entire
team of ten. Within that team of ten, we’re all generalists, so beyond that, we also
do things on an individual basis. I can speak to what I do, I do some screen. What
I’ve found more successful in screening is within an industry looking at EV to
sales because that highlights a couple of things.
One is where there’s a margin opportunity within that industry and also, often,
there’s a takeover opportunity because the buyer will see an arbitrage, if you will.
If there’s someone in the industry doing, say, 3-4% on sales and they’re doing 10%
and they believe there’s some synergies of acquiring them and putting them in their
business model, that’s sort of an opportunity to acquire revenue cheaply. I think
that’s a really good way to look, but we look at things like EV to EBITDA, EV to
OI, free cash flow yield. This is sort of typical value tools. We look at things like

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the stocks that are particularly down, bad earnings. They might have some sort of
crisis that you might go through and they’re being sold off, if you will, willy-nilly.
Those are some typical tools. I could teach you this, give you the Wall Street
Journal and you could pick the names we’re looking at in any given day. It would
be pretty easy to figure that out.
The third thing I think we do, which is kind of unique, is we keep a wish list and I
was just going to illustrate that very quickly on my board. If you think about the
world and let’s call this quality and this price, the world would like, if you will, a
shotgun blast off to the northeast corner.
What’s interesting is that the world can be quite volatile on price, but it’s not so
volatile on this quality spectrum.
What we’ve done when we’ve had free time when the markets are more
overvalued like they are today, we go back through and look through the wish list
and we look for names that we would like to own and typically they stay there.

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Now sometimes a company that’s really great, it can move off to a lower quality
area like newspapers did as Google came along, but generally they tend to stay
high quality or they tend to stay low quality. You pick this area in advance, ones
that you know you’d like to own. They typically are trading up in here, but
sometimes you get these opportunities where they fall in there and we monitor that
heavily. I think it’s a great tool to find out in advance, do the work in advance of
names you’d like to own, just continue to monitor those.

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MOI: With a global search capability, to come back to this concept of circle of
competence, help us understand where you’ve said no in the past for whatever the
reason was. Please explain to us perhaps by way of an example some of the limits
to just applying this framework. Going back to Mason’s earlier point about
investing in your best ideas and having a concentrated management style, we stay
away from certain industries and one of those we have generally avoided is highly
levered industries. We’ve stayed out of businesses like commercial banking and
that’s because of the high leverage factor. It’s also very often that the balance
sheets are somewhat opaque, so we don’t really know what they own, not in great
detail. We’ve typically stayed away from levered financial institutions.
Another area we’ve stayed from and Mason’s never really cared for is regulated
industries. We have not been heavy investors in utilities. We typically don’t go into
commodity businesses. We might look at those if we think we have low cost
producer status, so within commodities we would have a view towards just a small
selection of those names. Just to twist this question around, we typically look for

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businesses or industries where we’ve done quite well as in consumer nondurables,
media, I would say in the energy business, insurance, the P&C business and
insurance, the broking. Those types of businesses we fell we’re pretty good at.
MOI: When we think about geography, I know that you’ve invested in Japan as
well unlike other value investors. What about places like Russia, Argentina where
there are obvious crises and prices do come down? How do you think about those
perhaps extreme situations as I think that would be instructive?
Thompson: Let me talk about Russia and Argentina first. Countries like that, they
have these sort of macro issues, government issues, those types of things. When
you have a concentrated portfolio, even if you say, “This company in Russia’s
quite cheap,” it’s hard to say, “I want to own a big position in that,” knowing that
there’s some percentage that it could, say, be nationalized or some kind of arbitrary
rule put in effect where you, basically, have your assets taken away from you by
either the government or some sort of situation. The other thing I would say within
that is that if you go into the emerging markets – you’ve sort of touched on
Argentina – quite often, the big names in those economies, their utilities, their
banks, their commodities producer, so you don’t typically these franchised
businesses in some of the smaller economies.
Japan’s a different situation. There are some great companies in Japan, there are
some world leaders there. What we found is great businesses and we will invest in
those business on our terms. We want to get the people right and that’s around
incentives, that around the focus on shareholder wealth creation. That has been an
area that historically has been lacking in Japan. We see some movement towards
fixing that and improvement, so we’re encouraged. There’s a move towards more
focus on ROE, potentially being able to restructure businesses. There’s active
M&A particularly on the smaller companies there. There’s reason to hope that
Japan gets the shareholder orientation right. Again, there’s some great companies
there.
MOI: Thinking back to the framework of price, business, management, if the price

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then the great arbiter of it all? The position sizing, that’s perhaps looking a bit
advanced and jumping ahead in our conversation, but I’m curious. You mentioned
concentration. For example, in Russia perhaps there is a business and it’s available
at a great price, but you’re unsure about management, potential expropriation. Can
the price adjust for that to a point where it becomes compelling as an investment
case and then how do you perhaps think about concentration versus lower position
sizes in a basket approach. Some value investors have advocated, most famously,
Ben Graham.
Thompson: Mason is very adamant about being focused and focused on your best
ideas. He likes this crowding out notion, so always trying to find the better idea to
crowd out the lesser idea and keeping it really focused on that. It’s unlikely to see
us, if you will, nibble at 1% positions in a company in Russia to lower the risk that
way. We would prefer to focus on that core idea of a 5% position, if you will.
That’s where we focus on traditionally, we want to own a 5% position. It’s really
hard to say, people ask us, “Which is more important – business, people or price?”
I will say this, the one part that’s nonnegotiable is the price. We go back to Ben
Graham on that part, which is it’s a margin of safety. I’m repeating what everyone
else will tell you that you’ve interviewed, but for us, it increases the return when
we’re right and it reduces risk when we’re wrong. We’ve said for years we think
the greatest risk reduction tool available to us is a good price.
MOI: Let’s come back then to the chart you have drawn here for us. Thinking
about great businesses, we all want them, of course, as investors, the compounders.
What are some of your favorite reasons for mispricings when these great
businesses become available at attractive prices, perhaps leaving aside extremes
like ’08-’09? What are perhaps some other areas that you’ve found historically
really work to find great businesses at attractive prices?
Thompson: I would say for us it’s a couple of things. You hit on the best one,
which is a financial crisis. Then everything gets cheap. There are sometimes
industry concerns that allow you to buy things cheaply. We bought a lot of great

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hotel businesses after the unfortunate events of 9/11 when people were not
traveling and we were able to buy these really great businesses. We had a view that
over time, travel would return. We were also able to buy the aggregate businesses.
A couple of years ago, when people were very concerned about construction
activity and so the EV to EBITDA did not look so good, but we knew the
replacement value of those businesses and we were able to buy those at good
prices relative to replacement and private market values. I would say industry
concerns are one. Beyond that, I would say another factor would be where there’s a
cash flow issue where stated earnings don’t reflect the real earnings power of a
business.
This is not an extreme of that, but Aon has some goodwill that flows through that
basically lowers the stated EPS. It’s not a big deal, but that’s an example. That was
a bigger deal back when people used to depreciate or amortize goodwill. It’s less of
a deal these days. I would say there’s also a sum of the parts type notion where you
have a bad company hiding a good company, so you may have no earnings power
or you may have depressed earning power because you’ve got a franchise here in a
new startup business or maybe a disaster where they tried something and it just
didn’t work. Those are examples, I think, of how you can find businesses of value
even in times when the markets are more fairly valued.
MOI: You mentioned Aon. I’d be curious to come back here on that point about
understanding a business and moat that you talked about earlier. One of the things
that perplexes me with Aon and insurance brokers in general is just how resilient
their model has proven when you look around how other intermediary models have
been under threat from online models, especially. Perhaps that’s a good example to
think about and understand better how you think about assessing a moat with
confidence, thinking about what can really derail a business. Aon, many would
certainly argue it is a great business, but how do you then think about these types
of questions? Why wouldn’t their commission rates come down over time? Isn’t
there an attractive pool of dollars that competitors would want?

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Thompson: All businesses are under attack at all times. I would say the things Aon
has going for it on a couple of these fronts, I like to think of it as a bowtie, if you
will. Two ends of the bowtie. On one you have thousands of insurance providers
and I don’t know how many hundreds of thousands of buyers and so they along
with Marsh Mac as well as a few others control that information flow through the
middle. If you think about it from a buyer standpoint, unless you’re someone
really, really large, so maybe Exxon or something like that where you might be
able to create your own internal vehicle, it’s not worth your time to do and it’s hard
to aggregate all that information. I would actually argue that Aon and the industry
is doing quite a good job of actually improving the information flow and
potentially getting more value out of that relationship over time.
On the internet side and this disintermediation, I think there’s an issue.
Particularly, you’ve seen it happen in automotive, so anytime you can take an
algorithm and apply it with something like car data, I think you’ve got an issue
because you’ve got DMV data, you’ve got your driving record. Either it’s self-
reported or even nowadays monitored, mileage. You start aggregating this all and
you have an algorithm that can price it possibly more effectively than a broker.
Then I think you have this issue of disintermediation, but when you start going into
more complex type issues – insuring a refinery, a factory distribution center, a
trucking fleet – that’s all very hard to create a computer model that prices that
effectively. That’s where these big brokering teams have expertise that know how
to price, if you will, offshore oil rigs or aircraft insurance.
MOI: To extract that from this example now to the concept that you talked about
earlier, DCF valuation and taking a business, modeling it out into the future in
terms of cash flows, perhaps Aon is effective in the sense that it never looks cheap,
so it trades on 17-18 times earnings maybe. You mentioned earnings may
understate cash flow, anyway maybe a 6% cash flow yield growing. Not
necessarily compelling for bargain-seeking value investors, but is that then
underappreciated? Is it wrong to think that way about the valuation of a business
like that? Help us understand, going back to the DCF framework, how do you

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really account for a business like that?
Thompson: To be fair on Aon, we purchased that some time ago at much lower
prices, at much lower free cash flow yields. Today, it looks much more fairly
valued to us. I wouldn’t hesitate to call it a bargain. It’s a great business and has
attractive cash flow characteristics. I think the things we saw initially, we believed
the market might not have seen and this is like a time series. One of those was the
ability to continue to improve the operating income margins of both divisions. We
were skeptical on the human resource side, whether they could get the margins
they actually had targeted, but along the way they did some incredibly smart things
that helped increase the value quite a bit for us. It was a time series of three things.
When they relocated the business, re-domiciled to the United Kingdom, that’s
allowed them to do two things – recapture some cash that was locked up overseas
and also they’re reducing their tax rate. We don’t know where it’s really going to
end up, but it will be lower than it was in the United States and from a DCF
standpoint, that’s value creative. It allows more free cash flow available to us.
The second thing that we saw of late was, again, around our skepticism or worry
that they couldn’t get those margins in the human resource side. They’ve rolled out
an insurance model, very similar to what the federal government’s rolled out, but
this is setup for private employers. It’s an exchange. They’ve just rolled it out, it’s
early days. It lost money last money, didn’t create revenue. We went over and
looked at the Towers Watson, who had a somewhat competitive model. We saw
the margins that business had and we started modeling through it with a lot of
assumptions. You could start seeing that those margins actually could happen, if
this is successful. We continue to monitor that, but we have a much higher
confidence that those margins come through. Those are the sort of things we saw
along the way that kind of ramped up our value, but again today it’s much more
fully valued. I would say the third like for Aon that’s intriguing is they’ve had
some restructuring charges that have hurt cash flow and they’ve had pension
contributions, those will start coming down and there will be a higher free cash
flow, so more of the earnings will be available to us. We think that will largely go

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to share repurchases or some accretive bolt-on deals.
MOI: Thinking about a business like that in terms of just the compounding nature
of it, what is then the biggest risk that you see? I mentioned the commission rates
long-term and perhaps margins then are a result of that, but when constructing a
DCF on a business like that, what is the biggest concern that you would have?
Thompson: There’s two divisions in there. One is the risk side, which is the
broking business. We monitor that for changes. We have questions around that.
We’ve invested in the business for quite some period of time successfully, so we
have a pretty good confidence that things will remain quite good there for some
period of time and they keep reinvesting to make that business better. It’s not like
they’re sitting on their hands. There’s a lot of continuing to build that moat out or
at least keeping it status quo. The human resource side is more complex. There’s
more elements moving around in there. We monitor that. This new healthcare
exchange is interesting. I think it could propel them and make the business better,
but fortunately for us, it’s a smaller part of the business. It’s a little bit harder to
understand, it’s a little less clear what all the moats are, but I’d say the main thing
is just continue to monitor it and realize it’s not the most important driver of value
of the company as opposed to the real franchise.
MOI: Stepping back a bit from this Aon example, would you say the moat that
Aon has in the brokerage business is a nontraditional type of moat, it’s a bit
underappreciated? Thinking about moats generally, perhaps you can give us your
view as to which types of moats you find really the best or what do you look for
there and how would you classify Aon’s moat in that context?
Thompson: I used to joke about Aon. I used to say if you took value line and you
covered up what it actually does and the name of it, you just looked at the returns
in terms of growth, it would have a much higher multiple than it trades at. I’m not
sure if that’s because it’s in the finance industry is where it gets lumped in, but I
always just joke about that. Just cover up the value line page and tell me what you
think that business ought to trade at without knowing what it is. I think it is

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underappreciated to a degree, possibly because it’s in the finance sector. I think
that’s my answer on that. Frankly, I think the proof is in the pudding on moats. I
think it often shows up in returns. I’m impressed with Google as a moat because
they do such a good job of continuing to build it out. It’s an interesting model in
that it’s intent-driven advertising as opposed to passive. I suspect you have to stay
on top of that moat all the time.
Other businesses are quite interesting. We’ve always loved Budweiser as a moat
because it was branded, it had great distribution. I grew up in a family that had
convenience stores and what you realized when you have a convenience store
business is that there were several competitors. There were three different
distributors in town, but the Budweiser guy had a huge advantage because he
always came in with the largest hand truck full of beer and you have the other two
distributors come with much smaller ones. You realize there’s a huge scale benefit
by having a more efficient distribution channel and that just kind of feeds on itself
through the advertising, the brand awareness.
MOI: Help us understand this dilemma between known moats, you mentioned
Coca-Cola or Google now, Budweiser. People know about their moats, people
know these brands. What about unknown moats, getting to them before they
become famous? How does that perhaps differ and has that been a source of good
investment ideas? Is it even worthwhile as a value investor to try to identify these
moats? Is that possible or can we just in hindsight say, “Well, that was that,” but
help understand? I guess what I’m trying to ask is is it more productive for a value
investor to find mispriced known moats or to try to go for that Hail Mary and
identify the moat before everybody else. It seems that Warren Buffett has made it
appear that that’s quite easy to do, but it’s so hard, isn’t it, to find something before
it’s generally known that it’s such a great business.
Thompson: I don’t know the answer to that, I don’t think, but I know Buffett’s
talked about it and you’ve seen it before where you have sort of lightened pricing
power. If you can discover a lightened pricing power, that’s pretty powerful. It’s

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fairly rare. I would say if you were to go off and try to discover the next franchise,
I would spend a lot of time around incremental economics. It’s a smaller company,
starting off and it has a fixed cost around it. I use a retailing concept, for instance –
a retailer in the early days, which may not be a great moat necessarily, but you’ve
got all these fixed costs, your distribution centers, so the store level economics
might be quite good, so understand those store level economics or even like a
subscriber type business, so cable in the early days or satellite TV in the early days,
you understand that subscriber or that unit level of economics and then you see
how it levers over time. I think you could possibly start then discovering these
potential franchises in the future because of the fixed cost nature, the build out
required in the early days to build this franchise will have depressed ROEs and
over time, those ROEs will be revealed.
MOI: How has your understanding of moats and just in general the business aspect
of the three categories that are important to your framework, how has that evolved
over time? Give us sense of some of the key lessons you have learned or what are
perhaps some mistakes around the business side that you’ve made and that helped
you improve your process?
Thompson: I think the one thing I would say if we’ve, over time, appreciated it
more and more and around the people. It’s not enough just to have a cheap
business. You may make money doing that, but to protect yourself, it’s better
downside protection and better optionality on the upside to have, if you will,
everything. The things we’ve done over time and we’ve learned from, I think one
is monitoring very carefully those businesses. I think with the internet and with the
venture funding that’s available today, you have these profit pools under attack. If
you’re a young startup company and you see an area that you can disintermediate
very quickly, maybe efficiently, maybe very cheaply through some sort of internet
technology, I think you have to monitor these things a lot more.
The days when I was much younger, it was harder to attack these franchises, but
you see an industry decimated and totally change. As a matter of fact, you’ve seen

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it almost in the recorded music industry where when I was a kid, I would go to the
record store and then you had a business that moved towards [PH 0:39:49] piracy,
then you have where you pay 99 for an iTunes type thing that built out. Now₵
that’s going away towards the Pandora/Rhapsody/Apple Pay. I guess they’ve
attributed $500 million for Beats, the music service. You’ve seen three or four
generations of music changing dramatically through the internet and technology, so
I think you have to monitor it a lot more.
MOI: In terms of coming back to the valuation framework, so valuing a moat
versus the opposite of a moat and thinking about the valuation methodologies
there, give us a sense of that.
Thompson: Well, Staley Cates talks about it often. When you present an idea, he’ll
say like, “Why wouldn’t we just build it? Why doesn’t somebody just build it?”
That’s his concept of replacement and I think it’s a great, if you will, flip the
argument of a moat upside down for a minute and just think about the idea of
replacing it. I use this example sometimes about Google. Google has a market cap,
if you take out the cash, so an EV of about something north of $300 billion. If you
go look at the book value of the company and strip out the cash and the goodwill,
it’s something around $17 billion. I’m leaving the intangibles in there because I’m
assuming you have to fund those, but who knows? So $300 billion/$17 billion.
Why wouldn’t anybody create that business other than the fact it’s hard to raise
$17 billion?
Even if you split the business in half and just assume that my new company is
worth $150 million and Google’s now worth $150 million, that’s still a hell of an
arbitrage, so why hasn’t it been done? Well, it’s clear Microsoft has tried to do it.
It’s very difficult to do and it proves that. Google’s a very extreme example. Most
companies, especially midcap and above, trade above some level of replacement.
It’s very important to, I think, look at that and say, “Why doesn’t somebody
replace that?” It’s a build versus buy decision. Why go pay 2x for it on Wall Street
when we could build it for 1x? The answer needs to be because you cannot.

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Staley’s very good at that sort of logic of thinking that through.
MOI: When we don’t really have a moat that we’re dealing with, give us a sense
then of the valuation framework. Coming back now to price again, the DCF, what
are some of the other tools? How do you then look at that? I think you also
mentioned earlier a DCF won’t be good for a business that you don’t understand,
so what are some of the other methodologies that you do have to value businesses
that don’t have moats?
Thompson: I would say, first of all, if you don’t understand it, just stay away from
it. It’s a great way to lose money. Again, you might get lucky, but if you don’t
understand it, just stay away. That excludes a lot of businesses. It makes life a lot
easier because you just can’t do it. I would say if they don’t have a moat and we do
invest in companies from time to time that may have an assortment, if you will.
There may be a franchise business and a business that is more of an asset value
play. There you can focus on two things – replacement, but more importantly is the
private market value of those assets.
We were a big owner in Lafarge. In the Lafarge’s case, at the point in time we
bought that, their earnings were depressed because of construction around the
world was lower than normal, but we went through the assets and we know what
private market buyers would pay for a ton of cement, what they would pay for
aggregates, for either the reserves or for the production that comes out of the
aggregates. Once we totaled that up, we got a real firm belief that we knew what he
private market value of those assets was. In time, we thought the economies would
recover and the EBITDA and the OI and the free cash flow would square with that
valuation and that’s happened. I would say going back to that private market tied in
with that idea of replacement cost is a key concept.
MOI: When it comes to the valuation, you talk about the sum of the parts and
really thinking through present value of free cash flow in each business segment.
Sometimes those valuation methodologies tend to be deceptive in the sense that
you do invest as a passive equity investor initially and then you, on paper, can sort

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of desegregate things and make it seem as it they’re standalone businesses or that
there’s a different structure, which may conflict with how the management views
the business. Give us a sense of what are some of the main pitfalls of thinking
about valuation and more creative ways, not necessarily looking at it holistically in
a DCF fashion where there is one cash flow from the entire business.
Thompson: If I understand the question correctly, I think that the key part is to
make sure when you talk to management that they understand this aggregated
model and that they are driven and incentivized to increase shareholder wealth,
which would include themselves. If that’s the case and they understand all the tools
they have to increase that, then typically you see intelligent things happen. Good
management teams that are well-incentivized, they surprise you. They do the right
things. It’s when you have these conflicts, so I think a lot of it’s incumbent in the
early part of the process to make sure that it all ties in. now you’ll get that wrong
from time to time, so you may have to remind people how this works, but I’d say
in the main, if you get great partners, they surprise you on the positive side. By the
way, if you get bad partners, it’s a disaster sometimes.
MOI: For the private market valuation methodology, I’m curious how the external
environment affects that. In this record low interest rate environment, it’s almost
taken as a given that private market valuations are serious and that is an absolute
value, rational, in the real world, often it’s contrary. Trade buyers, even private
equity buyers, they would pay crazy prices. Give us a sense of how you think
through that and especially in the context of this low interest rate environment that
we’re in.
Thompson: We keep data on all the deals that we can monitor and we do keep
track of the interest rate environment during those deals, so we have a sense of
whether it was a very low interest rate environment with lots of liquidity or not.
Let’s think about the environment we’re in, we use it for two things. One is that we
typically don’t want to have a DCF that’s over the private market value. It’s kind
of a test that you haven’t gotten carried away with your assumptions. It’s flipping

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the logic over. If trade buyers typically pay the highest prices and you’ve come up
with a number higher than a trade buyer, then we’ve got a problem and we need to
square that. You still may be right, but let’s think about that a lot. We flip that
logic over. The other thing I’d say is to really think about the industry you’re in.
Some industries are rapidly consolidating and there are often buyers. It still may be
informative to know even in today’s environment what people are paying for
certain industries, but you don’t want to hold out. The whole case cannot rest on a
top pick in a private market valuation driven off today’s artificially low interest
rates.
MOI: We haven’t really talked about it, but in the context of DCF valuations, one
of the key criticisms in the terminal value. How do you think about that part?
Thompson: I think when you get to negative points on DCF, it’s the discount rate
and it’s the terminal value. What we try to do internally is to be conservative with
that. Sometimes you’ll miss companies that you maybe should have been more
optimistic about, but we’ve chosen to kind of dial that back. We used below long-
term multiples that we’ve observed in the market, so below 14, the 12-13 level in
the United States.
MOI: Then when it comes to research and valuing a business, you talk about the
80/20 rule as well. It’s so important perhaps in the case of doing a DCF, when is
‘enough is enough’ in terms of numbers and detail?
Thompson: The answer is it depends, I guess. I worked for our family business
before I went to grad school and we had all the insider information you would
want. We controlled the whole thing and we never really knew what earnings were
going to be. We got a monthly because it was internal, but you never really knew
even though you ought to know. I think there’s one thing, you have to understand
that running a business is very complex and so you’ll never know what the CEO
and the Chief Operating Officer know. You have to know when to stop. Otherwise,
I think you can scoot yourself into this perpetual doom of digging for information
that may have very marginal benefits. It’s important to get the big stuff right, but

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that’s where the art comes in. Where is enough? My point when I mentioned that
earlier is that you want to have in-depth knowledge and you want to have
conviction, but you can’t dig so deep that you never actually do anything with it.
Again, you have to make that personal call when you actually have gotten far
enough along.
MOI: You mentioned earlier Southeastern’s avoidance of regulated businesses. I’m
thinking about DCFs and it’s kind of wonderful when you have a regulated
business. I think Warren Buffett’s made that point. It’s certainly predictable. You
can put a lot of capital into it and certainly, it works for Berkshire and the position
they’re in. It’s a bit of a contrasting view from Warren Buffett toward regulated
businesses in the US, of course, to what you have stated. With DCF type
valuations, I’m thinking regulated businesses actually lend themselves to that, so
it’s perhaps a bit counterintuitive. Give us a sense of what is then the main issue
that you have with regulated businesses.
Thompson: We’ve liked businesses where the management has the ability to drive
the returns. I guess if you said you had massive amounts of capital to invest and
you wanted to have certainty around DCF, you might do that. If you’re more
selective around it, then you might see that as actually not something supportive,
but rather stops you out. In fact, over time, with low interest rates, you’d expect the
regulators to lower the returns that certain things can achieve. Again, we would
consider investing in those companies, but we generally have preferred companies
where the management can drive the outcome rather than a government policy.
That’s just been where we’ve chosen to position ourselves.
MOI: When it comes to thinking about this price aspect of the three categories in
your framework – business, people and price – what would you have learned there
over time? Again, what is something that perhaps has evolved in your approach
when thinking about the price aspect?
Thompson: First of all, all managements will tell you their stocks are undervalued
no matter what they’re trading at, so that’s not very helpful. What I do like and

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I’ve learned over time is if you ask them why, you can often learn quite a bit. I
remember there was a European company and I met the IR woman. She went
through the value of the company and I’ve never seen anybody do such a good job.
It was an oil and gas company with a divergent asset. She actually said, “We have
this number of kilometers of pipelines. Here’s the transaction prices. We have this
number of oil reserves, we have this number of tankers.” I forgot all the assets, but
the company clearly had gone and understood these assets and was willing to
transact them if the need be. Then you have the other extreme where a
management team might say, “Wall Street thinks we’re going to earn $3 this year
and the market’s trading at 15 times, so maybe we ought to trade at a premium to
that,” so something over $35 a share. That’s very unhelpful. It shows a lack of
understanding or an in-depth knowledge, which kind of scares you away.
MOI: That brings us to management and the people you’ve talked about are so
important to all of this. What is perhaps something there that you have learned and
certainly, it’s so difficult perhaps because it’s not as quantifiable as the business
and the price side, so we’re dealing with elusive assessments, very subjective.
What are perhaps some of the things that help you leave that subjectivity and
perhaps emotional things aside and focus on what’s measurable in management?
Thompson: One of the things we say internally and I sort of phrase it this way is,
“Watch the magician’s hands, not what he’s saying, not the smoke and the pretty
girl.” There’s distractive stuff, but watch the hands and that’s the cash flow. The
cash flow tells you everything, the record tells you everything. You often hear
management say one thing, but yet do another. I’ve heard management teams say,
“We think our stock is undervalued,” and the next thing you know, they’re issuing
stock. Square that for me exactly. You’re saying one thing, but yet doing another. I
think it’s really being skeptical of the PowerPoint presentations and what they’re
saying and really focusing on what they’ve done historically on the acquisition
front, when they’ve bought shares back and those types of things.
MOI: I’m curious, with your global experience and you’ve spent a great deal of

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your career also in Europe where one finds a lot of controlled situations, great
businesses are often in family ownership there. How has that US mindset about
management and control change, if it has changed, when you go to places like
Europe or in Asia?
Thompson: I’d say two things. It’s evolved. We put minority discounts on
companies. For some companies, I won’t name the ones we don’t, but there’s
several companies where we know the management team, we have high trust
factors in those that we don’t put a minority discount on. Then there are others that
we have zero and we won’t play. In between there, there’s a range, if you will, and
so we try to follow the record. We look at what they’ve done historically, how
they’ve treated minority shareholders in the past. The second part of that is if we
go into those situations, we try to stay at the same level that the management
team’s at. Not always the case, but generally we don’t want to be in a holding
company structure where they’re taking advantage of another publicly traded
company and we’d rather be at the same level, same holding company level.
MOI: You say that when it comes to management, the powerful concept is
incremental economics and you talk about variable versus fixed and incremental
investment opportunities, which you alluded to when we talked about the business,
but I’m curious, how do you identify that in a management team and what are
some good ways to think about the value that management can add. Especially as
value investors, I think we forget about that part a little bit and as you have
mentioned earlier, it can create a lot of value.
Thompson: First, they have to understand that it exists so that they have a business
that they can leverage through some degree of scale or levering the fixed cost base
and actually where they’re working to lower that fixed cost base. I think they have
to understand that. You have to believe that there’s some sort of moat, if you will,
there’s a reason why they can do it and no one else can do it, which is back to the
Kentucky Fried Chicken example in China or Disney’s opportunity to build parks
in certain parts of the world where only Disney can do those types of things. Then

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basically within that, they understand capital allocation and so we spend a lot of
time with that. What return hurdles do you need to proceed? What are the expected
returns of these various projects and if they get all that and they’re properly
incentivized, it’ll work. It’s really understanding their thought process, their list of
projects from best to worst. We like to see repurchasing shares in there, so it’s a
key to the concept. What happens also is when the stock’s very undervalued, then
the repurchasing shares should go towards the top and when you’re overvalued,
you might want to be issuing shares.
MOI: On a practical level, help us understand when do you engage with
management, how do you do that, at which point in the search and evaluation
process of a new idea and then what are the key questions or are there any
questions that you specifically hone in or standardize across management teams in
order to assess them properly?
Thompson: We meet with management. That’s part of the process. Again, there’s a
full disclosure act, so we can’t get any better information on what the upcoming
quarter is or this year’s EPS. We’re not trying to look for that. We’re trying to
understanding some of these concepts I’ve just talked about, how they’re
incentivized, how they view projects, how they view the secular environment, how
they view the competitors. Those are things they can talk about and you can ask
them that. There are also things if you go back in interviews and transcripts from
earnings calls that you can pick up, but you want to understand that stuff. That’s
really key. The second part of that question?
MOI: Is there any questions that you specifically hone in irrespective of what
business the company’s in or just even to compare managers across industries and
so on?
Thompson: We want to get a sense that they understand what the value of the
company is and it’s somewhat granular. It’s not this four times fifteen. We want to
understand that they have a process in place to allocate capital. They understand
the free cash flow, so those are questions that will always get asked. It really goes

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back to what I drew before. We want to understand is there a moat, do they
understand what it is, what are they doing to protect it? From an operational
standpoint, what can they do to improve it? It’s back to that business, people, price,
we want to really hone in on that, get those questions answered, so we can have a
conviction-led portfolio.
MOI: Now tying in all that we’ve discussed here in terms of the price, the business,
the people, you say that your approach is not unique, which I think a lot of value
investors will relate to, but you say it’s certainly not easy. Perhaps you can
summarize for us what are then really the hard parts of what we were just covering
here. When we cover it separately, it all makes sense. I think the difficulty is when
you want to tie it together and then you have to make compromises in terms of the
quality of the business, the types of people you’re dealing with or the price that
you have to pay or perhaps you don’t have to pay it, which is the important. Help
us understand, what are then the hard parts in really tying this together into a
successful investment framework?
Thompson: One of the hard parts is that you have to be contrarian to a degree. I
don’t think contrarian to be contrarian, but you’re generally going against the grain
somehow. Particularly, in nonfinancial crisis markets, but even there, if you went
into it in 2008-2009, you were buying even great companies when people were
telling you the world was coming to an end. You’re typically doing something a bit
against the grain. You’re seeing something that other people don’t necessarily see.
You see change that’s not necessarily clear to other people. There’s a bit of going
out on a limb. So few times have we ever just gone and bought a stock and it just
immediately went up. Often, you’re in part of the process. You buy the stock and
the next earnings call is still weak and so you see the stock go down. There’s this
internal confliction.
That’s where having done all the information work in advance and really believing
you understand that company and having a high level conviction, trusting the
management team to be able to deliver gives you that ability to withstand almost to

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certainty of looking foolish at some point in time in the investment cycle. I think
it’s the looking foolish, it’s having clients tell you that, “Gosh, how can you be so
stupid to own this,” because generally to get a good position in an undervalued
name, you have to be somewhat early. By the time someone identifies a catalyst,
the stock prices already reflects it.
MOI: What do you do then on the portfolio management side? We talked earlier
about position sizing a bit and you’re really adamant position on concentration.
Give us a sense of that in the context of that conviction that you talked about. How
much do you buy and how do you adjust your positon over time? Perhaps there’s a
good example that illustrates that from the past.
Thompson: Let me go back to business, people, price. If it really hits all those
boxes, in that rare example where it’s really clearly a great business, you’ve got
great people running it and it’s really cheap and it’s very liquid, we’ll typically go
ahead and get our position because those are rare and they’re hard to come by.
Once you start getting away from that, so let’s say it’s pretty cheap, it’s just right
there at it, then we might be more methodical about buying it. Obviously, if it’s not
very liquid, if it’s less liquid, let’s say, we’ll be slower to buy. There’s no rule
base, but it’s around liquidity, it’s about whether it ticks all those boxes, whether
we might want to buy a piece, buy a half position because we think there’s some
risk of earnings being weak for next year. Maybe buy the other half later. Each
one’s a case-by-case and there’s no rule.
MOI: Again, what is perhaps something that you have improved on over time?
When you talk about tying all these factors together and when you work with your
analysts and the team and people who join at Southeastern, what is perhaps
something that you impart to them quicker now than you perhaps did in the past
based on your experience?
Thompson: I’d say as a team, we focus on a lot. You’ve hit on some of these. One
is to really watch this moat and, again, I think a lot of this has been in the last 15
years or so as we’ve seen more disintermediation of industries. We want to be on

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top of that and look for the shifts, if you will, that can come quite rapidly. Another
one is we look for value build, so if we buy a company, every quarter or every time
they announce earnings, it could be semiannual, we revalue the business or if
there’s some sort of change in that business – tax rates get dropped in that country
or they sell a business for more or less than we thought it was worth – we just keep
revaluing that. We monitor that, we call it value build. What troubles us is when
there’s value diminution or flatness because at that point, then you have an issue of
time is no longer your friend. Time’s your friend. If you’re growing, it’s all happy.
You bought the stock cheap, it’s growing. You don’t necessarily care when it
closes the gap. This is a problem, so we really monitor that very tightly.
MOI: What are perhaps some resources you find helpful or any recent books that
you’ve read that you can share with us in terms of just improving constantly as an
investor, thinking about the world, thinking about how this all ties in together?
Thompson: Internally, we’ve give this to a lot of our friends and people we’ve
invested with, but we’ve liked the book, The Outsider by Thorndike and we think
it’s quite instructive about this separation of operations and capital allocation, how
to think about that. I think there’s eight examples given in that book, so we’ve
owned seven of those and we’re quite fond of this notion. We would love to
identify the next eight, so that’s a book we’ve been quite fond of. Your service,
anything that Warren or Charlie want to say is instructive generally. There’s a lot
of people we admire in the industry. I still like Jim Collins’ book, Good to Great. I
think it’s instructive just about avoiding hubris and focusing on the core parts of
your business and really driving these buzzwords like flywheels and stuff, but I
think that’s an instructive book.
MOI: Jim, is there anything that we haven’t covered that you think is important to
this framework that you employ at Southeastern, the way you think about valuing
businesses or anything else?
Thompson: The only thing I would say that makes us somewhat unique and I think
it informs an investment team is we have to invest our equity money into our

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funds. People talk about eating your own cooking, so we’re the largest investor in
our mutual funds and I think if you go back to the idea of a management team
being high incentivized, owning its own stock and focused on building shareholder
value, I think having an investment management team do the same is informative
and it really makes the conversation around the office. Then we don’t have
theoretical conversations about stocks. It’s never like, “Oh, that’s his portfolio,” or
“It’s just a 1% position.” It’s my money, it’s my daughter’s money, it’s my wife’s
money and so we really think about that and it really animates the conversation. I
think that’s a real critical part to the money management industry.
MOI: On that note, Jim, I want to thank you so very much for taking the time to
really be so instructive with us in terms of explaining the concepts of really what
drives your framework of valuing businesses at Southeastern. Thank you.
Thompson: Well, thank you. Thanks.

The Manual of Ideas interview with James Thompson of Southeastern Asset Management

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The Manual of Ideas interview with James Thompson of Southeastern Asset Management