Active management is a portfolio management strategy where the investment manager makes specific investments with the goal of outperforming an investment benchmark or index. Active management seeks to produce better returns than those of passively managed index funds. We are active managers because we believe in the logic of value investing—of buying the common stocks of good businesses at material discounts to our estimate of their intrinsic value. We value companies based on their ability to generate free cash flow and our approach requires that we not only develop a thorough understanding of how each company's operations generate sustainable free cash flow (know how it works) but also requires that we answer a series of questions about the company's business model, its strategy, its future prospects and its management (know what you own).

We define a high Quality of Earnings by how realistically we believe a company's financial statements portray what is taking place within the business (especially within the company's core business operations) and how accurately the financial statements characterize the sustainability of the company's earnings from operations. We assess the quality of a company's earnings by answering three important questions:

1. Do financial statements and other filings allow us to understand the reality of the company's unique business fundamentals, competitive edge and ability to generate free cash flow?

2. Does company management engage in conservative or aggressive accounting practices?

3. Is all material information necessary to evaluate the company properly disclosed?

In reporting GAAP-based earnings, companies are given wide discretion within the rules. Some companies make conservative assumptions, while others are overly aggressive, which can produce widely differing results depending how management sees the future. In our opinion, most companies engage in some type of earnings management. We believe there is nothing wrong or illegal about earnings management within limits. However, some companies exceed acceptable limits, and while their financial statements may be in accord with GAAP, they may not concur with economic reality.

As investors, we believe that an equity security is worth the discounted value of the issuing company's future expected excess cash flow. Thus, to value a company according to a model of discounted cash flow, an investor must adjust reporting earnings to arrive at true cash earnings. It becomes critical for us to determine the economic realism of management's assumptions and to eliminate management biases by making the appropriate adjustments to reported earnings data. For us, reliable valuations require an assessment of a company's Quality of Earnings; determining if its accounting policies reflect business reality; making accounting adjustments to eliminate reporting biases, and identifying positive or negative factors that may affect future free cash flow.

We are continuously searching for opportunities to invest in companies that possess the balance sheet strength, competitive advantages, operating efficiencies and appreciation potential that we believe will us achieve our investment objectives. In isolation our qualitative and quantitative screening processes only provide us with untested ideas. Whether we find an idea through a quantitative screen, an obscure trade publication, or a government filing, the real work begins with our forensic analysis of a target company's financial statements. Our initial analysis filters the ideas we have generated and eliminates companies that we believe are either fully valued or already priced-to-perfection. We also seek to separate companies with serious structural, financial or secular problems from those companies that are simply not performing to their full potential. Our initial analysis focuses on several important factors:

• Balance sheet strength: Our assessment of downside risk begins with an analysis of a company's balance sheet. Balance sheet strength enables a company to stay focused on strategic priorities during tough economic times rather than being forced to adopt short-term survival strategies which are often not in the long-term best interests of shareholders.
• Effectiveness of business model/Unique business fundamentals: We judge the effectiveness of a company's business model by its ability to generate free cash flow during both favorable and unfavorable economic cycles. We also seek to answer several important questions, including: What are the unique fundamentals of its business model that the company must cultivate? What elements of the business model are vulnerable to an economic slowdown or downturn? What is the ongoing level of investment required to maintain and/or grow free cash flow? Are there specific aspects of the business such as divisions or product lines that are underperforming and are candidates to be sold or shut down?
• Industry standing and competitive strength: An important measure of the effectiveness and uniqueness of a company's business model is its competitive strength and standing within its industry. Companies with sustainable competitive advantages can protect their operating margins and generate free cash flow in the face of strong industry competitors. We assess the durability of a company's competitive strength by understanding the economies of scale within its infrastructure, the strength of its customer relationships, the importance of its intangible assets and the value of its business proposition.
• Temporary problems vs. structural problems: While most companies endure varying degrees of performance problems, many may not be able to implement the changes needed to achieve a transformation that creates long-term shareholder value. To weed out possible value traps we look for specific financial, competitive and structural characteristics that, from our experience, indicate that the problems a company faces are temporary. When evaluating the investment potential of a company experiencing problems, we start by analyzing several company-specific factors, including: the viability of the core business, balance sheet strength, clean accounting, the cash flow pipeline, the quality of management and decision making, and the severity of the company's problems. Conversely, we also look for factors that we believe inhibit a company's ability to overcome its problems, including: weak core products and services, insufficient financial resources and controls, ineffective management, lack of transparency or poor corporate governance and previously failed attempts to get the company back on track.

Since companies that successfully pass our initial analysis have, in our opinion, normalized free cash flow potential that is not recognized or properly valued by the market, our next step is to develop a deeper understanding of the stability and reliability of the company's free cash flow potential under different scenarios. We undertake an intensive, forensic analysis of a company's financial statements; footnotes and other regulatory filings in order to assess what we believe are the company's normalized cash earnings, the capabilities and fiscal conservatism of the management team; and finally the Quality of its Earnings.

As we perform our analysis of financial statements we assess the quality of a company's earnings and make adjustments to reported earnings in order to eliminate what we believe are management biases or unrealistic assumptions. Our forensic analysis not only allows us to hone important data inputs for our valuation models, it also provides keen insight into factors that may be indicative of future earnings changes, the success of a company's strategy, the sustainability of its performance and the impact of management decisions on future cash flow. We firmly believe that a forensic analysis of financial statements is more useful to an investor than discussions with company management, or listening to management forecasts and earnings guidance.

An integral part of most institutional investors' investment analysis involves meeting with management in order to gain deeper insight into a company's strategy and prospects. Unlike most investors, we steer clear of meeting with company managements for two essential reasons: to reduce the emotional aspects of investment decisions and to avoid the short-term outlook that underscores most management guidance. Although most investors—experienced and novice alike—realize that fear, hope, hunches and solid information affect every buy, sell and hold decision; certain factors may exert undue influence over these decisions. A compelling narrative delivered by a charismatic CEO may overshadow financial data that could serve as an early warning sign of shifting fortunes or trouble ahead. Favorable short-term results or earnings guidance delivered by an overly promotional management team may mask the unfavorable economic reality of the company's underlying business.

For us, an assessment of management's capabilities is critical to determining the value of a company. We do not rely on direct contact with management to assess a company's prospects and potential. We believe that an accurate assessment of management's capabilities and the role management has played in the company's troubles should rely less on what management says and focus instead on what management has done and continues to do. One of the fundamental tenets of our investment philosophy is that a forensic analysis of a company's financial statements, regulatory filings and accompanying footnotes reveals the quality of a company's earnings, the success of its strategy, the sustainability of its performance and the impact of management decisions on future free cash flow. We believe that a forensic analysis of company balance sheets, income statements and other regulatory filings is more useful to an investor than management forecasts or earnings guidance. When assessing management we pay particular attention to the economic reality of the company's financial statements and related footnotes, the conservatism of its balance sheet and the quality and consistency of its disclosure practices.

We also evaluate management by analyzing the consistency and integrity of its shareholder communications and presentations over many years. In addition to conducting an in-depth analysis of financial statements and footnote, our process also “looks behind the numbers” through a careful and, at times, skeptical readings of company communications, press releases and shareholder letters. These communications contain valuable information, some of which we discern and interpret by “reading between the lines.” Shareholder letters, in particular, usually discuss the company's recent performance, its future prospects and may provide a more detailed discussion of the strategy that management believes is the right course for the company to follow. A careful reading of the company's language enables us to determine whether management understands the importance of financial strength, cash flow, working capital controls and the company's position within its industry. A good shareholder letter, in our opinion, describes how the company's strategic planning process anticipates, plans for, and implements change and provides insight into the quality of management and their enthusiasm for creating meaningful shareholder value over time.

Whether we are grading the performance of an existing company in our portfolio or monitoring a company we have been following as a potential investment, we read company communications for “heat”—looking for trigger words that, in our experience may signal a noteworthy change likely to affect the company's future value. While examining shareholder letters, in particular, we look for a degree of consistency with prior communications, a realistic discussion of the objectives and expectations for company performance and a discussion of shareholder-focused benchmarks management uses to judge its performance.