East Coast Asset Management

Christopher M. Begg, CFA, is the Chief Executive Officer, Chief Investment Officer, and Co-Founder of East Coast Asset Management. Prior to co-founding East Coast, Chris served as a Portfolio Manager and Research Analyst at Moody Aldrich Partners and a Portfolio Manager at Boston Research and Management. Chris is currently an Adjunct Professor at the Heilbrunn Center of Graham and Dodd Investing at Columbia Business School, teaching Security Analysis during the fall Semester. Chris received his BS degree from the University of New Hampshire and holds a Chartered Financial Analyst (CFA) designation since 1998. Mr. Begg is a member of the Boston Security Analyst Society and the CFA Institute. Chris is involved in environmental conservation serving as a Corporate Trustee of the Trustees of Reservations and co- founder of Humans for Oceans (H40), a nonprofit organization created to support ocean conservation.

Graham & Doddsville (G&D): Can you tell us a little about your background and what led you to where you are today?

Chris Begg (CB): I got into the investment business in 1994, after undergrad. I started working for a small investment firm in Cape Cod, where I grew up, and I knew right away that I loved the challenge of investing and solving puzzles, but I wanted to find an analyst position somewhere near Boston. I had an opportunity to join a firm called Boston Research and Management where I spent ten years. It was a great opportunity and afforded me the time to read a lot, study businesses and business models, and most importantly learn what kind of investor I was. During those formative years, and this is advice I always give my students, it is important to have a mentor and/or great heroes. If you don’t have the former, the latter is really important. Pick the right heroes in investing, and in life, and then learn as much as you can from them. Over my career, I have been lucky and grateful to have mentors, but heroes are available to everyone and the reservoir of their wisdom is infinite. As for heroes to emulate, Warren Buffett has and continues to be that light for me. I read and reread everything I can that both Warren and Charlie put out there. There were probably ten to fifteen other investors that were instructive and I would attempt to reverse engineer what they did, and try to understand how they achieved their superior results. What was their edge? What was the one thing that they were particularly good at? I tried to get to the point where I was able to deduce, “Okay, I see how their thinking produced that investment idea and does that align with the way that I think?” That was my process. I spent ten years just honing my temperament and all the while figuring out what kind of investment philosophy and process made sense for me. Certainly, value investing was the logical outcome of that, and then more specifically, what made a lot of sense to me is buying great businesses that you can own for a long time, and allow compounding to do the heavy lifting. That was an important realization. I eventually wanted to move on to keep learning and growing so I was looking to take the next step. I was introduced to a company called Moody Aldrich Partners. They were looking for someone to work with Amory Aldrich as part of a longer-term succession plan on the strategy he had stewarded for over thirty years. Amory is a great investor with an impressive long-term track record so the opportunity to learn from him was a logical next step. However, after a little over a year it was clear that I was ready to take a leap and start a company in order to be more in control of my own destiny. I had assets that were willing to come with me from my earlier relationships, and Amory really supported my decision, so in 2008 we launched East Coast Asset Management, and it’s been almost nine years now.

G&D: I know you said you had assets that were willing to move with you, but in taking the plunge and starting your own fund, how did you know you were ready?

CB: I guess the hardest part of starting, whether it be a fund or an investment management firm, is having trusted partners, clients, and assets that are going to support your effort. There are a lot of great investors that just don’t have the track record or the assets to make that leap. I am grateful that my circumstances leading up to the launch helped pave the way. I had worked with a handful of partners and clients for over ten years and as soon as I was ready, they said, “We’re coming with you, wherever you end up.” That was really the added comfort level that I needed, and I felt in my heart I had the investment management background to run what I thought would be an intelligent strategy. Looking back it has really been the journey that continues to be the reward. Even the challenges have enriched the path — I remember that first year in ‘08/’09 was pretty harrowing — both to get things set up operationally just as the market was dropping precipitously everyday. So my advice for students that feel this is your calling — stay lean and as Joseph Campbell has said, “Follow your bliss.”

G&D: Can you talk about your investment philosophy?

CB: There are three categories of investments that I’ve thought about, and it’s how I’ve structured the Security Analysis class that I teach at Columbia. They are compounders, transformations, and workouts. Two-thirds of our investment ideas have come out of the compounder category. What we’re looking for are businesses that are getting better, where they have some type of model that’s sustainable for a long period of time, and where the moat is going to widen. Because of that moat, they earn high returns on capital that we think will be sustainable in the future. What we’re looking for with compounders are upstream, often invisible and intangible advantages that lead to a visible downstream propensity to achieve superior economic returns. The upstream advantages we focus on are five-fold. In The Art of War, Sun Tzu rote that the five most important parts of assessing the potential of an army on a battlefield are the topographical advantage, the morale advantage, the meteorological advantage, the system advantage, and the commander advantage. Those five are perfectly suited for what we’re looking for in a business. The topographical advantage is the moat. The morale advantage is the culture. The meteorological advantage is resilience — how have they done and will they do in a tough environment? The fourth is the system advantage: Is it adaptive? Does it foster persistent incremental improvement? The fifth is the commander advantage. Ideally, we want a founder. We want a founder or a founder-like leader that’s running the business, and running it like an owner. We found most success with founders, but if we find a leader that has been groomed to steward the advantaged business and act like an owner, that works too. The ownership leadership trait needs to be deeply imbedded in the culture and is not always portable. We find that most companies are either playing a finite game or an infinite game. James Carse wrote a wonderful book on this very topic called Finite and Infinite Games. The infinite game is where the time horizon is very long, if not eternal, for the way the business is being run. It’s being run for the next generation, versus some quarterly or five- year objective. Certainly, there is a plan and there are goals, but there’s a big difference both in the culture and how they think about the business when the business is run for the infinite game. Think Berkshire, Colgate, and Danaher. There’s something very different about those businesses than what you’ll find where the leaders are trying to solve something over a shorter horizon. That’s what we’re looking for in the compounder category. With transformations, these are businesses that are going through an inflection point of change. Our best transformations eventually turn into compounders, but they currently are average businesses that have an average return on invested capital. Something is changing or transforming in the business or the industry, however, and we think it is going to produce better returns that aren’t currently priced in.

We focus on three types of transformations. Secular transformations are going to be where you have a post- industry consolidation, where the remaining players are going to enjoy better pricing power and more rational decision- making around competition, and the returns are likely to get better. The market struggles to see around these corners and struggles to value them effectively. Systemic transformations are where there’s a true system change in the organization, typically driven by a new process or new leadership. Like Danaher with their Danaher Business System. The third is separations. Separations are de-mutualizations or spinoffs, where there’s a real inflection point in both how the owners are being incented and how capital is being allocated. Usually, there’s a real mispricing that exists with separations where there are some forced sellers because the company is too small to be owned by a large institutional owner. We saw this recently when LiLAC Group came out of Liberty Global, which was a forced sale for a lot of institutions. Workouts are what we call, “60-cent dollars.” This is not just about grabbing net-nets, where there is a true value proposition and existing margin of safety, but where we can’t definitively answer if the dollar is growing. We don’t do a lot of workouts internally. They’ve always been a small proportion of the portfolio, and now they’re almost non- existent in our concentrated portfolio, because it’s harder to get the time horizon right on businesses that aren’t getting better. Also, the declining businesses are likely to get worse more quickly. Many of our mistakes have been where we thought we bought something with a significant margin of safety while knowing that it might be a melting ice cube. We thought it might weaken, but not for a long time out. But then it accelerated a lot faster than we thought it would. That’s one of the big lessons we’ve learned over the last five years. We don’t play much in that space, although it’s a well- travelled space for the hedge fund community as often there can be the perception of catalysts that help serve investors looking for shorter- term payoffs. We find “three- decision stocks” — buy, sell, and then figure out what to do with the proceeds — are not as ideal as finding businesses that we can thrive with over many years. The frictionless ideal is the one-decision type.

G&D: In your 2015 letter, you spoke about the power of compounding, and the difference between logarithmic growth and linear growth. Do you think that compounders are underappreciated? Do you think there is a market misperception there?

CB: In that letter, I talked about what we call the “twin lights” of the investment process: the quality of the business and the quality of the investment. We’re always looking to understand the best businesses in the world, regardless of price. We want to know them well so that when there is a potential opportunity, whether it be an overall market sell-off or something specific that might be temporary, we’re aware. Now, the quality of the investment has a lot to do with price. The price you pay will determine your rate of return. But also, with the twin lights of the quality investment, we’re looking at margin of safety. We’re looking to understand why it might it be mispriced. What do we understand that maybe everyone is ignoring? Why is this business hiding in plain sight? That’s the hardest one to answer because sometimes we don’t know, but we try to understand why we have this opportunity to own this mispriced asset. Or maybe we don’t and we’re wrong. I think it’s important to our efforts that we’re constantly learning and building our reservoir of knowledge on great businesses, businesses that are transforming and getting better, so that we can value them on a process-driven basis. If we’ve done the work on the business quality side we can act when the price is there. To answer your question as to if I think compounders are underappreciated and do I think there is a misperception there — the short answer is yes. I think many investors focus where there is a strong contrast and ignore businesses that are getting better incrementally without a lot of noise.

G&D: Is there a company that fits the situation you just described?

CB: Well sure, we have been talking recently internally about Sherwin Williams, which after reviewing some of the numbers continues to impress me. Sherwin Williams is a great company that has compounded at 22% or so since the recovery of 2009. You go back over, say, a thirty-year period, you’re looking at a company that’s compounded at around 15.5%. High returns on invested capital of 30% or better, and a great distribution system. A product where regulation makes it difficult to transport impedes e- commerce players from entering the competitive landscape. They are a local champion as Bruce Greenwald has written about in Competition Demystified. They continue to win with the professional painter in the local market. That should be in your universe of great companies, and it’s just that valuing it today is a challenge when you look at a company that’s grown earnings from $4 in 2009 to $12 now. Where is that $12 going to be in that next year or so, now that we’re nine years into a recovery. Valuing companies deep into a recovery, particularly if they’re cyclical, becomes more challenging right now. The questions for me on Sherwin have a lot to do with where are we in the cycle, and what’s this look like? Are we buying something at more than 20x earnings? Are earnings peak earnings? Or are we mid- cycle, and with this acquisition of Valspar, the company can gain more synergies and extract the next five-to-ten years of additional growth? It’s an interesting one to solve. Recently, some of my students pitched Sherwin Williams and I think this is just the kind of compounder business we love, one that is found hiding in plain sight.

G&D: Earlier you mentioned waiting for the right price. As a corollary, when do you think about selling these great businesses?

CB: If I could have one superpower as an investor, it would be revealing IRRs. There’s an inherent IRR for every single investment that you can look at based on your time horizon. That is the target investment’s essence. The job of the analyst is to reveal that return expectation within some type of acceptable probability range. The job of the portfolio manager is to allocate capital to those IRRs that are most deserving — meaning most asymmetric. It’s just as simple as that. Now, in practice, this proves very difficult because you’re dealing with lots of unknown information. We’re not talking about deterministic outcomes. We’re talking about probabilistic outcomes. But you can build a range of probabilities, a range of IRRs that are within your comfort level and that can prompt you to take action or not. Back to your question about sell discipline. If we’re revealing the IRRs, and a true IRR of anything we own is sub- optimum, meaning it’s appreciated to a point where the future IRRs will be low, or below something else we can own, it might be deserving of a sell. With companies that we like and we’ve been involved in for a long time, we’ll allow them to stay in the portfolio a bit longer. In other words, we’re comfortable with some lower IRR investments that we know and like as anchor positions. For example, Colgate may get expensive from time to time, but it provides some asymmetry to the portfolio, meaning very little downside despite the upside not being our best IRR idea. Price is going to determine that rate of return, which is going to drive our sell discipline. Most of our sales are where a compounder that was playing an infinite game becomes more finite and their moat appears to be weakening because of sector-related and environmental-related innovation. Maybe a competitor is reducing the entropy and friction costs that exists in their vertical and they are going to be exposed to a threat that they cannot compete effectively against. Think of brick and mortar retail; anything that a scaled e- commerce player can do will likely be at a lower cost. GEICO has been devouring the entropy of higher-cost auto insurance sold through brokers for over 80 years.

G&D: You had mentioned that so much of finding a great compounder is related to qualitative and intangible features. How do you assess them and test their resilience?

CB: As we take an idea through the process, the first thing we do is a first-principle exercise of trying to understand what the business is solving for. What entropy exists today that they are going to reduce for the benefit of their customers and all counterparties of the organization? MasterCard and Visa have been devouring the entropy of cash toward more efficient credit and debit transactions. That’s the number one thing that we ask ourselves. If the company we are looking for is the entropy point and has a fortunate pricing umbrella, we typically will start right there and focus on why this advantaged moat should persist. We prefer to own businesses that deserve the right to win because they are fostering a win with all their counterparties, including society at large. Now, the second thing we do is gather evidence through primary research. Here we talk to counter-parties to get answers around business quality. Customers, former employees, competitors, people that are somehow involved in the vertical in some way. It’s all very important. They can be anecdotal, but I think collectively once you’ve done all your work, it fills in a very clear picture. At that point, we’re building a model. We’re also reading the typical 10-Ks and 10-Qs. You’re starting to build the bottoms-up picture of the company. The third thing we do is categorize the investment. Does it look like anything that we’ve looked at in the past? Then we take it through the steps of our twin light process, looking at the quality of the business and the quality of the investment, to finally arrive at some range of IRR that we have confidence around.

G&D: You’re typically looking five to ten years out. Does that depend on whether managers are playing a finite game or an infinite game?

CB: Yes. Although we assess IRRs at the five-year duration, we’re looking at the qualitative factors that we think are going to drive the long-term success of the business. We’re looking much further out. Ideally, we’ve found a business that thinks outside of time. Managers feel like they’re stewards of the organization and they’re going to hand it off to the next stewards. It’s a very different mindset. Look at Berkshire, or Danaher, or the Liberty businesses, or Amazon. Bezos said it recently, it makes a huge difference when you’re talking seven-year numbers versus the time horizons on which competitors focus.

G&D: Are there any names that you would like to explore? You’ve discussed TransDigm in the past, there is a lot of tension in the stock right now, and we’d love to hear your

thoughts.

CB: Sure. We got involved in TransDigm in 2009. We were fortunate enough to speak with someone that had been involved in bringing TransDigm public and knew the business well; we understood the business model. We owned it through 2012 with an extraordinary return, but we sold in 2012 because we felt it was fully-priced. In hindsight,

we underappreciated how big the market opportunity was for what they’re doing, but we

continued to follow it.

We got back involved in 2014, but over the last year, we’ve been increasingly uncomfortable with our checks regarding the company’s focus on shorter-term profitability at the expense of long-term resilience. The culture felt like it was getting more fragile in the sense that they were being more vocal around their leverage and their pricing power. Today we feel there is a large observation effect that exists and creates additional fragility that was not there in 2014. We still believe this is a great business run by competent management, but we have chosen to step aside. Given the polarization on both sides of this argument, I would prefer not to say much more. We are fortunate as investors, particularly in public liquid markets, to change positioning to reflect changes in our inputs and not to get hung up with all the behavioral biases and friction that come with

defending one’s ego.

G&D: Speaking of behavioral biases, how do you guard against them?

CB: It’s a good question. I recently talked about this at the CSIMA Conference. There are a couple of valuable resources when it comes to behavioral biases: Cialdini’s work on the influence of psychology in human decisions and Charlie Munger’s speech on the “Psychology of Human Misjudgment.” I believe there are three big systems or phases in regards to this. The first one is instincts, the second is reasoning, and the third is insight. With instinct, the big thing you’re trying to solve for is how do I remove the obstacles that impede my ability to get to the second phase, which is what Kahneman calls system- two thinking. Many things get in the way: ego, self- preservation, hierarchy, territorialism, and ritualism. These all impede your ability to make rational decisions. What we try to do is think about the many obstacles that get in the way. It can come down to lots of behaviors that impede good behaviors. Are you taking lots of meetings with the same people and you’re exposed to groupthink? You can make a very, very long list, and I think it’s a very good process to go through to constantly re-check where you are obstructing your ability to be rational. In the second phase of reasoning, you’re also trying to remove blind spots in your process. I think about it almost in terms of a hologram: you’re trying to create this view to see the entire question or investment idea from every angle, so that you’re viewing this hologram three- dimensionally with zero blind spots. It’s hard to do, but building a reasoning process to help achieve this outcome is one of the most important parts of decision-making. Then you want to get to the final stage, which is a true, differentiated insight. What we’re all looking for is a differentiated insight that comes when you get through the reasoning process, when you remove the obstructions of the instinct and misjudgment process. That’s how I think about that decision framework and therefore the objective is the perfection of insight.

G&D: In what other instances have you had to reverse your thinking like you did with TransDigm? Are there flags that help you recognize when you need to reconsider?

CB: We recently sold two businesses which we owned for years. The first one is IBM. As we understood Amazon AWS more and more, we became increasingly less comfortable with IBM’s competitive advantage long- term in enterprise. We felt we owned it cheap enough; especially with the buyback, there were multiple ways to win. But the problem with IBM is that it’s become more path- dependent around how successful they will be in AI. We don’t like path-dependent outcomes. We’d rather have many ways to win. There are still some path-dependent outcomes that could be very good for them. It is important to note that if we have done our initial work well, anything we sell could go on to be a perfectly good investment. We only have a few slots in our portfolio and from time to time, the bar we set is higher than for what we already own, and therefore we move on. Phillips 66 is the other one. Since we got involved in 2012 it’s been a very good investment for us. However, we feel the next ten years are less clear on a decent proportion of their business, particularly, refining. I think there is a lot of uncertainty around energy and what that will look like in the future, because companies are finding a very real technological cost curve coming from solar. Phillips 66 has a great business in chemicals and likely will be fine, but we think there are other places to allocate capital where the probability range is going to be more attractive for us.

G&D: You’ve mentioned probabilistic outcomes and asymmetries, could you discuss how you think about risk and position sizing in the portfolio?

CB: In our Partner’s Fund, we own anywhere from eight to fifteen positions. Ideally, it’d be on the lower end of that if we had a high confidence in a few number of asymmetric ideas, but we typically own more ideas as we move through a cycle and things become more expensive. That’s where we are today; we are balancing a few more names as prices have moved higher and margins of safety have been reduced. But I think the most important thing when you own a concentrated portfolio is to understand the probability range of the outcomes and what the low end of that range looks like. We will bypass many great investment ideas if we think there’s even an infinitesimal potential for a zero, because it’s just not something we can underwrite. We prefer downside probabilities where if it is a zero it means it is a 0% IRR, but a 0% IRR still keeps our

capital intact.

The importance of seeing the world through a lens of probabilities is something that has been reinforced by studying the quantum world. When you look at quantum mechanics, there’s a whole world that, to me, seems so well-aligned with investing. The big take-away is that this whole world of quantum mechanics is a probabilistic world. You don’t know where any sub- particle is located, you just know the probability of where it might be. I think you’ll find the uncertainty that physicists deal with is very similar to the uncertainty that we face in investing. We’re dealing with so many things that are unknown and unknowable, and we’re building these probabilistic scenarios based

on all that information.

G&D: You mention in your letters making rapid, highly consequential decisions with incomplete and potentially erroneous data. How do you get enough conviction around

an idea?

CB: The Harvard Professor and bridge-playing expert Zeckhauser stressed the unknown, unknowable, and unique; I think you want to be able to build a bridge from that

space. That’s what an insight is. You’re going into the realm of the unknowable by reasoning through it and assessing all the probabilities, and realizing that it’s not path-dependent. There are a lot of outcomes where you can win. That’s how you get comfortable. That is how you look beyond the world’s fixed limitations and your own, those finite outlines and

boundaries.

When you think about the investors that understood Amazon in 1997 and the years that followed, that investment didn’t look like anything where a value investor could recognize a pattern. It was different. It was a scale economic shared model.

Maybe it looked like GEICO or Costco, but it didn’t look like the kind of things we were told

to look for as value investors.

As you go into the field of investing, your best insights, your best ideas are not going to look like what some of your heroes had invested in before. You’re going to have to find new ways to think about it.

The map will not be found in any book on investing but more likely found in the book

of nature.

G&D: We’ve focused a lot on compounders. Could we discuss some positions that fit your other models for

investing?

CB: Of course. We’ve recently added Danaher. You could argue that Danaher is a compounder, but we look at Danaher as this constantly evolving, systemic transformation. We love the mindset of the culture with regard to continuous

improvement. We think there are a lot of outcomes that could happen in their end markets, but because their system is completely adaptive, resilient, and moving, they’re able to continuously react, change course, and get better every day. That’s what gives us the confidence that they’re going to continuously solve for their end-markets. They have done that for over 30 years.

G&D: How do you think about cash in the portfolio, and do you look at it as an asset class or as dry powder for future opportunities?

CB: For our partner strategy, which is an institutionally oriented strategy, we think about our portfolio as a fully invested mandate. Now that being said, at any one time, we could be 0% to 20% cash, but cash is not a strategic investment where we’re trying to time the market. Yet if the world goes crazy, as it inevitably does, we will not make uneconomic or irrational investment decisions for our partners. Therefore a larger cash holding may be warranted temporarily. Sometimes we don’t have a replacement for a position that we’re selling. We want to keep buy and sell decisions very separate. We recently had a couple of sales in the portfolio, which frees up more cash than we have good ideas to put to work. We can reallocate to existing ideas, or we can hold a little bit more cash in the meantime until we finish working on something that’s in the final stretch.

G&D: Sounds like you find inspiration across many disciplines. How do you put things on your reading list, and how has this shaped you

your

ability to frame investments?

CB: I started a process almost ten years ago where I set aside a quarter’s worth of ancillary reading material around one topic. During that three-month period, I would read as much as I could on a subject, and do a deep-dive around one particular topic. I also allow myself to touch the other mediums that are related to that subject, especially in the arts. Whether it be fine arts or visiting libraries and museums, I fully immerse myself in that topic. I think it allows one to slowly build both breadth and depth. The quarterly letters I have written at East Coast have been an output that came from this process and that quarter’s reading. Over the last year, I’ve switched the quarterly letters to a year-end letter just from a time management standpoint and will reignite an interim memo writing process in between year-end letters. The other thing that we do here is something we call “What I Learned This Weekend,” where analysts submit a brief write-up on Monday morning on a subject where they take the team through the “ADEPT” framework. ADEPT stands for: Analogy, Diagram, Example, Plain English, and Technical description. Then we added “BE ADEPT,” which we call “Be memorable” and “Evolve our process.” That translates to, “Have we memorized what you’ve now taught us in some mnemonic or other way — some memory palace way?Also, how does what you’ve taught us relate our decision- making framework and investing?” It’s something we do weekly and it’s fun because it’s a multi- disciplinary habit that fosters some creative thinking. Throughout the week between conversations about business- specific objectives we will tend to revisit further questions and insights somebody has read on the subject. Subjects are typically in the large data sets of physics, biology, and human history.

G&D: It would be great to hear any advice you may have for students or for people interested in the industry.

CB: What I love about the Columbia students is that you have a lot of fanatics and individuals that are similar to us and approach learning with enthusiasm. Many of the students have such a deep level of curiosity and I think that’s just so important. It was what attracted me to teach there and feed off that energy of learning. Curiosity is the first bridge. The second bridge is creativity. Fostering curiosity, but also creativity in how one should think, because it’s going to be building these mosaics of information that leads to creative insight. Anything that can help foster those two things is really important. The arts and sports are a great way to practice creativity and hone that creative spirit toward mastering some craft and entering a flow state.

On the reading side, over the last couple of years I’ve found a lot of important and timeless insights in Eastern philosophy. What you find when you start to contrast Eastern versus Western philosophy is that Western thinking is where we’re trying to project a model onto the world, and we’re trying to see how our model or our projection aligns with the way we think things should be. Oftentimes, the reality is far off. In contrast, Eastern philosophy is much more about aligning yourself with the constancy of change, and looking at things from the potentiality and the propensity of the outcomes. We added Amazon to the portfolio this year, and it was one of those investments that we were fighting our own biases versus understanding the propensity and the potentiality of the outcome that was staring us in the face. My advice is that there’s just so much important information in Eastern philosophy that you can contrast against the basic scientific-method-reasoning process and arrive in a very different place from your peers. That’s something that has helped me a lot. If I had known earlier, I would have had many more years of these important books memorized in my head.

G&D: That’s great. Thank you so much for taking the time to talk with us today.