Mr. Garrison: First Foundation Advisors was started as an investment management firm in Orange County, Calif., approximately 20 years ago by a gentleman named Rick Keller, who is now the Chairman of First Foundation Inc. We manage money primarily for high-net worth individuals, and we were one of a few fee-only advisers in Orange County back in the early 1990's. We've managed a mid- to large-cap stock portfolio for quite a long time. I've worked as an Analyst and Portfolio Manager for the last eight years. Eric Speron joined us in 2007 from JPMorgan Co., and Roger Palley joined us last year from Neuberger Berman.
Our firm now manages approximately 1.4 billion in assets. Our client relationship managers do a great job communicating with and servicing our clients, leaving us to concentrate all of our efforts on equity analysis. I should add that approximately three years ago, we saw an opportunity to create a startup bank in Orange County to offer additional financial services to many of the same clients that we have on the advisory side, as well as other high-net worth individuals and businesses. We raised equity capital in the summer of 2007, which was fortuitous timing, given the value of the market at the time and its impact on our valuation. More importantly, the bank has been able to take advantage of the opportunity in the marketplace, where many legacy banks have struggled under the weight of bad loans written in the previous credit cycle.
TWST: What about the investment philosophy of the firm?
Mr. Garrison: First and foremost, we are value investors. It just makes intuitive sense to us to try and buy stocks of companies at a discount to their intrinsic value, or what we believe they are worth. We have a number of techniques that we employ to value companies across different sectors, but we firmly believe the value of a company is the present value of all future free cash flows generated by the business.
As I said before, we concentrate our efforts on the mid- to large-cap space, which for us means companies with market capitalizations of 3 billion and above. The stock market, being what it is, is given to bouts of fear and greed, and the volatility associated with the mood of the market gives fundamental-oriented investors opportunities to both buy companies at discounted valuations and to sell them when they become overvalued. The dynamics of the market provide endless challenges and opportunities for fundamental investors to create and preserve value for clients over the long term, so we try to take advantage by adhering to a consistent and repeatable investment process, which we have refined over time, based on our and other successful investors' experiences. Eric will talk in more detail about our investment process.
In terms of the type of companies we look for, we want to invest in what we consider to be high-quality companies. We define that as companies that create value for their owners, or companies that can invest their capital at rates of return in excess of their cost of capital. These entities can sustain the value spread or earn what is called "economic profits," building shareholder wealth over time. These companies typically have some special advantage, whether it be a great brand, patent protection, economies of scale or lowest-cost position, which allow them to earn returns above their cost of capital. The best companies enjoy a combination of these advantages. We've owned Diageo for a long time. Diageo not only owns a handful of the world's best-loved liquor brands, but is also able to reap economies of scale in marketing, as brands such as Johnnie Walker are popular globally. We also own 3M Co.. 3M is able to leverage its broad patent portfolio into over 50,000 products across sectors.
One of things that makes long-term equity investing such a great challenge, and something we spend a great deal of time thinking about, is the reality that robust economic profitability attracts competition and most businesses do not earn above-average returns into perpetuity. Returns most often revert to the mean. So even among companies most investors would deem to be "high quality," we try to stick with those we believe have durable competitive advantages that will at least slow the onset of creative destruction.
We assess the durability of competitive advantage by analyzing the sources of a company's returns on invested capital (ROIC). We distill down the drivers of that performance in order to understand how those drivers might change in the future. We put the company in the context of its industry or ecosystem and use Harvard University's Michael Porter's competitive forces framework to ask questions such as: Are there sustainable barriers to entry in the industry? Has the industry consolidated or has capacity left the industry, changing the competitive landscape? Does the company serve a fragmented base of customers with no bargaining power? Has the company been "robbing" it suppliers and customers for so long that it is bound to "give back" some of its profitability in the future? Will the company's products and services be more or less relevant in the future?
All of these questions help us frame our expectations for the key value drivers - growth and profitability. We model our expectations for revenue growth, profit margins and capital usage in order to arrive at free cash flow estimates, which we then discount back to the present at a required rate of return that is based on industry sector and risk factors.
We also replicate the exercise for what we believe the market's expectations are, using consensus estimates as a starting point in a "reverse" DCF analysis. When there are material gaps between what we believe a company's future free cash flow growth rate is and what the market believes it is, we become interested in determining if it is an opportunity.
But we are not done at this point. And no less important, we are looking for quality in other aspects of the business. A growing business that has solid competitive advantages in an attractive industry with favorable prospective returns on capital is one thing. But does it have the financial strength to match? Has the company been financing its growth through internally generated cash flows, or does it rely on what Warren Buffett calls the "kindness of strangers?" Are we going to have to worry about the company's financial strength in the next downturn, or will it be able to be on offense and opportunistic when things get ugly? This was the key lesson during the financial crisis. All stocks went down, but those that had questions about their financial viability got crushed. So we have been extra diligent in understanding the components of the balance sheet.
Free cash flow is the lifeblood of a business, and we want to know how every business we look at generates it over time. Most of the companies we look at in the large-cap space have solid profit margins. But how does that translate into cash flow? Our free cash flow focus often leads us to service-oriented firms with favorable working capital dynamics and low capital expenditure needs. Companies representative of this dynamic in our current portfolio include, AON Corp., Western Union, Bank of New York Mellon and Automatic Data Processing.
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