Source: Qile Club
Todd Combs, who has been managing the Castle Point hedge fund since 2005 with approximately $400 million in assets under management, was designated by Buffett as the leading candidate on October 26, 2010, and served as an investment manager at Berkshire Hathaway. In December 2025, he announced his departure from Berkshire Hathaway to join JPMorgan, where he will oversee its strategic investment group. The following is an excerpt from an article by Todd Combs discussing value investing.
Todd Combs Teaches Three Key Investment Principles
The necessity of conducting a comprehensive analysis for every potential investment and the importance of downside risk protection. According to Graham and Dodd, investing can be regarded as a 'passive art,' emphasizing more on protecting against downside risks rather than pursuing upside gains.
To succeed in investing, one must learn how to process information to determine when the odds are higher; the goal is to make informed decisions based on facts rather than narratives. In both investing and life, we cannot choose outcomes, but we can choose decisions that increase our chances of achieving desired results.
However, what does it take today to determine the intrinsic value of a company?
Key Takeaways
Stock investing has been described as simple yet not easy. Many concepts are frequently mentioned, such as 'don’t buy at high prices,' 'identify excellent management teams,' 'avoid speculation,' 'patience,' 'verify the accuracy of financial statements,' 'the market is a voting machine, not a weighing machine,' and 'focus on both qualitative and quantitative aspects of a company.' While these concepts may sound simple in principle, they are difficult to implement in practice.
The difference between a good analyst and a great one lies in the ability to simplify complexity and discern what matters most.
This point is often misunderstood, with some believing investors should stay superficial. In reality, simplifying complexity requires profound expertise. An analyst’s role is to dissect investments to understand their key components. A great securities analyst can break down a company into its most fundamental parts and comprehend each piece before reassembling it. Amidst the vast amount of information analysts absorb, there is always one piece of information that outweighs the rest. Identifying this critical piece is the essence of simplification.
Investors must always remember that no matter how impressive the numbers in a spreadsheet may look, they do not represent business reality. The figures in a spreadsheet tell a precise story, but not necessarily the correct one. For instance, overemphasizing quantitative factors may lead to neglecting qualitative ones, and vice versa.
Finally, evaluating both qualitative and quantitative factors simultaneously is highly valuable. Since seeking simplicity can be complex, I break this process into three aspects: finding businesses with good management, solid fundamentals, and reasonable valuations. You don’t need to expect perfection equally across all three aspects in every investment; there can be a modest degree of flexibility. However, all three aspects must be present. You can think of it as a multiplicative sequence, where a zero in any cell results in an overall zero, regardless of how large the other numbers are.
Principle of Simplification One: Seek Good Businesses
What are the characteristics of a good business? In short, first and foremost is having a competitive advantage, or as Warren Buffett calls it, a 'moat.' The wider the moat, the better. Secondly, possessing traits such as low capital intensity, pricing power, recurring revenue, endurance, and the potential for long-term growth means you have a great business. When evaluating good businesses, start with quantitative factors: focus on the balance sheet, accounting practices, and unit economics, then move on to examine cash flow generation. Simultaneously, qualitative analysis involves assessing management quality through reputation surveys and understanding product sales performance in real-time via channel checks.
Balance Sheet and Accounting
While most analytical focus will be on the income statement, conducting a proper and comprehensive analysis of the balance sheet and company accounting is like laying a solid foundation in a construction project.
When determining intrinsic value, work from the inside out rather than the outside in. Start with facts, not opinions. If you begin with opinions, even when facts contradict popular narratives, you may stubbornly cling to those opinions. Begin with SEC filings, annual reports, and industry magazine articles, not statements from management, employees, or sell-side reports.
The biggest mistake analysts can make in the initial research phase is evaluating a company based on earnings (or worse, management’s presentation of adjusted earnings). When you look at these reported figures, keep in mind that what you see is more a reflection of the management team's perspective on these facts than an entirely objective reality. The income statement is a snapshot of recent developments, and this snapshot may already be 'photoshopped' to appear more favorable. I prefer to focus on process rather than outcomes, so starting research with the income statement puts the cart before the horse.
When we start with the cash flow statement and balance sheet, we focus on the process and understand the flow of resources required to run the business. I not only like to think about the business broadly but also consider it from the perspective of unit economics. Imagine one dollar of revenue flowing into the company, passing through the cash flow statement, then the balance sheet, and finally the income statement.
This is how we ultimately arrive at the company’s return on invested capital, which is often a reliable and straightforward way to assess the quality of a company. Financial snapshots at different points in time are necessary but insufficient. I like to look back over the past ten years, examining changes in retained earnings, debt, and overall capital intensity while comparing them with changes in the company’s revenue growth.
I typically summarize the past decade using DuPont Analysis, a fundamental performance analysis framework promoted by DuPont. This technique breaks down the various drivers of return on equity (ROE) year by year into profit margins, asset turnover, and return on assets.
The balance sheet is also extremely useful in assessing sources of financing and the quality of earnings. For example, we might discover that a company has short-term floating-rate financing instead of long-term fixed-rate debt. In this case, due to risky financing decisions, the company could be highly sensitive to rising interest rates, potentially inflating profits artificially. A riskier balance sheet combined with aggressive accounting practices could lead to disaster. I find it interesting to compare the accounting practices of two very similar companies.
The means available here are almost countless. These aggressive measures continue to impact the quality of earnings of U.S. companies, and even astute investors often fail to detect these manipulations. Never take things for granted; if something seems too good to be true, it probably is. Aggressive balance sheet and accounting practices are usually not associated with conservative management teams or those focused on building a legacy for future generations, but rather with borrowing from future profits. Verifying and researching this forms the basis of our qualitative analysis.
Unit economics
A comprehensive understanding of the mechanisms of the balance sheet helps us identify key items within it and delve into them at the micro level to comprehend attributes like unit economics of a business. Just as you can analyze one dollar of revenue or cost through the cash flow statement and balance sheet, you can replicate a company’s unit economics using the same approach. For example, examining Costco's profit is one thing, reviewing its balance sheet is another, but understanding the unit economics of an individual store is more important than either. Although Costco does not publicly disclose the unit economics per store, we can use the disclosed information to estimate the average cost of opening a store through integrated analysis. Then, by estimating the time required for a single store to reach normalized operating income and profit, we can roughly calculate the return on investment (ROI) for an individual store.
Our goal is to disregard management discussions or analysts’ reports and position ourselves to understand the business as deeply as an owner would. Only then can you begin to connect the dots.
Principle Two of Simplification: Seek Good Management
The importance of excellent management is almost universally underestimated, yet it is one of the most crucial determinants of a company’s intrinsic value. As Graham and Dodd stated, “You cannot perform quantitative reasoning while tolerating mismanagement; the only way to handle such situations is to avoid them.” We must recognize that companies are made up of individuals whose decisions and judgments define the overall ecosystem of the company. Many analysts seem inclined to evaluate management quality based on conventional market narratives about the company. We need to gain deeper insights into management.
The method for assessing management performance is to examine their incentive structures, understand how they allocate their time, and conduct some reputation checks. Note that I did not mention attending investor day presentations or meeting with management. Evaluating the track record of a management team requires a comprehensive, detailed, and nuanced perspective.
It may take a long time for a company to successfully transform or decline. Decisions made 3, 5, or even 10 years ago may still be influencing current profits. Strong capital allocation capabilities are critical; having a good company and a talented CEO is insufficient to offset poor capital allocation.
Too many companies repurchase shares at prices above intrinsic value, engage in value-destructive mergers and acquisitions, or fail to adjust capital allocation according to changing economic conditions or new opportunities. Capital allocation is one of the most important aspects of a potential investor’s evaluation of a company’s track record.
Examine incentive mechanisms
Some say that the explanation for outcomes can be found in incentive structures. While we know that adopting a long-term perspective is crucial for business operations, there are often unfortunate incentives that lead to an excessive short-term orientation. The private owner of a great company does not worry about quarterly earnings, meeting market expectations, pushing products through distribution channels, employing aggressive accounting methods, or delaying long-term investments to improve short-term financial results.
To better understand management's incentive structures, I begin with proxy statements and examine them year by year for changes. Are the bases for executive compensation and stock option incentives reasonable? Are they measured against long-term performance or short-term stock price fluctuations, which may result purely from luck or even manipulation? Do they reward actual return on capital or revenue growth without profit? Are they providing the CEO with asymmetric upside by having the company take on excessive risk? Does the CEO frequently sell shares for 'personal reasons,' or do they act like a true owner and fiduciary? If the company were privately held, how might the CEO’s compensation and incentive structure differ?
Understanding how CEOs allocate their time
Time management is also important. I have never seen a CEO who, after traveling hundreds of days per year to meet with investors to promote themselves or their company’s stock, could still fully immerse themselves in the operational details of the business. Ask yourself: if this were your family business, wouldn’t you want your CEO to focus wholeheartedly on running the company? I want to support CEOs who focus on substance rather than superficial appearances.
Conducting reputation surveys on CEOs
Finally, I enjoy speaking with current and former executives who have either reported to the CEO or to whom the CEO has reported. This provides an excellent way to cross-check information. Intellectual honesty is critical for management teams. As the American theoretical physicist Richard Feynman said, 'You must not fool yourself, and you are the easiest person to fool.'
Principle Three of Simplification: Finding the 'Right' Price
Regarding pricing, legendary investor and author Philip A. Fisher said, 'The only true standard for judging whether a stock is cheap or expensive is not its current price relative to some past price, no matter how accustomed we are to that past price, but whether the company’s fundamentals are significantly more favorable or unfavorable than the current assessment by the financial community.' Investors must gain a deep understanding of the company behind the stock price.
Research Process
Scuttlebutt research, a term used by Philip A. Fisher, suggests that investors should act as investigative journalists to get as close to the truth as possible. I have seen many investors begin researching a potential stock holding by hearing a story, then calling a few friends to verify the story, listening to some conference calls, reading a few research reports, and starting to form their opinions. The danger in this process is that it often leads to forming views based on others’ opinions and analyses rather than developing one’s own independent perspective.
On the contrary, I first started with the company's annual letters, annual reports, 10-K and 10-Q filings, and other SEC documents from the past decade, as well as industry magazine articles and press releases. Does the company under-promise but over-deliver, or is it the opposite? Then I examine the earnings call transcripts again to see if the company delivers on its promises. Once I have a fact-based rather than story-based picture, I begin painting a realistic portrait like an investigative journalist. But questions remain to be answered—it’s time for channel checks.
Assessing Moats
How does one truly evaluate the depth and breadth of a business moat? Specifically, what is the competitive advantage of a company, and how unassailable is it? Of course, a long-term track record of high return on invested capital (ROIC) seems like a quick and easy way to judge this. However, the graveyard of capitalism is littered with companies that indeed had high ROICs for extended periods but eventually succumbed to competition—either directly from more astute rivals or due to shifts in the economic landscape. Investors must go to the front lines and conduct reputation surveys to determine whether the moat around the business is robust or fragile.
Channel Checks
Channel checks are akin to legendary detective work. They involve speaking with customers, suppliers, and former employees of the company. I always ask myself: If I were considering investing 100% of my net worth in this enterprise, what would I want to know? Is management consistently laying the groundwork for the future, or are they mortgaging it? What kind of pricing power does the company possess, and has it taken steps to maximize it? Or are there areas within the system that indicate room for improvement, suggesting further potential for enhancement? Business moats are not static; they vary in characteristics such as brand, low cost, convenience, and network effects—all of which form real but very different types of moats.
This in-depth, inside-out research serves multiple purposes. First, it helps us gain a deep understanding of how a business actually operates and the quality of its moat.
Second, it helps us understand trends in the business through key levers, aiding our assessment of whether the moat is narrowing or widening.
Third, it enables us to conduct rational analysis based on facts rather than opinions. It helps eliminate emotional factors, which are the enemy of rational decision-making. After such comprehensive analysis, if the price of the security falls after we buy, we may feel more comfortable increasing our position.
Fourth, it helps us understand the vulnerabilities or 'antifragility' of a business—a term coined by author Nassim Nicholas Taleb, meaning that while others’ fragility causes them to collapse, one becomes stronger. The best businesses are antifragile; that is, they continue to thrive and even deepen their moats during times of adversity and turmoil, such as when competitors falter, and the best customers and top employees might be poached.
Fifth, it helps us build foundational knowledge of many businesses and industries, enabling us to cross-validate our understanding over time and achieve compounding knowledge. This work creates milestones of expectations and progress that we can compare and adjust over time if necessary. Sixth, the approach of broad research holds significant power in forming perspectives. Conducting research using external knowledge and perspectives, combined with industry insights, can yield twice the results with half the effort.
Conducting this detailed study through document analysis and channel investigations allows you to feel reassured during the process of understanding a company. In-depth research enables investors to confidently answer some truly critical questions: Does the company have a sustainable and/or expanding moat? What will be the weakest link in the next five years? Is there hidden path dependence? Does the company possess pricing power, and how does it exercise it? How (anti)fragile is the company, and will it thrive during the next industry downturn? What conditions are required to replicate this company? Will the company’s moat be wider in five years, placing it in a more advantageous position?
Remember, simplicity is often better; in investing, difficulty does not earn extra points. You can find simple-to-understand businesses with strong, sustainable moats and franchises while avoiding situations where “when a strong management team meets a bad company, the bad company wins,” as the axiom suggests.
Determine intrinsic value.
As Warren Buffett wrote in his 1989 letter to Berkshire Hathaway shareholders: 'Buying a great company at a fair price is far better than buying a mediocre company at a cheap price.'
A company's value equals the sum of the discounted values of its perpetual cash flows. This concept sounds simple but involves several key variables in its calculation: the discount rate to be used and the estimation of these perpetual cash flows. Estimating future cash flows requires determining the company’s capital intensity, growth rate, and management allocation targets. Several examples demonstrate the importance of these estimates.
Assuming a constant 10% discount rate, a company growing at 15% annually without requiring any capital investment would be valued at approximately 26 times its current earnings (PE=26), whereas a similar company growing at 15% but needing to reinvest most or all of its earnings to achieve that growth would be valued at only 16 times (PE=16). A company growing at 5% without requiring any capital investment would be valued at 14 times its current earnings (PE=14), whereas a similar company needing to reinvest all its earnings would be valued at about 7 times (PE=7).
Compounding at a 15% return over 30 years would result in a value more than 87 times the initial investment, whereas compounding at 5% over the same period would yield less than 4.5 times the return. In this example, tripling the compound return (from 5% to 15%) almost increases the return twentyfold (87 times versus 4.5 times).
This example illustrates the importance of finding asset-light companies capable of long-term growth. Conversely, the worst companies are those that consume increasing amounts of capital to sustain growth while failing to exceed their cost of capital. Of course, there are companies that require capital investment to grow, such as railways, financial institutions, or retailers like Walmart or Amazon, where returns on new capital investments are entirely acceptable; such growth-focused capital expenditures will generate economic value over time.
However, price is the primary determinant of return. This was the great insight of Graham and Dodd. A great company at the wrong price can be a poor investment, while an ordinary company at the right price can be an excellent investment. But only at the right price can a rapidly growing company be attractive.
In recent years, during prolonged periods of low interest rates, many investors have flocked to growth at any cost based on simplistic and flawed formulas of earnings yield plus growth. Since price is the critical factor, one must adjust the growth rate by comparing the current price to the company’s intrinsic value. The value of growth diminishes because you’ve already paid a high price for it upfront.
Final Conclusion: What Matters Most
Humans continuously process complex information about the world, simplifying it for comprehension and placing it in the appropriate context. This enables us to make decisions. When I step outside in the morning and see my car, it is a complex network of metal parts and functions, but I simply perceive it as a thing called a 'car' and drive to work. Simple, right?
However, for some unknown reason, investors often tend to complicate concepts. As for myself, I firmly believe that adhering to the process I have described brings me closest to the true nature of things, and in investing, the essence of intrinsic value and margin of safety is paramount. For example, I ask myself, what exactly does this company do? What are the key drivers of its success?
Warren Buffett famously said, 'I am a better investor because I am a businessman, and I am a better businessman because I am an investor.' Investors attempt to look behind the scenes of a company’s operations, but they often realize how little they actually know.
From this vantage point, one can understand that even extensive research can only reveal a small fraction of what might be known about a business. Investors must find ways to deal with uncertainty and randomness. Complete information does not exist; only confidence intervals do.
Of course, this is the core reason why the margin of safety is so crucial in investing. If you start from the premise that you can only understand limited information, then naturally you need a buffer for error tolerance. The less you know, the larger the margin of safety required.
Editor/Rocky