This is the second in a three-part series exploring our complete investment approach.

In our first post, we went over the guiding principles in our investment philosophy. They are strongly influenced by the “value” and “quality” investing schools, with a few updates for the age of AI.

Now that we’ve laid out our guiding principles, we’ll use this post to walk through the methods we use to analyze potential investments. At the heart of our evaluation process is a single, powerful concept: free-cash-flow compounding.

Here’s the full series:

Part 1: Our Three Guiding Principles — The foundational beliefs that shape every investment decision

Part 2: How We Evaluate Businesses (this post) — Our analytical tools for identifying quality companies

Part 3: How We Make Investment Decisions — Our valuation framework for determining the right price

As a reminder, throughout this three-part series we’ll use two fictional companies (PMC and TTS) to illustrate every principle. These aren’t real businesses, but they represent patterns we see repeatedly in the market, with PMC representing the qualities we seek and FMC the ones we avoid.

Free-Cash-Flow Compounding: The Eighth Wonder of the World

All of our research ultimately serves one purpose: finding businesses that can reinvest their free cash flows at high rates of return for extended periods. This is the holy grail of investing, the mathematical engine that transforms good businesses into great wealth creators.

To understand why this matters so much, let's start with the basic math of compounding. When a business earns a 20% return on invested capital and can reinvest all its earnings at that same rate, something magical happens. The business doubles in value every 3.6 years without requiring any outside capital. After 10 years, it's worth 7.4 times more. After 20 years, 38 times more. This isn't linear growth, it's exponential wealth creation.

But here's the crucial insight: this only works when three conditions align:

• First, the business must generate high returns on incremental capital (the money it reinvests).
• Second, it needs opportunities to deploy that capital, what we call reinvestment runway.
• Third, management must have the discipline to reinvest wisely rather than waste money on low-return projects or excessive payouts.

When these three factors combine, you get a compounding machine that creates enormous value over time.

PMC exemplified this principle beautifully. They consistently earned 18-22% returns on incremental invested capital, meaning each dollar reinvested in the business generated $0.18-0.22 in additional annual earnings. With a large runway for growth—every major semiconductor fabrication plant required 50-100 of their specialized machines, and new plants were being built across Asia—they could reinvest most earnings at these attractive rates. Over 15 years, this reinvestment turned a $10 million initial equipment line into a $400 million business segment.

Management understood this dynamic perfectly. Rather than paying large dividends or buying back shares, they reinvested profits into R&D, new facilities, and strategic acquisitions. The CFO stated it clearly: "Why return cash to shareholders when we can generate 20% returns internally? Our shareholders win more from compounding than from dividends." This discipline meant PMC never needed external capital after their IPO; growth funded more growth in a virtuous cycle.

TTS demonstrated the opposite: value destruction through negative compounding. Despite rapid revenue growth, their unit economics remained negative. Each new user required $50 in acquisition costs but generated only $30 in lifetime value. Growth required constant external funding rather than internal reinvestment. While PMC's returns compounded like a snowball rolling downhill, TTS resembled a bucket with a hole in the bottom: the faster they poured in money, the more they lost.

The contrast becomes stark over time. PMC's initial $100 million investment in their precision equipment division grew to $1.6 billion in value over 15 years through internal compounding, a 16-fold increase without external funding. Meanwhile, TTS raised $800 million across five funding rounds, diluting early investors to nothing while destroying most of the capital. They confused growth with value creation, scaling revenues while demolishing economics.

With the importance of free-cash-flow compounding in mind, let's examine the specific tools we use to identify these compounding machines.

Free Cash Flow (FCF)

The foundation of compounding is free cash flow, the actual cash a business generates after accounting for capital expenditures needed to maintain operations. Without robust FCF, there's nothing to compound.

We calculate FCF using this straightforward formula: FCF = Operating Cash Flow − Maintenance CapEx ± Net Working Capital Changes

PMC's cash flow story demonstrates healthy economics. Last year, they generated $500 million in operating cash flow from real customers buying real products. Their maintenance capex of $100 million covered equipment replacement and facility upkeep, while a $20 million working capital increase reflected growing orders. The result: $380 million in free cash flow. Real money available for reinvestment at those attractive 20% returns.

TTS painted a starkly different picture. Despite $200 million in revenue and claims of being "contribution margin positive," their cash flow revealed the truth:

• Operating cash flow: $50 million
• "Maintenance" capex: $80 million (servers and development just to stay alive)
• Working capital increase: $40 million (unpaid marketing bills)

The result: negative $70 million in free cash flow.

Free cash flow strips away accounting fiction to reveal business reality. PMC's reported profits of $300 million looked modest because they wrote off new equipment quickly for tax purposes. But their $380 million in actual cash generation revealed true earning power.

Meanwhile, TTS reported $100 million in "adjusted earnings" by ignoring stock compensation, but their negative $70 million FCF exposed the deeper truth.

Not all free cash flow is created equal. We apply three critical quality checks:

• FCF Conversion Rate: PMC's FCF-to-net-income ratio averaged 95% over the past decade—nearly every dollar of reported profit became real cash. TTS's conversion was negative despite positive reported earnings.
• Maintenance vs. Growth Capex: PMC clearly separated $100 million in maintenance from $200 million in growth investments. TTS blurred this distinction, calling essential technology spending "growth" to disguise their burn rate.
• Sustainable Tax Rates: PMC's 21% rate reflected normal operations. TTS paid almost no cash taxes due to losses—when profitability arrived (if ever), taxes would further hit their ability to generate free cash flow.

With free cash flow established, we evaluate whether the business can sustain and grow these cash flows over time. Quality determines the durability of compounding. A business might generate impressive cash flows today, but without sustainable competitive advantages, those flows will inevitably erode as competitors attack. We examine four key dimensions of business quality to assess the longevity of cash flow generation.

Economic Moat: Sustainable Competitive Advantages

Warren Buffett's concept of an economic moat—sustainable competitive advantages that protect a business from competition—is crucial for long-term compounding. We evaluate five primary sources of moat:

PMC enjoyed multiple, reinforcing moats that protected their cash flows:

• Switching Costs: Semiconductor manufacturers spent years qualifying PMC's equipment, integrating it into production lines worth billions. Each piece of equipment required extensive testing, calibration, and technician training. Changing suppliers meant risking production delays, yield issues, and potential contamination; costs far exceeding any savings from switching. One customer told us: "Replacing PMC's equipment would mean shutting down our fab for months. The lost production alone would cost us $100 million."
• Intangible Assets: PMC's 300 patents covered critical manufacturing processes that competitors couldn't replicate. Beyond patents, their proprietary manufacturing techniques—developed over 40 years—represented accumulated knowledge impossible to reverse-engineer. Their brand reputation for reliability meant semiconductor fabs specifically requested PMC equipment in new facilities. This intangible expertise took decades to develop and couldn't be purchased or copied.
• Scale Advantages: As PMC grew, they spread massive R&D costs across a larger revenue base. Their $200 million annual R&D budget, while substantial, represented only 10% of revenue, allowing aggressive innovation while maintaining profitability. Smaller competitors couldn't match this spending without destroying their economics. This scale created a virtuous cycle: more revenue funded more R&D, which drove technological leadership, which attracted more customers, generating more revenue.
• Network Effects: While not their primary moat, PMC benefited from ecosystem effects. As more fabs used their equipment, more technicians became trained on PMC systems, creating a larger talent pool familiar with their technology. Equipment compatibility across the industry made PMC the default choice for new facilities.
• Cost Advantages: PMC's specialized manufacturing facility, built over decades, achieved precision levels competitors couldn't match without similar investments. Their vertical integration (producing critical components in-house) provided both cost and quality advantages.

These moats reinforced each other. Scale advantages funded R&D that created patents (intangible assets), which increased switching costs, which justified premium pricing, which improved scale advantages. This flywheel effect widened PMC's moat over time.

TTS possessed no meaningful moat, leaving their cash flows completely unprotected:

• Zero Switching Costs: Users could delete TrendVid and download a competitor in seconds. No data lock-in, no learned behaviors, no social connections that created stickiness. When asked about user retention, TTS's CFO admitted: "We need constant marketing spend just to maintain user numbers."
• No Intangible Assets: Their technology was commodity. Any competent development team could replicate TrendVid's features in weeks. No patents, no proprietary algorithms, no brand loyalty. Users didn't even remember the company name; they just used "that video app."
• Negative Scale Effects: Unlike businesses where scale creates advantages, TTS experienced diseconomies of scale. More users meant higher server costs, more content moderation needs, and increased regulatory scrutiny—without corresponding revenue increases. Growth actually worsened their unit economics.
• Reverse Network Effects: Social apps typically benefit from network effects, but TTS users didn't interact with each other, they just consumed content. Adding users didn't make the platform more valuable to existing users. Worse, as the platform grew, content quality declined, actually reducing value for engaged users.
• No Cost Advantages: TTS operated on expensive cloud infrastructure with standard pricing. Competitors using the same cloud providers had identical cost structures. Their venture funding actually created cost disadvantages: bloated headcount and expensive perks that established competitors had long ago eliminated.

The contrast was stark. PMC's multiple, reinforcing moats protected their ability to generate and grow cash flows over decades. TTS's complete absence of moats meant their cash flows (if they ever materialized) would evaporate the moment a better-funded competitor arrived.

Incremental Return on Capital: The Value Creation Engine

While economic moats protect a company's cash flows from competitive erosion, they don't tell us what happens to those cash flows once generated. Even the widest moat becomes meaningless if management squanders profits on low-return projects. This brings us to our next critical evaluation tool: incremental return on invested capital (incremental ROIC).

Incremental ROIC measures how effectively a company can deploy new capital. Unlike traditional ROIC which looks at returns on all invested capital, incremental ROIC focuses specifically on the returns generated by each new dollar invested. We calculate it by dividing the additional operating profit generated by the additional capital invested, examining multi-year periods to smooth out temporary fluctuations.

Think of it this way: if you invest $100 in a business expansion, how much extra annual profit does that generate? That's your incremental ROIC.

PMC's incremental ROIC averaged 20% over the past decade. When they invested $100 million in a new production line, it generated $20 million in additional annual operating profit. With their cost of capital at 8%, each dollar invested created $0.12 in annual value—a fantastic wealth creation engine. Here's what this looked like in practice:

• New Asian facility: $300 million investment → $65 million additional annual operating profit
• R&D center expansion: $150 million investment → $32 million in higher-margin product sales
• Strategic acquisition: $500 million purchase price → $95 million in synergistic profits

The consistency of these incremental returns mattered as much as their magnitude. Whether investing in new facilities, R&D, or acquisitions, PMC reliably generated 18-22% incremental ROIC. This predictability allowed confident reinvestment decisions.

TTS's incremental returns told a story of value destruction. Their invested capital increased by $500 million (mostly technology infrastructure and customer acquisition), while operating profits remained stubbornly negative. Each dollar invested actually accelerated losses:

• Server infrastructure: $200 million invested → $40 million increase in annual losses
• Customer acquisition: $300 million spent → temporary user spike but higher ongoing support costs
• "Strategic" pivots: $100 million in new initiatives → complete write-offs within 18 months

When your incremental ROIC is negative, growth becomes your enemy. The faster TTS grew, the more value they destroyed—a lesson many growth-at-any-cost investors learned painfully.

Growth & Reinvestment Runway: The Pathway to Compounding

Great returns on capital only matter if there's room to deploy that capital. Think of it as having a Ferrari engine (high ROIC) but being stuck in a parking lot (no reinvestment opportunities). We assess the "size of the highway" by examining addressable markets, expansion opportunities, and capital deployment potential.

PMC operated on a vast highway with multiple lanes:

• Core Market Opportunity: $50 billion semiconductor equipment market growing 7% annually
• Market Share Potential: Only 8% share in their niche, with fragmented competition
• Geographic Expansion: Asian semiconductor manufacturing booming, especially in China and Taiwan
• Adjacent Products: Natural extensions leveraging core expertise (metrology tools, inspection systems)
• Technology Advancement: Each new chip generation required more sophisticated equipment

The numbers painted a compelling picture. If PMC could capture just 15% market share (reasonable given their technology leadership) and expand into two adjacent products, they faced 20+ years of reinvestment opportunities at those attractive 20% returns.

TTS faced a parking lot, not a highway:

• Saturated Market: Consumer app downloads declining; attention, not features, was the constraint
• Winner-Take-All Dynamics: Network effects meant market leaders captured 90%+ of value
• Failed Pivots: Enterprise software meant competing against Microsoft and Slack from scratch
• Capital Intensity: Each new user required ongoing server and support costs
• No Pricing Power: Users expected free services; monetization remained elusive

Their pivot to enterprise software illustrated the problem. Starting from zero users, facing entrenched competitors, with no differentiated offering—where exactly would they deploy capital at attractive returns? Even if TTS magically became profitable, they lacked reinvestment opportunities to compound those profits.

Management Assessment: Good Jockeys Need Great Horses

Even the most talented management team can't transform a structurally flawed business. Great managers steering terrible businesses will eventually look incompetent—not because they lack skill, but because the underlying economics doom them to failure. While the jockey matters, the horse matters more.

That said, when you find a quality business, management becomes the difference between good returns and exceptional ones. Capable leaders optimize the compounding machine through smart capital allocation, while poor managers can diminish even the best franchise through wasteful spending or strategic missteps. We assess alignment, track record, and capital allocation skills to identify managers who enhance rather than erode business value.

PMC's CEO exemplified owner-operator leadership:

Skin in the Game: Owned 4% of shares worth $200 million

• Never sold shares despite multiple offers
• Family wealth tied to company success

Compensation Alignment: 80% of pay tied to ROIC and FCF per share

• No rewards for revenue growth without returns
• Long-term vesting requirements (5-7 years)

Strategic Clarity: Consistent strategy for 15 years

• "We're building a business for the next decade, not the next quarter"
• Turned down dilutive acquisitions despite banker pressure

Capital Allocation Excellence: Clear hierarchy of capital uses

• Reinvest at 20%+ returns
• Strategic acquisitions within circle of competence
• Share buybacks below intrinsic value
• Dividends only when no better opportunities

TTS's founder represented everything we avoid:

Misaligned Incentives: Stock options priced at $0.01

• Profited from volatility, not value creation
• Sold shares at every opportunity

Growth Obsession: "Growth solves all problems"

• Burned cash to boost vanity metrics
• Confused users with customers

Strategic ADD: Three major pivots in three years

• Photo sharing → video → enterprise
• Each pivot destroyed previous investments

Capital Destruction: Famous "profits are a choice" quote

• $800 million raised, nearly all destroyed
• No understanding of unit economics

We apply Joel Greenblatt's test: for every dollar retained by the company, has at least one dollar of market value been created? PMC retained $3 billion over 15 years and created $5 billion in market value—a 1.67x multiple demonstrating consistent value creation. TTS raised $800 million while destroying 90% of it in market value.

Key Risks & Disruption Threats: What Could Go Wrong?

Great investors think like business owners, which means contemplating what could kill their business in the next 10-20 years. We systematically evaluate risks that could derail the compounding machine, focusing on existential threats versus manageable challenges. The goal isn't to avoid all risks (that's impossible) but to understand them and ensure they're manageable.

For PMC, we identified several key concerns but found them manageable:

Cyclical Exposure: Semiconductor industry notoriously cyclical

• Mitigation: Variable cost structure allowed quick adjustments
• Historical evidence: PMC gained market share in last three downturns

Customer Concentration: Top three customers = 45% of revenue

• Mitigation: Industry consolidation meant these were the survivors
• Long-term contracts and high switching costs provided stability

Technology Risk: New chip architectures might require different equipment

• Mitigation: Deep customer relationships provided early warning
• R&D partnerships with leading fabs kept PMC at cutting edge

Geographic Risk: Heavy Asia exposure

• Mitigation: Diversification across Taiwan, Korea, China, Japan
• Political risks balanced by essential nature of semiconductor supply

The key insight: PMC's risks were cyclical and manageable, not existential. Their strong balance sheet and variable costs helped them navigate storms while weaker competitors sank.

TTS faced existential risks that materialized rapidly:

Platform Dependency: Apple/Google controlled distribution

• Reality: One algorithm change increased customer acquisition costs 3x overnight
• No mitigation possible; platforms held all the cards

User Fickleness: No switching costs meant users left instantly

• Churn rates exceeded 10% monthly
• Constant marketing spend required just to maintain user base

Competitive Threats: Zero barriers to entry

• Three copycat apps launched within months
• Deep-pocketed competitors (ByteDance, Meta) entered aggressively

Regulatory Risk: Privacy concerns mounting globally

• GDPR compliance costs exceeded $10 million annually
• Potential bans in key markets (like TikTok faced)

The pattern was clear: PMC faced manageable business cycle risks while TTS faced existential threats to their entire model.

Macro Risk Framework: Looking Beyond the Obvious

Beyond company-specific issues, we examine systematic risks that could break the compounding machine. Financial structure, macro sensitivity, regulatory exposure, and technological disruption all factor into our analysis.

PMC maintained a fortress balance sheet:

Conservative Leverage

• Net debt at 1.5x EBITDA
• No restrictive covenants
• Multiple refinancing options

Geographic Diversification

• Revenue split across US (30%), Europe (25%), Asia (45%)
• Natural hedge against regional downturns
• Supply chain redundancy

Variable Cost Structure

• 60% of costs flexible
• Quickly adjust to demand changes
• Maintained profitability through downturns

Regulatory Moat

• Some patents and environmental certifications
• Created barriers for new entrants
• Established relationships with regulators

TTS operated with fundamental structural flaws:

Cash Burn Dependency

• Required constant equity funding
• 18-month runway at current burn rate
• Each funding round massively dilutive

Platform Risk

• Entirely dependent on iOS/Android policies
• No direct user relationship
• One policy change could kill the business

Winner-Take-All Market

• Second place meant failure
• Network effects meant dominance or death
• No profitable niche strategy possible

Regulatory Nightmare

• Privacy law violations in multiple jurisdictions
• COPPA issues with underage users
• Data retention policies violated GDPR

The Bottom Line: It All Connects

Every evaluation tool serves one purpose: identifying businesses that can compound free cash flow at attractive rates for extended periods. The analysis must be holistic—each element reinforces or undermines the others.

PMC demonstrated how all elements align in a great compounder:

• Robust FCF providing fuel for reinvestment
• 20% returns on incremental capital (the engine)
• Decades of reinvestment opportunities (the highway)
• Multiple competitive moats protecting returns
• Aligned management optimizing the machine
• Manageable risks that don't threaten the model

TTS showed how missing any element breaks the entire system:

• Negative FCF meant nothing to compound
• Negative returns on investment destroyed value
• No reinvestment runway even if profitable
• Zero competitive advantages left them defenseless
• Misaligned management making poor decisions
• Existential risks that killed the business

When evaluating any investment, ask yourself: Do all the elements align to create a compounding machine? If even one critical element is missing, the machine breaks down. PMC had all the elements. TTS had none. The results were predictable.

Looking Back and Looking Ahead

In Part 1, we established our three guiding principles: thinking like owners rather than traders, demanding a margin of safety to protect against the unexpected, and staying within our circle of competence. These principles form the philosophical foundation that keeps us disciplined and focused on what matters.

Now in Part 2, we've shown you the analytical tools we use to evaluate businesses. From free cash flow generation to competitive advantages, from management assessment to risk evaluation—each tool helps us identify true compounding machines while avoiding value traps.

But even the best business becomes a poor investment at the wrong price. In Part 3, we'll complete our investment framework by revealing our valuation methodology. You'll learn how we use expectations investing and scenario analysis to determine when the market offers attractive opportunities. We'll show you exactly how we decided PMC at $80 was a buy while TTS at $50 was a clear avoid.

The investment process is both art and science, requiring discipline, patience, and continuous learning. With our principles as the foundation and our evaluation tools as the framework, valuation becomes the final piece that transforms analysis into action.

Stay tuned for the conclusion of our investment philosophy series.