Cook Bynum - Quarterly Letter Excerpts

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Excerpts from Quarterly Letters
Table of Contents
Margin of Safety .............................................................................................................................................2
When “Mr. Market” Frets, Opportunity Knocks ............................................................................................2
“Real” Risk .....................................................................................................................................................2
Geometric Means, Kelly Criterion, Portfolio Construction, etc. ....................................................................3
The Psychology of Errors ...............................................................................................................................5
“Moats” – What They Look Like and Why They Are Critical.......................................................................7
The Danger of Leverage ...............................................................................................................................11
“Invert, Always Invert” .................................................................................................................................11
Making Disciplined Allocation Decisions ....................................................................................................14
Greedy When Others Are Fearful .................................................................................................................14
Pricing Power and the Potential Impact of Inflation.....................................................................................15
Expanding the Geographic Circle of Competence........................................................................................16
The Importance of Price................................................................................................................................17
Avoid The Loser & The ‘Too-Hard’ Pile .....................................................................................................18
Commitment Bias .........................................................................................................................................22
Dissecting An Investment .............................................................................................................................23
Einstein, CERN and the Limitations of Models ...........................................................................................28
Wal-Mart de Mexico Postmortem ................................................................................................................30
The Mind of a Value Investor .......................................................................................................................31
MARGIN OF SAFETY
July 2003
We are actively looking for more investments that meet our qualitative criteria of good
businesses with a sustainable competitive advantage and with talented, honest management. If
these qualitative criteria were our only concern, we would have dozens of qualifying investment
ideas. However, price is essential to our process. We buy companies that pass our qualitative
tests when we can purchase them for roughly half of our conservative appraisal of their intrinsic
values. This “margin of safety” between a company’s real value and its currently quoted market
price will serve to protect us when we make a mistake and to generate outsized returns when we
are correct. “Margin of safety” is the cornerstone of our investment approach. While the
financial press is praising the recent advances in the market, we are disappointed. Rises in the
general market level decrease the investment opportunities that fit our criteria. We are still
looking vigorously through ideas in hopes of finding a few that we can add to our stable of
excellent businesses.
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WHEN “MR. MARKET” FRETS, OPPORTUNITY KNOCKS

January 2005
Diligence when adding new capital is imperative to ensure that existing partners are not
diluted out of sizable positions in businesses that we currently own. We have been quite
fortunate to acquire new positions and to add to most of our previously-held positions during
periods of growth. As the fund anticipates being a large net purchaser of stock in companies for
the foreseeable future, we welcome low and declining prices to build positions – even in
positions we currently hold. We are only concerned with the intrinsic value of the businesses in
which we invest. Stagnant or declining prices in the face of solid business performance are
simply an opportunity to own a greater proportion of the future profits of a business. As we
expect continued inflows of capital over the coming year, we hope that “Mr. Market” continues
to offer us bargain prices on our current investments. We would be delighted if “Mr. Market”
would offer us more businesses at substantial discounts to their true value.
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“REAL” RISK
October 2006
We are often asked to discuss our investment philosophy as it relates to our expected
long-term returns. Many people making investment decisions today at very large, sophisticated
institutions believe that an investment is less risky if it has a smooth progression of returns
month after month and year after year. We believe this type of thinking is pure folly. It is akin
© 2012 COOK & BYNUM CAPITAL MANAGEMENT 2

to thinking that you are free from hurricane risk by living in New York. Most people living there
now have no recollection of past significant hurricanes. In fact, New York bares the brunt of a
significant hurricane about twice a century and is considered the third most susceptible
metropolitan area to hurricane damage after Miami and New Orleans. Real risk is determined by
the prospects of the underlying securities that make up a portfolio, and it is magnified
exponentially by the degree of leverage employed. Taking large, leveraged bets and thinking
your investments are safe because historical volatility has been low is simply crazy.
At Cook & Bynum, we have earned significant outperformance over the last five years
while owning a concentrated basket of outstanding businesses. During this period, we have held
significant cash positions at various times of as much as 80% of assets while never having been
materially leveraged. Our average cash position has been near 30% over this five-year
period. We often talk to potential investors who do not understand this core philosophy on risk.
We are reminded of how delighted we are to have such a wonderful group of partners that
understand how to properly evaluate risk. We sleep well at night, as you should, knowing that
the intrinsic value of our stable of businesses does not change because of how manic “Mr.
Market” gets each day or each month. We will continue to mitigate risk and raise our long term
returns by insisting upon a “margin of safety.”
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GEOMETRIC MEANS, KELLY CRITERION, PORTFOLIO CONSTRUCTION, ETC. 1

April 2007
We have previously discussed in-depth the issues surrounding the purchase or sale of a
given security, but there exists another equally important problem for the investor – how to
allocate capital between competing qualifying ideas. It is not good enough to simply say, “This
is an undervalued business with a high margin of safety.” How do you decide how much capital
to commit to such an idea? The task is not simple because each choice will have slightly
different risk vs. return characteristics. While we build a portfolio one security at a time, we
must use a rational system to allocate our limited capital in the most-efficient way – that is to
allocate it with the highest chance of outsized returns while minimizing real risk (business risk).
The goal of the investor, therefore, is to maximize the geometric mean of possible
outcomes, as opposed to his arithmetic mean. The goal is such because the investor must always
have all of his capital invested. The geometric mean is the nth root of the product of n numbers.
The arithmetic mean is the sum of n numbers divided by n. For example, for the list of numbers
{0.5, 2, 3, 1, 0.2}, the geometric mean is the 5th root of (0.5 x 2 x 3 x 1 x 0.2) or 0.90. For the
1
The ideas in this section are simplified and synthesized from the following:
Kelly, J. L., Jr. (1956). “A New Interpretation of the Information Rate.” Bell System Technical Journal, 917-26.
Poundstone, William (2005). Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the
Casinos and Wall Street. New York, NY: Hill and Wang.

same list, the arithmetic mean is (0.5 + 2 + 3 + 1 + 0.2) / 5 or 1.34. Maximizing the arithmetic
mean is appropriate when you are playing games once, but in investing you are by nature playing
games (investment opportunities) repeatedly. Therefore, the investor needs to pick the games
that will maximize the long-run result of playing the games over and over again. The
appropriate goal for the investor, then, is to maximize the geometric mean of his portfolio. The
following example will explain this concept more clearly.
Let’s look at an example of a Wheel of Fortune with twenty-three spaces marked “$100”
and one space marked “Bankrupt.” While the arithmetic mean of this wheel is $2,300 / 24, or
$96, the geometric mean is $0 due to the presence of the “Bankrupt” space. While you might be
very happy to play this game with part of your money, if you play this game with all of your
money, you will go broke with 100% certainty in the long run. If you look at another Wheel of
Fortune with twenty $50 spaces and four $10 spaces, the arithmetic mean will be $43 and the
geometric mean would be $38. While the latter wheel will underperform the first wheel on 96%
of spins, it is the only rational choice for one’s entire portfolio.
A special case formula for maximizing the geometric mean was developed by Bell Labs’
scientist John L. Kelly, Jr. He showed that the rational gambler should put a percentage of his
bankroll in a given game based on the formula Edge/Odds. This formula has been dubbed the
“Kelly Criterion.” Edge is calculated at the expected profit of playing the game. Odds is the
public odds of playing the game. Suppose you have the opportunity to get paid 2-1 Odds on a
coin-flip. The Edge for this game would be 3 for heads plus 0 for tails divided by 2 for the
number of outcomes minus 1 for the initial investment, or 0.5. The Odds of the game are 2, so
you should bet 0.5 / 2 or 25% of your bankroll (portfolio) on each coin flip in order to maximize
your geometric mean and the long-run value of your portfolio. In investing, one can obviously
not know the Edge and Odds exactly, but understanding this concept is critical. Intuitively, as
the expected profit (Edge) of the investment choice rises, the investor should put more of his
portfolio to work in this investment. But note also that given a constant expected value, as the
Odds rise (in other words as the degree of certainty in the idea falls), the percentage of the
portfolio deployed should fall as well. So if the investor has two ideas with the same expected
return, but one is in a highly-leveraged financial company and one is in a very stable consumer
products company, the investor should allocate substantially more money to the consumer
products company because the Odds will be smaller. When we talk about risk, we are always
talking about business risk NOT volatility. So the mathematics of maximizing the geometric
mean proves that you make much bigger bets on ideas where the range of possible outcomes is
smaller even if the expected value of such options are slightly lower. It is, in short, the logic
behind concentration of capital when certainty is high. This strategy leads to the highest long
term returns.
A discussion of portfolio allocation is not complete without considering the nature of
leverage (borrowed money). When the investor uses leverage, he will almost certainly raise the
arithmetic mean of his portfolio returns, but he will be adding a bankruptcy space to his wheel.

As we have shown above, regardless of the arithmetic mean, this one bankruptcy space will
make the geometric mean (long-term outcome) zero. Even if there are thousands of spaces on
the wheel and only one bankruptcy space, the long term result of running a portfolio by simply
trying to maximize the arithmetic mean with leverage will be losing all your money - whether it
happens in one year, 10 years, 100 years, or 1,000 years. Our goal at Cook & Bynum will
continue to be to maximize our long-run returns without the permanent loss of capital, and that
goal will continue to preclude our using leverage.
The Kelly Criterion shows that a key to success in investing is to maximize the difference
between the actual odds of an investment opportunity and the odds that the market is giving you.
In other words, the greater the discount between the current price of a stock and its true
underlying intrinsic value the better. Our job is to find places where we have superior insights to
the other market participants. The other key is to accurately estimate how big our information
advantage is. If we underestimate the informational advantage, we will underperform as an
investor. If we overestimate the advantage, we will go broke.
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THE PSYCHOLOGY OF ERRORS

July 2007
An important differentiator between our selection process and the processes of the value
managers we respect is the time and effort we spend on analyzing how psychological factors
affect decision making. A number of different factors cause people to systematically make
mistakes in judgement – just to name a few:
1. People tend to think every new idea is a good idea.

2. Once someone has invested a lot of time researching an idea, he cannot view conflicting
facts objectively. Effort “becomes” reality.
3. People cannot accept that a decision they made in the past might have been a mistake and
will distort the current reality to make the prior decision seem logical.
4. People illogically reciprocate very small gifts or favors.
We spend a lot of time thinking about the psychology of decision making because the
human mind takes all kinds of shortcuts that are generally beneficial. Unfortunately, many of
these mental shortcuts can cause grievous errors of judgement when a situation or decision
presented is different from the pattern our brains are wired to process. Dr. Robert Cialdini calls
this phenomenon the “click, whirr” response in his book, Influence: Science and Practice.
Simply put, if we do not condition ourselves to look logically for psychological errors in decision
making, certain stimuli cause our brains to “turn off” logical thinking and run through a

potentially hazardous shortcut. Please pick up the book if you would like to know more in detail,
but given our limited space we wish to discuss just a few of the important factors we examine.
First of all, we analyze how we might be deceiving ourselves about the reality of a
company. We run through our checklist of common self-deceptions and irrationalities to make
sure that we are not taking a mental shortcut. We reinforce this type of thinking through critical
post-mortems such as the “Wall of Shame” we walk past in our office every day. The “Wall of
Shame” is a concept we borrowed from another investment manager. It consists of a bulletin
board with one side for errors of omission and the other side for errors of commission, with a
little summary of the error below the company name. While we prefer to learn vicariously from
others’ mistakes, we spend a lot of time dissecting our own mistakes in the hope that we will not
repeat them.
In the second tier of psychological analysis of a company, we try to determine how
management might be deceiving itself about what is really going on in a business. Management
could be committing outright fraud or intentional deception, but the clues for this behavior will
be different. Frequently though, a company’s management will be inadvertently deceiving itself.
Economics professor Tony Carilli 2 always says, “Incentives matter!” When management has an
incentive to deceive itself about a situation, it will likely do so not because it is dishonest, but
rather because the human brain is hard-wired to respond to incentives no matter how perverse.
The human brain can “honestly” justify all sorts of behavior if incentives are not aligned
properly. One recent example is the scandal involving the back-dating of stock options. Some
companies were committing outright fraud, but most were just being too casual with internal
procedures. It comes as no surprise to us that some management teams with outstanding track
records for integrity benefited from the casual nature with which they treated these procedures.
If the backdating was just random chance, you would expect such management’s backdating to
hurt or help their compensation in roughly equal measure. That scenario was not the case.
Otherwise honest management came out better rather than worse from their lax internal
procedures. “Incentives matter!” and when they are perverse, people justify all sorts of behavior,
often subconsciously. Our goal in this part of our analysis is to determine if management is being
as vigilant as we are at critically questioning its decision making process. Additionally, we pay
special attention to incentive structures throughout any company we research. Charlie Munger
has said that incentives are the most-powerful psychological influence on people’s decisions, and
that he has underappreciated this point for virtually his whole career even while being more-
focused on their power than 95% of his peers. 3 Look for misaligned incentives and see if there is
bad behavior.
The third tier of analysis applies to the customer’s decision. Customers will frequently
make decisions to buy products and services because of these same deficiencies of the human
2
Tony Carilli is a Professor of Economics at Hampden-Sydney College in Virginia.
3
Kaufman, Peter D., ed. Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger. Marceline:
Walsworth, 2005. 400.

brain. Understanding why that customer makes the decision to buy or not to buy is critical to
understanding the prospects of a business. Again, we are not speaking of dishonest management
using tricks and deceit to “steal” a one-time purchase from a customer. We think about how a
company is marketing its products or services and how psychology is a factor in the competitive
moat around a business. Is the customer making a somewhat irrational decision to buy a product
or service? Is he likely to realize that such a decision is irrational and stop buying that product,
or is the decision one that is reliably going to be repeated? Branded consumer products fall into
this category of behavior. Both Coke and Pepsi put sugar and a few other things into water and
sell it for a price premium to Sam’s Choice Cola. Their drinks are not “superior” in any
objective way from a taste or nutritional standpoint. Yet consumers repeatedly buy the premium
brands whenever they can afford them. Psychology is at work here. Coke and Pepsi have
roughly 200 years of combined marketing that associates their products with “fun” – sporting
events, concerts, vacations, the good life. The consumer is not being “tricked” into paying more
for an equivalent product; rather he has a strong emotional attachment to what the particular
brand represents.
Companies that have a repeatable model that gets customers to make a seemingly
irrational choice over and over again, such as an impulse buy at a checkout line or buying a
branded soap with the same ingredients as a generic product, generally have deep moats around
the business and outstanding long-term returns on capital employed. We seek to find just these
types of businesses.
Psychology is a powerful part of the entire investing process, and one that is frequently
under-analyzed. Combinations of the aforementioned psychological factors (and many not
mentioned due to space constraints) can have huge and exponential effects on the value of the
business, the performance of management, and the decisions made by the investment manager.
Just as pilots don’t fly without going through a checklist – missing one vital step could be fatal –
investing without using a psychological checklist can be ruinous to one’s investment results.
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“MOATS” – WHAT THEY LOOK LIKE AND WHY THEY ARE CRITICAL
October 2007
We often talk about a “moat” around a business. A moat is a sustainable competitive
advantage that allows a business to earn outsized returns on capital over time and allows us to
better predict the future prospects of a business. We could not buy businesses with conviction
without a moat. While a moat is a nice metaphor, what does one really look like? To identify a
moat it is critical to fully understand the customer’s decision.

First, what is the price elasticity of the customer’s demand? How sensitive is the
customer to the company changing prices a small amount higher or lower? A large change in
quantity demanded with a small change in price indicates relatively elastic demand. A small
change in quantity demanded with a large change in price indicates a relatively inelastic demand.
A business with a moat has relatively more inelastic demand for its good or service. If you look
at a traditional demand curve, where the Y-axis is Price and the X-axis is Quantity, a steeper
curve represents more inelastic demand for a good. Our job is to approximate the slope of the
demand curve in the relevant range.
Price of Good Demand Curve
Quantity
Second, what is the cross elasticity of demand for a given substitute? A substitute is a
good that can be consumed in the place of another good. How well another good substitutes for
the good a company is producing is critical to that company’s moat. For example, a flight to
Chicago on American Airlines is a close substitute for a flight to Chicago on United Airlines.
The demand for the American flight is likely to change significantly with a relatively small
change in the price of the United flight. In such a case, the demand for the American flight is
relatively elastic for a change in price of the United flight. Another example might be that of
Coca-Cola and Sam’s Choice Cola. For most Coca-Cola drinkers, a change in the price of Sam’s
Choice Cola will have almost no effect on their demand for Cokes. In such a case, the demand
for Coke is relatively inelastic for a change in the price of Sam’s Choice. If you look at a chart
where the Y-axis is the Price of a Substitute and the X-axis is Quantity Demanded of the original
good, the steeper the curve, the more inelastic the cross elasticity of demand is for that given
substitute. Any good has lots of substitutes, some of which are better than others. Substitutes for
Sam’s Choice Cola might include Coke, Pepsi, bottle water, tap water, milk, beer, orange juice,
etc. For each of these substitutes, the investor must approximately estimate the slope of this
curve over the relevant range in order to assess the depth and width of the moat.

Demand Curve
Price of Substitute
Quantity
Third, what is the cross elasticity of demand for a given complement? A complement is a
good that generally is used in conjunction with another good. The classic example of a perfect
complement is a right shoe for a left shoe. Clearly a consumer’s demand for a left shoe is going
to be inelastic for changes in the price of a right shoe. A more elastic example would be the
quantity of tortilla chips demanded given a change in the price of salsa. The number of tortilla
chips demanded will change slightly but not dramatically given a change in the price of salsa.
Once again, if you look at a chart where the Y-axis is the Price of the Complement and the X-
axis is the Quantity, the steeper the slope, the more inelastic the cross elasticity of demand is for
a given complement. Any good has many complements of varying elasticities, and the investor
must approximate the slope of these curves to estimate the sustainable competitive advantage.
Demand Curve
Price of Complement
Quantity
Many other factors exist that affect demand. For instance, the demand for some goods
such as Crocs is sensitive to time. Other goods like M&M’s are basically immune to this factor.
The demand for Crocs is almost certainly a fad, while the demand for M&M’s is not likely to
change for a long time. Estimating these types of relationships is also critical to understanding a
customer’s demand for a good.

The relationship between these substitutes, complements, and the price of the good itself
can be expressed as a multivariate surface. Below is an example of a demand surface in three
dimensional space, but the relationship exists in a surface that can be defined in N-dimensional
space, where N is the number of factors affecting the quantity demand for a good plus the
quantity dimension. A similar supply surface can be estimated taking into account such factors
as the cost of capital, cost of labor, cost of inputs, changes in government regulation, time’s
effect on competitors’ capacity, etc.
Demand Surface
Price of Good
Quantity
Price of
Substitute
Demand Surface
Price of Good
Quantity
Price of
Complement
Understanding a business’ moat is really about estimating the demand and supply
surfaces in N-space. The shape of these surfaces over the relevant range with respect to each
variable defines the company’s moat. The investor cannot ignore any variable in the N-

dimensional surface. Not understanding what time is going to do to the demand for Crocs or
what the price of housing is going to do to the sales of Whirlpool will lead to serious errors in
our estimates of a business’ intrinsic value. The shape of a company’s demand and supply
surfaces is critical to predicting the future prospects of the business.
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THE DANGER OF LEVERAGE
April 2008
As value investors, we make the assumption that the market is irrationally pricing a
security now, and we expect the market to value the same security more rationally in the future.
However, we have no expectation nor guarantee that the market will not value a security
substantially more irrationally in the interim. The intrinsic value of a security is the discounted
value of all future dividends (John Burr Williams). We assume that securities trade in some
mound-shaped distribution whose mean is the intrinsic value and which may or may not be
normally distributed. Given this set of assumptions, we believe cutting off one of the tails by
using leverage will lead to bankruptcy in the long run. The long run might be one thousand
years, but the math still dictates that such a strategy will inevitably result in ruin if you believe
that there is no limit to how irrationally a security can be priced either in magnitude or over time.
Additionally, the more leverage that is used, the more of the tail that is cut off. Borrowing
money to buy assets necessarily narrows the range of deviations from intrinsic value an
investment can have without causing bankruptcy. Additionally, psychological factors frequently
cause participants to underestimate the likelihood of “rare” events such as the proverbial
“hundred year flood” by a factor of ten. We will not employ a strategy whose long run expected
return is negative 100%.
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“INVERT, ALWAYS INVERT”

October 2008
The great 19th century mathematician Carl Jacobi was fond of saying that when you
encounter a tough problem, “Invert, always invert.” This principle has applications in many
fields, not the least of which is investing. The purpose of investing is to make money. Using
Jacobi’s principle we ask the question, “How do we not lose money?”
We start with the assumption that markets will approximate intrinsic value in the long-
run, but there is no limit to how dislocated markets can become in the short-run. This
assumption is at the core of all logical value investing. Our job is to purchase irrationally

underpriced securities and have the perseverance to hold them until they approach their intrinsic
value while recognizing that they can become more irrationally priced in the interim.
Let us examine this principle from a single-company standpoint first. To begin with we
attempt to avoid companies whose long-run expected value is zero. We suspect that this is the
status of a large percentage of all companies. For instance many financial companies are
managed to maximize profits and to be able to survive an x year flood but not a 2x year flood. A
common way that they look at risk is by VAR, or ‘Value At Risk.’ VAR is simply a statistical
tool that roughly says P% of the time (usually P is 95-99%), we will not lose more than $D in a
day or some such period. Even if one makes the huge leap that the inputs in such a calculation
are correct, the output says absolutely nothing about the remaining 1-5%. Those outcomes do
occur by definition. Your losses on those days could be many times higher than your
“measured” risk. We put “measured” in quotation marks because the risk manager is
substituting false precision for actual understanding of the risks faced. The model produces a
nice, neat number, but it is subject to Garbage In – Garbage Out. One can also question the
implicit assumption of normality in this system.
Inherent in this management policy is the undeniable admission that in the long run the
company will be worth zero. Preparation for the proverbial 100 year flood means that the 200
year flood will almost certainly wipe you out. This system does not strike us as a good model for
making money. Human nature tends to systematically underestimate the likelihood of a major
flood by a factor of two to ten, resulting in more permanent losses of capital than planned.
We recognize that this reasoning is essentially a critique of any business model that
requires leverage to earn an adequate return on capital, especially financial business models. We
suspect the model persists for a couple of reasons. First, managements typically are trying to
maximize profits on their watch and are not incented to ensure the durability of the business.
Second, financial businesses are basically commodity businesses in which it is hard to be smarter
than your dumbest competitor. A “winner’s curse” phenomenon exists (see Richard Thaler’s
work). If competitors recognized the certain demise of their businesses, the profits in the
intervening years paid out as dividends would perhaps more than make up for the catastrophic
losses when the floods arise and allow for an acceptable return on capital invested. We do not
expect industry participants to see the world as we do anytime soon. As such, we will continue
to remain on the sidelines in most financial businesses.
Leverage is just one way of many that causes companies to fail. You can imagine all sorts
of scenarios that would cause a company to lose its business including: new technology, legal
liability, strong competitors, shifts in tastes and preferences of consumers, labor risks, economic
slowdowns, natural disasters, management fraud, etc. We try to brainstorm the myriad of ways
that we can lose all or a significant amount of money in an investment. We then try to estimate
the likelihood of such an event and adjust for the human tendency to significantly underestimate
the frequency of such events. We find this to be the only rational way to limit individual
company risk.

For example, we are invested in the convertible notes in a Chinese infant formula
producer. A recent, much-publicized scandal has emerged where some producers were selling
tainted milk, which resulted in the tragic deaths and sickness of many babies. Most of the largest
Chinese producers have been implicated in the scandal. The company we have invested in has
been given a clean bill of health after extensive government testing. This safety is a direct result
of the senior management’s deep commitment to high quality products. The list of ways that we
can lose all of our money in this company is long. Two prominent such events on our list when
we invested initially were the government risk and a company-specific health scandal. However,
we lacked the imagination to predict an industry-wide health scandal that did not affect our
company. The opportunity created by this situation is immense as consumers search for a brand
they can trust. We hope that the company seizes this opportunity and thereby overcomes some
of the growing pains it has endured in the past. This investment remains by far the one with the
most ways for us to lose all our money but also the investment with the highest possible return.
While this situation yields the highest expected value, we control for the risk of permanent loss
of capital by position size.
The company-specific model of “How do we not lose money?” is easily generalized into
a method of portfolio construction. While we build a portfolio of securities one business at a
time, we cannot ignore the additional and sometimes correlated risks of owning groups of
businesses – that is, a portfolio. If you assume as we do that the short term irrationality of the
markets is limitless, employing leverage at the portfolio level will always result in bankruptcy in
the long term. We do not think it makes sense to employ a strategy that might be more likely to
achieve higher returns in a certain year if the only real upside is larger fees for the managers.
The cost, certain long-run bankruptcy, is far too high.
Another aspect of avoiding permanent capital loss at the portfolio level is to ensure that
multiple investments do not share the same individual risk of permanent capital loss. This
situation is the illusion of diversification. A manager might decide that an auto insurer, a life
insurer, and a super-cat reinsurer are all cheap, winding up with 30% of the portfolio invested in
these companies. One might observe no correlation between the results at these three businesses
for a long period of time, but does that mean that they are not correlated? Well, what if a major
earthquake strikes southern California? All of a sudden these companies have huge correlated
losses at the same time. While it is not pleasant to contemplate such events, one ignores them at
one’s own peril.
We try to be diligent and realistic in the ways our investments can fail. We demand a
margin of safety in the prices we pay for businesses to try to mitigate the chances of permanent
capital loss when one of these events occurs. We also strongly prefer to invest in businesses
where the chance of permanent capital loss is very low. We believe that these policies are a
significant factor in Cook & Bynum’s substantial outperformance over the last seven years.
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MAKING DISCIPLINED ALLOCATION DECISIONS
January 2009
This past year was difficult for virtually every asset class. Our results would have been
significantly better if we had had the foresight to simply hold cash. We were not that prescient,
but our policy of simply ignoring companies that we do not understand, use too much leverage,
have weak management, or do not have any competitive advantage we can identify (“invert,
always invert”) means that we did not own any banks, brokers, automakers or any other highly-
levered companies that have gone or may soon go bankrupt. The shares of some of the
companies that the fund owns have been marked down to fire-sale prices as fear has taken hold.
We liquidated several positions and added one new major position in the fourth quarter. We
liked the positions that we liquidated, but the reality was that the market offered some even more
attractive values. We sold a sizeable stake in one of the world’s most successful retailers to buy
into arguably the world’s best consumer products company through two different securities. We
have the cheapest portfolio and the most places to put cash since we began in 2001. However,
we do not know if the prices for assets will decline materially in the short term from these levels.
In January, we have continued to move assets from good opportunities to great ones.
Unfortunately, none of us can eat our relative outperformance over the last year. We put little
stock in our ability to predict when either the economy or the market will turn around, but our
lack of leverage and stable of quality businesses give us the liberty to wait. And just as
importantly, because we own quality businesses, we expect that the fund will both avoid
permanent capital loss and earn an acceptable return when the market begins to recognize the
intrinsic value of our holdings. We suspect the returns from holding equity securities in general
will be more than satisfactory over the next 20 years from these levels. We hope our investing
discipline will allow us to do somewhat better than the market generally over that period. We
always prefer the S&P 500 to go down as we intend to be a net buyer of stocks for years to come.
Lower prices generally will allow each dollar invested to own a larger percentage of the world’s
earning power.
♦♦♦♦♦♦♦♦♦♦
GREEDY WHEN OTHERS ARE FEARFUL

April 2009
The first quarter of 2009 saw continued turmoil and fallout from the bursting of the
housing bubble. The broad-based decline of virtually all equity markets around the world
continues to present us with attractive buying opportunities. We can give no assurances that
businesses that we believe are bargains at current prices will not continue to be marked down
even lower, but we expect returns from these levels in the businesses we own to be more than
satisfactory over the long run.

We further worked to increase our long term expected returns by selling cheap businesses
in order to buy cheaper businesses. Your assets are invested in strong businesses whose
competitive positions should improve as weaker companies fall by the wayside and struggle to
compete with better brands, better execution, better balance sheets, etc. even if the strong
businesses earn less in the short run.
♦♦♦♦♦♦♦♦♦♦
PRICING POWER AND THE POTENTIAL IMPACT OF INFLATION

April 2009
The recent shifts in monetary and fiscal policy in many of the world’s largest economies
have made it timely to discuss the effects of inflation on intrinsic value. Pricing power is a key
factor to predicting how a business will perform in an inflationary environment. To what extent
can a business pass on increases in the costs of raw materials to consumers through increases in
the prices of finished goods? Businesses have many different answers to that question.
Businesses with a high value added are likely to be able to pass on all inflationary costs, which is
a tremendous advantage. Proctor & Gamble sells everything from Gillette razors to Crest
toothpaste to Tide detergent. P&G’s moat consists primarily of their superior brands (years of
advertising and quality not easily duplicated), and secondarily, their worldwide sourcing and
distribution. In an inflationary environment, if the costs of their raw materials go up, they have
enough pricing power to pass along the costs to their consumers. The individual products are not
so expensive that one is likely to trade down, and substitutes are generally perceived to be
inferior.
We have previously written about understanding the demand surface for a company’s
products. You cannot estimate these surfaces mathematically – the data do not exist – but you
must understand the interplay of the demand for the product versus all of its substitutes and
complements to judge the quality of a moat even if you can only imagine the surface in 30
dimensions. Snickers has a great demand surface. Consumer demand around the current price is
relatively inelastic. A customer who is craving a Snickers has little demand for its substitutes at
the same price. Snickers sells at a large markup over the costs of production. The demand
surface has a particular shape allowing Snickers to have a lot of pricing power. It also helps
greatly that the product is extraordinarily cheap relative to an average person’s earnings or
wealth.
Now imagine the demand surface for an airline company. Say you are trying to fly from
Chicago to New York for pleasure – there are many direct flights, airlines and airports from
which to choose. Flights run basically all day and late into the night. A flight’s cost is a non-
trivial expense. Because of the absolute cost of air travel, the average flyer is very price-elastic.
Pricing is largely determined by demand surface as opposed to the supply of planes, pilots or any
other factors, as an individual airline cannot meaningfully raise prices without losing a lot of

passengers to its competitors. A unilateral increase will simply mean that airline is pricing itself
out of the market. Customers are quite willing to accept substitutes such as flying another
airline. Just as importantly, a good many customers are flying on a discretionary basis. If prices
are too high, they will simply decide not to travel at all. Consequently, prices will tend towards a
very low return to the owners of airlines. Airlines are likely to have a hard time passing on
increases in the costs of their inputs.
We do not make forecasts for markets and are certainly not macroeconomic traders;
however, we would be remiss if we avoided considering the positive and negative effects of large
changes in inflation or interest rates, etc. on the profitability of our businesses. While the United
States has experienced a relatively benign inflationary environment since the stagflation of the
1973-1981 period, we would be foolish to assume that the economy of the 1970’s or worse is not
possible. Conversely, Japan has experienced massive asset price deflation and a close to zero
interest rate environment since its market peak and property bubble in 1990. Luckily, we do not
have to be able to predict the economy in order to understand how economic variables can affect
the intrinsic values of the businesses we buy and sell as well as those we choose to avoid
altogether. We should and do try to think about how prepared our businesses are for such
inevitable shocks.
♦♦♦♦♦♦♦♦♦♦
EXPANDING THE GEOGRAPHIC CIRCLE OF COMPETENCE

November 2009
Your managers have just returned from an extended trip to Argentina and Chile to
research divisions of businesses in which we currently own stakes as well as to broaden our
circle of competence. We spent several days in Buenos Aires, Argentina followed by a driving
trip through much of northern and central Argentina. We then flew to Santiago, Chile from
Cordoba, Argentina for meetings and drove on to southern Chile. Some of our Mexican and
South American investments are consumer products businesses, and we know of no substitute for
shoe leather and tire rubber for seeing how the businesses are really performing compared both
to their potential as well as to their competitors. We love making hundreds of market visits to
judge presentation, pricing, execution, marketing, distribution, competition, etc.
We were able to spend a great deal of quality time with many levels of management in
one of our core holdings and to get a much better understanding of what is actually happening on
the ground. This company’s management is doing a terrific job in their execution. The people at
a variety of levels in the organization are very talented and motivated. We were pleased to see
that they were spending all of their time digging the moat around their business deeper and no
time maximizing profits for the short-run. The company is implementing a number of
intelligent, high-return capital projects, and we are confident that they will have several more
years of easy decisions to make. We love this kind of business – one that earns high returns on

invested capital while presenting management with easy decisions instead of difficult problems.
Hopefully, we will be able to purchase shares at bargain prices for years to come.
On the trip we were also able to prospect a number of potential businesses in both
countries. We believe that we meaningfully enhanced our network of contacts while widening
our geographic circle of competence. While the overall level of these markets may not be cheap
currently, particularly in Chile, we need to become prepared for when the markets do become
cheap. Favorable demographics, high savings rates, and low government pension/medical
liabilities are just a few of the characteristics that many emerging and recently emerged markets
exhibit that will provide helpful tailwinds to investors. Additionally, we can magnify our
informational and decision-making edge in such places because a large percentage of Western
managers and investment banks simply refuse to bother with such places. Many that do invest
are not doing the type of on-the-ground work that we think gives us an advantage. The less
sophisticated the market participants and the more difficult the research, the greater the
likelihood that we can identify good businesses trading at irrationally low prices.
♦♦♦♦♦♦♦♦♦♦
THE IMPORTANCE OF PRICE

April 2010
One of our four guiding principles of investing is to be disciplined about the price we pay
for any security. Our circle of competence includes many businesses that possess attractive
durable competitive advantages and that are run by capable management. However, unless the
market offers bargain prices, we cannot build in the appropriate margin of safety your capital
deserves when deployed. This concept is vital to our investment program because we will
inevitably make mistakes when evaluating the quality of a business or the people running it.
When we evaluate the thousands of facts we can accumulate to predict the future
prospects for a business, we are inevitably making hundreds of quantitative and qualitative
judgments. We are judging the strength of balance sheets and cash flows. We are judging how
deep the moat around the business is. Is this moat getting bigger, or is it shrinking? Is
management being honest with themselves as well as with us? Etc. Each of these judgments is
subject to some error because information is not perfect. We have to guard carefully against the
psychological misjudgments that would cause correlation in these errors. Additionally, many
endogenous and exogenous factors that we cannot even imagine will affect the future of a
business. One cannot know everything, and some things that are very important may not be
knowable. Nevertheless, when one invests in a company, one makes either an explicit or implicit
prediction of all of these factors.
The only prudent way to account for the uncertainty is to keep a laser-like focus on the
price we pay to acquire any security in a business. By this we do not mean that we quibble over
a few cents per share when acquiring or disposing of businesses. We use trading algorithms and

strategies to try and achieve the best execution, of course, but the larger principle is that we are
only willing to invest in a business when it is so cheap relative to intrinsic value that we have an
appropriate margin of safety built in. Do not be fooled by the fact that you can “calculate”
earnings to the tenth of a penny; GAAP accounting is full of accruals and estimates which may
or may not reflect actual business conditions. Intrinsic value calculations are only
approximations, so the logical way to reduce the chance of permanent capital loss is to only buy
at a substantial discount to our appraisal. The first rule of investing is to not lose money, so we
will not deploy your capital at what we feel to be substandard rates of return for the risk being
taken. Every decision to invest in a company carries an opportunity cost because that capital can
be deployed elsewhere in another security or elsewhere in time. Cash is the great cushion that
allows us to sit and wait for great opportunities. Our mandate is to buy concentrated positions in
good businesses at bargain prices – not to own equity securities at any price. When bargain
prices are not prevalent, we will wait patiently.
♦♦♦♦♦♦♦♦♦♦
AVOID THE LOSER & THE ‘TOO-HARD’ PILE

October 2010
Short-term quotational changes in the value of a business do not concern us. We do,
however, spend a significant amount of time thinking about how we might suffer permanent
capital loss in a holding, as this type of loss is a major obstacle to long-term investment success.
How can we foresee and avoid such occurrences? We are constantly thinking about what event
or confluence thereof will cause the business results of a company to be significantly worse than
our expectation. Bruce Berkowitz summarizes this concept succinctly by asking, “How do we
die in an investment?”
For each business in which we invest, we think about the inevitable march of certain
trends like the “Wal-Mart effect.” We define the Wal-Mart effect as the increasing domination
of retail by a few large, sophisticated operators like Wal-Mart, Costco, Home Depot, Tesco, etc.
What effect does this phenomenon have on vendors, customers, real estate developers, and
competitors? Many vendors do either the majority of or the plurality of their sales through Wal-
Mart. Do the increased sales volumes generated through this channel offset the lower margins
created by Wal-Mart’s purchasing power? Does a Proctor & Gamble have an advantage versus a
smaller consumer products company with Wal-Mart, or does Wal-Mart and/or the end consumer
take all of the benefits regardless of the vendor size? Does the Wal-Mart effect aid the vendor’s
business in the short run only to damage it in the long run? This trend is but one of many ideas
that must be considered in order to understand the future of a wide variety of businesses.
We have a long list of such trends, many of which are interrelated, that we constantly
think about because they impact the competitive dynamics of industries and markets all over the
world. The most important of these trends currently is the Internet (we know this is not exactly a

ground-breaking insight). We suspect the creative destruction caused by the Internet is just in its
infancy; what has happened to newspapers is just the tip of the iceberg. Pricing for all manner of
goods and services has become almost completely transparent. The incorporation of this trend
into our thought processes may or may not enable us to predict a winner, but it increases our
ability to avoid the losers.
----------
Compared to most investors, we put many more businesses in the “too-hard pile.” We do
this for a couple of reasons. First, we try to be disciplined in admitting our ignorance about
many things as we respect the boundaries of our circle of competence. Second, we frequently
see more uncertainty in the future than the typical investor does. You cannot be successful as an
investor if you uncritically accept the status quo. We think our focus on recognizing the
potential for disruptive change will help us reduce our exposure to permanent capital losses in a
variety of businesses and industries. Some of our ideas about the disruptions emerging in
education illustrate how we find uncertainty where conventional wisdom sees stability.
The current lecture/test model used since the Middle Ages was the best method of teaching pre-
Internet, but its weaknesses include:
 It presupposes student homogeneity. Students are expected to have similar prerequisite

backgrounds, to have similar aptitudes, and to move through the pertinent subject matter
at the same pace. Testing occurs only on material covered during fairly long intervals of
time (six weeks or so in many cases), and regardless of whatever mastery students
demonstrate over the tested material, everyone moves forward. As the teacher attempts
to adjust for the variances in the class, the pace inevitably becomes too slow for some
students and too fast for others. The result is a poor fit for the majority of students –
certain students lose interest and become bored while others fall further and further
behind because they never grasp the building blocks required for the next level of
material.
 The schedule is inflexible and does not match natural learning patterns. Current
teaching styles are generally based on a broadcast model that requires a physical
classroom, which forces students to congregate at the same time and place. This
requirement makes one hour minimum classes a virtual requirement and, by default,
teachers must move through material in a linear fashion. The end result is a general
decrease in comprehension across the board, which can worsen as a class moves forward
through a semester.
Computers and the Internet currently allow a different approach than what is employed in
the current model:

 Increase the digestibility and interconnectedness of subjects
– Break lectures into smaller pieces that match typical attention spans and allow
students to move at their own pace through material
– Cease assigning a low value to students’ time; if a student grasps a particular set
of material easily, he should be freed to spend time on another set he is struggling
with or should simply be allowed to advance to new material altogether
– Centralize content so students can easily cross-reference other subjects as needed
to promote improved comprehension (e.g., a 15 minute lecture on Ancient Greek
History may mention The Iliad, which includes a click-through to an introductory
lecture on Homer)
– Use the scale and the low cost structure of the Internet to allow lectures to include
far better visual demonstration, graphics, art, etc. (e.g., take a virtual field trip to a
reactor while studying nuclear energy to bring the subject alive)
 Let effectiveness rather than proximity determine from whom a student learns
– Have the “best” lecturer in each subject teach the subject matter regardless of his
physical location (this opens the world of “teachers” to anyone who can properly
convey an idea beyond the traditional boundaries of tenured professors, teaching
assistants, or education majors)
– Test the effectiveness of and subsequently rank various teachers in real time
through video viewing statistics and scores on follow-up quizzes (reward the best
lecturers in subjects and eliminate the substandard ones)
– Offer parallel tracks through material depending on the students’ identified
learning skills and preferences (visual, auditory, etc.)
– Create a mechanism whereby a student can ask for peer intervention from
virtually anyone on the web (even allow students to rate the effectiveness of peer
interveners and to pay these “tutors” through PayPal or another system)
 Continually assess comprehension to reduce the number of students falling behind

– Test more frequently for fluency in the covered subject matter to identify and then
remedy budding deficiencies
– Pinpoint when a student is stuck on a particular section or subject matter and
concurrently notify a teacher who can intervene one-on-one
 Mine all of the data that can be captured with the Internet-based system to continually
improve the science of education
Not surprisingly, the changes implied by this new and different approach are already
happening. A gentleman named Salman Khan began tutoring his cousin over the phone a few

years ago, and he gradually recognized that he could do better job teaching her by using a
simultaneous virtual chalkboard. From there he realized that he and his cousin would not always
be able to line up their schedules, so he used a simple and readily accessible software program to
pre-record his lectures. He posted these lectures on YouTube, and now he has thousands of
lectures and tests up on www.khanacademy.org. We encourage you to visit this wonderful
website. His model can fundamentally change the current educational system from kindergarten
through PhD level programs. Academic Earth presents another interesting and competing vision.
Its program combines all of the free material from such esteemed institutions as MIT, Stanford
and Yale. You can even get a degree, which begs an important series of questions:
 What if you are a self-motivated 18-year-old in Harbin, China; Santiago, Chile; or Cape
Town, South Africa? With a netbook and an internet connection you can have access to
the best teaching in the world.
 What if you are a self-motivated and intelligent 18-year-old in Boston, MA? Would you
pay a six-figure premium to get a similar education at Harvard? Is there a smaller
premium you would be willing to pay? Depending on the ultimate answer to this
question, the fixed cost structure at most higher education institutions could doom them.
Bill Gates postulates that when a disruptive technology comes along, the normal course
of things is for an upstart to embrace the technology and to replace the entrenched market leader
that seemingly has all of the advantages. If that is so, we suspect Salman Khan’s model will
beat the tens of thousands of PhDs he is competing against within education. The medieval
college system could fail quickly like the newspaper industry, or a hybrid model could develop
that can persist for many years to come (especially at institutions blessed with a massive
endowment or a taxpayer subsidy). Regardless of the actual outcome, we feel uncomfortable
projecting the income statements of many universities in 2020. We do feel comfortable putting
the higher education industry in the “too-hard pile.” To predict a great many businesses and
industries, we must analyze disruptive trends like this one while also anticipating new ones. We
believe that this type of vigilance and unusual thinking will serve to protect your capital.
♦♦♦♦♦♦♦♦♦♦

COMMITMENT BIAS
January 2011
It ain’t what you don’t know that gets you into trouble. It’s what
you know for sure that just ain’t so. – Mark Twain
Any honest post-mortem of the investment decisions we have made at Cook & Bynum
over the past nearly ten years will reveal plenty of mistakes. We have made mistakes because
we lacked perfect information. We have made mistakes because we improperly processed the
information we did have. And we have made mistakes because a variety of psychological
misjudgments have undermined the rationality of our thinking. Of course, it is not possible to
avoid all mistakes, but we do work diligently to avoid, as Charlie Munger describes it, “our fair
share of folly.” We believe, as Mr. Munger has also previously stated, that the avoidance of a
small percentage of mistakes will have a significant positive impact on our investment results
over the next forty years.
We try especially hard to avoid the pernicious effects of commitment bias. The
psychologist Dr. Robert Cialdini defines commitment bias as, “our nearly obsessive desire to be
(and to appear) consistent with what we have already done.” 4 Once a person makes a decision,
the human tendency is to misprocess subsequent data in support of that original decision. People
twist new data to confirm a hypothesis rather than rejecting it and forming a new hypothesis
incorporating these data. This powerful tendency to remain consistent at all costs also results in
people selectively gathering evidence and recalling only corroborating information from memory
while concurrently ignoring contradictory information. The compounding nature of successive
mistakes caused by this bias can lead an investor into a powerful non-virtuous cycle. When
combined with other standard psychological misjudgments 5, this cycle can be potentially ruinous
for an investor.
To avoid falling into these traps, we spend most of the time after we have purchased a
security discussing and analyzing why we might have been wrong to have done so. Given the
presence and power of the aforementioned bias, the subsequent information that supports our
decision to buy a company will be easily digested, but the critical information that reveals an
error in our thinking will be much more difficult to process. Therefore, our mindset must be one
that involves constantly questioning all of our core assumptions about a business. We should be
thinking about hypothetical developments that would disprove our original assumptions or
render them moot. This type of thinking makes it more likely that we will recognize mistakes
before they result in a permanent loss of capital.
We also attempt to avoid these psychological misjudgments by using a “buddy system.”
Anyone who has spent time with the two of us will tell you that we relish the opportunity to
4
Cialdini, Robert B. Influence: The Psychology of Persuasion. New York: William Morrow and Company, 1993.
5
For a discussion of these standard misjudgements, please see the talk/essay entitled “The Psychology of Human
Misjudgement” found in Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger.

challenge each other’s ideas and assertions. This activity is not simply good sport; we believe
that this environment helps prevent either one of us from walking too far out on a ledge. We are
certainly capable of falling into groupthink, but many simple errors are avoided by our rigorous
questioning of one another. We do not know everything that the other knows, but we can
generally ascertain when the other is outside of his circle of competence.
Interestingly, standard practice in the money management world is for managers to
promote with great conviction the positive aspects of their holdings while ignoring or dismissing
the negatives. The manager is supposed to defend vigorously the decisions he has made. This
approach sounds good in the media or in investor meetings, and its practice is reinforced because
it is effective in attracting new investor dollars. But this behavior actually increases the
probability of commitment bias because the commitment has been made both publicly and
repeatedly. For us, talking with potential investors about the appeal of Company A will likely
decrease our chances of noticing or appropriately synthesizing contradictory information. This
type of proselytizing increases our chances of succumbing to commitment bias in our investment
decisions. Instead of resorting to this standard practice, when we are compelled to talk about our
largest holdings, we try to open a window into our process of looking for the reasons why we
might have been wrong to purchase the business in addition to why we own the business. We
believe that this is the correct strategy both for making intelligent investment decisions as well as
for attracting the right kind of investors.
We suspect it is peculiar to devote a substantial part of our letter to a discussion of
mistakes for the third time in a year, but we strongly believe that our commitment to challenging
our own ideas is critical to your success. We must remain appropriately detached from the
businesses in which we invest in order to generate outsized returns over long periods of time.
♦♦♦♦♦♦♦♦♦♦
DISSECTING AN INVESTMENT
April 2011
As a way of further elucidating our investment approach, we wanted to illustrate the
research and investment process for one of our major holdings, Embotelladoras Arca, S.A.B. de
C.V.
Coca-Cola in Mexico
Going back to some of our first trips to Mexico, we have always been struck by the
strength of the Coca-Cola business there. In Mexico, Coca-Cola enjoys a much better
competitive position relative to Pepsi and to other brands than it does in the United States due
primarily to:
 Brand Dominance. More than sixty years ago, when it first entered the Mexican
market in a significant way, Pepsi attempted to gain market share by offering its

products at a lower price point than Coca-Cola. Mexican consumers, as consumers
typically do with low-priced, branded consumer products, equated the cheap price
with low quality. That brand positioning in the minds of the Mexican consumer has
not changed appreciably since. Our extensive channel checks across Mexico find
Pepsi consistently selling at a 10-30% discount to Coca-Cola on the shelves of many
different sizes and types of retailers. Pepsi is generally priced similar to the important
B-brand, Big Cola, which is produced by a Peruvian company. In fact, we think it is
more accurate to think of Pepsi as a “B” brand in Mexico, with no “A” competition
for Coca-Cola at all.
 Distribution Excellence and Reach. In Mexico, about 64% of beverage sales occur in
the informal market of “mom and pop” stores. These stores can be converted living
rooms, roadside stalls, or small corner shops and are logistically difficult for a bottler
to service. Because of their sheer numbers and the low sales from each, being able to
profitably distribute to all of these mom and pop stores requires substantial market
share and scale. Only four companies in Mexico have built these advantages: Coca-
Cola (the bottler in each territory), Grupo Bimbo (bread & confectionary), and the
dominant brewer for each area. 6
We have visited hundreds of these mom and pop stores. In a very small one, we
typically will not find Pepsi or other B-brands for sale at all. In a medium-sized store,
we may find competing brands, but what stands out most are the advantages that have
accrued to the market share leaders in each category. In these stores, Coca-Cola
products will be available cold in refrigerators while competing products almost
always will be hot on the shelf. The Coca-Cola bottler installing a cooler in Latin
America can typically triple the sales of a particular point of sale, materially aligning
the interests of the vendor with Coke. Pepsi’s scale in both capacity and brand
presence is too small to afford the necessary capital expenditures to invest in coolers
or the other aspects of a first class product presentation.
 Product Offering Depth & Breadth. Volume leadership gives the Coke bottlers the
critical mass to run a successful returnable bottle network. Returnable presentations 7
still represent more than a third of sales in Latin America. The profit margins on soft
drinks sold in returnable bottles are substantially higher than those for beverages sold
in disposable PET (plastic) presentations. With superior market share, Coca-Cola can
offer Coke, Coke Light (Diet), Coke Zero, Sprite, and Fanta in single serve, one liter,
2 liter, and 3 liter presentations in many points of sale. By contrast Pepsi is typically
6
FEMSA controls beer sales in northern Mexico, and Grupo Modelo controls the central area, including Mexico
City.
7
For clarity, “returnables” are glass bottles that are returned by consumers when they exchange empty bottles for
filled ones or for a deposit. Bottlers can reuse the returnable bottles 15-20 times.

only able to offer a single returnable presentation, if a returnable presentation is
available at all.
The returnable offering benefits consumers as well as the bottlers. The breadth of
presentations available to the Coca-Cola bottler provides strategic options with their
pricing to different economic groups. If Pepsi is selling its 2 liter PET presentation
for 14 pesos, Coke can offer a returnable 2 liter presentation at the same price (with
inherently better margins) along with a 1.5 liter PET presentation at the same price.
This “bracketing” is powerful; a consumer can choose between a cold returnable
Coke in the same size and price as the hot Pepsi in a nonreturnable bottle, or choose a
cold Coke in a smaller-sized nonreturnable bottle. Over and over again consumers
choose the Coke product, reinforcing the brand’s position in their minds.
Research of and Investment in Arca
These favorable market dynamics are strengthened by the tailwind of a generally young
population for whom Coke is a cheap, aspirational good. We have previously owned a sizeable
stake in FEMSA, which among other things owns about 1/3 of Coca-Cola FEMSA, which is the
largest Coke bottler in Mexico and Latin America. We bought FEMSA in part because we
recognized what a wonderful business they had in Coca-Cola FEMSA. Unfortunately, the free
floating shares of Coca-Cola FEMSA did not trade cheaply enough relative to intrinsic value for
us to purchase directly (i.e. it provided an insufficient margin of safety). So we began looking at
the other publicly traded Coke bottlers in Mexico and Latin America more generally to see if
there were any with similarly robust business dynamics at cheaper valuations.
Embotelladoras Arca fit the bill. Arca’s sole territory at that time encompassed most of
northern Mexico, which is the best Coke market in the world. Citizens there consume over 600
8oz. servings per capita per year of Coca-Cola products compared to U.S. per capita
consumption of about 400 8oz. servings per year. Northern Mexico is generally hot and dry and
home to most of the Mexican manufacturing base for U.S. exports, which helps make the
territory the wealthiest per capita in Mexico.
Arca was created through the merger of three independent, family-owned bottlers in
2000: Proyección Corporativa, S.A. de C.V. (“Procor”); Empresas El Carmen, S.A. de C.V.; and
Embotelladoras Argos (“Argos”). The newly formed company subsequently went public in
2001. Because the overwhelming majority of the company’s shares were controlled by the three
families, free float was small. Without a large free float available to trade, Wall Street firms
were unable to generate large commissions by creating research pieces about Arca. A rather
extraordinary company with a $2Bn U.S. market capitalization and solidly growing business
remained underfollowed.
We already had a good lay of the retail land from our many hours and miles driving
throughout the Mexican countryside on previous visits to investigate other opportunities. In
September 2008, we designed an additional driving trip through four bottlers’ territories,

including Arca, Contal, and Coca-Cola FEMSA, specifically to compare and contrast their
execution in the marketplace and to visit Arca’s headquarters in Monterrey. We set out from
Birmingham and drove to Tampico along the Gulf of Mexico, inland to Aguascalientes, and then
turned back north to Monterrey. It was clear that Arca was executing very well in both the cities
and the countryside. The company distributes to around 194,000 points of sale in its territory of
17 million people while averaging $7,392 in annual revenue for each point of sale. If Pepsi were
to distribute to all of these points of sale, it would probably average an unprofitable $1,000 per
point. We had previously studied the financials and were intrigued that a company of this size
could be trading for 7x forward net earnings while paying roughly a 9% dividend yield.
Operating margins were above 20%, and they are generally sustainable because of the business
moat characteristics mentioned above. Net debt has remained below two times EBITDA giving
the company a Mexican AAA rating from Standard & Poor’s. In total, we were able to buy a
wonderful business, run by outstanding professional managers appointed by the three families
who had their net worths at stake. The company operates in an industry we feel comfortable
predicting and was selling at a very significant discount to our calculation of intrinsic value.
Once we returned, we began buying all of the shares we could find.
Subsequent developments where Arca made particularly effective capital investments

caused us to like the company even more:
 Argentina. Arca purchased the bottling assets of several private bottlers in northern
Argentina that did not have the capital or the expertise to invest optimally in their
businesses. We flew down to Buenos Aires in the late fall of 2009 to examine the

acquisition for ourselves as well as to check out the competitors and peers. 8 During
this trip, we drove almost 2,000 miles through Argentina and Chile over two weeks to
see everything in person from bottling plants to the market. We spoke and toured
with regional managers who were singularly focused on digging the moat around
their businesses deeper and could not have cared less about next quarter’s earnings.
Many of these folks had worked at the private bottlers and had chafed under the
limitations of inadequate capital and contented owners. Under the Arca umbrella
they have been empowered and incented to grow the franchise value for the long run.
This change showed in their obvious passion for the business. You will not learn the
same thing about a company by speaking to a polished investor relations person at a
conference in Mexico City or New York City.
While traveling in Chile and Argentina, it was apparent that Arca was leveraging its
successful, time-tested distribution methods and readily available capital to execute
better than its competitors and to compare favorably with its Coca-Cola bottling
peers. In fact, in less than 18 months Arca had increased its share of its Argentine
market by over 5% through a series of simple initiatives:
– In Argentina, B brands are even more important than Pepsi (in a good deal of
Latin America, Pepsi simply hitches a ride on a beer distributor’s truck;
presentation and stocking are frequently poor as a result). One apple-flavored
B brand was especially popular in Arca’s Argentine territory. In response to
the B brand’s share of that market (about 7% of CSD9 sales), Arca worked
with The Coca-Cola Company to develop a Fanta Apple drink with a similar
taste to the local B brand. In the first three months, this new Fanta Apple
offering took 70% share in the apple flavor category. In a business where
driving volume is critical to remaining competitive at dispersed points of sale,
this type of improvement further deepens the moat around Arca’s business.
The B brands have less capital to both distribute and advertise. With the
success in the apple-flavored segment, Arca is duplicating the model in other
fruit-flavored categories currently being ceded to local B brands.
– Relying on the software and systems they had developed in Mexico, Arca
rolled out handhelds for their truck drivers that improved market sales data,
inventory management, and route optimization.
– Arca began a marketing initiative to encourage the purchase of more
profitable single-serve offerings in a territory where familial (large bottle)
sizes were the norm. Despite having lagged Brazil, Chile, and Mexico in
economic growth over the last 20 years, Argentina is still one of the wealthiest
8
Buenos Aires is controlled by Coca Cola FEMSA. Central Argentina and Southern Argentina are controlled by
Chilean-based public bottlers Andina and Polar, respectively.
9
CSD = Carbonated Soft Drink

per capita countries in Latin America. Arca management was tapping the
previously unfilled demand for a single-serve presentation.
– Arca invested in refrigerators and presentation/signage at points of sale.
 Bokados. As a new initiative in Mexico, Arca is leveraging the strength of its

distribution network by building a snack food business. Since Arca has a relationship
with all of the relevant points of sale, it makes sense to offer snack foods instead of
ceding that business to Frito-Lay. Consequently, Arca purchased a regional snack
food manufacturer, Bokados, and began immediately expanding the business and
placing the products in Arca’s distribution channels. The first few years of results
appear promising with sales rising 15% in 2010.
We love businesses that are continually confronted with “easy” reinvestment decisions
like these that produce a virtuous circle for them and continuous challenges for their competitors.
With these investments, we were more convinced Arca’s moat was expanding as they took
advantage of the opportunities presented. We increased the size of our stake as we revised our
calculation of intrinsic value upwards from what we had originally estimated. Our chief regret is
that at current prices, we will not be able to continue to buy the company with new investment
dollars. Though this investment summary is admittedly an incomplete picture, we hope it
demonstrates the framework we use to evaluate a business.
♦♦♦♦♦♦♦♦♦♦
EINSTEIN, CERN AND THE LIMITATIONS OF MODELS

October 2011
In 1905, a twenty-six year old patent clerk named Albert Einstein upended nearly two
centuries of conventional thought when his ideas of Relativity displaced Newtonian Physics.
Newton's model was useful and an enormous achievement but imperfect at explaining our world
– especially for objects or particles moving very fast. Einstein’s theories have now underpinned
a century of thought in Physics, but Einstein acknowledged that his theory could be wrong. He
even hypothesized a way to disprove it when he said, “No amount of experimentation can ever
prove me right; a single experiment can prove me wrong.” He meant that one needed simply to
find something that travels faster than the speed of light. Recently, physicists at CERN on the
Swiss/French border have experimented with sending neutrinos 450 miles through the earth to
detectors in Gran Sasso, Italy. The trouble is that the particles showed up on average about 60
nanoseconds earlier than anticipated, which implies that they exceeded the speed of light. While
it very well may be that some sort of error in experimental construction or measurement occurred
and the General Theory of Relativity still holds, it reminds us that we should be cautious about
relying uncritically on the models we have developed to explain our world.
This recent episode reminds us of George Box’s maxim that, “All models are false; some
are useful.” When we try to predict the future of a business, we must allow for the fact that

things can happen which we cannot even conceive. We believe past manias, bubbles, panics,
and depressions clearly indicate that the “unexpected” happens far more often than Wall Street
acknowledges. As increased computing power has lowered the costs of complicated
computations, risk management departments have proliferated at Wall Street banks and hedge
funds. These risk managers rely on complex statistical tools that attempt to understand and
manage the exposure of their firms to the millions of trades making up their balance sheets. At
the core of many of these tools, such as Value at Risk (VaR), is the assumption that security
prices will trade in a normal distribution (“bell curve”). Just because assumptions of normality
work well in the natural sciences and other disciplines where statistics are used regularly does
not mean a normal distribution fits financial market data. While we do believe that security
prices cluster around intrinsic values, we actually have little certainty about the frequency of
outlying events. We propose that the statistical tools used on Wall Street would have a better
chance of explaining “outliers” if they were instead based on Student’s t-distribution, which have
fatter tails than normal distributions and can be shown to be robust against departures from
normality10.
In other words, t tests have a better chance of protecting investors if their assumptions about the
way things will behave are wrong. The application of Student’s t-distribution and the
willingness of decision makers on Wall Street to acknowledge the limitations of their ability to
predict unexpected events would have a profound impact on their approaches, and they would
significantly reduce leverage and risk-taking while concurrently diminishing the likelihood of
bankruptcies. Of course, because the adoption of this framework would also decrease expected
short-run profits substantially, we do not suspect it will happen.
This same phenomenon of underestimating the frequency of outcomes that general
wisdom considers outliers has meaningful applications for operating companies as well. For
example, standard MBA theory requires businesses to manage their working capital as tightly as
possible through initiatives like “just in time” inventory management. While these programs
have merit, short-term inventory savings must be counterbalanced against the opportunity costs
10
King, M.L. “Robust Tests for Spherical Symmetry and their Application to Least Squares Regression.” The
Annals of Statistics Volume 8, Number 6 (1980): 1265-1271.

associated with being unprepared for rare events, such as this year’s earthquake off the Pacific
coast of Tohoku. While we will never know the total amount of lost sales of the Japanese car
makers from their supply chain interruptions, it would be interesting to know if the money they
saved on inventory over the past fifteen or so years has more than offset the forgone profits from
their current lost sales. Managers should recognize that squeezing suppliers, employees and
customers is not without an opportunity cost that must be judged with a long time horizon rather
than a short one. In fact, they should structure their balance sheets and the amount of cash on
hand in anticipation of negative externalities such that their companies are prepared to profit
when opportunities present themselves. The Mexican Coca-Cola bottler we own did just this in
the 2008 financial crisis – they put reserve capital to work when weaker competitors were
suffering. Their gains in market share over the last two years demonstrate the wisdom of
allowing for extreme events, understanding the impact of opportunity costs, and having a long
time horizon.
Ultimately, our models are necessarily inadequate at describing reality, so we spend time
thinking through their limitations to avoid mistakes. We continuously contemplate and discuss
how the individual businesses that constitute the Fund’s portfolio are positioned for the
unexpected. Following Einstein’s example, we hypothesize what would alter our expectations
for a business, and we recognize that our valuations are just theories, not certainties. We try to
purchase businesses whose understanding of the world influences them to take a long-term
perspective and structure a conservative balance sheet. On top of that we only purchase a stake
in a business when the market offers a margin of safety to allow for mistakes we may make or
events we cannot foresee. We believe this strategy helps to reduce the risk of permanent capital
loss.
♦♦♦♦♦♦♦♦♦♦
WAL-MART DE MEXICO POSTMORTEM

December 2011
Despite the generally poor performance of many emerging markets, one of our Mexican holdings
has become very expensive relative to our appraisal of its intrinsic value, even when accounting for the
decline of the peso versus the dollar. Subsequent to year-end, we began liquidating our position in Wal-
Mart de Mexico (“Walmex”), and we expect to have completely exited it by the time you receive this
letter. We first purchased this remarkable business in 2007 11, and it has more than doubled in value since
then. The first time we visited Monterrey, Mexico we asked the management of Soriana, Walmex’s best
competitor, all about their business. The recurring undertone of the discussion was that Walmex was light
years ahead of Soriana in all phases, and Soriana was using Walmex as a model for what they should be
doing. We visited Walmex’s management the following week in Mexico City and were blown away by
the sophistication of all aspects of their business. Since then we have made hundreds of store visits to
11
Incidentally, Richard owned shares in the company, which was named Cifra at the time, when he was 12. Cifra
entered a joint venture with Wal-Mart in the early 1990’s and ultimately sold a controlling stake to the Arkansas
retailer in 1997. Unfortunately, Richard did not hold onto his original stake.

Walmex’s various formats as well as to Soriana’s and to those of other competitors, including the
informal market. We have seldom seen a company with competitive advantages as big as those Walmex
enjoys – larger than even the advantages Wal-Mart (US) had over its domestic competitors in 1990. The
combination of exceptional operations, the accumulated knowledge of best practices, a deeper
management team, and superior access to capital makes Walmex truly an extraordinary business and
perhaps the finest large company in the world. In fact, Walmex has significantly outperformed our most
optimistic expectations over the last six years. Nonetheless, at the current price we no longer feel that the
company trades at an adequate discount to our appraisal of its intrinsic value, which regrettably leads us
to sell the business. We hope one day to buy it again when the price provides an appropriate margin of
safety.
♦♦♦♦♦♦♦♦♦♦
THE MIND OF A VALUE INVESTOR

December 2011
Seth Klarman, one of the best investment thinkers and writers of our discipline, recently gave an
insightful perspective on the mindset of value investors during an interview with Charlie Rose:
Value investors have to be patient and disciplined, but what I really think is you need not
to be greedy – if you’re greedy and you leverage, you blow up. Almost every financial
blow-up is because of leverage. And then you need to balance arrogance and humility.
When you buy anything, it’s an arrogant act. You’re saying: The markets are gyrating
and somebody wants to sell this to me, and I know more than everyone else so I’m gonna
stand here and buy it. I’m gonna pay 1/8 more than the next guy wants to pay and buy it.
That’s arrogant. And you need the humility to say: But I might be wrong. And you have
to do that on everything. 12
The human condition is such that investors are rarely deficient in arrogance, but humility in decision
making tends to be in short supply. We are relentlessly trying to impose a system of checks in an effort to
resist this negative natural propensity, including constantly challenging the assumptions key to every
current and potential holding. Nevertheless, mistakes are inevitable, which is why the exercise of
planning for them and then over-engineering – insisting upon a margin of safety by price paid being a
fraction of appraised value – is vital to investing success. This foundational element of Ben Graham’s
method helps to guard against basic human foibles.
12
A link to the full interview can be found in the C&B Notes section of our website at cookandbynum.com/cb-notes.

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♦♦♦♦♦♦♦♦♦♦

Excerpts from Quarterly Letters

WHEN “MR. MARKET” FRETS, OPPORTUNITY KNOCKS

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 2

GEOMETRIC MEANS, KELLY CRITERION, PORTFOLIO CONSTRUCTION, ETC. 1

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 3

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 4

THE PSYCHOLOGY OF ERRORS

1. People tend to think every new idea is a good idea.

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 5

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 6

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 7

Price of Good Demand Curve

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 8

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 9

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 10

THE DANGER OF LEVERAGE

“INVERT, ALWAYS INVERT”

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 11

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 12

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 13

GREEDY WHEN OTHERS ARE FEARFUL

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 14

PRICING POWER AND THE POTENTIAL IMPACT OF INFLATION

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 15

EXPANDING THE GEOGRAPHIC CIRCLE OF COMPETENCE

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 16

THE IMPORTANCE OF PRICE

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 17

AVOID THE LOSER & THE ‘TOO-HARD’ PILE

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 18

 It presupposes student homogeneity. Students are expected to have similar prerequisite

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 19

 Continually assess comprehension to reduce the number of students falling behind

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 20

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 21

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 22

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 23

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 24

Research of and Investment in Arca

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 25

Subsequent developments where Arca made particularly effective capital investments

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 26

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 27

 Bokados. As a new initiative in Mexico, Arca is leveraging the strength of its

EINSTEIN, CERN AND THE LIMITATIONS OF MODELS

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 28

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 29

WAL-MART DE MEXICO POSTMORTEM

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 30

THE MIND OF A VALUE INVESTOR

© 2012 COOK & BYNUM CAPITAL MANAGEMENT 31

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