To: East Coast Asset Management Clients and Interested Parties

From: Christopher M. Begg, CFA – CEO and Chief Investment Officer

Date: July 30, 2014

Re: Second Quarter 2014 Update – Horse in Motion

In East Coast Asset Management second quarter letter you will find our portfolio update and general market observations. Each quarter we highlight one component of our investment process. This quarter, in the section titled Horse in Motion, I will discuss the value of an ownership mindset and how it plays an integral part in a compounding triumvirate with a good business and an effective operator. As is our standard practice, client reporting, including performance and positioning, will be sent under separate cover.

East Coast Asset Management Market summary

An improving economy, reasonable valuations, and low interest rates continue to produce a favorable environment for the owners of equity investments. While year-to-date benchmark returns have continued on an upward trajectory, there has been a greater variance in returns across industries and companies. Due to more attractive valuations we have increased our per-share ownership in a handful of our businesses. We continue to look at businesses that have reached full valuation as sources of capital.

We expect persistent geopolitical uncertainty to test the nerve of investors as we move towards year-end. We do not view this continued unrest as a reason to change our long-term investment strategy of attempting to own some of the best businesses at reasonable valuations. We find solace in measuring knowable business fundamentals and price, which provide the foundation of return expectations and risk. Our objective of investing with a margin of safety and a long-term view of compounding will always be our rein and rudder.

East Coast Asset Management: The (Pari-mutuel) Stock Market

Twenty years ago this past May I began my investing career. In April of that same year, Charlie Munger, who together with Warren Buffett has provided the greatest influence on my investment philosophy, delivered what I believe to be one of the most insightful investment talks of all time. Speaking to business school students at the University of Southern California, he loosely titled his talk “The Art of Stock Picking as a Subdivision of the Art of Worldly Wisdom.” Like many timeless works, the lessons of twenty years ago continue to apply to today’s investment environment.

The lecture highlights a number of mental models that can be used to make rational decisions and then discusses a few mental models that apply to investing. Personally, I have found one of the most important insights to be the lens by which a rational investor should view the stock market: The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a parimutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market. Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. …

The market is based on the collective perceptions of the participants. As bets are made in the marketplace, odds change. When the market participants perceive good business results, the potential payoff or expected return diminishes, and when the market participants do not perceive favorable results, the potential payoff or expected return improves dramatically (if the business proves otherwise). The market for stocks and horses in this pari-mutual pool is quite efficient in tallying up these perceptions and then changing the odds (prices). However, perceptions and reality are very different. When the races are run and as companies are operated, the truths are revealed and we can see, with hindsight, which odds were mispriced. While perceptions do a decent job in the pari-mutuel marketplaces in assessing correct odds to winners and losers in aggregate, the system is perfectly imperfect and thus specific mispricings systematically occur. Our process is built around attempting to find these mispricings – asymmetric investment opportunities.

See full East Coast Asset Management Q2 2014 Investment Letter – Horse in Motion? in PDF format here.