Thomas A. Russo, Partner, Gardner Russo & Gardner oversees investments to the tune of $11.85 billion. He is a periodic guest lecturer at Columbia University's value-investing programme - the world's premier value investing programme headed by Professor Bruce Greenwald.
Mr Russo does not think generating free cash flow is a sufficient indicator of the investment worthiness of a company. Rather investment worthiness is determined by the 'capacity to reinvest' free cash flows and whether such investments create value in the long term.
The search for companies that have the capacity to reinvest turns Mr Russo to concentrate on a few sectors that exhibit such companies - sectors like food, beverages, tobacco and media. Companies that have the capacity to reinvest invariably have strong brands and that's where Mr Russo's stock-picking shines. His thought processes on brands is a masterclass that every value practitioner should learn from and will undoubtedly gain wisdom from. Ekramul Haque interviews Mr Russo to gain insight into his approach. Here are some excerpts. Dig in.
How has the concept of value impacted your investing style?
The metaphor with which Mr Buffett has helped me conceptualise the desire to add a pragmatic margin of safety to my investing has been to 'invest as if you were purchasing vegetables not perfume'. For example, when you look to buy a head of cabbage, you look to the leaves, their color, their feel, their appearance, their smell, their touch and any number of other variables, all of which collectively inform you as to whether or not you are getting your money's worth when you shop for vegetables. The margin of safety comes from assuring yourself on all accounts that the item of desire is worthy and by driving a tough bargain.
Consider just the opposite when one purchases perfume. You are typically invited by attractive cosmetic-counter professionals, designed through their dress, demeanour and delivery to lift as much money from your pocket as possible. With assurances that whatever perfume it is that they sell will change your life one is disarmed and surely susceptible to fascinations. In addition, one would never dare to think of asking for a bargain price off something that can be so potentially life changing as the proper scent. It has been clear to me over the years that I prefer shopping for vegetables than for perfume for the reasons expressed above.
You like family-run businesses. Why?
I prefer family-run businesses because of my belief that through them I can address a primary risk to public market investors, which is agency cost. Agency cost is the likelihood that those people who manage your assets, the owner's assets, do so with their interests in mind and not yours, the owner's interest. You are an absentee farmer, let us say, and an agent is managing crops for you on a farm in Nebraska. He takes too large a share and does things to 'feather' his nest. That risk is compounded in the world of public investing, especially since the late 1980s when stock options became such a furiously used form of remuneration for mainly American company executives.
The benefit of investing with family-controlled enterprises is that the family can exert dominion over managements in a way that faceless public shareholders cannot. They have control, so they can influence the strategic direction. They have control, which allows them to guarantee managers that if they embark on the right investment programs, they will not run the risk of being displaced from their jobs if midway through the investments, the costs of proper long-term-minded investments burden short-term results.
I think a third reason is that they, like me, seek the longest-term returns. The wise family-owned private company will deploy the profits from the current operations and invest at the expense of those profits to build future wealth, thereby minimising taxes and maximising long-term wealth.
Why have you said earlier that it is not enough for companies to throw off a lot of free cash?
The goal of investing is not to find companies that throw off free cash flows. The goal is to find companies that have the 'capacity to reinvest' that free cash flow into expanding the value of the enterprise going forward. It is really the reinvestment of cash flow that in fact is free when it relates to the existing business, but which, if properly deployed, can expand the enterprise enormously. That is the skill you want to have attached to a cash-flow engine.
You look for companies that have the 'capacity to suffer'. Can you explain to our readers what this concept is and why is it important?
The 'capacity to suffer' is required of managements if they are going to be free to invest the right amount that they have, without the fear of disappointing Wall Street analysts on quarterly numbers or without the fear of triggering activists.
A good example is Nestle, involving a product called Nespresso - a single-service coffee system - which Nestle developed for 15 years. To give you a sense of how patient their capacity to suffer was, Nestle did not break-even on developing Nespresso for 15 years. They developed a machine, they developed pricing power, and they developed the club and then they developed the online computer delivery of the single-serve coffee cups.
You also talk about the 'capacity to reinvest'. What is this and its significance?
The capacity to reinvest starts with the brand, which, as I said, is valuable because it is a product, which the consumer believes there not to be an adequate substitute for. I was reminded of what it means to be a brand when I was flying home at one point and the person sitting next to me on the airplane ordered a Jack Daniel's. The steward came back with a bottle of Jim Beam and the person I was with said, "No thank you. I would rather have water." He was brand-loyal to Jack Daniel's. That is extremely valuable.
Through our investments in Heineken, SABMiller, Nestle, Unilever, Cartier, etc., we have portfolio holdings that possess such aspirational items. Our long-term returns will simply depend upon the business manager's ability to open up new markets through investments in infrastructure, route-to-market distribution, advertising, wholesaling, warehousing, and all the things that will get aspirational products within arm's reach of the consumer at the moment of desire.
What happens when companies don't have the capacity to suffer or the capacity to reinvest?
When you do not have the capacity to suffer, you really sub-optimize. A quick example is Cadbury Schweppes. They attempted to open up Western candy to the Chinese market and they succeeded opening up markets in Beijing, Hong Kong and Shanghai.
With that success, they determined that they had developed loyal consumers after a three-year trial and even though it was very loss-making to do trials in those three big cities, at the end they had loyal consumers whose likely lifetime consumption meant that they had very high value to the company.
Cadbury was therefore prepared to invest from that experience into opening up the next 200 largest cities in China (cities with sizes down as small as one million people). Then, Cadbury really started to report start-up losses, because when you open up 200 cities to a product and a category that did not exist before, you have to spend a huge amount of money. Moreover, you are spending that money before there is a demand for your product. You try to create the demand while at the same time investing in advertising, warehousing, distribution, promotion at street corners, etc. You do nothing but lose money early on.
Doing this on a scale of 200 cities simultaneously meant that the operating profit, which was substantial from Cadbury's mature businesses around the world, was increasingly burdened by exploiting their legitimate capacity to reinvest. Despite the deepening reported losses, Cadbury was in the midst of converting consumers to their product, which would have had lifetime loyalties. They were willing to build wealth even while the roll-out was causing reported profits to weaken.
Along came a corporate raider who contacted the company, said that he had 3 percent of the shares that he wanted them to do something better because they were not earning enough money. The following week, the company announced that they would close these efforts in those 200 Chinese markets "because they were too far out in front of market demand."
That retreat increased reported profits but destroyed wealth. Those 200 cities went dark of Cadbury candy. All the people they had converted to date, which was a considerable number, who had lifetime values based on their probability of consuming the products regularly and profitably, were denied the products going forward and the company destroyed wealth even when they could say that they had increased their reported profits by no longer investment spending. That wrong decision was made for the wrong reason. However, the management lacked the capacity to suffer even though it had a brilliant capacity to reinvest.
You talked about companies that sell aspirational products. What is the importance of such companies for an investor?
Abraham Maslow talks about a hierarchy of needs. I am no expert in his theory, but what he talks about does make sense to me. People's 'needs states' create fertile ground for brands. According to Maslow, at some point you are looking for things that say something about you, that the shorthand for telling people who you are is by what you own, consume, wear or drink. There is a huge human aspiration and desire to be a part of something bigger than yourself. Coco Chanel, whose famous business now is at the top of the luxury goods business worldwide, once said that a luxury good, an aspirational luxury good let us call it, is something that "you do not need but cannot live without." I think that it is important if you can find those products that possess such life-enrichening powers.
Berkshire invested in Mid American (utility) and Burlington (railroad), both regulated businesses. When does a regulated business become attractive?
I think one of the very first points as to when they become attractive has to do with the relationship with the regulatory structure and the industry. The regulatory environment is just critical. It either flourishes or chokes off the return on those investments.
Once the regulatory team adjusts to allow for capital to come back into the business profitably, then you have to make sure that you exploit the investments and hopefully come up with best practices that allow you to yield a return from what once was an unrewarding investment into one that can reward because you have added on top of the regulatory scene new business skills that go a long way. Industries that have been relatively non-adventuresome by virtue of regulatory restrictions have not had the best management come into them over the years. So, when the regulatory environment improves, if you could deliver not only capital but also talent, the return on both is going to be quite high.
The Indian subsidiary of Nestle is trading at a trailing twelve month P/E of 46, P&G (India) trades at 62x and Hindustan Unilever at 42x. Are the local subsidiaries attractive to you in spite of high valuations, given that they have a higher earnings growth profile, or would you stick to the slower-growing parents?
I am more interested in the capacity of businesses to reinvest. I think we will end up with a more certain return with the parent company shares of Unilever trading at 15x earnings. The parent company earnings five years from now, reinvesting through companies that have reinvestment opportunities, like Hindustan (Unilever), and enjoying the return from their share of their local company's subsidiaries should offer attractive returns.
I think over time the lower-multiple entry to the admittedly lower growth rate in the parent company will probably out-reward my shareholders than if I went in and paid 50x Nestle India's operation earnings. You have to figure out the differential return required for each security to deliver performance. If you want to end up at 10x earnings ten years from now, the parent company will only need its earnings to grow at just below 3 percent per year for its shares to be priced at 10x earnings ten years out. Nestle India earnings by contrast will have to grow by at least thirty percent per year for ten years for its own share price to equal 10x its net earnings ten years from now. I prefer investments that require less to go right than that whose assumptions under Nestle India's valuation. I prefer as Mr Buffett suggests to step over one foot fences rather than ten foot fences.
Are you a proponent of buy-and-hold forever like Buffett?
My goal is to have a business that can unfold without me having to have the obligation to unload its shares. That requires that they have the capacity to reinvest, that they have the culture that gives managements the capacity to suffer and that they have internal redeployment of capital opportunities that will drive growth in intrinsic value on a per- share basis. If the business slows down its organic growth so that they can buy back the stock at a discount from intrinsic value, that will help keep the investment from languishing and we like it when that happens. Nonetheless, if for some reason the reinvestment rate dries up or the management in some way fails to continue to delight us, we are perfectly willing to sell.
What is your portfolio-balancing strategy? What is your average holding period? Is there a threshold limit for a single stock?
I am comfortable with holding large investments. My top ten holdings are 70 per cent. I have a handful of smaller positions that are being built or are being sold. During the course of a year I will probably rebalance the portfolio around positions that have gone up and have become overweight while they become less undervalued. This is especially true at the same time I have positions that become underweight, even though they have become more undervalued. So, there is a migration from less undervalued holdings to more undervalued holdings that takes place during the course of a year.
As I mentioned before, I am comfortable holding large positions. However, I tend to become uncomfortable when position sizes approach 13 per cent. Maybe that is my unlucky number and I figure I might as well not go above it. I have held stocks in tobacco companies for a long time and through that experience I have witnessed the fact that there is a certain amount that always remains unknowable. The tobacco industry has always been about one more lawsuit, one more way the government is taxing people, one more way of disrupting what seems to be fairly certain. With that experience and those scars I have become humble in my belief of how deeply I can know something. So I tap out around 11 to 12 per cent, rarely go above 13 and if I do I tend to pare in back. Almost everything in the portfolio has been held at least for five years.
How do you chill?
Investment management is a pretty unrelenting business, requiring reading an enormous amount of business-related materials, industry trade journals, newspapers from around the world, etc. However, I do like to find some time to spend reading more broadly, especially interesting books. Some of those books recently read include The Everything Store: Jeff Bezos and the Age of Amazon by Brad Stone, the remarkable story about Jeff Bezos and the insatiable desire for growth inside of Amazon. I also enjoyed the recent book Dream Big by Cristiane Correa on the 3G group of Brazilian investors with whom Berkshire Hathaway is partnered. Most recently, I am reading Erik Brynjolfsson's book The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies, upon recommendation from portfolio company CIE Richemont's, chairman, Johann Rupert. Johann suggests that his understanding of what Richemont needs to do to stay relevant to its long-standing luxury goods clients is partly laid out amongst the observations in this most remarkable book about the dawn of the post-machine age. In addition, one cannot ignore Berkshire Hathaway-related books, with a most recent nod to law professor, Lawrence Cunningham's remarkable recent release, Berkshire Beyond Buffett: The Enduring Value of Values. In addition to Lawrence Cunningham's book, Carol Loomis, Mr. Buffett's long-time editor for his annual reports, captured a remarkable historical perspective in her recently released Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2013. A must read. Finally, the extraordinary revelations about the on-going agency costs burdening the finance industry revealed by Michael Lewis' Flash Boys is clearly worth a summer read.
In addition, I tend to try to carve out some time when I am travelling the world for myself. I try to visit art museums when I go to major markets, as I find the sort of flow of art and the role of society of interest and it is something that I find rewarding. I spend a fair amount of time athletically in both tennis and less so with golf. But most of my free time I spend with family.
This story was first published in July 2015.