This interview took place on May 2, before Tom Russo gave his presentation to the 10th Annual Value Investor Conference in Omaha. Russo is a partner at Gardner Russo & Gardner, a firm with over $5 billion under management. He was previously at the Sequoia Fund, and has degrees from Dartmouth and Stanford. Last year, his partnership returned 22%.
Holly LaFon: Every time your portfolio comes out, I want to know if you bought a new stock, and every time the answer is no, you haven’t bought anything new.
Tom Russo: Since June. Of ’10. But we’re all in suspense.
HL: Are you ever going to buy anything new?
TR: Definitely. The most likely places that they’ll probably pop up are counterparts to the same businesses that we already own because the economics are good for Richemont (XSWX:CFR, Financial). They sell precious jewelry and luxury goods and watches to aspirational consumers around the world. The same economics drive Swatch. I don’t own Swatch, in big measure. I own it for a handful of clients. But that’s kind of the natural sourcing ground for me. I don’t own Compari. I do own Pernod Ricard (PDRDF, Financial), Diageo (DEO, Financial), Brown Forman (BF.B). Compari’s a great company. They have different brands and strengths in different categories than the three companies that we already own. I could own Compari.
Likely what would cause the moment that something would change is somebody will report numbers that disappoint and the stock will unwind because there’ll be a lot of panic and we’ll have an opportunity to rethink a position. What happened in 2010 why Anheuser Busch and InBev and Mastercard came in was that the things that were disturbing to the market were things with which I was very comfortable. And so the extra discount to which the shares traded provided an opportunity to buy what I would have liked to buy already, on sale, for reasons that I thought were passing and unimportant.
HL: I was going to ask you about Richemont because I’ve heard you talk about luxury goods and it seems like you’ve research that a lot, but I don’t see a lot of it in your top holdings. It seems like those were more skewed toward –
TR: It’s a one-off isn’t it? That’s why we said – what could be the source of new ideas? We’ve got Richemont, you have Louis Vuitton Moët Hennessy (LVMH, Financial).
HL: Okay. So you still think the luxury goods sector is a good one?
TR: Yeah, and what’s going on today there’s a lot of confusion and hand wringing over whether that’s true.
HL: What’s your perspective?
TR: The questions are: Is it still true if China imprisons people who wear watches that cost more than $50,000, will you get thrown in prison? We don’t know whether that will get so severely restricted, and if so whether it will be enforced, but that’s concerning the market obviously. The market will key off on the news.
Just to give you a sense of how volatile the market is, you just have to look back to the start of last week when gold did a free fall. Gold! Of all things. It did a complete free fall. It’s because the market doesn’t quite know what to do with slowing down China. So it took the news about China’s slower, somewhat softer economy and it’s extrapolated out into commodities generally speaking and into gold particularly. But that shows you the kind of reference that we live in. And yet it’s the kind of things that can make for a fairly rich opportunity.
If a 7.7% Chinese GDP is the signal that we’re about to go into global recession, I’d say that the signal’s being misread, and I will use that chaos that ensues to hopefully find some opportunities. That’s how I look at it.
That sets the tone. I have no real opinion about gold, at all. But what I’m impressed with is how you can see the kind of swings that you saw about news that requires extrapolation. You have to take the news and work with it and come up with all sorts of other reasons, and suddenly you can become nervous and unsettled.
HL: I know you’re a big fan of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) – that’s a large holding. Do you like the new portfolio managers? Do you think that they’re going to help your returns?
TR: Yeah, very much so.
HL: They’re obviously really good, right?
TR: Warren said something about them in the annual report two years ago, which is he gave them credit for having the capacity for knowing what is knowable and important. He often says investing is about knowing what’s knowable and important, and he gave them praise for having that skill. More recently he’s not only given them high praise but also substantially increased amounts of money to manage. And in addition, he credits them for increasing contribution across the organization into other areas of responsibility. So I would think that even though it would not end up to his portfolio credit, that Ted would have been very involved in the acquisition of ResCap. And I think the investment of ResCap is probably better off because of his ability to handle it. And I suspect that Todd may have had some contribution to Bank of America (BAC, Financial), which is a very important investment that Berkshire made, and for IBM (IBM, Financial), which was a big investment.
HL: He had to do with IBM?
TR: I only surmise he could have because in the past he’s been known as an investor who has done an enormous amount of work with mortgage pools. The biggest risk with BofA is what’s going to happen with the mortgage risks. So, if he arrived with a strong capacity to understand that, I just can’t help but think that must not surface in the conversation. And IBM he once owned IBM in size at his partnership and I’m sure he must have owned it for the same thesis which drove Warren to it, which would be something along the lines of a deep business moat because of the high switching costs.
HL: I wanted to ask you about your return in 2012. It was so good. What happened that year?
TR: I think it was Berkshire generated a return, which it hadn’t for a while, in part responding to its large share buyback, and the reaction that the market had to the implied higher intrinsic value represented by the fact that they were prepared to pay a higher premium over book value. So, that was a component. The international companies which were under such investor concerns because of Europe being slow and because of China being weak. The companies delivered good results and the market’s fears lifted, and so businesses like Nestle and Heineken and Richemont, the ones that were somewhat stalled because of those investor fears, as those fears lifted with performance underlying the business, the shares reacted positively. With the concentration of 70% of the money in the top 10 holdings, if a couple of those get it right there’s a big portfolio affect.
HL: You mentioned share buybacks, and I noticed that Nestle was going to cease them in 2011. So are those just not important to you, or what are your thoughts?
TR: Well, I think share repurchases are fabulous, at the right time for the right reasons. And I think dividends are fine at the right time for the right reason. But nothing is right at all times, especially for the wrong reasons. The problems with companies is that they take as Warren says a good idea to the extreme on Wall Street, and that’s usually the source of trouble. And so, if our businesses traded at discount to intrinsic value and we redeployed all the capital we can to grow the business and we’re still left with excess. Then a buyback’s good, and that’s what Warren did last year.
I thought Warren’s buyback was particularly valuable because his successors, whoever they are, even thought Warren has said that he’s a fan of buybacks, his successors would have always struggled if they had tried to implement it a buyback with the argument that Warren doesn’t do that, why do you? And now they don’t have that problem because they put $1 billion dollars and a half to work in buybacks already.
HL: They think of everything.
TR: Yeah. It certainly means that when the time comes that a buyback may be the right thing, they won’t have to face the threshold question, well, why didn’t Warren do it when he ran the place.
HL: And you’ve held Nestle (NSRGY, Financial) for a long time.
TR: I first bought Nestle in 1987, and it was at that time it was very difficult to buy, and it’s probably compounded at close to 15% every year since then, total return. And it’s partly because it was so unloved at the start that the returns have been so strong. But I’ve held it for 30 years, and it’s grown in large measure because of that capacity to reinvest, and we have this beautiful portfolio of brands. And they have the capacity to suffer. So for example they had global leadership in coffee, in Nescafe. On top of that they identified the single-serve coffee business as very on-trend because of the increasing number of people who live alone and who also want to have choice and variety. So it’s no longer enough to brew a pot of Maxwell House for 10 people because you have a big family. You’re living alone you want to have variety, you want to have just enough so you don’t waste. Single serve plays a big role in that. And they were willing to invest so heavily behind the development of Nespresso that they didn’t break even for 15 years. So I admired them. They have great domain expertise in coffee. And they have the capacity to suffer, through 15 years of not breaking even, to perfect the product so that by the time it came out it was a true winner. And so with that careful background, today the business does close to $5 billion. And it’s a very solid important franchise. That culture, of being able to take your domain expertise and move from one product to the next and then invest behind it to try to get it right, without rushing to try to show early profits, is at the heart of what I’ve learned from these businesses that do it right, as things required to have permanent excellence.
HL: That seems like what they’re doing now with their nutrition business? That is really interesting because my friends all care about nutrition, health, everyone talks about food.
TR: The question is, can Nestle capture your interest? For example, one of the great misses of our generation would be Chobani, Greek yogurt. You think about Greek yogurt from a business standpoint, and the number one company in the business, Yoplait, completely took a pass at it, when it was just starting out. It’s more nutritious, it’s better –
HL: Yeah, all my friends love it.
TR: Yeah. And yet, the traditional people didn’t define that value strongly enough, and the outsider now owns the category. Greek yogurt is now a safe 50% of yogurt and Chobani is 16% of that category. So out of zero, they now have a 30% share of domestic yogurt. And they never should have let that happen. That’s a really damning outcome.
HL: I didn’t know Yoplait didn’t own Greek yogurt. That’s what I think of when I think of yogurt.
TR: No. And now Greek yogurt brands like Chobani and La Flag, or something, all of those today have dominance in the domain. And so if Yoplait tried to bring the brand over, people would say that’s not Greek yogurt, that’s old stuff.
HL: Yeah, the other stuff seems fancier, and from another country, and so on. Do you have any thoughts on market valuations?
TR: Higher! Than they’ve been.
HL: Yeah! Why is that?
TR: And that’s too bad. And you understand that in my own world, I actually think ours might be a little less high than they look, and a lot of companies may be higher than they seem, because I think lots of business take steps to overstate their current results and sort of let the future be as it is because they’re not going to be around.
Our family-controlled companies I think are more inclined to take steps that burden the near term because they’re really trying to build for the next generations. And so, if our companies trade for 14-16x earnings, I recognize that that’s higher than 10, and yet I also believe that the current results are partly depressed, and that they will deliver future results. And so I expect that those multiples will go down.
HL: I thought that was a weird question to ask you because you keep things for so long and it’s not like you’re out hunting for the lowest valuation.
TR: Yes, but I do also rebalance. So if something becomes a much higher percentage, I will sell. Because that means it is less undervalued and it’s taking up more of the portfolio. So I will rebalance, and the money will go into the opposite, which is a business that I still think is attractive, whose price is lower and hence it has a smaller weight. It’s more undervalued and a smaller weight and that rebalancing attempts to rectify those two conditions. We’re giving the more underweight undervalued extra cash and bringing the more overweight, less undervalued positions down a bit.
HL: And we just had a few reader questions from people who wanted advice. One person is younger and is managing a portfolio that is $8 million –
TR: First of all, I’d say lucky them! But go ahead.
HL: But they don’t seem to think it’s good enough. They want to know how they can get more assets under management.
TR: The good fortune is that they get to manage other people’s money rather than the $8 million being their own. I believe that the best source of new business is from your existing business. To the extent that they feel you’re offering them an honest and an understandable service that they’ll be willing to invite others to consider you. And that’s been the best source of growth.
HL: The other person wants to know how many hours you spend making your initial purchase whether it’s within or beyond your circle of competence, and how do you know you have enough information to make a purchase?
TR: That’s a great question. I think it’s a question about judgment versus information. The information hunt never stops. But the decision about whether you can trust someone on the most important decision, which is reallocating the investment capital of the company, I think has to happen fairly early on. That decision is about character, and incentives, and an expression of how they view their job as the manager of public assets which you entrust ot them. So that comes from spending time with the CEO and the chairman and the very most senior management.
HL: You spend a lot of time visiting managers and such, right?
TR: Yeah. But it doesn’t take a lot of time, it just takes time. Because that’s going to be a question of the character of those people. And you’ll kind of get a sense for that.
HL: And whenever your companies reinvest, you talk about profit margin decline. Do you think that the profit margins recover gradually or do you just expect them to remain depressed for the foreseeable future?
TR: Well, I think it depends on how long-lasting the investment phase is. Like in Nestle’s case, they could invest a certain amount, 10 years ago it was $1 billion a year in development and emerging markets. They’re now investing $2.5 billion per year. So the original billion that they invested bought businesses that today 10 years later are generating a lot of profits. But the $2.5 billion that they’re investing today puts extra burden on that reported profit flow. I believe it’s a net benefit because that $2.5 will in turn yield its own results down the road 10 years later on top of the results that the first billion a year generated. But 2.5 is a big burden over the 1, and it will continue to weigh on returns. But a business that wants to have a strong franchise in the future has to be willing to spend in the present and that will continue to burden profits.
See Tom Russo's portfolio here.
Holly LaFon: Every time your portfolio comes out, I want to know if you bought a new stock, and every time the answer is no, you haven’t bought anything new.
Tom Russo: Since June. Of ’10. But we’re all in suspense.
HL: Are you ever going to buy anything new?
TR: Definitely. The most likely places that they’ll probably pop up are counterparts to the same businesses that we already own because the economics are good for Richemont (XSWX:CFR, Financial). They sell precious jewelry and luxury goods and watches to aspirational consumers around the world. The same economics drive Swatch. I don’t own Swatch, in big measure. I own it for a handful of clients. But that’s kind of the natural sourcing ground for me. I don’t own Compari. I do own Pernod Ricard (PDRDF, Financial), Diageo (DEO, Financial), Brown Forman (BF.B). Compari’s a great company. They have different brands and strengths in different categories than the three companies that we already own. I could own Compari.
Likely what would cause the moment that something would change is somebody will report numbers that disappoint and the stock will unwind because there’ll be a lot of panic and we’ll have an opportunity to rethink a position. What happened in 2010 why Anheuser Busch and InBev and Mastercard came in was that the things that were disturbing to the market were things with which I was very comfortable. And so the extra discount to which the shares traded provided an opportunity to buy what I would have liked to buy already, on sale, for reasons that I thought were passing and unimportant.
HL: I was going to ask you about Richemont because I’ve heard you talk about luxury goods and it seems like you’ve research that a lot, but I don’t see a lot of it in your top holdings. It seems like those were more skewed toward –
TR: It’s a one-off isn’t it? That’s why we said – what could be the source of new ideas? We’ve got Richemont, you have Louis Vuitton Moët Hennessy (LVMH, Financial).
HL: Okay. So you still think the luxury goods sector is a good one?
TR: Yeah, and what’s going on today there’s a lot of confusion and hand wringing over whether that’s true.
HL: What’s your perspective?
TR: The questions are: Is it still true if China imprisons people who wear watches that cost more than $50,000, will you get thrown in prison? We don’t know whether that will get so severely restricted, and if so whether it will be enforced, but that’s concerning the market obviously. The market will key off on the news.
Just to give you a sense of how volatile the market is, you just have to look back to the start of last week when gold did a free fall. Gold! Of all things. It did a complete free fall. It’s because the market doesn’t quite know what to do with slowing down China. So it took the news about China’s slower, somewhat softer economy and it’s extrapolated out into commodities generally speaking and into gold particularly. But that shows you the kind of reference that we live in. And yet it’s the kind of things that can make for a fairly rich opportunity.
If a 7.7% Chinese GDP is the signal that we’re about to go into global recession, I’d say that the signal’s being misread, and I will use that chaos that ensues to hopefully find some opportunities. That’s how I look at it.
That sets the tone. I have no real opinion about gold, at all. But what I’m impressed with is how you can see the kind of swings that you saw about news that requires extrapolation. You have to take the news and work with it and come up with all sorts of other reasons, and suddenly you can become nervous and unsettled.
HL: I know you’re a big fan of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) – that’s a large holding. Do you like the new portfolio managers? Do you think that they’re going to help your returns?
TR: Yeah, very much so.
HL: They’re obviously really good, right?
TR: Warren said something about them in the annual report two years ago, which is he gave them credit for having the capacity for knowing what is knowable and important. He often says investing is about knowing what’s knowable and important, and he gave them praise for having that skill. More recently he’s not only given them high praise but also substantially increased amounts of money to manage. And in addition, he credits them for increasing contribution across the organization into other areas of responsibility. So I would think that even though it would not end up to his portfolio credit, that Ted would have been very involved in the acquisition of ResCap. And I think the investment of ResCap is probably better off because of his ability to handle it. And I suspect that Todd may have had some contribution to Bank of America (BAC, Financial), which is a very important investment that Berkshire made, and for IBM (IBM, Financial), which was a big investment.
HL: He had to do with IBM?
TR: I only surmise he could have because in the past he’s been known as an investor who has done an enormous amount of work with mortgage pools. The biggest risk with BofA is what’s going to happen with the mortgage risks. So, if he arrived with a strong capacity to understand that, I just can’t help but think that must not surface in the conversation. And IBM he once owned IBM in size at his partnership and I’m sure he must have owned it for the same thesis which drove Warren to it, which would be something along the lines of a deep business moat because of the high switching costs.
HL: I wanted to ask you about your return in 2012. It was so good. What happened that year?
TR: I think it was Berkshire generated a return, which it hadn’t for a while, in part responding to its large share buyback, and the reaction that the market had to the implied higher intrinsic value represented by the fact that they were prepared to pay a higher premium over book value. So, that was a component. The international companies which were under such investor concerns because of Europe being slow and because of China being weak. The companies delivered good results and the market’s fears lifted, and so businesses like Nestle and Heineken and Richemont, the ones that were somewhat stalled because of those investor fears, as those fears lifted with performance underlying the business, the shares reacted positively. With the concentration of 70% of the money in the top 10 holdings, if a couple of those get it right there’s a big portfolio affect.
HL: You mentioned share buybacks, and I noticed that Nestle was going to cease them in 2011. So are those just not important to you, or what are your thoughts?
TR: Well, I think share repurchases are fabulous, at the right time for the right reasons. And I think dividends are fine at the right time for the right reason. But nothing is right at all times, especially for the wrong reasons. The problems with companies is that they take as Warren says a good idea to the extreme on Wall Street, and that’s usually the source of trouble. And so, if our businesses traded at discount to intrinsic value and we redeployed all the capital we can to grow the business and we’re still left with excess. Then a buyback’s good, and that’s what Warren did last year.
I thought Warren’s buyback was particularly valuable because his successors, whoever they are, even thought Warren has said that he’s a fan of buybacks, his successors would have always struggled if they had tried to implement it a buyback with the argument that Warren doesn’t do that, why do you? And now they don’t have that problem because they put $1 billion dollars and a half to work in buybacks already.
HL: They think of everything.
TR: Yeah. It certainly means that when the time comes that a buyback may be the right thing, they won’t have to face the threshold question, well, why didn’t Warren do it when he ran the place.
HL: And you’ve held Nestle (NSRGY, Financial) for a long time.
TR: I first bought Nestle in 1987, and it was at that time it was very difficult to buy, and it’s probably compounded at close to 15% every year since then, total return. And it’s partly because it was so unloved at the start that the returns have been so strong. But I’ve held it for 30 years, and it’s grown in large measure because of that capacity to reinvest, and we have this beautiful portfolio of brands. And they have the capacity to suffer. So for example they had global leadership in coffee, in Nescafe. On top of that they identified the single-serve coffee business as very on-trend because of the increasing number of people who live alone and who also want to have choice and variety. So it’s no longer enough to brew a pot of Maxwell House for 10 people because you have a big family. You’re living alone you want to have variety, you want to have just enough so you don’t waste. Single serve plays a big role in that. And they were willing to invest so heavily behind the development of Nespresso that they didn’t break even for 15 years. So I admired them. They have great domain expertise in coffee. And they have the capacity to suffer, through 15 years of not breaking even, to perfect the product so that by the time it came out it was a true winner. And so with that careful background, today the business does close to $5 billion. And it’s a very solid important franchise. That culture, of being able to take your domain expertise and move from one product to the next and then invest behind it to try to get it right, without rushing to try to show early profits, is at the heart of what I’ve learned from these businesses that do it right, as things required to have permanent excellence.
HL: That seems like what they’re doing now with their nutrition business? That is really interesting because my friends all care about nutrition, health, everyone talks about food.
TR: The question is, can Nestle capture your interest? For example, one of the great misses of our generation would be Chobani, Greek yogurt. You think about Greek yogurt from a business standpoint, and the number one company in the business, Yoplait, completely took a pass at it, when it was just starting out. It’s more nutritious, it’s better –
HL: Yeah, all my friends love it.
TR: Yeah. And yet, the traditional people didn’t define that value strongly enough, and the outsider now owns the category. Greek yogurt is now a safe 50% of yogurt and Chobani is 16% of that category. So out of zero, they now have a 30% share of domestic yogurt. And they never should have let that happen. That’s a really damning outcome.
HL: I didn’t know Yoplait didn’t own Greek yogurt. That’s what I think of when I think of yogurt.
TR: No. And now Greek yogurt brands like Chobani and La Flag, or something, all of those today have dominance in the domain. And so if Yoplait tried to bring the brand over, people would say that’s not Greek yogurt, that’s old stuff.
HL: Yeah, the other stuff seems fancier, and from another country, and so on. Do you have any thoughts on market valuations?
TR: Higher! Than they’ve been.
HL: Yeah! Why is that?
TR: And that’s too bad. And you understand that in my own world, I actually think ours might be a little less high than they look, and a lot of companies may be higher than they seem, because I think lots of business take steps to overstate their current results and sort of let the future be as it is because they’re not going to be around.
Our family-controlled companies I think are more inclined to take steps that burden the near term because they’re really trying to build for the next generations. And so, if our companies trade for 14-16x earnings, I recognize that that’s higher than 10, and yet I also believe that the current results are partly depressed, and that they will deliver future results. And so I expect that those multiples will go down.
HL: I thought that was a weird question to ask you because you keep things for so long and it’s not like you’re out hunting for the lowest valuation.
TR: Yes, but I do also rebalance. So if something becomes a much higher percentage, I will sell. Because that means it is less undervalued and it’s taking up more of the portfolio. So I will rebalance, and the money will go into the opposite, which is a business that I still think is attractive, whose price is lower and hence it has a smaller weight. It’s more undervalued and a smaller weight and that rebalancing attempts to rectify those two conditions. We’re giving the more underweight undervalued extra cash and bringing the more overweight, less undervalued positions down a bit.
HL: And we just had a few reader questions from people who wanted advice. One person is younger and is managing a portfolio that is $8 million –
TR: First of all, I’d say lucky them! But go ahead.
HL: But they don’t seem to think it’s good enough. They want to know how they can get more assets under management.
TR: The good fortune is that they get to manage other people’s money rather than the $8 million being their own. I believe that the best source of new business is from your existing business. To the extent that they feel you’re offering them an honest and an understandable service that they’ll be willing to invite others to consider you. And that’s been the best source of growth.
HL: The other person wants to know how many hours you spend making your initial purchase whether it’s within or beyond your circle of competence, and how do you know you have enough information to make a purchase?
TR: That’s a great question. I think it’s a question about judgment versus information. The information hunt never stops. But the decision about whether you can trust someone on the most important decision, which is reallocating the investment capital of the company, I think has to happen fairly early on. That decision is about character, and incentives, and an expression of how they view their job as the manager of public assets which you entrust ot them. So that comes from spending time with the CEO and the chairman and the very most senior management.
HL: You spend a lot of time visiting managers and such, right?
TR: Yeah. But it doesn’t take a lot of time, it just takes time. Because that’s going to be a question of the character of those people. And you’ll kind of get a sense for that.
HL: And whenever your companies reinvest, you talk about profit margin decline. Do you think that the profit margins recover gradually or do you just expect them to remain depressed for the foreseeable future?
TR: Well, I think it depends on how long-lasting the investment phase is. Like in Nestle’s case, they could invest a certain amount, 10 years ago it was $1 billion a year in development and emerging markets. They’re now investing $2.5 billion per year. So the original billion that they invested bought businesses that today 10 years later are generating a lot of profits. But the $2.5 billion that they’re investing today puts extra burden on that reported profit flow. I believe it’s a net benefit because that $2.5 will in turn yield its own results down the road 10 years later on top of the results that the first billion a year generated. But 2.5 is a big burden over the 1, and it will continue to weigh on returns. But a business that wants to have a strong franchise in the future has to be willing to spend in the present and that will continue to burden profits.
See Tom Russo's portfolio here.
