Thomas Russo - In Investing, "Then What?" Is a Very Good Question
An influential event in his life was Warren Buffett’s visit to Professor Jack McDonald’s class in 1984 at Stanford Business School. What struck him about Buffett was that he came across as a person who spent most of his time thinking about things that made sense to him, unlike things they taught at Stanford, which didn’t make any sense to him. For someone who started off as a bond analyst and later became an analyst with the Sequoia Fund, Thomas A Russohas really come a long way to make his mark as a value investor. He manages over $6 billion through separately managed accounts and the flagship Semper Vic Partners Fund. Russo has delivered a net annualised return of 12.61% since inception against 8.48% for the S&P 500. The 58-year-old attributes a large part of his success to Warren Buffett’s investment philosophy that propounds the importance of focusing on what you know and stretching your investing horizon to allow companies to compound value. Not surprisingly, a large part of his portfolio comprises foods, spirits and consumer companies that he believes have global brands, extensive reinvestment opportunities and the potential to keep growing.
How did the 50-cent dollar bill become one of your touchstones in investing?
A 50-cent dollar bill is just an expression that Benjamin Graham used and Buffett incorporated. The fact of the matter is that businesses are really dependent on timing. If you truly get a 50-cent dollar bill and the dollar bill doesn’t grow, your rate of return is completely driven by when you close that discount. When Graham wrote about it, one had to just take a look at the balance sheet to get that number. But today there are many liabilities that don’t appear on a balance sheet. For example, if you have to close a company on environmental costs, you cannot quantify pre-termination costs for labour and other claims. If you have a difficult time assessing liabilities because of legislation, you are probably better off finding a dollar bill that will grow in value. But then, that comes from the capacity to reinvest. However, a question that arises is: will managers invest enough, since the investments would come at the cost of earnings? For example, take the case of a hedge fund [Highfields Capital Management] that is averse to the Canada-based Tim Horton’s Coffee expanding in the US market. The fund wrote a letter to the CEO saying, “You have to stop making those investments as you are reporting losses and we want to ensure profits.” Despite upfront losses, investors should applaud a good long-term investment because if companies stop spending they can’t create competitive advantage.
How many companies in recent times have met your other investing criterion: the capacity to suffer?
Cadbury, which has a great market presence around the world, was doing a good job in China where it spent a lot of money, moving from the three big cities to tier 2 or 3 cities. They were losing money because they are in the process of developing a market. I was delighted because they had the first-mover advantage in 200 markets with over 1 million people. Then came along Kraft, which wanted to see better numbers. Soon enough, they closed down the 200 tier 2 or 3 markets, delivering back to investors seemingly better profits but one that ended up destroying value. They were losing money but they were developing a preference that would have played out over time. Or, take the case of Starbucks, which lost money but today has a leading position in China because of coffee. Now, coffee is habit forming and highly branded. I think they built something of lasting value. We have in our portfolio of spirits companies, those that were willing to go to China when the prospects weren’t that exciting. They have really great powerful franchises and yet they have only penetrated 1% of the market. That is a lot of opportunity.
But how do you know whether a very important capital allocation decision will translate into something meaningful down the years?
Take the case of Amazon and Barnes & Noble. Barnes & Noble decided to launch an electronic reader to take on the Kindle from Amazon. Now, Kindle wants to go after the iPad with Kindle Fire, but then it’s actually a touchpad. Barnes & Noble is better off keeping money in its pocket rather trying to come up with an e-reader, nor should Amazon pursue a product that will end up competing with Samsung touchpads. It is not a fair fight. In the case of Barnes & Noble, they are probably not going to get a return from their initiative. It is a judgement call and I have no way of knowing [whether it will succeed]. But in Amazon’s case, I am pretty sure there are millions of businesses that fear its [Amazon’s] capacity to reinvest and its ability to build a new platform to enter verticals that were once the privilege of a few. Even a company as vast and oppressive as Google is, in some ways, challenged by Amazon. If you are looking to buy a TV you will end up searching on Google, but if you are a believer in Amazon you trust yourself to get a good deal.
In India, ITC generates a RoE of over 100% in its tobacco business but is losing money for the past 10 years in its food business comprising biscuits, noodles, confectionery and dairy. We now have a situation where Nestlé, which lost money in the noodles business for 25 years before turning the corner, is facing intense competition. But the market is taking a favourable view of Nestlé versus ITC’s capital allocation decision. Between the two, what determines which one has a good or a bad capital allocation?
In a new category such as confectionery, ITC doesn’t have an aspirational heritage. ITC has great distribution and it can get the product into the market. But it’s my belief that, when it comes to making a choice, a first-time consumer who has to buy a chocolate will probably opt for Nestlé’s Kit Kat over the former because somewhere in the back of his mind Kit Kat is registered as a great aspirational brand. The same will hold true for Nestlé if it decides to enter the cigarette business and is willing to invest million of dollars to displace ITC. As long as ITC doesn’t lost focus of its cigarettes business in its attempt to go after the chocolate market, leaving its brands unprotected, I wouldn’t give Nestlé high marks for gaining traction in the cigarette business. So that’s a culture thing. Now, for example, Nestlé can source ideas from all over the world, but ITC can’t seek out its parent BAT for a best chocolate mix. It has no other sources for consumer insights and information for products. So, therein lies the answer.