I’ve written in the past on what I have learned from one of the greatest global investors – Tom Russo (Trades, Portfolio). I think the concepts of “capacity to suffer” and “capacity to reinvest” are profound. In this outstanding interview with Consuela Mack, Mr. Russo generously shared his further thoughts on “capacity to reinvest.”
Below are my notes:
Q1: What is your view on investing as storytelling?
A: It defines the parameters in which successful investors, it helps describes the questions that are best asked. So the advice and the technique is that you have to know how to ask questions.
Q2: What kind of stories make the best investment?
A: The best investment and stories are the businesses that have the ability to reinvest. Since we manage money for taxable individuals and our goal is to not to have a large turnover. This means we have to learn deeply about the businesses we own on a regular basis. By staying with business we know, we understand if they have the capacity to reinvest and suffer.
Q3: Explain the capacity to suffer.
A: It means the just the opposite of what Wall Street asks. When I meet with management team, my advice to them is for them to reinvest every penny possible. The jargon today is cash flow conversion, which means how much of your reported earnings can you pay out to investors. Wall Street wants that number to be over 100%. I just assume that it’s 0%. I assume the business has the capacity to consume all the capital they generate. An example is Berkshire, never once had they paid any money they generated. That compounding has taken place over decades by retaining every penny and reinvest them well. And reinvesting in that orthodox way gives them an enormous advantage over the years.
Q4: A criticism over Berkshire (BRK.B, Financial) has been the large horde of cash. Investors are saying I’m not paying you guys to basically hold cash. I’m paying you to invest the capital to my benefit. What do you think?
A: My answer is simply over what period of time. The need to have it happen immediately will prevent the better long term returns at Berkshire because it can generate higher return on capital by having the flexibility of having capital available. It’s difficult to reinvest in 2007 and 2006. But it allows enormous return when 2008 came along and that $55 billion cash is able to help GE (GE, Financial), Goldman SachsÂ (GS, Financial) at high rates. He may have earned those money along the way. But when the time came and he knew how to charge.
Q5: What kind of reinvestment opportunities do you look for?
A: I think in our experiences, the best reinvestment opportunities have been companies which have very knowable and appealing brands. Brands perceived to have no adequate substitute. And that in the consumer’s mind develops the manufacturer price-inelastic demand. The manufacturers are able to raise the price. For those businesses who happen to have awareness in consumers’ minds in developing market, it’s the reinvestment from the market that can no longer absorb the capital into these markets that can fully absorb the capital that generate high return on capital. It is in markets that have the brand awareness but not have the capacity to consume currently will have the capacity in the future, which is population growth dependent, consumer’s disposable income independent, which is under way around the world. Think about Nestle with product in 190 countries, they’ve been there forever. But the products have been out of reach forever. Today the products are in reach because Nestle is developing the route to markets, the advertising, and investment in retail channel to make them available. With that availability comes rising affordability as GDP per capita growth.
Q6: Your top 10 companies are 70% of your portfolio; 36% of that focused portfolio comes from emerging market. So the international piece is very important to you, why?
A: Because that’s where the growth will come from. We struggled with companies that lack the capital redeployment opportunity because they are geographically constrained. The business with a natural place to deploy the capital is just so much easier. I’ll use Brown Forman (BF.B, Financial) as an example. Twenty-eight years ago, their share crashed because of the problem of a poorly situated acquisition they bought in California. The family took the capital and developed a global market. At the time, there were only five markets in which they sell more than 50,000 cases. But they were willing to invest against current income for the future because they believed in the strength of the Jack Daniel brand. Today there are 50 markets where they sell more than 50,000 cases. It was expensive to do so against current income.
Q7: What do you mean by “capacity to suffer”?
A: It has to come through gears of underreporting income because of the investment burden placed upon by upfront spending. And that is something that very few companies possess because the concerns of requirement of Wall Street analysts to have predictable and excessive near-term profits and the pressure from activists who are telling management team if you don’t do something now, we’ll have someone come in and do it for you. In Brown Forman’s case, the family control structure can serve as a protection against those outsider pressure. It’s the same for Heineken or Richemont. So the management team at Brown Forman that has been driving the penetration globally has the security that knowing what they are doing is what they are hired to do. They will not lose the mandate simply because of institutional shareholders coming in and owning a large portion of shares. That gives us more comfort as shareholders that the future will be brighter. Interestingly the equity market generally don’t charge a premium on family controlled businesses. The measure of how you value that business is quite interesting because one thing you’ll recognize is that you’ll have underreported earnings so you P/E will be higher than businesses which are not willing to invest for the future. So P/E may lead to a different outcome when you are dealing with a business such as BF.B, which has been reinvesting so long for the future and current reported earnings significantly understated the true earning power of the business. The beauty of the businesses with capacity to suffer is that their competitors have been asked to do everything today but our companies with longer time horizon have better future prospect because the investment they put on the ground face less competition whereas the other people could easily be on the wrong side if they are being asked to return money and not burden income with future spending. Businesses that can absorb those realities of the reinvestment are much better off.
Q8: Is there a better metric than earnings then?
A: Market share. The growth in market share. In Brown Forman’s case, we’ve gone from five markets with 50,000 cases to fifty markets with 50,000 cases. We’ve gone from half a million cases of Jack Daniels to over 10 million cases. That’s a very important development because the next 10 million cases will generate far higher profitability than the previous 10 million cases.
Q9: You had a tailwind prior to this because the dollar was declining. Now the dollar has been strongly accelerating and that hurts your portfolio. What do you do?
A: First we visit the companies and ask them what can you do? And frankly there’s nothing much they can do. Phillip Morris (PM, Financial) does business in all other countries and they pull it back in dollars. They reported $4 plus or minus a share for years. But with constant currency it would be close to $6.5 per share. So the amount of earnings they reported affected by translation is much lower than had they not reported any foreign exchange headwinds. The real goal isn’t to have a currency neutral portfolio but to have our client’s money in markets where growth is faster.
Q10: You have held many of your top 10 holdings for many decades, even through financial crisis. Why?
A: The fact is that those are great businesses, great brands. It’s very hard to find the combination of businesses behind which you can invest with management who cares about investing for the long term, with owners willing to share with you on equal terms. It’s very valuable to find that alignment of interest and lack of agency cost. I can’t find them broadly and when I find them, I tend to stay with them.
Q11: Are you comfortable with Berkshire Hathaway beyond Warren and Charlie?
A: Yes. I am perfectly comfortable. It’s such a rare combination of operating companies that all have their own forward momentum. It’s a fabulous place for the seller of the business that has the kind of virtues that Berkshire seeks because of what they offer. They offer the seller to have a chance to have a liquidity event to de-risk their family in some ways while still have the privilege of operating the business they carefully created over decades with the same people without the pressure of a very quick sale to a private equity firm. It’s permanent capital. That’s really valuable.
Q12: One investment for a long-term diversified portfolio?
A: At this particular moment, it hasn’t been so for a while Phillip Morris is an interesting position. I’ve owned it for almost than 30 years. This is the internationally only business. The dollar has burdened their reported earnings by roughly $2.5 a share. They invested heavily against competitive assault across a variety of markets. They are in the midst of launching a new product that cost them a lot of money, over 2 billion cost in the past 10 years. They have launched in Italy and Japan that product, I think it’s very promising. Phillip Morris has created a product that caters consumer’s changing needs that most e-cigarette doesn’t’ deliver.