This is the transcript of Tom Russo's talk on the 3rd Annual Value Investor Conference held in Los Angeles.
BOB MILES: Welcome to the 3rd Annual Value Investor Conference held each year in Los Angeles in-between Warren Buffett’s Berkshire Hathaway [nyse: BRKa] and Charlie Munger’s Wesco Financial [amex: WSC] annual meetings. It is my pleasure to introduce to you our opening keynote presenter and the first speaker of the morning. You may have read about him in Outstanding Investor Digest [OID], and we've included his biography in your blue registration folder.
The abbreviated version of his bio is that Tom Russo attended Stanford University and received a Masters in Business Administration [MBA] as well as a law degree. As many of you know, Charlie Munger is a big fan and admirer of Stanford finance professor Jack McDonald, so when I mentioned to Professor McDonald that one of his prized students – Tom Russo was coming to speak to you this morning; he said that we couldn't find a finer presenter than Tom Russo.
After graduating from Jack McDonald's class in finance at Stanford, Tom worked for Bill Ruane at Sequoia Fund, which is the only mutual fund that Warren Buffett had recommended to his partners when he closed his original Buffett Partnership. After learning all about value investing from Ruane and Cunniff, Tom joined and became a partner of Gardner, Russo & Gardner, where he has built an extraordinary track record.
So it’s my pleasure to present our first speaker this morning to share his thoughts about global value investing in front of a very global crowd, an audience with representatives from all 6 continents—Tom Russo.
TOM RUSSO: Thank you and good morning. The title of my presentation today is “Global Value Investing.” Global is very timely, just coming back from Berkshire's annual meeting, where Berkshire announced a first and a quite large direct investment overseas. They've been signaling an interest for the past four or five years, and all of the non-U.S. investors in this room who have been going to Berkshire annual meetings for the last five years would have known that.
International shareholders in Berkshire Hathaway have been specially invited to separate sessions from the rest of us (US Investors) to build the Berkshire brand awareness amongst you international Berkshire shareholders, who then returned home and spread the gospel. And the gospel found a convert in Israel just this past month. And we now at Berkshire have a very large foreign and direct investment.
So I'm going to talk about global value equity investing…
…and I'm going to give it more than 40 percent of my best efforts. Even though global stocks -- non-U.S. denominated stocks -- represent only 40 percent of my holdings, they certainly represent a lot more of my awareness. And everything that I do has sort of a benchmark against the opportunity set for comparable investments, and that opportunity set is international.
The fact that over the years I've run portfolios that have roughly been 40 percent non-U.S. and 60 percent domestic is a byproduct of analysis, but it doesn't mean that a hundred percent couldn’t happen, and it's a function of where the businesses are most attractively positioned. I was speaking to somebody in Omaha this weekend, and he suggested that I should start my remarks by saying that I urge all of you to take a very, very short-term perspective about investments, to try to cover all industries and all stocks, to trade your account furiously to make sure you never fall behind any index, and that you don't concentrate your efforts but that you stretch yourself out so you can meet the consultant's requirements of being all things at all times. He thought that if I told you this, it would make my job easier as an investor because you would open up more opportunities for me. But I won't go down that path any farther than just to suggest that it's a possible interpretation of what investors should look for.
I thought I would cover a couple of topics. I'll start with a background as to how I became an investor with an eye towards foreign stocks, describe why someone from the middle of the United States might invest abroad, how I've invested abroad over time, and then close with some observations of the pitfalls--how I invested over the time. Then I'll share with you some observations of how one might stumble in foreign markets, and then finish with some interesting current issues about the global investment scene, and leave time for questions.
I was just speaking a moment ago with someone who actually knows where I grew up, which is a small town in the middle of Wisconsin. And you wouldn't think that would be a great start for global value equity investments, but it had some interesting characteristics. As a child, I did travel overseas a lot and became quite comfortable with early trips to Germany and other parts of the world. And already as an American, that's a subset of all Americans, because half of the Congress of the United States, for example, don't have passports and have never traveled abroad. So there is a certain ethnocentrism that prevails in the United States. And I had the good fortune as a child to travel.
My mother, for some reason, decided it would be good thing for a child growing up in Wisconsin to order newspapers from around the world. So for my tenth grade, we got newspapers from Tokyo and China and all sorts of weird spots. We'd open them up and try to decipher what they were talking about. But it had a particular resonance because I ended up spending much of my professional career investing in newspapers around the world.
The last thing about the town I grew up in was we had a company there named Parker Pen, which was at that time a global brand leader. Many of the people who worked there had exotic stories of travel abroad and building new businesses throughout the world. It was largely a non-U.S. company, so its fortunes fluctuated with currency because their profit streams were foreign.
Another observation I had was that as a child, though I did not have a mandatory paper route -- which seems to be required for all great investors -- I did try to invest early as a child. And the first thing I invested in was Pan American International Airlines. I lost a lot of money on that, but it started me off on the thought about international investing.
After that, I went to Dartmouth where I studied abroad, Stanford Law School and Business School, as Bob said, with Jack McDonald, and then Sequoia Fund where the value investment-- active lessons about value investing--took place. For me, that probably starts the story about investing abroad.
Sequoia Fund was different than any other investment firm that I've come across on Wall Street because they specialize on their own research. There's no contact, even though the firm may serve many billions of dollars, there is no research, there's no sell side contact. It’s based in New York, but really could be based anywhere. They focus on just a handful of industries. They specialize largely in consumerbranded companies, and those consumer-branded companies often have a global reach. Their selected businesses -- food, beverage, tobacco and media industries -- tend to generate substantial amounts of cash flow.
I started there in 1984, just after the 13-year bear market was beginning to churn and equity had begun to interest investors once again. But within short order in the mid-1980s, what developed was the decade of the leveraged buyout. As leveraged buyouts started to increasingly influence the valuation of companies in the food, beverage, tobacco -- remember, RJR sort of typified that -- and the media arena, the domestic valuations of those companies became over-heated.
At the same time as that occurred in the mid- 1980s, the leveraged buyout balloon, the ability to obtain information about foreign companies was increasing, and the competitive landscape for the businesses that I focus on (for example global food companies and global beverage companies) was broadening to include foreign and global competitors. So in the mid-1980s, the leveraged buyout of RJR meant that one of the great possible investments in the U.S. was taken away. But in an effort to understand RJR as an investor, it had become important to look at British American Tobacco, Gallaher, and Rothmans of Canada.
To understand businesses in the areas that I concentrate on (the circle of competence I draw is around food, beverage, tobacco, and media) I had to understand the foreign companies, because they're increasingly the competitive set. Once the domestic valuations for those businesses accelerated because of threatened leveraged buyouts, it was natural to then compare the valuations of their foreign counterparts. They were cheaper, and they remained cheap for quite a long time. And that's what led me into committing substantial amounts of money abroad.
So the question is then--why would an American invest abroad?
It's not a trivial question, because for the first twenty years of Berkshire Hathaway's annual meeting, when asked why Warren didn't choose to invest abroad, his comment was historically, "The U.S. is a very big market." He said, "We have sizable capital, but nothing to exhaust the possibilities by just looking throughout the United States."
His early comments also were that he didn't have the ability to know the people. It's an important comment. Because if you grow up in the United States and you meet somebody who has a background, you pretty well understand the important indices that that background describes to you about character. But if you meet with an English company and the man who runs it says that he went to Marlborough or he went to Eton, in America, those references may mean very little, though in fact they may spell out everything.
Warren's early comments were that he wouldn't be able to make the distinctions as it relates to the most important question that one asks as an investor: Who will manage the business on your behalf, and how will they think of you when they go to reinvest that abundant cash flow that consumer products businesses could generate? You just missed the signals because you were unfamiliar with the benchmarks. And then combine that with the adequacy of the U.S. market to absorb capital. It's really a setting that confronted most American investors when I started out in the mid-1980s.
But going back to Jack McDonald's class--he actually encouraged us in the early 1980s to look abroad. His simple observation was that 95 percent of the world lives abroad. It's a bit presumptuous to think that 100 percent of the interesting opportunities would be domestic when 95 percent of the people live away. That is fairly compelling math.
He made an early fortune investing in Japan, more specifically, in Japanese insurance companies during the 1960s. He also made a substantial investment in a business that he wrote up as a case study called Veuve Clicquot. Veuve Clicquot was a French champagne company, and the business was branded "Champagne of the State." But the interesting aspect of the case was that it was really a balance sheet story, not an income statement story. The balance sheet involved the enormous amount of reserves that were held in their cellar, as well as the real estate that they owned in the champagne region. And the public market value was substantially undervalued (the real estate assets) because they were pretty much focused on earnings per share, and it just showed that.
I was intrigued by that example, and especially so in hindsight because a very large concentration of my investment activity over time has been in spirits companies. It certainly was an early observation.
Investing globally can be very difficult.
The perspective of trying to invest abroad in the early 1980s though was an interesting one because it was quite difficult to do. Information was scarce. Currencies were often fixed and difficult to convert. The classes of securities in which one could invest were restricted. So a good example would be that in the mid- 1980s, I chose to invest in Nestlé. And Nestlé was a difficult company to invest in as an American because you couldn't buy the registered shares, you couldn't buy the bearer shares, which are not registered, so instead you had to buy something called participating certificates in bearer shares. You had to be willing to participate in an instrument that really was a second-class-citizen type investment. That was the world in Switzerland at the time.
Value Investing in India
Fast forward to today. People ask me what about investments in India. And in India, though I'm not really very up to speed on the particular nuances of the Indian market, I do know that a person returned from India excited about a local bank, but the local bank shares trading in India traded for a substantial -- maybe as much as 30 percent -- discount to the price of those same shares as you could purchase them in the U.S. There's a specific facility that's been created for the U.S. In order to invest as a U.S. citizen in those Indian shares, you have to participate in that facility and pay an enormous premium for that. This concept of classes of shares being restricted even continues to this day, even though it's far less burdensome than it was in the mid- 1980s.
At the same time, there was a large amount of friction or extra costs. And that had to do with high fixed commissions and stamp taxes and duties, and the financial process of investing abroad was difficult. There were a few global sub-custodians in the mid-1980s. As you can imagine settling trades abroad was a hair-raising feat.
Different accounting methods and standards can be a challenge for investors when investing globally.
Generally speaking in the U.S., there was still a significant trace of arrogance related to accounting standards. This was before Enron showed that we had little to be arrogant about. But when you'd invest in Europe in the early 1980s, people would ask, "But can you trust the accounts? Can you trust the accounting? And how can you make the adjustments for the accounting so that you know what you're buying is like American stocks that you invest in?" The concern over accounting was something that has over time diminished because we've shown our own abuse.
The early investment universe was also highly restricted because of trust departments in the U.S. If you happened to be serving the needs of a trust investor, most of the time they insisted on having only American Depositary Receipts or ADRs because they required domestic settlement of trades that you could effectively do through an ADR. So the concept of actually owning a foreign stock settled abroad was outside most trust departments accepted terms.
Those are the sort of issues that one confronted. As a result of that, global capital flows just didn't happen, and Americans were not invested abroad. As a result of that, the markets were in many instances a lot cheaper.
At the same time, even in the mid-1980s, Berkshire's chairman was out on the annual meeting circuit talking about the quality, the high quality, of certain businesses versus traditional economics of most businesses. In the early period, Europeans didn't really make that distinction as clearly. So if you had a newspaper company, the shares went down because there was a cyclical drop in advertising. The share price might go down even farther than the earnings decline because people didn't attribute a high standard or a high benchmark for newspapers because they were superior franchises. They traded them as though they were steel companies in terms of the market's fickle nature of embracing those businesses.
As Berkshire shareholders, we would have long learned from Warren's comments that then monopoly newspapers were like a drawbridge; they were a franchise to claim money. If in the marketplace, the newspaper shares were declining, because of economic miracles in a way that U.S. shares just didn't do any longer because people recognized the franchise, it provided an opportunity for an American to go in and purchase what are globally equally good business newspapers at bargain basement prices. There was just a lack of an awareness of the differences between certain types of businesses that open up opportunities abroad. That’s the context that an investor faced then. Some of the issues remain today, but many do not.
Global Value Investment -Weetabix
I'll just give an interesting example. In the early 1980s, I started to invest in a British company, which manufactured a favorite product of my wife, who is British. It's a cereal company based in England. And I started to invest in the shares. I was dealing with a local British broker, Neuberger Berman, which was my prime broker and chief custodian. Neuberger thought we were settling trades, and we went on for years like this. One day, they thought they'd do an audit just to see what number of certificates we had inhouse and sort out what we thought we had.
We were so far off that there was a team in Neuberger that spent the next two or three months trying to chase down certificates that we had assumed were delivered and never were. And they were owed us, but the delivery system that was casually set up then for a reasonably small company just weren't global and they weren't perfecting the trades. We thought we owned them. Neuberger thought they had them.
Finally, we went into sort of a red battle alert and spent weeks and weeks trying to chase down these certificates. We finally got it right, but that just gives you a sense of sort of the primitive environment that one faced.
My own perspective as to why I thought it was important to have a portion of my investors' funds abroad was, on one level, quite specific. Having studied at law school and having sort of recognized the way politics work, I just feel -- then did and still do -- that over time, Americans will devalue their currency. The process of democracy being permitted to promise more to their voters to get votes than they can deliver is a dangerous system. And we see it most forcefully today.
We have promises to make the world safe from all terrorists, and so we spend $90 billion on a war effort, while also promising investors to cut their taxes and the taxes of middle income Americans. With that type of promise, though it seems like we can maintain that construct in the U.S., over time just doesn't last.
As an investor, recognizing the nature of our political process, I felt really early on that it would be a wise thing to have a portion of our funds denominated in foreign currencies. That's one of the kind of macro moments -- one of the very few macro moments I've had over my career--but that's one of them.
I fled the overpriced U.S. market through and by leveraged buyouts, and in the process of doing that felt that the global counterparts were all in better position. So I could look at Hershey in the U.S., but in doing the research would come away with the feeling that Nestlé had a better business, it was more global.
U.S. companies are very often focused (operationally and certainly professionally, the people who work there) on this large and rewarding domestic market. The domestic market is big, it's 250 to 300 million consumers, and it’s the richest market.
At one point, Hershey's said, "That's it. Let's go home."
If you were at Hershey, you actually at one point at the end of World War II had a global business. Your products traveled around the world with the GIs. At the end of the occupation period in Japan, there was enormous demand for Hershey chocolate in the communities around the bases because it was the product the winners ate, and so the locals loved it. At one point, Hershey's said, "That's it. Let's go home." And they gave up what could have been a global franchise in a Coca-Cola-like fashion, as it would have followed the troops around the world. "That's it. Let's go home." And it was perfectly fine because the U.S. market was abundant.
But they didn't develop the people, and they certainly didn't distribute the brand in a way that was global. Think by contrast of Nestlé where they had about one-and-a-half percent of their employees living in Switzerland and something like less than one percent of the revenues are Swiss-generated. Their whole existence, their very essence, is built around nondomestic activities.
So that just makes them much more acutely aware about the market and how to conduct themselves in global markets. At the same time, the people who run the businesses are, by virtue of where the activities occur, far more international than what you have historically found in U.S. companies. If you're looking for businesses that will have the highest probability developing emerging markets or taking advantage of traditional markets abroad, my feeling is just by comparison, that I prefer to find those global leaders abroad.
I remember with Parker Pen particularly early as a kid and then just watching other businesses evolve over time, American businesses have had sort of a love/hate affair with foreign activities because of the impact of currency on the results. Often during times when the foreign currencies were quite weak, they would pull back from operations because they weren't producing the kind of results that they showed for those same operations during periods when the foreign currencies were quite strong.
You had businesses that had an on again/off again involvement with foreign markets. I think the foreign companies with which I've invested have been far steadier in terms of exploiting global opportunities, even despite the swings that currency effects. And that may be in large part because of the fact that they weren't driven by as short-term a compensation package as optionbased U.S. managers were. They had an ability to take a longer view.
It’s sort of a split decision as to whether it's better to invest with American icons abroad or with non-American icons abroad.
Those were my own perspectives as to why to invest abroad. I preferred some currency exposure and I preferred the more international staff that you can get with foreign companies. I think the foreign companies were more patient than what I was seeing in America. And then there is a value around the world in many instances (and this is sort of a split decision) as to whether it's better to invest with American icons abroad or with non-American icons abroad.
For most of my career, America has been very cherished. From the mid-80s through 9/11, you would have had a period of time when if you could have offered Coca-Cola or Nike or any number of American icons around the world, you were really selling something that the rest of the world without exception preferred. But, you know, at some point, those preferences shifted as the loyalties of the world's consumers regard America in different ways.
So to have Nestlé or Heineken or Cadbury Schweppes out in the marketplace means that if there is a sense that American products are less interesting to consumers for reasons that might be political, we have a fairly meaningful portfolio of offerings that go to market without any American sort of stamp whatsoever. Now, I said it's a split decision because there are a certain number of products that are just absolutely coveted for no other reason than because of the American association. So we have both. But it is an issue that you can be aware of.
My first investment in a foreign company came out of the spirits industry.
Veuve Clicquot from Jack McDonald proved to be of interest -- and that investment was in a company called James Burrows PLC, and it was a small English company whose main product was Beefeater's Gin. It's very symptomatic of how the world works in terms of the research process leading to an investment.
Another thing that's interesting about American companies, at least during the '80s and early '90s, is that we as a country have never really been particularly good at handling issues relating to currency. During the mid-80s, Brown Forman shares collapsed because they had made an ill-fated investment in California Coolers. Shares plunged far beyond the cost of that poor investment. I became interested in the spirits industry by looking at Jack Daniels.
It soon became obvious that the spirits industry in the U.S. was consolidating mightily, and that the people who were in the spirits business wanted to concentrate their brands by sole distributors in any given market. What had previously been scattered affiliations throughout many distributors were now allowed to concentrate with one distributor.
The conflict comes from having market share. The James Burrows family-controlled, single product company stood to lose out in that consolidation because they had nothing else to offer. They would lose out competitively. Consequently I was wary of the company. Then I looked at the valuation, and it was extremely reasonably priced at something like six times earnings without real estate from their restaurant business that they had. It was familycontrolled and had been a family-run company for well over a century, and a public family company for over a century.
As an investor in businesses, which generate enormous cash flows, my single most important issue to get right is what management will do with cash flow through reinvestment.
Because it was family-controlled, the British market discounted its value because they feared the company's propensity to self-deal. And I've often found that to be the case. It's an interesting conundrum. As an investor in businesses, which generate enormous cash flows, my single most important issue to get right is what management will do with cash flow through reinvestment. Do they care about the owner, or do they care about themselves? That's the number one thing. It's called agency cost and what's the likelihood that my agent, my hired hand who runs the business that I own as a shareholder (if you think about shareholders collectively), that they're going to think of their own interest instead of our interest? The answer is very high.
Most American companies, especially with options being the source of compensation, the odds are really high that they're going to think about themselves more than us.
So the one device that I've used to try to control against that risk has been to try to line up with family-controlled companies. Because at least in that case, the family can sit at the board meetings and parade over the managers who might want to take our money because there would be some taking of the family's money as well. You have some asleep-at-the-switch, corrupt or just dullwitted families, and it doesn't give you the protection that you'd like. But in some cases you can find that.
Most investors, however, fear family-controlled companies because the stories of corrupt ones or inept ones command attention. The discount is often wide in the family-run businesses. In the case of James Burrows, that was particularly so because it is still completely run by the family.
The family will shepherd your interest.
My feeling is that the family will shepherd your interest if they're honest, and then when it comes time to sell, they won't fight, because if it's right to sell, it's in their interest to sell. Whereas in public companies, they'll fight, because they will lose their position, the only thing that they have in life is their role as managers of the public company, and all the largesse that spins from that.
And sure enough, Whitbread acquired James Burrows. If you consider my Semper Vic 1984 – 2006 annual returns, the end results of this partnership, (which I've run since 1984, my last year at Stanford Business School), in 1987 was a year of unusual out performance. If you remember, it was the year that we had the great crash of October. But one of the reasons why my annual return was up 37 percent in 1987 was that we had made an investment around that time. Remember, I said that Brown Forman fell apart in 1986, so I began to do the research on the spirits industry, and by 1987, had made an investment.
In '87, Whitbread acquired James Burrows, and I thought I'd reinvented the laws of gravity because my partnership annual investment went up so much.
1987, one of my best years of outperforming the Dow Jones Industrial and the S&P 500, was a terrific confirmation that research that starts off of with a domestic company -- in this case, Brown Forman – that embraces the global landscape for their competitors, can uncover a company in a foreign market that actually is an international company based in a foreign market that might be quite under-priced, which is a more adequate investment than the domestic company with which you started the investigation in the first place. So I think that sort of set my antenna up.
A global investor and a value investor
At the same time in the early 1980s, I had asked a very simple question about a product that my wife used to eat, which is a breakfast cereal called Weetabix. And I said, "I wonder if it's a public company." Of course, it was hard then to find out anything about anything foreign, but I did figure out that it was public, it was very mis-priced, and we can take a look at that. So I think it gives a very good example of what it means to be both a global investor and what it means to be just a value investor.
EBITDA = Earnings Before Interest Taxes Depreciation and Amortization
In 1989 (I started investigating foreign companies in '87) this is where it starts. Weetabix's EBITDA was 19 million pounds and it had 7 million pounds of cash. I determined the business was worth 8 times EBITDA plus cash, less debt, and I came up with an intrinsic value of 13 pounds. With 11.87 million shares outstanding it was trading at 5.95 pounds per share. Then each pound was worth US$1.61 So that's the beginning of the story. Now, I would mention that I used the word EBITDA, which Buffett this weekend suggested was false signs and all sorts of horrors would ensue if you even mentioned those six letters in rough approximation to each other. But for me at least, EBITDA is useful because it helps me cross countries because of different depreciation schedules and amortization schedules.
It's one thing to say in a U.S. context that you've looked at pre-tax earnings rather than EBITDA. But when you start to look at Heineken versus Cadbury Schweppes versus Budweiser, and if you don't adjust for those non-cash charges -- and one way to do it is using EBITDA -- you have a more difficult time comparing across the market. I have used EBITDA, and I confess it in front of you.
Moving on, this is a breakfast cereal company in 1989. Intrinsic value, 13, trading at 5.95, very, very undervalued. There wasn't a single broker in London who knew anything about the company. I had a chance to start buying the shares. What appealed to me was they were probably the first company in England, one of the first three companies in England, to use television advertising.
When the question comes up about how does one do due diligence about a company that's based abroad, I say that anytime I meet an English family in Disney World or someplace and they have a little child, I'd go up and say, "Do you eat Weetabix?" and ask questions. And the thing that I was always struck by was they'd come back and say, "Yeah. And, boy, do they have a great advertising campaign."
I remember meeting one ten-year-old, and he said, "When I was nine, they had this campaign. When I was eight, they had that campaign." He could go all the way back from his earliest years and say what the campaign was as it evolved. It was really substantially a part of their corporate culture and their product set.
(To be continued)
BOB MILES: Welcome to the 3rd Annual Value Investor Conference held each year in Los Angeles in-between Warren Buffett’s Berkshire Hathaway [nyse: BRKa] and Charlie Munger’s Wesco Financial [amex: WSC] annual meetings. It is my pleasure to introduce to you our opening keynote presenter and the first speaker of the morning. You may have read about him in Outstanding Investor Digest [OID], and we've included his biography in your blue registration folder.
The abbreviated version of his bio is that Tom Russo attended Stanford University and received a Masters in Business Administration [MBA] as well as a law degree. As many of you know, Charlie Munger is a big fan and admirer of Stanford finance professor Jack McDonald, so when I mentioned to Professor McDonald that one of his prized students – Tom Russo was coming to speak to you this morning; he said that we couldn't find a finer presenter than Tom Russo.
After graduating from Jack McDonald's class in finance at Stanford, Tom worked for Bill Ruane at Sequoia Fund, which is the only mutual fund that Warren Buffett had recommended to his partners when he closed his original Buffett Partnership. After learning all about value investing from Ruane and Cunniff, Tom joined and became a partner of Gardner, Russo & Gardner, where he has built an extraordinary track record.
So it’s my pleasure to present our first speaker this morning to share his thoughts about global value investing in front of a very global crowd, an audience with representatives from all 6 continents—Tom Russo.
TOM RUSSO: Thank you and good morning. The title of my presentation today is “Global Value Investing.” Global is very timely, just coming back from Berkshire's annual meeting, where Berkshire announced a first and a quite large direct investment overseas. They've been signaling an interest for the past four or five years, and all of the non-U.S. investors in this room who have been going to Berkshire annual meetings for the last five years would have known that.
International shareholders in Berkshire Hathaway have been specially invited to separate sessions from the rest of us (US Investors) to build the Berkshire brand awareness amongst you international Berkshire shareholders, who then returned home and spread the gospel. And the gospel found a convert in Israel just this past month. And we now at Berkshire have a very large foreign and direct investment.
So I'm going to talk about global value equity investing…
…and I'm going to give it more than 40 percent of my best efforts. Even though global stocks -- non-U.S. denominated stocks -- represent only 40 percent of my holdings, they certainly represent a lot more of my awareness. And everything that I do has sort of a benchmark against the opportunity set for comparable investments, and that opportunity set is international.
The fact that over the years I've run portfolios that have roughly been 40 percent non-U.S. and 60 percent domestic is a byproduct of analysis, but it doesn't mean that a hundred percent couldn’t happen, and it's a function of where the businesses are most attractively positioned. I was speaking to somebody in Omaha this weekend, and he suggested that I should start my remarks by saying that I urge all of you to take a very, very short-term perspective about investments, to try to cover all industries and all stocks, to trade your account furiously to make sure you never fall behind any index, and that you don't concentrate your efforts but that you stretch yourself out so you can meet the consultant's requirements of being all things at all times. He thought that if I told you this, it would make my job easier as an investor because you would open up more opportunities for me. But I won't go down that path any farther than just to suggest that it's a possible interpretation of what investors should look for.
I thought I would cover a couple of topics. I'll start with a background as to how I became an investor with an eye towards foreign stocks, describe why someone from the middle of the United States might invest abroad, how I've invested abroad over time, and then close with some observations of the pitfalls--how I invested over the time. Then I'll share with you some observations of how one might stumble in foreign markets, and then finish with some interesting current issues about the global investment scene, and leave time for questions.
I was just speaking a moment ago with someone who actually knows where I grew up, which is a small town in the middle of Wisconsin. And you wouldn't think that would be a great start for global value equity investments, but it had some interesting characteristics. As a child, I did travel overseas a lot and became quite comfortable with early trips to Germany and other parts of the world. And already as an American, that's a subset of all Americans, because half of the Congress of the United States, for example, don't have passports and have never traveled abroad. So there is a certain ethnocentrism that prevails in the United States. And I had the good fortune as a child to travel.
My mother, for some reason, decided it would be good thing for a child growing up in Wisconsin to order newspapers from around the world. So for my tenth grade, we got newspapers from Tokyo and China and all sorts of weird spots. We'd open them up and try to decipher what they were talking about. But it had a particular resonance because I ended up spending much of my professional career investing in newspapers around the world.
The last thing about the town I grew up in was we had a company there named Parker Pen, which was at that time a global brand leader. Many of the people who worked there had exotic stories of travel abroad and building new businesses throughout the world. It was largely a non-U.S. company, so its fortunes fluctuated with currency because their profit streams were foreign.
Another observation I had was that as a child, though I did not have a mandatory paper route -- which seems to be required for all great investors -- I did try to invest early as a child. And the first thing I invested in was Pan American International Airlines. I lost a lot of money on that, but it started me off on the thought about international investing.
After that, I went to Dartmouth where I studied abroad, Stanford Law School and Business School, as Bob said, with Jack McDonald, and then Sequoia Fund where the value investment-- active lessons about value investing--took place. For me, that probably starts the story about investing abroad.
Sequoia Fund was different than any other investment firm that I've come across on Wall Street because they specialize on their own research. There's no contact, even though the firm may serve many billions of dollars, there is no research, there's no sell side contact. It’s based in New York, but really could be based anywhere. They focus on just a handful of industries. They specialize largely in consumerbranded companies, and those consumer-branded companies often have a global reach. Their selected businesses -- food, beverage, tobacco and media industries -- tend to generate substantial amounts of cash flow.
I started there in 1984, just after the 13-year bear market was beginning to churn and equity had begun to interest investors once again. But within short order in the mid-1980s, what developed was the decade of the leveraged buyout. As leveraged buyouts started to increasingly influence the valuation of companies in the food, beverage, tobacco -- remember, RJR sort of typified that -- and the media arena, the domestic valuations of those companies became over-heated.
At the same time as that occurred in the mid- 1980s, the leveraged buyout balloon, the ability to obtain information about foreign companies was increasing, and the competitive landscape for the businesses that I focus on (for example global food companies and global beverage companies) was broadening to include foreign and global competitors. So in the mid-1980s, the leveraged buyout of RJR meant that one of the great possible investments in the U.S. was taken away. But in an effort to understand RJR as an investor, it had become important to look at British American Tobacco, Gallaher, and Rothmans of Canada.
To understand businesses in the areas that I concentrate on (the circle of competence I draw is around food, beverage, tobacco, and media) I had to understand the foreign companies, because they're increasingly the competitive set. Once the domestic valuations for those businesses accelerated because of threatened leveraged buyouts, it was natural to then compare the valuations of their foreign counterparts. They were cheaper, and they remained cheap for quite a long time. And that's what led me into committing substantial amounts of money abroad.
So the question is then--why would an American invest abroad?
It's not a trivial question, because for the first twenty years of Berkshire Hathaway's annual meeting, when asked why Warren didn't choose to invest abroad, his comment was historically, "The U.S. is a very big market." He said, "We have sizable capital, but nothing to exhaust the possibilities by just looking throughout the United States."
His early comments also were that he didn't have the ability to know the people. It's an important comment. Because if you grow up in the United States and you meet somebody who has a background, you pretty well understand the important indices that that background describes to you about character. But if you meet with an English company and the man who runs it says that he went to Marlborough or he went to Eton, in America, those references may mean very little, though in fact they may spell out everything.
Warren's early comments were that he wouldn't be able to make the distinctions as it relates to the most important question that one asks as an investor: Who will manage the business on your behalf, and how will they think of you when they go to reinvest that abundant cash flow that consumer products businesses could generate? You just missed the signals because you were unfamiliar with the benchmarks. And then combine that with the adequacy of the U.S. market to absorb capital. It's really a setting that confronted most American investors when I started out in the mid-1980s.
But going back to Jack McDonald's class--he actually encouraged us in the early 1980s to look abroad. His simple observation was that 95 percent of the world lives abroad. It's a bit presumptuous to think that 100 percent of the interesting opportunities would be domestic when 95 percent of the people live away. That is fairly compelling math.
He made an early fortune investing in Japan, more specifically, in Japanese insurance companies during the 1960s. He also made a substantial investment in a business that he wrote up as a case study called Veuve Clicquot. Veuve Clicquot was a French champagne company, and the business was branded "Champagne of the State." But the interesting aspect of the case was that it was really a balance sheet story, not an income statement story. The balance sheet involved the enormous amount of reserves that were held in their cellar, as well as the real estate that they owned in the champagne region. And the public market value was substantially undervalued (the real estate assets) because they were pretty much focused on earnings per share, and it just showed that.
I was intrigued by that example, and especially so in hindsight because a very large concentration of my investment activity over time has been in spirits companies. It certainly was an early observation.
Investing globally can be very difficult.
The perspective of trying to invest abroad in the early 1980s though was an interesting one because it was quite difficult to do. Information was scarce. Currencies were often fixed and difficult to convert. The classes of securities in which one could invest were restricted. So a good example would be that in the mid- 1980s, I chose to invest in Nestlé. And Nestlé was a difficult company to invest in as an American because you couldn't buy the registered shares, you couldn't buy the bearer shares, which are not registered, so instead you had to buy something called participating certificates in bearer shares. You had to be willing to participate in an instrument that really was a second-class-citizen type investment. That was the world in Switzerland at the time.
Value Investing in India
Fast forward to today. People ask me what about investments in India. And in India, though I'm not really very up to speed on the particular nuances of the Indian market, I do know that a person returned from India excited about a local bank, but the local bank shares trading in India traded for a substantial -- maybe as much as 30 percent -- discount to the price of those same shares as you could purchase them in the U.S. There's a specific facility that's been created for the U.S. In order to invest as a U.S. citizen in those Indian shares, you have to participate in that facility and pay an enormous premium for that. This concept of classes of shares being restricted even continues to this day, even though it's far less burdensome than it was in the mid- 1980s.
At the same time, there was a large amount of friction or extra costs. And that had to do with high fixed commissions and stamp taxes and duties, and the financial process of investing abroad was difficult. There were a few global sub-custodians in the mid-1980s. As you can imagine settling trades abroad was a hair-raising feat.
Different accounting methods and standards can be a challenge for investors when investing globally.
Generally speaking in the U.S., there was still a significant trace of arrogance related to accounting standards. This was before Enron showed that we had little to be arrogant about. But when you'd invest in Europe in the early 1980s, people would ask, "But can you trust the accounts? Can you trust the accounting? And how can you make the adjustments for the accounting so that you know what you're buying is like American stocks that you invest in?" The concern over accounting was something that has over time diminished because we've shown our own abuse.
The early investment universe was also highly restricted because of trust departments in the U.S. If you happened to be serving the needs of a trust investor, most of the time they insisted on having only American Depositary Receipts or ADRs because they required domestic settlement of trades that you could effectively do through an ADR. So the concept of actually owning a foreign stock settled abroad was outside most trust departments accepted terms.
Those are the sort of issues that one confronted. As a result of that, global capital flows just didn't happen, and Americans were not invested abroad. As a result of that, the markets were in many instances a lot cheaper.
At the same time, even in the mid-1980s, Berkshire's chairman was out on the annual meeting circuit talking about the quality, the high quality, of certain businesses versus traditional economics of most businesses. In the early period, Europeans didn't really make that distinction as clearly. So if you had a newspaper company, the shares went down because there was a cyclical drop in advertising. The share price might go down even farther than the earnings decline because people didn't attribute a high standard or a high benchmark for newspapers because they were superior franchises. They traded them as though they were steel companies in terms of the market's fickle nature of embracing those businesses.
As Berkshire shareholders, we would have long learned from Warren's comments that then monopoly newspapers were like a drawbridge; they were a franchise to claim money. If in the marketplace, the newspaper shares were declining, because of economic miracles in a way that U.S. shares just didn't do any longer because people recognized the franchise, it provided an opportunity for an American to go in and purchase what are globally equally good business newspapers at bargain basement prices. There was just a lack of an awareness of the differences between certain types of businesses that open up opportunities abroad. That’s the context that an investor faced then. Some of the issues remain today, but many do not.
Global Value Investment -Weetabix
I'll just give an interesting example. In the early 1980s, I started to invest in a British company, which manufactured a favorite product of my wife, who is British. It's a cereal company based in England. And I started to invest in the shares. I was dealing with a local British broker, Neuberger Berman, which was my prime broker and chief custodian. Neuberger thought we were settling trades, and we went on for years like this. One day, they thought they'd do an audit just to see what number of certificates we had inhouse and sort out what we thought we had.
We were so far off that there was a team in Neuberger that spent the next two or three months trying to chase down certificates that we had assumed were delivered and never were. And they were owed us, but the delivery system that was casually set up then for a reasonably small company just weren't global and they weren't perfecting the trades. We thought we owned them. Neuberger thought they had them.
Finally, we went into sort of a red battle alert and spent weeks and weeks trying to chase down these certificates. We finally got it right, but that just gives you a sense of sort of the primitive environment that one faced.
My own perspective as to why I thought it was important to have a portion of my investors' funds abroad was, on one level, quite specific. Having studied at law school and having sort of recognized the way politics work, I just feel -- then did and still do -- that over time, Americans will devalue their currency. The process of democracy being permitted to promise more to their voters to get votes than they can deliver is a dangerous system. And we see it most forcefully today.
We have promises to make the world safe from all terrorists, and so we spend $90 billion on a war effort, while also promising investors to cut their taxes and the taxes of middle income Americans. With that type of promise, though it seems like we can maintain that construct in the U.S., over time just doesn't last.
As an investor, recognizing the nature of our political process, I felt really early on that it would be a wise thing to have a portion of our funds denominated in foreign currencies. That's one of the kind of macro moments -- one of the very few macro moments I've had over my career--but that's one of them.
I fled the overpriced U.S. market through and by leveraged buyouts, and in the process of doing that felt that the global counterparts were all in better position. So I could look at Hershey in the U.S., but in doing the research would come away with the feeling that Nestlé had a better business, it was more global.
U.S. companies are very often focused (operationally and certainly professionally, the people who work there) on this large and rewarding domestic market. The domestic market is big, it's 250 to 300 million consumers, and it’s the richest market.
At one point, Hershey's said, "That's it. Let's go home."
If you were at Hershey, you actually at one point at the end of World War II had a global business. Your products traveled around the world with the GIs. At the end of the occupation period in Japan, there was enormous demand for Hershey chocolate in the communities around the bases because it was the product the winners ate, and so the locals loved it. At one point, Hershey's said, "That's it. Let's go home." And they gave up what could have been a global franchise in a Coca-Cola-like fashion, as it would have followed the troops around the world. "That's it. Let's go home." And it was perfectly fine because the U.S. market was abundant.
But they didn't develop the people, and they certainly didn't distribute the brand in a way that was global. Think by contrast of Nestlé where they had about one-and-a-half percent of their employees living in Switzerland and something like less than one percent of the revenues are Swiss-generated. Their whole existence, their very essence, is built around nondomestic activities.
So that just makes them much more acutely aware about the market and how to conduct themselves in global markets. At the same time, the people who run the businesses are, by virtue of where the activities occur, far more international than what you have historically found in U.S. companies. If you're looking for businesses that will have the highest probability developing emerging markets or taking advantage of traditional markets abroad, my feeling is just by comparison, that I prefer to find those global leaders abroad.
I remember with Parker Pen particularly early as a kid and then just watching other businesses evolve over time, American businesses have had sort of a love/hate affair with foreign activities because of the impact of currency on the results. Often during times when the foreign currencies were quite weak, they would pull back from operations because they weren't producing the kind of results that they showed for those same operations during periods when the foreign currencies were quite strong.
You had businesses that had an on again/off again involvement with foreign markets. I think the foreign companies with which I've invested have been far steadier in terms of exploiting global opportunities, even despite the swings that currency effects. And that may be in large part because of the fact that they weren't driven by as short-term a compensation package as optionbased U.S. managers were. They had an ability to take a longer view.
It’s sort of a split decision as to whether it's better to invest with American icons abroad or with non-American icons abroad.
Those were my own perspectives as to why to invest abroad. I preferred some currency exposure and I preferred the more international staff that you can get with foreign companies. I think the foreign companies were more patient than what I was seeing in America. And then there is a value around the world in many instances (and this is sort of a split decision) as to whether it's better to invest with American icons abroad or with non-American icons abroad.
For most of my career, America has been very cherished. From the mid-80s through 9/11, you would have had a period of time when if you could have offered Coca-Cola or Nike or any number of American icons around the world, you were really selling something that the rest of the world without exception preferred. But, you know, at some point, those preferences shifted as the loyalties of the world's consumers regard America in different ways.
So to have Nestlé or Heineken or Cadbury Schweppes out in the marketplace means that if there is a sense that American products are less interesting to consumers for reasons that might be political, we have a fairly meaningful portfolio of offerings that go to market without any American sort of stamp whatsoever. Now, I said it's a split decision because there are a certain number of products that are just absolutely coveted for no other reason than because of the American association. So we have both. But it is an issue that you can be aware of.
My first investment in a foreign company came out of the spirits industry.
Veuve Clicquot from Jack McDonald proved to be of interest -- and that investment was in a company called James Burrows PLC, and it was a small English company whose main product was Beefeater's Gin. It's very symptomatic of how the world works in terms of the research process leading to an investment.
Another thing that's interesting about American companies, at least during the '80s and early '90s, is that we as a country have never really been particularly good at handling issues relating to currency. During the mid-80s, Brown Forman shares collapsed because they had made an ill-fated investment in California Coolers. Shares plunged far beyond the cost of that poor investment. I became interested in the spirits industry by looking at Jack Daniels.
It soon became obvious that the spirits industry in the U.S. was consolidating mightily, and that the people who were in the spirits business wanted to concentrate their brands by sole distributors in any given market. What had previously been scattered affiliations throughout many distributors were now allowed to concentrate with one distributor.
The conflict comes from having market share. The James Burrows family-controlled, single product company stood to lose out in that consolidation because they had nothing else to offer. They would lose out competitively. Consequently I was wary of the company. Then I looked at the valuation, and it was extremely reasonably priced at something like six times earnings without real estate from their restaurant business that they had. It was familycontrolled and had been a family-run company for well over a century, and a public family company for over a century.
As an investor in businesses, which generate enormous cash flows, my single most important issue to get right is what management will do with cash flow through reinvestment.
Because it was family-controlled, the British market discounted its value because they feared the company's propensity to self-deal. And I've often found that to be the case. It's an interesting conundrum. As an investor in businesses, which generate enormous cash flows, my single most important issue to get right is what management will do with cash flow through reinvestment. Do they care about the owner, or do they care about themselves? That's the number one thing. It's called agency cost and what's the likelihood that my agent, my hired hand who runs the business that I own as a shareholder (if you think about shareholders collectively), that they're going to think of their own interest instead of our interest? The answer is very high.
Most American companies, especially with options being the source of compensation, the odds are really high that they're going to think about themselves more than us.
So the one device that I've used to try to control against that risk has been to try to line up with family-controlled companies. Because at least in that case, the family can sit at the board meetings and parade over the managers who might want to take our money because there would be some taking of the family's money as well. You have some asleep-at-the-switch, corrupt or just dullwitted families, and it doesn't give you the protection that you'd like. But in some cases you can find that.
Most investors, however, fear family-controlled companies because the stories of corrupt ones or inept ones command attention. The discount is often wide in the family-run businesses. In the case of James Burrows, that was particularly so because it is still completely run by the family.
The family will shepherd your interest.
My feeling is that the family will shepherd your interest if they're honest, and then when it comes time to sell, they won't fight, because if it's right to sell, it's in their interest to sell. Whereas in public companies, they'll fight, because they will lose their position, the only thing that they have in life is their role as managers of the public company, and all the largesse that spins from that.
And sure enough, Whitbread acquired James Burrows. If you consider my Semper Vic 1984 – 2006 annual returns, the end results of this partnership, (which I've run since 1984, my last year at Stanford Business School), in 1987 was a year of unusual out performance. If you remember, it was the year that we had the great crash of October. But one of the reasons why my annual return was up 37 percent in 1987 was that we had made an investment around that time. Remember, I said that Brown Forman fell apart in 1986, so I began to do the research on the spirits industry, and by 1987, had made an investment.
In '87, Whitbread acquired James Burrows, and I thought I'd reinvented the laws of gravity because my partnership annual investment went up so much.
1987, one of my best years of outperforming the Dow Jones Industrial and the S&P 500, was a terrific confirmation that research that starts off of with a domestic company -- in this case, Brown Forman – that embraces the global landscape for their competitors, can uncover a company in a foreign market that actually is an international company based in a foreign market that might be quite under-priced, which is a more adequate investment than the domestic company with which you started the investigation in the first place. So I think that sort of set my antenna up.
A global investor and a value investor
At the same time in the early 1980s, I had asked a very simple question about a product that my wife used to eat, which is a breakfast cereal called Weetabix. And I said, "I wonder if it's a public company." Of course, it was hard then to find out anything about anything foreign, but I did figure out that it was public, it was very mis-priced, and we can take a look at that. So I think it gives a very good example of what it means to be both a global investor and what it means to be just a value investor.
EBITDA = Earnings Before Interest Taxes Depreciation and Amortization
In 1989 (I started investigating foreign companies in '87) this is where it starts. Weetabix's EBITDA was 19 million pounds and it had 7 million pounds of cash. I determined the business was worth 8 times EBITDA plus cash, less debt, and I came up with an intrinsic value of 13 pounds. With 11.87 million shares outstanding it was trading at 5.95 pounds per share. Then each pound was worth US$1.61 So that's the beginning of the story. Now, I would mention that I used the word EBITDA, which Buffett this weekend suggested was false signs and all sorts of horrors would ensue if you even mentioned those six letters in rough approximation to each other. But for me at least, EBITDA is useful because it helps me cross countries because of different depreciation schedules and amortization schedules.
It's one thing to say in a U.S. context that you've looked at pre-tax earnings rather than EBITDA. But when you start to look at Heineken versus Cadbury Schweppes versus Budweiser, and if you don't adjust for those non-cash charges -- and one way to do it is using EBITDA -- you have a more difficult time comparing across the market. I have used EBITDA, and I confess it in front of you.
Moving on, this is a breakfast cereal company in 1989. Intrinsic value, 13, trading at 5.95, very, very undervalued. There wasn't a single broker in London who knew anything about the company. I had a chance to start buying the shares. What appealed to me was they were probably the first company in England, one of the first three companies in England, to use television advertising.
When the question comes up about how does one do due diligence about a company that's based abroad, I say that anytime I meet an English family in Disney World or someplace and they have a little child, I'd go up and say, "Do you eat Weetabix?" and ask questions. And the thing that I was always struck by was they'd come back and say, "Yeah. And, boy, do they have a great advertising campaign."
I remember meeting one ten-year-old, and he said, "When I was nine, they had this campaign. When I was eight, they had that campaign." He could go all the way back from his earliest years and say what the campaign was as it evolved. It was really substantially a part of their corporate culture and their product set.
(To be continued)
