In the past I've written about some of the difficulties associated with being a long-term investor running a concentrated portfolio. One of the struggles for this type of investor is that they lack a sufficient number of trials in their early years to determine if their process is effective (said differently, to find out if they are a good investor). In a great interview with AQR, Ed Thorp said the following:
“I tell people that [the Efficient Market Hypothesis] is not true, but for you it probably is true. That is, most people don't have an edge. If you think you have an edge, it needs to be logically demonstrable. You've got to be able to defend it against a good devil’s advocate. If you can't do that, you probably don't have an edge. So, I think people should act as though it's true until they can demonstrate otherwise.”
In terms of demonstrating ability, an 80% “win” rate (however defined) over five hundred trials is more informative than the same percentage over five trials. It’s much easier for a trader with dozens or hundreds of bets that may be settled over the course of days, hours or even minutes to differentiate between skill and luck than it is for an investor with only a handful of investments that won’t be determined for years to come (and even then, luck still plays a role).
I think a variation of that concept applies on individual investments as well. Unlike the trader who measures success or failure against short-term market movements, the long-term investor (presumably) assigns as little value to Mr. Market’s opinion the day after he makes an investment as he did the day before the investment. Market efficiency does not suddenly appear because you’ve decided to buy a few shares. Implicit in the investment decision of the active investor is the idea that the market is inefficient at times, at least in the short term.
For long-term investors, the test to determine success or failure must focus on something other than the stock price (at least in the short term). Are there other ways we can attempt to judge the success or failure of an investment in real time without looking to Mr. Market?
Using Kraft Heinz (KHC) as an example may help. My thesis on the stock is that while there are clear long-term risks associated with private label and premium brands, an above average management team and a stable of high-quality brands (with some key category attributes that are not ubiquitous across CPG) will help the company find a path forward. In addition, I think disruption could provide an impetus for further consolidation, with Kraft Heinz likely playing a role. Based on the assumptions I’ve used in my model, I think the risk/reward for shareholders is reasonable at today’s valuation.
Now that we have the thesis, how can we test it over time? There are few quantifiable measures that come to mind, such as market share. For example, despite the rise of premium brands like Sir Kensington’s, Heinz still holds roughly 60% share of the ketchup market in the United States (the nearest branded competitor, Hunt’s, holds less than 20% market share).
In addition, as management noted on a recent call, this is the highest share Heinz has held in U.S. ketchup in recent history (the brand held closer to 50% share at the turn of the century). That only covers one of Kraft Heinz’s brands, but I think that data is encouraging. It doesn’t tell us about what will happen in the future, but it does say something about how consumers have acted in the past. I find it useful to think about why that’s the case, and what could cause it to change in the future.
As we think about future data points, the problems you run into with something like market share are that we're dealing with short periods of time and it’s not clear where the cutoff should be between a period of less than stellar results (which are all but certain to occur for even the best businesses) and a clear sign that your investment thesis is broken. As an example, does one quarter of declining sales or lost market share suggest a longer-term problem? How about if sales decline for a full year? And does it matter if sales are down 1%? How about if sales are down 2% or 3%?
Clearly the answer isn’t black or white. From a financial perspective, the importance of a single quarter to the intrinsic value of the business is close to zero. In my experience, there usually isn’t much worthwhile information to be taken from quarterly financials for the long-term investor.
If quarterly results are of little use, what else can we do?
I think the answer is to do the hard work before you make the investment. And then you wait. (To state the obvious, that does not mean closing your eyes to new information.)
If you accept my argument that the short-term financial results and market movements are of limited value to the long-term investor, I really don’t think you can have it any other way. What you can do is prepare yourself for some uneasiness, which usually shows up as wavering conviction if the stock underperforms. Spend a lot of time thinking about the long-term risks before you make an investment. Seek disconfirming evidence. In addition, ensure that you are entering the position with reasonable assumptions, as well as a margin of safety. When possible, I think you should try to think about those risks in numbers, not just as broad themes. That helps me stay level-headed.
For example, what’s the potential risk to Kraft Heinz from private label penetration? Let’s try to get our heads around this by looking at some recent data points. Here’s a chart from Treehouse Foods (THS) 2017 Investor Day event that shows U.S. private label market share from Nielsen:
As you can see, private label has increased its dollar share by roughly 160 basis points over the past eight years – not an immaterial amount, but not as much as some might suspect (I’ve seen Euromonitor data going back as far as 2004, which estimated private label held 14.5% share). There are some slides in this IRi report that also shed some light on what's happening in the market.
Here’s something else that caught my eye, from a July 2017 article in the WSJ:
“Big food sellers still dominate in America. The 25 largest food and beverage companies commanded a 63% share of $495 billion in U.S. food and beverage sales in 2016, according to consultancy A.T. Kearney. That is down from 66% in 2012, and even seemingly small market share losses hurt sales and profits. The top 25 companies averaged 2% annual sales growth from 2012 through 2016, compared with 6% for their smaller rivals, according to A.T. Kearney.”
I find those numbers less concerning than some of the headlines I see. It helps to get more granluar when possible (as I did above with the U.S. ketchup data). To clarify, I’m not saying these share losses are immaterial or unimportant. The point I’m trying to make is looking at the data gives us a way to think about what has happened - and potentially forecast what could happen in the future.
USDA data suggests at home food and beverage expenditures have increased by 3% to 4% per annum over the past decade. Considering what I’ve discussed above, I don’t think you should model anything more than low-single digit sales growth from Kraft Heinz in the U.S. (based on guidance given at the post-integration business update, I don’t think management would argue with that). I don’t see anything to suggest this assumption should’ve been materially different a year ago.
That’s one example, but it shows you how I think about building expectations.
How will I know if I’m wrong?
That’s a difficult question to answer. A sustained period of results that fell short of my expectations without explanation would be concerning. But that takes time. As I noted at the start of this article, I don't suddently look for Mr. Market for answers because I've bought a stock. That means I must usually wait years before I can determine if an investment was a success or a failure. That's the reality of being a long-term investor.
Disclosure: Long KHC.
