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Thomas Macpherson
Thomas Macpherson
Articles (122)  | Author's Website |

The Drift Factor

Keeping an eye on your investment means measuring how much drift takes place after your initial purchase

October 15, 2018 | About:

I used to be Snow White, but I drifted.

– Mae West

One of the more interesting stories in aviation history is the example of the Gimli Glider. The incident took place in 1983 with the new Boeing 767. Halfway through the flight, the plane ran completely out of fuel and was forced to glide to a former Canadian airbase and make an emergency landing. The mistake was made by a series of human errors and the simple fact that fuel calculations were made in metric (liters) versus imperial (gallons). Having loaded less than 50% of the fuel necessary for the planned flight, the crew found itself flying a glider over Manitoba rather than a jet airliner.

The Gimli Glider story has quite a few similarities to value investing. In the final analysis, a simple mistake can turn an event, a company, anything really, into something quite different than your expectation. The journey getting from point A to point B can become quite different than first envisioned. If a company’s strategy begins to wobble in year two, it’s likely you will be investing in a very different company in year five and something not even remotely the same in 20 years.

The Gimli flight crew thought they were flying the most modern jet airliner in the world. In a matter of moments, they were flying the largest and heaviest glider over flown. Sometimes a value investor thinks they are buying a jet but get a glider. Avoiding these unexpected conversions is one of the top ways to be a successful long-term investor.

In my time at Nintai Partners, I averaged an 8.7-year holding time for each portfolio member. Each year, we would evaluate our investment case of each holding with a particular focus on what we called the “drift factor.” This evaluated how different the company was from a strategic, operational and management sense year over year. Over time, we found that those holdings with the largest “drift” factor were almost always our largest losers. We also found the quicker (or larger) the drift, the worse the loss. Essentially, we were buying a jet that drifted into a glider (no pun intended).

Andrew Carnegie once said the way to become rich is to put all your eggs in one basket and then watch that basket. As a focused investor (from both number of holdings and number of industries), my job as an investment advisor is to allocate capital in companies that minimize drift over the long term. With such focus, the smallest amount of such drift can cause dramatic changes in the quality of the portfolio in a very short time.

That’s why it’s vital to be a very different critical thinker if you want to be a long-term investor. The idea of sitting by a lake reading Barron’s as your companies compound cash is somewhat correct but mostly wrong. Watching that basket all the time is like flying that jet – it takes considerable work.

To me the importance is to track the drift within the context that your holding period will be a decade or more. It’s a difficult path to follow. Here are the important criteria I use to assist in meeting these goals.

Confidence of same industry business in 10 to 20 years

It’s very difficult to invest in a company that you are confident will be doing the same thing in a decade or two. It’s a challenging exercise, but I think can be done with some (the operative word) accuracy. Research in five areas in particular can give an investor a reasonable shot at the potential for drift.

M&A: Has the company had a history of M&A? Are acquisitions largely accretive or small snap-on purchases to enhance current offerings? Do they enhance the company’s moat, making it harder for competitors to catch up? Conversely, has management done a deal that clearly destroys shareholder value?

Regulatory: Does the company have an advantage supported by government regulations? For instance, biopharmaceuticals will have a regulatory moat for branded products that can last a decade or longer. Conversely, is there a risk that regulations may restrict the company’s strategy or operations?

Technology innovation: In 1978, the head of Encyclopedia Britannica was famously quoted to the effect that encyclopedias were the safest product line to bet on in the future. I’m not sure what happened to that executive, but I hope he didn’t bet his future retirement based on his market predictions.

Business process innovation: The phrase “to build a better mouse trap” has been around as long as there has been ... well ... mousetraps. And yet for all the amount of times you’ve heard that phrase, a mousetrap is still a mousetrap, and the model designed in 1934 still has 90% of market share. The catch (no pun intended) is that the price has dropped roughly 90% since its introduction. Almost all of the cost squeezed (OK, that might have been intended) has been in better business processes (cheaper raw materials, cheaper labor, design tweaks, and so forth). 

Competitive moat: Competition can lead your investment company quickly astray. When you think of companies with wide moats from small (WD-40) to jumbo-sized (Coke or Pepsi), you can imagine them selling the exact same product 15 to 20 years from now. Investing in a product with a deep moat managed by great capital allocators is the value investor's dream.

Length of time of the investor’s ownership

As I mentioned earlier, my experience has been that the drift factor can be exponential when it comes to owning a stock for 15 to 20 years. In the doldrums in the history of Coca-Cola (NYSE:KO) in the 1980s and early '90s the company actually owned a shrimp farm and Columbia Pictures. How it got from carbonated beverages to raising future cocktail hors d'oeuvres and shooting films is a story in itself, but not the kind of story you want to hear as an investor.

Fortunately, the board and Bob Goizueta recognized the drift factor when they saw it. From 1981 until his premature death, Goizueta increased the stock price by 65 times. If you had held the stock during the '60s and '70s, you might have missed the slow drift away from Coke’s core competency. But for those who held on for the entire tenure of Goizueta, the lack of drift and return to laser-like focus on its core business made many peoples’ fortunes (just ask Warren Buffett (Trades, Portfolio)).

Conclusions

Over the course of my investing career. I’ve had quite a few holdings that fell prey to the drift factor. Several have been due to the deadly urge to acquire while being pushed by consultants’ assurances of “synergies.” Others have been simply that management and the boards didn’t keep their eye on the ball and saw competition fly by. In the case of Coke, they were saved by the fact that their CEO figured out less was more.

Which brings us back to the Gimli Glider. Passengers that day learned that gifted leaders and intense focus (with a little luck) can turn a rather dramatic drift problem into a positive solution. Quick reaction, identification of the problem and a practiced checklist can help an investor too. It can make all the difference between a safe smooth flight or a short and bumpy ride.

As always, I look forward to your thoughts and comments.

About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chief Investment Officer at the Hayashi Foundation, a Japanese-based charity serving special needs children and pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 4.9/5 (10 votes)

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Comments

Dr. Paul Price
Dr. Paul Price - 1 month ago    Report SPAM

Words of wisdom from a seasoned pro. Thanks for the article.

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago

Thanks Paul. It is much appreciated. I hope you doing well. Best - Tom

stephenbaker
Stephenbaker - 1 month ago    Report SPAM

Always a timely subject - thanks. As an aside, what do you think of KO today?

Thomas Macpherson
Thomas Macpherson premium member - 4 weeks ago

Hi Stephen. KO is a bit out of my circle of comptence (size, capital structure, product offering, etc.) so I'm not he guy to ask. The question is how does it fit into your investment model? I would love to hear your thoughts! Best - Tom

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