Tag: episode-1148

RUSSO: LONG-TERM VALUE TRANSCRIPT

May 22, 2015

CONSUELO MACK: This week on WEALTHTRACK, great global value investor Tom Russo looks for leading consumer brand companies with the capacity to reinvest and what he calls the capacity to suffer. Why both qualities matter are next on Consuelo Mack WEALTHTRACK Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack.

In preparation for this week’s interview with global value investor Tom Russo, I read some articles about Russo’s investment hero warren Buffett. One of them was by, Roger Lowenstein, author of a wonderful Buffett biography, “Buffett: The Making of an American Capitalist”. We’ll have more on the book later.

In his 2011 article, “A Harsh Look at the Real Warren Buffett”, Lowenstein was uncharacteristically critical of Buffett for a management decision he made about a key employee. We will have a link to the article on our website. What caught my eye was Lowenstein’s observation about Buffett’s quote “searing independence.”

Here’s what Lowenstein wrote: “In 1969, after a fabulous run as a hedge-fund manager, he decided that Wall Street was barren of opportunities and returned his investors’ money. This was unselfish as well as prescient. The market crashed. Then, in the mid 1970’s, when the market was mired in a virtual depression, Buffett leapt back into the game, now using Berkshire as his vehicle. America had abandoned stocks, but to Buffett, popular sentiment was irrelevant. Traders looked at trends, volume charts, and moving averages. Buffett peered beneath the stock certificate to the underlying business. By focusing on the long-term business prospects, he reclaimed the economic values that were obscured by Wall Street sophistry.”

Well, fifty years after taking control of Berkshire Hathaway, Buffett continues to focus on long- term business prospects. He owns a portfolio of roughly 80 companies, for “forever” as he puts it. He has never sold a share of Berkshire personally, and has only recently started giving shares to charity through to the Gates Foundation.

But what are American investors doing? They have largely abandoned buying individual stocks… they are switching from actively managed mutual funds that do, to passive index funds. And they are certainly not holding for the long term. Trading is in, investing is out. This week’s great investor guest, Tom Russo is from the old Buffett school of investing in businesses, not pieces of paper.

Russo is managing member of the investment advisory firm Gardner Russo & Gardner which he joined in 1989. He oversees more than $9 billion dollars of separately managed accounts and Semper Vic Partners, a Limited Partnership. The global value, long-term oriented portfolio has beaten both the Dow and the S&P handily over the last quarter of a century.

I began the interview by asking Russo about his view that so much of investing has to do with storytelling.

TOM RUSSO: I think it defines the parameters in which successful investors operate. It helps describe the questions that are best asked. I remember the firm I trained with, the Sequoia Fund. Bill Ruane used to have a question that he would ask of managements when we’d visit for example, and he’d say, “What are the chances that your business will lose money next year?” and all of the conversation of Wall Street was about whether the firm would earn $2.10 or $2.11, and Bill would say, “What are the odds that you’ll lose money?” And of course the management team is first perplexed. Finally they’re a bit disturbed. At the end of it they’ll say something like, “Well, look. For that to happen, the following three things would have to happen.” Well, those are the only three things you should care about, and so the device, the technique of investing. You have to learn how to ask the right questions, and I always remembered the one that Bill Ruane used so well.

CONSUELO MACK: So what kind of stories make the best investments as far as you’re concerned?

TOM RUSSO: Well, I would say the best stories for me or the best investments for me are those businesses that have the ability to reinvest since we manage money for taxable investors, and our goal is not to have a large amount of turnover which triggers taxes and forces you to learn deeply about businesses on a regular basis which I find to be elusive at best. So by staying with the businesses that we know and understand, if they have the capacity to reinvest, we’re much better off than if they don’t.

CONSUELO MACK: And explain what the capacity to reinvest means, because if you talk to most Wall Street analysts for instance or portfolio managers, they’re saying, “No, no. We want free cash flow. We want generated returns that are going to go to stockholders. So we want to see you, Mr. CEO or Ms. CEO, return cash to me in the forms of stock buybacks, in the returns of dividends,” but the capacity to reinvest means what to you?

TOM RUSSO: Well, it means just the opposite of what Wall Street is asking, so then I find that we’re on a very divided play field at that point. When I meet with management, my advice to them is to make sure they invest every penny possible. The jargon …

CONSUELO MACK: The opposite of what the rest of Wall Street is telling you.

TOM RUSSO: The jargon today is cash flow conversion, and that means how much of your reported net income per share can you pay out to investors. Well, Wall Street likes that number to be over 100 percent. I just as soon have it be zero. I just as soon have the business have prospective uses for capital that are sufficient to consume all of the net income let’s say, and it’s an example that’s been kind of pushed to my awareness through watching Berkshire develop all these years. They never once paid out the money that they generated, and they had ample internal uses for it, and watching that compound take place over decades based on retaining and the reinvesting well and reinvesting in a way that wasn’t orthodox in the first place. It’s unorthodox for a firm like Berkshire to hold $55 billion in cash at any given time just waiting for the next best opportunity, but it’s given them an enormous amount of competitive advantage over the years.

CONSUELO MACK: Berkshire Hathaway of course is one of your largest holdings, but a criticism of Berkshire Hathaway and any other company that holds a large horde of cash is that I’m not paying you guys basically to hold cash. I’m paying you to invest the capital to my benefit as a shareholder.

TOM RUSSO: And I think the answer is simply over what period of time. The need to have it happen immediately will prevent the better long-term returns that Berkshire can generate by having the flexibility of having capital available. The lamenting of how difficult it was to invest that money in 2007 and 2006 allowed for enormous returns when 2008 came along, and that $55 billion worth of cash had a very high calling to help bail out General Electric or Goldman Sachs or Harley Davidson at rates above 10, 12 and 14 percent, respectively. He may have not earned much along the way, but when the time came that the money was worth a lot, he knew how to charge and he had it available.

CONSUELO MACK: And he did know how to charge and, of course, everyone says, “All right, well, Berkshire Hathaway. Of course it’s Warren Buffett and Charlie Munger. Well, yeah, they’re going to do the right thing,” but the other companies that you invest in. So what kind of reinvestment do you look for? What’s the best kind of reinvestment? Because sometimes they can make terrible choices.

TOM RUSSO: It’s true. I think in our experience at least, the best reinvestment has for me been companies that have fairly knowable, certain and appealing brands, brands in effect being a measure of how something’s perceived not to have an adequate substitute, and that in the consumer’s mind develops, delivers to the manufacturer inelastic demand, all of which are terribly valuable, so you have a loyal consumer with loyal brands. The manufacturer is able to raise prices on them when they need to, to make a decent return. All that’s available in traditional markets for those businesses who happen to have an awareness in the consumer’s mind in developing markets. It’s the reinvestment from the markets that can no longer absorb capital into those markets that can fully absorb it and then generate a very high return on the incremental money that’s spent in markets that have an awareness of the brands that we own but don’t yet have necessarily the capacity to consume, but they will, and that’s population growth dependent. It’s consumers with disposable income dependent which is underway in the markets around the world. So think about Nestlé. It has products of 150 countries. They’ve been there forever, but the products have been expensive and a bit out of reach forever, and today they’re becoming less expensive and more in reach because Nestlé is developing the route to market, the advertising, the investment in the retail channel to make them available, and with that availability comes rising affordability as GDP per capita grows around the world. It’s an ideal investment.

CONSUELO MACK: You said the revenues of your portfolio of companies, and I think your top 10 companies are 70 percent of your portfolio, and 36 percent of the revenues of that portfolio, that very focused portfolio, come from the emerging markets.

TOM RUSSO: That’s about right.

CONSUELO MACK: And 15 percent from Europe. So the international piece is really important to you. Why?

TOM RUSSO: Well, because that’s where the growth is going to come from, and the companies that we’ve really struggled with over the years have been those businesses who lacked an outlet, a logical sense of outlet where capital have a high rate of return by expanding the business because they were geographically constrained. When the business has a very natural place to deploy the capital, it’s just much easier. Warren and Charlie, in terms of the world of storytelling …

CONSUELO MACK: Well, they’re domestic.

TOM RUSSO: They’re domestic, and they’ve attempted to go overseas, but the storytelling that I think about in that context is they like to step over one-foot fences. That’s what they say their goal in life is…

CONSUELO MACK: Meaning?

TOM RUSSO: It’s a limit to complexity of stepping over a one-foot fence, not a ten-foot fence, and for us I’ll give an example of Brown-Forman which …

CONSUELO MACK: My favorite manufacturer of my favorite bourbon which is Jack Daniel’s.

TOM RUSSO: Yes, Jack Daniel’s, and 28 years ago their shares collapsed because there’s a problem with poorly situated reinvestment. They bought a California cooler business that was quite poor. They owned Lenox. They owned Hartmann, a bunch of businesses non-core to Jack Daniel’s, and by the time I came around in 1987 they had so exhausted anything that they could do outside of Jack that they resolved as a family to take their free cash flow and develop the global business. Now at the time they only had five markets around the world where Jack Daniel’s sold more than 50,000 cases, but they’re willing to invest against current income because it’s expensive to open up markets. They’re willing to invest for their future based on the one thing they knew they could trust which is the strength of Jack Daniel’s. They had to pioneer it in markets around the world, and if you fast forward to today after having spent 27 years sort of carefully cultivating this business in international markets, they now have 50,000 cases in over 50 markets. So from five markets to 50, they’ve been able to get that brand established, and that’s been very expensive. So along that period of time they were deploying their capital to fund it, and the burden on income meant that they were probably understating their natural profit, but in so doing they built an enormous opportunity for the future.

CONSUELO MACK: And that’s another key concept that you look for in a company. We talked about the capacity to reinvest, what you call the capacity to suffer. What do you mean by that?

TOM RUSSO: Well, they had to come through years of underreporting profits because of the investment burden placed upon their upfront spending, and that is something that very few companies possess because of the concerns over the requirements by Wall Street analysts to have very predictable and excessive amounts of near-term profits and on the part of activists who are currently shaking up the tree and saying, “If you don’t do something right now, we have enough people to come in and do something better with the company.”

CONSUELO MACK: What gives a company the ability to withstand that pressure to have the capacity to suffer? Is it the family holding that you mentioned?

TOM RUSSO: For us it’s been, in the Brown-Forman’s case it was the family control. It’s the same with Heineken. It’s the same with Berkshire. It’s the same with Richemont. It’s the same with a host of the businesses that we own. It’s family control because the family can say as Heineken recently did when they received a full takeover offer, “No thank you. We’ll wait. We have our sight on our own future, and we’re independent. We can stay so.” In Brown- Forman’s case, nothing will happen with that company without the family’s consent, and so the management team that’s been driving the penetration globally has the security of knowing that what they’re doing is what they’re hired to do, and they won’t lose the mandate simply because of a fickle institutional shareholder comes in and out of large blocks of their shares. These are family businesses. I think that ironically gives me more comfort that the future will look brighter later than if they were purely public companies even though the equity markets generally don’t charge a premium for family-controlled companies because they’re so frightened about the malevolent family, the family that actually takes from the public rather than invest for the future, and so fearing that, the family-controlled shares often are available at lower prices. The measure of how you value that business, however, is quite interesting because one thing that you would recognize is that if in the case of Brown-Forman as they develop those 50 markets you have upfront burden on reported profits, your P/E is going to actually seem higher than it would be were they not willing to invest so deeply today for future business tomorrow. And so the valuation metrics so often used by investors which is P/E, may lead to a different outcome when you’re dealing with a business like Brown-Forman which for so many years has dedicated itself to investing against current income to build the future.

CONSUELO MACK: Is there a better metric than P/E? What would you … ?

TOM RUSSO: Market share.

CONSUELO MACK: Market share.

TOM RUSSO: Through market share and the developing…

CONSUELO MACK: So that’s what you look at, these global brands.

TOM RUSSO: The growth in market share. I mean here we’ve gone from five markets with 50,000 cases to now 50 markets. We’ve gone from half a million cases of Jack Daniel’s to over 10 million cases of Jack Daniel’s. Now that’s a very important development because the next 10 million that we sell will generate to the operating income a far higher share than the last 10 million. The development that they’ve been able to accomplish, however, is something that’s terribly important, and you can measure that and keep abreast of that.

CONSUELO MACK: The capacity to suffer now as we just mentioned, you run a portfolio that’s very international. You’ve had a tailwind prior to this because the dollar as you described in a letter was kind of gently declining. Well, now the dollar is not so gently. It has been strongly accelerating, and that’s hurt your portfolio. What do you do in a situation like this?

TOM RUSSO: The companies. First we visit the companies and say, “What can you do in this situation?”

CONSUELO MACK: Right, when the dollar’s this strong.

TOM RUSSO: And there’s very little you can do. I mean Nestlé reports in 100 different countries, 100 different currencies. Maybe not that many currencies but they pull it all together in Swiss francs at the end of the day. Philip Morris does business in every country outside the United States, and they pull it all back in dollars at some point. The burden on Philip Morris is that they’ve earned four dollars plus or minus a share for the past four years. That’s what they’ve reported, but in fact with constant currency it would be something close to the $6.50. So that amount of earnings that they aren’t reporting because of translation gets translated at P/E multiples to a lower price stock than what would have happened had they not had that currency headwind, but that reverses over time, and it’s happening as we speak. Actually the real goal isn’t to have a currency-neutral or currency-exposed portfolio. It’s to have our clients’ money in the parts of the world where consumption will grow and where investments will enjoy better returns, and I think with that exposure over time we’ll probably see stronger currency relative to those markets. It’s not unlike America relative to England in 1914 when England was the reserve currency. America was sort of an upstart new market, and we just out-produced and outperformed, and over time the dollar became a much stronger currency than the British pound.

CONSUELO MACK: Your top 10 holdings, as I mentioned, 70 percent of your portfolio. You’ve held many of them for well over a decade, and I’m looking Berkshire, Nestlé, Wells Fargo. Even through the financial crisis you held Wells Fargo. Philip Morris International through Altria, Richemont, Heineken, Pernod Ricard, Unilever, Brown-Forman. Truly buy and hold even through tough times. Why? TOM RUSSO: Well, the fact is those are great businesses. I was actually quite pleased to hear you say the names. They sounded very fine to me, the names. They resonate well.

CONSUELO MACK: They’re all well known.

TOM RUSSO: But they’re great brands. Typically they’re great brands. It’s very hard to find the combination of businesses behind which you can invest with managements who care about investing for the long term with owners that are willing to share it with you on equal terms within the world of family-controlled companies. I just read an article on Perry Ellis which is being sued by a couple of outside investors, and they said that the family, there are sort of insider transfers and all the rest of sort of $50 million over the past that many years. Well, you just don’t hear that about the Heineken family or the Brown family or Johann Rupert’s family in Richemont. Warren Buffett is a perfect example. They earn their money the same way we do by and large, and that’s really valuable to find that alignment of interest and that lack of agency cost. I can’t find it broadly, and when I do I want to make sure we stay with it.

CONSUELO MACK: We mentioned activist investors earlier. What’s your view of activist investors?

TOM RUSSO: Well, I think they’re painted with one brush, and I think that always as the case is a risk. I would think back over the years of some of the early work done by Carl Icahn or others, Boone Pickens for example. Very early in times they were up against an intransigent kind of corporate America muscle.

CONSUELO MACK: They were called corporate raiders back then.

TOM RUSSO: They were called raiders back then, but the fact of the matter is they were really unseating the seats of power. Now fast forward to today. I found myself once recently at a hotel going to a meeting. I arrived and there was a placard that says, “Corporate activist presentation upstairs,” and so I went upstairs. I looked at the handout. The first thing was, “Find a target.” Well, that’s not what I would think is sort of noble calling. You might end up with an activist position if a business that you otherwise wanted to participate in stumbled on issues of governance. I think it’s something that begrudgingly you get drawn into, but I wouldn’t want to spend my days doing that. I’d much rather…

CONSUELO MACK: You call yourself a corporate cheerleader as a matter of fact. So you find a target to cheer, not to shake up.

TOM RUSSO: Yes, yes. And also just to support and to make sure that there’s an opposite voice. When you’re a CFO of a company or a CEO of a company and the only thing that you hear from investors across the land is, “Give us all that money back and then some, quickly,” at some point you lose the sense that are other types of investors who might say, “Wait a minute. If you defer and you invest for the future, we may actually have a much better future than if we deplete the corporate right now with distributions and stop investing.” And the beauty about the businesses that have that capacity to suffer through long-term investing is that up against a field now diminished in their competitor vigor because they’re being asked to deliver everything today, our companies with a longer-term horizon have better prospects for results because the investments that they put on the ground face less competition, whereas the other people could easily be there alongside if they’re being asked to return money and not burden the income today with future spending. Our businesses that can absorb those risks or those not risks, but those realities of reinvestment are much better off.

CONSUELO MACK: Tom, I have to ask you about Berkshire Hathaway. So obviously Warren and Charlie are both senior citizens. Do you envision holding Berkshire Hathaway beyond Warren and Charlie?

TOM RUSSO: Yeah, I’m perfectly comfortable with that as an investment. 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 a business that has the kind of virtues and values that Berkshire seeks.

CONSUELO MACK: Because …

TOM RUSSO: Because of what they offer. They offer the seller the chance to have a liquidity event to de-risk their family in some ways while still having the privilege of running a business that they’ve carefully created over decades in many cases, with the same people without the pressure of dressing themselves up for a very quick sale to another private equity firm. It’s permanent capital. Now that’s really valuable to just some people because other people don’t care. They’ll take the highest bid.

CONSUELO MACK: Quick question for you. One investment for a long-term diversified portfolio. What should we all hold some of?

TOM RUSSO: Well, I’d say at this particular moment … now it hasn’t been so for a while, but right now I think Philip Morris is an interesting position. I’ve owned it for almost 30 years through various forms. This is the international only business, and the dollar has, as I said, burdened the report of profits by as much as $2.50 over four years in a row. They’ve invested heavily in defending against competitive assaults across a variety of different markets. They fought back contraband and unlisted cigarettes in all sorts of markets, and they’re in the midst of launching a new product that costs them a lot of money, over $2 billion invested in the new technology.

CONSUELO MACK: Which is …

TOM RUSSO: For reduced-risk cigarettes, that Philip Morris has spent over the past 10 or 15 years something like $2 billion. They have one today that they’re rolling out. It launched in Italy and in Japan. I think it will be quite promising. The senior management of Philip Morris who have always been dedicated users of the traditional Marlboro product line have switched, and they’ve switched to a product that satisfies their needs. Now we all hear about e- cigarettes. We see them. There’s a lot of discussion about whether they’ll be disruptive. The trouble is that they haven’t typically satisfied what the consumer wants. They want flavor and they want nicotine delivered in a fashion much like cigarettes, and what Philip Morris has created is a product that does that.

CONSUELO MACK: And we will leave it there.

TOM RUSSO: Thank you.

CONSUELO MACK: Tom Russo, such a treat to have you on WEALTHTRACK. Thanks so much.

TOM RUSSO: Thank you very much.

CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point comes from this week’s great investor guest, Tom Russo about his investment hero, Warren Buffett. Russo chose two of his favorite books about the “Oracle of Omaha” to share with us. So this week’s Action Point is: Add two Buffett books to your summer reading list.

The first is “Buffett: The Making of an American Capitalist”. It is also one of our favorites, written several years ago by top financial journalist, Roger Lowenstein, a past WEALTHTRACK guest and former Wall Street Journal colleague of mine, it provides remarkable insights into Buffett’s personality, thinking and investing approach.

The second Russo recommendation is “Berkshire Beyond Buffett: The Enduring Value of Values” by Lawrence Cunningham. Published in 2014 it tackles the question everyone asks about Berkshire Hathaway. What happens when Buffett is no longer on the scene? Cunningham makes the case that Berkshire’s hands-off, own forever culture is the glue that holds the company together and predicts that it will endure.

To see reviews of these two books and other WEALTHTRACK recommendations visit the WEALTHTRACK BOOKSHELF section on our website. You can also see more of our rare interview with Tom Russo in our EXTRA feature.

Thank you for watching. Have a great Memorial Day weekend and make the week ahead a profitable and a productive one.

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