We recently had the opportunity to interview guru Tom Russo (Trades, Portfolio) of Gardner Russo & Gardner about his investment strategies in global investing, as well as how he became an investor. The questions asked are from our readers.
Although we received around 44 questions, we were only able to use 15 of them due to time constraints, but we thank all of your for your submissions and encourage you to please continue to submit your questions for our Q&A’s with the gurus.
1.How did you begin your career as an investor and what steps did you take to become as successful as you are today? Also, what made you decide you wanted to become an investor?
I think my career probably started under the influence of my own family background. My grandfather’s career was as an investor and as a banker and an attorney. He grew up in a town called Titusville, Pennsylvania, which was blessed as having been the birthplace of oil. His family’s own experience as with his wife’s family experience in Titusville was full of business intrigue, fortunes made and lost. I find that to be quite fascinating. The oil went away at some point and the expectations of wealth that were built on that, proved to be fleeting.
Seeing the aftermath as a young child growing up in Titusville, and pondering the notion that a very modest place could become eternally rich seeming and then only sort of succumb to the cycles of business was quite interesting to me. I then ended up growing up in a town in the Midwest called Jamesville, Wisconsin. They happened to be the headquarters of a company called The Parker Pen Company. The Parker Pen Company, when I was growing up, straddled the world at the most powerful iconic pen. It was probably 80% international. My hometown had all these global business types running around and they had a business that was a terrific consumer brand. It was internationally able to grow.
That’s kind of become something that’s the heart of what I do as an investor. I look for great trademarks, great brands where they’re capable of reinvesting to grow their franchise internationally. I saw that as a kid growing up. I’ve also focused on family controlled companies over my career because it’s my belief that if you get the right family at the helm they can line your interests of the company more closely than companies that have no personal family input underway or any long term mindedness other than what stockholder options can do for management’s own personal wealth.
Ironically, The Parker Pen Company was not only foreign and global advantage but it also had the family control company. In that case, the family probably at the end of the day was unsuccessful at transferring what seemed like it was an enduring trademark to their many generations that followed. Today, it’s kind of just a memory in the hometown I grew up in. I was influenced by its presence growing up as it was romantic and intriguing to think that you could have something that people would cover just because of the way you decorated the pocket clip of your pen and gave it a trademark that became esteemed. I liked that quite a lot.
Then, early dabblings with stock were fairly illustrious I guess, though I was a student of Dairy Queen back in the early 1970s as a friend of mine recently reminded me having thought about Dairy Queen before Warren Buffett (Trades, Portfolio) took it over 100%. I was pleased to hear that though didn’t invest enough to change my life as a young man based on my early thoughts concerning from the annual report that my friend saw me reading about that company.
I did have an interest in investing early on. I fed that interest through studying at Stanford Business and Law School. Really, that’s sort of the first professional layer in which it surfaced. For me, with investing being kind of a question about corporate culture and then the kind of consumer acceptance of brands globally, I spent time as a student at Dartmouth College looking at some anthropology courses and history courses, economics courses to find out what people might care about through anthropology.
The cycles of history economically through the history department and then economics studying demand curve so we could figure out if the businesses that we own truly do have price inelastic demand and if so have they been able to harness the power that comes from that. those are things that I studied at Dartmouth, Stanford Business and Law School. I happened to have the great opportunity of studying under a man name Professor Jack McDonald who brought Warren Buffett (Trades, Portfolio) to our class in 1982.
That really opened my eyes to the way that truly thoughtful investing can be done. Warren talked about buying shares to hold forever because of the tax deferral benefit. He talked about investing only with management who you trust. You can’t trust the person who’s dishonest. That led to my thinking about corporate governance, ultimately the family controlled companies as long as you could find good families.
He also talked about long-term minded investing, quality of family. He also talked about the power of brands. That was one of the things that he also reinforced vitally in my career. He had bought Nestle’s (NSRGY) Chocolate and as he said in a report this year he had paid $35 million for it and its $72 billion Berkshire (BRK.A, Financial) (BRK.B, Financial) has to invest He talked fondly about the virtues of a strong brand even as early as the early 1980s. He’s just living the transition between Ben Graham’s style--net net liquidations that were the core of his early trafficking at Berkshire and he was moving into the investment process of better businesses.
Both because of the power that a strong franchise gave him to raise prices and both because he wanted to stretch out the holding period and if you have a liquidating then grant type investment your internal rate of return is wholly dependent on when you close the discounts. If it takes five years, you double your money.
That’s 14% takes you 10 years at 7% and 20 years at 3.6%. If you find a business that has the capacity to reinvest behind a strong brand that’s run by honest management and treat shareholders well, you can really add compound over time. That’s really the lesson that he was just picking up when I met Mr. Buffett in 1982. That probably influenced my decision to become an investor for my career more than anything else.
2.Which investors inspired you at the beginning of your career? Are there any investors that continue to inspire you today?
Buffett, yes. I had the great pleasure of hearing Charlie Munger (Trades, Portfolio) speak very early. He talked about the incredibly important thing to the investment business. It was advice I heard from Stanford Business School where he’s on board of visitors when I was there. It was basically that as investors terrific business there’s probably no more interesting business in the world trying to understand where the puck is going before other do and then profiting from it. His advice was simply that if you’re blessed with the ability to participate in this career which is quite hard to do and lucky in some levels of enter, you have to make sure you give back to society.
That was one of Charlie Munger (Trades, Portfolio)’s early advice. I think a lot about that and he’s very wise to have said that. The other investor who inspired me would have been Jack McDonald. Professor McDonald taught the investment course at Stanford Business School when I left and he spent his time focusing on company valuation, business franchise reinvestment opportunities and risks. Price as a component to the investment return requiring that you develop a margin of safety for even a good business at a discount price.
Professor McDonald also wove into his coursework not only Warren Buffett (Trades, Portfolio) stories about early investments there but also the work by Phil Fisher who was only up the road from Stanford. Phil Fisher had this view that in order to make a good investment, including all sorts of layers of information. He called it the scuttlebutt of investing. You want to talk to people who supply the companies you’re interested in.
Talk to people who are customers of the company. Do a 360 dive into all aspects of the company as though you were buying it to wholly own it yourself, in which case you want to reduce your risk by just knowing everything there is to know about a company. Phil Fisher largely and Professor McDonald constellation of great investors and so we had the chance to meet and learn from those investors through Professor McDonald.
Professor McDonald’s own personal contribution to the process that influenced me so heavily was in a time in the early 1980s when it was terribly difficult to invest internationally he encouraged investors not to be provincial and to recognize that only 4% of the world lived in the United States. We probably at the time had 50% of the equity market value. He didn’t think that was particularly fair or longstanding.
To the extent that I agree with him, it helped set me down that journey of global investing which is what I’ve been on ever since. Buffett’s observation about the powerful price and elasticity that you enjoy having a strong consumer brand sort of activated by interest and consumer brands and like to continue to favor them.
Because I find them to be interesting to research and fill capable of reinvesting because there’s a huge open market in the world for coveted brands that our companies can power up with investment spending. That way you get to at least have the prospects of a decent internal compound generated by the growth of the portfolio companies.
The trifecta for me would’ve been a Buffett, Munger, Jack McDonald, through jack McDonald Phil Fisher. Those were the ones that really sparked my interest as an investor. They are the ones who continue to spark it today. Atop of that early lineup in today’s world, obviously Seth Klarman (Trades, Portfolio) has been among the most disciplined and creative at the same time investors incapable of unearthing value across geographies asset categories, time horizons, all the rest. Has really pioneered all sorts of avenues for creative investment minds to follow.
3.Can you share your top criteria used to judge/categorize whether a company is considered high-quality (e.g. recurring revenue, high ROIC, low risk of business model obsolescence, pricing power)?
I think corporate culture, business integrity and management integrity, because as Buffett said when he met our class, you can’t make a good deal with a bad person. If you have a company run by a CEO who’s either reporting to you dishonestly in an effort to try to savor near term and the investable long term, or steal from you through side deals, sideways to make money options that are unjustly enriching, any number of ways that your chosen agents can harm you, it’s a concept of agency cost.
I think it’s terribly important if you’re going to hold an investment for a very long period of time you’re not going to get ahead if you don’t first establish what you believe the culture has the right values as it relates to their willingness to reinvest, their ability to reinvest and for whom they reinvest.
For the outside shareholder on equal terms you have a much better chance of prevailing. I think corporate culture and agency cost issue, addressing agency cost loom very large in my first cut of the company. After that, it’s all about price elastic demand. That’s what we’re looking for and that prices elastic demand is what drives recurring revenue, high ROC and reduces the risk of the business model. Because if a client prefers Jack Daniels to any other bourbon, there’s fairly low risk that that consumer will be swayed by the offer to have a Jim Beam or another product if they don’t believe themselves to be loyal to that brand.
That belief, that loyalty keeps consumers loyal as well as willing and able to pay the prices required if inflation drives up ingredient cost and they need to maintain margin through higher prices. That pricing elastic demand become terribly important. Finally, the third piece I would say in top priority, the first is sort of quality of the character, second is the quality price elastic demand. The third is do you have the power to reinvest.
Can this business grow and can it grow either by expansion of its current market, extending its current product adjacent category, setting the current business and geography? Can the business grow because, from my perspective, unlike most of Wall Street, I look for businesses that have a very, very, very, very low voluntary cash conversion ratio. Many investors seek companies that have cash conversion ratios up over 100% because it reassures them that they can distribute back to shareholders the earnings plus a lot more that comes from free cash flow from access depreciation.
I, by contrast, look for businesses that have the capacity to reinvest and that capacity to reinvest gives them the ability to deploy substantial incremental capital of the business and pursuit of new geographies, new brands, new adjacent products. That reinvestment is what we count on to drive the value of our shares forward over a long period of time. It’s a fairly certain reinvestment because they’re simply extending that which they already know and have into new markets and it reduces the right ones.
You also have some other powerful ingredients that help ensure the likelihood that that reinvestment will work. One of them is in the capacity to reinvest. You have management who’s both multilingual and multicultural. Without that I don’t think you’re going to succeed trying to develop your businesses in foreign lands. American companies are often burdened by illustrious pasts and illustrious large markets because the rewards are substantial if you just stay within the US. They don’t accordingly develop the strength to go abroad.
I think if you have brands that are covered by consumers and multilingual, multicultural management team able to take the brands’ core cash flow from your core businesses and underwrite the cost of going abroad, you have the capacity to reinvest. The next thing you need is to have your capacity to do the right amount of reinvestment because Wall Street wants you to show steady and quarterly earnings progression. As you deploy more and more capital to develop new lines and new markets, the expense of doing so weighs on your near term performance.
If you’re slavishly last to the mass of earnings per share growth or any number of things that are multidimensional requirements that Wall Street likes to force on companies, you’re not going to invest the right amount because it’ll disturb those demanding qualities. Companies that worry about the possibility of managements losing control of their company if they invest too much money because of the possibility of disappointing Wall Street, I think often underinvest.
By contrast, a company that’s family controlled where the family can support management and say that if you spend as much as we require and it burdens your income, it burdens your profits we will protect you from outside agents that seek to gain control of the business. That support is terribly powerful. That’s one of those components I think about the capacity to reinvest is ask for management to suffer from what Wall Street would otherwise declare to be a negative note and respond to them that the management and the owners are aligned at their belief.
That the payback for such investment will be significant and substantial and that they would have ample return over time but they just have to suffer through the near term. That protection that comes often from family control is quite useful for building enduring franchises.
4.Investing in quality companies for the long term requires one to estimate the company’s sustainable earning power over the long run. What is your approach to estimating a company’s earning power?
It’s a function of market penetration and the way in which a competitive landscape is established. The way I can best assure that the earnings power is going to be sustainable and maximize for the very long term is to invest with companies that take on the burden near term to lay the foundation that gives them ultimately what is known often is first mover advantage.
I can’t quantify how you measure that but certainly if you have the first mover advantage in markets that are just growing in a particular product and you end up having your brand identified with the product and being the consumer’s main choice. The advantages that come from such brand leadership involved route to market advantages you have bigger volume so you have lower per unit delivery. You have bigger volume so your advertising and promotion is spread out over fewer costs. You have efficiencies in maintaining your shelf presence and sponsorship promotion.
There are all sorts of benefits that come from the early lead that in turn then support the sustainable earnings power of the companies that we invest in over the long run. How I estimate the earnings power is in some measure like an outside shareholder and what we see is the blended earnings report for companies. Since our companies are powering up substantial spending on growth, we simply accept the fact that there’s a large portion of the potentially reported growth that is unseen by the markets. Think about a company that we invest in called MasterCard (MA, Financial), for example.
Global, able to address a huge market, 80% of the world commerce away from the US is in cash and that’s a very inferior form of payment. It’s an inferior form for governments that distribute social benefit down to its neediest citizens. It’s a inferior manner of payment for governments who want to police tax compliance. There’s all sort of reasons why cash is inferior. Our company MasterCard’s been set about growing in a very fast rate.
Their investment behind expanding the reach of payment systems around the world, especially in the fastest and most growing market. Now what happens is in a business like MasterCard, once you build the infrastructure for payments it’s very fixed and every incremental unit you pass over it absorbs ever increasing while it’s a fixed cost so the margin should expand with growth.
One measure of the earnings power of a company like MasterCard has to confront the fact that as heavily as they are spending upfront today, to innovate on 35 or 40 new programs that are underway around the world since the new CEO took over several years ago. As many of those programs that exist and they’re still in early stages, they are burdening the income statement in such a way that the operating leverage that normally would show up from a business of fixed cost by payment was the kind of growth and volumes that they’ve had over the past five years has just not shown up in the case of MasterCard.
Sometimes you might fear that that’s because the business is poorly run. In MasterCard’s case, it’s simply a measure of the amount of reinvestment they’re putting back into growing from this level beyond. That reinvestment burdens income and that burden keeps the operating margin from growing from 50% to 60%. Well, you know that in a high fixed business like payment systems that the margin would grow with the gross dollar volume growth. It hasn’t and in part it’s because of the measure of the investment that they’re spending back in the business to make it great forever.
The head of the company, the CEO, refers to the fact that he’s actually positioning the business for his CEO successor’s successor. The more he invests today in pioneering ventures to create payment systems for social benefit in Kenya in South Africa, the more enduring the reach will be in those markets and more embedded they’ll be. As the subsequent spending takes place on those savings platforms that the government gives out they’ll explore the benefit of the interchange fees of the spending that will increasingly take place in payment systems rather than cash.
It’s worth the fray. It burdens current income and yet I think it’s this sort of analysis that underpins our view that we’ll have sustainable long terms earnings power.
5.How does the weakness of the Euro (and thus the strength of the USD) factor into your large allocation of European equities?
I have 75% of funds invested in non-US companies, if you include Phillip Morris as a non-US company even though it’s headquartered in the US it does100% of its business non-US.
In any event, the weakness of the euro has certainly weighed upon the market sentiment towards the value of these businesses. They worry that the businesses are no longer as valuable an environment where the foreign currency’s declining.
In some ways, however, that foreign currency decline is what’s going to make those businesses over time more competitive. The businesses will attract more foreign purchasers as a result of the more appealing valuation. The businesses in the countries that we invested that have foreign currencies, often euro or other emerging market currencies will thus over time enjoy the benefit of increased economic activity because of the lower value of their currency making products and denominating markets more attractively priced.
I have long felt that in our current situation as a country that the likelihood that the doctor can weaken over long periods of time is higher than its strengthening. I think we have written tremendous checks and it’ll be very hard for this nation to cash as it relates to the spending around QE. Accordingly, having earnings and ownership denominated in foreign and non-US currency over time I think as it has in the past 25 years give us a tailwind to our performance.
This past years it gave a very hard headwind. I think over time the tailwind will arise from the fact that the countries we invest in internationally will contribute more to global commerce, they’ll have more employee citizens, more citizens in general because of the population growth.
With that will come more strength and with that strength I think firming currencies and I think the US, certainly Japan, as one of the mature markets have played some of that stuff in verse as we slowed down. In Japan’s case, as they have no population growth to drive consumption the west will probably struggle with their currencies over time even though they haven’t recently. At least US dollar hasn’t struggled at all.
The interesting secondary level of the currency analysis however has to do with the disappointment that American investors are beginning to experience at the sharp edge of the currency knife. The companies that make up parts of the S&P who are dependent on selling expensive capital goods, for example, or industrial items or any number of finished products from North America to export markets are finding that the export markets increasingly cannot afford products that are effectively 140% more expensive than they were 18 months ago.
The volume of sales go down under the weight of our strong currency. The absorption of manufacturing volumes goes down because of selling units and the units don’t absorb the product costs as well. The margin is at risk because of less absorption, lower volume and then the translation back of what reduced profits are being made abroad comes back to stronger dollars in the form of fewer dollars.
Suddenly you’ll begin to see as investors in North America an awareness that the strong currency is on many levels a threatening condition for American interests as opposed to one that was initially thought over the past 18 months as a safe haven from other countries problems. We face challenges because of the strong currency going forward. For that reason, I’m in part more confident as I am with non-US investment.
