This is the second portion of the interview we conducted with Tom Russo (Trades, Portfolio). The first part of ther interview can be found here. We would like to thank our readers again for the questions submitted. Due to time, we were unable to ask all of them.
6.The power of brands as “a share of the consumer’s mind” is clearly quite important to you and the cash flow that comes from that sort of moat. Any thoughts on technology brands (ex: Facebook (FB, Financial), Google (GOOG, Financial))?
I think it’s a very interesting question. Google’s fairly a very powerful brand, Facebook power brand. These are more than brands. Apple has its own characteristics as well. They’re more than brands, they are also places of price and elastic demand. If you want to do search, you really don’t have many other places to go than Google.
If you want to have sort of the full social network envelope surround you, it seems like Facebook’s the top choice--other than Alibaba--and some of the emerging non-US versions. Facebook certainly seems to envelope the life of the millenniums. I know all the people live their lives through those networks and so they’ve become increasingly valuable. There’s no question about that.
Interestingly I would say more interesting to me since I’m effectively under involved with those directly, more interesting for me is the fact that all Facebook or Google, Apple, Yahoo, Twitter, any number of different technological platforms are really important for our brands. They advertise digitally. They use the digital networks to speak about the traditional TV advertising campaigns that they’re going to launch ahead of time like they do leading into the Super Bowl. Then they have digital chatter during the Super Bowl amongst people who are watching and incentive to do so by the manufacturers whose interests are being advertised. After the Super Bowl people talk on for long periods of time on the internet about the impact of the advertising.
Our traditional companies, were brands matter terribly much have the ability for the brands to be lifted by getting the digital conversation going in a favorable way. Our companies also have powered up organizational capacities that allow them to make sure that they don’t let brand damaging conversations occur without response. Our company’s investing heavily in activation centers that go into the marketplace and address questions early on so that the reputational impact occur inadvertently adversely.
Then I’d say the other overarching factor, especially not only with the technology brands of Facebook and Google and other source of chat and search. More importantly, the advent of e-commerce has meant that consumers around the world are increasingly able to get products outside their local distribution network using e-commerce. You don’t have the same boundaries that favor, old fashioned products that face little competition because they controlled the chain of the market. Markets are opening up because of e-commerce and the consumers and their hunt for the “new cool” are willing to fairly quickly abandon the “old cool” at rates seen unprecedentedly.
I think it’s sort of 1920s flapper era type feeling where all that old is considered fairly dull and the new is coming in with a wave of enthusiasm kind of spoken about through the platform. That means that the traditionally ensuring brands have to fight the startups much more vigorously in the spirit industry, that’s artisanal spirits like Hudson Bourbon and the beer category it’s a legendary growth of craft beer. In the cigarette category, it’s sharp growth in e-cigarettes.
There’s so many businesses where the core platform’s being challenged by alternative startup endeavors which historically never would’ve gotten off the ground but for in some ways the buzz that gets driven by technology and the media, especially the digital media.
It’s disruptive to the length and the longevity and the potentially the health of consumer brand with all the chatter that takes place driving experimentation and new choices.
7.What is your strategy when the overall market looks frothy? Is there anything else to do other than increasing cash holdings and/or shifting to cheaper companies?
We tend to manage money for wealthy family offices and for people for whom the allocation to what I do--global equity with a sort of orientation for the consumer is just a part of an overall asset allocation. The concept of going to cash, shifting to cheaper companies it’s been taking all sorts of corrective action specifically within our portfolio is less than because the role that our portfolio plays within the overall portfolio, the families that we invest for.
They already had plenty of cash. They already have other people doing cheap companies. They have other people doing technology, oil, gas and so on. We play a very specific role and within that role I prefer to hold our holdings to cash because I think we’re generating more internally on the capital deploy in the company than we would be if we held cash.
That’s a statement that’s independent of today’s cash returns being only putting 1%. I felt the same way when the money market rates were 5%. I thought that our companies historically could do better than 5%. Even if the market doesn’t recognize the incremental gains that occur for the reinvestment, over time they will. Like a coil spring, it will release. That’s what I believe we get by staying the course.
Now, during frothy markets we do have the opportunity to rebalance portfolio holdings. At some point over the last three years Phillip Morris International’s up 45% one year. The shares moved up in terms of the percentage weight sharply because of that outperformance. We had the opportunity to rebalance back from some of those shares to business holdings in Heineken (HEIO, Financial) that had gone down. In valuation and with that they had become even more undervalued and even more percentage of the assets. We rebalanced Phillip Morris those two holdings.
That kind of rebalancing does take place fairly often. I think it adds a bit of an extra value. Our main gains come from getting the big ideas right.
8.What was one of the hardest years for you financially and what did you do to recover?
Well, I really haven’t done differently across the time horizon. The hardest year for us from a performance perspective would’ve been 1999 when Vic was down 2% and the S&P was up 27. I didn’t do anything. What we had was the capacity to suffer given us by our investors because we had the capacity to hold traditional businesses in an internet [inaudible 00:40:22] market when the ease of making money and technology seems to threaten traditional businesses that we long relied upon.
Our investment allowed us to stay the course. Around 2% the S&P was up 27. Into 2000, we were down further. The S&P was up more. It finally all broke and with the break we did nothing by way. When it did break what little capital was left moved back over to traditional businesses and it took years. In fact, only today has the NASDQ returned to the price that it reached in early 2000. During that time, our holdings may go up three or four times. I say that we did nothing even though we were 2900 basis points behind the S&P. other than just stay the course of our companies.
Check with them and make sure that they hadn’t suffered mortally as a result of the growth into the world. Then just encourage them to buy back stock and stay the course and reinvest like mad to build platforms when other people are distracted and facing the favorite ideas of the day. Our commitment was to ask our businesses to spend more heavily and to build deeper franchises. I think it paid out over time.
9.If you had to start a new portfolio today, would you still choose Berkshire (BRK.A), Nestle (FRA:NESM, Financial) and Heineken (HEIO, Financial) as big positions? Why/why not?
The answer to the portfolio weight, I would have the new portfolios roughly mirror the existing portfolio: Berkshire roughly 11.5%, Nestle 11%, Heineken up at 6-6.75%, Mastercard and Wells both over 7.
I believe that those are the proper companies and the proper rates. I don’t dwell on new money because there’s a lot of event risks surrounding one period point of time in funding a portfolio. We typically we’ll get the bulk of the exposures to mirror the portfolios and existing holdings and existing investors so that they’re covered with the same opportunity set. What little we have left over after the initial investment we work into those same core portfolio holdings opportunistically and as the markets give us opportunities to buy at better prices the same things that we want to hold for the long time for all of our investors.
We recognize the single event risk of putting all money in the first day. We blend our investments in but we will end up our goal is to have the investor own the same portfolio. As old investors did and with a belief that portfolio holdings are not a bit old in their spirit because they’ve transformed themselves along the journey serving investment.
10.How do you determine when it’s time to sell? Also, what is your reasoning behind not selling often?
There’s several layers. One is that the management does something that is unethical. That’s the first thing. If we get abreast that they’re telling us something less than the full truth we can’t stay on because at that point we know that our agent is either inclined to self-deal or self-deceive. Neither are those are very healthy long term. We decide right off the bat if we felt that the flow of information wasn’t honest or true.
If they make colossal mistakes in judgement in terms of how they’ve allocated our capital, viewing the opportunities set in the future differently deep and differently than what we believe to be we will probably part companies because of failure of the capital allocated so vastly damning of future return. Then we have been largely experienced over time with selling based on a forced gun to our head when somebody comes to take over our businesses we’ve had taken over very early on. We had owned up to nearly 20% of the company was taken over.
That's been a large factor in releasing capital for new ideas over time in the acquisition by other companies who cover our business asset. Then the last selling is that rebalancing that we talked about which is where there is just an opportunity to increase the prospective returns of the portfolio by reducing portfolio holdings that are still interesting but less undervalued that it becomes larger. Doing the flip side with the proceeds by deeper positions bad business that are more undervalued because prices have gone down and left underweight. That’s what we do all the time.
The reason for not selling often is my goal is to find businesses and invest and reinvest efficiently that they re-deploy our capital at a high rate, higher than I can outside their business. By doing so they will develop texts very well for my investors. That’s the goal.
11.Can you share your thought process used when analyzing the risk associated with a potential buy?
I think the idea is it’s whether or not you’ve identified people, because if it’s a potential buy that's outside our universe we would struggle to make sure that we know whether the people we’re dealing with are making the tradeoff properly for the long term versus the short term. I give you an example of that. We were looking at companies recently and one of the largest businesses in the country announced that they were going from a direct sales force to a broker sales force.
To a person invested in the food and beverage industry for a long time, that variabilization of once considered fixed cost as accomplished by taking your sales force. Dismissing it and just using a broker for those volumes that you’re actually selling seems to make sense until you realize that the scale advantage that larger businesses enjoy when they hire their own sales force is enormously competitive. The thought of companies giving that up to a person in the food and beverage industry is an enesma.
Yet, if I were not skilled in analyzing food and beverage companies as I hope to be over many executives doing this, I might not have reacted so powerfully against that measure. It seems silly to have sales people off-peak stop working hard. If you hire them for the peak and you actually owe it to your business’ vitality, not to give up the competitive benefit that you get from having a passionate sales force moving your product, properly positioning your product around retail outlets.
As I go to other businesses, let’s say if I wanted to look at the oil business, someone says that they’re going to stop drilling and just let other people drill for them. That may seem like a sensible thing but it may be giving up all the return. When I start looking at a business, it’s difficult to know whether I can properly access the difference between a smart move as it relates to how a company might reorganize the business versus one that might be driven by short term and dangerous principles.
That’s why I think the risks are largely managing capacity, management integrity, management honesty that has the dependent upon in your understanding what is important about a new industry and what risks that are in a new industry that might not be apparent to an outsider. Those are exactly the theories I think we face.
12.What kind of questions do you ask management to understand how the company is reinvesting and how willing it is to suffer short term earnings pressure as it reinvests?
All I can tell you on that question and I see it here. The only thing I can say to that question is that I think what I believe in the ideal world should drive business decision making about the capacity to reinvest along this term is that the same time something that managements will tell me is really a ludicrous concept. You can’t unleash a passion for short-term earnings losses.
If you let businesses for long periods of time say that they’re doing swell but they just keep losing more and more money, it’s not properly policed if the recipe for either damage management. Because they’re unable to stand up to the burden of making near term profits or you run the risk of just backing wrong startups that you’re casually throwing money and claiming that the profits will come later. Then hopefully retire before the judgement day arrives.
That’s kind of the constraint against the advice that I say in the extreme, which is to invest until it hurts and hope that you have management’s back covered. Because this way you’ll be able to invest for the best long-term payoff. I’m often reminded of my simplistic view of this process when senior management, CFOs and the public companies that I’ve invested in come up to me during a period of time when the they report.
There’s a certain amount of idealization that goes onto the extreme characterization that I offer. I do think it’s instructive and it’s important at its point, though it’s extremely hard to implement. One of the greatest skills that Warren Buffet has expressed over his career I would allege are his skills at incentivizing the right conduct within his businesses.
I understand at Geico he had since based on combined ratio and market share. The two are perfectly equally poised and you can’t favor one without losing the other. What you have to do to make your returns, your incentives is you have to come up with devices that allow both to win. That gives you better combined ratios and better market shares. That’s called advertising.
That’s called consumer insights, consumer service. It’s what has helped Geico grow from 2 million policy holders when Berkshire bought it to now over 11 million and increased the net worth of Berkshire’s holdings in Geico, who now owns the whole company by $20 billion over the period that he’s owned it.
The virtue of that is that he’s been able to make those reinvestments despite the burden on current income and he’s through his example so often illustrated the successful way to grow wealth even at the expense of short-term profits. Especially at the expense of short-term profits in many instances. It’s been a beauty to behold from the outside.
13.If you could do one thing differently, what would it be and why?
For me at least it would be spend the balance of how one spends their waking hours. I think for me at least it is the drive to get more time with more company specific communications. The tradeoff is investing between the general background context and the specifics of companies themselves is one that everybody strike differently. I would find that the one thing that I would and I continue to strive to do is more company specific and less context specific activities.
It wouldn’t be sell more often, sell less often. I often know there’s a refrain to this question and I often hear from people which is they say I wish I traded less frequently. I think the observation is often there that they’ve been better at picking than they are at holding. That’s just because people often have short term attention spans, they get swept away with the next best. Any number of reasons they have a short profit so they might as well take it because as people say you never get broke taking a profit.
For all those reasons, wise investors often say that the one thing they wish they did was trade less. That’s not particularly something that I’d necessarily struggle with because I’ve gone almost four years without buying a new position the last two positions from MasterCard (MA, Financial) and Anheuser-Busch (BUD, Financial). I would suggest that for me at least my charge at least internally is to spend more time with the gritty specifics of the companies, the managements and to fasten my attention on those specifics.
I think as Warren Buffett (Trades, Portfolio) has said, you’re supposed to spend your time focusing on the play that’s on the field and not on the scoreboard. I think it would also be the play and field not all of the stuff that’s going on in the surrounding community. Focus on the game at hand. That would be my observation.
14.You mentioned about the capacity to reinvest and that seems to be extremely important to you. For companies like Mastercard or Phillip Morris, they don’t really need reinvestments.
They don’t need it but the beauty is they’ve been able to deploy it. That’s what’s so exciting about MasterCard is that they actually have a place to put it. That’s because of the fast changing world of technology and vast opening up world of emerging markets that they have now the ability if they move to put a tremendous amount of capital to work in pursuit of an even greater mod of new business.
We’re excited about them laying down those investments. Phillip Morris has pulled out a couple billion dollars of capital over the years to try to come up with an alternative to a combusted cigarette. They’re deep involved in the process of developing that technology at the moment. You’re right, the core business does not require capital. You’re absolutely right.
The other thing I’d just say is be careful. I make sure to spend as much time as I possibly can with management, especially those in the developed emerging markets not to just blindly apply the admonitions from Wall Street to release working capital that has profited many consumer companies that a largely mature market profile.
The great evidence being a company called Reckitt Benckiser (RBGPF, Financial), which over the course of the early 5 or 10 years run by a tremendous manager name Bart Beck released a couple billion dollars of stale working capital under that inspired man’s vision. That money was then used to pay down debt and buy Beck stock. Massively fueled a great advance in shareholder wealth because that money actually wasn’t needed and it actually led to a lot of mistakes by having an extra $2 billion working capital hanging around.
You had stale products, you had dated products, you had broken products. The consumer wasn’t happy. The system didn’t flow healthfully. That’s a great western market story. However, when you’re trying to roll out India or Africa or China, you can’t under invest. They both have to be pushing forward because the trade requires the funding because it’s still primitive. If you don’t want to be out of stock you better have some solution of helping the trades stay in the stock.
The supply chain that you need to rely on to be authentic and non-destructive to your career here, your corporate interest, your suppliers probably need to be paid quickly. Because if you try to nickel and dime them like you might do in a western setting, you may find that they cut corners to try to remain profitable by lower prices. If they cut corners in developing emerging marketing you may read headlines about young children being killed by poison tainted milk.
Our companies have to understand that they can’t only think about the capital reinvestment in the balance sheet. They also think about working capital. To your question, we looked for the places in which our companies are capable of deploying capital and reinvesting. For those companies that can’t reinvest like Wells Fargo has recently approached the 10% global international deposit share limits and they could no longer invest in growing their banking franchise through acquiring deposits, they have to create value in other ways. They’re buying back stock. They’re increasing their payout ratio from 25% to 75%. That’s the right move.
I don’t control those moves like Warren does with his companies. We have to kind of take what we’re given. Our goal is to find businesses that understand that if they don’t have reinvestment opportunities they have to give them to invested shareholders.
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