Making hay while the sun shines

In the anniversary issue of Wealth Insight (July 2015), we had published a short interview of the value investor Thomas Russo, Partner, Gardner Russo & Gardner. We present the full, detailed interview of Mr Russo with Ekramul Haque in four parts, this being the second part.

What signals to you that the investments that a company is making are starting to pay off?
I think a good example is Nestlé's product called Nespresso, which Nestlé developed for 15 years. Nestlé has the 'capacity to suffer', even though they are not family-controlled. Being Swiss provides them with a sufficient long-term mindedness that, even though they weren't family-controlled, allowed them to invest for the long term. One of the products they decided to invest behind was a product called Nespresso.

Nespresso was a single-serve coffee system and Nestlé did not break even on developing this single-service coffee system for 15 years. It took them 15 years of investment spending before they broke even. The idea was both a single cup of coffee from an unusually high-quality machine that delivered true espresso shop quality and also a retail club-base in major cities around the world where you go and buy the cubes so the grocery store chain could not take out all of your margin. It allowed you to sell on a one-to-one basis in a very high-end luxury store setting both the pods with new flavors and the machines, as they introduced new machines. It took them outside the supermarket to give them pricing power. They developed a machine, they developed pricing power and they developed the club; and then they developed the online computer delivery of the cups.

That was a business that they invested in and it was a very, very slow, painful process watching them perfect the cup system and then to rollout the stores. Along the way, a competitor wanted to make sure that they were not left behind and they threw together a product called Tassimo. They stole their marketing budget from Maxwell House, a core coffee brand, and directed all their revenue to try to come up with a product that would deflect the market growth in Nespresso. By just shopping, the signals that I took that we were on the right path was to watch the exponentially growing success of the Nespresso rollout with both store attendants as well as machine sales. Then watching the very heavily upfront promoted, initial favorable results of Tassimo, be followed up with nothing but bleak and eventually disastrous results. The difference was that Nestlé invested behind its coffee technologies so that the 'capacity to reinvest' thoughtfully and they did so with the 'capacity to suffer' long enough to perfect it so that when it came to market it worked. You can compare the two outcomes and you realise the culture that gave birth to one had a very different set of management constraints than the culture that gave birth to the other. I take that as a signal within Nespresso of how good ideas are nurtured and hence it is the reason why I would have a large position in Nespresso's parent company and not the other company.

When should companies invest heavily?
In a portfolio company just recently, Wells Fargo, I think gave a perfect example of how to behave. When companies should invest, first and foremost, or not invest? The average company, if they were worried about Wall Street, would not invest in purchasing Wachovia in 2008. At that time, the entire banking system was fragile. Wells Fargo was not nearly so because it lacked the investment banking business that led so many of the money-centered banks into their condition. Yet in the midst of all that, because Wells Fargo had management and had a footprint that matched so well Wachovia's footprint.

For example, Wells Fargo, who made it through the crisis without bankruptcy and liabilities, probably should not have invested then if they want to be careful with their future results. Recognising that in the midst of a crisis they could buy something as strong as Wachovia at bargain-basement prices inspired them to invest. Wells Fargo has a very strong culture. They had a 14-percent shareholder in the form of Warren Buffett, they had Walter Annenberg as a shareholder, they had a purpose which is to build the business for the long term, and to do so in fairly simple businesses rather than the riskiness of Wall Street. When they had a chance to buy their equal-sized competitor in the retail business at 10 percent of their market price, they invested.

They invested in large measure in a way because nobody else particularly was positioned to invest at the same time. They could invest in it when no one else was willing to invest. That is, by the way, the absolute very best time to invest, when nobody else is willing to invest and that is what Wells Fargo did then. That is also, by the way, what has made Berkshire Hathaway so strong over the many years. Warren invests so often in businesses where no one else can invest because their managements do not have the capacity to suffer and so the answer is, you should invest when others cannot because they lack the capacity to suffer. Wells Fargo is a good example of that. They bought Wachovia, they knew that they would have five years of completely destroyed reported earnings, but at the end of it, they would be twice as large and they would have manned footprint geographically that the CEO recently described as 'the smile' because it goes from Alaska all the way down to North Carolina, across the fast-growing south-east to the best part of the country. He is able to buy it because nobody else would act at that time and he bought it at a very low price. He managed it all the way up to today to continue to make investments just like Wachovia and now today he is throwing off an enormous amount of free cash flow and he can no longer invest in commercial banks because they own 10 percent of the American deposit base and with that they are prevented by law from making any more acquisitions of banks.

Since that is what made them great and they want to stay within their core markets, this is no longer a time for them to invest in banks and instead, this year, they have announced that they would take their shareholder payout ratio for that income from 35 percent up to 80 percent, an additional 60 percent plus or minus with a split between increased dividend and a very large share buyback. So, the company that was wise enough to invest when it should, in the midst of despair when nobody else could, today when they are not allowed to invest because of regulatory restrictions knows enough to give the money that they have back to shareholders. Other less-wise management would diversify and in so doing risk that very thing that makes them great, which is their focus on a core banking customer. They would take the cash flow today and they would think that it was theirs as the management teams not the owners, as we do own it. They would go off and do something that would risk their franchise, but they are smart enough to know that what they are about is banking and the cash flow their banking generates for the time being that they cannot deploy, they will give back to their shareholders through dividends increase and through share buyback. It is very smart.

Warren Buffett gives us three other examples of when a company should invest and it is usually when nobody else can. A good example of that is GEICO. When they bought GEICO it only had one million policyholders and Warren thought it was the best car insurer and there were 112 million insured cars and he could not figure out why they did not have a greater share. The person who ran it when he bought it told him the reason was the first year of a new policy generates $250 worth of losses. Warren understood that a new policy, because of high persistency and because of low claims, had a $2,000 lifetime value whenever one was signed up. The probability suggested a newly signed-up insured represented a charge of $250 in the first year and had a lifetime value of $2,000.

The only thing between Warren growing the acquired company was whether he was willing to take the associated operating income losses resulting from growth. He had no problem doing that because he does not care one bit about reported profits. He is only concerned about wealth and so for the mere cost of a reported $250 loss per policyholder, he increased his wealth by $2,000 and he has grown since he bought the company. The public market, by the way, could not absorb those types of charges because if you have one million policies the second year you have acquired the company, you roughly have a $250 million loss even though the business is making money. Today Warren has 11 million policyholders and he said in the annual result that his willingness to take on that investment has added $20 billion of value to Berkshire Hathaway. Nobody else would have been willing to grow at that speed, however, because of the associated burden of the reported profits in near term. Warren did not have to worry about that burden because he is a shareholder who controls GEICO.

Two other examples, one of them Warren held $55 billion in cash, only earning 0.1 per cent in 2008 before the crash. He complained about not being able to put the money to work but he wanted to keep it safe and he kept it in Treasury bills and he only got 0.1 percent. If he had gone out and bought long-term bonds he could have made 5 percentage points and reported $2.5 billion more in profits but he did not. He kept it short, and when the market blew up and Lehman failed he was able to put that money to work with loans to GE at 12 percent and Goldman Sachs, I think at 12 percent, and Harley Davidson was at 14 percent. He had the 'capacity to suffer' unlike any other company, keeping $50-plus billion in cash earning nothing and derived the benefit that followed when that money became extremely valuable and he put it to work. Ironically, GE, to whom he leant that money, at such a high rate, had done exactly the opposite of what Warren was doing and they were using the overnight money market to fund $100 billion worth of their liability, which meant that they understated their interest expense from what they should have paid if they had a prudent, long-term oriented balance sheet. They should have been paying 4 per cent interest, but instead they were paying 0.2 per cent or something like that and overstating profits by $4 billion. That is a far more typical corporate move, which is to take steps to overstate near term at the risk and expense of long term and Warren's instinct was just the opposite - the burden for near term with less in search for more later. That is what he taught us and that is why he has done so well.

The last example of why such a perfect time for Warren to invest is when other people cannot involves the equity index put option because when he took on that liability he immediately marked to market and he declined in the equity markets globally and it goes straight to income. His reported profits were accordingly completely disrupted. You see, for him, since wealth was all he cared about, he knew that if he could get $5 billion dollars in premium to insure against a $37 billion global equity portfolio decline over 15 years that he would probably make out OK. The $5 billion he could invest and would probably triple over enough period of time and the likelihood that the global equity markets broadly speaking would be below where they started in 15 years with a pretty low probability. He was paid, I allege, far too much premium for that insurance policy. But the truth is, nobody else would have been willing to do it because they would have had to pass those losses through their income statements and nobody had that kind of capacity to suffer and in the first eight quarters that followed Warren's execution of that contract. I think the total was up to $12 billion of losses that he passed through his income statement on a quarterly basis. The idea about that is the proper time for him to invest in something like that is when no one else can because then he gets far better terms than anyone else could.

When should companies not invest?
For example, I think the answer is when the items to which they are thinking about investing in do not make sense relative to their core business. That is what Wells Fargo realised. They seemed to have a tremendous amount of cash flow. They could go out and buy any number of things. They could buy a hedge fund, etc., but they should not. Just because they could does not mean that they should. They have enough sense to know that and that by returning money to the owners the owners can take the different opportunity set and do something else with that cash rather than have a sub-optimal investment be made by a company that if they just stay focused on their cash will have a very bright future. They should not invest when doing so takes them away from what they already know and do well. Warren is often asked about people who do dumb things and end up financially harmed for it and he says he is always amazed that people will risk what they have and they need for what they do not need and often cannot have. I think that is a pretty good guiding principle.

Click here to read the first part of this interview.

This interview appeared in the September issue of Wealth Insight.