Podcast Summary
The importance of long-term investing in quality businesses: Identifying and investing in businesses with long-term growth potential can lead to better investment outcomes, even if it means holding onto an investment through market fluctuations and perceived overvaluation.
Key takeaway from this conversation between Patrick O'Shaughnessy and Chris Blumstrand is the importance of holding onto quality businesses for the long term, despite short-term perceived overvaluation. Blumstrand shared his biggest investing mistake, selling Ross Stores after making significant gains, only to see the stock become a 20-bagger in the following years. He admitted that he was anchored to the initial price he paid and hesitated to buy back in at a higher valuation. This experience emphasized the significance of identifying and investing in businesses with the potential for long-term growth and the ability to generate incrementally higher returns on capital. It's a valuable reminder that focusing on the quality of a business and its potential for long-term success can lead to better investment outcomes, even if it means holding onto an investment through market fluctuations and perceived overvaluation.
Investing in quality businesses run by quality managers: This investment firm focuses on buying outstanding businesses led by outstanding managers, with a long-term perspective and increased emphasis on management quality.
The investment philosophy of this particular firm revolves around the concept of quality, both in terms of the businesses they invest in and the management running those businesses. They prioritize quality over price and aim to buy outstanding businesses run by outstanding managers. However, their definition of quality has evolved over the years, with a growing emphasis on management quality and a long-term perspective. They've learned from past mistakes, such as investing in businesses with questionable management practices, and now prioritize businesses that align with their values and morals. They also spend more time analyzing proxy statements to understand compensation structures and incentives for management, as a significant portion of their compensation is tied to bonuses and stock options. Overall, their approach is to identify businesses that they can own for the long term and that are run by managers who share their values.
Focusing on free cash flow instead of sales growth: Companies prioritizing free cash flow over sales growth may cut costs in areas like advertising and marketing, but it could lead to a lack of focus on return on capital, which is essential for long-term value creation. Invest in companies with a strong focus on incremental return on capital.
General Mills, like many other companies, has shifted its compensation structure to focus on free cash flow instead of organic sales growth. This means that managers can cut costs in areas like advertising and capital expenditures to boost free cash flow, even if it comes at the expense of long-term growth. However, this approach can lead to a lack of focus on return on capital, which is a crucial metric for long-term value creation. For example, General Mills' acquisition of Blue Buffalo may not make sense on a return on capital basis, but since it contributes to top line growth, it could still earn incentive compensation for the company's leadership. Investors should look for companies with a strong focus on incremental return on capital, which ensures that new investments generate profits that exceed the cost of capital. Costco is a good example of a company that has successfully grown its returns on capital over time by expanding its store base and allowing new stores to mature before achieving maximum profitability.
Costco's Unique Business Model: Prioritizing Shareholders and Customers: Costco's membership program and efficient use of purchasing power maintain high returns on capital despite declining gross margins. Unique business features and initiatives benefit both parties and make companies resilient against online competition.
Costco's unique business model, which includes its membership program and efficient use of purchasing power, has allowed the company to maintain high returns on capital despite a declining gross margin. This model, which prioritizes the interests of shareholders and customers, has been a valuable lesson for the speaker. Additionally, the speaker values businesses with unique features and initiatives that benefit both parties, such as Costco and Dollar General, which are seen as resilient against online competition. However, the speaker cautions against private equity deals that prioritize short-term gains over long-term business health, as seen in the example of Dollar General's past leveraged buyout.
Dollar General's Success: Focus on Unit Economics, Expansion, and Management: Dollar General's success is due to its focus on unit economics, expansion plans, effective management, and serving rural markets with a wider range of products. Key strategies include assessing high-return investment opportunities and retaining good managers for improved training and lower turnover rates.
Dollar General's success can be attributed to its focus on unit economics, expansion plans, and effective management. The company's ability to differentiate itself from competitors by serving rural markets and offering a wider range of products has contributed to its growth. Additionally, Dollar General's initiative-driven approach, including the addition of cooler doors and expansion of store formats, has helped the company adapt to changing market conditions. Another key factor is the company's focus on retaining good managers, which has led to improved training and lower turnover rates. A successful investment strategy might include assessing the runway for capital reinvestment at high rates of return, particularly in businesses that offer unique distribution models, such as Nike, Disney, Richemont, and Cummins. In the case of Richemont, taking distribution back in-house has been crucial to maintaining control of the customer relationship and ensuring the luxury image of its brands.
Richemont's focus on brand value drives high gross margins: Richemont prioritizes long-term brand development, maintains inventory value through controlled distribution, and continues this strategy with recent acquisitions. Disney's move to control distribution offers similar potential.
Richemont, a luxury goods manufacturer, stands out for its high gross margins, driven by the value of its brands rather than the cost of materials. The company's chairman, Johan Rupert, prioritizes long-term brand development over short-term earnings. Richemont's growth was fueled by Asian demand, particularly in China, but sales took a hit when the Chinese government cracked down on graft and limited travel visas. Instead of marking down merchandise, Richemont bought back inventory and controlled distribution to maintain brand value. The company's recent acquisitions of Net-A-Porter and Watchfinder continue this strategy. Similarly, Disney's decision to take back control of its distribution, as seen in its move to stream content directly to consumers, is an attractive investment opportunity due to the potential for increased revenue streams and better control over pricing and brand image.
Control of distribution channels gives businesses a competitive edge: Successful businesses, like Disney and Cummins, invest in controlling their distribution channels for a competitive advantage. Disney's ownership of Hulu and ESPN apps, and Cummins' global network of service centers, are examples of this strategy.
Successful businesses, like Disney and Cummins, understand the importance of controlling their distribution channels. Disney's ownership of Hulu and ESPN apps allows them to run their content across these platforms, giving them a competitive edge. Cummins, on the other hand, bought independent service centers years ago and branded them under their umbrella, creating a global network of service centers that is a significant advantage for customers. Both companies have shown the value of investing in distribution and maintaining control over it. Additionally, the discussion touched on the contrasting investment styles of focusing on quality versus value, and the importance of growth as a component of the value equation. While some investors may prioritize price or quality over growth, it's essential to consider all three components to avoid potential value traps.
Value investors held Microsoft longer than expected due to continued growth: Value investors emphasized the importance of identifying compounding businesses, but acknowledged not all investments will be long-term holders. They shared an example of owning Subsea 7 for its strong management and growth potential, but not expecting a large return.
Even companies with strong historical growth, like Microsoft, can face valuation challenges that may not align with their intrinsic value. The speakers, who have a value investing approach, found themselves owning Microsoft for longer than anticipated due to its continued growth, despite their initial prediction of shareholder losses. They also emphasized the importance of identifying compounding businesses, but acknowledged that not all investments will be long-term holders. They gave the example of Subsea 7, an oil and gas engineering construction business, which they own for its strong management and growth potential in deepwater drilling, but do not expect to make a large return on. They also shared their admiration for Berkshire Hathaway and its evolution, but did not disclose their current stance on the company. Overall, the conversation highlighted the importance of careful analysis and a long-term perspective in investing.
Explaining Berkshire Hathaway's Unique Accounting Methods During Economic Downturn: During economic downturns, transparency and clear communication about a company's unique accounting methods and long-term investment approach can help preserve business and attract new investors.
During tough economic times, even successful businesses and their leaders face pressure and scrutiny from investors. In 2015, during a year of significant market downturn, Chris Davis of Davis Funds felt the heat from clients questioning the performance of Berkshire Hathaway, one of their largest holdings. Despite the underlying businesses within Berkshire and the Sempra portfolio having accreted in value, Davis recognized the need to explain the company's unique accounting methods and the long-term perspective of their investment approach. Initially hesitant to share the information publicly, a friend convinced him to publish the letter on his blog, leading to widespread interest and engagement from investors around the world. The letter, initially meant as a self-defense and business preservation tool, has since become a valuable marketing document and an example of how Berkshire's business model has adapted to various market conditions throughout its history. Berkshire Hathaway is a unique holding company with a collection of businesses and a management team that has built a durable, permanent infrastructure, pivoting at times to take advantage of major inflection points in the capital markets.
Berkshire Hathaway's Business Strategy Shifts: Berkshire Hathaway adapted their business strategy twice, moving from textiles to insurance in the 70s and from insurance to acquisitions in the late 90s, enabling them to grow beyond their stock portfolio's limitations.
Warren Buffett and Berkshire Hathaway pivoted their business strategy twice in response to market conditions and the value of their stock portfolio. In the late 1970s, they shifted from textiles to insurance, utilizing the float from their insurance business to generate high returns on equity. In 1998, they bought General Reinsurance to reduce their reliance on stocks and pivot away from insurance. Despite spending a significant amount of Berkshire shares in the deal, the allocation of capital towards bonds and cash enabled them to make large acquisitions in the following years. While the value of those Berkshire shares today would be substantial, the deals allowed them to invest in other areas and grow their business beyond what they could have done with their stock portfolio alone.
Berkshire Hathaway's growth from JENRE deal not just about Jen Re's value: Berkshire Hathaway's growth from JENRE deal came from investing capital in diverse businesses, leading to a net capital base of $110 billion.
That the JENRE deal's impact on Berkshire Hathaway's growth cannot be evaluated solely based on the current market value of Jen Re or the capital given up at the time of the deal. Instead, the value lies in how Berkshire used the capital from the deal to invest in other businesses, such as Burlington Northern Santa Fe railroad and various manufacturing, service, and retail businesses. These investments have significantly contributed to Berkshire's overall growth, making it a diversified conglomerate with a net capital base of $110 billion. The railroad and utility businesses, for instance, have become more valuable due to changes in the industries and Berkshire's effective use of leverage. The equity within these subsidiaries remains separate from Berkshire's parent company, making the business structure uniquely diversified and liquid. The discussion highlights the importance of considering the long-term implications of capital allocation and industry changes when evaluating the success of business deals.
Berkshire Hathaway's Value Beyond Book Value: Berkshire Hathaway's value comes from its leadership's capital allocation, durable electric utilities with high returns, tax advantages, succession planning, and attractive investment prospects in non-low inflationary world, as well as its railroad business' permanence and good management teams.
Berkshire Hathaway's value comes not only from its book value but also from the masterful capital allocation by its leadership. The company's electric utilities, which are arguably the best in the business, have the potential for high returns on reinvested capital and tax advantages. The durability of these businesses, along with the succession planning efforts, gives investors confidence in Berkshire's future. Despite the lack of dividends, the potential for high returns on investments made at today's dollars in non-low inflationary world makes Berkshire an attractive investment prospectively. The railroad business, while existing in an oligopoly, also has permanence due to its hard-to-displace nature. The company's good management teams and their succession planning efforts add to the durability and confidence in Berkshire's future.
Effective Risk Pricing by Warren Buffett and Ajit Jain: Understanding financial statements beyond reported numbers is crucial for accurate investment analysis. Berkshire Hathaway's success relies on Buffett and Jain's ability to price risks effectively, particularly in national indemnity business. Transparency and succession planning are desired by shareholders.
The ability of Warren Buffett and Ajit Jain to price risks effectively is crucial to Berkshire Hathaway's success, particularly in the national indemnity business. Jain's role as a brilliant underwriter has been highlighted by Buffett, and his absence or lack of a capable successor could impact Berkshire's ability to write certain types of business. Shareholders desire more transparency and involvement from Buffett and Ajit, not just for granular data on operating businesses but also to instill confidence in the succession plan. Another key takeaway is the importance of accounting adjustments in analyzing businesses. Semper Augustus emphasizes a rigorous approach to understanding the financial statements, going beyond reported GAAP and IFRS numbers to examine write-offs, write-downs, and other adjustments that impact economic profitability. Companies may underreport expenses or overstate equity to boost reported returns on equity, and it's essential to account for these factors to gain a clear understanding of a business's true profitability. Investors can learn from Semper Augustus's approach to accounting and the importance of making adjustments to reported numbers to gain a more accurate view of a company's financial health. By delving deeper into the financial statements and understanding the underlying economic profitability, investors can make more informed decisions and potentially uncover hidden value in their investments.
Impact of write offs, write downs, and accounting adjustments on equity and capital: Write offs, write downs, and accounting adjustments like defined benefit plans can significantly impact stated equity and capital numbers, leading to misleading conclusions about returns if not accounted for.
When analyzing a business or an index, it's crucial to consider the impact of write offs and write downs, as well as accounting adjustments like defined benefit plans, on stated equity and capital numbers. These adjustments can significantly impact returns on equity and capital. For instance, write offs and write downs can result in a loss of up to 15% of profits over a long period of time, leading to an understatement of equity and an overstatement of ROE. Similarly, the assumption of a 4% return on defined benefit plan assets, while historically common, may not accurately reflect current market conditions where a 9% return was once assumed. Failing to account for these adjustments can lead to misleading conclusions about a business or an index. Therefore, it's essential to make these adjustments to arrive at the right numbers and gain a clearer understanding of true returns.
Investment landscape changes lead to lower return assumptions and shift in strategies: Property casualty insurance offers undervalued stocks with consistent performance. Regulatory threats and high valuations keep some companies out of reach, but their high returns, low capital requirements, oligopoly structures, and long growth curves make them attractive prospects.
The investment landscape has changed significantly over the past few decades, leading to lower return assumptions and a shift in investment strategies. With return assumptions now around 6.5%, compared to the previous 9%, it's less of a drag on portfolios. One industry that has consistently performed well despite its challenges is property casualty insurance. The industry's mediocre reputation leads to undervalued stocks, allowing investors to find good businesses at modest prices. As for businesses that seem out of reach, such as Mastercard or Visa, regulatory threats and high valuations have kept many investors away. However, these companies' ability to maintain high returns through low capital requirements, oligopoly structures, and long growth curves make them attractive prospects for the future. The kindest thing anyone has ever done for me was a friend's recommendation to explore podcasts and prepare for this interview.
Early football experiences shaped speaker's character: Coaching and fairness instilled work ethic and determination in speaker during formative football years
The importance of hard work, mentorship, and fairness, instilled in the speaker during his formative years playing football, significantly shaped him into the driven and successful person he is today. From the age of 8, he was molded by various coaches, including his first coach, Ken Acker, who took the time to teach him the fundamentals of football and inspire him with kindness and encouragement. Despite being a terrible football player initially, the speaker was motivated by the game and the coaches' hard work and fairness. A pivotal moment came after a loss, where Coach Acker consoled the speaker and recognized his progress, further fueling his determination to become the best player he could be. The lessons learned from these experiences have stayed with the speaker and influenced his life beyond football.
The Power of Mentorship: Mentors provide valuable guidance, wisdom, and support, helping individuals navigate challenges and reach their full potential. Investing in the next generation through mentorship has lasting impacts on individuals and society.
Key takeaway from this episode of Invest Like the Best is the importance of mentorship and shaping younger people during their formative years. Several guests have shared their experiences and insights on this topic, emphasizing its significance in both personal and professional growth. Mentors can provide valuable guidance, wisdom, and support, helping individuals navigate challenges and reach their full potential. This theme highlights the importance of giving back and investing in the next generation. Overall, this conversation underscores the power of mentorship and its lasting impact on individuals and society. To continue learning and expanding your knowledge, visit investorfieldguide.com/podcast for more episodes, and join the book club at investorfieldguide.com/bookclub for monthly reading suggestions. Follow Patrick O'Shaughnessy on Twitter @patrick_oshag for more insights. If you enjoy the show, please leave a review on iTunes to help spread the word.
