What’s the first factor to look at when analyzing a company? How do you determine whether a brand creates a wide moat? Which method should investors use to estimate intrinsic value? How to detect and avoid investment mistakes before it’s too late? In search of guidance to these and other key questions on the art of investing, we have had the distinct pleasure of learning from famed investor Tom Russo, Partner at Gardner Russo & Gardner, through conversations conducted both in person and online at past ValueConferences events. Tom is also a keynote instructor at Latticework 2016.
Tom Russo has been one of the most generous value superinvestors in terms of sharing his knowledge and experience with the value investing community. Tom’s investment approach is focused on a small number of industries in which companies have historically proven to be able to generate high and sustainable returns on capital and returns of capital. These industries typically have included food, beverage, tobacco, and advertising-supported media. This focused approach reflects Tom’s training and discipline at the Sequoia Fund in New York, where he worked from 1984 to 1988. To broaden this otherwise narrow universe, Tom includes companies with smaller market capitalizations and companies in similar industries based outside of the United States. Indeed, Tom has had the foresight to recognize the benefits of international investing before many other investors did so. In the process, his clients have reaped superior investment rewards.
As always, Tom was articulate and insightful, adding many nuggets of wisdom even to those of us who have been following his invaluable advice for years. Such are the fruits of lifelong learning! In the following video and text excerpts, we show just some of the many highlights. The full video and transcript of our conversation with Tom Russo is available to members of The Manual of Ideas.
Tom Russo on the Event That Shaped His Path as an Investor
Thomas A. Russo (transcript): “I came upon value investing at the Stanford Business School in the early 1980s when Berkshire Chairman and CEO Warren Buffett came to our class and it was a class taught by Jack McDonald, who is a lone voice in Palo Alto towards thinking about investing as though you are acquiring pieces of companies and then assessing whether you think that the company had competitive advantage that would endure and then coupling those two discoveries into the process of investing regardless of the environmental concerns or academic principles that might be in contradiction to the bold assertion that one might just identify a company with superior economics and a strong culture that could pose the investment for the lifetime of the investor.
The man who spoke at Professor McDonald’s class, Warren Buffett, is the reason I think why today, people like me have the ability to presume that they have the trust of investors to attempt to invest for the long haul. He did it and has a lifetime of success to prove that it’s possible to consider great businesses, great managements and then align your investor interest alongside of them for the very longest term with disregard to the tools in modern finance, which have the academic imperator behind them. Buffett stands in contrast to that. It is because he has existed that people like myself and other value investors are able to say that we too would try to like to identify similar businesses, maybe in different industries than what Warren’s focused on or different geographies. I chose early on the international markets as a result of the same course where Warren spoke in that the professor, Jack McDonald, to the class in the 1980s—early 1980s—said, ‘Don’t be provincial. Look abroad’ and that spelled a huge difference for me as I’ve been going through my career with that idea.”
Tom Russo on Why Understanding the Culture of a Business Is the “Glue of Investing”
Thomas A. Russo (transcript): “Value investing is the camp that I guess I belong in if you were to categorize investors. And that value investing simply says you’re looking to try to buy a business at some margin of safety that comes about because the price pays a discount—a sufficient discount—from value given, granted. That discount is what you can determine through analysis of the strength of a business, through its component parts, its segments and then value of the enterprise—coming up with a sense of what it’s worth and then backing up liabilities, adding in financial assets and then coming up with a per share value and comparing that to what you’re paying.
And that’s a very mechanistic approach but the real glue of investing, I think, is understanding what the cultures are in those businesses that can do something with that discount and make it actually mean something long term. And that means to say that a discount from value can reward you by just closing, but the returns that you make from that closing are very time specific. If the discount closes in the first year of ownership you’ll make 100% on your money. If it takes seven years you’ll make 10% on your money. If it takes 14 years you’ll make 4%, 6% on your money, substantially declining rate of return with the passage of time. So what you really need to do if you’re going to find a discount value to begin with and then hold it for a long time without reducing—maybe even increasing your internal rate of return for the whole period—is you had to find a business capable of reinvesting.”
Tom Russo on the First Factor to Look at when Analyzing a Company
Thomas A. Russo (transcript): “Well for me it would be the people. It would be who owns it and then it would be kind of who runs it, what’s the quality of the management team—it’s very much people driven analysis. On the ownership side is if there is a strong holder who is likeminded in their long-term outlook I would find that to be a very early positive indicator that justifies setting out to do more work. If I found on that first test that there was something about the management that left me feeling it was opportunistic or short term driven I probably won’t embark on the analysis that follows. Threshold screening would be caliber of owners and then the management that follows.”
Tom Russo on How to Differentiate between Good and Bad Family Control of a Company
Thomas A. Russo (transcript): “One of the great indicators is the caliber of the people who are not family members who are active in and retained by the businesses that we choose to invest in. It’s really clear if you have a business where the family is abusing the franchise for whatever reason, whether they’re underinvesting, whether they’re siphoning off money, whether they have side deals with themselves to pay themselves premium for services offered or products delivered. They have ways in which they extract value from the public. Quality individuals tend not to find a way to those businesses. And so as you meet the various professionals up and down a business if you feel like there is just a B-grade quality to that organization it often reflects problems at the top and problems within the ownership.
So I think the real best test is “Are they able to recruit the industry’s best and brightest and keep them, incent them and then have them develop products that are world class?” I think that’s certainly the standard that you expect for a company like Nestle and some of their global counterparts, if they haven’t had the right nurturing environment or they treat their consumers with less attention than the company that operates it at Nestle’s level, they just won’t keep the same talent.”
Tom Russo on How to Determine Whether a Brand Causes a Wide Moat
Thomas A. Russo (transcript): “I think the real story with brand strengths and the return that you get from them is linked to the distribution and the retail channel. And to the extent that you are reliant upon the mass market where the retailers have enormous clout and you fail to deliver innovation on your brand platform, you are increasingly today going to suffer pressure on price.
So, it’s really incumbent upon the stewards of the brands that we invest behind that they innovate and that they add value and that they tell the consumer about it through effective marketing—whether it’s digital, whether with conversation or whether it’s broadcast, whether they create an atmosphere, whether it’s billboard—whatever the vehicle is—they have to tell the consumer that there is a reason why they’re asked to pay up is because some product feature warrants the premium price that they’re asked to pay.
And absent that in the grocery or the beer, spirits, wine are—absent that you’re going to face pressure and the pressure is going to increasingly come from the retailer and it’s going to be enforced against those who fail to innovate by retailer owned brands, which increasingly are viewed as adequate by consumers around the world when compared against just the me-too offerings of even strongly branded companies if they don’t add enough value through the communication or the innovation that the product should deserve to stay vital as a brand.”
Tom Russo on Which Consumer Goods Are in Danger of Commoditization
Thomas A. Russo (transcript): “There are categories that don’t lend themselves well to margins generally speaking and one of those categories has historically been dairy but we have examples in developing emerging markets where portfolio companies are adding a fair amount of value through dairy and dairy-related products because they are a tremendous way to deliver health and nutrition benefits to the developing emerging consumer, especially to the young consumer, for instance recognizing that the brain development at ages 0-2 is so terribly important in the health of a country and milk, which is in the western markets heavily commoditized in developing markets with proper application of healthful ingredients, becomes quite a good business for Nestle, for example.
Pasta is a pretty commoditized product around the world. There are a host of products that even when they’re branded don’t command much margin and our portfolio companies have been in those businesses and to their credit over time they’ve identified them and parted company with them. The frozen vegetables, frozen fish, frozen businesses in general—many markets have been poor and our companies have exited those.”
Tom Russo on the Relative Merits of Beer, Spirits, and Wine (Leaving Aside Valuation)
Thomas A. Russo (transcript): “In terms of capital allocation, I’m fairly agnostic between beer and spirits but have almost no direct exposure to wine as a category. I’ve always felt that the value add off of the commodity cost there and the pricing power that they enjoy in the wine industry just hasn’t been as rewarding as you get with spirits and with spirits increasingly where you can tier the pricing so sharply and aspirational consumers are willing to pay substantially more for components in the price hierarchy that don’t cost all that much more. And so there’s the possibility of tiering in a way that you really just don’t get with wine. And then beer compared to wine—the economics of beer at scale with dominant local brewers is just far more attractive than you ever find with wine because of the great production efficiencies and the scale advances that you get with brewing as opposed with a wine gathering and operation. So I prefer spirits and beer over time.”
Tom Russo on His Preferred Method for Estimating Intrinsic Value
Thomas A. Russo (transcript): “I would tend to think of the business as relative to the private market values that exist and are knowable through transactions that take place. That gives me a sense of what alternative buyers would pay for a business and that’s kind of a mathematical base case place to begin. I then think about the business and I think about whether we’re priced anywhere close to that number, and if we are perilously close to that number I’d probably pass. If there is a sufficient discount from that what we would then end up doing is projecting out what the regions in a business are capable of generating and in that regional analysis or else the line of business analysis—the segment analysis—you end up with portions of the business that can grow far faster, can receive far more capital.
We pay most of our attention into coming into businesses where there are regional or product line growth rates that are determinable and are substantially high enough to justify a valuation premium. And so most of the analysis is spent inside the segments to figure out where the greatest opportunities are in a business. Then value the segments independently and come up with a sense of whether the overall valuation is in the marketplace sufficiently below the value that you get from analyzing the segments to justify the investment. And then the power of being able to invest behind those segments or those geographies is not available across all companies and so we pay a high tribute to businesses that have that capacity.”
Tom Russo on How to Detect and Avoid Investment Mistakes Before It’s Too Late
Thomas A. Russo (transcript): “Part it’s the information that we get from ongoing contacts with companies that lead us to realize that the businesses that are in existence are different than those that we thought and I can think back on Citibank, which we owned—and we owned it for a variety of reasons—it was very global. At some point it was considered the first national bank of the United States. When the world’s currency crisis in the late ‘90s erupted there was a rush towards Citibanks around the world for deposit security. It’s a great global franchise. Sandy Weill owned several billion dollars worth of shares in the stock.
We assumed that he would be a forceful steward of our capital because at the same time he owned shares just like we did. He owned and paid up and that was his vast wealth and we assumed that as close to the business as he was that there would be supervision much like family controlled companies enjoy. And it was extremely global and we were intrigued by that and yet over the degradation that took place in the US capital markets things arose that just didn’t seem right to us and would constantly bring us back to the bank at some point we became aware of the activities around the balance sheet called SIVs and learned how they were struck and became quickly uncomfortable with that feature and what it represented to shareholders and the risks it represented. And so we left that investment. We were lucky to have had enough contacts with the company to come up with that observation in time to exit before the bedlam ensued.
And so that’s what we do. We try to get that information from meetings with companies and hearing… and then looking across at other businesses that relate to it. And we received good confirmation in Citibank’s case. We had an opposite example when we held AIG, which was less successful and in that case we probably believed management too late and too long for their assurances that their derivatives books would converge profitably over time and we failed to pick up from that process the fact that they wouldn’t enjoy time because collateral posting requirements would put them out of business in the meantime. But it’s a process of just making sure that you stay with the company and ask questions on the margin and listen to the answers and look at body language and try to stay ahead of adverse developments through that.”
Meet and learn from Tom Russo at Latticework 2016.