2018 Ivey Value Investing Classes Guest Speaker: Thomas A. Russo

and well that's a wonderful introduction thank you so much Jeff the way these things work is just like 40 years ago when my investment professor at Stanford Business School reached out to Warren Buffett and said could you come by and give the students the sense of what you think about as an investor of so2 it happened with George and then me and as I was so impacted by Warren's visit to our classroom that I've made a note in my schedule that says you know if you have a chance to speak to a class of people of self attributed to having a passion for investing taught by a passionate professor by value investing and you have a chance to convey some of the points that I was lucky enough to hear early on from Warren in our class and 40 years ago you should probably take advantage of that opportunity hence I'm here sadly for a short period of time as you suggest but you know I would love to at the end of this meeting leave you with very very simple thoughts and and I think the thing that we spend most of our time focused on is this this inevitable trade-off in investing which is how much pain can you take today for gain tomorrow and Wall Street is is uniquely set up not to have near-term pain the goal by Wall Street analysts the goal by corporate officers who depend on Wall Street analysts the presence of stock option grants which expire so they have a good tilt date on them and so they they create a requirement that that upfront pain is avoided as best as possible but if anybody's ever run a private family business they would know that the best returns come as a result of their willingness to risk what they have when they make an extension investment that will disrupt the current results but it does so with plan to expand the business down the road near term pain for long-term gain Wall Street is completely set up in an opposite fashion and it leads our businesses which I think for a variety reason we'll get to to have a great competitive advantage because if you do have the ability to invest for the longest term at the costs of the near term if you have the capacity to suffer Wall Street censure for doing that you have a huge competitive advantage because your competitors are trying to meet quarterly numbers and they're under investing and they're anticipating revenues and they don't they don't report expenses if they're too close to the end of the quarter and all that stuff and it really erodes business I was saying this to someone recently and he one of the participants in the gathering raised his hand and said that he had worked at at the time hewlett-packard and he said he said by common struck a chord because he remembers so many times and the quarterly call would come down to the branches and said you know we have to cut expenses because as we near the quarter we're missing our numbers so go back out whatever you're thinking of spending stop until later and of course they were thinking of spending when they were because that's the right time to spend it and if you if you don't spend or if you wait to spend later it's not it's not going to develop the same competitive advantage so that's really that's that's really it's a very simple I sub stable you know two of the hand versus one of the hand versus two in the bush so that's really the heart of value investing as let's see here I'm going to look for some assistance on the AV is there a advancing wand here let's see oh good I'm gonna see that's very good that's very good okay well let me go oh it's no there we go okay good anyways I have a long term investor this is a this is a photograph in humor my wife and I were in a safari during the worst time of the market they may have been Oh 8 and we're in the middle of June and the markets were in freefall every day we get up and go out to look for the the big five on Safari and every time we'd see an animal the guide would say to us look if you come upon one of these animals and you're out alone in the woods and it charges you stand perfectly still and let it run past because it won't chase you so long as you stand still you'll be fine that they showed us that for a dozen different threatening menacing animals including scorpions away whenever else and we came upon this one finally and and he said if you ever see this one charging you run like hell and of course the problem with that is you can't until it's right upon you don't really know which it is and so in our world markets are volatile we tend to buy and hold I would say that in that period of time with we came very close to having a more actively traded mindset culture this what I was referring to bird in the hand worth two in the bush it's in the investment business you want to play for more later and you're willing to give up what you start with to do so in my field of investing corporate cultures terribly important of the the ability to have your management represent your interest rather than their own is extremely important and and I was struck by this picture at some point with the Nestle come CFO who had been the country head in Japan and he admired this picture so he sure with us and what he said is that that that temple how many of you here from Japan maybe you can prove me right or wrong but said this temple was 700 years old none of the wood was but this temple was and that's very strange to think about because what it means is that the whole the whole thing's been done over a half a dozen times because of the aging process but when they when they put it back together it shares the same value it has the same look and it stands for the same principles and that that is what we're looking for it and the businesses that we own because they require management to run them that's a different requirement than what Warren Buffett had trained with than what he started with and so and when I saw him in 1982 I saw but a really interesting seminal point because he had gone from just at that time he was migrating from cheap 50-cent dollar bills to investing in businesses that had a franchise value and up until then you know a 50 cent dollar bill seemed pretty attractive just so long as you could close the discount in a fairly quick hurry because in that investment scheme if you buy a 50 cent dollar bill and you the discount doesn't close for a decade as they often don't your compound is only 7% if it closes the next day you buy it of course it's a hundred percent but time is not your friend in in in the investment world that was historically the value investment approach the margin of safety in that world was the fact that you're only paying 50 cents for bucks worth of goods but when I met with Warren in 1982 the margin of safety from his perspective had been migrated over to business franchise the quality of the business franchise is the margin of safety as opposed to the price paid and and and that had surface at Berkshires experience through C's chocolate one of the first businesses he bought and it was bought based on the belief that people were were loyal extremely brand loyal sieze chocolate and would pass on any other varieties and would pay up each year they were price inelastic in their demand because they didn't think there's an adequate substitute we searched the world for businesses where the consumer is willing to pay a higher price and and not not the flinch because if they weren't willing to then you'd be in the world of commodities you know if if the consumer felt like C's chocolate was just no different than Lin - no different than her she's no different then they wouldn't command the price so without committing the price they wouldn't have the margin without the March and they couldn't develop more more returns from investing back in the business so we look for businesses that have very strong brand awareness and that was what when Warren came to our class he had dissipated that migration from old fashioned value investing based on price paid to a look at the businesses capacity to compete based on the strength of a brand where the brand stands for the consumers mind the lack of an adequate substitute so the the the the two most important lessons that Warren shared with our class was first that the government only gives one break for investors that's the non taxation of unrealized gains so if you can do it you will you leverage your own return so for example the shares of Berkshire that I bought in 1982 after seeing him come through $4,000 today have 99 thousand dollars worth of of interest-free loan from the government because we haven't sold those shares and that extra extra 99 thousand dollars is the amount of taxes you would have to pay were you to sell the position now the beauty is we don't feel like there's any particular need to sell the position because their reinvestment opportunities going forward from here are fully sufficient to justify the share price today and and so it's amazing to think you can have you can make an investment this is sort of what got my my own particular interest going when you think of an investment that that costs a thousand dollars thirty five forty years laters worth three hundred and thirty thousand and you think it as the ability to compound going forward off that with with an open an open mandate that's pretty exciting and you know my own personal background I grew up in the Midwest I grew up in Wisconsin and it plays much like this and I always say of the investment process that I'm far more like a farmer than a hunter and we we've been farming our Berkshire share one share you know for you know thirty five forty years and we didn't have to do anything else every day Warren went went out and plowed the fields and delivered more bounty and the things going up but we have absolutely no interest in chasing down something that runs faster than us and that will likely not be able to fail we just as soon farm and and the beauty of it is you just attend to it attend to that so so the first the first point Warren made was that you want to find businesses that have the capacity to reinvest so that once you buy it it will in fact start to grow and and and and that embedded gain then then is what you're actually investing for is the unrealized gain what do you need to have the capacity to reinvest in my world you I've specialized in the consumer because I believe that the power of brands provide pricing power and and I often think about what businesses spend time with I think of those businesses that have developed dynastic fortunes and and you can think about brands like Marlboro or Heineken or Jameson's or Johnnie Walker any number of things and and they've made permanent wealth because once the brands become iconic they have a recurring recurring tomb in fact there's a wonderful thing how many of you are from India raise your hands if you're from India and then what would the standard duty free purchase be on return to India well is it within the world of alcohol I mean it's one brand this is a Johnnie Walker Black Label and its iconic anyway so we we you know the capacity reinvest is that around the world consumers are only now beginning to have affordability that they have consumer disposable income that's the byproduct of the growth of the developing emerging markets and so we are designed as have a portfolio that with our portfolio of international brands to encourage our managers to take the cash flow from the mature markets of our international companies think about a Unilever or Nestle and and encourage them to plow as much as they can into developing the emerging markets so that as the consumer those markets develop more spending power they will go back to brands that they've been aware of as part of their environment for generations but they just haven't been able to afford the products and so it starts as simply for instance in Nigeria where 25 or 30 years ago Nestle introduced bullion cubes under the name Maggie well they started by selling one cube at a time and and and and they built factories to have the capacity to serve that market well you know they they quickly proved that the market as it grew in affordability people bought more than one they bought two and suddenly the business doubled they bought three and it tripled and they're out of capacities that to build a new factory and the moment they put that new factory up and running it doesn't run the full full absorption and so their margins collapse for a while but then it fills back up and our job is to encourage those managers to make that type of investment so that they're ready for the consumer when they come calling with products like one bullion cube and and and the other things that the consumer leads with so the capacity to reinvest is that you have brands that that have aspirational appeal the the frame of reference in investing in the world of brands is that people very often like other people to know who they are by what they have what they consume what they wear and so it's it's so fundamental so deeply felt allegiance to brands that people have that is what I think gives us as investors up the ability to find businesses have very long reinvestment cycles and and allows us to do what Berkshire said is from the start find a business that you can own now and since it has reinvestment opportunities will advance in size over time without having you to pay any tax on it other other fourth forces that are valuable for reinvestment is population growth well that's all about emerging markets consumer disposable income growth that that's what happens when when you know the the families come in off the farms and they move to cities and suddenly they're working in cities so they have disposable income and the two spouses work and all the rest when I say that we're looking for companies that have global brands we really been global companies and so 75% of my portfolio is invested in businesses like Unilever Nestle Perrineau Ricard and they're internationally based mainly because they don't exercise stock options as much in the mix for compensation and without having that stock option leverage the the investment horizon gets to be stretched out because as I said the problem with psyche options is there's a good till date on those and so it puts a pressure when things work and and the best investments often exceed the horizon of stock options so we own we tend to own international companies that have that reinvestment in part because of the option free zone in part because historically most Western investors are not particularly keen on the prospects for Europe Europe seems a bit Slavic and it seems a bit tired and so investors fail to look through the companies that we have and and realize that through Nestle or Unilever you're actually investing deeply in emerging markets what you're doing so at lower prices because the investor doesn't really think that the European markets going to be very productive its despite Europe rather than because of it that we have the companies and the European trademarks are actually what made the businesses appealing in the first place because of the stature that Europe has long enjoyed so capacity to reinvest in our portfolio company the other thing you have to do is you probably want to have globally adept management so for example how many people in this room speak more than four languages three that's pretty good okay look at this and then two it's it's extraordinary yeah yeah it's extraordinary I'm you won't find that at the kraftfoods they speak point nine languages the you you just don't find the same kind of capacity that's that's if you want to be effective internationally the other thing you have to be multicultural in addition to multilingual and to get that how many people here raise your hands if you have a favorite cricket player again the same people but the fact is most Americans don't even begin to know the meaning of cricket and that you're 1.8 million people in people will go to bed tonight thinking nothing but great things about their favourite cricket player now in a company like Nestle or MasterCard MasterCard is run by eyeshape Banga he grew up in India of course he speaks three languages has extraordinary global rolodex we couldn't be happier than to have 11% of our money managed effectively by one of the most extraordinary leaders in business today who's Indian and and and manages to move around the world with extraordinary balance and so these those are those are some of the ingredients that that help with the capacity to reinvest by the way I can be interrupted so if anyone this is pressed with a question just raise your hand I think it may it may liven things up and I'm happy to respond so well the pricing mechanism a discipline is still very important so you know you have really have businesses that your perspective about what the growth possibility through reinvestment looks like is different with it than what the market ascribes it and I find that we end up more comfortable with probably slightly higher prices than a deep value investors because of our belief that we know what years 10-plus look like we're you know if you're only if you're only kind of certain on the years one through three and then you've make a couple of assumptions in year five and that's the end of your exercise you're going to come up with a different valuation than we will because we actually I think add value in in identifying those businesses that years ten and Beyond are the most promising I'll give you example Heineken you know when we first invested in Heineken 1986 it was 15% exposed to develop in emerging markets it had it had seventy percent of its business in sclerotic Europe and something like ten percent of profits were from North America which is the high-end premium that's that's almost 40 years ago over those years the family controlled Heineken expanded again and again and again and and and I invested it in as early as 1986 strengthened as I was with the belief that in their unique situation of being the world is preeminent brand and beer and also family-controlled that they would have a platform from which they could make investments without risking their independence and and that that enabled them from the outset to be a much more forceful acquire and builder and so over the years they were they were at the same time at the start they were less discovered so they were cheaper the shares that I owned first the Heineken 1986 I think we paid eight times earnings for them and then out nineteen times earnings so the world's changed mind you the interest rate in 1986 may have been 12% today the interest rate that's comparable is 3% so you've got all sorts of forces going on but the real trick with Heineken is that they kept extending their capacity to reinvest through one acquisition after another and and and and the price has moved along as it has and and we see their ability to continue to play capital well out beyond 20 years and so though some will have come along for parts of the investment performance that has been enjoyed since the start most leave because they made me an interim price target that reflects a view of something that's going to happen in the next five years and our difference is that I think we're much more right to the down and what happens 10 to 15 years out and that gives us more I think staying power more comfort at the same time you know we've have taxable investors largely and to the extent that a sale would trigger the tax on the embedded gain out goes the funds that we're investing sort of rent-free by the deferred tax you know we think hard about whether we make up the tax paid if if it's just a function of the valuation we made we may weigh the tax consequence a bit as well so the capacity to reinvest you have a series of features the real thing that distinguishes the businesses that we own though is in the investment process that our managers have something that most public companies don't which is the ability for our managers to invest with an eye towards very long-term performance and and and that those investments come at the expense of near-term results and most companies would love to have that capability but they don't family control companies do the Heineken family controls Heineken they have the ability to allow all of those investments to take place and and Wall Street's reaction to investments along the way is often harsh the shares price would drop sharply when they did things along the way and they did so impervious as management to the risks of losing their job or losing the control of the company because because they family control of the company and having that capacity for management to suffer through down grades and through the possible pressure from corporate activists and all sorts of things that's protected of them by virtue of family control they've just been much more effective in in investing for the future because they have the cap of capacity as management teams to suffer from the near-term pressure and we'll have a couple of examples but but the the summary basically is you need to have capacity to reinvest you also need it passing to do it with with with the Wall Street pressures that companies feel and and the the last thing I would say is that's added an enormous value in my career has been the ability to do nothing for vast periods of time you know it's it's really underrated you know holding hole in in the portfolio that we'll look at later in this slide day you know I think more than half of them I bought in the 1980s and and they've delivered a compound because of the reinvestments that that has been allowed to take place along the way um Heineken is good example in in terms of how the capacity to suffer story plays out um and in Heinekens Brazil moves recently our perfect example of it five years ago hi the second-largest Brazilian brewery was up for sale Brazil's dominated by ambev the Brazilian company that's or that was run by 3G and that business was were sailing and and the ability to suffer which as I say what's so important for our managers a express itself two ways in the one hand it is that the management teams have the ability to say no when Wall Street clamors yes and the other expression is that they have the ability to say yes when Wall Street clamors no and this example kind of puts them both together side by side so at the start five years ago Wall Street implored Heineken to pick up 15% stake in Brazil because they had a 15% stake and the idea will be how nice to fit them together and get them going and so Wall Street founded on Heineken to go ahead and buy it but when they looked at the books and they went through the auction process Karen in fact that the the somewhat lethargic Japanese brewery bought it for five billion dollars they bought the business that was for sale in Brazil Heineken was reviled by the analysts the shares were pressured because they didn't comply in all the rest but they said nope it didn't make sense at that price for them now four years later it turned out that the the Karen people made a real mess of the thing and by by four years of ownership they were losing money at the EBIT down level and and so they came back to the US and and offered it for sale now Heineken was demanded by the analysts they don't even think about going there it don't touch it don't even look at this is it's negative eBay table hiding take a look and said we'll take it and they bought it for 660 million dollars so the business that they were implored to take for five billion dollars they end up being employed not to take it at 660 that's where we are today though it's they're the reasons behind all this and one of the reasons is that once the best clothes on the deal there's a lot of work that has to be done they have to reorganize their distribution network they have to reset the brewery footprint and a lot of work to do and that work is going to disrupt earnings per share and no other company had the ability to go in and take on the next step which will be very divisive towards their earnings per share outlook for the next two or three years I could care less about it and the good news is the Heineken cares less about it because you know after they did the deal this time around Wall Street was sufficiently perturbed that the shares came down quite sharply and SABMiller came along and tried to take over Heineken during the period when the share price reacted negatively because of the disappointment that they didn't follow Wall Street's advice and the family said no and they had fifty point one percent of the vote and they were able to defeat a takeover offered now that same takeover offer for any public company without a controlled shareholder would have been the death knell the manager would have been sacrificed now having the power to do something like this means that they have great competitive advantage against those people who don't have the ability for their management's to suffer the kind of abuse that this company suffers for managed from from Wall Street when they take on a big deal like that we de mix I once owned 21% of Weetabix how many people here know what that is it's a inedible British sponge that you know no it's inevitable but my wife's from England so I know what it is it's inedible and it's a sponge it's an it was a profitable sponge and and I'll just share the slides here you know that means that may just not be legible anymore but I hope it is so if you here's the deal on this one if you look at the far right we basically bought the shares at half of its intrinsic value at the time with if you use eight times EBIT ah and and then netted that the debt from cash out of the cash value on the far right column that you'll see that it was worth 30 what does it say 11:30 we pay 595 um family control company so they had the ability to say no when Wall Street told them yes they were they were pressured countless times to make acquisitions but instead they knew what the business was that they were in they innovated around their business to try to create something that people could eat and and and but the the upshot was is that cash which is about three lines up from the bottom at the top section cash just grew and it grew over the period of our holding to a hundred and three let's just take a look here 103 million dollars and the the EBIT dog grew quite sharply up until about ninety nine would it start to trail downwards and the share price went up fivefold and then during the internet bubble it started to go down again but what you'll see here I hope in the next slide you'll see the growth in the intrinsic value per share and then what happened at some point around in the period around the internet bubble is people just stopped caring about bad tasting pretty cereal and and the shares slipped the intrinsic value continue to grow based on the multiple yuba table and the cash that was mounting in the firm not and then it all came together at the end when it was taken over by a uk-based private equity firm that thought they could actually sell the product in other countries and of course that was a mistake but and it's it subsequently made made the rounds but it was a it was it was you know when you say the manager has had the capacity to suffer I can assure you that during the period of time when we DivX shares went down so sharply even though the intrinsic value went up it was nearly impossible to keep the position in our firm because any American who had any curiosity at all they'd see that we owned 21% of Olympics would try it and then come back see this thing's like a sponge and I'd say no it's virtuous to all the rest and then the price starts to go down and you have absolutely no credibility so but but it all worked out well in the end interestingly if I can go back a slide that's all screwed up oh my god now we're really in untrod territory I have to write to work eat one more keep going here that's it okay so this one's go for this oh thank you okay so this one the only reason I came back to this is that one of the things that you see a family control company in this case look oh look at the the separate line five lines up from the bottom and I'll show you the number of shares outstanding now this business thrived over the period of time they had great workers and all the rest but they didn't give away stock options and so along that whole period of time the shares outstanding eleven point two million and so that was a plus and that's something that private families are far less likely to give away stock free like that unfortunately at the same time since since they they didn't have very many shares outstanding that most of it was still held by the family the one thing they did not do is take the hundreds of three million dollars of cash towards the end of buy back shares at you know a third of the value intrinsic value which they could have done towards the end if they had instead of getting fifty two dollars a year pounds per share we have received something closer to a hundred because of just buying back the outstanding shares before the transaction took place but but they were disinclined to do that and and it was sufficiently properly even despite that Berkshire is the best lesson evolved for how you can figure out what what it means to have the capacity to suffer and Geico is a great example of that Geico is is a business that when Warren bought it he thought it had the best prospects and should be the most popular insurance for cars and it only had a million policyholders 1% of the market and the reason was is that growth destroyed in this business destroyed reported profits because every new policy that you engage in the insurance business car insurance business loses money in the first year because you absorb all the costs associated with putting that business on stream and you end up losing two hundred and fifty dollars per new insured and and and in GEICO's case when he bought it there was they had a million policyholders and they were making a hundred and fifty dollars per policyholder that was mature and active so they were making a hundred and fifty million dollars when he bought the company and he wanted to grow it fast because he thought it was a business that really the market deserved but the trouble is if you're thinking about the model every new policy prime the book has a negative 250 impact in the first year and at the same time it has a $2,000 lifetime value for Geico because the the insured renew so heavily and they have relatively favorable loss experiences at least they did up until texting and and distracted drivers have caused trouble but um but if you think about the math and this is this is a try to follow this they're making a hundred and fifty million bucks on their mature business and and they have a million policyholders if they wanted to grow the next year by a million policyholders what would happen to reported income it would say yeah well it would go down it would go down to a - 100 million because they are still learning 150 but the at the new vintage crop causing them 250 million of losses would take away the 150 million of profits and actually show them as loss making now that is something that nobody can absorb except Warren Buffett because Justin care about reported profits he cares about intrinsic value and if every new policy you put on the book has two thousand dollars of lifetime value and you can do it for the mirror cosmetic operating income burden of two hundred and fifty that's the trade you supposed to do all day long and if you fast forward till the present Berkshire has taken the number of insured at Geico up to now fourteen and a half million they were up to about 12 million a couple years ago Warren wrote it up and he said he said the annual report because he's a very quirky guy for some reason he thinks that his shareholders are his partners and for some reason he thinks that if they're his partners that he actually has some kind of obligation to help them understand what the value of the business that they share is and and and without without disclosing things that he shouldn't because of because of the sec information requirements he's perfectly willing to periodically lob something up like he did with Geico and he said because of the growth in premium ensured that we've enjoyed since we bought it tacklers worth twenty billion dollars more today than it was only started and that's exactly 10 million new insured times 2000 that's 20 billion and so that's how the math worked though it would have stayed you know growing at 3 or 4 percent if if they if they didn't latch into the Berkshire universe where investment spending is something that they perfectly how comfortable to make now you think that the lesson is well enough learned but even this even even the start of last year when their hurricanes and and and and floods and earthquakes and so much the took place in tax in casualty or 2017 Berkshires competitors in the car insurance business stop writing new policies they seeded that business over to Warren because they already with the losses that they had suffered didn't think that they could take out any more burden even though that reporting 250 is really just accounting of the upfront cost so the crazy thing is is that even lat even has passed the 18-month period I think we've picked up another two million policyholders and and that's simply because people let them go because they didn't want to burden already burdened income even though it would deliver such a high intrinsic value to the business I'll stop any questions any thoughts yes yes oh good all right I'm gonna fast forward to Philip Morris and and to their capacity to reinvest in a product that they've that they spent two billion dollars researching that's that that funny-looking thing coming out of the guy's mouth and what that is is called IKOS and it's a it's a heat not burn tobacco device and and it delivers exactly the same amount of nicotine that a cigarette does which by the way is not the case for e-cigarettes which which deliver only two parts of nicotine whereas a cigarette the combusted cigarette delivers 19 parts of nicotine and that's part of what the consumer looks for when they spoke so an e-cigarette at two parts it's not going to convert many people permanently because they crave more the IKOS delivers 19 so the other thing is that delivers tobacco flavor whereas the e-cigarette stone they have fruit toddlers and also too weird stuff but so this thing is able to serve the smoker who wishes to quit so that they don't suffer from withdrawal from nicotine which they want and they don't miss the tobacco taste which they like it's so it's the equivalent of continuing to smoke but its equivalent of quitting at the same time because they lose 95% of their risks by not having combustion anyway so the beauty that the interesting thing about the story is that while while Phil Morris International was spending half a billion dollars a year for the past four years their competitors were effectively spending nothing in sourcing kind of second great poorly constructed and ultimately not successful products from Chinese developers so now if you're Philip Morris and and and you realize that over those same four years you had the period of the strongest dollar appreciation and Philip Morris is a us-based company for whom all of the profits are earned internationally so they are the most poorly positioned tobacco company in the world with the rising dollar because they make all of their money in India or in Indonesia they bring it back to US dollars and the dollar stores means that the profits that they've made are understand so at the very moment of time for over the past four years when the dollar rose the most and their earnings were already the most suppressed on top of that they came into the marketplace and spent half a billion dollars a year to come up with this product so I commend them for that because that is real suffering and mind you as managers they do have stock options and the stock options and in all their executive comp vests relative to total shareholder return comparisons to other tobacco companies all of the other ones spent no money on research and had no issues of the dollar so Philip Morris really reached for the for this this product and they had an enormous ability to suffer now fast forward the product has been launched and in the first the first quarter when it was launched in in Japan first market they sold 400 million units this year they'll sell 36 billion 400 million to 36 billion it has it has gone from I gave a reason there's a it has gone from 64 million in revenues to 3.6 billion it's not a twelve point seven percent of total net revenues for Philip Morris it's now it's it's it's up higher from December to today it's now sixteen percent of the Japanese market now mind you the the the people who have converted to the use of this product do not relapse back to tobacco and this product does not recruit kids unlike you know the things that the vapes the other things that sort of that that offer flavors and and other devices that attract kids and and and what's happening now is if they've reached over five million consumers they think that the product will get to two hundred fifty billion units by 2025 and the traditional cigarettes dropped from eight hundred billion down to five fifty I suspect that if it continues it'll be far higher on the new the new product and far lower on traditional cigarettes I think the rate of abandonment will accelerate and now they're going about the rest of the world and and and they have to invest a lot up front through boutique so they can train introduce people on the product and and that upfront investment obviously as part of their capacity to suffer other people chose not to make those investments and and nobody else has anything remotely close to 16 percent of the market share they've taken the same approach to different markets and you can see here here's Greece it's the third it kind of languished for the first three quarters and that a massive jump and I would not be surprised if at the end of this year that'll be up over six or seven percent of the market total the where's Korea Korea as well was was a market that was launched in the first the second quarter of last year with they had 0.2 percent market share it's seven point six percent and could very quickly get to 15 tracking Japan now there's nothing that's been like this now and just to give you a flavor though of how it is to be an investor in a business like this this afternoon the the FDA in the u.s. announced that was their belief that they're going to create an industry requirement that cigarettes have lower nicotine well if you make cigarettes with lower nicotine the only thing people will do with those is smoke one of them because they have a desired level and and if the government says you can only sell cigarettes that then deliver a certain level so it's a bit like markets in the US where you're only allowed to sell three percent alcohol beer it's a pretty quick math you drink for more than you would otherwise and and so everybody but the but the politics behind this stuff is just so excruciating they actually have created a product that allows people to quit smoking five million people have quit in Japan then it's extraordinary thing remotely close to that and those those are now off the risk factor because they don't get combustion the US FDA has found itself entirely flat-footed and out of the game because the thought leadership now is is on these reduced risk products and the kind of conversion that they're getting so they come up with a hail-mary to talk about about reduced nicotine regular cigarettes to try to gain some some relevance in the process but truth is they have a decision to make as to whether or not they'll let the company that makes that IKOS in the North American market when they go to market later this year tell the consumer that it is a reduced risk product when compared to the traditional cigarettes and the FDA has the ability say you can say that and in fact it's true and then 95% reduction because there's no smoke but but the fight over tobacco in general has been so long standings and the lines are so blurry so definitely drawn that it's not clear how they'll treat it I think Phil Morris is on exactly the right thing they invested an enormous amount is a huge expense to the to the workforce and we'll see so you know I'd say the the last point about this investment world is that the portfolio manager has to have the capacity to suffer and if you look at if you look at this table you will see that in the year 1999 Sam private partners was down 2% to the Dow was up 22 and the S&P was up 27 and and we did not have a massive amount of withdrawal of capital even though we are massively out of step with the market but the message from that period is to look at the performance relatively in the four successive following years and you'll see that that you know our our portfolio was more like a coiled spring than it was the leaky balloon and the four years had followed we gained an enormous amount advantage and so what you want to think about is money managers to make sure that you don't find yourself in a position where you're forced to act because your investors become frightened and nervous and mostly nervous about not making money when crazy things seem to get everyone rich and Jeff and I talked about that earlier tonight how do you go about managing your your your investor expectations and recruiting just the right type of investors and so but the the notion of the need for that capacity to suffer and as recently as the last three years when the SP was the the only game in town you know it was it was outperforming and though and and we did not suffer great withdrawals because we tell our investors at the start that there's absolutely no way the time when the results happen over time so in any given time but there is a belief that you can find businesses that will be able to like Heineken has and Phil Mars has to deliver results over time you know one of the one of the things that I think has given us the capacity to suffer as an investor is we don't have something that is very difficult because it's very alluring you know so many investors have a fee structure of two-and-twenty which you know creates an expectation among investors that they are going to be clearly superhuman and and and and superhuman enough to absorb the huge burden that - and 2010 rates and so we we charge 1% advisory fee that's it and and and we sort of convinced our investors to have very low expectations of what we're about to accomplish on their behalf and I think that's that's helped us a lot over the years so I'm the the most important message I'd leave you with is that you the number-one costs to investors is agency costs it's it's the willingness for most public companies to be managed for the far too near term options play a role in the lack of the ability to defend against Wall Street when bold steps are needed means that most companies can't those who are protected as what I think that the companies that we have found Berkshires the leader in that field with their others tend to be family control they tend to be able to call their own destiny and they tend to invest a lot up front and then they gain competitive advantage later on because others who they could be with didn't have the flexibility and that's that's what we stand for so any questions you gave an interview recently about mr. Baffert and you said if mr. Baffert is going to be able to book the remembers amount of cash to work possibly soon sure what well I think what I want to make sure people don't forget is that you never really anticipate where the next pitfall will come from and there will be a time you know in in in the in in the unraveling of our of our investment world we've had extraordinary investment returns over the past six or seven years and they're all built upon this very low interest rate base that we've enjoyed we're going away from that now and you know it's not it's not at all clear why things should be presumed to be smooth sailing going forward but when people you know project fear over Warren's ability to play that capital I think they they mistakenly view that the world be pretty steady place and that's that's not that's not been the history and you know for Warren to have all that cash available at some point in time I'm sure it'll be valuable I just can't tell when or what will be the catalyst yes keep making decisions he passed the decisions - yeah but I guess I better go Jane well you know clearly with I don't know is it 25 billion dollars in new fangled businesses like Apple and we'll just say Apple I suspect he's itching to buy Amazon and has entered into a partnership with Jeff Bezos a big you know the healthcare captive help healthcare partnership he speaks highly of B zosyn and E and he recognizes the grip that that company has on retail witnessed the fact that he's sold his enormous position maybe six billion dollars worth of Walmart not that not that long after the annual meeting last year when he extolled praise on B's oh so but but you know there are there are long-standing areas that both Ted and Todd had worked on for a long time that relate to Apple and other businesses that are more technological and if why is it invest serious and large amounts of money and those I guess the supports had to come from the - people have spent a lot more time with technology but I do think that you know he will be he's elephant hunting no question about it if he were to find a traditional company that had you know need to partner with him you know sort of the best answer for that is you know what Berkshire is going to need to continue to succeed is what Larry Cunningham talks about in Berkshire beyond Buffett where he talks about Berkshire being a place for people with the best businesses in the world who if they need to sell will naturally be inclined to come because he provides an ecosystem where great businesses are allowed to continue unchanged and the alternative is private equity and the moment you sell to private equity they're beginning the sales process for taking that business public or to sell it and so you know Berkshire office is a tremendous home for great businesses and and those businesses I would suspect are going to be more like the ones at Warren which would be the one who welcomed in but but the the fangs and whatever involvement that the Berkshire is going to have in that area of technology I would suspect as as a younger man's games kind of talked about the capacity to suffer how do you identify sort of management being exuberant with sort of the cash that they gain from the operations because like in terms of like the quantitative side yeah like the numbers would reflect that yeah it can be like sort of exuberant right no it's a very good question and I think of an example which was a company that I owned a long time ago we did very well for a long time then it then it became trouble it was well international Speedway and they own NASCAR NASCAR is a southern thing and people drive cars fast they drink beer and smoke cigarettes and it's absolutely revered and International Speedway came public and has across shareholdings with NASCAR the sponsoring body the France family owned all of NASCAR and a controlling interest in Speedway and we invested in Speedway and and it grew across the regions and grew profitably because they were opening up new markets and and and creating new venues and and they own the right to the tickets and and everything else there at least they spawned a lot back up to the Baron but but it turned out that they exceeded the natural market but it didn't mean that the parent which was the France family didn't still want to pressure the public company to make big investments because the family profited so it got to the point where they were trying to put a half a billion dollar Speedway on Staten Island on a toxic waste dump and at that point you know that that was such a bad misapplication of cash flow that we sold the company I shares and and we've never looked back because what what became apparent is that there are different levels at which the family would personally profit and at the at the by just by focusing only on growing the category even if it may lead to low returns on the public company they would make more money it's a lot like the coca-cola bottlers have a conflict with coke the concentrate and and so now if that business had found itself at the Berkshire for example the perfect solution and this what makes Berkshire so powerful is if you don't have something to use the money for it send it up to Berkshire and if you're if you're one of those divisions within Berkshire you're not forced to spend money if you can pencil out a good return there's abundant limitless amounts of money to spend and and in most companies that aren't as as you know thoughtful is Berkshire they end up with things like that International Speedway situation and at that point we sell the stock when they're making really dumb redeployment how do you as an investor beside that the capital reinvestment is in the right project because most of times we get to know in hindsight or after the fact that the project was not successful yeah one of the markers I think is for example a company like Philip Morris is ready to disrupt its own main line of products with the product before competitors come in so do you think that's one of the signs or what are the things that you look for when a company you know rain with such capital well you know obviously what I started with the conversation about the early days of of this European based portfolio where it became exciting to me was when when they realized that they could take their free cash flow from the mature west where they really couldn't effectively deploy it now that's not entirely true because for example Heineken over the past 20 years has closed down 45 different businesses building structures in Europe as the you know as the unified market allowed them to put warehouses and more appropriate spot and everything was done jurisdictionally in a kind of vulcanized manner historically but over the past twenty years honey is that a huge return on investment that they spent smoothing that footprint and making it all more effective the and so that we've been able to track that investment with our conversations with the company they talk about its open the benefit of it I think is is higher than the market believed it would be its but but you know the the best investments are sort of the Nestle rolling out a new product called bullion in the market that's ready for it and doing it at scale so that if they spark the interest that nobody else will get to take the business and then they get first mover advantage we like that my question is how do you choose an appropriate discount rate and I guess with these companies sort of like in Europe like Nestle in Switzerland if you're usually long-term bond yield do you do you use the right now they can raise capital multiple or multitude I guess of countries how do you sort of think about that when you're discounting cash flows well it's extremely difficult because if you say you're borrowing in different currencies different maturities and for different projects but Buffett has always said that he sticks I he said that 7% and you know as interest rates go down a lot lower than that but at least I don't follow those downwards because they'll give you ridiculous valuations and they're they're probably not to be relied upon and so but we live in a time when there's so much financial distress that's been masked over by low interest rates that that we take for granted these low rates and I don't trust them you know there is there is a reality that the that are feeling good recovery in North America at least in the US has come massively at the expense of elderly savers who would have planned their lives for a retirement with $100,000 8% CD and it's rolled over since 2010 at 1/2 of 1% and and and that's it so I think the pressure on interest rates will will keep you better off by not going not following the current rates down as low as they're gone all right so just in me a kind of manner of capacity to supper how do you manage your own behavior as well as the behavior of your unit holders especially in times where things get really difficult like in 2001 or in 2008 you know it's it's okay we went on Safari you thought but that really wasn't that really was very useless I was on the phone the whole time you know I think it's just just to be very clear with your investors from the start that you're in it for the long and that there are lots of there are lots of moments are along the way but but your focus is long-term and and that remains and you can you can make moves during periods of great stress that might improve the forward-looking component of your of your portfolio and so you should be very active and revisiting and if something if something's prospects diminish because of the swirl that you refer to in market sharp market retrenchment some you you probably well served to make some moves and so we do that either some on a small scale or a large scale and then it's the same question that that Jeff and I were talking about before the meeting which is how do you make sure that you have the right investors and for me what I typically done is I've ended up being a very small portion of my clients funds and so you know I'm not I'm not of the emotional awareness that makes them so frightened that they literally have to sell when things are going down I don't I don't give them the benefit of the discipline that that investors try to do but I mean when when investors panicked there's very little you can do to stop them from making moves that will harm them long term and and so yeah and as a money manager if you if you have that risk other clients of yours will suffer as well because you'll be forced to sell things that they already own so hey Thomas so come my question is coming out of undergrad was this what you expected to do and where there are some things that you wish that you have known starting off your career yeah I had early I had early models and our family of of investors and people who had had had a interesting balance I went maybe I wouldn't have spent the extra years at law school excited spend you know four years in graduate school but I think the legal perspectives adds a lot of understanding to some of the factors that have been quite important our investment universe so I don't begrudge still illegal you know maybe maybe sort of a bit more open-minded the earliest earliest days of the of the fangs because I would just bring it to everyone's attention you know there's no one who's had the better capacity to suffer than Jeff Bezos in the history of mankind nobody's been allowed to lose more money on a regular basis by shareholders who are who give him the capacity and and nobody's been able to build us stronger franchises in some manner as the result of that then has he so I probably should have been earlier and more thoughtful on it but I just took the cue for every also said I don't do technology therefore it's technology that's probably a mistake because I I could have figured out some aspects of it where it really is just a story about massively focused on consumer utility activities that he's done an excellent job on so probably probably to miss and my you all the things have control shareholders so if they want to invest at deep losses to develop you know Amazon Web Services or cloud services for example you know they won't lose control of the company and that was a big powerful benefit and I I didn't invest behind those aspects thank you for being here like I want to ask a question about when I read through your portfolio I see like a companies and basically you buy almost a whole industry for example in tobacco you buy like Philip Morris International on Chia and vit yeah so basically you buy the whole industry or for example for beer you buy Heineken and Busch InBev right Pina Ricard yes you and nano Foreman so what's the benefit of the by you they're like the whole industry almost about buying the whole industry and so the second question is you think about brands do you think of like bad human behaviors if they if they don't smoke they train beers or drink - why spirit let me let me understand your question again yeah well the one of the things about the industries is that they tend to have this extraordinary relationship with the consumer where they they they develop brand loyalty and the consumer doesn't believe there's an adequate substitute and you know one group of consumers feel that way about James since Irish whiskey another feels that way about Johnnie Walker Black Label you know it's it certainly has an enormous following in India another one feels that way about Martell cognac that's peridot recon and you know it's it's it's a privilege to have the opportunity to deploy capital across those different companies because each one of them because of their exposures their brands and their Jagger's and all the rest come back to us with a different blend of returns then for example if all of them were just in one company called Pangea or something you pull all the spirits companies together it would be a different investment than what we've got each one of those has a unique portfolio mixed in a capital structure and all the rest and so I'm delighted to have a chance to own a tonne multiple expressions of the same business and in fact hold myself back from buying more experienced companies right now the second question was what the syncretism like because like we come inside in two industries so basically people either like smoke or beer or tweeting why spirits so when you think about brands you always think about alway thing about bad human behaviors they was like well I haven't I mean if I felt that you know that people who go to the library on Friday night have sort of a commitment to that in a way that I could be involved with and they felt similarly passionate about the relation if there's some way to get involved I would but the trouble is we these are these are the businesses and by the way just to be clear society knows that of those businesses that they do have these extraordinary loyalties and guess what they do about it as governments around the world they tax them they tax them up to the Gill and and so the implicit question I think behind you the sort of implicit point behind the question is what about something that's not bad for you would you think about other things that aren't necessary bad for you and the one thing I'd say is that the businesses that we do on whether it's a cigarette company or it's a beer or it's very um the government is taking a whopping amount of the business away from us owners in New York City it's $40 for a pack of cigarettes the manufacturers get a buck $1 all the rest the state and local excise tax now at a buck they may make 80 cents per pack and they have a gross margin so they still are okay but you can imagine how much how much is dependent and how many different interests are fed off of that business and what we have to worry about is that the effort to pile on more and more and more claims against our businesses because you know at the end of the day the goal there is to have to keep raising taxes up to the point where it becomes revenue decreasing and at some point they'll become income elastic the price elastic demand and people say I can't buy that anymore and that's also where society sort of taking these things the and and and the revenues go to all sorts of social programs hi could you Mary run us through an investment you made that had but you met your criteria for price quality and had all the hallmarks of a great investment that didn't quite pan out as expected and what do you think you may have overlooked in retrospect or might tonight the idea is it is the International Speedway story I mean what I missed is that actually the family control was a negative in that business because you know it it put them on a mandate that's you know I said sort of Heineken had no and yes and yes and no in the case of speeding it was yes yes yes yes yes yes we just want to keep pushing money out into the creation of new tracks and the family control that decision-making so the public company is pouring money out into structures that kickback revenue royalties to the to the sponsoring body which is owned by the family and so I think that there's there's a much more inherent pressure there you know H&R Block we owned and and they miss invested their cash flow badly they bought they bought into enormous amounts of trouble and we finally sold this year's the what I missed there to begin with was that it's you know the lack of international investment opportunity made them landlocked and made them take second and third best choices because they couldn't do what would be very natural which is roll that product out around the world because nobody else has our tax code and and in most of the world nobody pays taxes like India and and you know they would love to have that tax processing software in India if it meant that somebody would pay taxes but you know I mean thoughts and just another follow-up question so you guys probably lived through a number of investment ideas yeah and over the long career you've had where would you consider the one investment you were looking into very seriously but didn't end up purchasing as like the one that got away and why didn't you decide to purchase at the time and why do you wish you had purchased it well I was I probably go just straight back to Google's for me because you know it's it's it's entertainment so it's a advertising the they have leadership and search they they have control over their destiny massively so they're able to do what they what they choose to regardless of the sacrifices to profitability and and and and and I and I didn't invest early on because of the rumblings and threats and actual filings of lawsuits against them throughout Europe for anti fair trade practices and I would I thought that they could hung up on that and and they constantly were able to kind of elude those risks and and and and the business has just grown mightily and it's it's still a pretty powerful business just going up a lot since until we spent time with it so and just one final question when I promised that stop talking after this is some value investors say that tech stocks and value stocks are inherently two separate things and the things don't overlap and then interestingly enough you just brought up Google so my follow-up question there would be what would you say to the critics that argue that value stocks cannot be tech stocks tech stocks and need not be value stocks I just think I think my mistake has been to understand what the actual product is so Amazon you know was was one of those businesses where I and lots of other people just said I don't do technology I can't understand it's too fleeting that the franchise's eroded because of decks technology there's no presumption why this and that would be successful and it turns out that he does a Amazon cloud service business and suddenly it's a huge subscription business and off it goes and it has very little to do about about you know driven primary technology just has to do with server farms and and capital deployment and and and and operational logistics of tensions so it's not deep it's not deep technology other than the data analytics which which are hugely important for the consumer business and so I I think the technology that they deploy gives them huge competitive advantage but I don't think that they're leaders in technology they're they ask the right question and they use technology to help them answer it hi Tom I've two questions the first one being on I guess family controlled businesses and management succession yeah when you're dealing with companies that have so much control how you see the risks of management succession and I guess the importance of good succession planning yeah it's it's handled differently by our portfolio companies in Heinekens case Freddy Heineken this is sort of the dynastic the dynastic view that I find appealing who was asked in 1986 you know why does he still work so hard and he pointed to this little boy playing in a sandbox just beyond the view and he said I worked so hard so that his grandchildren will be will be rich and of course that dynastic kind of view is what we like the line with that young boy now is 35 years old names Alexandra and he he could have gone into the company but he he went instead to Lyon capital where he bought Weetabix from me ironically because that was a private equity firm he so he spent five years in the private equity world in in the consumer businesses private equity consumer and and and he's he's developed a whole toolkit but he's not going to go operate in the company because the the observation there is that even if he was as good as he could have been the mandate that he would get would always kind of be questioned as to where there was blood rather than ability and at the same time that if he did rise up the Rings the family would worry that if he wasn't actually that good he would never fire himself so the family sort of encouraged him not to enter the fray but rather to serve on the executive committee at which point all of his talents that sort of looking at businesses can be applied towards thinking about Heineken strategically Alexander Ricard by contrast so and his uncle died prematurely became chairman and see it can't just CEO and will do so probably for 30 or 40 years if health permits because that's kind of in the history with the Ricard families they have a family patriarch who's the operating CEO and and he's certainly talented enough to carry the mantle in in prop Foreman's situations as a business that we you know for a long time there are no members of the Brown family operating the company at the moment actually they've had a they've had an anti nepotism rule for a long time so so it varies but in each case there's a huge effort to try to make sure that the family councils get the family members together frequently and and so create a kinship of the and an artificial continuity with each other because as people you know scatter around the world there's not the natural affinity towards shared outcomes that that would have happened historically and so all those companies have very active efforts underway they have family symposium and and and and in places where they can reflect on their shared destiny and as a second question and some students here at Ivy have the opportunity to do protocol a dual degree program I guess in your case it was a joint degree program how have you seen the benefits of multidisciplinary programs like what benefits have you seen them having there is a huge value in having a variety of different areas that you're familiar with and and what would be what would be the nature of your well I would think that that that will be valuable in any of the areas that you'd end up in as an MBA and I just met with the head of the head of Brown Foreman's international business last week and I was talking to a lots of you who wanted to interview there and he said well you know what I really wanted MBAs with computer science skills so if you want to go work for Brown farm with selling Jack Daniels around the world let me know and do that second degree because his point is is that we actually need that extra set of tools to either manage the process or involve themselves in it directly but it's the blend between being trained as an MBA plus having computer deep computer skills is what they found intriguing you bet oh I I never looked over here so who have any latent okay all right so no call questions from left field so they say at the end of your most recent letter to ship to investors you highlight some of your favorite Charlie Munger epigrams including a stock doesn't know that you own it yeah um which he makes and a caution against commitment bias and emotional attachment yeah so I was wondering what you think is your most significant personal bias as a value investor in what kind of processes you have in place to counteract that bias well it's clearly a commitment bias we I I sort of worship at the altar of all of these companies every every minute of my waking hours so and and I know it to be the actually case is that as long as I don't own something everything I read about it affirms my decision not to own it the moment I own even a single share on behalf of a client of that same company the next eternity I will read everything to try to justify buy more of it so it's just it's just amazing but it's true of me so then the question becomes how do I steal against outcome and do I have I have colleagues with whom I work we talk about our businesses and and you know I guess you know if if the bias becomes harmful because the businesses become overvalued or they operate poorly but I'm blind to the performance affective poor operators on if that's the case then I have people I work with who those sorts a time wake up and you're missing out on the fact that these guys who work in high anything don't show up to work anymore or whatever whatever the observation might be but what I really I really do have what I think is a very healthy case of commitment bias now I'm going to I'm gonna spoil that answer a bit because you know the field of behavioral finance you know obviously would love me not to have any any bias whatsoever and and what I would simply say is I think most of the issues that surface in the field of behavioral finance become ever more important the shorter your time horizon is it's things like you know earnings earnings reactions you know if there's an earnings that really that you think is coming at the end of the week there are all sorts of bye steps that investors take that that really are only important if your timeframe is quite near term but to have commitment bias on a business that you're going to hold for 40 years you know probably is a little different than the kind of it it just seems to me to be consistent with how you might feel about a business if you owned it yourself I mean the trouble is in the world of Wall Street you might think that's a negative to have commitment bias but if if you own the business if you own Heineken yourself you probably go around telling the world just how happy you were and in in in Wall Street parlance that means commitment bias and you can't make an honest trade but if you're gonna hold it for 40 years and you you want to celebrate it which is what we do I think you'd get a return from that particularly for us where we end up in intruding on the companies and say by the way you should spend even more don't worry about Wall Street spend more because we want to make more later on and so if you're gonna if you're going to have some kind of a ongoing dialogue with the business management's and what you're trying to do is extract from them even a bigger commitment for more more later investments I don't think commitment bias in that world would be a particularly dangerous that's what it's nor would it have been if you owned the company hundred percent yourself so when I heard the fine last question Tom what is the most important thing you learned in life and investing over the last 40 years well I could probably spend 40 years trying to think of the right answer it in the best thing hmm I you know I think in all cases it is it is it's what I have to do with you know staying true to your word if you say you'll do something do it and and and people people will grow to understand that you're reliable and then from that an awful lot can flow but if you can't start with that that level of personal integrity and reliability it's it it's hard to sort of channel your progress from from a start where you don't have the ability to make sure that your yeses mean yes and your knows minnows and you actually stand for something Thanks [Applause]

Channel: Ivey Business School

Views: 9,478

Keywords: Value Investing, Ben Graham Centre for Value Investing, Ivey Business School, George Athanassakos, Thomas A. Russo

Id: bcQmkpcQQ0I

Length: 86min 59sec (5219 seconds)

Published: Wed Oct 31 2018