When investor Jean Marie Eveillard was asked to describe the characteristics of a good analyst at a presentation, his response was “the capacity to suffer”. Thomas Russo picked it up and popularised it.

It’s true. A good money manager must have the ability to suffer though periods of bad performance. Russo, like all other value investors, had the experience to back him up. In 1999, he was invested in good businesses – Nestle, Heineken and Unilever, among others. They were terribly out of favour relative to the forces that were driving the market at the time. His fund was down 2% and the Dow was up 27%. During the early part of the following year, he was down 12-15% and the market up by 30%. He was able to stay the course because he had the ability to suffer. Naturally, the same can be said of his investors.

Russo applies this phrase – the capacity to suffer - to businesses too, when they choose to invest in growth which hits profits temporarily. He explained in an interview with Guru Focus a few years ago. When you invest money to extend a business into new geographies or adjacent brands or into other areas, you typically don’t get an early return on this. That means they have to have the capacity to suffer.

The importance of reinvestment

As an investor, Russo likes strong brands that have capacity to reinvest. According to him, such holdings can really compound over time giving you great bang for your buck. But businesses willing to invest hard behind growth need management that thinks long term.

In an interview with Outlook Business, he elucidates his point where he discusses whether the capacity to reinvest is followed by issues of whether managers will invest enough, since the investments would come at the cost of earnings. He cited the example of activist investors being averse to Canada-based Tim Hortons Coffee expanding in the U.S. market. Russo did not agree and believed that despite upfront losses, investors should applaud a good long-term investment because if companies stop spending they can’t create competitive advantage.

(According to Financial Post, hedge fund Highfields Capital Management LP of Boston and New York-based Scout Capital Management LLC, which held 4% and 5% of the company’s shares, respectively, pressured the Tim Hortons to scale back U.S. expansion, and instead direct capital to share buybacks. This was prior to the Burger King-Tim Hortons merger.)

A more popular, and very successful, example would be Starbucks. When Starbucks entered China in the late nineties, many were skeptical (not Russo) given the fact that Chinese people have traditionally favoured tea. Starbucks lost heavily in the initial years and was willing to bear the pain to attain its vision. Today, Starbucks has firmly established itself in China, which is also its key growth market. By having the capacity to suffer, they built something of lasting value.

In a presentation at the 9th Annual Value Investing Congress held last year in the U.S., he highlighted the example of General Mills, which took short-term gains over potential long-term ones. The company failed to invest when Greek yogurt was launched in the U.S. market. The leading Greek yogurt brand, Chobani, was launched by Turkish immigrant Hamdi Ulukaya (with a Turkish recipe – mind you) in 2007. Within 5 years the company was raking in about $750 million in sales. Last year, General Mills launched its Greek yogurt brand in an attempt to claw back lost market share.

If one were to adopt a mechanistic approach to categorising investing styles, Thomas Russo would be flung headlong into the value investing camp. He looks to buy a business with some margin of safety that comes about because the price paid is at a sufficient discount to value. But when you get to the “real glue of investing” (to use his very own words), Russo breaks away from the crowd.

A few weeks ago in an interview, he explained that unlike most of Wall Street, he looks for businesses that have an extremely low voluntary cash conversion ratio. Many investors seek companies that have cash conversion ratios up over 100% because it reassures them that they can distribute back to shareholders the earnings plus a lot more that comes from free cash flow from access depreciation.

He looks for businesses that have the capacity to reinvest and that gives them the ability to deploy substantial incremental capital of the business to the pursuit of new geographies, brands and adjacent products. That reinvestment is what we count on to drive the value of our shares forward over a long period of time. 

The importance of people

When asked what is the first parameter employed when sifting the wheat from the chaff, Russo speaks of the people factor. Very influenced by Warren Buffett (You can’t make a good deal with a bad person), he is driven by a strong sense of integrity and stresses on corporate culture, business integrity and management integrity. Henry Kravis’ aphorism on integrity (If you don’t have integrity, you have nothing) aptly describes Russo’s investing style.

He believes that if a company is run by a CEO who's reporting dishonestly or stealing from shareholders, the company is not worth backing. In other words, agency costs top the list of qualifying criteria.

(According to Investopedia, agency costs arise because of core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders.”)

He has often stated that if he is going to hold a stock for years, it is very important that he first establishes whether the culture has the right values as it relates to their willingness to reinvest, their ability to reinvest and for whom they reinvest. Corporate culture and agency cost loom large in his first cut of the company.

In an interaction with Beyond Proxy, he stated: 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.

This is a fundamental reason he gravitates towards family controlled companies or those where the founding families still retain control and significant investment exposure. He believes that such companies are uniquely positioned to bear burdens on reported profits in pursuit of long-term gains. They can align shareholder interests more closely than companies that have no personal family input underway.

The importance of going global

Even when it was not fashionable, he was a “global investor”. In an interview with Value Buddies, he claimed that his decision to look abroad in his hunt for value has made all the difference in his career. From the early 1980s, he has tapped into businesses that have had the capacity to reinvest abroad. This he believes has been a huge part of his success.

He once compared Kraft with Nestle, the latter being his top investment for many years. Kraft suffered a lot due to the domestic nature of its business. Nestle, on the other hand, has a share of the consumer’s mindset in over 100 markets around the world. The company has the capacity to reinvest money around the world and in an accelerated fashion because the world is growing in its consumer disposable income.

Little wonder that his portfolio over the years has held businesses and brands such as Nestle, Unilever, Mastercard, Philip Morris International, Richemont (a Swiss company that has global brands such as Cartier and Dunhill), Heineken, SABMiller, Google and Pernod Ricard. Shareholders benefit from the goodwill these brands enjoy across the world due to the rise of consumerism and opening up of emerging markets.

It is obvious that Russo lays great emphasis on the power of a brand. A strong brand commands price elasticity and drives recurring revenue and high return on capital, and reduces the risk of the business model. Price elastic demand is crucial because loyal consumers will be willing pay a higher price should inflation drive up ingredient cost and the company needs to maintain its margin through higher prices.

In an interview, he cited this example to drive home his point. He and a colleague had boarded a flight and his colleague ordered a Jack Daniel’s, a brand of whiskey. The steward informed him that they only had Jim Beam, another brand of whiskey. His colleague replies: “No thanks, I would rather have water.” Russo argued that if the steward came back and said “Yes, you can have Jack for a dollar more than Jim Beam”, he colleague would not have minded. That is what he meant about brand loyalty possessing pricing power.

To sum up, his philosophy is to invest in businesses that have a strong brand with the capacity to reinvest. Honest management is given priority with a special penchant for family controlled companies. Such holdings can really compound over time. It has worked for him. A partner at Gardner Russo & Gardner, which has over $5 billion in assets under management, Russo oversees $4 billion of the firm’s Semper Vic Partners fund. The firm outperformed the S&P 500 index by an average of 4.7% annually from 1984 to 2011 while the Semper Vic fund returned 14.6% annually after fees and expenses.

 

Larissa Fernand is the editor of the Morningstar India website.

 

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