MALE SPEAKER: Hello, and welcome everyone
to another episode of our Value investing Series.
We have a very special guest with us today.
So in thinking about introducing him,
I have to start off with a series of experiments,
a series of studies that were done
at Stanford by the professor Walter
Mischel in 1960s and '70s.
These are also most widely known as the Stanford Marshmallow
Experiment that you might have heard of.
Essentially, it was an experiment.
It was basically a bunch of studies in which children were
offered a choice between one small reward provided
immediately, or two small rewards if they waited
for a short period, which was about 15 minutes, during which
the tester would leave the room and then return.
The reward was sometimes a marshmallow, but often
a cookie or a pretzel.
In followup studies, what these researchers found
was very surprising.
These children who were able to wait longer for the preferred
rewards tended to have better life outcomes
as measured by SAT scores, educational attainment, body
mass index, and other life measures.
Now why am I mentioning this?
Our guest today is no psychology professor.
But he happens to be a Stanford alum.
And he happens to be a world famous value investor.
In speaking about his investing process and philosophy,
you will see parallels between delayed gratification.
Let me share a quote from his recent interview
with all of you.
He describes his process saying, "We
tend to benefit in life when we sacrifice something today
to gain something tomorrow.
That is true for companies.
That is true for individuals."
His focus, he says, is on businesses
that have the capacity to suffer, that is, they can
reinvest their capital at high rates of return
so that the wealth will continue to compound
into years into the future.
Thomas Russo, our guest, is a preeminent investor
of our times who began his investing journey in 1982
after an encounter that changed his life.
He was studying law and business as a graduate student
at Stanford when Warren Buffett came to address his investment
class.
As Mr. Russo explained in a recent interview,
he was dazzled by the speed of Buffett's mind,
his quirky delivery, and his beguiling
habit of courting everyone from Bertrand Russell to Yogi Berra
and the wisdom of his deeply thought ideas.
This inspired him to finding his own investment vehicle
and starting his value investing journey.
We are so glad that he's here in person
to share his experience and his journey
and his insights with all of us here.
Thank you for coming.
So without any further ado, ladies and gentlemen,
please join me in welcoming the one and only Thomas Russo.
[APPLAUSE]
THOMAS RUSSO: I'm so pleased to be here.
I actually thought the setting would
be a much different setting.
I thought we'd be underground in some catacombs with a group
of people worshipping an outlawed
faith in Silicon Valley, the faith of value investing.
But here we are, next to the free food,
the wonderfully lit room, great chairs.
So being a zealot in the investment business today
doesn't bear the marks that it did 2000 years ago
for religious zealots, I guess.
It's a great honor to be here, especially at this time.
It's a really good excuse to get away from the markets, which
is something that's welcome.
Even though I say that, we've had an unusual period of time
which reaffirms what [? Surapa ?] described
as this value investing preference for businesses that
have the capacity to suffer, because you think
about my last three years, we've certainly suffered when
compared to the S&P 500, which has been elevated by sort
of global capital flows.
And we've had businesses that, right through this,
have been investing in their strong global brands,
but showing a modest growth at the reporting level
because they often invest a portion of their net profits
against future business prospects.
Now recently, almost a third of our portfolios in beverages--
and the world is now quite reaffirmed about the value
of beverage brands through the noise about the AB InBev
acquisition of SABMiller-- we own both those shares,
and it's helped generate performance recently
in the face of a plunging market.
And then I was reminded of this again today, which
was the results of an announcement by JT Tobacco
to acquire American Spirit from Reynolds American Tobacco.
Well, quite extraordinarily, the price
was almost Silicon Valley-like.
It was 300 times operating income
for a business-- they paid $5 billion for a business
that I think had around $500 million in revenue,
much smaller base of profits because it's still
investing in its own growth.
But they saw something that they could take around the world.
And it reaffirms-- within a business like RJR,
where people often overlook the investment
because it lacks sizzle-- that the strength of the brand,
the predictability of cash flow, and the ability,
most importantly, to reinvest that cash flow going forward--
leaves it quite valuable.
I'm going to come over here so I can move some of these around.
I did, in fact, also welcome the chance
to come up because I'll talk tomorrow
to the students in Professor Jack McDonald's class, which
I've done for the past 25 years, having
graduated from his class.
And it was there that Buffettt came to our class
and provided some early insights.
I'll go through a couple of quick slides.
As an investor, you're always, at least in the value investing
world, encouraged to invest for the long term
and let market disruptions pass you by, hold on.
And I was reminded of this in June of 2008,
when I was in Africa with my family on a safari.
And every day we'd go out to visit the range
and look for animals.
Each one looks more ferocious than the next.
And every single time, the guide would say, look,
if you're ever separated from the group, and you're alone,
and you're being charged by a lion or anything
else-- a chameleon, anything that
might come at you-- freeze, and it'll ignore you,
run right past you.
But if you run, they'll chase you down.
That was the rule again and again and again.
Finally we came upon this guy.
And he said that, that's a Cape Buffalo.
If ever you're alone and you're separated from the group
and you see one coming charging at you, run like hell.
And so that happened in June of 2008,
when the market was just in free fall.
And at the time, I sort of felt like maybe we
should run like hell.
We didn't, and we haven't.
It's my belief, it's been my belief,
that equities are the preferred form
of investing for one capable of enduring short-term pain
for long-term gain.
Equities will be the best way to do that.
And along that line, I would just
want to make a point about this other Stanford experiment
that you referred to.
I do believe definitely in deferral in the investment
world-- as you can see, a little less as it
comes to marshmallows.
I tend to grab the big ones and eat them quickly.
But the principle's the same.
In fact, I incorporate the principle in one
of the early lessons that Buffett
gave at an annual meeting of Berkshire, where he said,
you know, really, investing is as simple as "Aesop's Fable."
It's about the bird in hand versus the bird in the bush.
The only thing you need to know-- because you know what
you have-- what you need to know, which is uncertain,
is what you'll end up with when.
And he says, it's as easy is that,
and then he says, it's as hard as that.
I'm in an audience at Google.
And I think I read that the minutes spent
on YouTube in the last second quarter versus the prior year
was up 60%, and that's on a million users.
And I can tell you that if you keep up that type of growth
rate, it won't take that long.
You'll know what you're going to have, which is a lot,
and it's going to happen soon.
But in most businesses you're not
blessed with 60% growth rates.
There's something much less commanding.
But it is about what you'll end up with.
And so I think that's a good emblem.
This I take from one of our largest holdings,
which is Nestle.
They, like Google, talk extensively
about corporate culture, because that
is what you can bank on when you make an investment.
We own businesses that are supposed
to reproduce themselves over time,
and you need a strong culture.
And the head of Nestle's Japan business once showed this slide
and remarked about how lovely he thought
that 700-year-old temple was.
And then he said, now, none of the wood's 700 years old,
but the temple is.
And I thought of that as sort of an apt metaphor
for what businesses are like.
I mean, none of you will be at Google at some point,
but Google will hopefully still be Google.
The timbers are all changed out here,
but it still stands for the same thing.
And you'll be a very different company when you're all gone.
But Google should still stand, in light
of its context at that time, as a business
with the same virtues and values as it is today.
And that corporate culture is extraordinarily
important to myself because most of the money that I oversee
is invested through me by wealthy families, family
offices.
And for them, it helps a lot to hold a business
for a very long time.
And the only way you can invest based
on that belief is if you get the corporate culture right
I came out of Warren Buffett's visit to my class in 1982
at Stanford Business School with a couple of sets
of information captured here.
First, the $0.50 dollar bill.
That used to be the old-fashioned way of thinking
about value investing.
If you buy $0.50 dollar bill, your margin of safety was quite
great because of the discount.
Your internal rate of return, however, depended exactly
on when that discount closed.
And if it closed in a year, you'd make 100% on your money.
If it took 10 years, you'd make 7% on your money,
and so on through the Rule of 72.
It's also problematic because it's taxable.
So in that old model, if you took that $0.50 dollar
and realized the dollar, you'd pay 40% tax on that now
because long term gains have been less favored.
And you have to redeploy the money
into finding something else.
That didn't seem like much of a thoughtful way
to conduct affairs from my perspective,
especially since, at business school,
Warren gave the class the primary benefit.
He talked about the only one thing
that the government gives you as an investor, which
is the non-taxation of unrealized gains.
They give you one other thing, which
is that you can deduct losses for tax purposes.
But you don't you want to go there.
You're much better off finding something
that you could hold so that the gains that you get over time
are unrealized.
So when he spoke at our class, Berkshire
traded at $900 a share.
Today it's at $200,000 a share.
It's never paid a dividend.
It's never done anything except compound.
And it's only because he's been able to reinvest
at such a high rate internally.
And rather than try to close the discount, the discount that we
started with, he just let the intrinsic value
compound and the market price will track it over time.
It
Warren also said that there aren't
that many good businesses in the world.
As an investor you should select a business
that you find interesting so you would follow it
and you spend more time with it.
For me, that was consumer brands.
Early Buffett investing was sort of
transformed once Berkshire bought See's Chocolate
in the early '70s.
And I heard from him early into that exercise,
but he already had realized that See's gave him the ability
to raise prices regularly, because the consumer doesn't
believe that there's an adequate substitute for the brands
that they embrace.
I recognized that once flying on an airplane,
and the person next to me ordered a Jack Daniels.
The steward said, sorry, we just have Jim Beam, and he said,
I'll have water.
I'd rather have water than the one
that I don't really identify with.
And that brand loyalty, by the way,
is what we look for at the heart of our businesses.
That gives pricing power, that gives predictability of demand.
In fact, it's that brand loyalty that, at some point,
you guys are involved with creating and sustaining
through all of the work that happens at Google.
But that's the sort of uber brand value
rather than the search brand value.
So we can talk about that later on,
because I'm intrigued by Google.
So what did Warren say?
He said margin of safety's required.
The $0.50 dollar bill, however, changed by the time I met him,
because he realized that a business that can price has
the ability to grow, and that growth is more powerful than
discounts of inert value.
He said, observe the tax efficiency of holding.
And then he said, you're probably
going to have to find managers who are owner-minded if you're
going to hold for a long time, because otherwise they'll
steal from you.
So the question is agency costs, and that's actually
at the heart of the investment contract
that you have with your public company managers.
There is a contract that says, you'll have the use
of my money, my investors' money,
but you have to treat it as if it's your own.
You can't prefer your returns to their returns.
That's very hard to find.
And so in my world, where I found it to be available
is through family-controlled companies
where the family exercise dominion on their own rights
over the management to do what's right for the next 10
generations of the family.
That's starts to feel comfortable to me because
of my long-term mindedness.
I like businesses that invest for the very longest term,
and do so with the owner in mind rather than management.
The average US public company, by contrast,
has no family entanglements.
It's purely public.
There's absolutely no image of a shareholder
when people think about the contract.
I actually met the CFO of Coca Cola recently,
and she referred to shareholders as stakeholders, and I said,
don't you really mean owners?
Because the word stakeholder-- I mean,
you could be a stakeholder if you're the community,
if you're this or you're that.
There are all these concepts.
But in business, what you really want your agents to think about
is the owner at some level.
Public companies are so far removed
from that it's not even funny.
Really, it's the idea of how do you make the public company's
money manage its money?
The most efficient way designed to do that are stock options.
And stock options have one problem,
which is the only work over a specific period of time,
after which, if the prices isn't struck,
they end up being worthless.
So the one thing public companies
start to spend an awful lot of time caring
about, way too much, is time.
They need it now.
And in fact, Wall Street loves companies
that are willing to present things early on because it
means that they can predict more clearly what the world's going
to look like than what natural outcomes ought to allow.
So they can say, General Mills is going to earn $1.50 this
quarter, and General Mills will earn $1.50 this quarter.
They won't really earn it, but they'll report it.
And they'll do that again and again and again.
And then over time, by taking steps
that get the outcome, to meet the target,
to keep the share price up-- because there's no volatility,
it's all predictable-- they hollow out the franchise.
Just the opposite of what we're looking for.
We're looking for businesses that
are willing to completely thrash the near term in pursuit
of the long term.
But in order to do that, they have
to have security in one issue, which is control.
That's where the family-controlled company
comes into play, because they can, with their super vote,
defend against the pressures that normal managements are
willing to assume in the complicit bargain
that they have with stock option-driven compensation.
I'll fast forward for a second.
I pulled this from the Google founding principles.
And right at the heart of what Google talks about,
and what I think gives you such endurance,
is this structure, this third paragraph down,
second sentence. "This structure will also
make it easier for our management team
to follow the long-term innovative approach emphasized
earlier."
They have the management's back covered,
and they allow, from that standpoint-- investments have
a very long payback, but upfront burden
to take place at full amounts, because it's
my belief that most public companies, the error
is on under-investment upfront to make sure
that the results are, in effect, overstated.
Now I use the term capacity to suffer.
It's a funny one.
It was partly derived from another investor
you may have met with or heard of called
Jean-Marie Eveillard, who runs SoGen's International Fund.
He was quite an early international investor.
And at a Columbia function I was at,
the business school, somebody asked him
what he looked for in analysts when he was hiring
to build as investment team.
And without a moment, he said, the capacity to suffer.
And I thought that was an appropriate definition.
And the reason he said that is that it's so rare to find
that in America, because as a country,
we always think that every single day should be better
than the prior day.
Actually, there's a great quote in the book
that I just read, "Work Rules."
And he talks about a guy who was in a cubicle, and he said,
every day of his life is worse than the day before.
That's the capacity to suffer.
But in the investment world, the capacity to suffer
is hard to find.
People expect returns to come easily, regularly,
and they don't.
And so his recognition was that you
have to have people in the investment
business constitutionally prepared
to have deferred results.
All right.
So if we start out believing that we're
going to hold something for a very long time, what
it needs to have is the capacity to reinvest internally.
For me, I used consumer brands as the industry
through which I invest because they tend to be very enduring.
You think about Communist China.
After the veil lifted and commerce could go back in,
the number one cigarette in Communist China the next day
was a cigarette that hadn't been in the country
for 55 years of Communism.
It was the old British American tobacco
brand called State Express 555.
Hadn't been in the market, but somehow it was still
in the brains of the consumer.
Same thing with Romania when the wall went down in Romania.
The number one thing that the Romanians wanted
was Chesterfield cigarettes.
Well, you can't even find them anymore.
But that brand endured for 55 years in the consumer psyche.
And what we look for is the ability
to reinvest behind those brands.
The strength of the brands tend to allow
for more regular free cash flow because of the pricing power
that you get.
The likelihood of finding owner-minded businesses
goes up with consumer brands because they
tend to have been, over the life of the company, more
self-funding.
You think about why it is that most American companies don't
end up with control shareholders,
because if you're in a crummy business,
it takes a lot of money to grow.
And you have to raise additional equity again
and again and again to fund the growth.
And at the end, if it's a sufficiently competitive crummy
business, you're going to have horrible results and no control
shareholder.
The presence of a business that still
has control held by the family is an evidence of the fact
that the business is, at its heart, quite cash generative.
Now it's not enough just to be cash generative.
What you really want is to have the capacity
to have that cash that the mature markets deliver,
in the world of consumer brands, available for reinvestment
globally where 95% of the world exists in population,
and where GDPs are escalating, and where
consumer disposable income is just growing.
And so we want to have brands that have relevance abroad,
which gives them the capacity to reinvest mature market cash
flows into growing markets.
It leads this portfolio that I oversee
to be primarily European.
That's for a couple reasons.
One, the European managements aren't nearly so accustomed
to compensation based on equity options.
And so this notion of having to do something
quickly-- and fabricate numbers to make sure
that the Wall Street analysts are pleased enough
to keep the stock price high enough for your options
to be worth something-- doesn't exist over there.
They pay people cash.
The brands that exists in Europe have been abroad more
historically, and hence are more embedded in the culture.
In India you have Hindustan Lever.
Well, that's Unilever.
You have Cadbury of India.
That's Cadbury Schweppes.
You have Nestle of India.
They've been around, in the case of those three,
for at least 50 years.
And their aspirational character was developed
over that period of time.
And that aspirational character gives pricing power.
And that pricing power allows for reinvestment.
So we're looking for global brands.
We like the developing emerging markets,
because that's where the newly formed demand is arising.
That's where the markets are un-invested in.
And that's where GDPs are rising.
Everything I'm telling you, actually,
was more true as a context two years ago than today.
If you think about the stories of the current world, collapse
of commodity prices, pulling back of manufacturing,
China coming back.
So lots of what I've built into my investment thesis
is sort of in flux.
And it's an interesting time.
But it certainly has been, for the past 25
years of the course of my investment
creator, a one-way tailwind, the opening up of markets
leading to the transparency and liberalization of societies,
leaving people free to buy things that they'd long aspired
to, leading our companies to have a place
to pour back their free cash flow into meeting
that consumer need as a group.
What else do you need?
And this also favors international community.
One thing you need to expand internationally--
if that's where your growth is going to come from-- you
better have multilingual and multicultural managers.
Multilingual surfaces quite quickly.
In this audience, how many people
here speak more than three languages?
Good It's rare.
It's really rare in North America.
It's not at all rare in Europe.
So at Nestle, I think the top 100 people in the management
team speak four languages.
And at Kraft Foods in Illinois they speak 0.9.
Multicultural.
That's important.
Let me ask somebody a question here.
How many people-- just by raising your hand--
how many people have a favorite cricket player?
See, you're a very unusual company.
That's what makes Google great.
Nowhere else, if I ask that question,
will a single hand go up.
1.7 billion people go to sleep each night
thinking about their favorite cricket player.
And if you're going to be effective internationally,
you probably want to have somebody who
understands that story line.
So the capacity to reinvest is not democratically shared.
I made light of Kraft.
Indeed, we had and sold all of our stake
in Kraft because of their provincial portfolio
and their lack of natural reinvestment.
They tried to go into China, they failed, they came out.
They had no people to develop the market.
They didn't understand it.
And it's a domestic company, and it's
a company that's made lots of money selling cheese
and cookies and meat to Americans.
And America was a big enough market
that it kept their ambitions fully staffed.
But they had no capacity to go internationally.
We want businesses that can.
Nestle, Unilever.
They have the bench strength, they have the brands,
they have the cash flow, they have the understanding
of where the puck's going.
Now in order to do it the right way,
you have to have the capacity to suffer.
That means that when you open up a new market,
you're going to have unabsorbed fixed costs in spades,
and that will burden current income.
If you're not protected through major shareholders who
support that long-term vision, I can assure you-- today
especially so-- you will have any number
of a dozen different activists come in by 1% or 2%
of your company and demand better.
You can do better.
If not, we'll kick you out.
And no management team wants to do that, especially midway
through an investment cycle.
I'll give you a quick example.
We own shares of Cadbury Schweppes.
It's a terrific business.
They had three pillars.
They had gum, chocolate, and hard candy.
Each one of those came from a different background.
in Each one was dominant different parts of the world.
Put it all together.
They had great market presence in parts of the world that
had been massively underserved.
The joy of eating sweet things.
So what do they do?
They decide that they try to launch the business in China.
And they start out in Hong Kong, Beijing, and Shanghai.
And they knock the ball out of the court, everyone
believes it's a good business.
The Chinese line up.
They like it.
They go to 200 of the next cities in line.
So that takes you down to cities of a million or more,
but there are 200 of them.
Now the suffering really starts.
Now they're spending a lot of money.
They have to introduce the brand,
they have to build awareness and all the rest.
And they do it across 200 cities.
Now I heard from the CEO of the company sort of midstream
through this.
He understood that the investment spending
was going to just overwhelm the reported profits out of Hong
Kong, Shanghai, and Beijing.
In fact, they'd show losses for as long as they could see.
And every year that went by and they invested like this,
they built net worth because they converted consumers
who became loyalists and who had lifetime consumer patterns.
And you can know the upfront value of a converted customer
addicted to sweet things.
They were midway through the process, losing a lot of money.
Along comes Nelson Peltz, knocks on the door and says,
you gotta do better.
The numbers just aren't advancing.
You have to do something.
Give us some earnings.
So the board and the CEO went home over the weekend,
came back and said, right.
We think we have China wrong.
That investment work we're doing in those 200 cities.
We're way out in front of our skis.
It's just not working.
Let's close it.
Now with that, they manufactured income
because they stopped bearing the costs
of investing for the future.
They destroyed wealth, because all the people
who had bought on board the brands now no longer could
source them.
And away went the equity, the goodwill
that they had created through that investment spending
midstream.
And they lacked the capacity to suffer,
because when a raider came and rattled their cage,
they said fine.
We'll do just what you need.
We have a handful of examples here,
which I'll go through quite quickly.
I'd say the best example of a company,
too, that had the capacity to suffer.
One is inside this room.
You know, you think about all the kind of projects
that Google incubates, burdening profit
with an idea, maybe, of where it'll end up, but in some cases
not even.
That's extraordinarily powerful.
And you have lots to show as a result of that.
That scale would be a very interesting one,
because I think you have an awful lot
to show for the willingness to suffer.
And Amazon.
Amazon's way out, even beyond you guys.
I'm not sure that they'll ever report a profit.
But they certainly have the capacity to suffer.
So do their shareholders.
Well, of course they get rewarded for it.
The price has gone up so much.
So the businesses that we'll look at are more traditional.
Berkshire is the best one.
That's why I learned this subject.
Warren talks about it all the time.
But Geico's a great example.
Much like confectionery in China,
it's expensive, it turns out, to bring on an auto insured.
And so when Warren bought controlled Geico,
he asked the CEO why they only had two million policyholders,
and the CEO said, because it's too expensive to grow.
Every new policy we put on the book
loses $250 in the first year.
And ongoing insured make $150 per year of operating profit
for the company.
So you have two million policyholders making $150 year,
so they were reporting $300 million of profits.
And if they wanted to grow a million new policies
the next year-- because as Warren said,
they had the best business, under-penetrated,
the market should have more of them.
So why not grow it by a million policyholders?
What would happen to the operating income that year?
It would go from 300 to 50 assuming
that the other business didn't grow at all.
Now no public company can endure that kind of volatility.
The activists would be on that thing so quickly.
Inside Berkshire, it didn't matter.
Warren controls 40%+ of the stock.
He's never told investors that he's
in the business of manufacturing reported earnings.
No one get stock options.
He gets paid $100,000 a year.
It's all about owner's equity, intrinsic value,
and how do you grow that with certainty as best you can?
Well, no better reinvestment than to take that $2 million
insured base up because of its persistency and its low claims,
lack of adverse selection as they grew.
They had a lot of room.
And by the way, even though the first year cost, reported loss
of a new insured was $250 upfront,
the moment they signed up the net present value, lifetime
value of each insured, $2,000.
That's $150 stretched out forever, brought back.
Now, so for the mere inconvenience
of reporting a $250 loss upfront,
they put on $2,000 of value.
Warren got it.
Today, 14 years later, they have 11 million policyholders.
And in the annual report he said to investors,
because he's a fair partner, if you're
thinking about selling the business, your shares
in Berkshire, understand that book value doesn't capture all
that we've got that's good.
And he said, for instance, at Geico we've added $20 billion
of value since we bought it.
Now that's that $20 billion that comes
from those 9,000 new insured.
And the only way you get there is
by having the capacity to let the income statement
bear the burden.
And over that time, they took their annual ad spending
from $30 million up to $1 billion.
And you'd all know that, because watching television
is really a series of Geico advertisements these days.
Another thing that Berkshire did was,
the equity index put options.
There's a group that had $37 billion
worth of equities, market value equities,
around the world for different markets.
And whatever the reason, that group
had to be able to say to their counterparties
that that $37 billion was not at risk.
They needed for their collateral,
whatever the reasons, to have $37 billion.
And so Warren was asked to insure
against the potential for that portfolio to decline in value.
He sold them a put option.
In return, we received $5.3 billion to invest,
unfettered, for 18 years.
It was non-callable and it had no collateral
posting requirements, which are the killers in this business.
So why did Warren get $5 billion to insure
against the decline of equities over 18 years
when, likely, the course of equity values is up over time?
It's because the people who needed that insurance
had nowhere else to go.
First, Warren had the capital.
He had $50 billion of spare cash which sort of buttressed
his claims-paying appeal.
Other people who might take the $5 billion
don't have the capital balance sheet or the culture
to provide for the ultimate payment
if the world went to zero and they owed $37 billion.
Warren has that, and the culture would honor that.
The other thing, the more important thing,
was nobody else would touch this stuff,
because every quarter there is a mark to market requirement.
And it absolutely crushes reported profits.
So for example.
After they signed it, received the $5 billion,
the equity world markets collapsed
and they had six quarters in a row of over $1 billion
worth of charges to the income statement,
some periods as much as $3 billion,
because global equities collapsed.
And every time it collapsed, they'd
have to pass through the reported profits,
the mark to market.
OK.
So at the end of the day he had $13 billion
less in earnings cumulatively over that time.
But he had $5 billion which he had put to work.
And that's sort of the last story about Berkshire.
Another way in which you could see his capacity to suffer
added enormous value was that during the crisis-- well,
during the period leading up to the financial crisis of 2007
and 2008, Warren, at the annual meetings,
always lamented the fact that he had $50 billion cash hanging
around on which he was only earning .01%.
And that's the safe return.
That's sort of the federal treasury bills that are secure.
Since he kept it in cash, he might as well keep it secure.
But he was only making .01%.
01%.
If he had standard company practices,
he never would have kept $50 billion of cash
in overnight money.
He would have gone out three, 10, 14, 40
years on a bond portfolio and would have had a 4% yield.
He kept it at .01% because he didn't trust inflation
or credits to support having $50 billion
in longer duration investments.
The difference between 4% and 0.1% on $50 billion
is $2 billion a year.
That's the amount he suffered by under reporting,
because he kept his money in liquid treasuries.
That requires a lot of suffering because $2 billion
is a lot of money, even to Warren.
Now ironically, to show you how American companies behave,
at the same time that Warren was belly aching about only making
.1%, General Electric had taken $100 billion of their borrowing
and brought it into commercial paper overnight
to capture those same low rates.
Now it's a different story for General Electric, though.
You have businesses that have long-term funding requirements
where you can't responsibly borrow overnight to meet.
You can do so if your goal is to manufacture earnings.
And off $100 billion in the overnight market,
where they might be earning 2%-- they may be paying to 2/10
of 1%, let's say, maybe even .03% in the commercial paper
market-- they should have been paying 4%, exactly like Warren.
In their case, they should have stretched out their liability
structure.
But by taking it all into commercial paper,
investment bankers assured them that they could swap them out
at any minute.
They could go back long.
They could go into yen, any currency they wanted.
It was just a number after all, wasn't it?
Well, they forgot one thing, which
is that overnight markets can shut down.
And when Lehman burst, GE had $100 billion of overnight money
that they couldn't roll.
Warren, happily, had $50 billion which
he could use to help them out.
And he gave them the right to $12 billion of his money
at 12% with hundreds of millions of shares of call options.
In case the company did well, he would
have the privilege of making the equity that they recklessly
threatened by their non-owner minded ways.
Now they were not at all unusual in this.
This is what public companies do.
They bring down the rest of the cost because it helps flatter.
In GE's case, that was $4 billion of manufactured income.
Now this I would complain to you about.
However, there's one mega force on the landscape that's
done one worse than that, which is the United States
government.
We have taken our borrowing from $9 trillion to $18 trillion
through QE, most of which was not invested but was
transferred, to try to stimulate some kind of economic growth
in the absence of a Congress that doesn't meet.
And we keep that money predominantly
in overnight borrowings.
The yield curve of the US Treasury
is abysmally short term, and we are massively
understating, when we look at our own deficit, what
this country has put itself into, which is $9 trillion
of additional borrowing coming through at sort of 1, maybe 1,
1.5%.
And the real cost of that burden will
be very apparent at some point when rates go, uncontrollably
by us, upwards beyond our control.
Anyways, I hope that what, for me,
has been most educational from the time
I first heard Warren speak at Stanford to the present--
this notion of how the capacity to reinvest surfaces
is best illustrated by those three ideas in Berkshire.
And there have been a whole series of business
that have done it afterwards.
Nestle is extremely well-positioned
in the landscape of what I look at by virtue
of having all these billion-dollar brands widely
v distributed throughout the emerging markets,
aspirational, and available, increasingly,
due to the hard work of multilingual, multicultural
people delivering their business.
The company does not hurry.
When I first invested in the business's shares, 1987,
the CEO then, because of Wall Street's miserable reaction
to their patience, said, well, what
is Nestle's planning horizon?
This is the CEO.
And he said, without a flinch, he said, our planning horizon
is 35 years, but we tend to break it up
in five-year increments.
Now this is what you want of a company
if you're thinking long term.
I think American companies have a 35-minute, not
year, planning horizon.
This graph, I think, just demonstrates
what it is that we're about, what we're going for,
which is on the far left, as you look at low per capita GDP,
and then you move up to the right,
you go from subsistence to buying, to buying better,
to buying luxury.
And there are two or three billion people
in the world sort of at the far left of 2,700.
I think in China now today it's 7,000 GDP,
but it's bifurcated badly, probably 500 million
of less than 1,000.
In India there's half a billion less than 1,000
in the rural areas.
The country's probably much higher.
But it's that migration from subsistence with no commerce,
to commerce, into brands that we're in the midst of.
And that's what we invest behind.
The company has the patience on reinvestment.
If you look at the very top of this little chart
you'll see in Nespresso.
Very, very top.
It's a business that they pioneered about 20 years ago.
It took them 15 years-- maybe it was 25 years, I don't know.
It took them 15 years before they broke even
on that business.
They lost nothing but money for the development phase.
And they built it right, and they tested it.
And along the way, when other competitors
had wind of what they were doing,
they came out with products that were not nearly so competitive,
like Tassimo by Kraft, and some others who were
more interested in short term.
Nespresso built their business to last,
and today they do $5 billion of business.
Now it's not an unblemished record,
because Keurig's a huge business.
They should have shut them down.
And Starbucks has grown to be an enormous presence in the coffee
business, and they probably should
have been more adept at that.
But they still, nonetheless, had the capacity
to deliver a truly great business in Nespresso, which is
what these boutiques look like.
Let's think here.
We could go on.
I'll just give you a quick overview.
Pernod Ricard, great portfolio of spirits.
Two in particular, Martel and Chivas,
they acquired through Seagram's.
When they bought it, it was in the year 2000.
China was going through a downturn.
There was a company called LVMH and Diageo, who owned Johnny
Walker and they own Hennessy.
And those were the two largest brands in China from the west.
At the time they were about two million cases.
At that time, Diageo said, OK, China's going into a funk.
We'll just pull out because we want to protect our income,
our reported profits.
Why spend the money now when the market's turned down?
We're probably not going to get a lot of yield from that.
Let's take our brands home, maybe come back later on.
At that time, Pernod Ricard had just
acquired Seagram's, and with it came Chivas, like Johnny
Walker, Markel like Hennessy.
And they said, well, you know what?
We're a family.
We own the business.
No one can take us out.
We don't have to worry about reported income.
Why don't we go in and see what we can do?
Now since then, obviously, China has recovered.
Chivas and Martel succeed.
They're not the largest Western imported spirits in China.
Diageo struggles to get relisted in the country
that they once commanded but left.
They left for the wrong reason, which
was maintain that earnings per share, because why not not
suffer if you don't have to?
Well, they should have stayed.
The long-term prospects of this business,
however, are not yet scratched.
The white space, looking forward in their portfolio, in China
there are half a billion cases of baijiu, local spirits
consumed per year.
All of the premium Western businesses, in total,
do only four million cases.
So we've got 549 million cases that we can go after.
And an agitant to this will be the great growth
in the Chinese tourists.
There'll be over 100 million tourists this year from China.
As they go to Europe, they observe.
They're already minded towards those western trademarks.
And they'll come home with a couple of bottles
through duty free and start to sort of serve
as local ambassadors for the brands.
I think less than 1% penetration over time
will be a very attractive platform from which
we will grow these businesses.
In India, if they weren't the case
that the government has had such barriers to trade,
we could see that business even bigger.
I would ask the question of anybody here
who travels duty free into or from India,
what two bottles of spirits does every Indian buy
when they return home?
Yes.
AUDIENCE: I don't know if it's typical,
but I buy the Glenlivet.
THOMAS RUSSO: Oh, you're very high end.
AUDIENCE: [INAUDIBLE]
THOMAS RUSSO: Oh, you're high end.
No, it's Johnnie Walker Black Label.
The numbers, Black Label's the big one.
But the Indians consume 125 million cases
of what looks like scotch, locally made.
Imports are very thin.
And Puerto Rico controls the market, along with BJ
[? Maya ?].
But when and if-- well, I guess I'd say,
because of what Modi said yesterday at the SAP Center--
when, not if, free trade descends,
we will sell so much scotch whisky, authentic whisky,
into a market that prefers it over their local brands
that the investments in Diageo and Pernod Ricard
will just, I think, be pulled along.
In the meantime, they're suffering.
They're not absorbing their costs
because it's expensive to maintain market presence
and only sell at the very highest end because of trade
barriers.
Anyways, Pernod, I think, it stands
where it does because again and again and again,
like in 2000 with China, the family
has the ability to out-compete standard public companies who
worry about stock options and quarterly numbers
because they're free to think long term.
And if you sat there and watched a public company dismember
their premium status in China, and you said,
but for quarterly earnings they would've stayed,
and you go in to that void, it's a terribly attractive
structural advantage.
I think we pick up by sticking with these businesses.
SABMiller.
I like this slide.
It's now, unfortunately, in the midst of being taken over,
which is a disappointment because they
had the right mindset.
They were South African breweries. .
They were a pariah company.
They started with nothing.
And today they are the second largest brewery
in the world, maybe the largest because
of the Chinese operation.
When they invest to develop the future,
however, look what happens to the EBITDA margin.
Revenues went up a lot over this period of time.
This is some time back now.
Revenues went up a lot as they were pouring money
into developing the markets throughout Africa that they
had a toehold in, but recognized at some point
that they were under investing.
They stepped up the investment massively,
grew revenue, grew volumes.
EBITDA margin plunges.
That's good.
That's the burden on reported profits
that came from the upfront development costs of opening up
those markets.
They had the ability to absorb that because of the control
shareholder group.
And Brown-Forman's the last one I'll talk about.
It's ironic.
This is how screwed up America is.
In Brown-Forman's case, what I call the virtue of family
control, which is the alignment of interest
for the long term, which means that they're often treated more
cheaply in the marketplace because people
worry about corrupt families.
But the irony is that instead of celebrating family control,
in their proxy statement, they have
to have a section that says, "A risk factor is
a substantial majority of our voting stock
is controlled by members of the Brown family,
and collectively they have the ability
to control the outcome of shareholder votes including
this and that.
We believe that having a long-term
focused commitment and engaged shareholder base provides us
the important strategic advantage, so on and so forth."
However, they flag it as a risk factor.
I celebrate it as really one of the great things.
And I first invested in their company in 1987.
They had made a bunch of investment banking-driven
acquisitions, all of which flopped.
And at that point they committed as a family to do nothing
but grow Jack internationally.
Wall Street despised the shares.
They had sharply declined when I made the investment.
The company had committed, at that point on,
to take what their heritage was and invest
against the future spending internationally.
At that time-- let me go-- oh, I'm
going the wrong way-- at that time, as this shows here,
international markets were only half a million cases.
This was when I bought the shares.
Domestic was 3 and 1/2.
And they committed to growing that business abroad.
Now that meant nothing but years of burden
on the income statement.
Fast forward to today.
They have to almost 10 million cases internationally.
The US business came back because bourbon, for reasons
nobody knows, became popular.
So it grew.
But the international one is the deliberate result
of investment spending.
If you look down below, in 1987 they
had five markets that had over 50,000 cases, four
with over 100.
Today they have 41 markets with over 50.
The march towards 50 is very unprofitable.
You have all the fixed costs of a distribution network,
partnering, advertising, promotion.
You're not making a lot of money.
Over 50, you start to make a lot of money.
I think the next 10 million cases
will be much easier to get than the past 10 million cases.
During this time-- let me just take a look back here.
The business that I first invested in--
if you look down this list, it says
gross profit of $563 million.
Today they have $2 billion.
Operating capital 182 [INAUDIBLE] $971 million.
They dedicated themselves to doing nothing but growing
the business.
And they have the voting control of the family
that allow them to do it unflinchingly.
When they had left over cash, they
took it to buy back their shares, 360 down to 215.
And the EBITDA went from 200 to 1 billion.
And the share price went from $3.76 to today, it's $110.
And it's been about a 13% compound, which
is sort of what you can really aspire to in public equities,
in companies that don't have the kind of profile
that Google enjoys.
But this is a hand very well-played.
Family had a business that had integrity,
that had a culture that's extraordinarily
focused on making sure that nothing that they do
dishonors Jack Daniels, the heritage.
And they're willing to tell that story broadly
at the cost of current income to deliver
long-term wealth to the family.
And so I show it because it worked.
We have plenty that haven't worked,
just by the way, where the spending didn't
sort of yield results.
But one of the things you have to understand
is that I think businesses have to have that capacity
to suffer.
And it's true to say that investment managers have
to have the same capacity.
And so if you look at the history of my portfolio
returns, you'll see in 1999 we were down 2%.
The Dow was up 27, the S&P was up 21.
In the following three months, I think
that both of those indices were yet again up higher,
and I think I was 10% down first half of 2000,
and the NASDAQ was up another 50%.
I had to have the capacity for my investors
to allow me the right to underperform by 29 percentage
points if I was going to deliver the kind of returns
that we have, long term.
And if you look, as a result of being enabled to be out of step
for that period of time, we ended up
adding the most value ever in the subsequent three years
by not having the same declines that
consumed what looked like those early Internet
vapor returns that influenced the market.
I need to have the capacity be totally out of step
with the market if we're going to add value long term,
and that year was a good example.
Now this year I think I'm down 1% at the top,
and I think the Dow and the S&P are both down 8%.
So the markets have become quite volatile.
This is the portfolio.
The names should be kind of kind of familiar.
Berkshire, Nestle, MasterCard-- brilliant company-- Philip
Morris.
Most of them are international.
Most them are family-controlled.
And I think on that note, I'll just ask for questions.
AUDIENCE: I have several questions.
Maybe I'll give everyone a chance and come back.
THOMAS RUSSO: Let me take my tie off and settle in.
Fire away.
AUDIENCE: Easy questions.
One thing that stands out in your portfolio is MasterCard.
It's unlike the other holdings you have.
It's a strong consumer brand, not
a family-controlled business, very asset light.
I think if I look at the financials,
most of the cash flow convert into free cash flow.
Not that many opportunities to reinvest, but a long runway.
So kind of being different from all the other holdings,
would you maybe share your thoughts
on how you think about it, and the factors like this option
in the long run and things like that affect
MasterCard more than other things?
THOMAS RUSSO: Yep.
It's a great question.
It's a big holding.
It's really aligned to capture exactly the same forces
that I'm looking at in the consumer portfolio, which is
the rise of commerce globally.
And understand that, at the moment,
85% of the global commerce is still cash.
And MasterCard set about to convert that.
And they have some partners in this process,
and they have the capacity to suffer along the way.
Not because it's family-controlled,
you're right.
But they somehow have gathered a group of investors,
including us, who have been willing to grant them the right
not to have operating leverage flatter their statements.
What happened is, when we first invested, the world collapsed,
the shares plunged in 2010 because of trouble
in domestic debit.
MasterCard's it's all about global credit.
But the domestic debit business changed after the Durbin Act,
Dodd-Frank, and the shares sold down to a modest level.
I met the management team, and the business is fine.
They're highly exposed to the growing and developing
markets, which I like.
It wasn't until Ajay Banga became CEO
that I bought my first share, having known him at Citibank.
He's an illustrious globalist, and has
the best Rolodex in the world.
And since he has to implement this business
through other partners, generally around the world,
he's a perfect person for the business.
He also had a capacity to understand
that his job was to deliver to his successor a much
stronger company.
That's his view.
And so every year since he's been at the helm,
the gross dollar volume of business,
pass-through of their business, is growing about 13% a year.
It's a very high fixed-cost business,
so all that advance suggests a higher margin.
You don't see it.
He's taking that incremental operating income that
arises from more volume over a fixed base
and reinvesting it regularly back into programs.
He has 55 projects that he started since he was there.
He hires, against your great demand, PhDs and millennials,
and he's changed the orientation of the company.
And so they poured back into the business investments
against the income statement that
keeps the income statement low, lower
than it would be if they just let those advances.
Now, the trick is, they have partners in this business.
They have partners in the form of governments.
And n Africa, for example, the government
wants payment systems because they
want to be able to disperse social benefits to the intended
beneficiaries without exposing them to the horrors of check
cashing locations, which are surrounded by casinos
and bordellos and people who are trying to steal their money.
Instead, they drop the money into biometrically activated
cards or phones as payment devices.
It's very efficient.
And it gets rid of all the frictions, 25%
to cash a check and all that stuff.
It's gone.
Other countries implement payment systems
because they want to enhance tax collection.
The Koreans understand that their people will not
declare taxes honestly, and so 93% of commerce in Korea,
by mandate, is being done through payment systems, not
cash.
They just don't trust their citizens.
And the way you get around that is
to have a taxable audit that's part of the MasterCard record.
And so we have all sorts of products
that are high technology payment systems using all sorts
of phones and other devices.
And there's just a general movement.
And since I'm oriented with the belief
that global commerce will grow, we
have 85% of that that's in cash we're going to convert,
a higher base over time.
So it's expensive.
It's gone up from $20 a share to $90 since I bought it in 2010.
So at $90 it's not as compellingly undervalued,
but I still think they have so much work ahead of them
that it's a worthy hold.
AUDIENCE: [INAUDIBLE], is the capacity to suffer evident
in the fact that MasterCard has significantly lower margins,
although very nice margins, than Visa's?
THOMAS RUSSO: But that's because they're investing so much.
AUDIENCE: So do you think that's why Visa--
THOMAS RUSSO: That's the measure.
AUDIENCE: So maybe the indication
is Visa is not investing as much?
OK.
THOMAS RUSSO: Yeah.
They have their own problems.
They have to buy Europe.
They don't even have the full global map yet.
And so they can't invest with certainty like MasterCard can,
because they know that if MasterCard comes up
with something, they can go around the globe just
like that.
They have to stop at the European gate and say,
can you do this?
They'll say no, yes, maybe.
So it's just not as harmonious.
And I do think that MasterCard is way outspending.
The history, at least now-- Visa has a new CEO,
and they're probably altogether much better at their game.
But that, historically, could explain the difference.
And I like that, I think, competitive position that you
see with that lower margin, because they're investing more.
AUDIENCE: Thank you.
Wonderful presentation.
THOMAS RUSSO: Thank you.
AUDIENCE: Thanks a lot.
I had a question about controlling the companies.
You said there's a family controlled factor
that comes into play, and that helps in basically
investing in the long term.
Do you feel it's exactly the same kind of control that comes
in with a tiered share class, where there are some classes
that have a higher [INAUDIBLE] than some--
THOMAS RUSSO: It's the same.
It's blocking.
It's the thing that allows you to say to someone
who would like to come along and ask you to change
your orientation, where the answer is no, we like it,
and you can't make us, however that's sourced.
Now there's a lot of hand-wringing over the fact
that super voting shares mean that you control without having
the economic interests aligned.
This is a company that set itself up that way.
It's a young, new company, and that was the terms
under which they embarked.
And I think it's healthy to have that kind of stability.
We'll see with time.
But I think it means that you guys, you people,
can all do exactly what it is that most inspires you,
and do so without regard to the possible hot breath
of an activist, because--I mean, think about how Yahoo is all
congested by virtue of people coming in insisting they do
this and this and that.
You really can't run a business in that context.
And you have the right to be free from that.
And it should allow you to surface things more
competitively.
Yes.
AUDIENCE: I was curious to hear if you think that there's
a place for value investing in technology companies,
because the nature of the industry is so dynamic.
I'm not sure if you're familiar with Clayton Christensen's
book, "The Innovator's Dilemma."
A lot of the-- in the cycle of maturity of tech companies,
they get to a point where they're almost like incumbents
defending market share and sort of investing
in financially viable investments, which
I guess, in the technology industry, sometimes
are not those which ultimately capture
the market in the long run.
So I know traditionally value investing
is reserved for more mature, predictable, slower moving
types of industries.
So I was just curious to hear your thoughts on that,
like whether the strength of a brands like Google or Uber
or something like that could help those companies persist
in spite of the dynamism.
THOMAS RUSSO: Yeah.
I think it's a great question.
I remember Clayton Christensen actually unleashed
the sort of excess of 1999.
Going back to that time, his book
was basically a battle cry for companies
to be willing to destroy themselves to succeed.
That was the whole idea.
And the beautiful image of it was
that you had CEO-to-CEO businesses, where
the old technology and everything that
ran the business made sense CEO to CEO, and down
to the very bottom of R and D, both
the customer and the technology company
recognized that the old ways were horrible.
But they could never get above-- they could ever implement it
because the top, who had to approve stuff,
was quite comfortable with the way that things worked.
And there would be an outside enterprise that would then
engage what they already knew in house, because it
was impossible to champion an in-house solution
against the kind of static top that the disruptions,
typically, that happened elsewhere--
but they didn't have to-- at research level, even in those
mature businesses.
The awareness was there.
It just couldn't get up, and that's culture.
And so ultimately, you've got to have a culture that's
willing, as it seems this one is, to source ideas broadly
and don't do so sort of command control from the top.
That at least gives you a shot, I think, at it,
because otherwise, the technology's so fast moving,
you'll quickly obsolete it unless you've got that culture.
This place may seem to have that, in which case
you've got the willingness to destroy what you relied upon
and move into other things.
AUDIENCE: You mentioned a lot in your discussion
about investing in companies that have demonstrated
the capacity to invest for the long haul,
and to suffer, and to really, like, make investments
where it hurts.
But the question that I come up with, especially regarding,
say, your Geico example, is how do you
distinguish companies that are actually
willing to make hard investments that are going to pay off
versus ones that are just chasing after things that
are actually to short-termism?
THOMAS RUSSO: You know, it's so interesting a question.
In fact, I have a slide that I rushed by,
and it says, you know, capacity to suffer is not enough.
And I had Barnes and Noble, and I had the Nook.
And you think, what?
Now Barnes and Noble's controlled by Riggio.
So he had control.
So he could do it.
But why would you ever want to go after you and Apple
on a laptop or a tablet or a book reader?
What possible stupidity was that?
Now mind you, along the way they had a $1 billion for Microsoft
and $600 million from Pearson.
So it wasn't their money.
But wow.
So it's got to be right.
And that's the trick.
That's the only thing that determines
our returns over time is-- for instance,
I had a huge position in newspapers going into 2000,
because I often think about a measure of whether I want
to invest in business is, how many dynastic fortunes do you
realize have been made from this business?
Well, there was no more dynastic source
of fortune than the newspaper business, historically.
Every city, the most prominent people in the city
owned the newspaper.
They controlled politics, money, and everything else.
And they had been able to survive
each generation of technology by incorporating
from print to radio, radio to TV, TV
to cable, cable to something else.
And then along comes the Internet,
and they say no, we don't want to share
our playground with you.
And it was the most unbelievable stupid moment
in the history of capitalism, because they
had learned over the years that to survive, they had to change.
They had to do exactly what Clayton Christensen said.
They had to be willing to kind of go
into these new technologies that threatened
through exclusive print revenue stream
for radio, and then for TV.
That was very Christensen-like.
And along comes eBay and Amazon, and they
say no, because they were both designed originally
to incorporate a newspaper platform.
No.
And that cost them dearly, because the air went out
of that balloon real fast.
And so it's not enough.
And it's not even necessary.
I just find it to be a place where
we have had some success, sort of thinking through what
it is that we want.
When we embark upon investing in businesses that we're
supposed to hold for a really long time,
I think these ingredients help keep
me focus on important and knowable factors.
MALE SPEAKER: With that, thank you
so much for a great presentation and wonderful conversations
with us.
Thank you.
THOMAS RUSSO: Pleasure.