The Joys of Hunkering Down

Its been a crazy week in the market, but it has been another quiet week in Lake Wobegon. Usually, people think about hunkering down in the winter time, but Josh Peters has a great quote on the pullback (emphasis added)-

Glaser: The pullback was caused by a lot of things--everything from concern about China to the Federal Reserve. Do any of these concerns lead you to think there could be dividend cuts on the horizon or weakness in the real economy, or are these just things that are impacting the market but not the businesses themselves?

Peters: Nothing new has emerged on that front. I still think that, in looking at the energy sector, you have to be concerned. You want to make sure that you're on very high ground and that you've got companies with very strong balance sheets so that they can afford to have their earnings and cash flow drop significantly for a period of time without having to force a dividend cut.

Outside of that area, we're still at a pretty high level of profitability across the board. Where payout ratios are generally higher tend to be in the more stable industries--like your REITs, like your utilities, like your staples. So, overall, the backing for dividends in most of the market still looks pretty good. The question that arises is, "Does this presage some recession that, even if it starts in China or in some other emerging market, rolls around the world and eventually drags the U.S. down with it?"

This is why I try to stay hunkered down all the time and why the bulk of my portfolio--typically 75%--is going to be in very defensive names like the ones we've already been talking about. I reserve some of my portfolio for more cyclical names. I own Chevron (CVX)--that falls in the cyclical category. Wells Fargo (WFC)--a bank, to me, is cyclical. Industrials are cyclical. But even in those cases, I feel like I'm getting the sufficient protection, as well as long-run total-return prospects, that make owning those stocks worthwhile. The rest of it, I really want to be able to trust those cash flows and trust the dividends and even continue to grow the dividends even in the downturn. That's a standpoint that has served the strategy very well over more than a decade now. 

Indeed, why not stay hunkered down all the time?

I wrote about some research via John Authers and SocGen that showed that patient quality investing beats the market and that patient value was better still. However, most people do not work in finance, they have jobs and lives. And so this is a case where second best (quality) is beats first (value) when you have a job. Monday was a prime example.

I know a few folks got great bargains on Monday am, kudos to them. I would have been very excited to buy Visa in the lows 60s, for example. Here is the thing - I was too busy to act on it, because I am not a full time pro I missed the brief window.

Here is another point, I know a handful of folks who got great bargains on Monday, but I know multiples more who spent the weekend worrying about their portfolio. You know what? You only get a few dozen Augusts. Do you really want to burn any time on an August weekend fretting? No. How much time would you spend worrying about whether people are going to still eat Cheerio's between Sunday and Monday? I will round it down to the nearest digit - zero.

So value is great when it works, but quality is a fantastic plan B, you may be a step behind the great value investors, but you will still have a fair chance to beat the market and enjoy your summer weekends, too.

To Sleep Well at Night Buy Businesses Not Sardines

The wild gyrations in markets brought to mind a mindless species - sardines. Specifically, the story that Seth Klarman shared:

“There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The teller said, “You don’t understand. These are not eating sardines, they are trading sardines.” Like sardine traders, many financial-market participants are attracted to speculation, never bothering to taste the sardines they are trading.”

People freaking out about prices is not new. But these people have the wrong end of the stick. The whole point of investing is that you are a business owner. Being an owner means having the fortitude to hold through cycles to achieve long run excess returns. 

The headlines are predictably apoplectic, but context is severely lacking. Let's say you own McCormick Spice, the world's number one spice maker with sales all across the globe. They pay a low 2% yield but they grow it each year and raised it by around 2.5x in the last decade. Its reasonable to assume there are decades of growth ahead of McCormick. After all, people love spices and the origin of the stock market all the way back to the Dutch East India company. That shows you the longevity of people's taste for spice.

Just like pretty much everything else, McCormick shares traded down over the last few trading sessions. McCormick now sells for $77/share. About a week ago the shares were around $84/share. Examples like that are what makes people panic. But should they? 

$84 was an all time high for McCormick. So at today's price we are talking a 10% discount to an all time high. How many business owners would readily give up their company which has excellent, long run sustainable demand just because it was valued 10% lower than a week before? 

Zooming out is usually a good idea in situations like this, here is a long run chart for McCormick

Gee that does not look too bad.

If you invested $1,000 in McCormick Spice in 1995, you would have $12,183 today. Its compounded at 13.2%. No genius insight required, just the idea that people like spice. Sure the market can get spicy at times too, but that is not a reason to run for the exits if you like the companies you own.

Sonho Grande (Dream Big)

Two years back, Buffett recommended the book "Dream Big", the story of 3G Capital, which I finally got around to reading. When Buffett recommended it he was referring to 3G's involvement in the Heinz deal and how much he liked doing business over the years with Jorge Paulo Lemann. Since then, 3G spearheaded deals with Tim Horton's and the Kraft Heinz merger. I figured it was finally time to read the book.

Its not an investing book, more of a business history and all the of the history leading up to 3G is covered in detail. Since they started in Brazil there was a lot I did not know about the founders, and I suspect it will be new to most US investors. 3G has a much bigger name now controlling so many well known North American and global brands, its a fair question to ask, how did a few people from Brazil with no particular advantage pull of this feat?

Its easy to see why Buffett appreciates doing business with 3G. They are at the same time quite successful and very focused on discipline and results. They are also modest. My favorite quote in the book is at the end. When the author approached Lemann with the idea to write a book, he did not think they were worthy. Lemann said "All we did was copy a little from Goldman Sachs and a bit from Walmart. Nothing more than that." That's a pretty big understatement from a firm that controls beer across Latin America, Anheuser-Busch, Kraft Heinz, Tim Horton's, Burger King, and a lot more besides.

One key to success is a major focus on costs and zero based budgeting, managers have to fight every year to justify budget items. The mantra is that costs are like fingernails, they have to be trimmed regularly. This mantra is playing itself out at Kraft Heinz right now, the cuts go way beyond jobs - no free cheese sticks for employees, employees can't bring competitors food for lunch, printing on both sides of the paper, and so on. The goal for Kraft Heinz is to take out $1.7B in costs by 2017.  The book does a good job showing that this is not new to 3G, this playbook is their DNA and it has evolved for decades.

They have a strong culture where they look to find and empower PSDs - Poor, Smart, and Deep Desire to get rich. 3G's process has identified many of these folks over the years, such as Carlos Brito, and once they are able to find them, the recipe basically is to give them the playbook,  keep costs way down, latitude to operate, and big incentives to deliver. Brito came from nothing, worked his way up to CEO of Anheuser-Busch and ended up with 0.18% of the company's shares after delivering on the aggressive performance metrics set for him.

The culture is high on meritocracy and low on formality. Beto Sicupira comes to the office in scruffy jeans and a backpack. "the simplest guy in the whole world." Like Berkshire and Walmart, results matter, puffery doesn't. People matter, Oscar Telles still is involved in the new employee orientation, to ensure the culture stays consistent.

Selecting the right kinds of businesses to invest in matters with this approach. 3G buys low cyclicality, low capital businesses like consumer staples firms. These companies are ideal for the 3G approach, if you tried the same playbook at another firm, it might not work nearly as well.

One criticism is that 3G does not do a lot of traditional innovation with product launches and such. I am not sure if that is that big a deal. Look at P&G, GE and other firms that spent the last decade acquiring, now they are shrinking brands as fast as they can. 3G has run this focused playbook for a long time. In reading the book I was left with the distinct impression that it would be no fun at all to compete against these guys. When your competition can sustain a cost advantage it probably means they also have an advantage in focus and in customer service. That's what Sam Walton and Hunter Harrison figured out.

Like Berkshire, 3G does not do grand strategic plans.  When 3G originally started in the beer business they looked around Latin America. The richest guy in Venezuela was a brewer. Same with Colombia, same with Argentina. They thought - they can't all be geniuses, it must be the business model that is good.  That is where the genius of 3G lies, finding simple, scalable businesses and focus on them. Then get the right people, give them room to operate, excellent incentives and give them room to run. Its a  recipe that has delivered and should continue for years to come.

Use an Investing Strategy that Any Idiot Can Use

Great recommendation from Harold Pollack that your investing goals should fit on a standard 4x6 index card. Simplicity has a quality all its own.

One of my investing mantras is based on an old Peter Lynch quote, invest in businesses that any idiot can run, because one day one will.  This nugget of investing wisdom has kept me out of a lot of trouble. Not that there are not great managers out there, obviously there are. For example the highly enjoyable book "The Outsiders" describes the huge gains investors enjoyed from the managerial feats and capital allocation wizardry of the likes of Buffett, John Malone, Dick Smith, and others. What investor wouldn't want to have those kinds of managers working for them?

Well one problem is that very often you only know who the great managers are after they have been wildly successful. That means two things, first many of the gains are in the rear view, and second that the manager however good they may be, now operates with a larger base which equals less opportunities.

Another problem with seeking great managers and many of the ones described in The Outsiders, is the techniques that they use are indistinguishable a priori from incompetents and crooks. For example, John Malone built one of the great track records in history, however he did it based on massive debt loads and continuous M&A. If you built a portfolio that focused on finding companies that have huge debts and lots of acquisitions, you may find a Malone, but you probably end up with HP and worse. That's my basic problem with looking to invest in great managers, the chain saw, in the hands of a skilled professional, is a great tool for clearing forest. In the hands of a newbie you lose (your own) limbs.

So my twist on the Lynch rule is that individuals should use an investing strategy that any idiot can use, because one day one will.

My index card starts with four elements taken from Charlie Munger, who is clearly not an idiot (6 min mark):

1. Buy things you understand

2. Moat - Ensure there is a durable competitive advantage

3. Management integrity and ability 

4. Price matters, don’t overpay

Because I am not as smart as Munger, I use a few more checks to further idiot proof my process

5. Safety - Balance Sheet, earnings cyclicality

6. Quality Income - Free Cash Flow, dividend yield

7. Dividend Growth - ability to grow dividend over time

I think that leaves me enough room on the index card for a small drawing. Don Yacktman's recent talk at Google described a useful, simple concept to use forward rates of return so that you analyze a stock similar to a bond. The process identifies investing candidates with low capital requirements and low cyclicality as the best starting place.

The other quadrants like Low Capital plus high Cyclical or Low Cyclical plus High Capital can house interesting opportunities, but must account for these risks. I think this sums it up well. Don Yacktman is clearly not an idiot either, he has one of the best track records of performance of any big mutual fund manager over multiple decades, and stacks up well next most any other manager. But the key distinction is that however skilled Yacktman is following his basic process does not require any particular genius insight to buy PG, Coke, and Pepsi and hold them for 20 years.

Now I just need an index card! What is on your index card?