“It is really the reinvestment of cash flow that in fact is free when it relates to the existing business, but which, if properly deployed, can expand the enterprise enormously. That is the skill you want to have attached to a cash-flow engine,” he said in a presentation at Talks@Google.
Thomas Russo is an eminent value investor, who joined Gardner Russo & Gardner as a partner in 1989. Since 2014, he has served as Managing Member of the company and as general partner to Semper Vic partners, a global value, long-only, equity investment partnership. He manages over $12 billion through Semper Vic partnerships and separate accounts.
An 1984 MBA/JD from Stanford Business and Law Schools, Russo invests in a few select industries like industry food, tobacco, media and beverages in which companies have historically proven their ability to generate high and sustainable returns on capital.
He likes to invest capital primarily in equity. “I consider myself to be a farmer — not a hunter. And I think most people on Wall Street are hunters. They like to fell big beasts. But I’m very comfortable planting a few rows and just tending to them carefully,” he says.
Russo said it is essential to invest in strong global brands that offer huge growth potential in emerging markets. “Investors should keep their investment emphasis on value and price and look for companies with strong cash flow traits, strong balance sheets and a history of generating high rates of return on their assets,” he says.
Why Russo prefers family-run businesses?
The renowned investor prefers to invest in family-run businesses, because through them one can address a primary risk that public market investors face, which is the agency cost.
Agency costs occur when a company’s management or agents place their own personal financial interests above those of the shareholder or principal in a publicly-held company.
Also, most family-controlled enterprises seek long-term returns as they deploy profits from current operations and invest at the expense of those profits to build future wealth, thereby minimising taxes and maximising long-term wealth.
“The benefit of investing in family-controlled enterprises is that the family can exert dominion over managements in a way that faceless public shareholders cannot. They have control and can influence the strategic direction. They have control, which allows them to guarantee managers that if they embark on the right investment programmes, they will not run the risk of being displaced from their jobs if midway through the investments, the cost of proper long-term-minded investments burdens short-term results,” says he.
The draw of investing world
Russo says while studying at Stanford Business School, he once attended Warren Buffett’s guest lecture and was very impressed by Buffett’s wisdom and his approach to investing. Henceforth, he decided to follow in the footsteps of the investing legend and pursue a career in value investing.
Real glue of investing
Categorising himself as a value investor, Russo says investors should look to buy businesses with some margin of safety that comes when these businesses are available at a sufficient discount from their actual value. This discount Russo feels can be determined through analysis of strength of a business, through its components, its segments and then value of an enterprise and then finding out the liabilities and adding it financial assets and then coming up with a per share value and comparing that to what an investor is paying.
Russo feels the above approach is very mechanical and the real glue of investing is understanding a company’s culture. “A company’s culture is one aspect that separates great businesses from the mediocre or poor ones. Businesses with healthy cultures are successful and provide attractive investment opportunities while those with cultures that are unhealthy tend to perform poorly, leading to share price under-performance and permanent loss of capital,” he says.
Russo says although a company’s future success is a function of the culture it follows, it often gets overlooked in the investment process as it is difficult to measure it given its qualitative rather than quantitative nature.
Factors to analyse a business
Russo believes the first factor to look at while analyzing a company should be the people who run it. He feels if a company has a strong, high caliber leader with a good management team then it is a very early positive indicator that it may be a good investment option. “On the ownership side if there is a strong leader who is like minded in his long-term outlook I would find that to be a very early positive indicator that justifies setting out to do more work. If I found on that first test that there was something about the management that left me feeling it was opportunistic or short term driven I probably won’t embark on the analysis that follows. Threshold screening would be caliber of owners and then the management that follows,” says he.
How to test the real quality of business
Russo says the real test of the quality of a company is its ability to recruit the industry’s best and the brightest and holding on to them and having them perform world class business operations. He says if a company doesn’t have the right nurturing environment or treat their consumers with less attention, then they just won’t be able to keep the talented resources. This indicates problems at the top and within the ownership of a company, says he.
“It’s really clear if you have a business where a family is abusing the franchise for whatever reason, whether they’re under-investing, whether they’re siphoning off money, whether they have side deals with themselves to pay themselves premium for services offered or products delivered. They have ways in which they extract value from the public. Quality individuals tend not to find a way to those businesses. And so as you meet various professionals up and down a business, if you feel they are of B-grade quality, it often reflects problems at the top and problems within the ownership,” he says.
How to avoid investment mistakes
Russo says it is important to detect and avoid investment mistakes before it starts to take a toll on an investor’s wealth. “This can be achieved by trying to get vital information from meetings with companies and management calls and then looking across at other businesses that relate to it,” he says.
Investors should make sure that they stay with the company and ask questions on the margins and listen to the answers and look at body language and try to stay ahead of adverse developments through that information.
“It’s the information we get from ongoing contacts with companies that lead us to realise that the businesses that are in existence are different from those that we thought they are. We have been mostly lucky to have had enough contacts with companies to come up with important observations in time to exit before the commotion begins,” says he.
Companies that have ‘capacity to suffer’
Investors should look for companies that have the ‘capacity to suffer’ as such companies can become compounding machines with the ability to reinvest at a high rate of return. They have a strong global brand presence because they have a culture focused on long-term growth.
Russo says the ‘capacity to suffer’ is required of management of these companies as they need full freedom to make the right amount of investment without the fear of disappointing analysts on quarterly numbers or without the fear of triggering activists.
He believes in order to extend a business into new geographies or adjacent brands or into other areas, the management requires high fixed costs and capital to fund it, and that can negatively impact stock price in the short term as these businesses do not get early returns.
“To become compounding machines, it takes time and patience, which not all managements and shareholders have who focus on the short-term results and which can hurt their chances of long-term success just to keep the shareholder base happy,” he says.
According to Russo, companies with the ‘capacity to suffer’ forgo the opportunity to take a short-term profit and are instead ready to suffer in the short term in favour of investing for the long term.
How ‘capacity to suffer’ applies to individuals
Russo says the ‘capacity to suffer’ is also applicable to individual investors, ad it pertains to the ability to say no when everyone around is saying yes. According to him, in order to become successful, investors need to have the capacity to suffer short-term pain when owning stocks.
He says one should focus on maintaining value investing discipline by developing tremendous patience and perseverance, which can help them in becoming successful in the long run. “To invest in companies with a ‘capacity to suffer’, you must be able to suffer along with it. In other words, you need a high tolerance for short-term pain. In a rising market, it takes a tremendous amount of patience and capacity to suffer in order to maintain the value investing discipline. Watching others make easy money is nothing less than suffering. It’s real – the suffering caused by the feeling that one is missing out. But it doesn’t last forever,” he says.
(Disclaimer: This article is based on Thomas Russo’s presentation at Talks @ Google)