We had the distinct pleasure of catching up with superinvestor and global value investing thought leader Tom Russo ahead of the 2013 annual shareholders meeting of Berkshire Hathaway.
Tom Russo is the managing member of Gardner Russo & Gardner, where he manages more than $10 billion in a long-only, global value strategy.
In the wide ranging conversation, Tom helped us better understand the long-term issues for Berkshire Hathaway investors, assessed the businesses of several major consumer non-cyclical and other large companies, and shared additional insights of interest to global value investors. We are delighted to bring you the full conversation in audio form and as a transcript below.
The following transcript has been edited for space and clarity.
Thomas A. Russo: It’s a pleasure to be here especially on account of Berkshire. It’s a fun time to reflect back on all of the earlier years of Berkshire Hathaway meetings and anticipate the upcoming meeting. This might be my 27th or 28th visit to Omaha for the Berkshire Hathaway annual meeting. It’s a process of reaffirmation of the core values. I personally think there are values that have become more refined and more focused over the years. What I take away through my own investor evolution during that time is an ever increasing awareness of the value of companies that have the ability to reinvest internally. That’s not something shared broadly if you think of the difference between a domestic food company in North America and Nestle [Swiss: NESN].
Nestle is enriched by a legacy of having been in 120 markets for over 100 years. Their brands are already well-established and they have a global culture that puts the capital to work efficiently in exploiting the opportunities those markets offer today because of growth in income and disposable income.
Nestle is enriched by a legacy of having been in 120 markets for over 100 years. Their brands are already well-established and they have a global culture that puts the capital to work efficiently in exploiting the opportunities those markets offer today because of growth in income and disposable income. That’s something that’s quite valuable. It’s not captured in the share price. As an aside, over the last twelve months, Berkshire would have taken advantage of a company that has a somewhat similar portfolio of assets in the purchase that Berkshire made of its large interest in the going-private Heinz [HNZ] transaction. It’s a terrific transaction for Berkshire and it recognizes that businesses that have the capacity to reinvest, in the case of Heinz, it’ll be in India, in China and some other emerging markets where they’ll heavy up their investment, I suspect. Those are very valuable.
So you start with a belief that not every business has the kind of strength competitively that allows them to move forward and to compound. Then you have the question about, does management have the right incentives and the right protection that’s required to invest the proper amount? In the case of Berkshire Hathaway, that’s just an absolute yes. We can think back over time together of investments that Berkshire’s been able to uniquely profit from because they’re able to do things at times when nobody else would act. And so the playing field of competitors for the types of deals that have made us an enormous amount of money at Berkshire is very, very narrow because most companies don’t have the capacity to absorb the adverse consequences to reported profits that accompany the right amount of investment.
If you’re Nestle and you want to take advantage of that wonderful heritage you have in markets, you’ll have to be willing to spend $3.5 billion a year on developing manufacturing, marketing, distribution, advertising, promotion, point of sale, all of the things that are required to pull more consumers towards your product are very expensive. In the process of those upfront structural cost investments, whether they’re investments in working capital, in plant and equipment or whether investments of the income statement and advertising, promotion, you’re going to end up burdening your current reported profits.
If there’s one lesson I’ve seen Warren take advantage of so well over the years, it’s the profits that come and the wealth that’s driven long term by companies able to take the short term burden on reported profits. Wall Street doesn’t allow that option for most public companies. Management in most public companies feel too trapped or too wed to smooth the stated, reported profits that they don’t dare migrate from that treadmill, and those companies who can have an enormous competitive advantage. Berkshire’s one of them.
It’s probably the key lesson that I’ve learned over the 27 years of going to Berkshire is the importance of being willing to abandon the course that most companies are sucked into and the competitive benefits that accrue from that.
The Manual of Ideas: Tom, you’ve been studying Berkshire Hathaway for decades. It remains your largest position across your $6 billion portfolios. What perhaps has surprised you reading this year’s annual report?
We are in the middle of a housing recovery after all, and there’s an enormous exposure in Berkshire, whether it’s Johns Manville, whether it’s MiTek, whether it’s Shaw, whether it’s Benjamin Moore, Acme Brick and Clayton Homes.
Russo: There are some things I’m quite looking forward to hearing more about. The increasing role of both Ted Weschler and Todd Combs is very important. I think it’s systemic. It’s more than just a fact that each of them is receiving allocations of increased capital to oversee directly. It’s the assistance that they’re increasingly providing Warren and the firm across all sorts of non-portfolio areas. That’s where we have a peek at what the future, the very longest term at Berkshire, will look like because they will, if things continue to develop, most likely share terribly important positions for the very longest term with Berkshire. We have the ability to learn more about the evolution of the organization.
It’s a moment to cheerlead some companies. We are in the middle of a housing recovery after all, and there’s an enormous exposure in Berkshire, whether it’s Johns Manville, whether it’s MiTek, whether it’s Shaw, whether it’s Benjamin Moore, Acme Brick and Clayton Homes. We have this extraordinary portfolio of companies that have been really tightened down and made leaner over this wrenching downturn of the past five years, and they’re poised to show some very interesting performance. It will be off of a much more cost effective base, and so we’ll hear about the promise within the portfolio of existing wholly-owned companies.
I’m looking forward to hearing about the firm’s view on their involvement with 3G through the acquisition of Heinz. There’s an awful lot of interesting story behind that investment, it’s a large investment.
This year, a friend of mine has been added to the question providers, Jonathan Brandt, alongside of a short seller. We’ll have Jonathan’s hand at helping to surface some of the nuances of Berkshire. He’s the most deeply-studied of all in the subject and they will have a short seller’s point of view, so that’ll be engaging.
Over the last several years, some aspects of Berkshire have been tested. Certainly, the situation with David Sokol has probably put Berkshire on a much more tightened and even keel as it concerns how in the future the firm will police its governance and its organization broadly. Very important. It came as a result of something that was in the grand scheme of things, reasonably manageable, obviously personally harmful and disturbing. But it ends up with a firm that now, probably better than before, understands what conduct is allowed and not.
Those are some of the general thoughts. I learned an enormous amount by walking among the booths before the meeting and talking to the management. One of the most interesting aspects of that over the years has been to talk to the management of companies that are newly-acquired and really the question they provide most insight from is, how’s life different? And without question, the comment I get back, whether it was with Matt Rose from Burlington Northern or whether it was the head of Benjamin Moore, the head of Shaw carpets, is that within Berkshire they’re allowed to do what they’re supposed to do.
Robert Shaw gave an interesting story about that years ago, after they were acquired. He found himself committed to Wall Street by virtue of their own expectations that they could rollout a series of Shaw stores so that carpet stores at Shaw would compete in effect with Home Depot [HD] and Wal-Mart [WMT] and the people who have historically been their customers. It was a thought of how to capture the downstream margins and actually improve the performance and competitive advantage of Shaw generally.
But they found midway through the experiment that doing so was beginning to really, really alienate their main customers and they lost one of the two, Home Depot or Lowe’s [LOW] as a customer, as a result to that. They found that they were damaging their pre-existing route to market considerably. They knew it. However they promised Wall Street that they’d rollout a hundred stores and they were only twenty stores into the rollout, and they were frightened about taking on the investor disappointment, so to speak, if they did what was right long term for the business and stop the experiment before they got to a hundred stores. They knew at that point, every additional store probably was costing them future value rather than delivering more future value.
In diapers [in China], I heard from Procter & Gamble [PG] two years ago, maybe three years ago, that at the time, of the number of households that were eligible for using diapers the country had 2% penetration. Out of the entire universe of child-bearing families only 2% of them used diapers at the time. And of those families, on average, they only used one diaper a day.
Robert Shaw, head of the company, said, the fabulous outcome of joining Berkshire was the next day they’re a part of Berkshire Hathaway they did the right thing. They closed down that operation and they redoubled their efforts to try to win back disaffected customers.
That’s a story you hear again and again and again that once joining Berkshire Hathaway, businesses are free to start to do the right thing. It’s an enormous competitive advantage. I read that the same thing happened with Burlington was the amount of capital available for making strategic investments without regard to the income statement went up considerably. With Lubrizol, the year after they were acquired, they made three or four strategic investments that they had lined up but were reluctant to pursue as a public company because they feared that Wall Street reaction might be a negative and so they had delayed those transactions though they still esteemed them. Upon acquisition, immediately thereafter, they made the acquisitions.
This culture of doing what’s right, no more and certainly no less, is rare and it’s one to celebrate. It’s one of the expressions of which are lessons learned each year in different manners and so it’s what invites you back if you’re a student of Berkshire every year.
MOI: Just to come back to the latest big investment, the Heinz deal, you mentioned there’s an interesting story behind it. Do you care to share more about that?
Russo: It’s a story of the developing emerging markets. Heinz has been, obviously for Americans, from the United States perspective, one of our celebrated businesses. But around the world it has a different expression. In England, it’s considered a British company and the products there are tomato soup and baked beans. That’s something that we don’t quite even appreciate. Ketchup was a very slow product to take overseas.
Anyways, the global exposure is pretty strong. In the developing emerging markets they have products that are quite interesting. In India, they have a standard infant formula business that’s maybe the third or fourth largest in India. It’s important and it’s growing and they can commit more capital to it and probably accelerate the growth.
If you think about the kind of opportunities you see in China, I can speak to diapers probably more than to the infant formula, which was what Heinz will offer them. In diapers for example, I heard from Procter & Gamble [PG] two years ago, maybe three years ago that at the time, of the number of households that were eligible for using diapers the country had 2% penetration. Out of the entire universe of child-bearing families only 2% of them used diapers at the time. And of those families, on average, they only used one diaper a day.
Heinz has been, obviously for Americans, from the United States perspective, one of our celebrated businesses. But around the world it has a different expression. In England, it’s considered a British company and the products there are tomato soup and baked beans.
So here you have a question of penetration and frequency. Penetration is very small. Frequency almost deplorable because you can’t imagine as a parent of a young child which day part you’d use that diaper because only one a day is not nearly enough in America. They probably use twelve a day or something. But there you have the story, penetration 2%, frequency one a day. If you went two a day at 4%, you’ve already quadrupled the business. And that’s at 4%, you go three a day at 8%, you can just imagine the kind of investment opportunities and the return on investment. The amount of white space, pardon the pun in the diaper business, but the amount of white space in that investment is extraordinary.
The same could be true about baby formula with the caveat being that the companies have to be above reproach in terms of how they source the product because China has a history of poor conduct with its local competitors in infant formula. The western competitors, whether it’s Nestle, which we have a big investment in, or whether it’s Mead Johnson [MJN], or whether it’s Heinz, have to certify that the market is safe for the parents to use. And as they do so, and move through modern trade, it’s a very important business. In India, they have a product that’s almost unfairly attractive. It’s a highly nutritious, high protein drink that Indian mothers are assured will help their young boys become taller and smarter. It’s hard to imagine you’re allowed to sell something with such suitable claims to a mother’s anxieties about what they would all wish for their child. The fact of the matter is that it’s a protein nutritious drink whether it’ll make the children taller or meaningfully smarter based on just the consumption is really quite unimportant. The fact is it promises a lot and it actually has a nutritional base that does improve the development of children and it’s a very powerful product.
They can invest behind the promotion, the route to market, the marketing of these businesses in markets where the current penetration or frequency are very, very low. That’s what they probably saw in the business. They also would have seen in Heinz a business that had the capacity to reorient their focus in the mature markets to deliver probably against the market’s needs and maybe to do so by spending a lot less.
Wall Street in general tends to focus on variables that don’t always apply broadly. For example the R&D budget at Heinz, Wall Street may demand of Heinz that they spend 4% on R&D. In truth, it’s quite arguable that there’s not all that much innovation that can go into ketchup. We’ve figured out that the bottles turned upside down are better than straight up because they squirt easier, they’re plastic and all the rest. But at some point, you’re done.
The potential for overspending to meet that Wall Street demand is always there. The same ratio drive by analysts for public companies shows up elsewhere. For example, I read recently a report congratulating a company because they had a very high conversion ratio which in Wall Street terminology means the ability for the company’s net income to end up as free cash flow and they celebrated a high conversion ratio.
I actually personally would celebrate a very low conversion ratio because I admire companies that generate enormously high amounts of profits but who have even better amounts of capital demands for reinvestment of that money into future businesses. The fact that a business throws off cash flow that’s indeed free of the ability to reinvest is less interesting to me.
When you think about the components of a reinvestment scheme, which was what I’m looking for, you have a business that has a core profitable center and the ability to invest against their opportunities in markets that are developing, an investment that indeed will lower reported profits so on the conversion ratio you have to deal with impacted lower profits. But then, ideally, they would be spending multiples of their net income to position the business to make money on behalf of investors and to develop wealth for decades later to come.
Wall Street rewards a high conversion ratio. Wall Street rewards a low working capital as a percent of sales. In the case of those companies like Nestle, you’re supposed to invest in working capital because the route to market requires that the retailers have funding so they’re not out of stock. It’s a very difficult process to stock a traditional channel. And the last thing a company like Nestle would want to do is starve that channel of capital. It’ll show up on higher receivables, ultimately.
When you think about the components of a reinvestment scheme, which was what I’m looking for, you have a business that has a core profitable center and the ability to invest against their opportunities in markets that are developing, an investment that indeed will lower reported profits…
The other thing that they cannot afford to do is run roughshod over their suppliers in a country that’s developing. So, instead they invest an enormous amount of money in the process of local sourcing – very expensive, very costly, builds a much higher accounts payable business. And so the two sides of the working capital story, investing heavier in supply, investing in the channel in both cases lead a company like Nestle growing sharply in developing emerging markets to a higher percent of working capital.
All of these are by-references to what is it that Wall Street requires of businesses is often exactly the opposite from what is best for the long term wealth of owners. When managers respond to Wall Street’s playbook rather than shareholders’ playbook is where businesses fall short of the extraordinary example that Berkshire has provided us because on all those same measures, Berkshire will take the choice that will inevitably compromise the near term and reward us for the longest term.
MOI: What do you make of the deal structure itself? Again, a very well-negotiated deal, you’ve got warrants, you’ve got preferred, what do you make of that?
Russo: My goal is to commit capital at high rates of return for owners. This transaction, much like many of the transactions that took place in 2007, 2008, 2009 is a blend, and even as recent as 2011 with Bank of America [BAC]. It’s a blend. It’s an extraordinarily executed risk management balance between equity and certain return of capital with a high current return. That’s the blend between equity or warrants and a preferred or a fixed income from the recipient.
In all of those cases, if you think back about what was done, Berkshire shareholders would have ended up because the world avoided financial armageddon, we would have done better in almost every one of those transactions were it not for the fixed income portion, but rather if these were equity investments. The fixed income portion has the burden of giving back the capital at a later moment when the world is less uncertain. And so the high returns that you get for example with the General Electric [GE] or Goldman Sachs [GS] transaction at the time when the markets were most fearful, that capital comes back at the time when interest rates and the thirty-year bond today are less than 3%.
The requirement to redeploy that money attaches to the deals at the start when those deals are balanced to protect the downside as much as they were. You’re forced to reinvest at a later date and it’s at less interesting terms because there’s less chaos and less fear, and less loathing in the market place.
In the case of Heinz, from my perspective, if the company had been more leveraged with outside lenders, the return to equity holders, as Berkshire [is] a 50% equity holder, would over time be much better. Berkshire has the benefit of a preferred return for a while, but that cash comes back to Berkshire. I’m not sure with the preferred that we’ve taken out enough public market thirty-year financial obligations at today’s historically low rate.
As a Monday morning quarterback, I would have probably preferred a large stake of equity like we received and then the company itself going to the marketplace and borrowing at 3.5% thirty-year paper in lieu of that preferred. But that’s something that probably wasn’t available and the deal that was struck is going to be extremely interesting, I think.
MOI: It seems that with the last few years, certainly during the financial crisis and now again with the Heinz deal, really what comes to fore is Warren Buffett’s extraordinary ability to negotiate these deals. Whereas perhaps in history just passively investing in Coca-Cola [KO], publicly listed, that was much more prominent within Berkshire, whereas now you have these private businesses and the importance of these negotiated deals. Does that worry you at all in the context of any succession issues at Berkshire and who can negotiate such deals in the future?
In the case of Heinz, from my perspective, if the company had been more leveraged with outside lenders, the return to equity holders, as Berkshire [is] a 50% equity holder, would over time be much better.
Russo: Quite honestly, the story about Todd and Ted is that story. It’s my understanding that Ted may have been very involved with the ResCap transaction, he may have been very involved with the Media General [MEG] funding in a very clever creative way, I understand – just the sort of thing that you’d want and expect from Warren. But if, in fact, there’s another set of hands capable of executing at the same level of “wow” element, then that’s extraordinary valuable to know about. That’s what we learn as we see more of the two investors who have come in and who are increasingly responsible for financing transactions, possibly even creating and conceiving of them.
Warren Buffett has said that he came up with the Bank of America transaction alone in the bathtub. But I understand that Bank of America had been a long standing and meaningful investment for Todd Combs. And so I wondered whether Todd was somewhere near the bathtub at the same time only to the extent of being able because of an enormous amount of knowledge specific to that company, of being able to provide some assurance.
Because at the end of the day, we did as a firm extend $6 billion plus or minus in an investment and in fact returned for that receipt the most spectacular warrants I’ve ever seen which were 700 million plus warrants that struck at roughly the share price and had a ten-year life.
At Berkshire, if the world becomes safe for banking again over the course of the next decade, those warrants could make us $20 billion or $30 billion dollars. It’s a phenomenal, phenomenal return on a $6 billion preferred. It’s an extraordinary return. There are already four points in the money, it’s a $3 billion plus unrealized gain. I do think that the ability to see through all the potential pockets for trouble within, as broad a firm as Bank of America probably requires the assistance or the judgment of someone else who is deeply-schooled in the subject. And there you see the possibility of one of those two investors adding great value.
MOI: Warren Buffett states in the letter that he asks the managers of his subsidiaries to unendingly focus on moat-widening opportunities and they find many that make economic sense. Can you walk us through some of these moat-widening opportunities that you see within the Berkshire portfolio? Where are you most excited about these opportunities?
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