Fundamental analysts spend an inordinate amount of time with Microsoft Excel software trying to gauge the magnitude and direction of the future cash flow evolution of a company with detailed projections around revenue, margin and earnings trajectory. Yet over time, the lesson one learns is that, more often than not, it is what is not in the excel spreadsheet that counts.
Our belief has always been that companies exist in an ecosystem, and understanding and analysing the ecosystem gives us the best chance of making accurate judgements around its future earnings trajectory. However, with the fast pace of technological disruption changing the landscape and ecosystem in every industry, the work of a long-term investor has become more difficult. The moat for most companies seems a lot leakier than it once did! In fact, one must step back and ask whether it is even possible to imagine what an industry or company will look like 10 years from now, let alone try and predict their cash flow and earnings for that time period?
We would posit that analysts buried in excel spreadsheets would have scarcely had the imagination to predict how Netflix, Amazon, Apple, Facebook & Google would change the world as we see it or equally would have been hard pressed to forecast that in one of the best bull markets in history (2009-2018), GE, the largest industrial company in the world, original uninterrupted member of the Dow Jones (for over 120 years) would be a shadow of its former self in just under 10 yrs.
So how does an active investor capitalise on these changing times?
- Extend time horizons: Paradoxically while disruption and uncertainty have increased, the importance of investing with a medium to long term horizon has never been greater. Albert Einstein called compounding the eighth wonder of the world (‘he who understands it earns it…. he who doesn’t pays it’). Long-term investing gives our money more time to stay invested. This gives greater opportunity for compounding and growth, and reduces dependence on the vagaries of the stock market. Further, from an active investor’s perspective, one must also recognize that the game and its rules have changed; the battle for short term investing is already lost to algorithms and high frequency traders. However, these depend on the quality of data inputs and once you extend time horizons less frequent data means less ability to make probabilistic judgments and decisions. Hence patience and compounding are your friends over time, and it is only over time that artificial intelligence yields to natural intelligence.
- Play to our human strengths: Creativity and empathy make us human and differentiate us from machines which are generally products of strict rules and instructions. To differentiate ourselves we need to focus more on what makes us unique. Consequently, in our process, we find the importance of personal interactions be they company meetings, site visits and regular interactions with management teams has only grown in importance. (I have yet to see an AI join us at the table with senior corporate management or at a mine visit - when that happens I will keep you posted!).
- Importance of Management: Indeed when moats are falling away at a fast pace, the importance of great managements only increases. Investing is all about searching for those leaders and once you find them, sticking with them as they evolve their strategy to fight against growth and economic headwinds with constant innovation. If your choice is right, again compounding will be your friend.
The constituents of what makes a great management team are constantly changing and evolving and are probably too exhaustive to list. Even though our horizons are long, we need to constantly observe and evaluate these changes.
Below are some thoughts around what we have learnt while searching for management teams worthy of our patient capital!
- Culture eats strategy: The Peter Drucker quote ‘culture eats strategy’ captured it all and has proved timeless. Great management teams understand that ‘constant change’ (a necessity in the age of disruption) is not possible without having the right culture in place. However, some leaders have modified this quote to ‘culture breeds strategy’ To give an example, Satya Nadella’s vision for Microsoft was well articulated in his first few ‘emails to employees’ (and well elaborated in his book ‘Hit Refresh’, which we highly recommend). He wanted to re-energize the organization and make the organization a tool for employees to achieve their ‘purpose’. In 2015 the organization changed its mission statement from ‘a computer on every desk and home’ to ‘empower every person and every organization on the planet to achieve more’. Through meetings with various senior employees & leaders in Microsoft, it became clear to us that these were not just high-sounding statements but that every level in the organization was energized and using them as a North Star to execute towards. As a result, under Nadella’s tenure as CEO (which mirrors our ownership of the stock) Microsoft has seen its share price grow from $35 to 93$ vs. the previous ten years where it essentially stayed flat.
This mission statement demonstrated that to be successful in the new age, it is essential to have:
a) a sense of shared purpose for the entire organization
b) recognition that companies must strive (through their products and services) to consciously improve
the lives of everyone they impact
c) a culture which will re-energize and constantly breed new ways to win
- Capital allocation & Incentives: The "holy grail" in investing is to find an excellent business, trading at a discount to fair value with a management team that allocates capital well. Capital allocation (reinvest in the business vs buy a competitor v/s return capital to shareholders) is by far the most important decision that managers take. How they make those decisions is in no small part driven by the incentives that drive them. We consequently like to see incentive structures that promote long term thinking (in sync with our investment horizon). We also prefer to see more returns-based incentives with metrics tailored to the company/industry. rather than blunt ‘EPS growth or TSR based metrics’ which many a times incentivize poor M&A activity or are so out of management control so as not to matter. Lastly we are fans of high management ownership and avid followers of how insiders treat their stock. A good anecdote to illustrate this is from February 2016, when investors were worried about a global recession and markets were in turmoil. Jamie Dimon of JPMorgan Chase (another portfolio holding) backed-up his message of calm by buying $26mn dollars of stock with his own money at £53$ a share. As of end of March 2018, with the stock trading at £110, he and all those who followed him, had pretty much doubled their investment in two years.
- Confidence and Paranoia: We have observed that strong management teams exhibit a high degree of duality. Nothing captures this better than being confident about your strategy and execution yet consistently paranoid about everything that could impact that equilibrium and throw you off that high horse of success. Most management teams we meet, display a high degree of confidence. Paranoia is not often on display and therefore we seek more of it. Put simply, if the management team is ‘always paranoid’ as investors we sleep easier. A good example of this was our meetings with Facebook in 2017 (which we covered in our note ‘Why I took a break from Facebook’) which suggested that the company and the market was not ‘paranoid enough’ about privacy issues as well as the risk of government regulation. Recent events have suggested that even for a fantastic management team like Facebook, a degree of paranoia would have helped.
- Positive difference to the world: in our view strong management teams try to not lose sight of their ‘raison d’etre’, - to try and leave their company, customers, employees and the world in a better place than they found them. This trait, however, is one of the most difficult to evaluate (or count) given it has only shades of grey rather than being black and white. I must clarify that this strategy is not an ESG approach and neither does it aim to become one. Yet we find that thinking about the long term necessitates that we evaluate company strategy and execution through the lens of their impact on the world and is an area where we think, as active managers, we can make a positive contribution to the discussion. Given the shades of grey, this remains an evolutionary concept where one must try and constantly keep pace with society and investor demands.
My approach to thinking about how management teams make a positive difference
- The easy Red lines: Tobacco, Defence & Russia - My simple view is that strong returns can be generated even when avoiding investing in companies that make products which have a high likelihood of harming people - Defence and Tobacco hence rarely find a place in my portfolio (in spite of Tobacco stocks having excellent yield characteristics and defence stocks obviously doing well under regimes that fuel turmoil). Enthused by research about smokeless cigarettes causing significantly less harm, we did briefly engage with and invested in certain tobacco companies at the forefront of this innovation. Unfortunately, we discovered that the thesis (of less harm) was based on research funded by the tobacco majors and hence less reliable than we thought - leading to us exit the investment.
- Rule of law within a country AND high corporate governance standards: These within a company are extremely important to us. Emerging markets do offer challenges in judging governance standards and require regular and close monitoring and possibly higher margins of safety on inception of the investment. The exception is Russia, which strikes us as one market where it is difficult to decipher where the apple falls when it comes to both governance and more importantly the rule of law making it very difficult to estimate downside risk. Consequently, as a rule, we have so far avoided investing in this market and continue to wait for some positive change before committing investor capital.
- Clean Fun: Nintendo, Activision Blizzard, E.A., Ubisoft, are all software companies which make popular games like Pokemon, Call of Duty, Battlefield etc. These have been great investments for us in the past due to the digitization of the distribution channel (move from CD/DVD to online downloads) which has led to strong earnings and cash flow growth. With e-sports and the potential for e-gaming their moat also seems strong. More recently, however, our thinking has evolved and we have focussed our investments on Nintendo vs. all other games software makers. This is on the view that, whilst there is little to differentiate these companies on valuations and growth prospects, the one difference is that Nintendo’s games are all clean and family-fun oriented. For the other developers, this holds less true. Our view was framed during a site visit to a gaming show + development facility where, while extremely impressed with the creativity & energy on display, we were also very disturbed by the content of some of these successful games. Most successful games and those under development seemed to be all some version of armed warfare, sniper or shooting games. While these games are extremely addictive (hence their characteristics of strong pricing power) to us these games also desensitize violence, and are not something we would like to see our kids play! We even observed a game under beta development of how to be a crack cocaine dealer. A focus on Nintendo, given our worries, seemed to be the right course of action.
- Climate change & the Ecosystem Conundrum: When we look at our fund through the ESG lens, the names which score the worst are generally our investments in energy or mining companies. Our opinion here is slightly contrarian to current thinking on ESG. Our analysis focuses on analysing companies by seeking to understand their place in the ecosystem and the value chain and then looking for the best management teams in that field. In my view (and this is a personal view) upstream companies get unfairly tarred with a negative ESG mark. We believe in climate change and the negative impact of fossil fuels on our planet. Yet fossil fuels remain at the core of how we power our economies whether they be developed or developing and will continue to be for some time to come. Reducing (or asking companies to reduce) investments in this area could cause oil shocks which in the past have been big contributors to economic recessions that cause untold misery to the weaker sections of the population. It would be unfair to knowingly wish this especially on developing countries who will bear the brunt of any super spike in oil at this stage of their evolution (and in fact would not be in keeping with the UN 2030 sustainable development goals in terms of reduction of poverty). Further, oil and its derivatives are present in every part of the value chain of our daily consumption items, from the plastic packaging around anything you buy from your grocer or online to the laptop/IPAD that you are probably reading this note on.
- The discussion on energy hence needs to be wholistic and not just focus on the upstream part of the chain who we view as part of the solution rather than the core of the problem. Having said that, we absolutely believe that companies need to have a strategy for a world without fossil fuels, and also a strategy of how to make use of the limited resources without causing undue harm to the ecological ecosystem and the communities they work within. Indeed Shell, a portfolio investment has recently published its Energy Transition report of how it plans to navigate away from fossil fuels over the next 50 years.
- For mining companies operating in tough environments the same principles apply: it is difficult to envisage a world today without steel or aluminium or iron ore and the mining companies are extremely important parts of the global industrial value chain. We keep an open mind on investing in these sectors while at the same time maintaining a high degree of engagement with our investee companies on these issues of worker safety and security and environment and ecological management.
- Healthcare and the ethical dilemmas: Probably the most fascinating sector with its ethical dilemmas is the healthcare sector. A prominent sell side research house, recently put out a note suggesting that from an investor perspective the best-case scenario is to be invested in chronic care drugs (i.e. those which, once you are on, you need to take them for the rest of your life) rather than drugs that cure (great for the patient). This is for the simple reason that chronic care drugs guarantee a long-term earnings stream while ‘cure drugs’ are a one-off treatment which the market does not value highly due to lack of ‘future growth’. Gilead’s Hepatitis drug is considered a prime example of this. Gilead stock has paradoxically done poorly, the more patients it has cured, as demand has fallen and is likely to be lower in the future for its products. A classic ESG conundrum for the entire sector, worthy of an engaged debate.
This note turned out to be much longer than I intended, but disruption, management quality, pricing power, moats and the societal impact of the companies that we invest in are all issues we are passionate about. The world we live in is complex and finding those investments which balance returns with doing the right thing is not always easy. Yet we must try, and try harder!
In all humility, we are also conscious that this is an evolving field and would love to engage further to learn your perspective to enhance ours.
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