Costco - Culture and Competitive Advantage

An enduring competitive advantage is a must in any would-be investment.  Generally, there are just a few kinds of "moats" including a low-cost position, high switching costs, high barriers to entry and network effects.  In rare cases, a corporate culture can be included on this list.  Part of the reason investors ought to be wary of investing in a company based on its culture is because it's inherently difficult to measure, particularly for outsiders.  Nearly all companies insist in public that they have a one-of-a-kind culture, and the loyal, motivated staff that goes with it, but usually it's not true.  In addition, while a winning culture only exists if it has spread throughout an entire organization, it takes just one imperious, foolish or unethical CEO to destroy it, so even if it exists today, it may be gone tomorrow.

A recent BusinessWeek article makes a compelling case that Costco belongs to the very short list of companies with a culture so favorable to employees that it gives the company a competitive advantage, and is so ingrained that it's almost certain to endure over many decades.  In general, and unlike many of its competitors, Costco sees workers as an asset to invest in, rather than a cost that must be reduced.  (Costco's unique culture also includes a genuinely customer-friendly approach, and a commitment to keeping costs low that’s double-stitched into the company's DNA, but this particular article focuses on employee relations.)

In the US, Costco pays workers an average of nearly $21 per hour, almost three times the minimum wage and about twice what most notable competitors pay.  In addition, the company's health care package is far more attractive than what rivals typically offer.  In fact, many competitors are cutting workers' hours to below 30 per week, the threshold at which Obamacare would force them to offer coverage.  The company insists that its generosity isn't charity, but is motivated by bottom-line results.  Not only does a generous approach lower turnover and training costs, the company notes, it increases loyalty and productivity.  There's much truth to this claim.  Turnover is a mere 5% for workers who've been with Costco over a year, and a vanishingly small 1% for executives.  These saving indeed hit the bottom line: net income was $1.7 billion in the year ended 2012, up 33% from 2008, despite a stagnant economy.  

However, it's clear that there's a moral element to Costco's approach.    The CFO acknowledges that the company could make more money if wages were lower by a few dollars an hour, but says simply "We're not going to do it."  In short, the company simply believes that it's the right way to behave.  Jim Sinegal, Costco's long-time CEO and head culture-maker, recently retired.  This represented a rare occasion where, if handled poorly, the company's principles could have been undermined.  It didn't happen.  The new CEO believes the same things as his predecessor.  It doesn't hurt that the board includes Berkshire Hathaway's Charlie Munger, who, along with Warren Buffett, has been instrumental in building one of the business world's most unique and impressive corporate cultures.

While its culture is likely to give Costco an ongoing edge over its brick-and-mortar rivals, a long-term competitive threat exists online.  Amazon and similar firms have largely cut out workers, since they've cut out the physical retail channel altogether, and sales over the internet are growing significantly faster than in-store buys.  However, the faster growth is happening from a very small base, and Costco's large scale will allow it to offer low-priced wares online just as it does in the physical world.  In summary, Costco has a wide, shark-infested "moat" that's likely to ensure stellar long-term performance.  Currently, the stock is trading at a designer price, not at a discount, but Costco possesses all of the other elements of a superb investment.  

Source:  www.businessweek.com/articles/2013-06-06/costco-ceo-craig-jelinek-leads-the-cheapest-happiest-company-in-the-world

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An Interview with Tom Russo

In a Spring 2012 interview with the Graham & Doddsville newsletter, Tom Russo offered his thoughts about investing.  He explains an interesting quality that he looks for in management: "the capacity to suffer."  What he means is that he admires managers that ignore short-term results - or at least don't always feel the need to completely maximize every penny of earnings in the current quarter or year - while investing for the long-term.  For example, consumer products companies presently making investments in fast-growing areas like Africa, which do not earn stellar - or, in some cases, any - returns now, but are likely to in the future.  Rather than dipping a cautious toe in new waters, Russo advocates an all-in approach, citing Starbucks' aggressive but successful foray into China.

Russo ventures into a fascinating but rarely-discussed matter in investing: the power of gut feelings.  He confides that he had a funny feeling about the managers at Diamond Foods, though he didn't short the company's shares.  Surprisingly, he offers an anecdote from none other than the ultra-rational, fact-obsessed (at least in business-related matters) Charlie Munger, who sold out of Freddie Mac shares long before they peaked, because something in his intuition said he should.

Russo, who once worked at the Sequoia Fund with the late super-investor Bill Ruane, focuses in part on multi-national companies operating globally, and has interesting things to say about the need for ongoing opportunities to reinvesting in an existing business.  Clearly an expert on such businesses, Russo addresses the fundamental strength of Brown-Forman, the commodity-related challenges facing Kraft, the striking power of Pepsi's Frito-Lay business, and more.  In addition, he holds forth about the attractive economics of aggregates firms, and the merger between Vulcan Materials and Martin Marietta; discusses his philosophy on investing in global firm headquartered outside of the US; offers several reasons to avoid short-selling; and affirms the notion that it's easier to be independent by ignoring Wall Street, even if you are located in New York.

Source is here.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Book Review - The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, by William Thorndike, Jr.

William Thorndike Jr.'s The Outsiders considers eight Hall of Fame CEOs (and, in some cases, the small teams that they worked closely with), the only executives that passed his twin tests: outperforming companies in their peer group, and besting the performance of General Electric's Jack Welch, widely considered one of the finest managers in business history.  Thorndike found that unlike the jet-set, media-savvy, wheeling-and-dealing, larger-than-life Welch, the truly elite eight were modest, private, and humble.  Their most notable qualities, however, were cerebral.  As Bill Stiritz of Ralston Purina put it: "Leadership is analysis" (145).  And all of the featured executives had the independence of mind to turn analysis into action.

Warren Buffett has noted that most CEOs, however exemplary their abilities in areas such as marketing, production or administration, tend to be poor capital allocators.  They're executors, not investors.  However, decisions about what to do with a spare dollar are just as important to the long-term performance of a business as the day-to-day operations.  In terms of specific policies, most of the featured CEOs repurchased shares, but none paid a significant dividend; all focused on one version or another of cash flows, rather than emphasizing earnings; and none provided earnings guidance to analysts - in short, they behaved like investors, rather than operators.  They didn't out-manage Welch; they bested him in the area of capital allocation.

Perhaps Thorndike's greatest achievement in the book is to resurrect the largely forgotten story of Henry Singleton, who Warren Buffett regards as among the greatest capital allocators in the history of business.  No business major, Singleton earned a PhD in electrical engineering, was awarded the Putnam Medal as the best math student in America, and played chess at an almost-grandmaster level.  In 1960, he and a partner founded a small firm, Teledyne, a conglomerate that swallowed a mind-boggling 130 companies in its first decade of existence, using his own firm's high-priced stock as the currency.  While the sheer scale of his shopping spree might suggest an indiscriminate approach to acquisitions, Singleton was in fact a bargain-hunter: he never paid more than 12x earnings.  

Singleton understood that using Teledyne's stock to fund acquisitions made sense only if that stock was fully (or over) priced, and by 1971 he had grown the share count by about 14x.  However, when the conglomerate form fell out of favor on Wall Street, Teledyne's stock swooned, and he correctly reversed course.  Not only did he never again issue a single share of additional stock, he spent the next decade-plus retiring an unheard of 90% of Teledyne's shares.  In part by issuing stock at an average P/E of 25, and buying it at an average of 8, Singleton managed to grow EPS by a world-beating 27% per year for 33 years.

Just as he had earlier retreated by repurchasing shares that had been previously issued, Singleton eventually decided to dismantle the conglomerate that he'd spent his life building.  He spun out several of Teledyne's largest operating companies, and sold what remained to another firm, but only at a full price.  What was it all for?  A 20.4% stock return over nearly three decades, or an 180-to-1 increase. 

John Malone, who has made his eye-popping fortune in the cable and media industries, allocates capital, and leaves operations to a trusted number two, as well as local managers.  For many years as he built his empire, Malone was the only significant cable company CEO to strive for cash flow growth, rather than increases in EPS.  In fact, the now widely used acronym EBITDA was coined by Malone.  (Admittedly, this is not a wholly desirable accomplishment).  Recognizing that scale is a powerful competitive advantage for cable operators, Malone bought smaller competitors at a heated pace, but managed to do so on attractive economic terms.  Not only did size lead to lower costs - and higher cash flows - per subscriber, Malone used it to strike unique deals in which he acquired stakes in up-and-comers such as BET and Discovery in return for access to his imposing subscriber base.  Thorndike argues convincingly that Malone used joint ventures more often and more effectively than any other CEO ever has, perhaps adding a sixth category to the Big Five types of capital allocation.  The scorecard: 30.3% per year from 1973 to 1998, over 900-to-1.

Inevitably, a book about capital-allocating CEOs will include a chapter on Warren Buffett and Charlie Munger.  While the chapter itself covers no new ground, it's an able summary of the twin Oracles of Omaha, and offers a nearly up-to-date performance record: 20.9% over 45 years, or a 6,265-to-1 return.  But Buffett and Munger cannot be bound and contained in a single chapter.  In fact, the book reads a little like an experimental, post-modern literary work, in which the mischievous author (Buffett) writes a book wherein its main character (Thorndike) writes a book about the author (Buffett).  After all, Thorndike, like most investors, almost certainly first heard of Tom Murphy and Dan Burke of Capital Cities and Henry Singleton from Buffett; Kay Graham would not have fared nearly as well as she did without the active, ongoing counsel of Buffett, long the Washington Post's largest shareholder; Buffett invested in General Dynamics well before it became a must-read case study; and most of the books Thorndike cites are about, or have been recommended by, Buffett and Munger. 

Though Buffett, Munger and Singleton are three of the finest, most original minds in the history of business and investing, better capital allocation is possible for most CEOs, regardless of their ability to play chess blindfolded or perform complex calculations in their head.  In fact, the book left this reader frustrated: a few of the case studies offer formulas that are so simple they border on boring.  How difficult can it be, after all, to close or sell poor businesses?  To be sure, not all businesses can be above average, but shareholders as a whole would be meaningfully richer even if CEOs were better at just one simple task: discriminating between paying a dividend and repurchasing cheap shares.  For even a moderately disciplined chief executive, buybacks are a far more attractive option over the long-term, since most stocks are undervalued in the market from time to time.  Thorndike is more optimistic than this reader about the potential uses of leverage: even the uber-talented John Malone nearly succumbed to bankruptcy - largely because of debt that he inherited, but not entirely - and few CEOs will be mistaken for Malone.  

Rather than merely reassembling and reinterpreting publically available material, Thorndike conducted nearly 100 interviews, talks that included many of the (surviving) subjects themselves, as well as people who worked directly with them, adding freshness to the book.  In addition to the stories noted above, he offers analysis of the Dick Smith at General Cinema, and Bill Stiritz at Ralston Purina, case studies unknown even in many business schools.  And for active investors, Thorndike addresses a few potential investments, including Transdigm, Sara Lee, Exxon Mobil and the collection of companies controlled by John Malone.  This fine book ought to be read by most investors; but it's an emphatic must read for all CEOs.

Source: Thorndike, Jr., William.  The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. Boston: Harvard Business Review Press, 2012.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Mohnish Pabrai on Investing Mistakes

Investors should listen when Mohnish Pabrai speaks.  He recently gave an enlightening interview, in which he discussed his personal experiences as an entrepreneur, and the relationship between being a businessperson and an investor; his "all-in" bet on financial companies; his "two-outta-three-ain't-bad" philosophy of investing errors, borrowed from John Templeton, and, affirmed, he claims (not convincingly, in my view) by Warren Buffett's experience; and the opportunity costs of committing capital, among other things.

I'd like to highlight, though, his candid exploration of his mistakes, a few of which led to substantial and permanent losses of capital.  One was Sears Holdings, which sits on real estate that's worth far more than the company's market cap, but can only be monetized by liquidating the business.  Despite a prominent theory which holds that people act only according to the cold calculus of economics, most CEO's are not hot on the idea of liquidating the firm they preside over (or perhaps this affirms the theory: after all, why dismantle the company that's paying you such an appealing salary?).  Either way, the alternative that's best for shareholders is not always the option that's pursued by management.

A second misstep was his investment in Pinnacle Airlines, a contract operator that flew on behalf of traditional airlines, including Delta.  While Pinnacle had a cushy cost-plus arrangement, shielding it from the challenges of the airline industry, making money from customers that are losing money is not a recipe for long-term success.  When they fall, so do you.  Pabrai concedes that he should have better understood the full economic ecosystem that Pinnacle was operating in (Charlie Munger would greatly respect this lesson, as the ecosystem is among the 100-odd "Big Ideas" that he draws wisdom from).  Finally, his worst failure was his position in Delta Financial, a company that wrote, bundled and securitized mortgages, and was felled by the recent financial crises.  His position, 10% of his portfolio, went to zero.

Nearly all prominent investors will concede that they've made mistakes, but when pressed to provide specific examples, few are keen on discussing them in detail.  Post-mortems are grim, after all.  But kudos to Pabrai for doing so, and allowing the rest of us the opportunity to learn from his mistakes for free, rather than paying to do so first-hand.

Here is a review of Pabrai's book The Dhandho Investor

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.