How to pick compounders – lessons from Tom Russo

Tom Russo joined Gardner Russo & Quinn LLC as a partner in 1989. He is a value investor who concentrates on long-term compounders, particularly companies with strong brands. Here is a chart showing his fund’s returns versus the S&P500 index.

Russo has earned roughly a 13% annualised return over this period!

His most notable long-term holdings include Berkshire Hathaway, Nestle, Brown-Forman and Heineken.

Below, I’ll discuss the lessons I have learned from Russo’s interviews and annual letters.

1. Successful compounders must have a “capacity to reinvest”

The “capacity to reinvest” means the business has room to grow in a market. Below is how Russo assesses this capacity of a business.

Russo looks for global brands

This is because brands have pricing power and will likely grow alongside population and worldwide disposable income. He believes that brands that are recognised globally can naturally reinvest in emerging markets and grow business value over time.

He looks at the total addressable market

If a business makes up a small portion of an overall market, this means the business has a huge runway to grow. Let’s look at two key portfolio holdings and how Russo thought about their runways for growth at the times he invested:

  • Richemont (owner of Cartier) had room to grow because 85% of global jewellery sales were unbranded.
  • Mastercard had a huge runway for growth because 85% of global commerce was still paid through cash or checks.

Finally, Russo looks for multicultural and multilingual management that can steer a business worldwide

2. Successful compounders must have a “capacity to suffer”

Russo describes his idea of a business having a “capacity to suffer” as a business’s ability to endure poor short-term reported income in order to boost long-term value. He has consistently explained that successful businesses that create long-term value have to be willing to endure pain today for gain tomorrow.

Here is a quote from Russo:

Managements must be allowed to incur near-term burdens on reported profits when investing to seek long-term growth in intrinsic value on a per share basis

For example, if a business can generate 20% returns on capital by opening a new factory overseas and growing its market share, it should take this opportunity regardless of its effects on next year’s profits. Although the amount paid for the actual factory does not reduce net income as it is a fixed asset (other than the annual depreciation charge), there are expenses in setting up the factory that would reduce net income. As a result, short-term income will reduce. The reality of this situation is that in 10-15 years, the business would’ve added a substantial amount of earning power through this investment. Russo wants to own businesses that prioritise this outcome over reporting huge profits in the short run whilst foregoing these wealth-building investments.

How does he find these businesses?

Russo likes businesses that are controlled by founding families. Roughly 60% of his portfolio contains businesses that are controlled by the founding family, including Berkshire Hathaway, Pernod Ricard and Brown-Forman. Here is Russo on this topic:

The families, with their controlled shares, so long as they have the proper long-term vision, give management the authority to reinvest even when they have to suffer through the upfront burden on reported profits caused by such appropriate levels of long-term investments.

Let’s look at some examples Russo gave below.

Berkshire Hathaway’s investment in GEICO

Around the mid-90s, GEICO reported a $250 loss in the first year a new policyholder was acquired. In the subsequent years, however, they earned an average of $150 per policyholder each year. Therefore, they needed the capacity to suffer through this decline in reported income in order to acquire more customers and build intrinsic value. Buffett understood this, ramping up advertising spending from $30m in 1996 when he bought GEICO to over $1b in 2021. In 1996, GEICO had 1.5m policyholders. Let’s look at what happens if GEICO hypothetically added one million policyholders in 1997.

As we can see, GEICO would’ve entered reported loss-making territory. Russo uses this example to illustrate how reported profits might look poor, but in reality, the long-term earning power of a business might be significantly enhanced if management accepts these short-term income burdens. With GEICO, Buffett prioritised acquiring policyholders because he knew that over time, each policyholder adds value to the business despite the reported loss they generate in their first year.

Nestle

Russo explained a scenario with Nestle, summarised below:

  • One factory was operating at ~120% capacity, meaning it had fully absorbed all the fixed costs and was overstating margins and thus profitability
  • Opening another factory would not only reduce profits due to start-up costs, but it would also take this capacity away from the old factory
  • Now, with two factories operating at lower capacity, margins are actually understated because all the fixed costs that must be spent each year to keep the factories running are not being absorbed as much as they could be
  • However, as an owner of this business, Russo preferred Nestle’s decision to increase its operating capacity to prepare for stronger demand in the future over the alternative of maintaining high short-term profits.

By suffering through the short-term reported profit burden, Nestle added intrinsic value by having the capability to serve more customers and thus generate more profits.

3. Successful compounders must avoid agency costs

An agent is given the power to make decisions on behalf of a principal. Agency costs refer to the incentive clash that can occur between an agent and the principal.

On discussing what he fears in investing, Russo said “really the first and only is agency costs”. So that begs the question, how does he avoid them?

Family control helps reduce agency costs

As mentioned above, Russo likes to invest in family-controlled companies. These generally encourage management to build long-term wealth as opposed to reaching short-term profit targets.

Avoiding businesses with excessive stock option compensation helps reduce agency costs

For stock options to reward you, it has to be worth something on a given day. So the managements whose fortunes depend heavily on stock options become very attuned to days…In the process of making sure that the shares can be worth as much as humanly possible at any given time, managements all too often fall prey to Wall St who promises them a high valuation if they only agree to make their earnings (estimates) each quarter.

Management with significant stock ownership can also help reduce agency costs

If the agent (corporate management) takes the position of the principal (the shareholders), agency costs will likely be reduced.

I hope you enjoyed the read!

Sources
  1. Tom Russo Talks at Google 1
  2. Tom Russo Talks at Google 2
  3. Semper Vic Partners Letter to Investors August 2021
  4. Tom Russo at Guru Focus
  5. Thomas Russo talks about Buffett and long term Investing with Tim Schaefer
  6. Russo Long-Term Value – WEALTHTRACK

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