Tom Russo is a world-renowned value investor who focuses on global brands and their ability to reinvest money around the world that display a “capacity to suffer”. Tom is a partner and portfolio manager at Gardner Russo and Gardner, a hedge fund based in Pennsylvania. Tom was heavily influenced by Warren Buffett when Buffett came to speak to his investing class at Stanford Business School in the 1980s. Buffett taught him that investors can identify companies with superior economics and a strong culture that could turn into a lifelong investment. Tom popularized the term “capacity to suffer,” which he adopted from investor Jean Marie Eveillard.
Russo believes that the “capacity to suffer” can be applied to both the investor or money manager and to the company itself. When applied to the company Russo uses the term “capacity to reinvest”.
Capacity to Suffer
An investor must develop the temperament to be able to see their portfolio drop 30-50% during big sell-offs or a big reaction to the news a company has released. Companies may reduce their forward guidance because they plan to reinvest their cash flow back into the business or enter a new market. This is not necessarily a bad thing. A company that is able to reinvest at a high rate of return will create value over the long run but may reduce short-term earnings. This long term value creation will be captured in the stock price if you are patient and don’t overreact to the quick drop in stock price. This is the “capacity to suffer”. You may have to watch a company’s stock price languish while they pour money back into the company to increase the value over the long term.
Stocks don’t typically go “up and to the right” on a stock chart without some bumps along the way. If you sell your shares every time there is a bump or a setback and buy when things start looking a little greener than you will be doing the opposite of buying low and selling high. This will limit the returns you think you should be achieving.
Capacity to Reinvest
The company and its management must have the ability to prioritize the long-term future of their company and not succumb to the pressure of meeting quarterly guidance numbers. If management begins to make poor decisions to boost quarterly profit numbers it will inevitably lead to cracks in the business. While tricks employed to boost profit numbers in the short term are no longer in their toolbox, earnings and the overall outlook for the company will suffer.
Let’s explore some examples of businesses that had the ability to invest in themselves for the long run:
Former Starbucks CEO Charles Schultz was speaking with investors during a time when Starbucks was expanding rapidly in China. Schultz began a dialogue with analysts that went something like this:
Analyst: “When will you show profits [in China]?”
Schultz: “How big do you want us to be?”
Analyst: “When will you show profits”
Schultz: “How big do you want us to be?”
And this continued. Schultz continued by saying that he thought shareholders and analysts wanted Starbucks to dominate China. In order to do so, they need to aggressively expand and reinvest in their China operations which would result in Starbucks not showing a profit in China for some time. Schultz believes that many American companies are trying to establish a foothold in China without creating a negative impact on their earnings. This resulted in companies only having a small base of operations in China that in the long run was not competitive.
Schultz recognized that to truly enter China they would have to suffer decreased earnings and reinvest their money to expand Chinese operations. Was Schultz right? As of January 2019 Starbucks has 3,521 stores in China. By investing in China, Starbucks and its shareholders were able to continue the growth of Starbucks after the U.S. market had become saturated.
If Schultz was concerned about meeting short-term guidance, he may not have aggressively pursued expansion in China and been stomped out by other up-and-coming brands like Luckin Coffee, which they are currently competing with. Starbucks displayed a capacity to suffer by foregoing short term earnings. They wanted to ensure they developed a lasting position in China that would lead to long term success.
Nestle is one of Tom Russo’s largest holdings. In 2013 Russia experienced a currency crisis when the ruble plummeted in value. This drove foreign businesses out of Russia. Nestle doubled down on its investments in Russia by building facilities, making acquisitions and continuing to spend on marketing. Nestle was able to make meaningful advances because labour was cheap and the market was craving investments. How did this end up for Nestle? Nestle has a $2-billion-a-year business in Russia.
Many companies fled Russia during this time of turmoil for fear they would report losses and not meet earnings guidance. Short term thinking that hindered long term results. By showing a capacity to suffer Nestle was able to ride out the currency crisis and develop a $2-billion-a-year business while other companies were fleeing.
SAB Miller is the second largest brewery enterprise in the world. SAB Miller has worked to establish a dominant position in sub-Saharan Africa. This part of the world has received no attention from many of the world’s largest brewers. In 2011 SAB Miller invested $500 million into Asian and African expansion. This massive investment led to revenue and volume growth, but their EBITA margin dropped sharply. This is a great example of the capacity to suffer. SAB Miller was willing to lose money in the short term in order to establish their brand in a region that is experiencing growth.
Many people in sub-Saharan Africa were drinking homemade beer that was of poor quality. SAB Miller made the bet that when the disposable income of the residents of this region increased they would shift away from homemade beer to better quality, better tasting SAB Miller beer. The residents were already familiar with SAB Miller because they had been in the region for years and had an established brand.
Enbridge is an oil and gas pipeline operator and is a company I own in my portfolio. Enbridge is in the process of rebuilding its Line 3 pipeline that runs from the oil sands in Alberta, Canada to refineries in Superior, Wisconsin.
The process of permitting the pipeline has been an extensive and exhaustive process. There are many groups that believe that Alberta oil is contributing to climate change. There are also concerns that if the new pipeline has a spill it could do irreparable damage to pristine lakes in Minnesota.
On March 1st, 2019, Enbridge learned that the pipeline would not be completed until November 2019, which will push back the projected operating date of the pipeline to the second quarter of 2020 instead of the second quarter of 2019.
As a result, Enbridge’s stock sold off 6%. I am not overly concerned that the pipeline will be cancelled as Enbridge has gone through the most exhaustive permitting process that they have ever been through. Management is confident they will get the required permits. By recognizing that this is a short term issue I understand that some short term suffering should result in long term gains.
The more regulation that is heaped onto pipeline operators the more valuable their pipelines become. It is increasingly more difficult to build pipelines in North America, creating a large barrier to entry to the regulated pipeline industry. Once the Line 3 pipeline is finished it will be a great generator of cash flow for Enbridge for years to come.
Long Term Time Horizon
Investing with a long term time horizon and an understanding that things aren’t always going to be perfect is a great way to minimize return-killing mistakes. If you respond to short-term fluctuations in stock prices, it leads to selling low when things don’t look great and buying back in when the stock has rebounded and the news starts to sound better.
By developing a “capacity to suffer” and looking a little deeper into why the stock price is moving the way it is, it can lead to a great understanding of what the company is trying to accomplish. A company that is increasing its research and development spending will take a toll on earnings today but this spending may result in a new product that takes the company to another level.
Tom Russo believes that investing in companies that conduct business through a long term lens is a great way to build your portfolio. In a 2017 speech, the CEO of Amazon, Jeff Bezos, said:
“I ask everybody to not think in two-to-three-year time frames, but to think in five-to-seven-year time frames.[…]
“When somebody… congratulates Amazon on a good quarter… I say thank you. But what I’m thinking to myself is… those quarterly results were actually pretty much fully baked about 3 years ago. Today I’m working on a quarter that is going to happen in 2020. Not next quarter. Next quarter for all practical purposes is done already and it has probably been done for a couple of years.”
This is the long term thinking that we want to look for in our CEOs. They don’t succumb to Wall Street pressure to meet the short term guidance but focus on building a sustainable company that can reinvest in itself over the long haul and as owners of the business, we can reap the rewards.
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