With Tom Russo, Managing Partner at Gardner Russo & Gardner
As part of our new “Great Investor Series,” this is the first “What’s in Their Wallet” segment which can also be found here.
Tom Russo, Managing Partner at Gardner Russo & Gardner, a hedge fund managing about $12 billion, is a recognized thought leader in the field of investments and devotes time lecturing and educating students.
Before we see what makes Tom a Great Investor, it’s interesting to hear how it all began for him, how he segued from a career in law to the world of finance as a money manager when circumstance put one of the greatest investors of all time in his path.
An Early Lesson in Investing from Warren Buffett
As Tom tells it, he was a student in 1982 at Stanford’s Law and Business Graduate Program when his value investment professor brought in one of his colleagues to speak to the class—that colleague turned out to be Warren Buffett. Where most investment conversation at the time had to do with modern portfolio theory, Tom recalls that Mr. Buffett spoke about investing in businesses as though you owned them yourself with such “clarity of thought it that parted the way for me.”
At that defining moment of Tom Russo’s career, Buffett laid out a specific 3-prong analysis of what a business must possess to have a competitive advantage:
- The non-taxation of unrealized gains, which requires the investor to think about businesses that have the capacity to grow, the capacity to reinvest.
- Before investing, you must know that the management whom you trust to reinvest will do so with the owner’s, rather than the management’s, interest in mind.
- Invest in businesses that you like because you’ll probably work harder at it and be more intuitive about it.
By following these guidelines through the years, Tom says sixty-plus percent of his investments have been in family-controlled companies, which to some may imply more risk, but in actuality, there is less risk. In addition, the favored companies are ones that throw off a lot of cash, are able to reinvest that cash successfully, and have global aspirations and brand recognition.
A Great Investor Knows the Difference Between Instant and Slow Roasted Coffee
To be a smart investor, Tom advises, you must have a long-term view and the capacity to suffer; you want to invest in companies willing to make strategic moves in a timely mindful manner that will pay off in the future and one that is strong enough to keep corporate raiders from breaking through the door.
It took Nestle 15 years to perfect Nespresso, the most successful premium single-portioned coffee on the market. During those developmental years of laboring over the crema, the beans, the scent, the bar pressure, the technology, and the marketing strategy, imitators rushed to the scene, pushed their products out the door, and ultimately failed. Nestle, by taking its time, did it right and launched a classy, profitable member of the Nestle Group.
Stock Options: Who Wins And Who Loses?
One of the reasons Tom says he’s invested so highly in internationally based companies is that they use stock options as a far smaller portion of compensation than they do in the US, where the practice of dangling stock options has actually become a destructive practice.
Tom explains, “With options, you suddenly introduce into the equation of reinvestment an element called time. Your options are good for three years, and if the price isn’t $72.50 three years from now, they’re worthless. You as the manager have every ability to deliver the kind of results that Wall Street demands of you to get to $72.50 in three years, but that might actually come at the cost of the future because you may cut spending. You may make the numbers and ruin the value of the company in the process.”
When Scandal Strikes a Company Like Wells Fargo, Do You Stay or Go?
It’s difficult to get the facts straight when a Federal investigation intervenes, as also happened with the automobile and cigarette industries, so Tom says, “I’m inclined to stay put in a situation like this, generally, without heroics.” “When the hot animal spirits run, it’s not the time to establish the rights and the wrongs and the liabilities because it’s a political process. Over time we’ll better know.”
The Shared Philosophy of Warren Buffett and Aaron Burr
In the Broadway show Hamilton, Aaron Burr says to the young Alexander Hamilton, “Speak less, smile more.”
Warren Buffett’s advice to the young Tom Russo was Hamiltonian in the sense that investors should “think more and trade less.”
Steve Pomeranz: I’m excited to kick off our new “Great Investor Series” where we will identify and talk to the world’s most talented and successful investors. We also call it the “What’s in Their Wallet” segment to find out where these great investors see today’s greatest opportunities. So join me now and allow me to introduce Tom Russo. Tom is a partner at Gardner Russo & Gardner, a hedge fund managing about $12 billion. The partnership has managed to beat the S&P 500 handily since inception. Tom is also a thought leader in the field of investments and devotes time lecturing and educating students and others. He has kindly agreed to spend some time with us today.
Hey, Tom, welcome to the show.
Tom Russo: Thank you so much.
Steve Pomeranz: I’m so glad you’re here. I know that you initially set out to become a lawyer and, then in the 80s, you changed your mind. How did you end up as a money manager?
Tom Russo: I was blessed to have had some influences that helped shape my activities. I went to the Law and Business Graduate Program at Stanford and, little did I know, when I signed up, I learned thereafter, that the value investment professor with whom I studied had been a very, very early colleague of Warren Buffett’s. So in 1982, he had Mr. Buffett come to our class, and he spoke with a clarity of thought that parted the way for me because most of the investment conversation at Stanford—and most of the business schools in the country—have to do with modern portfolio theory; and Mr. Buffett and my professor spoke about businesses, investing in businesses as if you owned them yourself. Not a question of generalizations, but very specific analysis about what businesses possess a competitive advantage.
Mr. Buffett spoke about three things to our class. One, the non-taxation of unrealized gains, which require the investor to think about businesses that have the capacity to grow, the capacity to reinvest.
The second thing he mentioned was that when you reinvest money, you probably have to make sure that the management whom you trust to reinvest to do so with the owner’s interest in mind rather than the management’s interest in mind. What he refers to there is something called agency costs. That is the proclivity of managements to try to make owner’s wealth, their wealth. You look for businesses where the reinvestments are made for the benefit of the owners. Where I’ve discovered it with practice—and certainly where Mr. Buffett has developed it through his own endeavors—is that family-controlled companies often have the ability for managements to be supported by and also reviewed by owners at the board level. Sixty-plus percent of my investments at the moment and most of the past decades have been invested in family-controlled companies, which is quite unusual, and it has given us a slightly interesting benefit that to most investors, family-controlled companies suggest more risk, not less risk.
Steve Pomeranz: Right.
Tom Russo: I think it’s more risky because of the risk of self-dealing families.
Steve Pomeranz: Exactly, and with families’ interest coming number one, shareholder’s coming second, you’re finding those businesses where the family is looking to enhance wealth for shareholders and their family alike.
I would say that your strategy is to harness the power of compounding achievable in certain businesses. You’re looking for companies that throw off a lot of cash, but that alone is not what the driver is. It’s getting that cash successfully reinvested. It doesn’t sound to be that hard, but I think it is quite hard. Tell us about that.
Tom Russo: It’s terrifically difficult and basically some companies are landlocked, for instance. Some companies operate well in the United States. Think about H & R Block, which I once owned, they did a great job consolidating the US tax prep market, but thereafter they had no organic place to redeploy their capital and off they went on a mission.
Steve Pomeranz: Tangents, mortgages, and all kinds of investment brokers.
Tom Russo: Exactly, so that really took them off the hunt, but they had no shame of their own. They just couldn’t push that beyond. Our businesses ideally have their brands impregnated around the world in the minds of global consumers; and our job as business owners is to encourage management to invest the funds in advance of the expression of that demand, even at the cost of current income, so that they get first mover advantage.
Heineken opens up the premium beer market in the US, so that Brown-Forman opens up the American bourbon market worldwide so that Nestle opens up the single-serve coffee market. We want our company managements to know that it’s in our long-term collective best interest for them to invest deeply against future opportunities, even when it burdens current income; and they should know that family control in many instances is going to be valuable in keeping them out of harm’s way when current results are harder to report because of the investment spending abroad that will set us up for a brighter and richer future.
Steve Pomeranz: My guest is Tom Russo. He is a partner at Gardner Russo and Gardner and they have handily outperformed the S&P 500 over many, many years. We talked about this capacity to reinvest, but along with that comes the capacity to suffer. What does that mean?
Tom Russo: Just as I expressed. That is a very likely burden that a business manager will face when they spend the right amount of money preparing for the future demand well in advance of its current existence. When businesses go into markets and, for example, Nestle pioneered—just to take one business—the bouillon cube business in Nigeria. This is a product that, at the start, wasn’t very affordable to most consumers. It wasn’t expensive because it was sold one cube at a time, but that still stretched the finances.
As the GDP per capita rose in Nigeria and people had more spending power, they bought more of these over time, the loss-making startup factory became a flush with profits fully-committed factory years later. Then they added a second factory, which took returns down as the business that existed after the second factory completed was spread between two less profitable factories, and they both became full and now a third came along and a fourth. It’s that reinvestment even when up front before the capacity utilizes and profitable that it sets you up for a rich future. Focus on wealth, not reported profits.
Steve Pomeranz: One of the stories that you told as I was researching our discussion today was the story of Nestle and Nespresso. I happen to be a user of the Nespresso machine. I love it. It makes cappuccino and espresso coffee and it’s very convenient, extremely well-designed and so on. You said it took them 15 years to develop that.
Tom Russo: To break even.
Steve Pomeranz: To break even.
Tom Russo: I visited them through the process and they labored over the crèma, the scent, the beans, the technology, the bar pressure, all of that. While they were doing that, other companies rushed products to market, so there was a competitor that was in the coffee business and not only did they starve their long-standing soluble roast coffee business of marketing dollars to promote the product, but the product that they were trying to promote wasn’t really very good, so they gave up what they needed which was supporting the business that they already owned for a product that wasn’t well researched. Against that backdrop, the slow, methodical approach won out with Nespresso.
The other component of Nespresso is from the very earliest stage, this is where their management’s been so decisive and thinking beyond the current box. Even when they were creating it, they were trying to create a platform that they could go to market independently from supermarket pressure because as they looked forward into the competitors that they found that supermarkets through pressure of store brands and clouded purchasing, were increasingly trying to take manufacturer revenues away. They wanted a marketing channel that they could control from the start to the finish. They had the entire margin of that channel and nobody can deprive them of the margin on their cubes as a result.
Steve Pomeranz: Very interesting.
Tom Russo: As a result of that. Holistically thought.
Steve Pomeranz: You talk about this capacity to reinvest, to have a long-term view, and the capacity to suffer, which also I think means the capacity for management to withstand a lot of the pressures that management is under. For example, if you take a look at the average company who has to report positive earnings on a very short term basis, if they don’t, then maybe corporate raiders will come in, pressure …
Tom Russo: Exactly.
Steve Pomeranz: Yeah, so how is a company like Nestle or any other company that has fit your criteria, how do they withstand those pressures?
Tom Russo: If you have the controlled shares, like Heineken owns 50.1% at the family level of the holding company shares which own 50.1% of the company shares. You have voting control in some level, and you can just send the company packing who comes by and wants to disrupt your business.
Steve Pomeranz: Buffett has the same thing with Berkshire Hathaway.
Tom Russo: Absolutely, absolutely. I’m actually a fan of structures that provide management who have the willingness to invest in the long term, that protection from the change of corporate control or not. One of the reasons why I’m 60-plus percent international in our composition portfolio holdings, as well as because over the years, the international based companies have used stock options as a far smaller portion of compensation whereas, in the United States, they’ve really become the kind of gluttony that they’ve become.
The reason it becomes so destructive isn’t just the fact that the dilution takes place without being identified when you’re giving away future shares. The future has a habit of coming to the present and suddenly you’ve got more shares outstanding and that’s a very corrosive process. If you’re giving away a tremendous number of shares, you end up diluting the investors.
The biggest problem, however, is that with options, you suddenly introduce into the equation of reinvestment an element called time. Your options are good for three years and if the price isn’t $72.50 three years from now, they’re worthless. You as the manager have every ability to deliver the kind of results that Wall Street demands of you to get to $72.50 in three years, but that might actually come at the cost of the future because you may cut spending. You may make the numbers and ruin the value of the company in the process.
Steve Pomeranz: You’re really sacrificing the future to make sure that everybody who’s got stock options is satisfied and happy and your shareholders are happy in the present, but at that date, but 15 years in the future you may have a much-weakened company. You said that you …
Tom Russo: You will find that you weakened it up by virtue of failing to expend the money for the very longest term. A great example of that would be General Mills with Chobani. Along came this upstart; General Mills looked at it from a distance; it didn’t seem so threatening. They had the colossal weight of the Yoplait business in their favor with 50% of the US market and, for a very small amount of money when Greek yogurt under Chobani first started out, they could have deflected the consumer by launching a Yoplait Greek and then capturing that phenomenon. But by waiting and not investing that money, which had no return, only losses up front, they ended up actually compromising the quality of the remainder of their time as a yogurt producer because, if the Greek section has taken up half the business and the old trademarks have a problem now crossing over to this business, now that the Greek-only franchises have owned those consumer goodwill points.
Steve Pomeranz: Tom, let me move on here a little bit in the interest of time. You have a reputation for holding onto companies for a very long time. I think most of your portfolio you’ve held on for more than 10 years.
I have a question about what happens when a company starts to exhibit characteristics that are not entirely suited to your strategy. I’m thinking in terms here of Wells Fargo. We’ve all considered Wells Fargo a wonderful company that actually enjoys a little extra premium because of the way they’ve run the business. Warren Buffett is a known investor, a lover of the company, and yet in the last few months, they’ve had a terrible scandal. A shameful scandal in my view, and it looks like it’s going to have an effect on the company for a few years to come. Nobody can really tell. How do you treat … What’s the big picture that you see when you look at a company in your portfolio that’s gone through this?
Tom Russo: The trouble with this particular situation is that it’s very hard to get the facts right and to get the orders of magnitude right when it’s an investigation in front of the House and the Senate that you’re observing. I see this over and over and over again.
When they brought the automobile industry down, when they bring the cigarette industry in, there is such a vilification that is so pressing. There are other aspects to the bank. There are other aspects to the story. There are other explanations as to how you end up with this occurring at what would seem like a greater frequency than you would have ever hoped for but, in the scheme of things, still the sort of thing that the bank will be in a full position to be able to restitute financially, and they’ll have to plead their case to restore their good will. When the hot animal spirits run, it’s not the time to establish the rights and the wrongs and the liabilities because it’s a political process. Over time we’ll better know.
Steve Pomeranz: Would you be buying … I’m not asking you personally for a buyer-seller recommendation…but in terms of your philosophy when the animal spirits are running and this way they’re running hot, they’re running negative. Is the time when you would many times come in?
Tom Russo: You’re supposed to be more of a buyer at a moment like that than the seller I can assure you if you believe in what you thought was there. At the moment, the only thing I have from the opposing camp is a very, very political moment that … I’m inclined to stay put in a situation like this generally without heroics.
The movement in the share price has been 7 or 8 percent relative to the release of the news, so it hasn’t been catastrophically adjusted. I generally have learned through Berkshire and one of the great lessons I learned from Warren at the very start watching him and then hearing his advice, is it’s been Hamiltonian where in the play of Hamilton, they say … Aaron Burr says to young Hamilton, “Speak less and smile more.” I think investors should think more and trade less.
My goal is really to stretch out that investment horizon and try to see what things might look like 5 to 10 years out. In that case, with Wells, you’ve got this magnificent internet bank percolating along. They’ve introduced some P to P capacities that will go after Venmo. There are a lot of interesting things happening. Right now the tension is pretty clouded. I hope that they’ll have the talent to address this crisis and its proper handling because it has to be completely addressed because it is at the heart of their good will.
Steve Pomeranz: Tom Russo, Managing Partner at Gardner Russo & Gardner. A little insight as to what makes a successful investment strategy with someone who is very well-reasoned and well-spoken. Thank you very much for joining me, Tom.
Tom Russo: Thank you. Pleasure. Bye.