1 year ago

Graham & Doddsville


Page 30 Simeon Wallis

Page 30 Simeon Wallis second is operating margin expansion and the third is reducing the capital intensity of the business, often reflected in improvements in working capital turns. For the public companies, we add a fourth driver: shareholder yield. Shareholder yield is often revealed in the Financing section on the Statement of Cash Flows. Is money flowing out of the business, and is it paying off debt and reducing the share count? Or is money being brought into the business, increasing debt, and raising share count? It’s traditionally been ownerfriendly when you reduce the amount of capital in the business. We also use another mental model that started with how we work with our private companies, but has transferred to evaluating public companies and their management teams. We uncreatively call it “VSD”: Vision-Strategy-Drivers. John Wooden famously used a pyramid to explain his drivers of success. We borrowed that. Vision would be at the top of the pyramid, Strategy would support the vision and the Drivers would be the base, supporting strategy. For our established companies, we want them to have a tenyear, high-level vision that helps employees, key suppliers and customers, as well as the board, have a good sense of where our management team is taking the company. It motivates employees that they are part of a special company. It distinguishes us in our customers’ eyes because we’re seen as more aggressive in addressing their needs than competitors. This leverages the concept of starting with the end in mind. The Strategy answers the question “How are we going to achieve our vision?” Namely, it identifies what are the key operational items the company will need to execute on, what are the key capital and operational investments that will have to be made to support the executing the priorities, how competitors are likely to react and what are the trade-offs that will have to be made, since everything has an opportunity cost. Lastly, the Drivers are the critical activities that management will focus on and that can be measured in order to execute the strategy. As we developed this framework, we saw how it is applicable to evaluating publicly traded companies, especially in conversations with management. If a management team can’t credibly and lucidly describe how they are allocating their key resources toward specific objectives that they want to achieve over the medium to long term, I believe any investment thesis beyond reversion of the earnings multiple is difficult to make. This is particularly true for compounders. The last few years I’ve guest lectured at Columbia in the Value Investing Program in Chris Begg’s section of Security Analysis. I use 3G’s Ambev investment and Heico as case studies—from annual reports, interviews, shareholder letters and articles, one could clearly see where management was taking those companies using the VSD framework. We put more faith in excellent managers than many traditional investors, especially value investors. Management, in our belief, matters more the longer a position is held. In our opinion, the premium the market pays for outstanding management relative to average management is frequently too narrow. On the public side, we typically buy what we believe is the best management team in an out-offavor industry. We have deeper conviction that they’re going to make owner-friendly decisions and less likely to impair capital. It’s also a belief that management can make a difference in key situations. That comes from operating companies, allocating capital, and serving on boards overseeing executives. The difference can be dramatic particularly the decisiveness and focus on the critical few decisions and inputs that can have disproportionate impact on profitability and sustainability of the returns on capital. G&D: How do you evaluate a management team when you’re trying to look at so many different options in the public space? What tools do you use? SW: I don’t want to visit or speak with management until I’ve thoroughly researched them and the investment controversy. I want to avoid their influence in how I approach thinking about the business. I want them to address my critical questions and I need to spend time to determine what those are beforehand. (Continued on page 31)

Page 31 Simeon Wallis A great executive can simplify the business and her thought processes in her communications. She remains consistent in how she talks about the business and what she is focused on. She communicates in easy-tounderstand terms devoid of company and industry jargon. Decisive in actions, makes difficult decisions quickly and is candid about industry conditions. She is honest and transparent in communications. I determine this by reading ten to fifteen years’ worth of shareholder letters, interviews, and conference call transcripts. I ask, “Is the management team focused on the key drivers of the business? Do they understand what their relative competitive advantage is? Its source? Are they focused on the same metrics year after year?” This sense of what to do and why do it is internalized. One lesson I’ve learned in operations is that it’s very difficult to manage and influence employees. Simplifying and creating clarity in terms of where a business is headed and what matters enables organizations to take actions more quickly and to be more responsive to changing dynamics. Great managers understand a business creates value satisfying customers or adapting to the marketplace, not at the headquarters. The frontline people need to understand what management is thinking because they reflect management’s thought process around what matters. Clear communications and incentives are the best way to do that. Great managers understand their relative competitive advantage and focus the business’ resources in that area. A great example is GEICO and Berkshire. Buffett understood that the direct-toconsumer model enabled the company to avoid higher cost distribution than competitors. As a result, he could 1) invest some of the savings in lower prices for customers and 2) increase spending on customer acquisition in the form of advertising that GEICO was a better value proposition for consumers. “Our best situations have been when management has not taken very much capital—in the form of equity—off the table. Reducing equity stakes is usually a yellow flag, if not a red flag, for us.” If he was thinking short-term, GEICO’s advertising budget would have grown at a far slower pace than it has. But Buffett sees the tie between the competitive advantage and the long-term value of an additional policy holder to GEICO’s intrinsic value. I’m sure many value investors have been fooled when management teams say the right things. After William Thorndike published The Outsiders, value and fundamental investors were telling management teams, “You have to read this book. This is the way to do it.” The management teams listened and spouted out, “Buying back shares. Returns on capital.” I believe that ultimately burned many fundamental value investors because management lacked a true understanding for why the actions of The Outsiders mattered. As Seth Klarman has said, you either get value investing or you don’t. This was the same thing—it wasn’t internalized. An investor who sat down with management probably could have determined this if they applied the “5 Whys” line of questioning to why this approach to capital deployment was correct. After looking over longer periods of communication to assess authenticity, I focus on the proxy filing to evaluate incentives. Performance-based compensation tied to return on invested capital and freecash flow growth are great. Ignoring the balance sheet or capital base is a red flag. Adjusted EBITDA is a negative for that reason. Adjusted EPS is even worse. G&D: Can you talk a bit about the types of companies that you’re looking at for the public portfolio? SW: On the public side, we’re value investors. We focus on buying companies that are at modest valuations relative to either their normalized earnings or normalized free cash flow, three to five years out from now. We’ll place a modest multiple on that profit or free cash flow, credit management for share repurchases if that’s part of the company’s history and determine, given our expectations, whether we could double our money in three years or quadruple it (Continued on page 32)

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