No. 7: Musings from working, Holding compounders is good for financial health, Marketing to senior citizens, Nike's DTC success
I thought being part of a corporation would make me a worse investor somehow. It’s true that excess time spent at work took time away that I could have put into researching industries and companies. On the other hand, it taught me about how business from the inside. Not just the valuation and analysis needed to make smarter business decisions, but also the realities of hiring, retaining talent, and how culture is a living, breathing thing.
It also taught me some other stark realities which are hard to fathom from the outside:
Flywheels and doom-loops: There is no such thing as a steady-state situation. I have found that a business either is in a flywheel or a doom-loop – though the speed of spinning differs.
If a business is performing well, this can lead to profit, which leads to increased investment budgets, which lay foundations for future growth. This leads to more profits still, which then attracts talent, which then leads to increased capacity to reinvest for future growth, and so on. This can happen in many ways, depending upon context.
If a bad business is losing money or margin it usually tries to cut costs. However, it can’t cut costs in a vacuum and assume that the business stays good in the meantime. It must do so in an environment in which it is losing profit, losing employee morale and bonuses, driving key talents to leave, which then could lead to sales and supply disruptions in the worst case. This leads to a kind of downward spiral if the cost cuts are not performed surgically enough.
It’s easy to theoretically understand as an observer. But being in these businesses physically added a layer of learning which is hard to fully grasp from a book or article.
Incentive systems matter: This is quite self-explanatory, but what surprised me is just how much compensation drives outcomes. Talent flows to other businesses where bonuses and salaries are higher. Therefore, businesses generally take actions to pump up their bonuses, even if they are short-sighted decisions. This is not because managements are stupid or greedy. It’s that they are aware of the second-order effect – which is that talent leaves and managers get fired if bonuses aren’t reasonable over long periods of time. And especially in tight job markets, if management take long-term decisions which lower current bonuses, their key employees might not stick around to see out the change – unless there is some other secret sauce keeping talent in place.
The key here is obviously to design compensation systems that are simple enough, transparent enough, and reward the right kinds of behavior. But in a large company, what I have seen is that it’s very tough to strike the right balance to get everyone behaving well. After all, as Warren Buffett says, “you can’t have a city of 300,000 people and not have misbehavior.”
Industry matters: Having worked in both disadvantaged industries and businesses with very strong brands and competitive advantages, it is apparent that the industry really matters. Some businesses are very tough to operate in – and only throw up impossibly tough decisions to make. Operating natural resource assets high on the cost curve was one of these tough environments where even Class A managers couldn’t have made a dramatic difference.
On the contrary, businesses with strong competitive advantages and high returns on capital can thrive even with mediocre managements. The underlying businesses are so strong that operating and investment decisions become easier. It’s not that managements can be totally incompetent and still survive, it’s more that they don’t have to be Elon Musk to make the company work.
Holding Compounders is Good for Financial Health
Yen Liow had an interesting take on investing in “compounders” – i.e. businesses with compounded earnings growth for many years to come. The hardest part of owning them is that everyone likes them, and valuations tend to swell to abnormally high levels. Therefore, the hardest part of owning a compounder is to not sell it, even when it trades at a premium to underlying value.
My lesson here was in selling shares of Ferrari when it was spun out of Fiat Chrysler in early 2016. Ferrari was arguably one of the most valuable brands on the planet – despite the company not having paid a single cent for advertising in its 80-year history. And in 2016 it was paired with a great manager, Sergio Marchionne, who was hell-bent on unlocking the brand’s full potential. The stock market predicted a rosy future for the company, valuing it at a high multiple of earnings. What ultimately happened was better than even the rosiest of predictions – the stock has risen 6-fold since my sale, with earnings growing at a high compounded annual rate. The opportunity cost of that sale will likely be huge by the time I am older.
Buying back a compounder at a higher price is very hard behaviouraly. That’s why if I somehow end up with one in the portfolio, the best thing I can do is nothing.
Marketing to Senior Citizens
I was deeply interested in this podcast. Senior citizens (aged 65+) control around 75% of wealth (at least in the US). It makes sense too. People are growing older and staying healthier in general. This means they are likely to work longer while not passing down wealth to their heirs.
What it also means is that they are probably the most powerful consumer group. The podcast talks about how CPG companies should market to senior citizens and create products for the needs of this demographic.
There’s a second point I thought of. Brands tend to date and stay relevant for a limited time - absent consistent marketing investment to refresh them. Every company faces a choice as to how to spend marketing dollars. They could choose to refresh existing brands, devoting resources to connecting to a new wave of consumers. I notice some old German food brands in store trying to capture a younger wave of consumers by talking widely about their carbon footprint improvements and sustainability efforts on social media – instead of channeling dollars towards TV ads which would more likely keep their older consumers engaged.
The other choice would be to say that your company’s brands are no longer relevant, and it would be a waste of money to get your brands to tap into the current zeitgeist. In this way, perhaps a company like Kraft Heinz would not try and invest dollars behind putting legacy ketchup in the hands of Instagram influencers (I don’t know, maybe they tried this) but instead take the profits from ketchup sales to older consumers and use proceeds to buy new food brands that appeal to the current millennial zeitgeist.
Most CPG companies in fact do both – no decision is binary. And in fact, my Kraft Heinz example above is not entirely accurate because Kraft Heinz probably still spends a small amount of resources appealing to younger consumers. But the podcast illustrated to me that it might be a mistake to try and continually refresh brands to appeal to younger audiences when the older audience continues to make up the greatest share of consumer wealth. If this is the case, some companies would probably benefit more from ageing their old brands along with the older consumers to increase ROI on marketing.
Nike’s DTC Success
This article basically says it all. I’m always impressed when large brands embrace a new channel and use scarce resources to invest in ideas that may not be profitable for a long period of time. Nike has gotten way out ahead of competitors with great resource allocation decisions made by far-sighted management.