Tom Russo of Gardner, Russo & Gardner delivered an insightful speech at the 2011 Value Investor Conference in Omaha. While thinking about Amazon.com and its heavy reinvestment in the company's expense infrastructure, I revisited portions of the presentation. I'll draw heavily from it below. (You can access the full speech in pdf format here.)
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It's Hard to Make a Dollar Bill Grow...You Need the Capacity to Suffer
It's hard to make that dollar bill grow, that's the problem. And in public companies typically it's the case that managements are not prepared to invest as fully as they could in pursuit of the growth of the dollar bill...So what I've looked for are businesses that for one reason or another are willing to invest hard behind their growth. And what that means is they have the capacity to suffer.
When you invest money to extend a business into new geographies or adjacent brands or into other areas, you typically don't get an early return on this. And this is a very important lesson.
Most public company managers worry about...[what]...they may encounter...if they invest heavily behind a new project, they may show numbers that are unattractive and they worry about the loss of corporate control.
He [Buffett] told management at GEICO just to grow the business even though each new policy holder that was put on the books cost an enormous amount of losses the first year. They had high net present values and you've seen the history. I think the number insured at GEICO, because of Berkshire's willingness to show the losses up front, have grown from just under a million policy holders to almost ten million. And his spending to drive that growth that just burdens operating income up front has grown from $30 million a year to almost $900 million....
...But the fact is by spending up front, having the elasticity, the willingness, to burden your income statement and then getting the results in the future is a very nice trade off.
One of the examples that comes to mind...is Charles Schultz, the chairman of Starbucks, who several years back spoke to investors, and there was one nettlesome young analyst who kept asking the head of Starbucks when they would show profits in China.
And the dialog went back and forth: When will you show profits? He said, how big do you want us to be? When will you show profits? How big do you want us to be? And it went back and forth like this.
And the answer was - and I think it's the true one - if you want us to dominate China, then let us not show profits for a long time. And if you permit that, we will end up at the final analysis with a dominant position in an important market with moat-like characteristics. If you try to establish, as so many American companies did, a base in China and do it without impacting earnings, you'll do it with a very small business that won't have a competitive franchise.
And that trade off is just as clear an expression of this notion of the capacity to suffer. Now Schultz isn't going to lose Starbucks because he has enough stock to keep it on the course that he chooses. But there are many companies that don't have that control. Most don't. And so they favor short-term results versus the long term.
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Capacity to suffer. I like that. To Russo's point, there is a common thread that unites his GEICO and Starbucks examples, a thread which can extend to our evaluation of Amazon. That is, an ownership structure that keeps investors at bay because someone (or some entity) has enough control to keep to a strategic path that offers long-term benefit despite short-term suffering...trading the opportunity to build a franchise for less profit (or losses) today.
With somewhere around 20 percent of Amazon shares under his control, CEO Jeff Bezos remains firmly in control of business strategy and is willing to forego instant gratification as he builds a franchise for the long haul. He is hailed as a genius when revenues grow but panned by the financial media when there are signs of slowing down. All the while, the dude abides. He stays the course of his longer term vision for the franchise.
It would be easy enough to straddle the fence between investing for the future and satisfying the call for ever improving profits. It's called earnings management. Most managers of guilty of it to varying degrees.
Though I've never sat anywhere near the catbird's seat in a publicly traded company, I can imagine the temptation to do this is profound...that there's always a nagging itch from employees with options, shareholders, your own net worth measurements to make a little compromise here, hold back on some needed investment there...to feed the earnings machine, pacify Wall Street, and prop up the stock price. Just scratch the itch a little bit. It will feel so much better.
But once you scratch it, does the itch actually ever go away? Doubtful. You end up getting caught up in the endless game of analyst expectations. By bowing to it, you become complicit, and it's hard to tap out.
I expect plenty of managers have a strong sense of where they can invest their dollars to fortify their competitive advantages, expand their moats, and grow their franchise. But they are too invested in the earnings management game to take the short-term hit that's likely to follow. Or they know it could threaten their tenuous hold over strategic control. Or they suspect they would lose their job if Wall Street says results are in decline. Even if they had the intestinal fortitude to suffer through the tempest, their job could be pulled from them before they had the chance to show that ability.
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