Below are some ideas I’ve been noodling on, but that are too short for a blog post of their own. So, I’m stringing them together here.
First, “footnotes to Phelps.”
You may have heard of Alfred North Whitehead’s famous quote:
“The safest general characterization of the European philosophical tradition is that it consists of a series of footnotes to Plato.”
Recently, I gave a talk to my investors which I titled “Footnotes to Phelps.” Phelps being Thomas Phelps, author of 100 to 1 in the Stock Market. As new studies of big winners keep coming out, it seems to me they all echo Phelps as philosophy echoes Plato.
I was thinking of this when I read a short book titled The Intelligent Quality Investor: How To Invest In The World’s Best Companies by @long_equity, which I enjoyed. (And when I say short, I mean short: 58 pages of text. You can read it in one sitting).
The book looks at the best performers over the last 40 years. The twist here is that the author adds the concept of “linearity.”
Basically, the closer the long-term stock chart looks like a straight line up, and to the right, the better.
So, here are two charts - the top is United States Steel and the bottom is Constellation Software (which I own in the fund):
The bottom is a good example of linearity; the top is not. As the author notes, companies with highly linear stock charts tend to be companies that are consistently profitable, reinvest their profits and are not overly impacted by economic downturns.
From here, the study sort of reverse-engineers what produces charts like Constellation’s. I won’t give it all away, but one key component is to convert a high percentage of earnings into free cash flow per share. I like how the author says it:
“Therefore, all businesses, regardless of their sector and the products and services they sell, should be judged as being in the free cash flow generating business.”
Reminds me of Heico (which I own), whose management team seems to repeat all the time how they are looking to generate free cash flow. But converting earnings to free cash flow per share is not enough to climb the peak of big multi-baggers. You need to create value by earning a high return on capital. These companies tend to outperform companies with lower returns.
The author tells us:
“The MSCI World Quality Index consists of companies that have high returns on capital… Over the last 25 years, there has not been a single 10 year period when the quality index did not beat its benchmark [the MSCI World Index].”
(Now, you might protest that 25 years is not long enough. After all, the last 25 years may have been great for this particular style for various macro reasons. I think the logic does not change and there is other research that supports the same conclusion. I wouldn’t get hung up on this point).
So now we are getting closer to finding more Constellations, but we still have to add one special ingredient – which is the ability to allocate capital and continue to earn high returns on capital. That’s heaven. As the author puts it:
“How future-proof a company’s growth is, is best supported by evidence that the company can allocate capital efficiently, add value to its supply chain and shield itself from competition.”
And that is the subject for the rest of the book. As I said, I enjoyed the book and I recommend it. The author also includes a list of “quality companies worth analyzing,” which gives you a good place to fish. (90% of my portfolio makes his list!) And for $11.99 at Amazon, it’s all well worth it.
As I mentioned, there have been a number of similar studies since Thomas Phelps wrote his book 100 to 1 in the Stock Market back in 1971. What’s remarkable is how well what Phelps found still holds up today. All these studies – including, of course, my own in 100 Baggers – are, in a sense, footnotes to Phelps. He said it all first. He had all this figured out – high returns on capital, growth, etc. long ago. We’re all playing variations on his tune.
But that’s the nice thing about investing wisdom. It is timeless.
How To Assess Corporate Culture
Investors talk about corporate culture, but what does that mean? What’s a good corporate culture?
I’d say culture is hard to define and assess, but includes areas such as how a business deals with employees, customers and suppliers. And how a business pays and incentivizes its executives. Those are some things I think of when I think about culture. And some of these are easier to assess than others.
For example, let’s consider employees. Sometimes you get clues in the 10-K.
Brown & Brown, which I own in the Woodlock House fund, has a whole section in their 10-K titled “Culture.” In that section, they share the following:
“Over 20% of our Company is owned by teammates, which we believe cultivates a unique ownership culture. We strive to provide multiple opportunities for teammates to share in the ownership of Brown & Brown and to help create personal wealth, including through our employee stock purchase program, our 401(k) plan, and long-term equity grants. With more than 60% of our teammates owning stock in our Company, we operate with an ownership mindset that influences how we invest in our business and the work we do for our customers.”
Well, that’s what we want isn’t it? We want an ownership culture. You see something like this, it is probably an indication of a good culture. It’s not the only thing, but it is something. Perhaps this contributes to Brown and Brown’s industry-leading free cash flow conversion rate, and the long-term market-beating performance of the stock.
Good cultures also tend to have low turnover among employees as compared to peers. Sometimes companies will comment on turnover in their 10-K. Old Dominion Freight Lines (another holding of mine) says this in their 10-K:
“The 10-year average turnover rate for our driver graduates is approximately 6.9%, which is below our 10-year average turnover rate for our Company-wide drivers of approximately 9.8%.”
Old Dominion invests in their employees by providing a training program. Drivers that complete that program tend to stick around more than others. That 9.8% turnover rate is low for trucking anyway. Again, another indication of a good culture at work.
In addition to employees, how businesses deal with their customers can give you clues. There is where expert networks, such as In Practise, Tegus and others, can help. Sometimes you get gems, like this one from an Old Dominion customer, published by Tegus:
“When I'm sitting around talking to 10 people about XPO, no one has anything good to say about XPO. That's from a service standpoint. It's not there.
Old Dominion really has a customer service, customer satisfaction model throughout their company. And I include the drivers in that, I include the dispatches in that all the way up to the CEO of the company. They really care about things.
When I have a problem with Old Dominion, I can pick up the phone and I can immediately get a manager on the phone at almost any place in the country, and they will do everything they possibly can to solve my problem right then. So if I call Saia, I'm lucky if I get anybody, but one of the regional dispatchers to talk to me. And usually, their answer is there's nothing I can do about it.”
Now, this is just one person’s opinion. But if you start to get a string of similar comments from different people, you may be on to something.
You’ll also start to find that good cultures tend to go along with winning firms. Old Dominion is taking market share at a rate of about 1% per year and has industry-leading metrics in all the important categories (on-time delivery, claims, etc.). It also has industry-leading ROICs by a wide margin.
So while culture is difficult to define and assess as an outsider, it seems to be an important aspect of a winning business.
The Investable Universe Shrinks
Anytime I have two separate conversations with two different people who bring up the same idea, I pay attention. In this case, both brought up the idea that the more they learn and study about businesses, the more they find their investment universe shrinking.
It seems counterintuitive at first. If you spend a lot of time studying businesses all over the world, you would think your circle of competence would widen over time and you would find more ideas, not fewer ideas.
However, it doesn’t work that way in my experience. Over time, you get pickier. Your checklist grows longer. And so naturally the list of companies that hit all those boxes starts to get shorter.
I always marvel at these funds who say they have investable universes of hundreds of names. My goodness, I have a hard time finding ten names I love. I exaggerate, but not much. I have ten stocks in my portfolio now and I’d be hard pressed to name ten more that I’d love to own at the right price.
So, I was glad to hear from a couple of other like-minded investors – within a week of each other – that they were experiencing the same thing. And they wondered aloud whether it was a good thing or not.
It all depends on your style. Pickiness is good for the long haul investor. If you buy something you are not all that enthusiastic about, you are unlikely to hold it for long. You’ll be too quick to chase the next shiny spinner that dances across your view. Worse, you will probably sell what you have at a bad time. And that new shiny spinner might have a nasty hook.
What's your experience been? Are you getting pickier?
I liked Buffett’s letter. It was his shortest. But by the time you get in your nineties, I guess you don’t mess around. Anyway, the main point I took away from Buffett’s letter was that a small number of good decisions over a lifetime of investing go a long way.
He pointed to Coca-Cola as one example. He paid $1.3 billion altogether for Coke by 1994 and today that stake is worth $25 billion and pays $704 million in dividends. Coke is about a 5% weighting in Berkshire’s net worth.
You might say he should’ve sold Coke when the price got nuts in 1998. It took more than 15 years for Coke to get back to that price. And while Coke was a great business for a long time, whether it’s still a great business today is debatable.
Nonetheless, Buffett’s main point is a good one. We will all make mistakes as investors. Buffett reminds us that he made lots of mistakes. And yet… As Buffett wrote, “The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders.”
Of course, as Phelps would remind us, you don’t get to see the flowers if you keep pulling them before they bloom.
Thank you for reading!
Published on March 3, 2023
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