A Capacity to Suffer and Setting the Right Expectations

by Scuttlebutt Investor


If you owned a business all by yourself, you wouldn’t care at all about maximizing reported numbers.
— Tom Russo

Who the heck would want to watch movies on the Internet?

The year is 2012 and Netflix (NFLX) is coming off a banner year where it reported record operating income and EPS ($376mm and $4.28 respectively) on the back of a declining yet still healthy DVD by mail business.  The previous few years had seen Netflix deal a death blow to its primary competitor -Blockbuster Video. With healthy profits and competition out of the picture, what better than milk the business for its cash flow and ride out the wave of juicy profits for several years to come.      

This is a move that shareholders might have applauded at the time but it is precisely what Reed Hastings (CEO of Netflix) didn't do.  Just one year later (2012), operating income declined to ~$50mm and EPS took a nosedive to $0.31.  The driver?  A significant, several hundred-million-dollar investment in content to support the newer streaming business.  Rather than milk the profits of the DVD business, Hastings decided to pour everything and then some into the future- the streaming video business.  Yes, sure - the success of Netflix is very obvious with the benefit of hindsight some 7 years later but at the time it wasn't so obvious to the Street and investors.  As a result, the stock got punished.  It went from a high of $40 in July 2011 to languish in the $10 to $15 range from late 2011 through the end of 2012. 

I tell this tale about Netflix not because I am practicing my Harvard Business School case writing skills but because this decision by Hastings to reinvest for the future gets at the crux of the "capacity to suffer". Let’s delve a bit deeper.

Source: Data sourced from Netflix public filings

Consistency is wonderful unless it masks an intolerance for "pain" or complacency

A straight line that is "up and to the right" is a beautiful sight when it comes to a graph of a company's revenue, earnings, free cash flow or any other financial metric that matters.  I get excited when I see that a company has performed so well that everything looks so perfect.  More often than not, that excitement is quickly tempered by a dose of skepticism.  How is it that Company X has managed to grow its earnings and cash flow so consistently over that many years?  What has the management team forsaken in the pursuit of that perfectly consistent growth and line graph?  

As an investor - yes - I generally like consistency and predictability in the businesses that I buy an ownership stake in, but I don't like when that consistency and predictability is artificially manufactured.  I don't like when management teams dial back marketing investment or any other important investment because they want to hit an arbitrary 10% earnings growth target that they committed to a year prior.  In other words, I don't want earnings consistency at the expense of activities that widen the moat.  I'm ok if earnings take a hit because the company wants to make an investment that has the potential to bear fruit later.  This is more or less the core idea behind the "capacity to suffer" or the "capacity to reinvest" -  It's an idea that's been popularized by value investor Tom Russo over the years and one that I’ve become quite enamored with after hearing him speak about it on a few occasions like below.

As exemplified by the Netflix example, the crux of the "capacity to suffer" is that great companies and their managers need an ability to suffer through years of "pain" where they under-report their earnings so that they can invest and build for the future. Why "suffering" though- well Wall Street participants (analysts, media, etc.) and more recently, certain activist investors will vocally and publicly lambaste management teams that aren’t growing their earnings or cash flow fast enough or that take short term hits to their earnings in pursuit of longer term goals or a vision. These managers sometimes have to put their jobs on the line to do what is right for the long-term health of the business at the expense of a glowing earnings report that shows healthy increases in profits. Usually, the stock price also suffers as a result as sell side analysts write up SELL recommendations admonishing companies that don’t deliver expected increases in profits or metrics quickly enough.  We saw this play out with Netflix in 2012.  

As a long term investor playing the “long game”, managers that have an ability to turn their backs to the conventional Wall Street “wisdom” and grow long-term earnings power is precisely what I want. In reality- this is what all rational investors should want but objectives and incentives aren’t always perfectly aligned. I don’t want a manager that’s manipulating the numbers by pulling up expenses, pushing out contracts or buying back shares when the price is too high just to hit a arbitrary EPS number.  But in reality- this happens all the time. I’ve witnessed this absurd, self-inflicted pressure to smooth out earnings first hand over many years in main street corporate America. I’d rather companies put that effort into improving the fundamentals of the business and widening the moat. This means that earnings won’t always be smooth and sometimes they will be lumpy and that’s ok.  

Great companies and their leaders do this from time to time- they don't hesitate to report a down quarter or year because they increased marketing investments or product investments for the long term health and viability of the business. And many a time, the stock price takes a beating as they report an earnings miss or signal a desire to invest. These leaders are willing to turn their back to Wall Street and do what is right for the longevity of the company.  I like this type of leader that has the backbone to suffer through everything that’s thrown upon them including a stock price that gets hammered.  I respect a leader like this that is willing to forsake the short term in the interest of the long term and it's the type of leader that I want running a company that I own.  
 

Sufferers versus the Expectation Managers

There is another class of leaders that are yet one notch above those with a capacity to suffer - and these are the leaders that set the right expectations. And by expectations, I'm not talking about setting quarterly earnings guidance. On the contrary, I’m referring to setting expectations for the long term.

A leader that sets the right expectations for the long term clearly lets shareholders and other partners know their goals and objectives upfront. They often clearly let shareholders know that they aren’t singularly focused on hitting an EPS number in the quarter. They often let shareholders know that they are long term oriented and their actions and investments will reflect this orientation.  By setting the right expectations upfront, they are trying to avoid future suffering.  By setting these expectations upfront, they are warning future speculators that are willing to sell at even a whiff of supposed underperformance to stay away.  Unfortunately even these managers and leaders that set the right expectations upfront still need a capacity to suffer.  Sometimes their share prices still take a pounding and they are criticized by the Wall Street elites.  Over time, however, the hope is that they are able to establish a reputation that enables them to ignore the short termism pervasive on Wall Street. 

In our experience, quarterly earnings guidance often leads to an unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability.

-Short-Termism is Harming the Economy by Warren Buffett and Jamie Dimon

 

I’ll touch on what I believe is a crucial point here. And that is a key competitive advantage that setting the right long term expectations provides to companies. Companies that set appropriate long term expectations (not quarterly earnings guidance) are provided with a certain freedom to operate that they can invest in the initiatives that make the most sense for the long term health of the business even if they might not pay out immediately and even if this puts a dent in earnings. This freedom gives them a leg up on competition that has promised to deliver a certain EPS number or profit to the street. That competitor doesn’t often have that same freedom to forsake their quarterly earnings and make investments in the business. 

Here's the thing though- setting expectations of a long term outlook and predisposition the first time inherently requires suffering.  The stock takes a beating as a long term outlook is perceived as synonymous with earnings declines.  And often this suffering continues for some time as that freedom to operate is not easily doled out by Wall Street.  Sometimes it takes years upon years until Wall Street backs off as the management shows signs of progress.  Sometimes Wall Street doesn't back off or progress is too slow for them and management is shown the door as the pressure for a spineless Board becomes too much.  In addition to Netflix - a few other examples that come to mind:


Amazon (AMZN)
It feels a bit like cheating to use the example of Amazon as it used too often either because it is a good example of long-term thinking or because there are too few good examples. From Day 1, Bezos has made it very clear that he is going to be focused on the long term and not be handcuffed by a quarterly earnings numbers. Read his 1997 annual letter here that clearly lays out this long term ambition and it reads like it was written yesterday. This ability to set clear expectations to investors upfront has enabled Amazon to invest massive sums over the years into building out its online retail business and also adjacent businesses even though these initiatives didn’t have an immediate pay off. Now imagine one of Amazon’s primary competitors like Walmart. When Walmart's earnings miss by a few cents or it's e-commerce growth doesn't live up to expectations, the stock price gets punished as happened several months ago. Why- Walmart provided earnings estimates to the street and the street is holding Walmart to these.  They are handcuffed to a certain target that they have inflicted upon themselves, limiting their freedom to act in the interest of the long term.  The reality is that Bezos, despite establishing this very clear vision, philosophy and expectations upfront, has had to maintain the temperament and capacity to suffer as his stock price has taken a roller coaster ride over the past ~20 years.  In the early years, criticism of Bezos and his approach was quite common and it is only in the recent 5-7 years that his business genius has been recognized and praised.  

Target (TGT)
Keeping on the example of retail, Target is an interesting case.  In 2014, Brian Cornell took over as CEO of Target and announced that he would make changes to the business to pivot it back towards growth - including making new investments to cater to consumer needs and wants.  This included new format, smaller stores and also bringing back the fashionable yet affordable clothing and housewares that made Target, Target.  And the stock price rallied a bit over the coming two years.  But in early 2017, when Cornell announced that they would invest significantly to modernize stores and build out their merchandise assortment the stock took a nosedive falling from the $70's to the $50's over a few months as the Company suffered through lower revenue and margins.

We will accelerate our investments in a smart network of physical and digital assets as well as our exclusive and differentiated assortment, including the launch of more than 12 new brands, representing more than $10 billion of our sales, over the next two years. In addition, we will invest in lower gross margins to ensure we are clearly and competitively priced every day. While the transition to this new model will present headwinds to our sales and profit performance in the short term, we are confident that these changes will best-position Target for continued success over the long term.
— Target Fourth Quarter 2016 Earnings Release (2/28/17)

Since then, Target has renovated hundreds of stores and built billion dollar revenue brands like Cat and Jack from scratch and the results have been quite strong with strong comp sales and traffic trends as of late.  And it totally makes sense - in world where retail competition is fierce and you're competing against the 800 pound gorilla that is Amazon, you have to adapt, lean into how you can differentiate yourself and this requires investment, investment that impacts earnings.  Have you been in a remodeled Target lately?  It's a wonderful shopping experience.  They also invested to create some smaller format stores and also improve the e-commerce experience.  All of these moves make complete sense especially to anyone that recognizes the threat that Amazon poses to Target.  Yet the stock got punished because Cornell wanted to do the right thing and invest for the long term.  Short-termism at its best.  I think investor sentiment has since turned the corner as the stock price has began an uptrend.  No doubt that Amazon still poses a major threat to Target but they continue to be better positioned to compete.  

Alphabet (GOOG)
Alphabet/Google and suffering probably haven't been mentioned in the same sentence very often.  After all, Google's online search business is the goose that lays golden eggs and funds everything from free lunch to self-driving cars.  But as of late, Google management has adopted a capacity to suffer and has had to set the right expectations.  In a world where search funds everything, you'll defend it tooth and nail against any existential threats like changes in consumer behavior with search.  This includes consumer transition towards searching on mobile devices and also increasing usage of home assistants like Amazon Echo.  As a result, Google has suffered through many recent quarters where it has intentionally contracted its margins to pay high traffic acquisition costs to ensure that for example, Google is the preferred and default search engine on Apple iPhone devices or subsidize its new hardware devices like Google Home to ensure that its strong position in search isn't diminished as consumers adopt new modalities.  In the case, of Google though, the suffering has been modest and contained as aggregate profits continue to grow at a healthy clip even as they invest.  In fact, management has been very clear to set expectations recently that they aren't focused on margin expansion, but rather absolute profit growth.  This has probably tempered stock gains over the last year as Google has underperformed many of its tech peers over the last year but this "suffering" and investment clearly make sense from a long term perspective.  

The Philadelphia 76ers
Not exactly a public company example but an example that is near and dear to my heart as a Philadelphian born and raised.  For several years, Sam Hinkie ran the Sixers as General Manager and followed what has been termed "The Process".  The premise goes like this - the Sixers needed to be really bad for several years in the short term so they could get better/higher picks in the NBA draft and eventually land a few great players that would enable them to win a championship in the long term.  So Hinkie traded away any good players for draft picks and let the Sixers basically tank -play with a bare bones team that went on to lose 72 out of 82 games in the 2015-2016 season. Hinkie was forced out/resigned late in that season.  That summer, Philly got the first overall pick in the draft and selected Ben Simmons, who has worked out really well so far.  Two years have passed since then and Philly recorded 50+ wins and got to the second round of the playoffs in the 2017-2018 NBA season. 

Was Hinkie's "process" the right one?  Hard to say for sure- a lot of teams that were mediocre to pretty bad back in 2013 are a lot better now - the Raptors and Blazers come to mind.  It's possible that another strategy could have been just as successful or more successful but there's no doubt that the moves that Hinkie made have worked out well for the Sixers and put them in a position to go deep into the playoffs into the coming year.  Hinkie set clear expectations of his long term strategy very early on in his tenure and demonstrated a definite capacity to suffer - in the case of sports, a willingness to be really bad for a period of time to enable the team to be great in the long term.  Unfortunately- like Wall Street, many fans and the NBA lacked this temperament, which ultimately led to Hinkie's ouster.  The pressure was too great from the NBA as Hinkie's process shed light on a glaring flaw in the NBA draft system.  The last thing they wanted other teams to do was tank.  The other issue was that fans didn't have a capacity to suffer - despite the years of suffering that they had inevitably experienced as a Philly sports fan.  Sports fans want their teams to be good and when they aren't good, they want to know that they've tried (Side note: Hinkie wrote this interesting letter when he "resigned” from the Sixers).

 

Suffer On

I evaluate many things when I assess a potential investment and the quality of management is high up on that list.  An ability to think long term, set long term goals/expectations and a capacity and a willingness to suffer (or reinvest) to meet those long term goals are an important assessment of management quality.  In some cases, an ability to set and manage long term expectations alleviates a need to suffer, although more often than not, suffering is inevitable until a company can establish a certain reputation with Wall Street or management is vindicated for its suffering.  Some of the same people who are now lauded as the business geniuses of our time (Bezos, Hastings) have had to suffer through long periods where their actions were held up as bad judgment or poor allocation of capital only to be vindicated later on.  So I say to the managers of companies where I have some ownership- Suffer on!


En route to Omaha

by Scuttlebutt Investor


Like Muslims go to Mecca and Jews go to Jerusalem, those of us of the value investing faith also have a pilgrimage to make. We go to Omaha to pay our respects to the Oracle at the Berkshire Hathaway Annual Meeting. This year is my first year paying homage. It’s been nearly 10 years in the making but like a good religion, my faith has only strengthened over that time. And our spiritual leaders (gods to some) - Charlie Munger and Warren Buffet aren’t getting any younger. Figured it was time to make the trek.

See’s candy store right next to my departure gate for Omaha. Coincidence?  I think not. 

I'm excited to meet people who are fellow devotees (met a few wonderful people on the plane in fact) and also hear the gospel straight from the horse's mouth.  I'm also excited to hear more about:

Apple: Buffett recently announced that he bought another 75 million shares of Apple.  That would make it one of the largest positions in his portfolio at nearly ~250 million shares and a market value of ~$30 billion. He's told us before what he likes about the business - it's the ecosystem and the natural replacement cycle as a result of the low likelihood that someone is going to switch to a competitor.  But would love to hear more about what continues to tickle his fancy about Apple (when he owns a Samsung flip phone!)

Health Care: Earlier in the year, Buffett announced a joint venture of sorts with Jamie Dimon and Jeff Bezos and their respective companies at fundamentally rethinking healthcare to potentially buck the cost curve and bring down medical care costs.  Todd Combs was heading up the initiative and search for a CEO.  I'm interested to hear about the progress on tackling one of the biggest problems facing our nation and the world at large.  

The Bet: Ten years ago, Buffett made a bet with hedge fund manager Ted Seides that the S&P 500 could beat any basket of funds managed by the "smart" money picked by Ted. The S&P blew the pants off all of the funds picked when the bet wrapped up at the end of 2017 even though the S&P only produced an annualized return of 8.5% over that time. He spoke to it at length in his annual letter but I'm sure it will come up in the meeting.

Loading up the Elephant Gun:  As of the year end 2017, Buffett has ~$116 billion of cash on the balance sheet so the question arises - what does he want to buy next?  General equity prices are high so maybe he's waiting out the market for a more "sensible purchase price".  The recent annual letter did express an interest in acquiring more real estate brokerage businesses in what is a very fragmented industry.  Although Berkshire Hathaway HomeServices is the second largest real estate brokerage operation in the country, it only did 3% of business last year. In the annual letter Buffett said, " Given sensible prices, we will keep adding brokers in this most fundamental of businesses."  But brokerage operations will hardly dent $116 billion so excited to read between the lines for any other clues on acquisitions.  

Also, for those of you making the same trek or just maybe streaming from afar, I thought I would share some of the things I’ve been reading and perusing over the last few weeks as I prepared for this journey.  See below.  For those that can't make the pilgrimage to Omaha - the Annual Meeting will be live streamed on Yahoo Finance as it has been the last two years and will also be available as a podcast, a few days after the meeting. The podcast was a godsend for me as I could listen to it in chunks on my drive to work.  On the other hand - if you plan to be in Omaha in the flesh- give me a holler!

 

My Hit List to Prepare for the Pilgrimage to Omaha  

The Snowball: Warren Buffett and the Business of Life

Buffett: The Making of An American Capitalist

HBO documentary called "Becoming Warren Buffett" which also seems to be on YouTube

Podcast of last year's meeting chunked out into 10 wonderful episodes (thank god)

Posts I wrote about last years meeting: A New Appreciation for Tech and Luv for the Airlines

All the past annual letters

An anthology of past annual letters

And of course- this year’s annual letter


Brand as a Durable? Competitive Advantage

by Scuttlebutt Investor


Last week, I was invited to lunch with members of the value investing club organized by Googlers internally in Mountain View. I had a fun time with an incredibly smart group talking about moats, competitive advantages and the durability of brand as a competitive advantage.  The latter being one of my favorite topics.  It was a good discussion and there were lots of great questions that made me think about a few things in some different ways.  We also dug into National Beverage Corporation (FIZZ) as a case study on brand.  You may not have heard of the company but you might know its #1 product (see presentation below).

Thought it would be worth sharing my presentation here for all interested.  Click the button below to download it.  Note that I made some tweaks to the original presentation, mainly to add in notes where I voiced over things.  

  


The Coffee-Can Portfolio

by Scuttlebutt Investor


I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches - representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.
— Warren Buffett

(Download an easily readable pdf of this post here)

 

What if I told you to buy the shares of five companies but you can't sell those shares for 10 years?

You have to hold on to those shares through thick and thin until 2028.  That's a heck of a long time for a lot of things to happen.  Under those circumstances, what five companies would you pick?  Easier said than done.  Ideally it is companies that can stand the test of time and meaningfully grow their earnings and value over time thus maximizing your return.  This idea of making investments and not touching them for a long time to let the magic of compounding do its work is the core idea of the "Coffee-Can Portfolio". 

 

Background

I recently finished reading 100 Baggers by Chris Mayer- a decent and easy read (even for the novice) that can probably be polished off in a couple days.  Thanks to AMM Dividend Letter for recommending it.  Unfortunately the book is not in print anymore so you'll have to pick up a used copy.  Mine looked like it was stolen from the local public library.  Fortunately the "This is no longer the property of the King County Library System" stamped inside alleviated my guilt.  To sum it up though - the book goes back into history (to 1962) to study stocks that have returned at least 100x to analyze what they have in common and to better enable the identification of these types of stocks in today's market.  It builds on the work of a previous writer (Thomas Phelps) who wrote "100 to 1 in the Stock Market" - a book that fortunately is still in print after a long hiatus.  The core principle to making 100x or more on your investment is identifying companies that have a long growth runway and holding on through thick and thin.  In other words, "Buy right and hold on".  This latter part of "holding on" is where most investors fall flat.  Most investors sell far too early to reap the full gains that they would otherwise make.  

There is one part of the book that I've become quite intrigued by and enamored with.  It is called the "Coffee-Can Portfolio" and it is referred to as a crutch that can help with the "holding on" part that most investors (including myself at times) are quite terrible at.  The notion of the "Coffee-Can Portfolio" was originally introduced in the 1980s's in a paper by Robert Kirby (a portfolio manager at the Capital Group). The idea is a reference to the Old West when people would put all of their valuable possessions in a coffee can under the mattress and not really touch them for a long time.  If you translate this same idea to stocks - you basically find the best stocks you can and let them sit and marinate for a long time - Mayer proposes 10 years.  This isn't all that different than the punchcard idea proposed by Buffett that I quoted at the top of this post - I know most are familiar with this quote.  The genius lies in its simplicity at protecting us from our own vices that include impatience, boredom, groupthink, herd behavior and short-termism.  These behaviors result in our selling great companies too early or just buying a smattering of things rather than making a significant investment in our highest conviction ideas.  The reality is that great investments often take a long time to play out and compound into multi-baggers, but you have to hold on for this to happen.        

While I have always been a proponent of playing the long game and rarely selling, I've never quite committed to the idea in the way that the coffee-can portfolio is described.  And that's really all it is - a mental commitment to one's self.  There's no physical impediment to selling these investments at any time other than just the personal commitment to holding on that one has made upfront.  However, going in with this thinking and commitment and understanding the reasons why is still a powerful deterrent to selling too early.  

 

The Thought Process

I got quite excited by the idea of deciding which companies I would put in my coffee can.  But I simplified it even further.  As discussed above, let's say I could only pick 5 companies (versus Buffett's twenty punches) to go into the coffee can and as Mayer suggested- I couldn't touch the coffee can for 10 years or until 2028, what companies would I put in it?  A somewhat of a scary thought - 10 years is a really long time to commit to.  As Buffett articulated - you have to think really carefully about what you put in.  

The first thing I contemplated was my objective.  Investing by definition is forgoing consumption today to consume more later - in this case, 10 years later.  So the objective is to maximize return, which of course means that you can't lose money.  But pure preservation of capital and maximizing the growth of capital can sometimes be at odds with each other.  Choosing between these two objectives required me to think about the size of the overall investment in the five companies.  If the coffee can is a significant part of the my net worth, I would probably want some element of conservatism to it.  However, if I was structuring this as a small investment with some "play money", I might be more aggressive and go all in on some companies with high growth potential (that also have greater potential downside). For the purposes of this exercise I assumed that the amount is significant and I resolved on companies that have strong growth potential but somewhat limited downside. Easier said than done.

Now to the fun part - What do I buy?  My initial inclination was to buy some of the great tech companies of our generation - the FAANG stocks as they're called.  Facebook, Apple, Amazon, Netflix and Google.  Surely they are growing and performing really well.  But there's a potential problem here.  The market caps of nearly all of these companies are pretty massive.  Trees don't grow to the sky.  The law of large numbers would tell you that the upside has to be limited when companies are that big.  There are surely no 100 baggers lurking among the FAANGs.  Best case - maybe a 5 bagger - but even that feels like a stretch.  To be clear - a five bagger (highly unlikely) over 10 years ain't too shabby but there's the potential for much more to happen over 10 years with a smaller company.

My mind then turned to developing markets where there is massive growth potential - China and India for example.  China has the BATs - Baidu, Alibaba and Tencent.  But these suffer from the same challenges as the FAANGs - their large size potentially caps the upside.  But there are also many other companies in these markets with smaller market caps and strong growth potential like Ctrip.com, JD.com, MakeMyTrip or Dr. Reddy's Labs.  The problem here - these companies and their domestic consumers are not squarely within my circle of competence. I have no easy way to analyze or understand Chinese or Indian consumers so while I know that these markets are growing like mad, I don't know that much else.  

Surely, small caps are the answer then.  Generally - they benefit from having longer runways for growth with smaller market caps that can appreciate multiple times over.  The 100 Baggers book also preaches that smaller companies are preferred.  The challenge here is that it's difficult to prognosticate what companies will be duds and what companies will be studs amidst thousands of small caps.  It's easy to say - wow, if you bought Apple way back when it was on the brink of bankruptcy, you would've made so much money.  But in reality, that probably wasn't a good decision at the time - Bad decisions can lead to good outcomes and good decisions can lead to bad outcomes.  Still, it seems to make sense to at least have one small cap with a lot of promise in the mix because if it does take off, the gains on it have the potential to offset other losses many times over.

In the end, I realized that this exercise was quite hard but I settled on 5 companies (with a definite US bias).  I don't have a perfect answer for why these five might be better than some other five. The reality is that you could just as easily swap out another company in here and have a strong justification. There's no right answer. But you have to have some belief that these companies will continue to prosper over the next 10 years if you are to put them in your coffee can.  In fact - these are the general criteria I used in selecting the five companies.  

  • Long growth runway (large Total Addressable Market or TAM) or expected demand from now until Judgement Day
  • High returns on capital and ability to reinvest at high rates.  The reinvestment part is important as you don't want companies paying out earnings in dividends that trigger tax consequences and require me to find other places to invest that money 
  • Profitable or a logical path to profitability if the company is investing in its business
  • Excellent management that is adept at allocating capital. The importance of this cannot be understated. 
  • Wide moat that protects the business from competition and a management team focused on continuously widening it
  • Smaller market caps preferred.  Emphasis on the preferred here because I violate this preference here. 

 

The Coffee-Can Starting Five

Before I get to my starting five, I should include a couple caveats. 

  • While I do like these companies as long term investments, my intention with including these picks is not necessarily to make stock recommendations but rather illustrate the thought process that I went through in picking these companies for the Coffee-Can portfolio.
  • I haven't developed a detailed thesis on each of these companies here in the way that I typically do.  I've only shared my high level thoughts on investment merits. 
  • I can't opine on the valuation of these companies.  As with the market as a whole, the valuation of these companies appears to be on the high side.  Having said that, great companies with strong growth prospects often trade at premium multiples.  I can't in good conscience recommend buying indiscriminately at current prices.  On the other hand, valuations also looked high a year ago and two years ago.  There's never really a perfect time to buy and it's impossible to predict where the market will go in the short term, but we know it is up in the long term.  So whether these five or some other five companies - we can help mitigate some of this by cost averaging over some time period and buying during market corrections.  Even great companies become mis-priced from time to time.   
  • I've tried to diversify my picks among industries, overall secular trends, market cap and also geography, but five companies is still a very concentrated portfolio for the average investor as it may not provide the level of diversification sought.  Some investors may want to increase it to ten or more companies.  Whether five, ten or twenty companies, the objective remains the same - to be really thoughtful about the companies in the portfolio and then hold on to those positions over the long term. 

My five:

Amazon (AMZN): Probably not a surprise to anyone here. Amazon hits on all the criteria above, with the exception of smaller market caps. But the potential of Amazon and the immense Total Addressable Market it is going after cannot be ignored. Global retail on it's own is a massive market and this doesn't even take into account the option value of all of the other businesses that Amazon is involved in or looking to enter (AWS, delivery and logistics, banking, streaming video, the list goes on).  Furthermore, the secular shift from offline to online will continue to provide it with nice tailwinds for the foreseeable future.  Bezos is a business genius that is likely to meaningfully grow earnings power by finding places to reinvest cash flow over the years to come.  

Netflix (NFLX):  Again with the FAANGs?  Yes - Netflix is among these but it is the FAANG with the smallest market cap (at $140bn - sounds crazy that I am saying that is small) and a fairly large market opportunity.  Netflix's subscription video streaming business has global ambitions and the scale of the business should enable them to spread high fixed costs for content over an ever increasing base of subscribers, that currently sits at ~120 million globally.  Yes, the space is getting increasingly competitive as media companies aren't sitting still.  HBO, Disney, Hulu, Amazon, Apple and others want to stake their claim in the space as well with competing streaming services.  But Netflix's focus and capacity to invest up to $8bn on high quality content in 2018 should continue to solidify its position as the primary streaming service for consumers.  Furthermore, CEO Reed Hastings has been way ahead of everyone in the media industry in understanding where the market was going.

Boeing (BA): Boeing has had a massive run up over the last ~2 years.  But can you think of any other company in the world that has the next 7 years of revenue already in the bag? Probably just Airbus (Boeing's main competitor).  Boeing has a backlog of nearly 6,000 planes which amounts to 7 years of production.  And Boeing benefits from an incredibly wide moat with high barriers to entry. It's fairly difficult and technically complex to make large passenger jets.  There's really only one other company (Airbus) in the world that does it.  China will eventually become a competitor with the Comac C919 but it will be a few years until the first one goes into service and several more years until it has any type of foothold in the market.  Even then, they will only be able to compete for some of the short haul business (smaller planes for shorter distances) and it may be a long time before customers outside of China sign up to order.  A multi billion dollar services business maintaining planes for airlines that the company is building out provides option value.

C-Trip.com (CTRP):  C-Trip is an online travel agency (OTA) and is the equivalent of an Expedia or Priceline for China. C-Trip’s travel portals enable Chinese consumers to book all things travel related like accommodations and flights. C-Trip has a large share (~35%) of a fast growing market. China is the largest source of tourists in the world with 4.5 billion trips taken in 2017- nearly three times as big as the US- and growing at a faster pace. Rising wealth in China shouldncontinue to benefit travel demand and drive C-Trip’s business over the long term.

Coupa Software (COUP): This is a wildcard pick of a relatively smaller company (<$3bn market cap) that benefits from a large addressable market - helping companies manage their spend.  Anyone that reads this blog knows my fondness for software, especially enterprise software (as articulated in my post on CDK).  Enterprise software is wonderful for a couple reasons: 1) it is sticky i.e. it benefits from high switching costs.  Once a company adopts a new software platform, it is reluctant to switch lest it retrain its workers and incur the organizational cost and pain of making a switch; 2) it typically provides a nice recurring revenue stream, especially Software as a Service models; 3) it benefits from high operating leverage as most software costs are fixed so every marginal customer is very high margin as the business scales.  Coupa provides procurement and spend management software to enterprises.  The Company is on a path to profitability as it consistently grows its customer base and spend under management.  Furthermore, the value proposition is compelling for its customers as it helps them save money.  

In ultimately landing on these five, I filtered though a much larger list of companies and there were several that were very close to making the cut.  In the end though, I committed to choosing only five.  Some of the runners up that also fit most of my coffee-can criteria are: Tencent (TCEHY), Shopify (SHOP), Workday (WDAY), Constellation Software (CSU), Alibaba (BABA) Intuitive Surgical (ISRG), JD.com (JD) and MercadoLibre (MELI).

As I stated previously, I don't have a perfect answer for selecting the five I did over a much broader set.  Rather, I just wanted to illustrate the thought process and the value that the coffee-can approach can provide in protecting us from our own worst behaviors (impatience, boredom) when it comes to investing.  

What are the five companies that you would put into your coffee can for ten years?  I know- there's a lot of thought that needs to go into it, but perhaps you've already thought about it or maybe you just have one or two companies you would put in.  If you're up for it - I created a little survey and would love to report back what I hear in a follow-up post.  While I'm sure there will be a lot of the expected,  the more interesting feedback will be some of the companies that are lesser known and maybe even the rationale.  Very brief Google survey here.