The Capacity to Suffer
10 minute read here.
We’re trying to keep most stuff short since I know you’re doom-scrolling TikTok and emails like this one on the toilet. No, no, look, it’s fine. I’ve no illusion you’re sitting by the fireplace, bathrobe on, pipe in hand, deep in reflection. I read the Wall Street Journal in the bathroom, too.
You guys are increasingly coming from diverse backgrounds. Despite that, I think this one will be fun for the whole family.
Our title is an idea I shamelessly stole from Thomas Russo, one of the founders of Gardner Russo & Quinn, which has run the $10 billion Semper Vic fund >30 years. Long ago, I (and a couple of you!) attended a lecture he spoke at. One of the topics he discussed was how to think about managers and exceptional businesses.
He shared was what he called “the capacity to suffer”.
He meant it one way, but I think you can generalize it and that’s the insight we’ve got here today.
First: long-term reinvestment within a business
The way Russo meant it is this: the capacity to suffer is about how companies choose to reinvest internally. Do they think and make smart, long-term bets? Or do they do what’s smart short-term but doesn’t help long-term?
Short-term managers might “empire build”, for example. They know: if you acquire other businesses, the company gets bigger, and fast. They may not be buying ideal targets. They may not pay disciplined prices for those targets. They may use too much debt. That’s because buying for value and strategic logic isn’t their goal. They’re in it for themselves at the cost of the shareholder. They know: CEOs of big businesses make more money than CEOs of small businesses.
By contrast, an executive team has the capacity to suffer if they’re doing something that looks silly in the short-term — e.g., because it decreases shareholders’ profits a little and isn’t maximizing their salary next year — that improves the business in the long-term (for example by making it harder to compete against). Because many investors are short-term-oriented, the company may look silly because it’s burning some of the existing business’ profits.
Semper Vic owns shares in JPMorgan Chase & Co. (JPM), the largest US bank. Mr. Russo would tell you the executive team clearly shows the capacity to suffer.
Today, JPM is expanding into an attractive market and building a new bank in the UK. It’s losing money, and will for years. The CEO, Jamie Dimon (a genius banker), often mentions this bet might play out over 10-20 years, or they might fail in a few years, pull the investment, and re-allocate shareholders’ money elsewhere. They know how to run this play, but they can’t know with certainty it’ll work. They only know it’s likely to work, yet will take a long time.
There is no short-term reason to do this.
They can only do this if they’re thinking about what that bank’s long-term economics look like, there’s a sense of the timing and investment needed to get there, and one can see how it’d work financially (even after a long time). This is what business builders do. They’re artists, the business their canvas. People like this also tend to have a strong set of internal principles and are unwilling to compromise on them for short-term results, even if it means pain.
The capacity to suffer is a differentiator in good businesses when thinking about whether the management are prudent stewards of the shareholders’ money and are trying to build the value of this economic castle while widening the competitive moat around it. Those with the capacity to suffer allocate capital intelligently even when it doesn’t appear so if you’re looking through a short-term lens. You could bring a short-term oriented CEO into JPM, and that executive could instantly “increase profits” by exiting the money-losing UK bank and focusing on the US. While more profitable next year, it’s less valuable overall. Jamie Dimon suffers for it, in a way.
Todd Combs, who sits on JPM’s board and is a long-term oriented investment manager, often identifies CEOs with the capacity to suffer by asking them:
If you were a private company and nobody cared about you trying to maximize near-term quarterly results, what would you do differently today?
You could ask this of any of the companies you run or are invested in.
Any of us could also ask it of ourselves, and that’s the real insight:
If you were a private individual and you didn’t care about prestige, social status, buying a boat, or getting a raise next year, and your sole yardstick for success in life is what you wrote in your autobiography in 30 years, what would you do differently today?
Second: investing and the inability to suffer
Even though Semper Vic only invests in high quality, durable businesses, Thomas Russo’s insights are something I’ve rarely heard from individual or professional investors despite the fact many strongly prefer “quality” businesses.
It feels like we’ve spent the last 2 years in what I’d call the “quality bubble”, particularly among large, publicly traded, North American businesses. Everyone wants to own “quality businesses”. Maybe because others want to own them too, so it seems like the thing to do because it’s working. They’re great businesses, after all. How can you be fired by managers or clients buying great businesses that are going up?
The problem is today, some of these trade at prices that look a little disconnected from their long-term prospects. No matter how wonderful a business is, none are worth infinity dollars.
Adding to the issue, long-term interest rates are higher than they used to be, and the likelihood of an impending recession is also higher than it used to be. Both of these are bad for both corporate profits/earnings, and for asset prices and valuations.
Take Procter & Gamble, which we owned in 2018 and sold a year later.1 Reverse-engineer P&G at the time:
You were paying $180 billion for P&G. It earned ~$12 billion annual free cash flow, and was earning 60% on its invested capital, so it had low reinvestment needs.
This price tag was such that the market believed P&G would grow at ~2% long-term, and profit margins would stay at slightly depressed levels.
P&G’s end-markets don’t grow at 2% through the economic cycle, though. They grow at ~3.5% (~1.5% above inflation). But P&G was slowly bleeding market share. It didn’t seem like things would change, so that 2% belief formed and that’s what the stock price reflected. It didn’t help that the executives were compensated to hit a 2% growth target despite P&G being the dominant player in markets growing 3.5%. What compensation consultants do for boards of directors is a secret shared only with God.
Why was it bleeding share?
At its Gillette business, for example, P&G failed to notice consumers could increasingly buy razors online. It didn’t pivot its distribution and marketing to address changing tastes and purchase habits. An opening was growing, and Dollar Shave Club (DSC) and Harry’s had stepped in. P&G lost well over 10% of the market before it woke up. Later, in came Trian, an activist investment fund. It lobbied shareholders, fought a proxy fight, got a board seat, publicly pointed out the absurd compensation structure, fixed those incentives, and lit a fire under management’s feet.2
It also helped that DSC’s and Harry’s executed a “judo strategy” in such a way that they were eventually acquired by P&G’s competitors.3 The buyers made them into profitable businesses to justify the prices they paid to buy them. I believe they did it mostly by raising prices to what consumers were normally willing to pay, bringing back rational competition and ending a price war intended to grab market share.
Within a year, the stock ripped from $72 to over $100 as soon as signs of bleeding stopped and growth accelerated.
Today, there’s nothing wrong with P&G as a business. After fixing itself, organic growth accelerated from ~1% in fiscal 2018 to 5%, 6%, 6%, 7%, and 7% in the 5 years ended fiscal 2023.
Today, what’s wrong with P&G is that there’s nothing wrong with it.
It’s doing great. It’s also a fantastic, go-to place to hide if you’re afraid of what’s going on in the world today: it has pricing power in an inflationary environment, and its volumes aren’t cyclical because it sells razors, toothpaste, shampoo, laundry detergent, and other fast-moving household and beauty products. People buy this stuff whether inflation is up or down, interest rates are low or high, and the economy’s growing or shrinking. It’s “all weather” and worry-free.
Since everyone knows this, investors have piled in. P&G looks more fully valued than ever vs. its future. It’s now a $340 billion company, doing $14 billion in annual free cash flow: the multiple of free cash flow was 15x in 2018, and is 24x today.
Yet other than fixing fixable issues, the business has not changed. The end-markets have not changed. It’s a slow-growing, mature business. It’s in slow-growing, mature markets. There’s a decent amount of pricing power, and some volume growth from population growth.
If you now reverse-engineer the $340 billion price tag and discount cash flows at 8%, the market now believes this is about a 5.5% growth business forever, which will earn >50% returns on capital forever. That seems… implausible at best?
Said another way, using that 8% discount rate and reasonable 3.5% end-market growth with not much ability to grow market share, the business might be worth $230 billion, fully a third less. Big yikes.
Clearly, the price implies a belief P&G has a better future ahead than ever before, yet that seems implausible. Already, management expects slower sales growth, and margins are falling.
What really seems to be going on is: it’s the perfect stock to pile into if you’re deathly afraid of the business cycle over the next 2 years and you need to hide under your bed until the macroeconomic monsters go back in the closet. You lack capacity to suffer.
Suffering as an Investor
We have almost 25% of net worth in Brookfield Corp. (BN), which we bought this year. It’s experiencing a couple strong macroeconomic headwinds you can’t call the end of. You could try to time the issues by waiting until Brookfield starts telling you things are fine now, but you don’t know where the stock will be by then. It’s not even clear that would work, since market participants often begin to price in recoveries months before they are underway.
What does often work is buying into excellent businesses experiencing temporary problems. You then just need to sit around for 1-5 years until the problems are fixed.
In my opinion, that’s what Brookfield is, and it’s what’s happening today because:
Interest rates are rising as the Federal Reserve induces a recession to rein in inflation, and
Many of Brookfield’s investments — especially real estate, where it’s big — have floating-interest-rate mortgages against the buildings.
The residual cash flow these buildings produce decline a little more each day as the banks eat a bigger piece of the cash flow pie. All Brookfield’s competitors and most real estate owners anywhere are having this problem (especially for offices). If you read the news, you might have noticed several owners monthly are cracking under the weight of interest expense and are handing the keys over to their banks.
Yet underneath this pain — which accounts for a small portion of Brookfield’s long-term enterprise value — is an incredible business run by an intelligent and disciplined executive team who have run it for decades through bubbles, financial crises, and more, and they act like stewards of shareholders’ capital. Many of Brookfield’s other businesses are practically bomb-proof: this is stuff like hydroelectric dams on 40-year contracts with governments, and oil pipelines. The revenues are contractually tied to inflation and customers must often pay whether or not they use the service. There are other bomb-proof businesses, too, like a monopoly on contracts to service most of the world’s fleet of nuclear reactors.
Its main business, Brookfield Asset Management (BAM), charges fees to manage other people’s money. In many cases, the fees are charged on the amount of money the clients originally put in, not on the value of the investments at any point in time. When asset prices go down in a recession, these funds’ revenues stay utterly flat. The business has 60% operating margins and doesn’t require any investment dollars to grow because the only cost is paying smart guys in offices to buy, fix, and sell businesses. There are no manufacturing plants to pay for and build if you want to grow. Because of tailwinds in the alternative asset management industry, this business has the opportunity to grow 6-15% annually for many years, and it is one of the top 5 competitors in the world in an industry of hundreds.
BAM makes Google’s economics look like a joke.
To own a piece of Brookfield, you need only have the capacity to suffer through today’s problems, bombarded every day with a volatile stock price and news of office towers going bankrupt.
Thank you again for your support and I hope you have a fantastic Canadian Thanksgiving. There won’t be anything from me this weekend as I will be with family, so I wish you well.
Chris
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Disclaimer: someone whose portfolio I manage owns shares in JPM. They and I also own Brookfield Corp shares (BN and a little BAM). None of this is investment advice, and I have no fiduciary or legal responsibility for your investments. Do your own research.
And which we wish we still owned during COVID so that we could have sourced cash by selling it for better ideas amidst the chaos, since “defensive” companies’ prices don’t fall as much during tough times.
P&G also wasted millions in shareholder money counter-lobbying Trian.
Dollar Shave was acquired by Unilever in 2016, and Harry’s was taken out by Edgewell (which owns Schick razors) in 2019.