Cognitive Dissonance Revisited

Chuck Akre’s firm lives inside my head. “The Art of (Not) Selling” is causing soul searching, confusion, and even a bit of anger. That anger is self directed.

For the longest time I searched for The Answer. Immersed in “value investing” books, praying to the alter of Buffett and Graham, and searching for The Formula. Here’s the problem: The Formula doesn’t exist. Only models and theories.

The past year was a good one for SCG. Given some of our large holdings, it’s remarkable that we kept pace with the index. That said, our performance was catapulted by a large position in Charter Communications, which is not a “value investment” as defined by deciles of valuation. Other meaningful contributors to performance included Apple, Netflix, and J.W. Nordstrom. Our portfolio continues to own J.W. Nordstrom and Charter as of this writing.

Going forward, the portfolio will look different from last year’s portfolio. Much of the change is attributable to our firing of a manager, which brought a substantial percentage of the portfolio “in house.” The decision to part with our previous manager was not easy, but it was the right decision. From hereafter, we completely eat what we kill.

Our strategy is to accumulate minority interests, in businesses we understand, at values that make the risk of permanent capital impairment minimal. As stated before, in the past year, the portfolio benefited from churn. Unfortunately, your manager is concerned he “learned” the wrong lessons.

Focusing on entry price has been a worthwhile pursuit. However, would it not have been better to be invested in quality companies with long runways? Sure, the entry multiples would have been higher, but the tax drag on the portfolio would be lower and we’d still own the businesses. See Charter as an example of a business that wouldn’t screen cheap but almost certainly was when we acquired our interest.

One could reasonably argue that worrying about not focusing enough on terminal values is a great “late cycle” indicator. Maybe, but also maybe not. Two quotes come to mind (thank you to @tsoh_investing on Twitter):

  • “The role of financial markets is to take money away from mediocre and underperforming companies and put it in stable, growing, high return on capital companies. Money has an almost metaphysical attraction to places where it is put to careful, good use. You can fight that trend, and invest in companies, for instance that are deeply undervalued and mismanaged – and some people are successful investing in the dregs – but very few over the long term. To use a whitewater kayaking analogy, freshwater seeks saltwater, and you can fight that if you want, but paddling upstream eventually is likely to become highly problematic.” https://microcapclub.com/2015/05/i-passed-on-berkshire-hathaway-at-97-per-share/
  • “Generally speaking, I think if you’re sure enough about a business being wonderful, it’s more important to be certain about the business being a wonderful business than it is to be certain that the price is not 10% too high … That’s a philosophy that I came slowly to. I originally was incredibly price conscious. We used to have prayer meetings before we would raise our bid an eighth. But that was a mistake. And in some cases, a huge mistake. I mean, we’ve missed things because of that.” – Warren Buffett, 1997 Shareholder Meeting, Morning Session.

In defense of our strategy, with the exception of Wells Fargo, I think it’s hard to argue our holdings are “poorly managed.” Facebook is one that many would argue should fall into that category. Personally, I might agree. However, that is a judgment call and, to the extent possible, we will invest based on fundamental truths. One of those fundamental truths is Zuckerberg built one of the biggest social networks ever and acquired two more. Thus, management is at least acceptable.

The current contemplation of whether our focus on entry price is misguided stems from a different framing of math. On one hand, it is very hard to lose when you are purchasing a $1.00 for $0.50. However, it’s also very hard to win big and IRRs will depend on how quickly the market realizes that $1.00.

On the other hand, investing is one of the few games where winners can run for a very, very long time. Importantly, strong organizations attract strong people. Those strong people tend to win. Consequently, while there is momentum in stock prices there is also business momentum. Thus, $1.00 can turn into $5.00 over time. Has a focus on entry price undervalued the momentum benefiting truly great organizations? Perhaps. To not at least contemplate that question is to remain stupid. We will not do that.

To be clear, we own our perception of good businesses. Each serves an important function in its customer’s lives. Many of these businesses are mature and cannibalizing shares. Therefore, on a per share basis, we are quite comfortable with our existing portfolio’s growth rate. Moreover, the portfolio is reasonably priced. As of this writing the Top 10 holdings, accounting for 64% of the portfolio are as follows:

Note: The weighting of the positions in this year’s portfolio are materially different from last year’s. As stated above, this is the result of firing a manager and merging the portfolios. Going forward, all major accounts are consolidated and further large changes are not anticipated.

Of the businesses listed above, Phillip Morris (PM) appears to be the one at greatest risk of deterioration. That said, we own the company because it sells an addictive product, has room to take prices, and is a low cost producer. Longer term, it’s plausible that PM acquires other cigarette makers (it recently tried to acquire Altria) and the volume deterioration is slower than anticipated. Phillip Morris rhymes with AB InBev (now a smaller position due to portfolio consolidation) because both entities have dominant positions, are suffering from volume declines, and benefit from raising prices.

Going forward, SCG will probably own fewer of these types of businesses and look to own businesses that are growing volumes as well. Mr. Akre makes a compelling case that it’s better to own a business that can grow its way out of a period of overvaluation. I will put more energy and focus into finding those situations.

Thank you for your continued trust. I commit to taking fewer actions in the future and finding greater long term, durable, investments. For now, our results have been satisfactory. Thus, expect at least some of the same behaviors to recur.

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