Thoughts Post Malone

I recently attended Liberty Media Day.  I’ve known about John Malone for a long time, but never saw him in person. A couple things stick out in my mind:

  1.  The importance of a long term mindset
    • Dr. Malone talked about where he sees the media and cable industries going. His vision, as I interpret it, is the cable companies and the wireless companies eventually merging.  In the meantime he believes distribution companies should focus on incorporating Netflix and Amazon’s product offerings into their distribution channels. So, in Malone’s ideal world the cable company would drive traffic to Netflix and Amazon and receive a referral fee.  It’s an interesting concept but Netflix and Amazon aren’t suffering from a customer acquisition problem.  Therefore, I don’t know how receptive they would be to this proposition.  Regardless, Malone turned down an offer for his cable company at a substantially higher value than it trades at today.  He seems unfazed as he believes over the long term Charter will create more value than the offered price.  
    • Malone started his career at a smaller cable operator.  He left McKinsey to take a shot at building a company.  The company was called TCI and the road to success was uncertain at best.  That said, he stayed focused on his goal and thought strategically about the long term despite the short term outlook.  Today he has significant influence over a legitimate media empire that contains SiriusXM, Live Nation, Formula 1, Discovery Communications, Charter Communications, Trip Advisor, The Atlanta Braves, and he is the largest land owner in the US.  Time plus focus can accomplish astonishing things. As Tony Robbins says, “People overestimate what they can accomplish in a year and underestimate what they can accomplish in 10 years.”
  2. Some management teams just win. 
    • Listening to John Malone and his CEO, Greg Maffei, it’s pretty clear they are playing chess and the other guys are playing checkers.  Malone’s control of the entities enables Maffei to take a long term outlook.  Contrast that to AT&T, which has a substantial asset base but also has the pressure of meeting quarterly earnings estimates and worrying about a substantial dividend payout.  The guys at Liberty and their companies have a structural qualitative advantage AND the skill to exploit that advantage.  Those are situations I want to align myself with.  See also Berkshire Hathaway, Markel, Brookfield Asset Management, Constellation Software.
  3. Setting Yourself Up For Success Matters…A LOT
    • Liberty Media issues tracker stocks.  Tracker stocks are derivatives that are used to highlight the business value of the business segment within Liberty Media.  I never understood why people were comfortable owning them.  Now I have a better understanding.  Malone uses tracking stocks because he likes the entities under one umbrella because “there are antitrust and tax benefits on intercorporate dealings.” To begin, its pretty astonishing to hear him say that out loud.  Second, it’s exactly how Buffett thinks about antitrust and tax as well.  But Buffett doesn’t say anything like that publicly.  Tax avoidance is a large part of why Malone is so wealthy.  Lesson: set yourself up for success on the front end in order to take advantage of long term success.

In closing, I didn’t know what to expect from “Liberty Day.” I knew other people loved Malone and Maffei, but I never understood the following.  After watching them for a day I began to understand why people follow them so closely.  I intend to read everything I can get my hands on to better understand how they see the world.

The importance of ROIC and Growth

I’ve seen a lot of discussion lately about whether low ROIC businesses are better than high ROIC businesses.  ROIC means “Return on Invested Capital.”  There are a couple different ways you can define invested capital but for these purposes I am going to borrow Joel Greenblatt’s definition and call it PP&E + Working Capital.  I will note, however, that I also deem any additional necessary assets or liabilities as part of invested capital.  For instance, an airline has many assets via lease.  These are obviously necessary to the airline’s operations and therefore cannot be excluded from an invested capital discussion (an offsetting adjustment to add back rent and subtract hypothetical depreciation would be necessary in this instance).

Anyway, many people say high ROIC businesses are inherently better investments over the long term than low ROIC businesses.  Why is this?  Well, it is because a business with high ROIC tends to grow earnings per share faster than a low ROIC business BECAUSE there is not a need for reinvestment.  As Warren Buffett says, you dont want to own a business that consumes all of its capital and has none to pay back to its shareholders.  Instead, the perfect business can earn capital, require no additional investment and (a) invest that money back into marketing or some other channel to grow sales or (b) return the capital to shareholders.  Why? Because all of the cash is cash for the owners rather than cash for the business then the owners.

That said, there is nothing inherently superior to a steady state high ROIC business and a steady state low ROIC business.  Why?  Because if you are paying a multiple of earnings then the income statement will already reflect the cost of depreciation (and consequently your reinvestment rate, assuming the firm is run well) in both firms.  Therefore, the multiple you pay will be much more important to determine your success as an investor in a steady state firm.

However, nothing in this world is steady state.  Ideally you are looking at a firm that is growing.  And in a growing firm, take a look at the following (elementary) example.

As you can see, the earnings growth rate of the firm has grown by 31.6% in each instance.  HOWEVER, the free cash flow distributable to the firm grew by 2.6 more units in the firm that requires no incremental capital.  If we assume a 5% free cash flow yield on this investment, the firm that requires no incremental capital to grow its earnings base will be worth 52.6 units more than the firm that requires capital.  Which is just to say that no incremental capital, combined with growth, can be an incredibly powerful force that lifts the value of your investments.  Hence the reason software firms are worth so much more than industrial firms.