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.

The Art of Not Selling

Chuck Akre, one of the most interesting investors in the world, recently had his firm issue a blog post discussing their sell discipline, or lack thereof. The meat of the post was:

“In addition, we try to resist the temptation to sell (or trim, even) on the basis of valuation alone. We are unfazed when our businesses are quoted in the market at prices above what we would pay for them. It might be worth reading that last sentence again for emphasis.

Why? For three reasons…

First, when selling because of valuation, it is often with the idea that there will be an opportunity down the road to buy back in at lower prices. In our experience, it seldom works out this way.

Second, of the thousands of publicly traded companies, there are probably fewer than one hundred that meet our criteria, and opportunities to buy them at attractive prices are few and far between. Unlike average businesses that can be traded like-for-like on the basis of valuation alone, growing and competitively advantaged businesses are just too hard to replace.

Third, the very best businesses tend to exceed expectations. What may seem like a high price today may be proven to be perfectly reasonable in hindsight.”

See https://www.akrecapital.com/the-art-of-not-selling/ .

The post has caused some cognitive dissonance for SCG. For one, our portfolio has benefited from churn. Specifically, churn among one of the greatest companies in the world: Apple. Note: Apple never exceeded a 5% portfolio position at cost, which reflects some concerns cited below.

Our first investment in Apple took place in early 2013, after Steve Jobs died and there were concerns about whether the iPhone would continue to sell in droves. We held that position until 10/22/2018. We repurchased Apple on 12/28/18 to then sell again on 11/19/19. To be sure, our portfolio missed out on another 10% move from 11/19/19 to 12/31/19.

There is a decent chance the churn activity cited above reinforced bad habits. Further, it is only one memorable example so (a) it’s statistically insignificant, (b) increases the chances of memory biases, and (c) could be a great example of “resulting” (measuring success based on results as opposed to process). Further, your manager believed, and still believes, he probably sold too early. So, why sell? The answer is duration risk.

At this valuation, Apple is valued at roughly a 5% free cash flow yield. That valuation implies the company has to exist for 20 years and the company must generate this level of cash flow for an investor to extract the cash flows from the business. Importantly, Apple is repurchasing shares at an impressive pace. However, those repurchases do a lot less for investors at this valuation than they did at our purchase valuation.

Perhaps the error of commission, by Akre standards, was purchasing Apple given some of our business durability concerns. That said, if Apple isn’t quality what is? Ultimately, our read of Apple’s “tea leaves” is less optimistic than our perception of the market’s read. More importantly, we were offered our perception of a healthy price for the business. Thus, we exited the position despite seeing a plausible way for Apple’s price to increase at least another 40%. Note, our strategy does not, and will not, depend on selling shares to buy them at lower valuations. When we sell we intend to move on. Apple presented a unique opportunity in a short amount of time, it was an asset we understand, and we thought the probability of permanent capital impairment was low given the valuation and buy back pace.

Was that a mistake? Perhaps. In retrospect it was definitely a mistake from a tax perspective. That said, selling is a “mistake” we anticipate making over and over again. However, your manager is committed to working harder to find businesses we can hold for the long term regardless of valuation. Said differently, you can expect your portfolio to get more expensive but also more durable over the years to come.