Harnessing The Current: Benefiting From Value Creation In Investing

As the great, late Charlie Munger said:  "Investing is simple, but it isn't easy. And anyone who thinks it's easy is stupid!"

I went snorkeling during the winter break while on vacation with my family. While swimming, I had an investing insight that was really profound. Although it should have been obvious.

Our boat took us to snorkel at two different locations. At the first one there was a strong current against us. Even the really good swimmers in our group struggled. I certainly did. Sometimes it took a lot of effort just to not be pushed back.

The second location was much different. It was a "drift snorkel."

We started at one place, and the current took us over the reef. All we had to do was to make small adjustments to see the fish that we wanted. Almost no effort.

Well, it struck me that in investing, the equivalent of "current" is a company's ability to grow value per share. When investing in companies with stagnant or declining value, you are swimming against the current.

You can be really good, and still make scant progress. But when you are investing in companies that are capable of building value over many years, all you need to do is to make small adjustments. And to periodically check to make sure that the current hasn't changed.

What Contributes To Value Growth?

In my 20+ years as a professional investor, one thing has become completely clear: it’s impossible to have a business that can meaningfully grow value over the long-term without the right management team. There is a good reason why when you read Philip Fisher’s Common Stocks and Uncommon Profits that the majority of his 15-point checklist can be reduced to just one word: management.

The right management can’t overcome a really terrible business, hence Warren Buffett’s famous quote that “when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” However, a great management team can take a business that’s just OK and create a company that is growing value.

Conversely, if you have a great business with a strong competitive advantage, you can still have a company that doesn’t grow value. How? Management can just mis-allocate capital, say to foolish acquisitions, and the quality of the business will never make it into shareholders’ pockets.

For much of my investing career I focused on business quality first, thinking it to be by far the most permanent aspect of any company. After all, the management can be changed or the balance sheet improved far more readily than the structural economic characteristics of the business can be changed, right?

So I would check that management was at least OK, didn’t have an obvious history of self-dealing or a bad record, had reasonable incentives in the proxy statement, and call it good. That’s the most we can say about many public-company management teams. Unfortunately, that’s not enough. At least not for substantial long-term value creation.

Management Characteristics For Value Creation

First, the best management teams aren’t primarily driven by financial incentives. Instead, they have a strong intrinsic motivation. They can’t help but try their very best to grow business value. And no compensation consultant or Board of Directors is going to be able to change that meaningfully by tinkering with the compensation formula.

That’s not to say that they don’t want to make money. They do, and they should. It’s just that it’s not their main motivation.

Second, they are inoculated against doing stupid things with shareholders’ capital. They don’t need to be capital allocation geniuses. However, the conventional thinking among CEOs and Boards just won’t do. Nor will the typical reasoning, implicit or explicit, that justifies decisions because “the other kids are doing it.”

No. The best managements think from first principles. It might be as simple as a “do no harm” approach that returns capital unneeded by the business to shareholders after internal investments are satisfied. Or it might be something more value-creating. However, it’s never the middle-of-the road, “do stuff just to make us bigger and call it strategic” approach that so many CEOs adopt.

So, the checklist is simple. For meaningful long-term value creation, you need management with:

1. Intrinsic motivation that is driving them to excel at managing the business.
2. Ingrained first-principles thinking on capital allocation.

No more, but no less. And that’s quite rare.

What About The Rest Of It?

What about sustainable competitive advantages, a long runway for growth due to a large addressable market, positive secular trends and so on? Those can help. However, I think that you can have a company meaningfully growing value over the long-term even in the initial absence of these factors.

Let me give you a few examples of companies in boring, mundane businesses with limited market growth and plenty of competition that nonetheless have created a lot of shareholder value:

• Ecolab (ECL): The company, and its legendary CEO Al Schuman took a low-growth, hyper-competitive business selling cleaning chemicals by the gallon and transformed it into a global, competitively advantaged company with good growth and an unassailable market position. From his start date as CEO in 1995 until now, many years after his retirement in 2006, Ecolab’s stock produced a total return of 45x vs 15x for the S&P 500, or an annualized rate of return of 14% vs. 10%.
• O’Reilly Automotive (ORLY): This retailer of car parts produced a 20% annualized rate of return over the last 30 years, vs 10% for the S&P 500. The total return difference is staggering – 270x vs. 17x over the last 30 years. That’s despite a very competitive marketplace and plenty of other competitors that had the same opportunity and yet have fallen far short of O’Reilly’s success.
• Ross Stores (ROST): If you were told in the early 1990s that the Internet was about to take off, that online commerce would take massive share from brick and mortar retailing and that Amazon would become the beast that it is today, would you bet on a boring off-price clothing retailer? And yet Ross Stores has produced a 22%+ annualized return over the last three decades, a 442x total return vs 17x for the S&P 500. How? Consistent execution of a niche strategy that proved timeless regardless of the massive changes happening in the world at large.

What you didn’t hear about in the examples above is anything about some groundbreaking new technology or a hot secular trend that aided these winners. And many companies that did have secular tailwinds behind them fared far worse.

Imagine yourself sitting at the beginning of 1994 and someone telling you about all the technological and societal changes and trends that would happen over the next 30 years. Then they would ask you a simple question: which stock will do better, one of the three above or Cisco Systems, the dominant maker of the plumbing of the Internet? It turned out, counterintuitively, that each of the three stocks above did meaningfully better than Cisco did.

It’s not luck. It’s not technology. It’s not secular trends. It’s management.

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About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.

Note: An earlier version of this article was published on the Behavioral Value Investor Substack