Cook & Bynum Fund commentary for the year ended December 31, 2015; titled, “Foreign Market Opportunities & A New Investment.”
A few years ago, many in the financial and economic communities were enamored of the potential of the BRIC countries (Brazil, Russia, India, & China), who were all being propelled by varying combinations of strong demographics, rising middle classes with spending power, and plentiful natural resources/commodities selling at historically high prices. Many investors projected strong GDP growth well into the future and thus justified premium prices for businesses that were domiciled in and/or transacted within these geographies. The tide has clearly turned in the last eighteen months, and a good portion of these same investors has eliminated these countries from their portfolios – often for good reasons.
The decline in emerging markets all around the world is a welcome opportunity, however. Markets that other investors have scorned are often fertile hunting grounds for us, so this repricing has made a number of business that are interesting potential investments more attractive. Further helping us, the strengthening U.S. dollar has increased our purchasing power abroad. We hope the downdraft in securities prices in these places continues.
In fact, a new position that Cook & Bynum Fund acquired in January is just such an opportunity. We have researched this business for years, including a series of trips to visit the company’s operations in South America, without expecting the confluence of events that created this particular situation. Management has a history of treating shareholders as partners and focusing on growing intrinsic value, and we are hopeful for a satisfactory return over the next ten years. We will delay any further disclosure about this position until required in the hope that we may have an opportunity to acquire more shares at attractive prices. We will continue to do research like this in order to find the next opportunity, and we remain prepared to allocate our cash when other investors/speculators panic.
Cook & Bynum Fund – Holdings Overview
Please find below a brief summary of each of the Cook & Bynum Fund’s holdings as of December 31, 2015.
In 2011, Cook & Bynum Fund started building a stake in Microsoft at $24/share. At that time and after adjusting for net cash, the company was selling for just seven times earnings. The market was generally focused on the success that Apple and Google were having in the consumer space and appeared to be ignoring Microsoft’s position within corporate information technology. We felt that even if Microsoft stumbled completely, the stickiness of Office and Server would return at least seven times earnings to shareholders in run-off mode. We were receiving a free option on any success the company might have with consumers and with the cloud, as well as any continued growth in the core corporate IT business. The transformation of the company that is evident today was already underway, as management was adjusting its strategy based on the understanding that the company should give up some profitability in Windows to secure the future of Office and Server. With Office and Server continuing the successful transition to Software as a Service (SaaS), we believe the business has one of the widest moats in the technology industry as Microsoft’s position will remain sticky for at least another decade. We could not be more pleased with the job that Satya Nadella has done since he took over as CEO. Unfortunately, the market has recognized the changes and repriced Microsoft up to almost 16 times fiscal year 2016 earnings net of cash. As the price has risen, our expected future returns have declined. We sold about half of our original position in October 2014 at $47/share, and we sold half of the remaining position in October 2015 at $54/share. We continue to expect good things from Microsoft, and we would have preferred to maintain a sizable position at a lower price, but the stock’s rise has made the discount to intrinsic value too small for us to feel comfortable owning a large position.
Pancho Garza and his colleagues comprise one of the best management teams in the world, and they bottle and distribute Coke products in the best Coca-Cola market in the world (Northern Mexico). They relentlessly focus on whom they call the Boss – the customer – which is good for both the customer and profits. We have seen their method work over and over again as they have expanded in different product categories and different geographies across Latin America (and now just a tiny bit in the US in the company’s snack foods business). Management’s efforts have made you more money than any other single company, and we hope to remain partners with Arca for decades to come. We wish the share price would decline so that we could buy more of the company.
Cook & Bynum Fund have followed Embonor for about eight years, but we first acquired shares in 2014 when its valuation fell to a compelling level. Embonor bottles and distributes Coke products in most of Chile outside of Santiago and in Bolivia. The latter market continues to grow at a fast pace, and it will be substantially bigger than the Chilean business as time goes on. We have found that consumers steadily switch to prepackaged beverages (ready-to-drink) as their per capita incomes go from $5,000/year to $20,000/year. Although the progress will not be smooth in Bolivia, this demographic and economic transformation is underway. These decades of growth are a very attractive time to be selling ready-to-drink products if you have adequate market share to distribute to the mom-and-pop stores that control most of the retail market. Embonor enjoys this competitive edge in Bolivia, and its valuation remains modest. We expect that the company’s execution will continue to improve as their market grows.
We first took a big stake in Coca-Cola in the aftermath of the financial crisis of 2008-2009 when it traded off to a P/E ratio of 12, as cheap as it had been on a multiple basis since the mid-1990’s. For most of the company’s history, realizing growth was simply a matter of selling more concentrate in more places while raising prices a little less than inflation – volumes and the price of concentrate were the only two variables that really mattered. While Coca-Cola still has one of the best economic moats around, its business has become more difficult. Sugar-sweetened soft drinks have come under attack as a convenient villain in the war against obesity in the developed world, and it remains to be seen if this vilification will permanently alter the growth trajectory of Coca-Cola. The company must continue to innovate products that delight consumers with fewer calories. One of Coca-Cola’s big initiatives has been to work with bottlers to sell more value added products rather than just more volume. Consumers have shown a willingness to pay extra for the “right” amount of Coke at the right price. Packages of six 8 oz. cans might sell for the same as packages of six 12 oz. cans, for instance. Consumers who simply want Coke for the lowest price will buy the larger can package. Others who may want to control their portion size can pay more per ounce for the package of smaller cans. People need to consume a lot of liquid in a day, and clearly they prefer tasty liquids to plain water for a decent portion of their consumption. Add to that fact that safe prepackaged drinks are an increasingly affordable convenience in much of the emerging world, and Cook & Bynum Fund believe Coca-Cola continues to have a long runway of earnings visibility.
Many years ago Berkshire’s look-through earnings were dominated by the insurance business and the equity portfolio. The equity portfolio and hence stock picking are less important now to the future of Berkshire as the wholly-owned operating businesses, including insurance, dominate the overall company’s intrinsic value. Many of these wholly-owned businesses enjoy substantial moats and a culture that encourages deepening them. These are no small advantages. We have purchased Berkshire Hathaway twice in our career – both occasions at 1.1 times book value. Our current investment was initiated at this valuation back in 2011. We believe Berkshire is generally worth about 1.7 times book value as a rough valuation metric. As we write, Berkshire has declined to 1.3 times book value. We would be delighted for the company’s intrinsic value to compound for a long time with the stock at this multiple of book value.
Procter & Gamble
Procter & Gamble remains one of the two preeminent global consumer products companies. P&G sells strongly-branded products across a wide range of categories spanning laundry detergent to beauty supplies to health care products, which provides the company a deep moat. Like most U.S. exporters, revenues have faced a headwind as the dollar has strengthened, but organic sales growth has remained modestly positive. P&G continues to focus on its large, successful brands while selling or paring back less important ones with inferior moats, although we have not always agreed with management’s decisions about which to sell and at what prices. Procter & Gamble is fairly valued, and Cook & Bynum Fund are comfortable with it as a small position in the portfolio.
We wrote at some length about our investment in Walmart in last quarter’s letter, and the meat of that commentary is still available on our website if you would like to revisit it. Similar to Microsoft in 2011, retail commentators have been fixated on Amazon’s innovation and growth over Walmart’s existing franchise. Make no mistake, Amazon has and is undeniably doing some fabulously innovative and disruptive things. We are regular Amazon customers ourselves, but unfortunately for the company’s shareholders, Amazon earns no profits in its retail business. This expansion will almost certainly continue as long as Wall Street allows the company to finance its ambitions at an effectively zero cost of capital. At some point Amazon shareholders will seek an adequate return on the capital employed, and all fifty states will require Amazon to collect sales taxes. When these conditions come to pass, Amazon’s prices will rise (as they already have in categories they dominate). We expect wealthier customers to continue to pay for the tremendous convenience of Amazon’s offering, but we concurrently anticipate that price sensitivity will lure middle class customers back to the low price leader. And we believe that Walmart will remain that low cost provider. Management is also working hard to add convenience to its offering in a number of ways, including hiring better associates, improving the in-store experience, and building a first class integrated online/bricks and mortar solution. Amazon will continue to undermine profitability in retail for some time, but despite some setbacks like the recently ended unsuccessful experiment with Walmart Express, we believe Walmart’s domestic business will be bigger in a decade than it is now. In our view, the biggest threat will actually come from Aldi and Lidl. Cook & Bynum Fund have seen these two German companies destroy the profitability of grocery businesses in a number of markets around the world, most recently in the UK. Last year’s stock price drop did not coincide with a dramatic decrease in Walmart’s intrinsic value. The net result is an increase in this investment’s discount to intrinsic value, making us optimistic that Walmart will offer an adequate return from current levels over the next decade.