Cook & Bynum portfolio update for the third quarter ended September 30, 2016; in which they discuss the the sale of the fund’s stake in Procter & Gamble.
U.S. stock markets are at all-time highs after bouncing hard off of first quarter lows and zooming further ahead following the November election results. As of the end of November, the S&P 500 – after being down more than 10% on the year on February 11th – is now up almost 10% for the year and is extending the historically long bull market well into its eighth year. This updraft has been in the face of broadly disappointing corporate earnings for much of 2016. Climbing stock prices that coincide with stagnant or falling profits mean that valuations have been further stretched at a time when they were already well above long-term historical averages. The net result of expensive markets is that our opportunity set is more limited, but the longer these conditions persist the bigger an ultimate dislocation promises to be. The potential reward for investors who remain disciplined and patient throughout concurrently grows.
Procter & Gamble
In July, we sold the Fund’s stake in Procter & Gamble primarily because it was trading near our estimate of intrinsic value. The investment has been a strong long-term holding for the Fund with a cumulative return of over 66% since we initiated the position in mid-2009. A confluence of factors have lowered our future expectations for the business and contributed to our decision to sell. First, P&G’s moat has eroded in a couple of its most important markets, including razors and laundry detergent. New offerings in both of these categories have gobbled up market share, and the ongoing threats range from a dedicated online competitor for razors (Dollar Shave Club) to increased foreign “A brand” competition for detergent (Persil). Second, in the past couple of years, management announced a plan to start selling brands/businesses that it has determined are “non-core” assets. We are generally not fans of this type of strategic move, as we do not believe there is a good reason why multiple and varied brands cannot co-exist and thrive under the same corporate umbrella. In fact, in most cases this structure is a competitive advantage; for example, product/brand teams can share best practices, enjoy enhanced bargaining power with customers, and increase overall product reach. Unfortunately, management has been moving forward with this plan, and on more than one occasion has sold assets for less than we thought they were worth, which is obviously destructive to the value of the business. For instance, P&G recently sold Duracell to Berkshire Hathaway at a price we believe undervalued the business. As the Fund has a larger stake in Berkshire Hathaway, this transaction is a net positive for the Fund, but it speaks to Procter & Gamble management’s increased focus on attracting a growth multiple from Wall Street and decreased focused on growing long-term shareholder value. In total, these factors reduced the value of the business and decreased the gap between what we think it is worth and the value at which the market currently has it priced. Despite this decision to exit given valuation concerns, Procter & Gamble remains one of the world’s best consumer products companies with a wonderful collection of underlying brands and businesses, and it is a company that we will continue to follow with great interest. Perhaps the company will again trade at a value that makes it a compelling risk-adjusted opportunity for the Fund.Increasing Our Odds
As our investment in Lindley earlier this year and the elimination of the Procter & Gamble position reflect, our mandate (i) is focused on finding attractive investments one-by-one and (ii) affords us the flexibility to invest capital only when we think an investment is truly compelling on an absolute basis. We assess individual investment opportunities based on our estimate of their expected returns and the likelihood that the underlying businesses will perform close to our expectations for them. This decision-making process is an exercise in assessing probabilities, and we are constantly trying to stack the odds for success in our investor’s favor. We believe two particular factors are most important for accurately predicting which investments will do best over the long-run:
- The first is the sustainability of a company’s moat. A sober assessment of a company’s competitive advantages and how long they will last is the key to understanding the long-term cash-generating prospects of a business, and hence, estimating its intrinsic value. Often this evaluation cannot be done effectively, and an investor should put the company into the “too-hard pile” and just move on. However, higher quality businesses do have competitive characteristics that allow an investor to project a company’s results to the right order of magnitude 10+ years into the future. Sometimes these advantages are on the supply side, but more often the best businesses have demand side advantages (pricing power, lack of suitable substitutes, no dependence on complementary products, patents, better R&D, etc.) that make future profitability more predictable.
- The second factor is a company’s current stock price. In what we consider a ‘law’ of investing, future returns from an asset are inversely related to the price paid for it. Buying a stock at a price that is a meaningful discount to its intrinsic value serves to prevent permanent capital loss – the biggest enemy of long-term outperformance – when an investor makes a mistake in his analysis while also providing for outsized returns when that analysis is correct. In other words, buying at an attractive price both decreases risk and increases potential return.
Alas, market participants usually value businesses with great moats fairly accurately. When an investor can acquire such a business for a cheap to fair price, however, history suggests that Mr. Market will likely catch on sooner or later and reprice the business close to its intrinsic value, rewarding the patient investor in the process. We are in search of just such opportunities that offer both of these dynamics and meet our other core investment criteria.