Great Companies are Forged During Crisis
A few years ago, my wife and I visited the beautiful Muir Woods just outside of San Francisco. Walking into a grove of redwoods standing over 200 feet tall is a stunning sight.
Aside from a hospitable maritime climate, one of the ways the coastal redwoods are able to grow to the sky is that they have a fire-resistant chemical in their bark. While this superpower doesn’t eliminate the risk of destruction, the fire resistance allows a high percentage of redwoods to endure natural fires that destroy overgrowth on the forest floor. In turn, they benefit from more sunlight and more space to grow.
Whether in nature or in business, growth breeds complexity and complexity dampens growth. At some point, the complexity becomes tinder for an external shock – or crisis – that fuels destruction which in turn is the genesis of the ecosystem’s next phase of growth.
A crisis is indiscriminate in wielding damage. All parts of the ecosystem are impacted. Those parts that survive the crisis, however, are in a better place to capitalize on the next phase of growth.
We set out to only invest in truly outstanding businesses because we believe that, like the coastal redwoods, they possess certain resilience attributes that help them endure and get stronger through crises.
What are some of these attributes?
- Moat. What a durable competitive advantage ultimately provides a company is time. Time to develop new products, time to correct mistakes. Companies who are instead out in the “open field” can only act and don’t have the luxury of being able to react. During a crisis, having the time to react thoughtfully and strategically becomes a more valuable asset than in the growth phase where action is more highly prized.
- Relevance. If you’re delivering a product or service that solves a customer’s need the day before a crisis, it’s highly unlikely that the customer’s needs will change the day after a crisis. It’s true that the customer may need less of a product during a crisis, but relevant products remain top of mind and are not easily eliminated.
- Stakeholder value. Suppliers, customers, employees, and other stakeholders are more willing to make sacrifices to support companies in crisis when they’ve long felt respected and supported by the company.
We demand these attributes and more from our companies because, as long-term investors aiming to hold great businesses for long periods of time, we are aware that crisis is at some point inevitable during our holding periods. The last thing we want to do amid a crisis is wonder if we should change horses in midstream.
During March 2020 when it became apparent that crisis was at hand due to COVID, our team stress-tested every one of our companies to see how they might fare in scenarios that seemed unfathomable a week earlier. We concluded that we were confident in all our companies’ ability to fight through lockdowns of various lengths and severity.
To be sure, all our companies were negatively affected by COVID lockdowns to some degree – Booking had negative revenue in April 2020 due to travel cancellations – but we believe they all came out stronger while some of their weaker competitors floundered.
The crisis we’re facing today – namely stagflation panic amid rising oil prices, inflation, and geopolitical conflict – is different from March 2020, but we think it will similarly test every global company’s resilience. Here again, our confidence is bolstered by the high-quality companies we own.
During Home Depot’s fourth quarter earnings call, COO Edward Decker provided commentary on why he thinks the company will endure in this environment, which incidentally, almost lines up exactly with the resilience attributes I mentioned above:
“We have a powerful foundation and distinct competitive advantages. First, as I mentioned earlier, our unique culture and values as well as our knowledgeable associates will remain a competitive differentiator. Second, our stores are the hub of our business and will always be important in the future of home improvement retail. We have a premier real estate footprint that provides convenience for the customer.
Third, we believe we have the most relevant brands and products and are continuously driving innovation in the marketplace. Fourth, we have a best-in-class supply chain and have demonstrated our ability to operate with agility and navigate any environment. And finally, we have consistently improved the interconnected shopping experience as our customers increasingly blend physical and digital worlds for their projects.”
Moat, relevance, stakeholder value.
We believe that the market has indiscriminately punished stocks with high multiples, calling the group’s valuations into question due to stagflation worries. And broadly speaking, the market is right to call many companies’ valuations into question. We’ll probably find out that a lot of companies that were propped up by an era of low inflation and plentiful and cheap capital were undeserving of their multiples.
But premium companies like the ones we own deservedly tend to trade at a premium to the average company. Nevertheless, some of them have been thrown out with the bathwater in recent months.
As we discussed in our post on the quality margin of safety, we aim to own exceptional businesses where, looking back, we could have paid a lot more than the market price – even when the stock looked expensive on a multiples basis – and still come out with good returns.
To generate such returns, our companies must be able to survive various crises and get stronger on the other side. We believe each of them possess the necessary resilience factors to do just that.
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