At the 2017 Berkshire Hathaway Annual Meeting, Warren Buffett and Charlie Munger lamented not investing in Amazon, Google, and Wal-Mart earlier on.
Berkshire-owned GEICO was a major Google search customer and Google executives even asked Buffett’s advice on how to lay out their prospectus ahead of the company’s 2004 IPO. “I had plenty of ways to ask questions…and educate myself,” Buffett recalled, “but I blew it.”
Why might Buffett and Munger have missed those golden opportunities? While the complete answer is more nuanced, one reason might be natural value investor skepticism when it comes to investing in Visionary leadership.
A common thread among Amazon, Google, and Wal-Mart is that they were all built by Visionary leaders: Jeff Bezos, Sergey Brin and Larry Page, and Sam Walton, respectively.
Visionaries tend to be purpose-driven, intrinsically motivated, and growth oriented. Moats are typically non-existent initially, though there can be massive moat potential if they execute on their vision.
||5-year revenue growth post-IPO year (CAGR)
||Big question marks in early years
||“To be Earth’s most customer-centric company, where customers can find and discover anything they might want to buy online, and endeavors to offer its customers the lowest possible prices.”
||· When will Amazon turn a profit?
· What happens when Wal-Mart responds?
· Isn’t it just an online bookstore?
||“Organize the world’s information and make it universally accessible and useful.”
||· Is Google just another dotcom stock?
· What stops another tech company from doing search?
· Isn’t the dual-class structure a sign management isn’t shareholder friendly?
||“Saving people money so they can live better.”
||· Can it work outside its home territory?
· Why won’t shoppers stick with full-service retailers?
· Why can’t others mimic their discounting model?
Source: Bloomberg and company annual reports
With the benefit of hindsight, we know these three turned out to be slam-dunk investments, yet their success was hardly assured along the way. Indeed, Amazon’s stock had massive drawdowns on the path to its stellar long-term performance. And sometimes for good reason.
From a capital allocation standpoint, Visionaries can make bold bets in the wrong direction. Amazon made several large investments that failed miserably, the most notable being the Amazon Fire smartphone. Google Plus never took off as a social media challenger to Facebook.
Further, Visionary CEOs can make investments today that are designed to achieve a long-term goal, but may seem stupid in the short-term. A classic example is Netflix founder, Reed Hastings’ decision in 2011 to turn away from the DVD rental business and toward internet streaming. Such decisions don’t always sit well with analysts and investors focused on quarter-to-quarter results.
We can also point to plenty of Visionary-led businesses that flopped altogether. Sales growth stalled, profit margins never materialized, the company couldn’t execute, or competitors came along before the company could fully scale. When you’re investing in an early-stage, Visionary-led business, the range of potential outcomes is extremely wide.
But that’s what you hope to find in a Visionary-led business: optionality. No one building a valuation model on Amazon in the late 1990s could have possibly factored in the new businesses the company would enter in the subsequent decade and beyond.
Because of the call option-like payoffs of investing in Visionary-led businesses, their stocks also tend to trade at high multipless relative to comparable firms in their industries. These are often idiosyncratic businesses, as well, making them difficult to value based on relative multiples.
The combination of massive uncertainty, unproven business models, and expensive-looking stocks is not an ideal mix for traditional value investors.
Value investors are much more comfortable with what we call Optimizer CEOs. Optimizers typically run mature businesses where efficiency, frugality, and a repeatable capital allocation strategy are paramount to success. Moats have already been established in many cases.
The Optimizer CEO is best exemplified in Will Thorndike’s book, The Outsiders, which heralded eight CEOs (including Buffett) that, according to Thorndike, “followed a virtually identical blueprint: they disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income.”
To be a great allocator, Optimizer/Outsider CEOs need a steady source of cash flow from the underlying operations. As such, they’re often found in businesses and industries that feature recurring revenues, long-term contracts, or habitual consumer purchases. Among the companies featured in The Outsiders, for instance, are defense (General Dynamics), cable television (TCI), and insurance (Berkshire Hathaway).
Or consider Danaher, which rose to prominence under the leadership of Steven and Mitchell Rales in the late 1980s by acquiring manufacturing businesses and applying their kaizen-based Danaher Business System to remove inefficiencies and improve margins and cash flows. These cash flows were reinvested to acquire more companies that were subsequently immersed in the Danaher Business System. Rinse, wash, repeat.
Even if the stocks of proven Optimizers are expensive, the range of outcomes is narrower given the steadier nature of the operations and management’s track record. Their effectiveness is regularly evident in quarterly and annual results. When a large acquisition is made, synergy targets are reliable and often exceeded.
Visionaries vs. Optimizers
Neither type of CEO is uniformly better than the other. Much depends on the company’s stage in its lifecycle and its underlying business. For example, a company that installs an Optimizer too early in its lifecycle could unduly smother innovation and growth.
Conversely, a Visionary may need to hand the reins to an Optimizer once the company has reached scale, and margins and returns on invested capital (ROIC) become more important to investors. Rarely can a person play both CEO types well. Companies like Starbucks, Microsoft, and Apple have all struggled with leadership style transitions.
Further, a given company might need a Visionary and Optimizer at different points. Consider the challenge blue chip consumer-packaged goods companies face today. For decades, it made sense to have an Optimizer as CEO of a CPG firm. There was steady demand for branded products, they had pricing power, and margins held up. Today, however, blue chip CPG firms face fresh competitive threats. Many of them could use a healthy dose of creativity and might benefit from a Visionary CEO.
Finally, you want a creative Visionary leader to solve problems for which there isn’t a known answer and to navigate dynamic competitive landscapes. You wouldn’t want a Visionary running a bank or regulated utility, however. Optimizers work best within relatively stable competitive settings and where best practices are known and achievable.
Both Visionary and Optimizer CEOs should be of interest to investors. The important thing is to know what you’re looking for.
||Growth and innovation; Fulfill mission
||Maximize cash flow and ROIC
|Capital allocation strategy
||Reinvest in the core business
||Opportunistic buybacks and M&A
||Energetic, perhaps cult-like
||Loss of focus, no moat materializes
||Poor execution, lack of investment opportunities
One reason value investors may balk at investing behind Visionaries may have to do with perception. If you incorrectly assess an Optimizer-led business, you’re unlikely to fail alone, but incorrectly assess a Visionary-led business and you invite ridicule. This is unfortunate and is something we try to inoculate ourselves against.
Decades from now as we recall old investments, we’ll undoubtedly recall a few winners we incorrectly passed on, just as Buffett and Munger did. We’ll also correctly pass on a few losers, too. We can live with both. What we will regret is passing on a company because we were afraid to make a mistake.
As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Alphabet (GOOGL), Starbucks (SBUX), Apple (AAPL), and Netflix (NFLX). These companies represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.
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