Investing wisdom behind the 'capacity to suffer'

Starbucks nailed it. Warren Buffett comprehended it. General Mills failed at it. World renown investor Tom Russo shares his wisdom with engaging illustrations.
By Larissa Fernand |  22-02-18 | 
 
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Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

This post has been written by Larissa Fernand, Editor at Morningstar India. 

The phrase capacity to suffer is often attributed to Tom Russo because he is primarily responsible for ushering it into mainstream investing discourse. But it was Jean Marie Eveillard who brought it to his attention when he was describing the characteristic of a good analyst. Russo just picked it up and ran with it.

Its application serves a dual purpose. It could indicate that a good money manager, or investor, must have the ability to suffer through periods of underperformance, however dismal. On the other hand, it can be applied to businesses too. For instance, should they invest money to extend a business into a new geography, they typically don’t get an early return on this. This means that they must have the capacity to suffer the short-term loss.

How Starbucks made a mark in China

When Starbucks decided to set foot in China, scoffers abounded. After all China has a tradition of drinking tea that dates back thousands of years. To their credit, Starbucks entered in a rather self-effacing fashion without attacking the tea-drinking culture or resorting to bold and blatant conventional advertising. A well thought out strategy helped them to virtually create a demand for the product.

They established themselves as an aspiration brand, targeting Chinese who want to be viewed as, not necessarily Westernized, but modern and cool. Starbucks also had a status attached to it, which is why the prices in China are higher than the same drink in the U.S. They stuck with this strategy of premium pricing despite protests. And, in sync with this positioning, they began to open stores only in high visibility locations or high traffic areas.

It worked. And how!

In The New York Times, Andrew Ross Sorkin presented the reader with some mind-boggling figures regarding Starbucks’ plans in China: Starbucks is opening more than 500 stores a year there — which amounts to more than one new store a day; creating some 10,000 jobs in China annually. In Shanghai alone, there are already 600 stores. He culled out those statistics from the company’s statement in July 2017 and put it in perspective with these words, “New York City has about half as many stores as Shanghai.” That very same month, Forbes reported that Starbucks has targeted 5,000 stores in China by 2021.

At the Value Investor Conference in 2011, Russo used the example of Starbucks’ expansion plans to elucidate the capacity to suffer.

One of the examples that comes to mind is Howard Schultz, the chairman of Starbucks. Several years back when speaking to investors, there was one nettlesome young analyst who kept asking him when they would show profits in China. 

Schultz responded by posing another question: How big do you want us to be?  And the dialog went back and forth: When will you show profits? How big do you want us to be? When will you show profits? How big do you want us to be?

And the answer was – and I think it’s the correct one – if you want us to dominate China, then let us not show profits for a long time. And if you permit that, we will end up at the final analysis with a dominant position in an important market with moat-like characteristics. If you try to establish, as so many American companies did, a base in China and do it without impacting earnings, you’ll do it with a very small business that won’t have a competitive franchise. 

And that trade-off is just as clear an expression of this notion of the capacity to suffer.

The reputed earnings of a company may be temporarily burdened by start-up losses from investments.

When Sorkin wrote his post, he spoke to Howard Schultz who was convinced that the market in China for Starbucks is going to be larger than the U.S. The efforts to do that would require time and money – tremendous amounts of it. So much so that shareholders complained in the early days of the endeavor. “The years of losses built pressure from both within and from the street to leave and abandon the China market,” Schultz told him.

Starbucks has continued to invest more deeply in China. Has started growing coffee in Yunnan Province and is discussing the prospect of ultimately creating a global brand of Yunnan coffee with the Chinese government, similar to what Starbucks has done in promoting its coffee from Colombia, Ethiopia and Sumatra. 

Capacity to suffer means you are incurring short-term pain in order to achieve long-term gains in the future. 

How Warren Buffett acted on this

During a talk at Google’s headquarters in September 2015, Russo narrowed down on Warren Buffett and his investment in Geico. The latter was a solidly profitable auto insurer with low expenses because it bypassed agents and sold directly to the consumer, with a focus on low-risk drivers.

Buffett questioned the CEO as to why the company had a mere 2 million policy holders. Pat came the reply, it’s too expensive to grow because every new policy put on the book lost $250 in the first year. However, each ongoing insured made $150 per year of operating profit for the company. Now 2 million policyholders making $150 a year resulted in $300 million of profits.

The logical step would be to add a million new policies the following year, because, as Buffett explained, they had the best business and were sharply under-penetrated. But what would happen is that $300 million would drop to $50 million (working here on the assumption that the other business didn’t grow at all). That did not faze Buffett. In his mind, there was no better reinvestment than to take that $2 million insured base up. He knew the intrinsic value of the firm and wanted to grow that.

From 2 million policy holders, Geico increased that number to 11 million over 14 years. And in the latest annual report (at that time), Buffett noted that Geico had added $20 billion of value since Berkshire bought it.

The only way they got there was by having the capacity to let the income statement bear the burden.

How a gigantic firm lost out by refusing to think ahead

In a conversation with MOI Global last year, Russo spoke of General Mills. One of the businesses inside the company was called Yoplait Yogurt which basked in the glory of having won the yogurt war in North America, and was earning something like $350 million a year.

At one time, they heard about a yogurt startup in upstate New York in an old Kraft factory. A few of them went and checked the fledgling startup to sell Greek Yogurt, but whose founder was Turkish, not Greek. They were not impressed. They told their bosses that they had nothing to worry about and suggested they not spend any money since their revenue numbers would anyway match the expectations of the street.

Big mistake.

Last year, Fortune reported that in 2016, 9 out of the top 10 yogurt brands enjoyed rising sales. While the tide lifted all the other boats, Yoplait’s sales sank by 23%, after a 7% drop the prior year. A shipwreck for General Mills since it contributes to 18% of company revenues.

General Mills should have confronted the competition at the start. As Russo noted, Chobani could have been put out of business within the first year by aggressive tactics. For about $10 million they could have gone after the niche and they would have had a running start on the brand. If it had worked, they would have been able to immediately squelch the Turkish Greek yogurt maker.

General Mills should have indulged in the capacity to reinvest. They should have redeployed capital in ways to continue to delight the customers. They blew it with Chobani because of their short-termism.

This is a company that owns brands such as Cheerios, Yoplait, Nature Valley, Betty Crocker, Wheaties, Pillsbury, Old El Paso and Häagen-Dazs. While they cleverly played off Yoplait’s Frenchness to convince Americans they liked yogurt, the company got caught flat-footed by upstart Chobani, which brought “Greek-style” yogurt to the American palate with artisanal and natural ingredients.

Often, businesses that overspend upfront, develop a more competitive advantage later.

Let’s end with Russo’s words during an interview on this subject.

When management makes those investments, they must have the capacity to suffer. They have to suffer during the start-up period of those investments because they are not necessarily linked to at the hip with the Wall Street expectations of smooth and steady quarters, but they are able to withstand the burden of the investment cycle. It is inevitably certain that profits are low or non-existent during these early years. And if you do not have the capacity to suffer through that period, you will shy away from making the accurate amount of investment. Your management will under-invest at a time when they have set an advantage and will allow competitors to come into the market.

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