IIC 2021: A Conversation with Chris Mayer – Author of 100 baggers

Speaker: Mr. Chris Mayer, Portfolio Manager & Co-Founder, Woodlock House Family Capital

Moderator: Prof. Sanjay Bakshi, Managing Partner, ValueQuest Capital LLP

Contributed By: Kapil Mehra, CFA, Volunteer, CFA Society India

Chris is a prolific writer and has written four books, ‘Invest like a Deal Maker’, ‘World Right Side up: Investing Across six continents’, ‘100 Baggers: Stocks That Return 100 to 1 and How to find them’ and ‘How do you know’. The conversation was in a Q&A format and started with his latest book “How do you know”.

Q: Please explain this concept of Labels as mentioned in your book.

Ans: Investing and life is full of tricks and illusions and stories that are crafted to create stories in our heads. As a result, labels like Value & Growth get formed in our minds. It’s difficult to make people drop these labels these help them look at the work in a big picture way. Value is not necessarily a subjective concept and is inherently in the minds of the people doing the valuation. Instead of thinking on such broad-based lines like something is good for the economy it’s better to think as something is good for a specific industry or a company. So, one should try to break the labels into smaller quantities and assess their impact giving them creative insights.

Q: In the book you introduced a concept that ‘Our World Changes Continuously and Nothing Remains the Same’. Please explain this concept a bit more.

Ans: No episode of life plays the same way every time. For example, the crash in March-2020 was quite different something unlike what we had previously. Had you put the past pattern of crashes in comparison, then you would have believed that it will take a long while to recover. However, it received sharply within a few months and one of the fastest recoveries of a bear market ever for S&P 500 which is on record. Every event we live is different from what we have lived before.

Q: While most events tend to be different but at a larger scale the events tend to repeat. Please advise best way to reconcile these events in our minds.

Ans: There are all kinds of patterns and pattern recognition is very important. As per my experience, owner invested businesses do better than CEO run businesses (who do not hold any stock in the company) as owners tend to have significant skin in the game. So, that’s a good historical pattern that I like yet at the same time I do not want to get too lazy about it and generalize the concept as there are many bad owner operated businesses as well. At times the owners paying lot of stock tend to manipulate the minority shareholder. I have heard many say that this company is the next Berkshire Hathaway but it rarely plays out that way.

Q: Please explain The Date Trick that you used in the book which helps you remember that it’s not the same this time.

Ans: It is a very simple idea which comes from the famous philosopher of the 1920s, Alfred Kigipsky. He says that whatever idea you have just date it. For example, you might feel that Berkshire Hathaway is a great company. So just date this in on paper. If later, you feel that you no more feel the same way then you are free to change your thought and say that you no more feel that way. This way your mind understands that what you felt in the past could be different this time.

Q: There were certain business groups that I avoided during my early investing career thinking that they were not doing things in the interest of the minority shareholder. But along the way the father handed over the business to the son who was professionally educated, and he changed the course of business totally. I still didn’t invest into that business due to my age-old impression of the company, but things changed. Does it help to have a clean memory on the things and start afresh?

Ans: Things change with time and we should be prepared to accept the changes. For example, Warren Buffett made excellent returns in rail-roads business and this industry was once seen as a bad investment choice. So, with time the changes if figured out correctly can be beneficial. Similarly, family-owned businesses do well in the US but in Asia they are known for misery to minority shareholders.

Q: In India we have examples of outstanding performances by hired hands with the right incentives who have created enormous wealth for the investors.

Ans: Yes, it’s very much possible. Specially in India the hired hands have performed very well. With the right incentive though tough to get can be a good way to manage the companies. For example, it’s Tim Cook at Apple not Steve Jobs yet enormous value creation has happened under him.

Q: Going back to 2015, when you wrote the Book 100 Baggers. What has changed for you since then?

Ans: Yes, I have changed a lot. There are a couple of things like change in emphasis. I think I will emphasize more on the idea that we should focus on businesses which generate higher return on capital. Also, very important that they are able to reinvest these returns in the same business over and over again so that they are able to make super high returns and this thing compounds over and over again and makes super high return. So, fallback of this model is that dividends should be lesser for these companies so that they are able to compound the capital at a higher rate.

Q: Coming to ROCE (Return on Capital Employed), how should we treat the intangible capital of businesses like pricing power, patents etc. which modern accounting ignores which will make the capital base quite high.

Ans: Yes that can be a huge capital base. For instance, Ferrari’s Brand Equity will be very high but  for calculating the accounting ratios of return on capital I will avoid that since it can get too philosophical.

Q: Money in the business (Return on Invested Capital) is not same as money in the company. Lot of times businesses sit on excess cash which pulls down the ROCE of these businesses. Which return metric should we look before investing?

Ans: I think you should look at both. Important to understand what cash is getting invested into the company and returns generated on that and also important to know how much cash the company is unable to wisely deploy which is affecting their ROCE. Companies need to be good capital allocators as well. So best is to look at both metrics.

Q: Sometimes the cash deployment can be low because of factors like cyclical industries or having more cash on the balance sheet makes you more stable. So, how do you justify that?

Ans: Yes, I will be happy to look at companies that are not the top ROCE players but will hold in my portfolio due to stability, safety and lesser debt. Pandemic has taught us this.

Q: Businesses can manipulate ROCE by reducing the capital base through things like taking lower capital, just in time techniques, lower working capital, paying later to vendors etc. which makes it look good until one day it all collapses. So, how do you distinguish higher ROCE to higher stability.

Ans: Yes, you are right that being too narrowly focused on a higher ROCE company and ignoring other factors like stability, management, debt can be a risky bet. At times, people manipulate the numbers to earn incentives. So, it’s more of a personal style of investment. As I follow a conservative approach so for me the people running the business are more important than the numbers.

Q: Is it right to say that the spread between ROCE & Cost of Capital is important and the amount of money that you can throw at that spread i.e., by way of compounding that will further boost the ROCE and make the spread more attractive.

Ans: Yes, that’s important and the other most important thing to note is that how sustainable that spread is.

Q: Coming to your book 100 Baggers, while its simple that you find high ROCE business like 25% and let it compound for 25 years so you get a 100 bagger but in practice the real-life deterrents don’t allow us to do so like high valuations, pandemics, markets about to correct, company related issues etc. So, how you manage this?

Ans: Even the best performing stocks like Berkshire Hathaway, American Express have had tremendous drawdowns & challenges so the strategy should be to just stick to them for a long period of time. This is most challenging part where you need to hold a stock which is 80% down in your portfolio. Financial industry works on changing the stance, but we need to stay put with the good investments which is very critical to make 100x returns.

Q: How do you evaluate managers on capital allocation skills?

Ans: It’s easier to invest in companies with capital investment opportunities as the compounding works and we are sure of the returns. However, capital allocation part is tough as it involves buybacks, acquisitions, dividend treatment. So, a great capital allocator will do the buy back at the right time not always. For example, one of the company’s I own did an excellent buyback for USD 100 million and stock performed well. Capital allocation skills are not common, and mistakes do happen.

Q: Given the popularity of passive investing where do you think we are headed? With average life span of companies only 20 years so the index gets loaded with the momentum names. Is indexing a bubble?

Ans: I do not think that indexing is a bubble. Getting entry in the index helps and things can look upwards but there has to be a point of equilibrium till things pick up. I have always picked stocks basis their long-term potential irrespective of their position in the index. Indices get flow of funds so at times it can be very tough to beat the indices.

Q: There are these 3 buckets in business called Business Bucket, Management Bucket, Valuation Bucket. While Business & Management can be objective to assess but Valuations can be very subjective and based on dreams, hopes and stories. How do you manage the Valuation part.

Ans: I usually buy businesses that are more mature and have a track record of returns and earnings. I focus more on free cash flows before the discretionary spends and get an idea what you are paying for. You can’t pick all the winners, so you need to pick an area you are good at and stay with it. It’s ok to miss opportunities around. Mistakes of omission of a 100 bagger are always there but you need to be comfortable with that. Even Warren Buffett missed Google and Amazon!