Why I Focus On 'Inevitables'

by: Long Hill Road Capital
Summary

Inevitables are businesses that are virtually certain to be much bigger and more profitable 5 and 10 years from now.

The big advantage I derive from owning Inevitables is that I can maintain my confidence in them regardless of when the accrued value gets reflected in stock prices.

It is significantly more likely that I lose confidence in a lower-quality or "thesis-reliant" investment if near-term business results do not pan out the way I expected.

The opportunity cost of not owning businesses that are inevitably compounding in value over time is far too high for me.

In Warren Buffett's 1996 letter to Berkshire shareholders, he wrote the following about companies he called "Inevitables."

Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.

Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables. But I would rather be certain of a good result than hopeful of a great one.

Of course, Charlie and I can identify only a few Inevitables, even after a lifetime of looking for them. Leadership alone provides no certainties: Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility. Though some industries or lines of business exhibit characteristics that endow leaders with virtually insurmountable advantages, and that tend to establish Survival of the Fattest as almost a natural law, most do not. Thus, for every Inevitable, there are dozens of Impostors, companies now riding high but vulnerable to competitive attacks. Considering what it takes to be an Inevitable, Charlie and I recognize that we will never be able to come up with a Nifty Fifty or even a Twinkling Twenty. To the Inevitables in our portfolio, therefore, we add a few "Highly Probables."

You can, of course, pay too much for even the best of businesses. The overpayment risk surfaces periodically and, in our opinion, may now be quite high for the purchasers of virtually all stocks, The Inevitables included. Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.

A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. Unfortunately, that is precisely what transpired years ago at both Coke and Gillette. (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette?) Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding. All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander. That's not going to happen again at Coke and Gillette, however - not given their current and prospective managements.

When I first read that in 2007, I thought investing only in Inevitables works for Buffett and Munger but it isn't necessarily for me. It only took about 10 years, including 7 years of managing money professionally, for me to come around to Buffett's view on Inevitables.

I'm going to tell you what attracts me so much to investing in Inevitables. First, I'll define it in my own way. An Inevitable is a business that is virtually certain to be much larger and more profitable 5 and 10 years from now. If I would be comfortable investing a quarter of my net worth into a company, and have the stock market close for 10 years, then we may be talking about an Inevitable.

Why have I come around to focusing on Inevitables?

There have been times in my career where I made an investment based on a specific thesis that would have to play out for the investment to be materiallly successful. For example, a strategy change would cause margins to accelerate. Or a new revenue stream would take off. Or the company would be sold to a strategic acquirer. I'll call these "thesis-reliant" investments. Sometimes these theses played out, but often times they only partially did or didn't at all. In the unsuccessful cases, I typically held the stocks for 2-3 years while they did nothing, plus or minus. Sometimes they declined and bounced back, while other times they rose a bit and then fell. I'd sell them and move on.

You may be saying, "Ok, well that's not the end of the world." It's not like losing your entire investment. That's true. It's better than that. But I've increasingly begun to question whether I can improve the financial result of my bad outcomes in investing. For a lot of people, a bad outcome is losing 30% or 40%. For me, a bad outcome, outside of a few outliers, has usually been breaking even, more or less. I attribute that to trying to pay prices that don't reflect much chance of my bull thesis playing out. Then, if it doesn't, the stock doesn't fall too much since it was never pricing in those expectations to begin with. But I'm now fully appreciating that I can improve the financial results of my bad outcomes.

Sitting on a stock that does nothing for 2-3 years before selling it has an enormous opportunity cost. The S&P 500 typically appreciates 7%-8% per year on average, so this 5% or 10% portion of my portfolio might do nothing over 3 years while that money invested in the index could have been up 26% (1.08^3).

Opportunity cost is not a new concept to me. So why has it taken me this long to stop investing in these "thesis-reliant" investments? And what's the big insight I'm now finally understanding?

With "thesis-reliant" investments, the sell decision that occurs if the thesis doesn't play out is what buries the nail in the coffin of the investment. Selling them isn't necessarily the wrong move at that point, not at all. The wrong move was owning a business in the first place that I could so easily lose confidence in if a specific thesis doesn't play out.

With the world's greatest businesses, they are constantly growing their revenue and their cash-generating potential. Regardless of what their stocks do over in given year, the business itself is always making progress, always expanding, selling more widgets to existing customers, finding new customers, or establishing new adjacent product lines or revenue streams. These businesses have a relatively small market share in a very big addressable market and the competitive advantages necessary to capitalize on its opportunity. So the long-term outlook for the business almost always remains positive.

If I hold one of these Inevitables for three years, and the stock does nothing more or less, I can rest assured that the underlying business is much more valuable today than it was three years ago. The value of the business has compounded, and the moat has probably widened and deepened, despite whatever the stock may have done. While I'd usually prefer for the stock to have grown along with its underlying value growth, it's not the end of the world because I simply have deferred gratification. The gains will inevitably come. As a result, I have no desire to sell the investment, crystallizing a bad investment. Instead, I can sit on it, knowing it's only a matter of time before I'll get paid. With any luck, that should be the bad outcome of Inevitables-- disappointing results on paper for a few years before worthwhile positive returns over a longer time period.

Now let's compare that to a lower quality thesis-reliant investment that does nothing for three years because the thesis didn't play out as expected. I don't necessarily have as much confidence that underlying value has been accruing to me for those three years. Maybe the business is now in a weaker state because one or more of its initiatives failed. Maybe executive turnover or low employee morale is now hampering the company's ability to recruit. Selling could be the right move here.

Or maybe value actually has accrued to me and it's just deferred, but whether that's true or not is less important than whether I have the confidence to sit tight and wait for it. My own confidence to wait for my deferred gratification depends entirely on the quality of the business and whether I believe it is destined to be much larger and more profitable in the future.

So whether or not selling the thesis-reliant investment turns out to be a good or bad decision in hindsight doesn't even matter. I lost confidence, sold, and crystallized my lost opportunity cost.

Had I owned a high-quality compounder that was destined to be much larger and more profitable, I'd never would have dreamed of selling it after three years without getting paid. Imagine buying 30% of a fantastic private business, holding it for a few years, attending board meetings, getting periodic updates, and watching it grow bigger and more profitable. Then someone comes along and offers to buy your stake at the same price you paid three years ago. You'd laugh them out of the room. But that's what a lot of people do in the stock market all the time. Despite seeing the profits made and the cash flow accruing to them in the financial statements, many investors bail out without waiting for their profits because something causes their confidence to change.

Great businesses are profitable over time, and owning them Makes. You. Money. That should go without saying. And it's true regardless of whether a business is private or publicly-traded. But you don't always get paid every month or every quarter or every year. The profits become reflected in stock prices on their own schedule, and you have no control over it. You often have to wait for it, and the market is excellent at causing you to lose confidence and sell at wrong times.

Buffett once said,

The stock market is a device for transferring money from the impatient to the patient.

Well said. The public stock markets have an uncanny way of turning the fundamental advantage of business ownership, a high probability of making money, into a crushing disadvantage. How else could so much of the public consider the stock market "risky?" "Business ownership" is not considered "risky" by the public. The key is it is entirely up to the investor whether an investment in a stock represents long-term business ownership or not.

Owning Inevitables for the long-term allows me to maintain my confidence in them throughout the ups and downs of their business and the stock market's volatility.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.