Have you invested in a company that has “Capacity to suffer”?

Ashish KilaPerfect GroupWhen Jean Marie Eveillard, the French International Investor who serves as the senior advisor at First Eagle investment fund, was asked to describe the characteristics of a good analyst, his response was “capacity to suffer”. That’s true. A good money manager must have the ability to suffer through periods of bad performance. Thomas Russo picked it up and popularized it. Thomas Russo, also known as Tom Russo, is a partner at Gardner Russo & Gardner. Russo manages around $4 billion in Gardner Russo & Gardner’s Semper Vic Partners fund. Tom Russo has an MBA degree from Stanford. Russo has returned 14.6% annually after fees and expenses. Russo has managed to beat the S&P 500 index by 4.7 percentage points annually between 1984 and 2011. Russo invests in companies with strong global brands that have the huge growth potential in the emerging markets. Thomas Russo, like all other value investors, had the experience to back him up. In 1999, he was invested in good businesses – Nestle, Heineken and Unilever, among others. They were terribly out of favor relative to the forces that were driving the market at the time. His fund was down by 2% and the Dow was up by 27%. He was able to stay the course because he had the ability to suffer. Naturally, the same can be said of his investors.Thomas Russo applies this phrase – the capacity to suffer to businesses too, when they choose to invest in growth which hits profits temporarily. In most cases due to market pressures, companies are not willing to hurt short term profitability to business for the long term and hence few companies which are willing to do so appear to be overvalued due to depressed profits.What Tom Russo means is that to identify the companies he mainly looks for companies who have displayed the ‘Capacity to Suffer’ in the past and are on the verge of emerging stronger. The emphasis of the article is to show capacity to suffer as a framework and we have chosen the examples of Agro Tech foods and Wonderla Holidays to further discuss this framework.What are the Characteristics a company must have to say that the company has - “Capacity to Suffer” as per Thomas Russo:-i.“Brands”:-Invest in companies which have “brands” whose awareness has already affected much of the world. In the case of ConAgra Foods' (AgroTech’s Parent company) consumer brands can be found in 99 percent of America's households and enjoys No. 1 and No. 2 positions in their respective categories. ii.“No Initial Return”:- The “Capacity to suffer” is key because often the initial spending to build on great brands in new markets has no initial return.In case of AgroTech, the chart and data shows below that while making the capex, there haven’t been great returns. Source: Company data & Perfect Research EstimatesIn case of Wonderla as well, the following impact is shown below: Source: Company data & Perfect Research Estimatesiii.“Capacity to reinvest”:- Look for companies which have the “capacity to reinvest”.In case of AgroTech, company has been spending high capex (~Rs150Cr) in last 4years to set up 4 new manufacturing plants(3 in India and 1 in Bangladesh).Total number of plants will go from 2 to 6. In case of Wonderla Holidays, it can be seen that company has the capacity to reinvest. Company started its first park at Kochi in 2000 and then the second park at Bangalore in 2005. Now company is setting up its third park at Hyderabad which is expected to be operational in 2016 and the fourth park at Chennai and company has plans to keep on opening further parks going forward. All this shows that the company has the capacity to reinvest. iv.“Huge Scope to grow”:-Tom Russo says look for those companies which have a huge scope to grow going forward.AgroTech has a huge scope to grow and thus the Capacity to suffer taken in initial days will be fruitful in the future.Source: Company data & Perfect Research EstimatesIn the case of Wonderla as well, there is a huge scope for the company to grow which is clear from the table below:Source: Annual Report Adlabs Imagica & http://www.iaapa.org/resources/by-park-type/amusement-parks-and-attractions/industry-statistics v.“Tolerance”:- Capacity to Suffer is the managements’ ability to endure through early burdens on reported profits in short run in order to advance their long term competitive advantage. There may be burden on margins of the company in the short term and company must be able to tolerate this burden.In case of Agro tech, the burden on margins can be seen clearly below and the management has been patient enough. Source: Company data & Perfect Research EstimatesIn case of Wonderla Holidays, the burden on margins is shown in the chart below:Source: Company data & Perfect Research Estimatesvi.“Expand Business for future success”:- Tom Russo says look for management which take decisions to expand business which could impact near term reported earnings but hold the key for future success and growth for the company.In case of AgroTech, management could easily invest in Sundrop and increase the topline but management is taking decisions of expansion in the food business where they have a clear right to win.vii.“Expansion of Product Line”: After placing popcorn in India successfully, Agrotech is now expanding their product line by placing peanut butter in the market.viii.“Aggressive Capex”:- The problem with investing smoothly is that when you are trying to invest in new market, smooth investment spending really doesn’t give you enough power to make an impression.In our case of AgroTech, company is not making smooth but aggressive capex. ATFL has spent about Rs. 150 Crs. in last four years to set up 4 new manufacturing plants. Source: Company data & Perfect Research EstimatesIn case of Wonderla, the aggressive capex is shown in the table below. Source: Company data & Perfect Research Estimatesix.“Have Patience”: In case of Agro Tech also, the management has been patient enough. ACT II popcorn was imported in 1999 but got locally manufactured in 2007 only. Management kept patience till the capacities are developed and they understand the dynamics of foods/snacks business.In the case of Wonderla Holidays, management has been patient enough. They started their first park in 2000 and then the second one, after a long period of 5 years, in 2005.Now, after a period of almost 10 years, company is setting up its third plant at Hyderabad in 2015. Therefore, the management has been patient enough.x.“Long Term Competitive advantage”:- Companies must be able to advance their long term competitive advantage. In case of AgroTech, company has no major competitor in Act 2 popcorn in India. Company has successfully placed Act 2 popcorn in India where now it has an edge over the others. Now, it is focusing on the peanut butter to further advance their competitive advantage.In India parks are offering tickets at the high prices. For example, Adlabs Imagica has priced its tickets from Rs. 1500-1800. But Wonderla’s low cost structure allows it to offer tickets at around Rs. 700 to 1000. xi.“Outside Analysts’ View”:- look for promoters who ignore the analyst and fund manager’s short term view on the stock prices.In case of Agro Tech, price chart given below shows that there hasn’t been much movement for a long time. But, management completely ignores the views of outside analysts and fund managers. Source: moneycontrol.comIn the triangle of quality, cost and time, one can get two out of three. In case of Agro Tech, management has chosen high quality at low cost, they are ready to wait patiently but don’t want to get the quality and cost structure wrong.xii.“Focus”:- concentrating on one aspect: AgroTech’s vision is to become the “Best Performing, Most Respected Foods Company” in India. Also outside analysts have been pushing them for the launch new products but management has been much focused on entering areas where they have the clear right to win.In the case of Wonderla Holidays, the company has been focused enough to keep the cost structures low to offer value for money. (Cost of setting up Hyderabad Park is Rs. 250 Crs. vs Rs. 1650 Crs. for Imagica) Source: Stalwart Advisor reportTo conclude, “Capacity to Suffer” is a key ingredient for long term wealth creation and one must not make the mistake of punishing companies in the short run for choosing pain to develop long term competitive advantage.Disclaimer: The name of the stocks mentioned above is for educational purpose and not for recommendation.Sources:http://www.insidermonkey.com/hedge-fund/gardner+russo+%26+gardner/135/ https://www8.gsb.columbia.edu/valueinvesting/sites/valueinvesting/files/Graham%20%20Doddsville_Issue%2023_Final.pdf http://www.atfoods.com/our-brands.html http://www.moneycontrol.com/india/stockpricequote/edible-oils-solvent-extraction/agrotechfoods/ATF https://www.youtube.com/watch?v=skrSif0vhOk http://www.iaapa.org/resources/by-park-type/amusement-parks-and-attractions/industry-statistics Ace Equity Software