Tom Russo at European Investing Summit

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Thomas A. Russo

Partner, Gardner Russo & Gardner

Exclusive Transcript (lightly edited, may contain errors)

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Exclusive Transcript

(lightly edited, may contain errors)

Thomas A. Russo, Partner, Gardner Russo & Gardner

“How to Invest in Europe — A Superinvestor Perspective”

European Investing Summit 2012

Host: Welcome back everyone, to this live keynote session at

European Investing Summit 2012. We’re very excited about this

one. This session came about last minute but we’re just very

flattered to have with us Tom Russo. I’ll let Oliver properly

introduce Tom. He will then share his remarks with us. After that

we’re going to have a Q&A session. As always, feel free to write

in your questions at any time into the online interface. This

session is being recorded and will be available in the online

conference area within 24 hours. And with that, Oliver, please go

ahead.

Host: Thank you, John. We are very fortunate to have with us one of

the world’s greatest investors, Tom Russo of Gardner, Russo

and Gardner. Tom is a global value investing heavyweight. From

his early days at the Sequoia Fund in the 1980s to now


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overseeing $6 billion of capital through separately managed

accounts and Semper Vic partnerships. Tom has had the

foresight to recognize the benefits of international investing

before many other investors and has so skillfully executed on this

approach. We are very delighted he has taken time out of his

schedule to be with us today, to update us on his latest thoughts

on Europe and beyond. So without further ado, Tom, the floor is

yours.

Russo: Thank you very much, Oliver and John. I am delighted to

participate. This is the most high tech thing I’ve ever done. I think

my two children—in their mid to late 20s—will celebrate the fact

that I have been involved with a webinar and speaking indirectly

through not only an online version but also through this

conference. So it’s exciting. And I have had the great pleasure,

really from my Stanford Business School days when my

professor, Jack McDonald, suggested that Americans are far too

provincial as investors and they should in fact look abroad where

95% of the world lived, even though back in the early 1980s the

investment market of global equity values were concentrated so

heavily in the US. The promise was all abroad even then and I

had the good fortune of having someone I admired steer me that

direction. In the early days—very tough to do. American-based


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investors were quite skeptical because the US market seemed to

be certainly sufficient in terms of the returns that were possible to

get and there are two expressed concerns, which since they last

to the present they’re probably worth expressing.

Early days people worried about accounting and they said, “How

can we trust the accounts?” and at the time, for instance, when I

first started to buy Nestle [Swiss: NESN] in 1987 the semiannual

report was only four or five pages. It was very scant. But it gave

you the important information and with the culture of the firm

being on course and the annual reports being disclosures

sufficiently deep the midyear didn’t seem a problem. To me what

it meant that an ADR facility couldn’t be established and people

avoided the stock because they didn’t get American style

accounting—that was to their discredit. And over the years we’ve

seen that the greatest mistakes and frauds have been often

American accounting based frauds. So accounting was a

problem for investors but I was able to comfort myself with that.

And the other expressed concern was “What about the currency

risk?” and my answer then and now remains “As compared to

what?” because as an American, if you consider foreign

currencies to only be a source of risk it’s a fairly ethnocentric way


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of viewing the world and there are elements embedded in QE3

today at the most extreme but over the past several decades

there have always been elements that led to lower dollars over

time and I was prepared to accept the risk of the opposite back in

the 1980s and we’ve been benefited by having foreign exposure

over time.

Fast forward to today. The question becomes “What’s the value,

particularly in the European companies?” and the context seems

so horrible with the collapse of the euro imminent and with

sclerotic economies but I’ve found that amongst the companies

that we’ve owned over time the European companies have done

a great job often in the thing that I find to be one of the biggest

risks, which is the risk of agency costs. We’re able to find in

European companies often family controlled companies where

managements are incented to take the long view and the

companies are able to turn down the quarterly earnings noise

more forcefully out of the European based than American

counterparts enjoy where the drumbeat for quarterly estimates

and meeting them is much deeper. So in Europe the lack of the

option compensation culture has meant that the urgency with

which projects yield results has been lessened and so historically

the businesses have had less option pressure.


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Many of our European businesses enjoy the fact that they had

already gone abroad decades ago with the empires so Cadbury

was in that position, Hindustan Lever’s presence is shared by

Unilever [London: ULVR], but those were part of the early British

influence in India. All over, European companies have been

involved with Africa far longer than American businesses ever

were, so there is a brand preference that’s a legacy that we’re

able to patch into. I think that’s been very helpful as those

markets have grown under the recent past. The brands that were

embedded are those that are aspirational and our businesses are

able to reinvest behind developing those brands for the market.

And so we have a fair number of European companies with such

global brands and embedded presence abroad.

The other thing about the European situation at the moment is

that there is such global pessimism that there is little regard

given for businesses that have succeeded in Europe for the long

term. In fact there is some burden that comes from that. I think of

two portfolio holdings—Heineken [Amsterdam: HEIA] and

Nestle—who are often censured by investors because they’re so

heavily present in Western Europe and that’s deemed a burden.

But over the past five years operational gains have come that


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have long been needed but unavailable in Europe. Nestle, for

example, having owned Perrier—a French based business—for

so many years and unable to get needed work relief, over the

past couple of years has had labor relief sufficient to give them a

chance for enough profits from that long staggering division that

they’ve invested heavily behind brand marketing and now the

brand’s growth rate is up into the low 20% range and with that

are finally coming profits because the cost structure has been

modified and that was something that did not happen willingly but

it happened under Sarkozy by virtue of the fact that there is just

so much pressure on France to become more market effective.

I’m not sure how that will develop with the new leadership in

France but it certainly was an example of how progress was

made. In England, for example, Heineken has closed four

breweries and they actually share production of their beer now

with some other breweries in England to try to get best cost. And

so even though there is a fear over sclerotic Europe, the

businesses that we have who run there are able to run more

effectively, harnessing technology to be more efficient and also

by work changes that have allowed for best practices. I am just

back from a visit to China where I met with management from

Nestle who wanted to showcase their involvement with this


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important growing market. It’s part of the fear today in global

investing is the slowdown in China and at the level of selling

Nescafe coffee or Chinese-sourced confectionary or Chinese-

sourced beverages like peanut milk one would see a fairly robust

and vibrant market when you tour. The arrival of western style

retailers is helping the business to become more effective and

more efficient.

The willingness of Nestle, in their case, to use local joint venture

partners means that they’re able to harness the insights about

the local consumers’ tastes but deliver to those businesses the

kind of world class production and accounting and operational

structures that Nestle has mastered elsewhere. So it’s a positive

relationship but they do retain local owners and local managers

in a very high and elevated way, which is a change for Nestle as

they try to gain greater share in this fast growing, important

market.

And the general level of business as I saw it—at least at the

consumer side—remained quite active and there is still a great

buzz on there. China, on the other hand, confronts a power shift

and there are certain adjustments that are coming about because

of that. There is a huge amount of chest beating over the


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controversial islands between China and Japan, which is venting

a lot of past grievances and it’s not clear how that’s going to work

out. I also met with Brown-Forman [BF] management and they

have a traditional effort to try to gain access to the extraordinarily

large Chinese local spirits market and there are modern

developments that are happening as the western competitors for

spirits become less dependent on key retail and are opening up

their business to the consumer more broadly as the off premise

and the less formal trade develops in China for spirits and

Brown-Forman is addressing that through their Jack Daniels

brand and some other products that they’ve developed for the

market.

Most of the global businesses that we own in the international

markets—Heineken, Nestle, Unilever—they typically have local

shareholdings available to local investors in many of their key

markets. I was accused by one of my former colleagues of being

a “sissy investor” in the international world by buying the

multinationals. Some people on the trip to China were celebrating

the fact that you can participate in the local markets more

forcefully by buying shares of their local subsidiaries—and we

can talk about the thoughts behind that. And the valuations for

businesses like those I referred to are not cheap. They’re low to


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mid teens multiples of next year’s earnings. Those earnings are

slightly burdened by reinvestment spending to develop the future

platforms. But in general they’re not at compelling crisis

valuations anymore but the capacity for the reinvestment to go

on for a long time and the ability to address large, open spaces in

the marketplace—the growing population, the rise in GDPs and

the rise in consumer disposable income—mean that I think that

the businesses can earn their way into the current valuations and

with that I’ll open up the floor to questions.

Host: Tom, thank you very much for those remarks. I want to remind

everyone that if you’d like to ask Tom a question feel free to send

it in through our online interface. We do have questions coming

in fast and furious here. There is one from Joe Koster who is a

very thoughtful value investor in his own right and he writes that

at a presentation in Omaha in May Bruce Greenwald mentioned

how Nestle is the perfect hedge for either inflation or deflation.

Based on your comments today and in other places I assume

you probably agree. Can you give any examples of other

businesses that can thrive in either an inflationary or deflationary

environment and is pricing power the overwhelming

characteristic to look for in identifying such opportunities?


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Russo: Pricing—well thanks for the question—pricing power is really the

result of the company’s total process of delivering products that

have attributes that they determine the consumer wants

sufficiently, that the consumer believes there to be no adequate

substitute. And that really is the job of the companies that we

invest in is to capture deep consumer insights so they know the

needs that they then can address through rapid innovation of

products that offer the ability to meet those consumer needs. And

that’s what we look for and as a result of that the consumer

believes that there is no adequate substitute for the products that

our businesses offer and they’d be willing to bear a little higher

cost as a result of that if costs indeed must go up to face inflation

pressures and cost of goods sold.

Nestle prominently describes their efforts to tap into the

developing emerging market through something called popularly

priced products and usually that means reformulated products so

that the cost to deliver a Nescafe coffee at the earliest stage of

consumption in developing markets is going to be lower because

the product is reformulated. It had different attributes and so they

can deliver it in an expensive channel to market with sufficient

margin because they often reformulate the product.


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As far as affordability, the products come to market in one or two

serving packages and so the consumer, at the early stage, can

afford it because the product portions are small. And so they can

afford it. There is margin built in. The cost structure is modified

because they reformulate the products for the market’s needs.

And that’s how you can survive the rising potential costs of

energy for distribution or ingredients for the manufacturing.

In terms of deflation I ascribe a fairly low amount of time worrying

about that because I don’t see how we’ll get that over time and

so our businesses are more possessive pricing power to offset

the growing costs rather than holding onto their prices during a

time of declining costs. So I’m not as schooled on deflation and

what it will mean for a firm like Nestle as Bruce is, but the real

driver for Nestle is going to have to be the migration from

popularly priced products up the pricing ladder to products that

have more attributes and more value delivered and that comes

along with the rise in GDP and consumer disposable income in

the developing markets where we are at.

The deflation—that might occur and it may be more western

European and more developed market deflation matching the

weakness in those local economies and in that area the


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companies have to be able to focus on cost management without

any abatement whatsoever—a ferocious focus on cost—and

there, technology plays such a huge role. And our businesses—

at the best level of operation—are putting out best practices that

are run through SAP systems and system wide operating

systems that allow them to operate in developed markets where

pricing pressures placed on them by retailers and deliver

products that are manufactured with less operating cost and

that’s the return to technology investment that our businesses

are making.

Host: We have a question from Dave Sather who writes some family

controlled businesses are good stewards of wealth while others

are not. You don’t seem to be scared away by control families.

What characteristics do you use to differentiate between good

family control versus bad family control?

Russo: One of the great indicators is the caliber of the people who are

not family members who are active in and retained by the

businesses that we choose to invest in. It’s really clear if you

have a business where the family is abusing the franchise for

whatever reason, whether they’re underinvesting, whether

they’re siphoning off money, whether they have side deals with


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themselves to pay themselves premium for services offered or

products delivered. They have ways in which they extract value

from the public. Quality individuals tend not to find a way to those

businesses. And so as you meet the various professionals up

and down a business if you feel like there is just a B-grade

quality to that organization it often reflects problems at the top

and problems within the ownership. So I think the real best test is

“Are they able to recruit the industry’s best and brightest and

keep them, incent them and then have them develop products

that are world class?” I think that’s certainly the standard that you

expect for a company like Nestle and some of their global

counterparts, if they haven’t had the right nurturing environment

or they treat their consumers with less attention than the

company that operates it at Nestle’s level, they just won’t keep

the same talent.

Host: Tom, another question from Dave Sather is what is the attraction

or deciding factor why you seem to favor Heineken or SABMiller

[London: SAB] as opposed to Anheuser-Busch InBev [BUD] or

Brown-Forman over Beam [BEAM]?

Russo: Well, one of the answers to that question in some ways involves

the benefit that accrues to an investor who is long only. I have


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great colleagues in the investment business who are long-short

advisors and often there is a pressure to identify the best and the

worst in an industry group and so in that environment kind of the

good may fall out because they’re not necessarily really bad or

they’re not great and so they’re not reviewed so carefully. And for

me, if I can find businesses that are generally great—and there

are a host of different companies that compete in it—I am

perfectly comfortable owning all of them. I don’t tend to own all of

them or many of them, at least at the same percentage weights,

and so the balance between the percentage weights has to do

with valuation and strength of the franchise and the quality of

management. And so that evolves—those portfolio holdings go

up and down in weight depending on what the market does and

depending on what kind of measures the companies do to

advance their business.

I didn’t have any holdings in Anheuser-Busch, for example, even

during the years when I owned SABMiller and Heineken and

Guinness for a concern over the quality of what the company

under the family was able to deliver off that great franchise and

made an investment in the business once I spent time with the

management that came in from AmBev and InBev, given what I

learned from them was their capacity to make the right


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investments to grow the business in those top five beer markets

around the world where they had dominant positions as a result

of the acquisition and it was a smaller position. It’s no longer…

It’s much more meaningful. It’s grown as I’ve grown comfortable

with the work they’re doing in markets and as the industry

consolidates there are some growing rational attention to the

need to make money in markets where previous managements

may have been more focused on something as unrewarding as

just plain old market share and they fought over bragging rights.

The teams increasingly in the business today are fairly return on

capital minded and I’m comfortable having a variety of different

exposures to the business because they all have areas of

specific strength that often are not overlapping.

Host: Thank you Tom. Our next question comes from Christoph Stahl

who is joining us from Munich—and by the way, what a

wonderful way to have a conversation with fellow value investors

all around the world. We literally have people on the line from

every continent. So Christoph asks, leaving aside valuation,

which would you consider to be the best alcoholic beverage

company or type of company—beer, wine or liquor? And would

you then rather wait until you can add funds to this best company


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at a fair price or invest in some other but cheaper company at a

lower price?

Russo: In terms of capital allocation, I’m fairly agnostic between beer

and spirits but have almost no direct exposure to wine as a

category. I’ve always felt that the value add off of the commodity

cost there and the pricing power that they enjoy in the wine

industry just hasn’t been as rewarding as you get with spirits and

with spirits increasingly where you can tier the pricing so sharply

and aspirational consumers are willing to pay substantially more

for components in the price hierarchy that don’t cost all that much

more. And so there’s the possibility of tiering in a way that you

really just don’t get with wine. And then beer compared to wine—

the economics of beer at scale with dominant local brewers is

just far more attractive than you ever find with wine because of

the great production efficiencies and the scale advances that you

get with brewing as opposed with a wine gathering and

operation. So I prefer spirits and beer over time.

A great business, which I’ve appreciated more fully with the trip

recently to China, is the very high end competitors in China’s

enormous spirits business. They have the capacity to charge, I

think, for a 150 year old bottle of Maotai 38,000 renminbi and the


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kind of brand loyalty and packaging innovation that they have in

the high end local market in China is quite impressive. We have

businesses in the West that I think are doing excellent work and

our portfolio includes in no particular order but all terrific—we

have Diageo [London: DGE], Brown-Forman, Pernod Ricard

[Paris: RI]—there are a host of other spirit companies that are

quite attractive as well, which we constantly consider. Beam I

have not had any investment in. I’ve tracked it. They’ve had

some terrific recent success with some products.

I think for me, to see pricing restored on their core Jim Beam

brand would be very encouraging as that unusually large

business for them has had a history of lack of confident pricing

and the category of bourbon ought to enjoy confident pricing and

that would be something that is important to see in Beam’s case.

But the industry is well represented and there are lots of

businesses that we have not yet invested in the spirits industry

that are very attractive and it’s just going to be a question of price

and getting to know management better.

Host: Our next question is from Simon Denison-Smith of Metropolis

Capital, who by the way hosts the wonderful London Value

Investor Conference and he asks that value investors often


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describe a strong brand as a moat. From our perspective, a

strong brand does not always seem to give a company pricing

power. Do you agree with this and how do you determine when a

brand does cause a wide moat and when it does not?

Russo: I think the real story with brand strengths and the return that you

get from them is linked to the distribution and the retail channel.

And to the extent that you are reliant upon the mass market

where the retailers have enormous clout and you fail to deliver

innovation on your brand platform, you are increasingly today

going to suffer pressure on price. And so it’s really incumbent

upon the stewards of the brands that we invest behind that they

innovate and that they add value and that they tell the consumer

about it through effective marketing—whether it’s digital, whether

with conversation or whether it’s broadcast, whether they create

an atmosphere, whether it’s billboard—whatever the vehicle is—

they have to tell the consumer that there is a reason why they’re

asked to pay up is because some product feature warrants the

premium price that they’re asked to pay. And absent that in the

grocery or the beer, spirits, wine are—absent that you’re going to

face pressure and the pressure is going to increasingly come

from the retailer and it’s going to be enforced against those who

fail to innovate by retailer owned brands, which increasingly are


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viewed as adequate by consumers around the world when

compared against just the me-too offerings of even strongly

branded companies if they don’t add enough value through the

communication or the innovation that the product should deserve

to stay vital as a brand.

Host: Next we go to Brian Hetherington who is asking what are your

views regarding the strength of demand from emerging market

consumers for high end western brands and then have those

views changed at all recently?

Russo: I’d say the trip to China, which I just returned from, offered an

interesting wrinkle to the question that you ask. We flew out of a

second tier city airport on the travels between Shanghai and

Beijing and this is a second tier city which happens to have ten

million people living in it so the airport was extraordinary, brand

new and vast and as we traveled through the airport there were

just like in any American airport extraordinary large numbers of

retail opportunities and all of the stores looked like those that you

see at the new terminal at JFK. However, upon closer

examination as you walk by the stores, you would see that

instead of Prada the brand was Betchi [sp] or something, their

trademark and brand that accompanied retail venues at the


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airport that looked every bit as high end and as luxury as the

retailing offerings that you’d see in western airports. But they are

local names I had never heard of. That’s the first time something

that I’ve pondered, whether it would happen or not, that I saw

starting to develop, which is the rise of copycat local offerings by

brand. Relatively confident prices so that’s new and it’s

something worth keeping in mind and exploring.

And what else may have surfaced in the appetite for western

brands—I still think that the consumer around the emerging

markets where brands have been present for a long time but

unaffordable, when they have some incremental spending money

and that process of obtaining that is the rise in the GDPs that are

in many markets underway because the markets are being

developed for the first time in Africa, for example, as the source

of resources for China and the trickle down effect of jobs created

has growing numbers of people first time ever able to consume—

well they like the western brands that have been around but

unaffordable and that’s what they choose. And I think the

companies that we invest in have a duty to make sure that they

continue to have that initial instinct and then satisfy them by

offering the product with a compelling entry price, with

formulations that suit the market—in many instances that suit the


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market particularly in a way that delivers health and nutrition or

some kind of added value.

And with that in mind, across the continents I think the western

brands still have a role to play, at least as the countries move

forward and then they have to be careful in markets like China to

make sure that their products remain vital enough that the

copycat local brands at high prices don’t start to develop a

following that doesn’t refer to the western styled products that

they imitate. So it’s two different answers—one for the

developing market and one for the developed markets like—

increasingly developed markets—like China.

Host: Tom, a slightly more technical question from Matt Goetzke who

asks what discount rates do you use and how do they vary by

country or business when evaluating a new opportunity for

purchase?

Russo: I would say that the discount rate is sort of 10%, which is

completely irrelevant to today’s interest rate environment. It

historically had been sort of the long-term treasury rate plus a

risk premium but it’s also the hurdles that I believe equity returns

ought to be able to generate for investors. So it’s consistent with


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what my belief is—is that equity investors ought to expect over

time, over market cycles, and have double-digit returns to

warrant the risk that they take. And so the discount rate I have in

mind when I look in companies is still far higher than it ought to

be in some ways, in light of the very low nominal rates that exist

today.

Host: We next go to Giulio Battisti who is asking what’s the very first

factor or parameter you look at when you analyze a company.

Russo: Well for me it would be the people. It would be who owns it and

then it would be kind of who runs it, what’s the quality of the

management team—it’s very much people driven analysis. On

the ownership side is if there is a strong holder who is likeminded

in their long-term outlook I would find that to be a very early

positive indicator that justifies setting out to do more work. If I

found on that first test that there was something about the

management that left me feeling it was opportunistic or short

term driven I probably won’t embark on the analysis that follows.

Threshold screening would be caliber of owners and then the

management that follows.


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Host: And Pablo Gonzalez asks which method do you use to actually

estimate and arrive at intrinsic value for a company?

Russo: I would tend to think of the business as relative to the private

market values that exist and are knowable through transactions

that take place. That gives me a sense of what alternative buyers

would pay for a business and that’s kind of a mathematical base

case place to begin. I then think about the business and I think

about whether we’re priced anywhere close to that number, and

if we are perilously close to that number I’d probably pass. If

there is a sufficient discount from that what we would then end

up doing is projecting out what the regions in a business are

capable of generating and in that regional analysis or else the

line of business analysis—the segment analysis—you end up

with portions of the business that can grow far faster, can receive

far more capital.

We pay most of our attention into coming into businesses where

there are regional or product line growth rates that are

determinable and are substantially high enough to justify a

valuation premium. And so most of the analysis is spent inside

the segments to figure out where the greatest opportunities are in

a business. Then value the segments independently and come


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up with a sense of whether the overall valuation is in the

marketplace sufficiently below the value that you get from

analyzing the segments to justify the investment. And then the

power of being able to invest behind those segments or those

geographies is not available across all companies and so we pay

a high tribute to businesses that have that capacity.

Host: Thanks. I want to just go to Oliver real quick. I think he has a

specific question and then we’ll continue with the questions that

have come in.

Host: Tom, last time we talked it was at the time of the Berkshire

Hathaway meeting. I’m just curious if you could update us all with

your latest thoughts on Berkshire. The stock is up a bit since

then. What are your latest thoughts?

Russo: I have been very impressed by the increased confidence

expressed by Mr. Buffett towards his team of analysts and

portfolio managers who now work inside of Berkshire with

portions of the capital. A substantial increase in the capital

allocation suggests a confidence in their ability, which I am

delighted to see. The increasing potential for the advisors to

participate in different aspect of Berkshire, which has been


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referred to by Warren’s letters, is very encouraging. Berkshire

Hathaway’s annual report suggests that they’re involved with

operating divisions as they contemplate acquisitions. They may

be involved with some of Berkshire’s own acquisitions at the

corporate level.

That capacity is very, very valuable and if it surfaces to the work

that’s being done by Todd Combs and Ted Weschler we will be

far better off as Berkshire shareholders as they prove up that

capacity because it will in a large measure indicate that the ability

for Berkshire to continue to reinvest its float in growing operating

cash flows at high rates of return will be better off over time as

those two mature into greater and greater responsibility. That, I

think, is terribly important and to the extent that each are involved

with guiding the subsidiaries as to how they might consider the

acquisitions that they contemplate or the capital prices that they

contemplate—that will fill a capacity I think that’s been so long

well served by Warren Buffett. So the development around this

capital allocation process I found to be most encouraging.

Host: Konstantinos Mihalopoulos is wondering whether, Tom, you’ve

looked at a lot of companies in India or spent much time thinking

about investment opportunities there. How do you view the


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investment environment in India, especially with many family

managed companies?

Russo: Well, it’s a very good question. There are family managed

companies there and we have both spent time in India with

meetings involving our global companies that wish to showcase

the promise of their local market presences in this enormously

important market for future growth. So I would say that I

approach the market with extraordinary amounts of enthusiasm

for what our multinational companies will be able to do there over

time. They struggle to get land base in India that’s certain and

predictable because the bureaucracy is fairly impenetrable and

the infrastructure is very difficult.

But if you talk to the people at Philip Morris International [PM]

they are moving forward with plans on how they can participate

in that market where the vast preponderance of tobacco

consumption is done through products that are not western and

yet the market has an appetite for western sales products and

Philip Morris is trying to enter the market in a way that can deliver

against that promise of the products more expensive and so it

requires rising GDP to afford the products that Philip Morris will

offer but they’re working towards that. Heineken has a 40%


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interest in United Breweries [India: UBBL]. That business is still

nascent.

The average Indian consumes less than 1.5 liters per capita of

beer. They like beer. It’s a problem with the regulatory

environment. At some point not far back there were only

something like 15,000 licensed beer distributors in India. It was

an extraordinary number to think about. There is probably that

many on the Upper East Side of Manhattan so it’s an opportunity

for both Heineken through United Breweries and SABMiller

through their own direct holdings in India to have a very strong

business over time and they’re investing behind it and I’m excited

about the prospects there.

The spirits companies, I think India may be the fourth largest

market already for Pernod Ricard around the world. It’s

extraordinary given the amount of restrictions that they face

bringing in the products that the consumer most wishes in that

market, which is made in Scotland whiskey. It’s a whiskey

market—India—and they—Pernod—has done a fine job

competing in that market as has Diageo in the local spirits market

and increasingly in the premium imported spirits market.


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But that share of the total Indian consumption is way too small

relative to what the consumers would prefer and it’s a problem of

bureaucracy and tariffs and quotas and barriers that over time

will lift. And I know both Diageo and Pernod Ricard are investing

a tremendous amount of money in advance of that happening to

develop capacities to suit the market’s appetite when it’s more

open. We can keep going but those four companies are all

important portfolio companies—five of them including Philip

Morris—and they’re all deeply involved with developing their

markets as best they can in a difficult market to tap into.

Host: Next we have an interesting question from Marc Heilweil who

asks are there consumer goods companies which you feel are

not differentiating themselves enough to withstand house or local

brands? He suggests perhaps Tiffany [TIF] overseas or

Kimberly-Clark [KMB].

Russo: I don’t think I can call out specific names. I think both those

companies—from my experience with them—have done a

particularly good job of developing their businesses abroad. But I

don’t have any particular examples. I mean there are categories

that don’t lend themselves well to margins generally speaking

and one of those categories has historically been dairy but we


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have examples in developing emerging markets where portfolio

companies are adding a fair amount of value through dairy and

dairy-related products because they are a tremendous way to

deliver health and nutrition benefits to the developing emerging

consumer, especially to the young consumer, for instance

recognizing that the brain development at ages 0-2 is so terribly

important in the health of a country and milk, which is in the

western markets heavily commoditized in developing markets

with proper application of healthful ingredients, becomes quite a

good business for Nestle, for example. Pasta is a pretty

commoditized product around the world. There are a host of

products that even when they’re branded don’t command much

margin and our portfolio companies have been in those

businesses and to their credit over time they’ve identified them

and parted company with them. The frozen vegetables, frozen

fish, frozen businesses in general—many markets have been

poor and our companies have exited those.

Host: Next I want to go to Eric Fourmentin who is asking in an

environment where money printing is the rule for years to come,

is it time to consider some heavily indebted companies—maybe

companies that have long term fixed rate debt?


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Russo: Interesting question. I would say that businesses that have large

amounts of long term debt probably have gotten themselves into

that position by virtue of the structure of their business and the

structure of their industry and so I probably would not chase that

as a preliminary screening as a good investment to make but I

would observe that there is something that was quite interesting

in a talk by Mary Buchanan at Columbia Business School last

week where she lamented that one of the problems in today’s

markets, especially in the industrial company environment where

she often finds value, has been the pension—the world of

pension fund liabilities and the sharp decline in interest rates that

have driven massively higher the pension and liabilities—have

created cash flow burdens for businesses that are forced to

allocate capital to make up the holes and define benefit

obligations.

And at some point that story will play out in reverse. Interest

rates will go back up and the amount of underfunding at low

interest rates will reverse and possibly even lead to overfunding,

in which case businesses have asset values that might accrue

based on a change in that environment. She mentioned that it’s

something that is hard to contemplate at this moment because

the direction has been so decidedly downwards sloping but may


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on reverse be an area of important development. And that is

something I would consider as important—heavily indebted

companies would so often get there by virtue of their own

industry dynamics, I may not screen for that.

Host: I think at this time we can take at most three more questions.

Tom, you have been extremely generous with your time. Is it

okay if we do three more with you?

Russo: Lucky three.

Host: Okay. Thanks.

Russo: Sure.

Host: So, Emmanuel Daugeras asks how do you decide that an

investment was a mistake. Are there any criteria you use for

that?

Russo: Part it’s the information that we get from ongoing contacts with

companies that lead us to realize that the businesses that are in

existence are different than those that we thought and I can think

back on Citibank, which we owned—and we owned it for a


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variety of reasons—it was very global. At some point it was

considered the first national bank of the United States. When the

world’s currency crisis in the late ‘90s erupted there was a rush

towards Citibanks around the world for deposit security. It’s a

great global franchise. Sandy Weill owns several billion dollars

worth of shares in the stock.

We assume that he would be a forceful steward of our capital

because at the same time he owns shares just like we did. He

owned and paid up and that was his vast wealth and we

assumed that as close to the business as he was that there

would be supervision much like family controlled companies

enjoy. And it was extremely global and we were intrigued by that

and yet over the degradation that took place in the US capital

markets things arose that just didn’t seem right to us and would

constantly bid us back to the bank at some point we became

aware of the activities around the balance sheet called SIVs and

learned how they were struck and became quickly uncomfortable

with that feature and what it represented to shareholders and the

risks it represented. And so we left that investment. We were

lucky to have enough contacts with the company to come up with

that observation in time to exit before the bedlam ensued.


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And so that’s what we do. We try to get that information from

meetings with companies and hearing… and then looking across

at other businesses that relate to it. And we received good

confirmation in Citibank’s case. We had an opposite example

when we held AIG [AIG], which was less successful and in that

case we probably believed management too late and too long for

their assurances that their derivatives books would converge

profitably over time and we failed to pick up from that process the

fact that they wouldn’t enjoy time because collateral posting

requirements would put them out of business in the meantime.

But it’s a process of just making sure that you stay with the

company and ask questions on the margin and listen to the

answers and look at body language and try to stay ahead of

adverse developments through that.

Host: I want to ask a question by Guru Prasad who is wondering

whether you look for companies with some of the characteristics

mentioned in the book Hidden Champions of the 21st Century. He

says basically these are companies that hold dominant positions

in niche markets—so maybe a little bit smaller than some of the

multinationals. Could you maybe tell us whether you have found

some of those companies—leaving aside valuations for now—I


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think he’s just looking for some quality companies that dominate

their niche markets?

Russo: I haven’t had the chance to read the book. I would say that in

general I always inquire when looking at niche companies that

dominate small markets what happens when those small markets

become bigger markets and when they become big enough to

warrant the entry of other competitors who can then come in and

disrupt the market dominance of an early champion like that

which you discuss. And I can think of two fields where this

question comes up from time to time and my caution over

dominant niche players exists and I’ll give you the one example

is the insurance industry where there are specialty grades of

insurance that are focused upon by certain purveyors because

they’re too small to be serviced by the big houses.

And I can think of the example of the bars and the entertainment

venue market in insurance being relatively specialized grade

where only people who understand the dynamics of that market

can really underwrite profitably, generally speaking, because

there are risks and exposures that are unique to the industry and

business is small enough that the majors don’t focus on it. When

business gets bad in say the hotel restaurant business for the


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insurers they look over to the profits being made in the narrower

field that is specialty and they pour into it during the period of

time when the main markets are turning down and disrupt the

rates—the pricing environment.

And so a cyclical factor overwhelms the specialized niche nature

of that market every so often and the good news is in that

particular field is that when the majors finally get done with it they

lose an awful lot of money because they discounted the premium

and they’ve taken on risk that they didn’t even know about. They

can’t mitigate those risks. But it’s a cycle of boom and bust that

addresses even a niche business because of outside forces.

That’s one example.

The other example is chemical businesses. I am often told to

look at especially chemical manufacturers because they have a

niche product but as that business gets big enough it gets big

enough that a major chemical enterprise might covet the margins

and the now growing volumes sufficiently so that they apply new

capital to the markets to go in and try to seek some of those

higher margins from the specialty grade but the specialty grade

and the process becomes commoditized. And so I haven’t really

used dominant niche as a screening variable because of either


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the opportunity for cyclical overruns like in the insurance side or

secular degrading that takes place when markets that are

specialized become big enough that they then attract competition

and they commoditize them.

Host: I want to end it with a question from Manuel Salceda, which I

think is a fitting question for this conference. It’s not an easy one

but I’ll ask it anyway. Tom, where do you see Europe in ten

years? Do you still see it as a group and thriving? What’s your

outlook?

Russo: Typically where I operate as an investor is I am an incrementalist

and so I would suggest that those are great fears of significant

dislocations and transformative dislocations. I am generally of the

school that things that have been for a long time will likely

continue in roughly the same way for longer than most people

expect and so I guess I would approach that question with that

general view of life that you’ll likely see much of the same.

The differences in this case are that the whole world of Eastern

Europe is still part of the equation and it has spillover effects on

what’s going on along its borders. I think about especially

Poland, Romania, the Czech Republic and the disruptions that


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those markets cause several of our companies as it relates to the

premium pricing that takes place in the market like Germany and

the alternatives for lesser prices coming in from those

neighboring countries.

I suspect over the next decade that those neighboring countries

may become more like the west as they enjoy some of the

benefits of their productivity and so may become more west-like

even in eastern and central Europe. That’s a factor and then we

have the question about whether the EU continues to expand or

not and you think about a country like Turkey or some of the

other parts of the world that might want in and I’m unclear how

that process will play out but across Europe in general—Holland,

France, England—I suspect that they will go through a fair

amount of turmoil. Certainly France likely will in light of the recent

elections and the changes that might or might not stick.

But I’d say ten years from now you’ll still have markets that look

relatively unchanged and much like what they’ve been and that’s

consistent with the way I sort of philosophically approach the

world in general and then how it shapes my view about investing.

I think the rest of the world will have much more transformation


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and that’s the area behind which I think apply capital to

participate in over time.

Host: Well with that, if we did not get to your question please feel free

to go online into our conference area and ask it there. Tom, I

really cannot thank you enough for taking the time to address our

audience, to share your wisdom and insights. We appreciate it

very, very much. Thank you.

Russo: Thank you, John and Oliver, for the chance. I have just elevated

myself in my family’s esteem because I have participated in

what’s called a “webinar” and I think really this whole process

that you put together is fascinating and I hope that those who are

interested in the international space as investors continue to look

there because it’s really an area of promise and opportunity, at

least from my perspective. And the forum provides access to a

lot of people participating in the same field in many similar

fashions so thank you for the chance to speak and take care.

Host: Tom, thank you very much and good evening to all of you.

Tom Russo at European Investing Summit

Economy & Finance

Transcript of Tom Russo at European Investing Summit