Reflections On Trusting Management, Everyone Knows It's Expensive, Markel Reunion
Thoughts on recent topics
On trusting management
In Good Company has found a place on my regular podcast rotation. Nicolai Tangen, the CEO of Norges Bank Investment Management regularly has interesting guests and asks sharp questions.
A recent episode featured Rachel Botsman, an author who writes extensively on the subject of trust - an important topic for investors to consider when evaluating management teams.
Botsman brought up two frameworks that I found valuable.
One is when we say we “trust” someone, we should add, “…to do what?”
The other is that we most often approach people with trust and then look for signs not to trust them.
Over a long enough timeframe, it will hit the fan at every company. When that happens, it helps if you trust management.
…to do what?
As investors, the trust we put in management should be predicated on their ability to increase the value of the business. Managers can have agreeable personalities and we might trust them to watch our pets or in another personal capacity, but they may not be good allocators and leaders. Other managers may be unpleasant but are incredibly thoughtful and effective at their job.
Perhaps the order of operations, then, in evaluating management is to first answer whether or not we trust them to run the business and then consider other intangibles.
I believe that someone who can be trusted with little can be trusted with much (hat-tip Luke), so one way to evaluate management’s trustworthiness is to pay attention to how they respond to little things.
As an example, consider how Costco responded to a recent unionization at one of its warehouses. While other retailers and restaurants battle unions with questionable tactics, Costco effectively said, “You know what? We’re the ones who messed up and we need to get better.”
It’s a sign that when faced with a difficult choice, Costco will take a position of integrity, which is an inherently long-term, value-minded approach.
Botsman’s second point about starting new relationships with trust and then looking for signs not to trust the person resonated with me as a Midwesterner, as that is the regional default setting. However, when I brought this up with my wife, who’s from the East Coast, she observed that she takes the opposite angle. She tends to be more apprehensive and looks for signs to trust someone new.
Upon reflection, I’m not sure that there are two absolute starting points. I doubt anyone starts with unconditional trust and works backwards, after all. But it’s been useful to consider where on the spectrum of initial trust I typically fall and to be aware of the associated risks (easier to fool) and opportunities (quicker to establish virtuous relationships) as I evaluate management teams.
Everyone knows
I’ve owned shares of Costco for eight years and it’s traded with a premium multiple to the S&P 500 the whole time. I can’t recall a period where other investors didn’t think Costco looked expensive.
And yet, the stock has outperformed by a wide margin.
Thus far, it’s paid to ignore the concerns.
That said, Costco’s multiples have detached from its historical trends. To be sure, I have pared my large holding in Costco, but don’t think it’s as overvalued as some believe.
One of the mistakes investors have made with Costco is that they haven’t asked why Costco might deserve the multiple it does. Intuition would suggest that a retailer growing its topline at mid-to-high single digits and EPS in the low-to-mid double digits is expensive at 30 times let alone 40 or 50 times and bound to revert to the mean sooner than later.
And that may prove to be the case. We may look back and say that Costco was overvalued today and future returns were diminished due to multiple compression, even if the business performs well.
But before you take that stand, you should consider scenarios in which Costco might deserve that multiple.
It’s possible, for example, that consumer behavior has fundamentally changed since COVID. Quarantines taught us that it’s better to keep a stocked pantry at all times, just in case. Warehouse clubs like Costco have become part of shopping routines for more people as a result.
Indeed, while many businesses that benefited from COVID demand, which Costco certainly did, experienced a bullwhip effect once quarantines eased, Costco did not have that issue. Demand has continued apace.
To be sure, inflation incentivizes buying in bulk and Costco members have been conditioned to understand that they are getting the best possible prices for the goods being offered, supported by increasing bargaining power over suppliers. Management has played this beautifully by not increasing membership prices, even though they very well could have with little impact to churn.
Its cash-heavy balance sheet has also come in handy and its interest income ballooned as short-term interest rates rose. Refinancing risk is minimal, and because Costco owns most of its warehouses and the land they sit on, wholesale transfer pricing risk is also minimal.
Costco still has a long road of store growth ahead. Its slowness in adding warehouses is a feature, not a bug. While most retailers would have opened as many stores in China as possible following initial success, Costco stuck with its playbook and slowly-but-steadily built out the warehouses and local supply chain to ensure a consistent member experience. Costco’s competitive advantage period could be much longer than you think.
There are more potential reasons for Costco’s premium, but I believe I’ve made my point. When “everyone” thinks a stock is expensive or cheap, in the words of Mark Twain, it’s best to “pause and reflect.” Consider scenarios in which reversion to the mean may not occur or at least not occur for a longer time than the market expects.
Markel Meeting
I’m in the airport on the way back from the Markel shareholder meeting in Richmond, Virginia. It was my first time at the event and I was curious to know how it differed from the annual Berkshire event in Omaha.
Hosted at the beautiful University of Richmond campus, the event is less spread out than Berkshire and is a bit more formal with business casual dress. With a fraction of attendees, it allowed for more serendipitous meetings and longer conversations.
The events surrounding the annual meeting are all put on by Markel rather than independent organizations. Most of the events are about Markel or its subsidiaries, which is useful to shareholders who may not be as familiar with the Markel Ventures holdings. There was a value investing panel hosted by Robotti & Co. which featured a dozen or so stock ideas from thoughtful investors.
That said, Markel is clearly taking a page from the Berkshire playbook and I could see the event becoming much larger in the coming decade, which would diminish some of its current charms.
Markel were great hosts and put on a fun event. As a Markel shareholder for nine years, it was good to put some faces with names.
Perhaps because I’m in Cincinnati and there aren’t as many investors coming through town than if I lived in Chicago or New York, I increasingly appreciate these events to connect with other thoughtful investors - including some Flyover Stocks subscribers! Thanks for saying hello.
Stay patient, stay focused.
Todd
At the time of publication, Todd and/or his family owned shares of Berkshire Hathaway, Markel, and Costco.
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