Memo #8: The one busy shop not in the mall; why Brown-Forman is still good
And the cult of passive indexing
Newmarket is a ghost town but Hikoco isn’t
We have our office in Newmarket. Most of Newmarket is now a ghost town. It’s sad — and I think landlords have a lot to answer for here. You can’t demand high rent if there’s no demand. Though it appears many landlords have not cottoned on to this fact. And yet today I went to Hikoco to conduct some market research (Korean skincare is popping off1). 1) Hikoco was busy, with about 30 people there and a line for the counter — on a Monday. 2) The quality of the products are good and they are cheap. 3) The staff are lovely, and the environment has soft lighting. This shop just gets it — they understand the audience, understand what they want, and they sell it at a good price.
I couldn’t help but wonder2 if more shops would be open and doing well if they operated more like Hikoco. You gotta sell what your audience wants. This seems like a simple and obvious fact about retailing, but one that appears to be missed a lot. Consider Chemist Warehouse, another wonderful company — it’s busy, barebones, and you can find everything you could possibly want there. Here’s Jack Gance, one of the company’s co-founders, on the secret sauce:
What he detests are business leaders detached from their customers. Jack tells me about a conversation he had with the CEO of a leading Australian health company selling a significant amount of product to Chemist Warehouse. Jack asked the freshly appointed CEO, a non-founder, if he knew the name of Chemist Warehouse’s representative buyer - the key influencer who determines which products Chemist Warehouse will buy and in what quantity. The CEO was not able to. Jack asked if the CEO knew the buyer’s name from one of Australia’s largest supermarkets, another key client. “Jack, I know the CEO of the supermarket chain, but I don’t know the buyer by name. I’m a CEO of a multinational business, I have thousands of clients and it’s impossible for me to know every buyer by name”, he said.
Seems obvious, but amazing how many CEOs and managers miss this point. Your buyers are your most important thing if you’re in the business of selling! If your head is in the clouds (or up your derrière), you’ve got no chance.
Met Gala Lala
You know it isn’t a proper Eden memo if I don’t talk about the Met Gala, the increasingly moribund and irrelevant institution that may be the only piece of duct tape and hope holding together the Conde Nast empire (or at least Vogue). This year’s Gala mostly felt like by-the-books writing-it-in banal vanity — a Hunger Games without any bite.
Worth noting though the amount of outfits by both Valentino and Burberry. Lana Del Ray wore a voluminous dress that I didn’t hate by Valentino, while Cardi B, etc, wore outfits from Burberry.
We all know that Anna Wintour tends to approve each outfit and designer — this is a tacit admission of what will be pushed in the next year — Valentino, which is 30% owned by Kering with the company having the option to acquire the remaining shares by 2028, and Burberry, which I have consistently said is so cheap it offers compelling value — especially now that they company has reclaimed their roots as a British brand — think Burberry bikinis (+14% uptick recently), Glastonbury, that whole early 2000s thing… most of all, Burberry feels accessible in a way other brands don’t — I suspect this will be an important driver going forward.
On the cult on passive
It seems you can’t go a day without seeing someone on TikTok or Instagram talk about why you should simply buy an index fund and forget about it. “Passive does better!” the acolytes of indexing cry out, like religious zealots of the capitalist age. However, Seth Klarman put the dangers of passive indexing fairly well in his 1991 classic, Margin of Safety:
Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis.
Indeed, at the extreme, if everyone practiced indexing, stock prices would never change relative to each other because no one would be left to move them.
Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover.
Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers.
Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock worth more today than yesterday. In effect, people are willing to pay more for that stock just because it has become part of an index.
I.e. if you have a bunch of monkeys, and all the monkeys buy the same bananas, then you’re going to end up with a giant pile of bananas and they’re all going to be indiscriminately valued. It’s banana-rama!
You can see the results for yourself when a stock in NZ enters or exits the MSCI Global Standard index — Infratil, for example. Infatil entered the index and Spark was dropped from it, triggering a rush of buying and selling of the respective stocks. Nothing fundamental about either stock had changed, of course — simply put, it’s all about flows.
Of course, if you have someone like Grandpa Buffett, you’ll see how passive indexing is put to shame (amazing to see how many passive guys went to Berkshire in Omaha recently — perhaps these guys missed the memo on how Buffett invests).
So imagine my surprise when I read Stuart Kirk’s column on Buffett in the weekend. It is titled “The mass delusion of Buffett worship3”.
The “Sage of Omaha” himself questions the very thing we venerate. Buffett is both the god of active investing as well as its harshest critic. According to his many sermons on the impossibility of outperforming an index over long periods, his record shouldn’t exist.
This is extraordinary, and one wonders if Mr. Kirk has ever actually read any sermons and essays by Buffett. For instance, Buffett’s 1993 letter:
Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long- term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know- nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.
On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly- priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: "Too much of a good thing can be wonderful."
You have to scratch your head and wonder what Mr. Kirk has been reading.
Of course, if you are a know nothing investor owning an index could make sense. It is a bet on GDP rising, basically. You can be agnostic to every company you own because it doesn’t matter if Coke or Pepsi does better — you own both, so you just care if the GDP of America goes up.
Consider Jack Daniel’s
Of course, most investing is about forecasting that the GDP of a country goes up — consider the argument for Brown-Forman, which makes Jack Daniel’s. About 150 million bottles of Jack are sold a year, or 14 million cases. In 1980 the company sold 2.4 million cases of Jack. That’s a CAGR of 4.09%, while the compounded annual growth rate the US GDP was 5.49%. The numbers roughly align. It makes sense when you consider all humans need liquid, a bunch of them will reach for alcohol, and as the world population expands the sales of X liquid will go up simply by virtue of wealth growth + population growth.
The hard part about investing actively is you need to decide when a company is worth more than what it’s selling for. Let’s use Brown-Forman again. The company had revenues of ~$68mn in 1951 and ~$4bn of revenue last year. That’s an annual growth rate of 5.74% over 73 years. So we know the company can consistently generate revenue.
But what else? How strong is their biggest product? (Jack) — well, take it from their 1972 annual report:
There are few annual reports written this clearly these days. If you know any Jack Daniel’s fans, you’ll know just how vigorously they defend their favourite drink.
What I’m saying is: we know that Brown-Forman and its flagship product hold a psychological stranglehold over their customer base, and they grow sales steadily over time. Their return on capital is excellent -- 16.4%, and their price to earnings ratio trades well below what it historically trades at.
At this point you need to make a few assumptions: you need to assume that the crowd is wrong and people will still keep drinking alcohol, and you need to assume the quality of earnings that Brown-Forman makes will continue. You do not need to make any herculean assumptions — single digits growth is fine, thank you very much.
It is an uncomfortable place to be, because the rhetoric is “alcohol is dead” (tell that to the 14 million cases of Jack sold last year). It is not a fashionable industry. There is no whiz-bang technology, no AI, no shiny new thing. To my mind it seems startlingly obvious that Brown-Forman is a high quality company that has been sold off due to market sentiment rather than any fundamentals. That’s why we invest actively — to find opportunities like this4.
https://www.ft.com/content/c858c453-bf69-4184-bcdf-2432601a3914
All that is required is a little patience — see Memo #7 on the importance of duration.