In a 1988 shareholder letter we defined “nirvana in investing” as finding a company with three characteristics:
- “It is a superior business.”
- “It is exceptionally well-managed.”
- “The managers reinvest the naturally occurring excess capital as well as they run the business enterprise.”
Twenty-five years later, we commonly refer to these characteristics as the “three-legged stool” and they continue to guide our approach to investing our partners’ capital.
We attribute this rare longevity to the intuitive, teachable and repeatable nature of our process. It is also pleasing to us that our strategy is easy to explain to our clients and partners across a range of investing acumen. Along these lines, John Neff discussed the intuitive concept of a “Bottleneck Business” in his white paper. In this white paper, I will elaborate on the second leg of the stool: exceptional people.
Warren Buffett wrote in 1989 that he has “never succeeded in making a good deal with a bad person.” Our collective experience has been the same.
Unfortunately, bad people do not walk around with self-identifying signs around their necks. Neither do exceptional people, for that matter. Judging the quality of managers is the most subjective leg of the stool. It is more art and less science: there is no formula.
So how do we do it? We read piles of shareholder letters, proxy statements, and biographies. We frequently leave our offices in idyllic Middleburg to visit corporate headquarters, manufacturing facilities, and retail locations. We try to ask open-ended questions so we can see how managers think. It doesn’t always hit us over the head right away so sometimes we have to go back more than once.
The issue of integrity
A common thread to the managers of our portfolio holdings is that, in our judgment, each is at least as well endowed with integrity as they are with skill. Skill without integrity is insufficient.
The issue of integrity, in our mind, comes down to whether managers treat shareholders as partners. A company’s shareholders are often anonymous to its managers. Do managers nonetheless feel an obligation to treat those shareholders fairly?
A close reading of the proxy statement can be instructive. We look at both the size of the pay packages as well as the incentives that trigger cash and equity bonuses. We love to find managers that have “skin in the game” through outright ownership of common stock. We are especially turned off by managers that claim ownership via unexercised options. They often exercise and sell as soon as they can!
Executive compensation plans often emphasize metrics such as growth in operating income or pre-tax earnings. However, if the corresponding equity awards result in an increase in shares, what occurs on the company level will not occur on the per share level. As we’ve often stated, small percentages when compounded add up to a large number over time and the same is true for seemingly modest levels of options dilution.
Another common thread among exceptional managers is clarity of thought when it comes to reinvestment decisions. In our experience, poor capital allocation decisions can destroy more value, more quickly, than any other management action. Disappointingly, we often discover that managers who excel at running their businesses fall victim to “fuzzy thinking” on the issue of capital allocation.
The most common example that we have encountered recently is the payment of a dividend solely to enlarge the potential shareholder base (some funds by charter will only invest in companies that pay dividends). The decision to pay a dividend, in our mind, should be based on a careful examination of alternative reinvestment options (namely, a lack thereof) and an expensive stock that makes more tax-efficient buybacks unattractive. Other commonly encountered examples of fuzzy thinking include a fixation on the near-term “accretive” or “dilutive” impact on earnings per share of acquisitions, or buying back shares irrespective of valuation (often to achieve the arbitrary goal of offsetting options dilution).
One illustrative example of an exceptional manager who meets the criteria above and has contributed to the outcomes in our portfolios is Bob Sasser, CEO of Dollar Tree, Inc.
Bob Sasser has been the CEO of Dollar Tree since 2004. On his first day on the job, Dollar Tree had 2,500 stores, annual revenue of $3 billion, and free cash flow per share of $0.65. The stock price was $10.
At the end of 2016, Dollar Tree has more than 14,000 stores, inclusive of 8,000 Family Dollar stores acquired in 2015. Annual revenue was more than $20 billion, and free cash flow per share is closing in on $5.00. The stock price at the end of 2016 was $77.18.
The compound annual growth rate for revenue and free cash flow over this 13 year period is approximately 16%. We often say that our expected return in an investment will approximate the rate of growth in free cash flow per share. Such has been the case with Dollar Tree, as the stock price has increased at a 17% CAGR over this same period.
This is an impressive track record for any business, and especially so for a retailer. Retail is a historically difficult business. The competitive landscape is constantly evolving (e.g. Amazon.com) and there are many case studies about once-great retailers who have since fallen on hard times.
Bob Sasser and his management team have succeeded, we believe, because they have maintained a singular focus on providing a great value for their customers in clean and conveniently located stores. The Dollar Tree team is the epitome of the hedgehog in Jim Collins’ parable about the hedgehog and the fox: they know one thing and they do it really well!
The culture that Bob Sasser presides over at Dollar Tree is commendable, in our view.
For one, management does not make excuses. It is common in retail for management teams to attribute poor performance to adverse weather (they never seem to call out weather when it benefits results!) or to changes in the calendar (e.g. Easter moving from the 1st quarter one year into the 2nd quarter the next year). Not so for Dollar Tree. Bob Sasser challenges his team to perform regardless.
Secondly, compensation is fair and largely based on performance. Forbes magazine in 2011 listed Bob Sasser as one of the “best bosses for the buck.” Key performance metrics are GAAP metrics as opposed to an “adjusted” metric of some sort (we jokingly call such metrics “profits before all expenses”).
Third, they keep a low profile. Headquartered in southeastern Virginia, management spends its time running the business as opposed to attending a myriad of investor conferences. We believe it is noteworthy that news of the Dollar Tree acquisition of Family Dollar did not appear on the front page of the Wall Street Journal as a rumor before the deal was officially announced – rare, especially considering it was the largest U.S. retail acquisition (measured by store count). Furthermore, Dollar Tree stayed above the fray while competing bidders and Family Dollar management engaged in a public tit-for-tat.
That leads to the fourth point. They should not be underestimated. Family Dollar ultimately agreed to be acquired by Dollar Tree despite the fact that a competing bidder offered a higher price, to be paid in all-cash (Dollar Tree offered cash and stock). We believe this is attributable to Bob Sasser and his team’s astute analysis of the psychological factors at play with Family Dollar’s management team and Board. For example, it mattered to Family Dollar that its headquarters would remain in Matthews, North Carolina. It also mattered that Dollar Tree planned to operate Family Dollar under that brand on a go-forward basis, as opposed to re-naming it to something else.
Finally, Bob Sasser and his team have a keen sense of capital allocation. Through 2016, Dollar Tree has never paid a dividend because they realize that the best use of cash is building new stores, which pay back the investment in ~2 years. Excess cash has been returned to shareholders via share repurchases, which are more tax efficient than dividends and also afford management more flexibility. Lastly, Bob Sasser and his team took advantage of historically low interest rates to take on debt in order to acquire Family Dollar. We believe that acquisition, which more than doubled Dollar Tree’s store count, will be seen as well-thought out as it was well-timed.
All considered, we are asking a lot of our managers. We realize that exceptional businesses with vast reinvestment opportunities are rare. Exceptional managers may be rarer still. Finding all three is our Holy Grail!