Learning from Legends

By Ser Jing Chong - September 2, 2012 | Tickers: BRK-A, NFLX, SBUX | 0 Comments

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Shelby Cullom Davis was a rather unknown investing figure until a book titled The Davis Dynasty, written by John Rothchild, was published in August 2001 and made him a little more publicly known. Davis turned $50,000 in 1947 into nearly $900 million by the time he passed away in 1994. That is a compounded annual return of 23% for 47 years – a record that can make anybody an investing superstar! Davis accomplished this monumental feat by investing mostly in well-run insurance companies that were selling at attractive valuations and holding for the very long term.

Some of his holdings that were purchased in 1950 remained in his portfolio even in 1990. Judging from Davis’ track record, buying and holding of great companies is a lesson to behold but that is not what I want to talk about here. As I was reading The Davis Dynasty, I found a really interesting nugget of information that I think offers individual investors some great lessons.

Besides all three of them being bona fide investing legends, can you name one other similarity that Davis shares with Benjamin Graham and Warren Buffett? The answer is that in 1976, all three of them were shareholders in GEICO at the same time. GEICO is an insurance company that was acquired by Buffett’s Berkshire Hathaway in 1995.

Back in 1975, GEICO was in serious trouble due to CEO Ralph Peck’s decision to relax its criteria for offering insurance policies. GEICO’s share price reached a high of $61 in 1972, but by 1976, the share price had collapsed to $2. It lost $126 million in 1975 and by 1976, the company had ousted Peck and was teetering on the edge of bankruptcy. Davis and Graham both had invested substantial portions of their own fortunes in GEICO way before the problems started and had suffered significant paper losses at the peak of GEICO’s troubles.  After Jack Byrne replaced Peck as the CEO in 1976, he approached Buffett to come up with a rescue plan. Peck promised Buffett that GEICO would reinstate its stringent rules for offering polices and Buffett, recognizing the temporal nature of GEICO’s troubles if Byrne stayed true to his promise, started to invest millions of dollars in GEICO shares.

The rescue plan involved an equity offering that would dilute the holdings of existing GEICO shareholders by a large extent. Davis got offended at the offer and did not see the possibility of GEICO’s future return to profitability and promptly sold all his shares. It was a decision that he regretted all the way till his passing as GEICO’s shares eventually rose from $2 all the way to a split-adjusted $300 before getting acquired by Berkshire Hathaway (NYSE: BRK-A).

To me, this is a really interesting story because it taught me three very important lessons that I would like to share:

1) Even the best of the best make huge mistakes – Davis built his fortune almost exclusively through insurance stocks but even he made a mistake in assessing GEICO’s future in an industry that he was intimately familiar with. Some investors look at the sales made by high-profile fund managers and think that they should copy what the fund managers sold, but that is not always the case. The merits of a company should still be investigated by individual investors before coming to their own conclusion.

2) It pays to be an independent thinker – Davis stood by his view on GEICO’s prospects even though it was in reverse to Graham and Buffett’s thinking. Davis turned out to be wrong on that particular call but throughout his career, he prized independent critical thinking and stuck by his guns.

3) It is okay to make mistakes in individual ideas in a portfolio - Even by missing out on GEICO’s future profitability, Davis still made a tremendous fortune. Davis lost a huge chunk of his investment in GEICO when he sold his shares but he still turned in a magnificent performance in the end. This goes to show that a portfolio can withstand huge mistakes and still turn out wildly successful if the investment philosophy is sound. Davis proved that in spades.

As I was reading about Davis, a recent 13F filing made by legendary billionaire hedge fund manager Julian Robertson’s Tiger Capital got me thinking about Davis’ mistake in selling GEICO. Tiger Capital announced in its Q2 13F filing that it had sold its stakes in Starbucks and Netflix. I have no insight into Tiger Capital’s investment objectives in those two companies, but I do know a little about Starbucks (NASDAQ: SBUX) and Netflix (NASDAQ: NFLX) and I think Tiger Capital might have made a mistake in selling them a little too soon.

Starbucks

Starbucks made its name in American corporate folklore by opening stores to sell coffee. Over time, their product line became more diverse but still retained the heavy emphasis on delivering quality coffee to their customers who visit their stores. Recently, people have begun questioning Starbucks’s longer term future after the release of their latest quarterly results on July 26 – its share price fell by 9.4% in a single day on July 27. As of Aug. 27, Starbucks’ TTM P/E and P/S was about 28 and 2.9, respectively.

For a company that had a year-on-year quarterly EPS growth rate of 19.4%, Starbucks does seem a little expensive at first glance. However, Starbucks has growth initiatives that are either newly implemented or in the pipelines. These initiatives have not been able to contribute to Starbucks’ financial results in a meaningful way yet, but have huge promise of doing so in the future.

The ones listed below are just some examples:

• Starbucks launched the Refreshers energy drink concept in July 2012 in their domestic and select international stores. The energy drink market is estimated to be around $37 billion globally and with the management and marketing smarts of Starbucks, there is a good chance they can capture significant market share.
• Starbucks will continue to roll out Evolution Fresh high-quality fruit juices in even more of their stores domestically. There is also the potential to release these drinks in their international stores. In our increasingly health-conscious society, it is not hard to imagine quality fruit juices with health benefits being popular with the masses, hence providing Starbucks another shot at healthy growth.
• Starbucks also recently acquired La Boulange bakery to improve upon its core food offerings. Starbucks may well evolve into a major player in consumer products, selling high-quality coffee, juices, energy drinks and food products instead of just relying on its traditional coffee offerings.
• China and India are both huge markets that can provide years of store growths for Starbucks if done properly. For the most recent quarter, year-on-year growth for sales and operating income in the China/Asia-Pacific region stands at 31% and 37%, respectively. These are very good numbers and with Starbucks planning to open 250 new stores in China and another 250 in the Asia-Pacific region in 2013, chances are good that this region can continue to deliver stellar results and deliver growth for Starbucks in the future.

Sure, Starbucks may still look expensive even after considering these growth initiatives but often times, investors will have to pay up a little premium for growth. And let’s not forget that Starbucks also has a stellar management team led by CEO Howard Schultz – that in itself would command a slight premium too. In my opinion, the future looks bright for Starbucks and thus, I would consider a position in Starbucks even if I see Tiger Capital selling its entire stake.

Netflix

Netflix’s issue is cloudier than Starbucks, but it is very interesting when looking at the potential that Netflix has. Netflix offers unlimited streaming of movies, serials, documentaries, and more to subscribers for a fixed monthly fee in the US and other countries. They also provide DVD rental delivery services to their US subscribers. Netflix’s share price has had a tumultuous history, dropping from its high of $300 in July 2011 to a low of $54 in early August 2012. However, throughout the fall in its share price, Netflix’s total subscriber count (the lifeblood of its business) has increased steadily from 24.6 million in July 2011 to 30 million in July 2012. Netflix wants to be a truly global streaming business and deliver streaming content to as many customers around the world as they can.

Currently, Netflix operates in the US, Canada, Latin America, UK, and Ireland and has just announced plans to enter a select few Scandinavian countries by this year’s end. Besides US and Canada, the other markets have not achieved profitability but as the number of subscribers in the international markets increase, profitability should find its way to Netflix. This will increase the value of Netflix as a business.

Netflix also has a unique opportunity to provide a brand new way for content producers to produce serial programming. Netflix has already funded a well-received original production in Lilyhammer and there are other works in the pipe line like House of Cards and Arrested Development. These shows will have all their episodes released simultaneously so that viewers can ‘binge’ on them in one shot.

This opens up a whole new creative world for the content producers as they can make each episode last as long as is needed, plus they can also inter-weave complex story lines in the shows without fear of viewers missing them as they can always find older episodes with the click of a mouse. Furthermore, there are also opportunities for interactive programming such that different endings can be chosen by the viewers or the episodes can even be arranged in non-linear fashion for a more engaging viewing experience. All these are made possible by Netflix giving huge creative freedom to the content producers and also because the streaming platform of Netflix removes time constraints that traditional broadcasting channels face.

Over time, prolific content producers may find Netflix to be more attractive financiers than the traditional powerhouses like HBO. When that happens, Netflix can start to build up a powerful library of original content that can become the next water-cooler topic. This has the potential to increase the value and attractiveness of Netflix to new customers. In short, I see a lucrative opportunity in Netflix even if a hedge fund legend like Julian Robertson fails to see its potential.

Conclusion

It is often easy to panic and sell whenever we see high-profile fund managers selling stakes in companies that we own. However, as investors, it often pays to investigate the story further on our own because we might see things the fund managers have overlooked or vice versa; like how I evaluated Starbucks and Netflix and think that they are attractive investment opportunities. Even the very best can make errors in judgment, so never take their word as gospel. Like Shelby Davis, we all will make mistakes but never ever substitute independent critical thinking with following the actions of others blindly. 

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