Insights

Recently, we came across an interview with Francois Rochon, Founder of Giverny Capital, which we found to be a worthwhile read. You can find the link to the full interview below. We also included some excerpts that we thought were especially relevant for you to read, adding emphasis wherever appropriate.

On the main traits of a quality business

Rochon provides some great insights on defining a quality business. As he states, “.. I think one very good indication is a company that has a high return on equity for many years without leverage. So I think your leverage can sometimes distort the calculation of return on equity.

So, it’s really looking at companies that can earn; I would say, good return on capital. And that can be sustained for many, many years. So it’s not a year or two or at the top of the cycle; it’s sustainable in years.

And there’s a reason behind superior returns. You can find some kind of competitive advantage within the nature of the company or its culture. Either it can be a brand or a first entry to a technology service that makes them very special and unique. But basically, they have a competitive advantage.

That’s probably the main characteristic of a quality company.”

On areas to avoid and life expectancy of corporations

“I would start by what I would avoid. If you sell a commodity oil or some kind of metal, zinc or steel or copper, I think it’s very hard to develop a competitive advantage. ..if you look at history, there are very few technology companies that have been able to be leaders and sustain their competitive advantage over decades. It’s tough because it changes so rapidly. If you miss a turn somewhere, yeah, you can be cast out of the market very rapidly.

Doesn’t mean that you can’t find a great company in those sectors with some competitive advantage. And, you know, Microsoft (MSFT) is probably one of the great enterprises of all time. So it’s certainly possible.

But you know, when you study the history of American corporations, the life expectancy is not that high. A lot of companies will disappear after a few decades, and some that used to be, you know, great, great companies, I mean, Kodak or Xerox, the company still exists, but you know, it’s not as dominant as it was many years ago, IBM or Sears, for instance. So it’s very hard to keep on being dominant and having this moat. The moat for any company is always shrinking or expanding, always.

So you have to always be open to follow what’s happening to the company and try to find those that the moat is increasing and perhaps avoid those that the moat is decreasing. I mean, in the retail industry it has been very hard to find permanent winners.”

On position sizing, the importance of capital allocation, and compensation practices

“Probably in my younger years, I was more confident in my decisions. ..I usually start with 1 or 2% with a new
investment, and as I get more confident in my decision, I will increase it. And the goal is to have something like 20 to 25 names with an average weight of about 4%.

And I have my own personal way of looking at it, and I think 20 to 25 names is kind of a good balance between having sufficient diversification. So you reduce the risk of, you know, one or two mistakes. And also, at the same time, it’s focused enough, it’s concentrated enough so that you have odds of beating the index.”

Rochon also talks about the importance of capital allocation and compensation practices when he states, “..the ideal situation would be…an example of that would be probably Fastenal 30 years ago. I mean, Fastenal, 30 years ago, was managed by Robert Kierlin, and he was the CEO and founder. He owned, I don’t remember, 25% of the shares. He was paid a hundred thousand dollars a year. And, you know, he had no stock options. So that was the ideal situation. He was a great entrepreneur and great, great culture. They were very low cost. He owned a big chunk of the company, didn’t have stock options, and his salary was very modest, so that’s the ideal situation. 

The non-ideal situation is when a manager is paid a lot of money, doesn’t have a big stake, and he’s not necessarily rewarded exactly in line with how the shareholders are rewarded.

And then probably the one great quality that is needed for CEO is capital allocation. So if you’d gone with the company for 10 years, a big part of your return will be linked on how yearly profits were reinvested. Did they make acquisitions, did they buyback stock? Did they give dividends? Did they develop new products? .. it has to make sense in terms of building a culture and, you know, increasing the moat the business has compared to their competitors.”

On investment psychology

“..one of the very important things for an investor is probably the psychology or the mentality. So the emotional coefficient, not the intellectual coefficient. But it’s kind of an observation, and my observation is most human beings that have a normal DNA sequence have this gene which I’ve called the tribal gene. So when the tribe runs, you know, they have the instinct of running with the tribe. And because it’s probably, there’s probably a good reason for the tribe to be running. I mean, probably 25,000 years ago, you were in an old village, and a big tiger would come up, and everyone would start to run while the thing to do was to run. So this gene was passed over many thousands of years of evolution.

And it’s just how the human being is programmed, but for some reason it’s probably a defect. 5% of the population doesn’t seem to have that gene. They can go one way when the tribe is going the opposite way, and they can think for themselves. They can think in new ways.

..So when everyone wants to buy tech stocks or Bitcoin, they’re able to think by themselves and say, well, I don’t think it makes sense. And it’s very hard, like you say to fight a gene because, you know, people will rationalize it, but at the end, it just responds to natural impulses.

I do believe that to be able to have better than average return on the stock market. I think you need to have a missing tribal gene. If you have it, I think it’s very hard to beat the index. If you don’t have it, I think it’s possible. ..if you are part of the normal 95% of the population, I think it’s almost impossible over many years, of course, to do better than the average because you’re not able to go one way when all the others are going the other way.

.. Not to follow the crowd is an exception. It’s not the rule. Just how human natures are. ..I do think that to beat the index over many years, I think you have to be in that 5% that don’t have the tribal gene.”

On the kind of companies we invest in and the impact of valuations

“I think Warren Buffett had a perfect phrase to sum it up, he said it many years ago, but I remember it was an annual meeting: “If a company has a great future but a lousy past, we’ll miss it.”

So I would say that’s really what also we’re trying to do. We’re trying to first find company that has a great past and a great present. I mean, they have good return on capital, they’ve rewarded shareholders in the past, they have a competitive advantage, a great balance sheet, and we believe that everything is in place for continuation in the future of those great results.

But if the company has a lousy past or is a very young company that doesn’t really have much past, I think it’s very hard to have an idea of what the future will look like. You’ll probably take risk, and sometimes it will work out. Sometimes it won’t work out.

The danger is to find a company that does have a great future, but it’s already priced in the level of the stock market today. So if you buy a great company that trades at, I don’t know, a hundred times earnings and, you know, earnings increase by sixfold in the next decade, but the PE ratio falls to 20 times, you know, didn’t really have a good return because so much of the future that was great in the end was already discounted in the price. So you have to be very careful when you’re buying the future.”

Finally, Rochon provides some great advice on investing mistakes or errors of commission and omission. At MAEG, we believe it’s crucial to remain transparent about mistakes and assess the errors of omission on an ongoing basis to learn from them and continually minimize such errors.

Link to the full interview: https://bestanchorstocks.substack.com/p/a-conversation-with-francois-rochon