How We Think

Our Approach to Industry Selection

Our objective as investors is to compound capital over long periods of time at the highest return possible while minimizing the chances of permanent losses of capital. We believe the best way to achieve this is to concentrate capital in companies when they are priced significantly below our estimate of intrinsic value. With the explosive growth of passively managed mutual funds and exchange-traded funds, the active management industry has increasingly sought to mimic this asset gathering by minimizing tracking error[1]. To minimize tracking error, one should first diversify across industries to match the industry weights of the index. Being underweight (or overweight) an industry increases the likelihood of periods of relative under (or over) performance. Our strategy stands in sharp contrast. We do not deploy capital in all sectors of the market. We pick individual businesses, but we would argue that understanding which industries to avoid can be important to generating attractive long-term returns. Our approach to industry selection is built on two principles: circle of competence and return on capital.

Staying within one’s circle of competence is critical to avoiding permanent losses of capital and plays a significant role in our industry selection. Unknown risks arise unexpectedly when one ventures into industries outside of one’s competence. We study industries where we are likely able to develop differentiated expert knowledge about at least one company and the key drivers to the success of that company. We are less likely to be able to thoughtfully predict the key drivers of a company if it is in an industry with these characteristics:

Commodity Prices
Commodity prices are difficult to predict, and so are industries whose profits are heavily dependent on underlying commodity prices. Companies that sell a commodity obviously fit this category. For other companies, the price of a commodity is so important as an input that they can be equally difficult to predict.

Commoditized Products
Undifferentiated products are equivalent in the eyes of the consumer which can lead to fierce price competition. In a commoditized industry, it is hard to be smarter than your dumbest competitor. In contrast, differentiated products can lead to sustainable pricing power.

Regulation
Government regulators can, and often do, unpredictably change course. Predicting the government’s agenda, and possibly the corruption at work influencing it, is often a prerequisite to success.

Legal liability
Major lawsuits can permanently impair the value of a company, and rulings by a judge or jury can be unpredictable. Some industries by nature have more exposure to this risk.

Information Asymmetry
In some industries, insiders have superior access to valuable information and the means to express their superior knowledge in the market ahead of you.

Geopolitics
Geopolitical concerns often supersede the interests or capabilities of a single company. Mercantilism is alive and well, and competing in industries subsidized by governments is ominous for profitability.

Cyclicality
Macroeconomic cycles are difficult to predict, and so are industries whose profits depend on their positions in the cycle. Peak parts of the cycle can simulate high economic returns, but only temporarily.

Though we occasionally find diamonds in the rough in industries with these characteristics, we allocate most of our time to industries that are understandable and where we can develop an edge relative to other investors. Return on capital is a measure of financial profitability comparing the profits of a business with the capital invested in it. A high return on capital is a sign of a good business. Not all industries are created equal. The economic characteristics of some industries lead to an attractive return on capital, while those of others do not. The graph below shows the return on capital dispersion among U.S. industries[2]. In pursuit of attractive long-term returns, we seek companies with high returns on capital and, often as a result, will happily concentrate our capital in industries where we find several of these companies.

Return on Invested Capital by Industry for the Russell 3000, 1990-2021 

Source:  FactSet and Counterpoint Global. Note:  Excludes financials and real estate; minimum of 100 million of sales in 2021 U.S. dollars. Morgan Stanley and Michael J. Mauboussin, “ROIC and Intangible Assets”

One example of such an industry is Coca-Cola bottlers in emerging markets. Our concentration in this industry is based on the insight that branded consumer products, and beverages in particular, are better businesses in emerging and frontier markets than they are in developed markets like the U.S. and Europe. Emerging markets typically have more fragmented and informal retail which makes superior execution in the route to market an important and sustainable competitive advantage that typically accrues to the market leader. Evidence of this can be seen below in the 2023 operating margins and the pre-tax returns on tangible capital of the three largest public developed and emerging market Coca-Cola bottlers. We compare pre-tax return on tangible capital[3] instead of return on capital to adjust for the impact of acquisitions and different tax regimes, which isolates the comparison of the underlying businesses. Emerging market bottlers do better on all metrics. Since May 2006[4], an equally weighted portfolio of the six bottlers below has compounded at 13% annually, which is comfortably ahead of both the S&P 500 and shares of The Coca-Cola Company. Note this return is similar to the average return on capital today for emerging and developed bottlers of 16% and 14%, respectively. Additionally, emerging markets usually have young and growing populations with rapidly expanding middle classes that drive increases in per capita consumption of many consumer products. This growth tailwind provides a runway for emerging market bottlers to deploy incremental capital at these attractive rates of return. We lose no sleep avoiding industries with low returns on capital, even if it all but guarantees periods of relative underperformance to a benchmark. Passive indices in emerging markets typically have high concentrations of industries with low returns on capital, and we think Cook & Bynum’s disciplined investments in emerging markets have widely outperformed the MSCI Emerging Markets index partly because of our avoiding these industries.

Our inability to identify a margin of safety in U.S. investments has been a headwind to our relative performance in the last decade. U.S. equities have outperformed most asset classes over the past decade on the back of the technology industry. The U.S. is home to the world’s best and most dominant technology companies, and we have not been meaningfully exposed to the value creation at these companies[5]. The outperformance of these companies for such an extended period has created the highest valued enterprises in the history of the world. Apple became the first U.S. company to breach $1 trillion in market value in 2018, and today the S&P 500’s six largest companies are worth $3.0, $2.6, $2.0, $1.9, $1.8, and $1.2 trillion. Historically, the largest companies outperforming the index is unusual. As shown in the graph below, for the last seventy years the largest U.S. companies tend to underperform the broader market. We have and will continue to demand a margin of safety to put our capital at risk. Technology is not an industry that we avoid or de-emphasize. We have long admired the competitive moats built around today’s technology giants and their growth potential, but also acknowledge that competitive landscapes in technology do evolve more rapidly than in other sectors and regulatory risks continue to threaten the largest companies. In the quick and short-lived market selloff of 2020, these are the companies we looked to first and vigorously debated buying. We certainly made mistakes by not doing so given how their businesses have evolved. Today, we do not see a margin of safety in any large U.S. tech company though others may. We think some have sustainable competitive advantages and significant growth potential but also are exposed to constantly evolving regulatory, geopolitical, and competitive risks.

S&P 500 – Top 10 vs. 490 Equal Weighted

Source: Compustat, S&P, GMO.  Data from 1957-2023. 

[1] Tracking error is the difference between the return of a portfolio versus its benchmark.

[2] This graph shows return on invested capital (ROIC), which is a term often used interchangeably with return on capital. ROIC is a company’s after-tax operating earnings divided by the sum of equity and debt capital less cash. The Russell 3000 is a stock market index tracking the stock performance of the 3,000 largest companies listed on stock exchanges in the United States.

[3] Pre-tax return on tangible capital is the operating earnings of a company divided by the sum of its property, plant and equipment and net working capital.

[4] May 2006 is when the last of these six bottlers went public.

[5] The Fund held a position in Microsoft from 2011 until 2018. The Fund has a small exposure to Apple via its position in Berkshire Hathaway initiated in 2011.