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Investing Insights From an Asset Management Pro

Chris Hill, The Motley Fool

In this episode of MarketFoolery, host Chris Hill talks with Bryan Hinmon, chief investment officer of The Motley Fool Asset Management team, about some of the investing lessons that Bryan's learned recently.

Companies like Facebook (NASDAQ: FB) and Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG) are known for their long-term thinking, sometimes at the cost of short-term gains, but there has to be a balance between long-term vision and short-term goals for sustainable success. Free cash flow isn't an inherently positive metric, and investors need to know how to distinguish between good and bad. Also, learn why Tractor Supply (NASDAQ: TSCO) has fallen off the track in the past few years and other stories.

A full transcript follows the video.

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This video was recorded on Feb. 7, 2018.

Chris Hill: It's Wednesday, February 7th. Welcome to MarketFoolery! I'm Chris Hill. Joining me in studio today, from Motley Fool Asset Management. It's not Bill Barker, it's the guy in charge. It's Bryan Hinmon.

Bryan Hinmon: Oh, snap!

Hill: Thanks for being here! I appreciate it.

Hinmon: Sure thing. 

Hill: We're taping this a day early because Wednesday, I'm heading out early to San Francisco, but I wanted to basically take you away from your job, because not only is it earnings season, but it's also a slightly more volatile market than we've seen recently.

Hinmon: I have a good team I'm leaning on. I'm making Bill Barker work for once.

Hill: For once, finally. Here's what I wanted to talk to you about. And I have no idea what's happening in the market because I don't have a crystal ball, so I don't know what's happening on Wednesday. While people are listening to this, they may be like, "Why aren't you talking about X that happened on Wednesday?" That's because we're taking it the day before. But, I enjoy following you on Twitter. I especially enjoy following you on Twitter when it's earnings season, because I not only learn some things, but I also learn how you think, and that's what I wanted to do in this episode, to take some of your tweets and have you unpack them a little bit and explain a little bit more. Some of them have to do with your evolution as an investor, and some of them have to do with concepts that I think are interesting for investors. I'm going to go in no particular order here. 

Facebook reported last week, and you had referred to what you call the capacity to suffer. For those who might have missed Facebook's latest quarterly report, one of the things that came up was, in a nutshell, CEO Mark Zuckerberg expressing a willingness, which really shouldn't be a surprise to anyone who has paid attention to Mark Zuckerberg, he expressed a willingness to sacrifice short-term bottom-line results for long-term public good of his company. You call it the capacity to suffer. You refer to someone, Russo. Who is Russo?

Hinmon: Tom Russo, famed value investor.

Hill: In terms of the capacity to suffer, that seems like something that's great if you're Facebook or Alphabet, if you're a company that has a cash-printing machine in the back room. But, when you're looking at a given company, how are you evaluating any given company through that lens of the capacity to suffer?

Hinmon: I'm glad we called out Tom Russo, because I can't take credit for the phrase capacity to suffer. It's something that he looks for in all of the investments he makes, and his track record is phenomenal. So, like many investors, we're trying to reach out into what is already known and has been tested and learn from other people's mistakes. This is one that I lean on heavily and try to incorporate when I'm learning about how CEOs behave, how they're allocating capital. You bring up a great point in that the capacity to suffer, and you framed it up pretty well, it's forsaking short-term for long term. It's a heck of a lot easier to do that when you have a business, like Facebook does, that doesn't have any problems for money. 

But, I think what the exercise does is, it forces you to understand that CEOs and their management teams are constantly making trade-offs. These are trade-offs for strategy and investments you're going to make to either hit the quarter or create intrinsic value for the long-term. So, it's an exercise of getting into how decisions are actually made. And what I love about Zuckerberg and Facebook is, he couldn't be any clearer about his desire to build Facebook to an enduring business. And he doesn't care about the short-term. And you see this elsewhere. When I'm looking at management teams, it's all about piecing together different, maybe disparate, pieces of evidence, into a picture that makes sense. It's the mosaic theory. He's very clear about it. He often times talks about their roadmap being three, five, and ten years, and their strategy to address that. So, you can tell that they are thinking long-term.

Hill: In the case of Facebook, it's frequently pointed out that Mark Zuckerberg, sitting right next to him, has Sheryl Sandberg. And maybe he can afford to think long-term and think about, "We can sacrifice the short-term," because Sheryl Sandberg's job is much more short-term. He has her right there to push back when necessary and say, "Let's not completely forsake the short-term." When you're looking at any given company, are you looking for that type of team? I guess, maybe a better question is, is there a stronger case to be made for companies that have a strong management team as opposed to a single person who can handle everything?

Hinmon: Without a doubt. There's value to the balance there. This is reminding me of a quote from Howard Schultz. I'm going to paraphrase it because I can't recall it off the top of my head. He was talking about investing for the long-term vs. hitting quarterly numbers. He basically has said that the long-term is made up of many quarters. So, you have to have those two time periods firmly in each hand as you're making these decisions. As we think about capacity to suffer, I think Schultz and Starbucks is another great example if this. Probably eight years ago or so, they were making massive investments in China. And that segment of the business was losing money. And analysts were calling for a strategy change, saying, "How can you keep throwing money at this? When is it going to turn green?" And Schultz said, "Be patient. We want to do this right. We see this, long-term, as a market that could rival the size of our U.S. business." Fast forward to today, and the China region is responsible for half the growth that Starbucks is experiencing. They see it as a market that's going to be larger, one day, than the U.S. market. So, balancing those short-term and long-term considerations is critical, and I think it's something that the stock market will reward you for if you do it consistently. Jeff Bezos and Amazon is an obvious example of this, but you see it in other situations as well. Not everybody gets the credit. You have to earn the credit.

Hill: Moving on to another company, you were going through Texas Instruments' quarter and posted a note about a quote that you pulled from the management at Texas Instruments. "We believe free cash flow will be valued only if it's productively invested in the business or returned to owners." I looked at that and, for some reason, it was like a light going off, like, "Oh, right." Because when I read that, I thought to myself, "I think every time I've read a quote from a company talking about free cash flow, I have automatically given them credit." And I think what you're pointing out is, that's a nice reminder that, no, just having free cash flow is not worthy of credit in and of itself.

Hinmon: Yeah. Texas Instruments is a great case study in productive utilization of cash flow and capital allocation. If you go to their investor relations website, they actually have a slide deck specifically around capital allocation. They clearly lay out their strategy for what they're going to do if they generate excess cash. You hear people say, all the time, that value is a function of discounted future free cash flows. And I believe that to be true as an investor. But, it's important to understand what free cash flow is and what free cash flow isn't. It's funny, you wrote a note to me saying, "I didn't really think about whether free cash flow was good or bad." One way that free cash flow can be thought of as bad is, it can be thought of as an acknowledgement that there isn't sufficient reinvestment for the business. So, a company doesn't necessarily have anywhere to reinvest in its business to generate future value. Another way that it can be bad is if there's extra money left over and you have a CEO who's interested in empire building, and he or she goes out and buys businesses simply to get bigger, or because they don't have a better use for the capital. So, it's a nice reminder. It's nice to hear management teams be thoughtful about what they're going to do with their free cash flow, instead of having a mindless use of it.

Hill: I would say I'm sorry for calling you out on this next point, but you've already called yourself out, so I'm just bringing it to light on this podcast. You wrote something a few days ago, "Reading through Tractor Supply and finally realized how I messed this one up." Tractor Supply is a company that comes up every now and then. I know it's a company that Motley Fool Asset Management has focused on for a while. For those unfamiliar, what's the thumbnail sketch on Tractor Supply, and what, in fact, did you realize your mistake was?

Hinmon: They're a rural retail company. They sell things to the farmer lifestyle. Things like animal feed and farm equipment, that sort of thing. And it has been a phenomenal growth company, and a phenomenally performing stock over the past 15 years. We've had investment in Tractor Supply for some time in Motley Fool Asset Management, and it's been a good one. However, for the last couple of years, the stock has really fallen out of bed. We've taken some big losses in it. I really think one of the best uses I get out of Twitter is, it's sort of a diary, a way to log my investing thoughts at the time to track back later. So, every once in a while, I'll have one of these, where a light bulb goes off and it's like, man, I realize how I screwed up. With Tractor Supply specifically, there were some things going on that were probably ... things were going so well that I didn't question enough when the times were good. And by the time that I realized, it was too late, the market had realized before I did. And in this case, it was threats from online competition and a decline in oil markets caused sales to go down a little bit, and then all of these problems came to light. So, it's sort of the Warren Buffett quote, you see who's swimming naked when the tide goes out.

Hill: Yes. And by the way, that mistake you mentioned, every investor makes that mistake. Even the great investors, early in their careers, they make that mistake of, essentially, things are going well for, pick your time frame, a year, two years, three years, and then that investor starts to pay less attention, because hey, times are good, things are going well, and it's easy to lose that discipline and think, no, why do I need to rigorously dig into every quarter when they've obviously proven they can get it done every single quarter?

Hinmon: Yeah. What ended up happening, my lack of diligence, the things I should have been asking questions about is, wow, this company is growing really well. They're opening up 100 stores a year, more and more people are coming, the concept is really catching on. And when a retail company had success like that, that's reflected in the financials, so it looks like everything's going really well. But for any growing business, it's really important to understand how the company, how management, is building the guts of the operation to be able to handle being a larger, more successful company. And this makes total sense. The way you run your household when it's you and your wife is going to be completely different than when you have three or four kids. Right?

Hill: Oh, yeah.

Hinmon: There just have to be stronger systems in place to make sure that the wheels don't fall off. So, any growth investment that you're looking at, it's very critical to understand how they are investing in the systems that are going to allow the business to scale, or not. We see, Under Armour is a great example of that right now. Under Armour, I believe, grew too big too fast and couldn't handle the demand that was out there. And it's suffering from that right now. They're trying to retrench a little bit and build up the internal operations to be able to support further growth. It's exactly what happened with Tractor Supply. I simply didn't ask the hard questions. What are they doing with their back-office software and point-of-sale software? How are they interacting with customers and building loyalty? How are they handling product assortment as they're growing this fast, and suppliers? And are they missing online? And, in fact, they were. They just weren't investing in these capabilities. So, when consumer tendencies changed just a little bit, it really shined a bright light on what they hadn't been doing.

Hill: I'm glad you mentioned Tractor Supply, specifically the number of locations they were opening, because one of the things that has changed for me personally as an investor is, I have gotten to the point, whether it's a retailer or a restaurant concept, I've got to the point where any time a company is talking about the number of locations they're opening. As an investor, I want to know, why that number? Now, sometimes the question for me is framed as, why that many? That seems like a lot, are you being too aggressive? And sometimes it's framed as, why that few? Are you that slow? But, I think you can almost never go wrong as an investor, not necessarily challenging, but just simply digging into and finding out for yourself, what is the process that this company goes through to decide at a given number? Because it frequently happens, at the end of Q4 earnings, where they say, "Here's our forecast for the year," or it happens in the January quarter and they'll say, "This is our forecast for this calendar year." They've come up with a number, it's always good to know, how did they arrive at the number?

Hinmon: Absolutely. And one of the things you're seeing at Tractor Supply is, they were anticipating opening just over 100 stores. They're dialing that back to about 80 in the next year because their ability to manage and management team's attention can only be spread so thin. So, now that they're focusing on all these other areas -- installing a new POS, doing more omnichannel initiatives, rolling out customer loyalty programs -- they simply can't open as many stores and do it well. So, I think it's important to remember that any growing company is going to go through growing pains. This is fairly normal. But it's our job as investors to keep our eye on the ball and keep asking hard questions.

Hill: One last thing before I let you go. Maybe I shouldn't have been surprised by this, if I had spent the time to think about it or delve into it in the way that you do, because you are so diligent, and you do so much homework. But, you had called out Procter & Gamble, which is a company that we've talked about constantly on this podcast since we started doing it in 2011, and specifically with P&G, with all the brands that they have, literally thousands of ad agencies and marketing agencies.

Hinmon: It's astounding.

Hill: I hadn't even thought of that. I never would have guessed that number, given that they don't have thousands of brands. So, at a minimum, you could just say, even if you want to silo it and say, one ad industry for -- that's so much more messed up than I thought it would be, and it makes me even less interested in Procter & Gamble as a stock.

Hinmon: To level set here, Procter & Gamble, in their earnings call, they were trying to make a point of how much money they're saving. And they're coming off of a $10 billion cost savings initiative. They're trying to rally investors, saying, "Look how great we are at cutting costs." But you sort of have to stand this statement on its head and think about it a little bit. They announced that they've already reduced the number of ad agencies that use by 60% -- from 6,000 to 2,500, saving $750 million in agency costs. That's incredible. But then they go on to say, "But we're not done. We're entering into another $10 billion cost savings program. We're going to reduce the number of agencies we use by another 50%." So, they're going to go from 6,000 to 1,200 or so, which still seems like a ridiculous amount. One of the things that has been causing P&G so much trouble lately is upstart brands, and the ability that the internet has provided small brands to grow into something significant and establish a brand presence without using an ad agency, just by whipping out a cellphone and taking a video, putting it on YouTube and hoping it goes viral. So, you still have P&G with a long way to go, another $10 billion in savings. When I hear things like this, it makes me say, no wonder that an activist investor is involved, urging you to change things pretty dramatically.

Hill: And if you think about how traditionally -- let's take it away from P&G for a second. Any company that's doing significant amount of advertising has natural tensions within that company, because the people responsible for the TV budget -- it's all about their budgets. Everyone is protecting their budget. The TV people want their budget, the radio people, the podcast people, the online people, the print people, and they're all agitating for even more budget. There's the creative struggle. So, when I read this, and I was reading through what you had posted on Twitter, all I could think of was, put aside the agency fees, I just thought about how many staff hours are wasted every month by back and forth infighting simply over budgets.

Hinmon: That was my comment I made on Twitter, too -- how many people does it take to manage 6,000 agencies? What a seemingly incredible amount of waste. It just goes to show that in these large, mature, older-stage companies, when you're thinking about removing costs and what a healthy margin profile could look like, there's probably more fat to cut than you realize.

Hill: If you want to read more from Bryan Hinmon and his colleagues, you can go to foolfunds.com and read the insightful comments every month from The Motley Fool Asset Management team. You can also get on Twitter and follow Bryan Hinmon. I know it's your busy season, I appreciate the time.

Hinmon: Happy earnings season, Chris!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you tomorrow!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Bryan Hinmon, CFA owns shares of Facebook and Starbucks. Chris Hill owns shares of Amazon, Starbucks, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, Starbucks, Twitter, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool has the following options: short March 2018 $200 calls on Facebook and long March 2018 $170 puts on Facebook. The Motley Fool recommends Tractor Supply. The Motley Fool has a disclosure policy.