[00:00:03] Clay Finck: Welcome to The Investor’s Podcast. I’m your host, Clay Finck. It’s great to have you as in today’s episode, I’ll be covering a book by Joel Tillinghast called Big Money, Thinks Small.
[00:00:14] Joel Tillinghast is an investment legend who has managed money with Fidelity for 36 years and manages 70 billion. Peter Lynch hired Joel at Fidelity and he described him as one of the greatest, most successful stock pickers of all time since 1989. Joel has beaten the market by 3.7 percentage points, which is just an incredible.
[00:00:37] During this episode, you’ll gain insights about how the future is entirely uncertain and some level of speculation is required in every investment. What speculations are acceptable for Joel’s conservative investment approach? What you need to understand about a company prior to investing? Joel’s thoughts on why he chooses not to invest in gold. Why investing in countries with the fastest GDP growth may not be the best decision and so much more.
[00:01:06] At the end of the episode, I’ll do some stock analysis on two companies that focus on acquiring businesses for their continued growth, Brown and Brown insurance and Constellation Software. Constellation Software specifically is a very interesting case study as Mark Leonard who has at the helm of the company, has increased the share price of Constellation at an astounding rate of return of 34% annually increasing the stock price by over 125 times. So be sure to stick around and tell the end of the episode to learn more about Constellation in the brilliance of Mark Leonard.
[00:01:40] With that, let’s dive right into today’s episode.
[00:01:47] Intro: You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.
[00:02:07] Now Peter Lynch wrote the foreword to this book and he gives Tillinghast quite high praise. He says that there are many skilled investment professionals whose funds have beaten their benchmarks, and Joel Tillinghast is right up there with them, and that there are a lot of books out there that purport to help you become a better investor but few mesh the human aspects of investing and business with the number side. And even fewer do that by drawing on the experiences of arguably one of the most successful stock pickers and active mutual fund managers over the past three decades.
[00:02:41] Lynch was actually the person that ended up hiring Tillinghast at Fidelity in 1986. He says, I have witnessed Joel’s growth as an investment professional, and I continue to be amazed by an almost unworldly ability to consume mountains of information about hundreds of companies at a time, analyze them and distill them and use it to find long-term winners while avoiding many of the losers.
[00:03:06] Lynch received a cold call from Tillinghast and Lynch was immediately blown away by the knowledge that this guy had. Immediately after he received a call, he called the head of Fidelity’s investment division and said, we’ve gotta hire this guy. He is just unbelievable. In his book, Joel argues that you cannot learn to become a great investor.
[00:03:25] But you can learn from the investment mistakes of others to be a more successful one. Things like investing patiently and rationally rather than investing emotionally and based on your gut or the mistake of chasing fads, fast-changing industries or commoditize businesses with a lot of debt. He breaks down five key principles for avoiding investment mishaps in the.
[00:03:48] Tillinghast opens up the book by saying that this book is about succeeding and investing by avoiding mistakes. The organizing framework of this book in five parts is that we will reap pleasing investment rewards if we make decisions rationally invest in what we know. Work with honest and trustworthy managers, avoid businesses prone to obsolescence and financial ruin and value stocks properly.
[00:04:12] With the help of this general approach, Tillinghast has outperformed the Russell 2000 and the s and p 500 by nearly four percentage points a year and over 27 years, $1 grew to $32 in the Fidelity low price stock. And a dollar in the index grew to $12. One of Tillinghast keys to successful value investing is patience.
[00:04:35] Value investing is all about buying something for less than one believes it’s worth, and then being patient enough and letting time be on your side. He points out that in the mutual fund industry, funds with lower turnover tend to perform better. This is counter to our natural human instinct, which tells us that we need to take action in our portfolio in order to achieve some.
[00:04:57] His first lesson of investing rationally brings him to mention the countless bubbles of the past and how quickly large groups of people become irrational as if the bubble they’re in is different than all of the bubbles in the past. When emotions are all stirred up inside of someone and they become delusioned by narrative talking points, they lose their ability to reason and can’t really separate fact from fiction.
[00:05:20] He says that crowds are impressed by spectacle, images and myths. Misinformation and exaggeration become contagious. Prestige attaches to true believers who reaffirm shared beliefs. Crowds will chase a delusion until it is destroyed by experience. One bubble we can all learn from from the past was the South Sea Bubble in Great Britain in 1711.
[00:05:43] The South Sea Company was launched as a scheme to privatize British government debt and the crown granted South Sea exclusive rights to trade with South America. Holders of this government debt could swap that debt for South Sea Shares and South Sea would collect interest. Interest income was South Sea’s only source of earnings at the time.
[00:06:04] In just six month shares in the South Sea Company rocketed by eight times based on just purely speculation around the South American trade industry, and it really had no tangible earnings to back up the hype. Even Sir Isaac Newton lost money in the South Sea bubble, as he stated. I can calculate the motion of the heavenly bodies.
[00:06:24] But not the madness of the people. In chapter three, Tillinghast breaks down the major differences between speculation and investing. He says that quote, in the public eye, it all looks like gambling, and sometimes it is. Wall Street confuses things further by calling all of their customers investors in quotes awkwardly Every investment involves some sort of speculation about future event.
[00:06:49] More dangerously, many who believe they’re investing are actually speculating. The distinctions matter because investors gather information and manage risk and uncertainty differently than speculators. Tillinghast explains that investment is a product of thorough research that indicates that capital is broadly secure and an adequate return should be earned.
[00:07:13] Speculation, on the other hand, oftentimes gets a bad reputation in the value investing community, but it’s something that is really a key part of our daily lives. Very few decisions that are based on forecast in the future can be made with absolute certainty. But he says, among the most treacherous speculations are on share prices, commodity prices, and crowd psychology.
[00:07:35] Since we don’t want to speculate on share prices, commodity prices, and the sentiment of the crowd, well, what really is worth speculating on Tillinghast states that topics that are worth speculating on include whether management will make the right decisions when the time comes. Whether an industry is prone to failure because of commoditization, obsolescence, or financial overreach, and what a securities value might be, because we’re anticipating responses to challenges and opportunities that have not yet presented themselves.
[00:08:07] No one really knows. However, the track records of executives and industries can provide useful indications. For example, brick and mortar retailers will have to sell on the internet or risk being destroyed by. My speculation center on which categories of merchandise will move more slowly to the internet, how the internet and in-store transactions might combine, and which chains have the systems and adaptability to serve customers in both formats.
[00:08:36] Benjamin Graham, who is the father of value investing, state of that. An investment operation is one in which upon thorough analysis promises safety of principle. In an adequate return, an adequate return may be something greater than what you could get in the bond market. For example, in the US today. You can purchase a bond for around 4% before accounting for inflation.
[00:08:59] Many value investors, I’ve studied target a return of at least 10 or 15%, and I tend to use a 10% discount rate when I’m doing my own DCF calculations. Tillinghast provides a four point checklist to help guide people to better understand whether they are investing or speculating. One. Are you thinking about the profits of the enterprise as a whole over time?
[00:09:22] Two, have you investigated enough to feel fairly certain about your conclusions? Three. Will the business remain stable enough to say that your capital is secure? Four. Is it reasonable to expect an adequate return throughout the book? Tillinghast explains some of the basics around investing, such as if you’re not willing to do the research around individual stocks, then you should just stick with low cost index funds, and then stocks are the best vehicle to build long-term wealth.
[00:09:49] We should ensure we aren’t paying excessive management fees or expense ratio. If you do decide to invest in individual stocks for yourself, Tillinghast believes that you must stick to investing in businesses that you understand and know really well. He explains. To understand a business, you must understand what every segment does and how they all make money.
[00:10:10] You must identify the factors that will produce its future earnings and be able to make a more or less accurate stab at forecasting them. Not all industries are equally easy to understand. Some industries such as biotech are impossible for most laypeople. After a little study, you’ll find that some industries are brutally competitive and unprofitable while others are consistently lucrative.
[00:10:34] Peter Lynch commonly says that you should start by researching companies that you’re familiar with in your day-to-day life. But Tillinghast points out that familiarity can also work against investors. How do you continually invested in the single largest company in the s and p five? From 1972 through 2016, your compounded returns were less than 4% per year, while the index earned over 10%.
[00:10:59] Sometimes investors are duped into believing that familiar names are safer investments. Familiar staples in the American economy such as Walmart and Apple may very well be safer bets. But it’s good to be aware that familiarity may lead us to be biased towards a particular company. In order to understand the company, you wanna understand a number of pieces of the business.
[00:11:21] You wanna understand why customers buy that particular product, why they might stop buying it or switch to a competi. This also ties into familiarity. I’ve covered William Sonoma’s stock in the past, and Tobis Carlisle said that during the Mastermind episode. His wife buys all of her furniture for their house from Williams Sonoma.
[00:11:41] So for many people, it’s just a really good brand that customers are attached to because they know what they’re gonna get and they can rely on the quality. And Williams Sonoma has really won that trust over their customers. So that’s just Williams Sonoma is an example for how I think about understanding the company.
[00:11:58] Other items that are worth noting around understanding a company. Understanding the company’s competitive advantage and what makes them different from their competition, how the business actually makes money, what causes their profitability to rise and fall? What is the driver of the company’s growth?
[00:12:15] What threats the business faces that may cause it to fail, as well as how good of an idea you have on where the business will be in roughly five years. This all ties into the circle of competence concept as. Your circle of competence contains businesses and industries you are competent in and have special skill or insights into some industries are going to fit much better into your circle of competence than others.
[00:12:40] And that’s totally okay because at least for me, there’s no way I even want to analyze or understand all of the tens of thousands of businesses that. I just don’t have the time or the mental capacity to do so. You only need to have conviction and a strong understanding in a select few companies. I appreciated that Tillinghast didn’t just focus on stock picking like Lynch did.
[00:13:02] In his books, he talks about a wide range of topics including the overall economy, economic forecast, and gold. Here’s an excerpt I wanted to share regarding gold specif. The garden variety versions of failures to consider intrinsic value and take in new information are permanent bears who always expect stocks to tank and gold bugs.
[00:13:25] This isn’t to say that bear markets don’t occur or that gold can’t be a useful store of value. Value. Investors are likewise intent on preserving capital, but we worry about the opportunity costs of holding such assets that produce little or no income, like cash or gold. Perma Bayers and gold bugs often tells sagas of impending disaster with accelerating inflation, usually following from high in rising consumer and government debt.
[00:13:51] Every data point is reinterpreted to support their cause. It’s intelligent to worry, but that doesn’t mean the most worrisome analysis is the most intelligent. I have some sympathy for the perma bears as the average PE of the s and p 500 in the quarter century. Between 1992 in 2016 has been higher than the quarter century before it, or just about any quarter century since the index was.
[00:14:16] Some argue that higher multiples are justified by globalization, increasing monopoly power in new technologies. Those who believe market valuation metrics are nonetheless mean. Reverting have appeared to be perma bears. A distinction might be found in their actions during bear markets like 2009 when market multiples tumbled far below even the averages of longer histories if they bought stocks.
[00:14:40] They are not perma bears. Gold may be a store of value, but how much value isn’t? Since gold earns no income, it has no intrinsic value, but over time, it does seem to have an average value based on a basket of consumer goods with huge variance. Yet, in 2001, gold traded at $270 an ounce, and in 2011, $1,900 even making a generous adjustment for consumer price inflation.
[00:15:07] In 2011, the real price of gold was five times what it had been a decade earlier. The popularity of tales of hyperinflationary disasters peaked coincidentally, in a weird parallel to inflationary fears, large quantities of securitized paper gold were issued. Investors with a sense of value in the ability to change their mind might have reduced their gold holdings at that time.
[00:15:32] I think this is a really interesting point of discussion. The traditional value investor will say that over the long run, stocks are the best performing asset class because they’re productive assets and you don’t have to guess whether now’s the time to own gold or now’s the time to own stocks. You just hold the stocks for the long run and you know you’ll turn out well.
[00:15:51] Plus value. Investors wanna buy something for less than it’s worth, and it’s impossible to value gold. So why even bother is their perspective. The other side of the coin for why people invest in. Or even Bitcoin nowadays is because the debt levels are just increasing higher and higher, as Tillinghast mentions in that eventually reaches a point where the debt simply can’t be paid back in real terms.
[00:16:13] So the gold bugs believe that high inflation is inevitable, which in theory would be beneficial to gold and not as beneficial to stocks in general. I can understand both sides and believe that everyone should come to their own conclusions. Of course, I personally chose to allocate to both gold and Bitcoin because I foresee a good chance we see a lot of asymmetric upside in at least one or the other.
[00:16:35] But that definitely doesn’t prevent me from investing in equities as well to get the long-term benefits from those. This reminds me of what Bill Miller said on William Green’s richer weiser. Happier show that the purpose of investing is not to invest in productive assets. The purpose of investing is to make money, and there are a number of ways to do that.
[00:16:53] You don’t have to just pick stocks. You don’t have to just pick gold, just pick Bitcoin. But some people choose to do that. Just stick with stocks or stick with gold or. More power to them if they decide to go that route. Golden Bitcoin are more so macro type bets. They’re based on this really big picture and this big macro approach and.
[00:17:13] The overall economy is just extremely complex as well, to say the least, which can make it even more difficult to decide whether a non-productive asset is a good investment or not. To counter this difficulty in this complexity, Tillinghast encourages us to think small. He says, so instead, I try to think small.
[00:17:33] There are fewer news reports on a specific company than on the economy as a whole. Analysis of stocks is less a matter of careful interpretation than analysis of the economy. It’s not inside information. It’s simply that most people aren’t paying attention, especially if the company is small. Everyone makes mistakes and figuring out what the future will.
[00:17:55] If the connections are clearer and more direct, your forecasts are more likely to be accurate. Unlike more cosmic subjects, it is easier to know what you don’t know with the specific stock. Both macro investors and stock pickers must fearlessly seek the truth. But for me, smaller errors are easier to admit.
[00:18:14] Once I’ve committed to a theory that explains big important things, I rarely change my mind. It’s more unsettling to admit that I don’t comprehend the world around me than a small situation of narrow interests. While I make fun of investors who incessantly think that the stock market is about to implode, or that gold is the only safe asset, I also have my own settled beliefs.
[00:18:36] An idea about a specific stock is just one of. And I know all along that a certain fraction of them will be dus. A smaller mistake is generally easier to repair. Thinking small not only reduces the severity and frequency of errors, but it also puts you in a better frame of mind to expect them and fix them.
[00:18:57] I think this is one of the common pitfalls of gold bugs or Bitcoin maximalist, is that once you take a stance because of things like groupthink and other psychological factors, I very rarely see someone revert back to being, say, a stock picker or having the opposite opinion. I like Tillinghast insight that we rarely change our mind on these big, broad ideas.
[00:19:20] This also relates to an idea I discussed during my episode covering Guy Spears book The Education of a Value Investor, which was that we tie our identity to something. It becomes extraordinarily difficult for us to revert back our opinion or viewpoint once we take that. To counter this Geis beard just doesn’t talk about his stock picks for the most part, so he’s much more freely to change his mind when the facts change.
[00:19:44] In chapter eight, Tillinghast covers the considerations when investing internationally. Investing internationally adds a whole new layer of complexity to an investment approach. You’re likely dealing with a different currency, different inflation rates, different growth rates of the economy, different political situations, just to name a.
[00:20:03] This is why I personally tend to stick to the US and avoid investments such as things in China, which are becoming much more popular. Our We Study Markets newsletter team has a great article covering the risks investing in China. I’ll be sure to get that linked in the show notes for those interested.
[00:20:20] The biggest advantage of investing internationally is that your opportunity set is substantially bigger. As many countries have more public companies than the US, TE Tillinghast cautions against focusing on countries with the most runway for growth in GDP per capita because these countries historically didn’t perform the best for investors in these countries.
[00:20:41] Said Japan and Italy had among the highest growth in GDP per capita, but stock returns in Japan were roughly average and Italy was comparatively low. Italy’s average stock market returns were only 2% in the study while the US was on the higher end, around six and a half percent. Many other countries were somewhere in between.
[00:21:00] And it’s also worth noting that Italy even had higher levels of GDP growth per capita than the US. Australia, Sweden, South Africa, the us, UK, and Canada had the best stock returns from the year 1900 through 2015. GDP per capita didn’t grow particularly fast in these countries, but several of them had the tailwind of high population growth.
[00:21:23] Tillinghast prefers to invest in countries. With the rule of law that are cheap on a relative basis, rather than looking for countries with high growth in GDP per capita. Starting in chapter 13, Tillinghast explains that there are four elements of value within a company, the profitability or income, the company’s lifespan, future growth and certainty.
[00:21:43] One of the most important in overlayed parts of this equation is certainty. Lately, I’ve been reading a book called The Joys of Compounding by God, babe. Gotham had this brilliant insight into how Warren Buffett views investing in uncertainty. Most of our listeners are probably aware that Buffett says that he invests in what he calls his circle of competence in businesses that he can know and understand really well and be really certain about the company’s future.
[00:22:10] When he finds a business, he is certain of their future. Then he evaluates whether the stock is cheap enough to. . But if he’s not certain about the company’s future, then he just stops his analysis there and just doesn’t even think about investing in the company, which really sounds obvious. But Buffett states that 99% of the stock ideas he comes across fall into the two hard category for him, which I believe would really surprise many people, me included.
[00:22:36] Just let that sink in. Buffett, who is known as the greatest investor in the world, admitted that he does not understand 99% of the businesses. He comes. So that’s just a really good reminder that we don’t need to have an opinion about the vast majority of businesses in order to be a successful investor.
[00:22:55] Gotham says that the basic idea behind the circle of competence is so simple. It is embarrassing to say it out loud. When you are unsure and doubtful about what you want to do, do not do it. So Buffett only invests in businesses that he is highly certain on in order to make an attempt to eliminate any potential risks that may pan out in the future.
[00:23:17] Tillinghast points out that in a rapidly changing world with companies rising and falling faster than ever, investors have fared best in in. That cater to daily needs where customers can’t or won’t switch. Unless Tillinghast can be shown that customers don’t view a product as a commodity, then he will assume that it is a commodity.
[00:23:36] And commodity industries tend to have mediocre profits as well as be very capital intensive. Alternatively, industries with no substitutes and companies with no competitors tend to enjoy the highest returns, survive the longest, and deliver the greatest value. He says that w he generally avoids commodity businesses.
[00:23:55] If he had to invest in one, then he would go with an oil business because of the limit on supply in the relatively inelastic demand, meaning. If the price of oil increases by a lot, then it doesn’t have a huge impact on demand. This is true in my own life, for example, as the price of gas really doesn’t affect my decision to go on a road trip or drive to the grocery store.
[00:24:16] I’ll pay for gas, whether it’s $2 a gallon or $6 a gallon, and that’s really where the term any elastic demand plays in there. He says that demand for oil continues to increase while the Earth’s resources and supply of oil is finite and global reserves are being depleted because of the boom bust nature of the oil industry.
[00:24:35] Tillinghast builds conservatism into his investment approach by assuming that oil prices in the future will be lower than today’s spot price or the 10 year average, in addition to looking for companies with a low production. That are in a politically stable country. Additionally, he wants them to be cheap on a PE basis and have little to no.
[00:24:55] Trey Lockerby released a great interview covering the oil industry and Buffett’s purchase of oil companies like Chevron and Occidental with expert Josh Young back on episode 4 68 in August of 2022. I’ll link that in the show notes as well. What really sets Tillinghast apart from some of the other investors I’ve covered here on the show is he ensures that a company is really, truly undervalued and he is not overpaying for the.
[00:25:19] He has a four-part checklist he provides that he uses to help ensure that a company is undervalued. First, does the stock have a high earnings yield, which is the same as a low PE ratio after normalizing the earnings. Second, does a company do something unique that will allow it to earn super profits on its growth opportunities, which is essentially asking, does the company have a moat?
[00:25:42] Third, is the company built to last or is it at risk from competition, fads, obsolescence, or excessive? And fourth, are the company’s finances stable and predictable into the extended future, or are they cyclical, volatile, and uncertain? He says this checklist does not catch every undervalued stock, but it does coal out the most common sources of disappointment.
[00:26:05] It does not guarantee that bad things can’t happen, but it does improve your odds when I can fill my portfolio with stocks with all four qualities. I see no need to consider those with defects. Most stocks will fail this screen, but that does not mean that they are not undervalued. In those cases, you must work through a full DCF watch, full of the risk of forecast error stemming from the known point of vulnerability.
[00:26:29] Tillinghast walks through the case study of United Healthcare, which he bought in 2010, around $30 a. The stock advanced to $150. By 2016, the stock had a low PE as it traded at a PE of just 7.3, providing a 13, almost 14% earnings yield. The company had steady growth, steady return on equity of 20%, which was above the median of the s and p 500 at 14% in being the largest health insurer in the country.
[00:26:59] UnitedHealthcare had a significant moat that gave them immense negotiating leverage in economies of. The only question mark around the company was the impact that Obamacare would have on the company, and if government regulations would be increasingly difficult for health insurers to be profitable going forward.
[00:27:17] For his fourth test of assessing certainty, the industry that United Healthcare was in had extremely stable and predictable revenues. Insureds would sign up for coverage at premium set a year in. Health insurance is a service that will always be in demand, and a lot of people stick with the same plan year after year.
[00:27:34] The overall business was definitely certain in terms of the durability. Before considering any of these regulatory concerns, Tillinghast talks about a ton of different subjects. In his book, he talks about bubbles, IPOs, technology, and its role in the economy. Globalization and a whole lot more that I won’t be getting into during this episode.
[00:27:53] But during his final chapter, he says that two icons of investing, Warren Buffett and Jack Bogel point in completely opposite directions. Buffett personifies an utterly idiosyncratic style of active investing while Bogal created the Vanguard s and p 500 fund. Both approaches are systems for minimizing regret with your investment decisions.
[00:28:16] The indexing approach Bogal advocates for defaults your returns to the average of the market and removes any risks of getting overly emotional, assuming if you really don’t know what you’re doing and you’re just making silly mistakes with investing. But Buffett and Bogel don’t represent the only conceivable way one can invest.
[00:28:35] He says, quote, the path you choose and sometimes must develop depends on your emotional character, knowledge and curiosity. It’s always critical to rationally examine one’s own motives, capabilities and limitations, but it’s important to do it. Many people prefer the contentment of the easily practical to shooting for the stars and often missing.
[00:28:57] Don’t torture yourself if you’re not cut out for stock. Picking like Buffett not only is telling us more apt to search for cheap companies, he’s also very, very diversified relative to someone like Buffett especially. He’ll hold hundreds of stocks while Buffett is fine being concentrated in just a handful.
[00:29:14] I think this is a good transition point to discuss and assess a couple of different companies. Recently I booked an interview with Chris Mayer for the We Study Billionaires show. Chris is the author of a very popular book called 100 Baggers. That interview is scheduled to be released on the We Study Billionaires Podcast on April 8th, and I’m really excited to chat with Chris because his approach and philosophy is to stock investing I feel aligned fairly closely with mine of, you know, we’re looking for high quality businesses with high returns on capital that have a long runway ahead. And this is very similar to Terry Smith’s approach, who I just recently covered on the show on episode TIP526.
[00:29:52] Chris Mayer manages a fund called Woodlock House Family Capital, and thankfully he has shared the companies that he holds in his portfolio. A couple of which I wanted to dive into today’s episode. The first company is Brown and Brown Insurance. Chris has tweeted a few times about this company, as he said that after their most recently quarterly released, they had another solid year. So I figured I’d dive in, take a look at the company and see what I find.
[00:30:18] Founded in 1939, brown and Brown Insurance is an insurance broker headquartered out of Daytona Beach, Florida. They focus on primarily selling property, casualty insurance, and employee benefits. They’re the fifth largest insurance broker in the country, and they have 450 locations since they’re a broker or intermediary that sells insurance.
[00:30:39] Their primary source of revenue are commissions paid by insurance companies, and to a lesser extent, fees paid directly by customers. Their 2021 annual report states that their four business segments offer a wide range of insurance solutions and services for businesses, government institutions, professional organizations, trade associations, families and individuals.
[00:31:00] When I pull up our TIP finance tool on our website, I see that they increase their revenues from 1.2 billion in 2012 to 3.4 billion in the most recent year. Their net income and free cash flows continue to march up or over time. Operating margins are consistently in the mid to high 20% range. Their PE at the time of this recording is around 26, and their price to free cash flow is just under 19.
[00:31:27] Then before I turn back to the annual report, their return on invested capital is consistently nine to 10% in recent years. That might be a question I ask Chris, if we get the chance to discuss this company during our interview. The stock returned almost 16% to investors over the past 10 years, excluding dividends.
[00:31:44] While the s and p 500 delivered a return of around 10%, and they pay out a relatively small dividend, but they’ve increased that dividend for the past 29 years in a row, giving it the status of a dividend aristocrat. Turning back to the 2021 annual report, they grew sales that year by 10% organically in almost 17%.
[00:32:06] Overall, the company completed 19 acquisitions with annual revenues of about 132 million, and this contributed to their overall revenue growth. The report states that we grow our business organically and through the acquisition of like-minded companies. Our focus on growth and profitability enables us to self-finance many of these transactions.
[00:32:29] Cultural fit remains the most important ingredient to a successful acquisition, followed by favorable financial terms. Then a bit later, our capital management strategy is based on the philosophy of investing. To optimize returns and minimize debt. We strategically deploy capital. To invest internally acquire firms and return capital to shareholders while maintaining a conservative debt profile.
[00:32:53] Chris had mentioned that Brown and Brown is really good capital allocators, and I love how they show this chart of how their cash was spent over the year. 12% of cash went towards share repurchases, 7% for capital expenditures, 16% for dividends, and 65% went towards acquisitions. So they’re really plowing a lot of money back into buying other companies.
[00:33:15] Their largest acquisition was an insurance broker out of Ireland named O’Leary Insurances. But the great majority of Brown and Brown’s presence is in the United States. The company’s CEO is Jay Powell Brown, who is the grandson of Adrian Brown, who originally started the company back in 1939 with his cousin, hence the name Brown and Brown Insurance.
[00:33:36] Jay became the CEO of the company in 2009 and has been with the company for 27 years and get this. Jay Powell Brown, the CEO. Owns 2% of outstanding shares valued at 332 million, and his dad, Jay Hyatt Brown, owns 13.3% of outstanding shares valued at 2.2 billion. So these two combined own 15% of the company, and then the total insider ownership is almost 17%, which is really, really good to see that we have that strong alignment of interest between managers and shareholders for Brown and Brown insurance.
[00:34:15] In the annual report, it shows the results of operations for 2021 and then compares it to 2020. The majority of their revenue comes from commissions and fees from selling insurance at all their various brokerages. Commissions and fees were up 17% year over year, while overall revenue was up just shy of 17%.
[00:34:34] Total revenue was just over 3 billion leading to a net income of just Shai of 600 million. Then the report breaks down their revenue into four business segments from largest to smallest by revenue. They got their retail national programs, wholesale, brokerage, and services. So the business really isn’t all that complicated from a high level as the majority of their revenue simply comes from commissions and fees from selling insurance.
[00:35:00] When I do an intrinsic value calculation for Brown and Brown, I looked at how much their free cash flows have grown over the years to help project those out into the. Over the past 10 years, free cash flows have grown by around 15% annually, so I wanna project some sort of growth with a little bit of conservatism as well.
[00:35:18] I went ahead and projected free cash flows to grow at 10% for the first five years and 7% for the following five years. And then I put a terminal value on the company at 15 times free cash flow into year. Discounting all those cash flows back to today. I come up with an intrinsic value of around $68.
[00:35:36] While the stock today trades at $58 per share at the time of this recording, that gives us a 17% discount to intrinsic value, assuming that the business is able to achieve this decent level of growth. So if the company is able to achieve these decent results relative to what they’ve achieved in the past, I’d expect the stock to return somewhere in the 10 to 12% range.
[00:35:57] Of course, nothing said on this podcast is intended to be financial advice. This is all just my opinion and based on the research I’ve done. What I really like about the company is their stability and their consistency in their business. They continue to grow their free cash flows despite the pressures over the past year or so, and the stock has held up much better than a lot of other growth names.
[00:36:19] The results have continued to be strong throughout 2022. The company has a long history of success and they still have the family of founders in the company who own a ton of shares, and based on their history, they’re really good managers. So I’d expect them to continue to deliver consistent results for the business, excluding any crazy recession that’s essentially outside of their.
[00:36:40] I think that family control companies like this do a better job of focusing on long-term value creation, and I think that’s something that Chris points out as well in his analysis. Rather than trying to play games with Wall Street and trying to hit their quarterly earning targets, family owned companies tend to be much more long-term oriented and not play these Wall Street games.
[00:36:59] My concerns for the company include their company’s moat and how they’ve been able to grow free cash flows consistently at a higher rate of return than their return on invested. So I’ll have to tap into Chris Mayer’s knowledge on the business to hear his thoughts. Part of the return on invested capital piece may be fueled by higher debt levels, their debt to equity ratio, which as of the most recent quarter looks to be around 0.8, whereas 10 years ago it was 0.25.
[00:37:27] I’d expect that higher interest rates might be a bit of a headwind for them in the future if they’re utilizing debt in order to make these acquisitions to help fuel that growth. Next, let’s transition to one of Chris Mayer’s other picks here. The one that really piques my interest was Constellation Software out of Canada.
[00:37:45] This is a company that was mentioned and caught my attention as well, and William Green’s Richer, Wiser, Happier series with Francois Rochon. He heavily focuses on quality companies. Francois said that the reason he invested in Constellation Software was because of their leader and president, Mark Leonard, who he regards as a really great human being.
[00:38:07] Here’s a clip of that episode with Francois chatting with William about his investment in Constellation.
[00:38:14] William Green: You obviously have invested primarily in the US over the years, but there’s an important component of your portfolio that’s Canadian companies, which is particularly interesting for the rest of us since you obviously have local knowledge as someone who’s lived in in Canada for a long time.
[00:38:29] I remember once, I think last time we, I don’t know if you had already, uh, picked out Constellation Software but I’m fascinated by that company because the CEO or I guess the, the president he’s called, has a kind of cult following.
[00:38:43] He’s sort of often viewed in the same way as, uh, as a Bezos or a Buffett in certain circles of, of the software world, for example. Can you talk about that? Because I remember you saying at one point that really that entire investment in consolation software was based on the fact that you thought Mark Leonard was this extraordinary leader.
[00:39:03] Francois Rochon: Yes. I remember as yesterday, I think there was a Christmas party in 2013. I was at some friend and uh, young friend of mine, very young. He asked me if I know this company Constellation. And I was a little ashamed because I thought I knew all the great companies. So, uh, I said, no, I don’t. Then, so I think it was almost on Christmas Eve, I read the, the 2000, well probably 2012 report software written by, uh, Mark Leonard.
[00:39:37] And I remember when I read that that was Love at first sight. I said, this is my kind of. I knew it because 20 years of reading other reports, that was on the best I’ve read. And I of course did a little more research, read about the company, read the annual letters, tried to understand everything about the company.
[00:39:58] And probably a month later, I, I think the, the day after I read the annual report, I bought a few shares just to follow it. But a month later you made a s sizeable investment in the company and never sold a share. So that was almost, uh, nine years ago.
[00:40:14] William Green: Have you met?
[00:40:16] Francois Rochon: Yes. A few times. And then I think he’s a great guy. He’s a great human being, a great businessman, and, uh, as great as you can.
[00:40:24] William Green: What makes him stand out as a business leader?
[00:40:28] Francois Rochon: That’s a good question. You know, people want some scientific approach to, you know, assessing managers, what makes a great manager, manager. But I remember a friend of mine said, well, this is the kind of person you’d like him to marry your daughter.
[00:40:48] And I think that sums, uh, all the great managers, uh, either Tom Gayner or Mark Leonard or [inaudible]. They’re great human beings. You want them to manage your capital. I mean, if I had to go away, uh, you know, always use that analogy of the Gilligan Island test. If you’re stranded on the Desert Island for 10 years, I know you remember that show at Gilligan Island.
[00:41:16] Who would you entitle your capital with? And uh, that’s one question I asked myself. Do the CEO of the company we invest, I’ll be happy for him to manage our capital. If I’m spending 10 years on island, and I think Mark Leonard, uh, I would sleep very well at night. Uh, this, uh, there’s Rhode Island knowing that, uh, he’s there in managing Constellation Software. Same thing with Tom Gayner [inaudible] and Warren Buffett at Berkshire.
[00:41:50] William Green: It’s actually, it’s a great insight with someone like Tom Gayer, who I know well, from Markel, which you’ve owned, I think for 10, 10 years now. Ally.
[00:41:58] Francois Rochon: Yeah. Close to 10 years.
[00:41:58] William Green: I mean, Tom, you would, yeah, you would just, you know, if you keeled over, you’d say, you know, before you keeled over, you’d say, Tom, can you just make sure my family is okay financially? Like you manage, you manage the money and make sure it’s…
[00:42:09] Francois Rochon: He’s great. He’s great.
[00:42:12] William Green: Yeah, it’s interesting. That’s a great filter actually, to think of who you want to partner with, not just as a money manager but as a CEO and most of us, I think, because most of us don’t really think of our investments in such a long-term way, we underestimate the importance of that personal element of that trust.
[00:42:32] Francois Rochon: Yeah. And these are not easy to to explain because they’re kind of subjective. They’re based on judgment and, but you know, as you get more experience, I think that’s something that, uh, comes with experience. Better judgment. Well, I like to think so, and that judgment helps us, you know, select great people because, you know, we’ve heard a lot.
[00:42:59] We’ve seen a lot. And, uh, we can see, uh, great managers because they’re so. And I would probably go back to the art analogy here. When you go to museums and go to and visit, you know the best museums in the world, pretty quickly you can see which are the greatest artists. And so I always say that beauty is hard to describe, but when I see it, I know.
[00:43:27] And I would say that if you look at lot of art in your life, you’ll be able to identify masterpieces. Think it’s the same thing with companies and CEOs, if you see a lot of them, if you read a lot of annual reports and you study a lot of companies and a lot of businessmen and business women over the years, after a while he’ll be able to identify the really great ones.
[00:43:50] So as I mentioned,
[00:43:51] Clay Finck: Chris Mayer has this company in his fund as well. He actually wrote an article back in June, 2020, all about it on his website, which I’ll be sure to get linked in the show notes. Chris writes, so what if I told you about a company with great returns on invested capital, low leverage, Modi businesses, a great capital allocator at the helm, an owner oriented culture, and a history of mouthwatering returns?
[00:44:16] Would you be interested since the company’s IPO in 2006, the stock is up 125? And this is in February, 2023. It’s up 125 times. So it’s already reached Mayor’s 100 Bagger status since their I P O, but it wasn’t until recent years did Mayor research the company to purchase it for his own fund. So Constellation is in the business of acquiring, building and managing vertical market software businesses in Canada, the us, the uk, and the rest of.
[00:44:49] It’s industry-specific software businesses provide specialized in mission-critical software solutions. They were incorporated in 2005 in their headquartered in Toronto, Canada. So many people in the US might not know about this company because it’s in Canada, since many investors like to focus on the country they’re in.
[00:45:08] Chris explains that he read through Mark Leonard’s annual letters and he became really interested in the company from. Similar to what Francois was talking about in that episode, Chris says, Leonard writes his letters in a way I wish all CEOs would write letters from one business owner to another fellow owner.
[00:45:26] He focuses on things that matter, like return on invested capital and writes thoughtfully about how to think about and evaluate the business. Then there are passages that make Leonard seem like a special character in the ferment of founder, ceo. Leonard says, I’ve traditionally traveled on economy tickets and stayed at modest hotels because I wasn’t happy freeloading on the shareholders, and I wanted to set a good example for the thousands of employees who travel every month.
[00:45:54] Then there are other bits that Leonard w writes that speak to a good owner centered culture. We incent managers and employees with shares escrow for three to five years so that they are economically aligned with shareholders. In return, we need and want loyal employees. If they aren’t planning to be around for five years, then they aren’t going to care much about the outcome of multi-year initiatives, and they certainly aren’t going to forego short-term bonuses for long-term profits.
[00:46:21] And then later he says, of his managers, we also pay them. Well, they are all millionaires many times over with much of their net worth. Invested in escrow, CSI share. Chris says, these ownership attributes are hard to find in public companies, and I value them highly. Their presence alone would have me interested to learn more.
[00:46:43] Then Chris talks a little bit how Constellation is richly valued on a multiples basis because the company is just so good at performing acquisitions, and if these acquisitions of the future aren’t as successful as those in the past, or those opportunities just aren’t there at scale, then the stock price could definitely suffer tremendously.
[00:47:01] That’s somewhat been the story over the past 10 years. Yet Constellation has continued to, you know, just chug through these acquisitions and continue to outperform to a large degree. Over the past five years, for example, the stock has delivered an average annual return of 24% annually. And if I remember right, I don’t think the stock has ever declined more than 30% over its entire lifetime from 2006 through 2023.
[00:47:25] Not one drawdown of 30% or. Their return on invested capital is spectacular at 27% per year on average over the past five years. I think what Mark Leonard is doing at Constellation is really something special and incredible. Even looking back during the great financial crisis, you wouldn’t be able to tell there was a recession.
[00:47:45] The share price just continued to chug along upwards, but of course it was trading at a much lower multiple back then as. The stock chart ever since it went public is just relentless, which means that, of course, they’re treating at a pretty high multiple today. I pulled together data on where the company has traded historically.
[00:48:04] Back in 2012, the price to free cash flow was around 17, and then it increased to around 20 for a few years, and now it’s increased to a price to free cash flow multiple of 30 over the past couple of years. If you look at the PE for Constellation, you’ll find that it’s nearly 80, which is very high, but this is because the net income amount is much higher than the free cash flow because there are significant amortization write-offs that are non-cash expenses.
[00:48:29] Essentially, a way to think about it is that accountants assume that the intangible assets that Constellation owns are declining in value. While Constellation doesn’t believe this is an accurate measure of what is actually happening economically, Leonard states internally, we think about the adjusted net income as the cash profits we generate after paying cash taxes.
[00:48:53] The most significant variation from gap net income is that we assume our intangible assets are not diminishing in economic value. This is a critical assumption that our board challenges and that you as shareholders need to monitor the way we support the ever expanding intangibles. Value contention with our board is by regularly forecasting the cash.
[00:49:15] For each of our required business units and then comparing them to our original acquisition costs to calculate the acquisitions. I r R. Now I dug more into what Constellation actually does, and Mark Leonard is very much trying to take this Buffett like approach of. Buying companies that will deliver strong returns for Constellation, typically smaller companies.
[00:49:36] And then they incentivize the managers of those companies to allocate capital effectively. So essentially they’re trying to align the incentives of the managers with those of the shareholders. They also specialize in acquiring smaller companies, and they’re pretty good at avoiding debt and making these acquisitions.
[00:49:54] A lot of people say that Leonard writes like Warren Buffett, and I can understand why people say that In February, 2021, his most recent letter, it said most of our competitors maximize financial leverage and flip their acquisitions within three to seven years. CSI appreciates the nuances of the VMs sector.
[00:50:13] We allow tremendous autonomy to our business unit managers. We are permanent and supportive stakeholders in the businesses that we control, even if their ultimate objective is to eventually be a publicly listed company. CSI’s unique philosophy will not appeal to all sellers in management teams, but we hope it will resonate with.
[00:50:33] In parallel with our established and growing small and mid-sized v m s practice in our nascent large V m s practice, we are trying to develop a new circle of competence. We are seeking attractive returns, a sustainable competitive advantage, and the ability to deploy large amounts of capital outside of V M s.
[00:50:53] That will require highly contrarian thinking and is likely to be uncomfortable in the early going. Hopefully, we have built enough credibility to warrant your patients as we explore new and underappreciated sectors. End quote. Here’s another bit that I felt was too good not to share regarding having a longer term oriented shareholder base.
[00:51:14] Moving on to the manage the stock versus manage the company issue. I used to maintain the belief that if we concentrated on the fundamentals that our stock price would take care of itself. I’m coming around to the belief that if our stock price strays too far, either too high or too low from that intrinsic value, then the business may suffer.
[00:51:34] Too low, and we may end up with the barbarians at the gate too high, and we may lose previously loyal shareholders and shareholder employees to more attractive opportunities in previous letters. I’ve talked about how important long-term oriented employees, customers, and shareholders are to both our strategy and organizational design.
[00:51:55] A long-term orientation requires a high degree of mutual trust between the company and all of its constituent. I do, of course, think there are some risks for Constellation. They’re acquiring companies, which is what really anybody can do. I think if they wanna pay 5 million for a company, I’m sure there’s somebody else out there that’s willing to pay a bit more.
[00:52:15] So the competition has really flooded in as Constellation has really made a killing, applying the strategy, and there’s no shortage of companies trying to copy what they’re doing. If anything, I think Constellation is a really good case study for what makes a great. They have a great management team that works to be very honest and transparent with their shareholder base, and they have the track record to prove it as they’ve continually produced high returns on invested capital.
[00:52:39] So that wraps up my analysis on Constellation Software. After doing my initial research for this episode, just a bit of a spoiler, I went ahead and read through all of Mark Leonard’s letters and any other writeups I could find on Constellation. This company I feel is so special that I actually ended up taking a relatively small position in the company.
[00:52:59] And I’ve recorded another podcast episode solely dedicated to Mark Leonard in the business of Constellation. The episode will be released on Monday, March 4th. So if you enjoyed learning about Constellation, mark your calendars for the evening US time on March 4th to tune in to my deep dive covering Constellation Software in Mark Leonard. I promise you won’t want to miss it as this is just an incredible and unique business with the very admirable leader at the helm.
[00:53:28] All right. That wraps up today’s episode. If you enjoyed this episode, make sure you’re following the show on your favorite podcast app so you can get notified of these episodes on our next release.
[00:53:38] Also, my interview with Chris Mayer is coming up soon, so feel free to tweet at me or message me on Twitter to let me know what questions you have for him. I’m really looking forward to the interview and know the audience will love it. My username is @Clay_Finck on Twitter, Clay_Finck.
[00:53:57] With that, thank you so much for tuning in, and I hope to see you again next week.
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