Talk Your Book: Hidden Pricing Power

0:00Today's Animal Spirits Talk Your Book is presented by Madison Investments. Go to Madisoninvestments.com to learn more about their Madison Mid-Cap and Madison Large-Cap strategy, which comes in both SMAs and mutual funds. That's madisoninvestments.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Batnick and Ben Carlson work for Ritholtz Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritholtz Wealth Management.

0:35This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. Today was an interesting episode because we spoke with a portfolio manager who is only considering the fundamentals of the business. He's what you call a bottom-up stock picker. But nevertheless... You know, I think early in my career I called it bottoms up. What did I call it? You call it bottom up. I think you're right. I think I used to call it bottoms up.

1:06You know what we did want bottoms up? It's bottom up. It is bottom up. But we used to inner tube down a river. My parents have a place that's on a river, the Pier Marquette River in northern Michigan. And if you saw a stick sticking out of the water, you told people behind you bottoms up because that meant you had to watch out for the stick. Otherwise, you're in the rear end. Anyway. Yeah, the more you know. Yep. So even bottom-up stock pickers who are really unconcerned with the macro vicissitudes, which is the word that I think I'm using right, the ups and the downs, you can't not pay attention to the macro because it's such a defining time for that.

1:44meaning like the cost of capital, which is a big one, interest rates, you can't not pay attention to that stuff. However, it doesn't mean that stock pickers should necessarily construct a portfolio based on where the Fed is today and where they might be in six months, because the truth of the matter is the Fed doesn't know. How are stock pickers supposed to know? Right. You have to be aware of what's going on in the macro. I don't think that makes it any easier to predict what's going to happen next. So we talked to Haruki Toyama, who is a portfolio manager at Madison Investments. And we asked him a lot about this.

2:16He's written a lot about the fact that we've had these different inflation and interest rate regimes and things sure seem a lot different now. And we don't know what the next cycle is going to look like or how long it'll last. And a lot of the questions we asked him, his answer was, listen, I don't know. Like we're paying attention to it. We're definitely trying to understand how it impacts our companies, but that doesn't make it any easier for us to predict what will happen. And I think the people that do try to use the macro exclusively to predict what's going to next in the markets, you probably have a better shot of being wrong than you do right.

2:44Yeah. I think last year was an unusual year in the sense that 99 times out of 100, if I give you the macro for the next year, assume that there's no extremes, right? If I tell you, okay, earnings growth is going to be this, GDP growth is going to be this, retail sales, interest rates, inflation, et cetera, et cetera. You might be able to maybe guess what the market would do in response to that, but probably not. Last year, all you need to know was inflation is going to hit a 40-year high and you probably could have positioned your portfolio for a certain way. But the point that I'm making is even if you knew, even if you really knew, you still don't know what the stock market is going to do.

3:19So in this conversation, we get into the things that actually matter that are durable ways of thinking about construction and portfolio, not just for the next six months, but for the next six years. So here is our conversation with Haruki Toyama. We're joined by Haruki Toyama. Haruki is a portfolio manager and head of mid-cap and large-cap equity at Madison Investments. Thank you for coming on today. Well, thank you for having me. Let's start here. I'm looking at your large-cap holdings. This is a concentrated portfolio, which I like. It's got 29 holdings, an 89 % active share, which means that you are very differentiated from the index, presumably in this case, the S &P 500.

3:58And if I'm looking at your holdings, I guess the way that I would describe it, and I'm going to be honest, I haven't heard of all these companies, but I think just at a glance, I would describe the theme as companies with a durable, competitive advantage. How would you describe your style of investing? That's a very good observation because we actually look for three key things in an investment. But we like to say that first among equals is that the company have a wide and deep moat. Some people call it a sustainable competitive advantage, durable competitive advantage. We think a moat encompasses a lot more than just competitive factors.

4:41So we like to use the term moat, but I think that's basically it. The three things we look for are a wide and deep moat. We like the company to have good growth prospects. We think sometimes we make mistakes in our investments or valuations, sometimes just sort of a one-shot deal. And so we like to find companies who can own for 5, 10, 15, 20 plus years. And so growth is important. We want the company to be worth a lot more 5, 10, 20 years from now than it's worth today. So we're not just waiting for the valuation gap to close. And that final piece is that we want the company to have a pretty strong balance sheet.

5:14We know that no matter how wide and deep the moat or how great the growth prospect may be, there's going to be a lot of unexpected bumps along the way. And if it doesn't have a strong financial position, it won't be able to weather that storm. So those are three things we're looking at. And that's aside from the investment valuation itself of the stock, of course. Do you find that it's harder to find companies with a strong moat these days because of the way that innovation seems to be happening faster and technology is becoming more of a permanent part of our lives? There's a lot of these stats that show the turnover in the S &P 500 is increasing in terms of companies that don't stick around for as long as they're not, their tenure is not as long.

5:50Is that harder than it was 15, 20, 30, 40 years ago? I think you're probably correct in the sense that there are probably a smaller percentage of companies with a wide and durable remote compared to say two, three decades ago. But I'm not sure it's really translating to fewer opportunities for us. And while that's the case is I think sometimes babies get thrown out in the bathwater. And so let's take an easy example, The brick-and-mortar retail industry has been absolutely decimated by e-commerce. Amazon specifically, of course, but e-commerce in general. However, because sometimes that sort of trait is well-known or became well-recognized some years ago, a lot of companies got thrown out and the valuations got extremely low because people got scared of Amazon.

6:41So sometimes you get these opportunities because exactly that moat is getting shallower and narrower. For certain industries, you tend to find every once in a while that some of the good companies that actually maintain a strong moat get thrown out. So it's not quite clear to us that we're finding fewer opportunities. But I think that general observation is correct, yes. All right, I'll throw you a softball sticking with these competitive advantages. What is it about them that makes for an attractive investment? Is it the predictability of future cash flows? Does the market tend to underprice these companies because they are potentially sort of boring?

7:17What is it about it that investors get paid to bear this specific type of risk? It varies. I don't know that there's any one trait necessarily or one thing the market overlooks, but you hit upon a good one, which is the market tends to be overly focused on really high current or near-term growth. It's exciting. There's something going on. There's a new product, a whole new market segment that's created, or maybe a company is disrupting the industry, so it's gaining share very quickly right now. So when that happens, we obviously look at those companies because if there's something there, we're interested.

7:52We're not avoiding high growth by any means, but they tend to be well-recognized. And so we do tend to find a lot of value in the companies that may be more boring, just like you sort of mentioned, and they're getting above average growth. and that growth rate may be more sustainable way longer than people think. And those are hard things to wrap your head around, just sort of intuitively, instinctively. The power of compounding is very strong. So when you can grow 10%, 12 % for 10, 20 plus years, the math turns out that a company is worth a pretty high multiple today. I appreciate the analogies you use in some of your letters that you sent us because you use movies as your backdrop.

8:34Michael and I are big movie buffs as well. You used When Harry Met Sally to talk about growth versus value. It sounds like, I think that's kind of the old Buffett line. They're kind of attached at the hip, but it sounds like your investment process kind of takes a similar route where you're not pigeonholed into one area or the other, and we're just getting the highest growth stocks. We're just finding these lowest valuation companies. You're trying to straddle the line between the two. Maybe you can talk about that and how that fits into the process. I think that's fair. Again, we're fairly eclectic in our approach.

9:03We're just looking for companies, like I mentioned, those three big characteristics, and some of them grow moderately fast, others grow very fast. We do tend to avoid companies that are very slow growing, because I mentioned, you know, we're not hoping to just sort of get the valuation gap to close. Just to use old Buffett analogies again, we're trying to buy dollars for, say, 60 cents or 70 cents. But if that dollar doesn't grow, then we're counting on that 60, 70 cents to get up to 95 cents, 98 cents. We're counting the market to sort of close that gap. And then we have nowhere to go. So it becomes a relatively short or medium term investment for us.

9:43And because we're hoping to own these companies for many, many years, we want that dollar to end up being$1.10,$1.21,$1.32, too, right, if you were to compound at 10 % a year. And so that even if the market never ultimately recognizes that full value for many, many years, at the very least, we'll feel comfortable that the value of the company is growing at a pretty decent clip. We can be patient. So that's kind of how we think about it. Mathematically, when you try to value a company, you use the same formula, regardless of whether it's a quote, value stock. Every company is worth the discounted stream of cash flow from today until forever.

10:27And so whether that cash flow grows or shrinks, you still use the same formula. So being bottom-up stock pickers, I imagine that this is a low turnover portfolio. I imagine that there's no trading in anticipation of what the Fed might do or where the economy might be heading. But that being said, you just mentioned the discounted cash flow. And the biggest input to that is, of course, interest rates. So today's cost of capital is a whole lot different than where it was in the past. How do you think about the role of that in your portfolio construction? Yeah, that's a great question. Because we're so bottoms up, we tend to tell people that we ignore macro or don't pay that much.

11:04Can't do that anymore. You never could. That's not 100 % true. I think what we're trying to tell people is we're not any better than others in predicting the macro environment. We don't think we are, to be honest, we're pretty skeptical that anyone else can really do it consistently. But let's set that aside. We don't think we have that capability. So what we know or what we think is that we can't really tweak our portfolio or, quote, position it to do well in certain macro environments and not do well in others. We're not trying to make a prediction ever of where rates are going or inflation is going.

11:43And that's true not just today because inflation and interest rates are a hot topic today. But three years ago, five years ago, we always considered that there was a possibility that rates may go up or inflation may go up. So even five years ago when no one was talking about inflation or rates going up, we made sure to invest in companies that we thought would be able to thrive in a rising inflation environment. You talked a little about in this one of your letters where you talk about these companies that have realized versus unrealized pricing power. I've never really heard it laid out like that.

12:16So maybe you could explain what that means and how that translates from companies that have the ability to do that versus companies that don't. Yeah, that's a great point because ultimately pricing power is great. If you raise prices above general inflation or general costs, Over time, that will compound into very high prices if you're charging. So you may do great for three years. You may do great for 10, 20 years, continue to raise prices. But at some point, what you do is, number one, you're creating a very high pricing umbrella, inviting competitors to come in. So you want to try to avoid that.

12:54And number two, you will ultimately cause your customers to look harder and harder for alternatives. So you want to avoid that. So we love pricing power, but we also love companies that don't push it to the ultimate maximum. And they would prefer to continue to provide good value to customers and find ways to increase their efficiencies. And so what that means to us, so in other words, a company might have really strong pricing power, but not use it, which they might decide that management, if they're long-term thinking enough, would decide that's a better way to build a franchise 10, 20 years out.

13:32Here's a company that did have pricing power, but then they went too far. They used it. And for me, they lost it. I'm talking about Starbucks. They pushed me too far. I'm done with that place. That's exactly right. Right. And so that's part of the issue is that 20 years ago, they had great pricing power. So if you invest in Starbucks, great. You enjoy the fruits of probably 10, 15 years of continuously rising prices well above cost. Things are great. Think about it because when you raise prices, it makes your revenue growth look good and your margins expand. And if you're a shareholder, 5, 10, 12 years, you're just telling yourself a wonderful story that's backward looking.

14:11Now, you also don't want to step off the train too early. So it's a really difficult balance to try to figure out when a company has pushed it too far. Well, I'll tell you right now, they pushed me too far. I'm out. $4.50 for medium iced coffee? Come on. I have to draw the line somewhere. That's exactly right. So that's kind of what we think about, right? What ultimately is the market size for someone like Starbucks charging$4.50 for a relatively basic cup of coffee? That's the kind of stuff we think about. And we use the example in our letter of a company we don't own, but we used to own for a very, very long time, Costco.

14:47They understand that they don't want to push pricing. We think they do have pricing power, something like their private label business. The quality of their private label is tremendous. Yet they continue to offer that much, much lower prices versus a brand name product. They certainly have room to close that pricing discount with the brand name equivalent if they wanted to. but that might be, in their opinion, at the expense of their sort of brand value bringing. You think a lot of companies, and I tend to agree here with you and Michael, that a lot of companies could be making a mistake here if the environment shifts somehow, because a lot of it is still driven, I think, by consumers still being pretty flush or having pretty strong balance sheets.

15:26If that changes or the economy slows down, a lot of these companies are going to get caught off sides with the prices they have. Absolutely. It's interesting you mentioned the inflationary environment today because this is what's causing a pretty big conundrum, which is Consumer packaged goods is a great example to talk about. These large food and beverage brand companies that thrived for 30, 40 years. For many, many years, they did continue to raise prices to take advantage of their brand value. Now, what you've seen for the past 10, 15 years is, number one, the retail channel has consolidated quite a bit.

16:00You have behemoths like Walmart in the U.S., Target. You have online behemoths like Amazon. they now have the clout to keep the pricing clout in check. Also, they have the ability, I guess, now the supply chains are robust and they have their own brand. They have the ability to bring out private label. So these brand companies to maintain or try to maintain their margins today in inflation in the world are pushing price. but that is leading to lower volumes and that can end up becoming sort of a long-term spiraling decline because ultimately you can't just keep lowering volumes and maintaining your margins by raising price because you're just going to sell less and less units every year and at some point your business kind of goes away.

16:49I agree. Michael is a Starbucks guy. I get my caffeine through Diet Pepsi or Coke Zero. Like a psycho. We're talking like a 12-pack for like $8.99 now or something. You can raise prices and deal with lower volumes now, but to your point, how long is that going to last as a long-term strategy? That's right. The more your units decline, the more you have to raise prices to make up for that lack of scale, and then it just becomes a spot. You have a lot of exposure to the consumer in your portfolio. I'm looking at names like Dollar Tree, Lowe's, TJX, Visa, Nike. The consumer is what drives the economy, And there's been a lot of debate on the excess cash, how much is actually left from all of the stimulus.

17:30Where do you think the consumer is today? I think it's become very clear over the past, call it, three to six months, that consumer spending is slowing. They're becoming a little bit more value conscious. You had about a year or two there, which, as you mentioned, was a pretty flush time for consumers in the sense that there are lots of things that you weren't spending money on, whether it was eating out of travel. And so you can see that bank balances and cash balances were building. And there was a period of 12 to 18 months where companies were essentially telling everybody, we're not seeing any price elasticity.

18:06We're raising prices to cover our costs, and we're not seeing any slowdown in demand when we do. I think in the past sort of three to six months, you've seen actually that change. And so consumers, they're starting to respond to value. They're starting to shift from sort of the higher price tier segment products to more middle tier, lower tier price products. And they're starting to push back in some of those prices. So I think that's what you're going to see over next year or two. And of course, a lot of it depends on the path of inflation and where that goes. But I think you are definitely going to see a little bit more return to value.

18:41So you mentioned that we have a lot of consumer spending related companies that profile. You'll notice a lot of them are very much value segment of the consumer. world. So Dollar Tree, for example, they're selling very low price products, very basic needs to customers. And so we're very comfortable there. You mentioned that you don't like to predict the path of rates and inflation, and I fall in that same camp. I can't imagine anyone who three or four years ago would have said, I predict inflation is going to be higher and rates are going to be higher because a pandemic is going to hit. No one could have foreseen that.

19:13But in one of your pieces, you talk about how since World War II, there's essentially only been three different cycles for inflation and rates. You had this post-World War II period of the mid-60s where you had flatlining rates and finally in the mid-60s to the 80s, rates came up and you had higher rates and higher inflation. And then 82 to 2020, call it, you had this disinflationary period where rates fell. And over that long of a time period, that's not that many secular cycles of things happening. So I think a lot of investors these days look at these past cycles and assume, well, well, we're going to have to have one of those going forward now.

19:50And the next logical one is rates are going to keep going higher, whatever. I wonder, without the ability to predict what's going to happen, obviously, is it even possible to have cycles that long anymore? Or is thinking that way going to get investors in trouble, assuming because we have such a small sample size to go on, are things just going to be mini cycles from now on as opposed to these really long, decade-long cycles that play out? I'm just kind of thinking out loud here and wondering what your thoughts are? That's a good question. It kind of relates to the whole life cycle question you had about companies, how much more quickly they can be disrupted.

20:23So what does it mean for corporate life cycles? And I think it's a good question to ask from a macro standpoint. And I think the obvious answer is that we don't know and I don't think anyone knows. If I had to guess, we will continue to have these long cycles. But I think you're right. The reason we have cycles is that information flows at a certain speed and people tend to react and behave and then change your behavior at a certain speed. That's why cycles happen. That's what the economic cycle is. People get too optimistic, there's too much spending and capital expenditures, and then you have a little overcapacity and people cut back and so on.

20:59And so I think there's definitely the potential here that because information flows so much more rapidly than ever before, that those macro cycles do become short. The market corrects faster. 20 to 30 years ago, you didn't have the Fed chair talking about all these great reams of data you get on almost real-time basis. 30, 40 years ago, there was a huge lag between when they got the data and when those things happened. And just the amount of data wasn't nearly as much as before. And so it's very possible you have faster cycles. I'm not sure that really changes how you should invest. It's not going to change how we invest.

21:37I guess there's a small case to be made that that might mean there are more short-term trading opportunities. We've just found that argument. It's been hard. It's possible that's there, but if you look at our performance patterns, it doesn't seem like we've been hurt by that. And so it's hard for us to think that we're going to have the ability to sort of make those shorter term macro calls any better than we have the long term calls. The market and the economy have withstood a lot from an unprecedented rise in interest rates. If you compare this hiking cycle to others, it just goes straight up, whereas the others are more gradual.

22:15We've got a yield curve that's been inverted forever. ISM manufacturing is heading in the wrong direction. Housing is frozen. Leading economic indicators aren't looking great. Oh, by the way, the banks and lending, which is going to clamp down. I mean, things are looking not so great. I'm asking you to guess. Why do you think the overall market hasn't responded to what seems to be an obvious slowing economy? First thing I say is this is probably the most anticipated recession in my career. And my guess is, I'll say that again, next cycle and the cycle after that. Again, because there's so much information flow out there that I think people's sort of opinions, consensus opinions, switch gears much faster than ever before.

23:01And so this is interesting because I didn't also make the case that that's why these bank runs happen in the first place. Information flows so quickly between depositors at Silicon Valley Bank that they were all talking to each other, whether it's on WhatsApp or text or through social media. that it just sort of enabled this contagion to happen at a much, much faster rate than before. And so you could see something similar here. Now, I'm not sure I would agree with the thought that things are more uncertain than before. I think things are always uncertain. I just think that people sometimes forget about the uncertainty and risk.

23:44When you have these placid, long periods in the market where nothing goes wrong, the economy is doing fine, people forget about it, but that doesn't mean the underlying risk isn't there. And so I would disagree with the statement that risks are any higher today than they were six months ago, one year ago, three years ago. I just think there are moments in time where people tend to highlight them more than others. Now the question is, well, if that seems to be the case, how come the market isn't down? I think it's essentially kind of what you're saying. And the answer is we don't really know. We do agree that the market is a little bit on the expensive side.

24:17So we do scratch our head sometimes. But again, we try not to think of that because the issue really is I'm not really sure if everyone's anticipating a recession to happen. It seems that odds are pretty good just in terms of the odds the market are giving us that it could be wrong. Michael was reading some of the holdings before, I believe it was from your Madison large cap product. You also have a Madison mid cap product. When I first joined the industry back in the early 2000s, I worked for an institutional investment consulting firm who actually one of our managers was Madison Investments.