A Conversation on Quality Investing with Christian Billinger
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A Conversation on Quality Investing with Christian Billinger
Hi reader,
Welcome to a new episode of the Best Anchor Stocks podcast. Today, I have the pleasure of talking with Christian Billinger, chairman of Billinger Forvaltning AB, a privately held investment company based in Karlstad, Sweden.
I decided to contact Christian after listening to him speak about quality investing, as I believe the investment style of Billinger Forvaltning is pretty similar to that of Best Anchor Stocks. We focused the conversation on quality investing and on the concept of “hiding in plain sight.”
I prepared a transcript of the conversation (which you can read below) but the conversation is also available in audio format on…
I hope you enjoy my conversation with Christian and don’t forget to subscribe if you do!
Before starting, a brief disclaimer: Nothing said in this conversation should be considered investment advice of any kind. Do your own due diligence. The participants may or may not have positions in the securities discussed.
Leandro: So, first of all, Christian, thanks for taking the time to be here. I think the best place to start is by understanding your investment philosophy. I know you're a quality investor, but how would you define quality investing in one sentence?
I'll give you maybe even two sentences if you want.
Christian Billinger: Thank you Leandro, and thank you for inviting me onto the podcast. I'm excited to be here. I listened to the first episode with Chris Mayer. I'm a fan of his writing and I thought it was an excellent conversation, so thank you. I guess the core of quality investing for me, Leandro, is this idea that stocks follow earnings.
That's really the core of it. And I think usually when you hear people defining quality investing, they will focus on the characteristics of the underlying business and this idea of owning, so to speak, great businesses. So they'll refer to key metrics like return on capital employed, organic growth, or aspects of the business model, usually in the language of moats.
There's certainly things that I look at, but I think in a way, you know, you can take a different perspective and look at it from the investor's point of view. And if you take that perspective, the focus is really on owning businesses where the returns that I can realize as an investor mainly come from the performance of the underlying business, obviously, plus minus a bit, depending on the price or multiple we buy and sell at.
But it's really about generating returns that reflect business performance. And it follows from that, that owning the best businesses should generate the highest returns over long time periods, right? Because that's where you should see the highest sustainable rate of earnings growth. And one sort of advantage of defining quality investing in that way is that you also take valuation into account.
So it's not just about the business, although it's mainly about the business quality, it's also about not buying into that great business at a valuation where you will almost inevitably not realize that sort of underlying performance. You know, I think in another way, quality investing is simply investing according to this timeless principle that you want to pay less than what you're receiving.
And it just happens that for us, the temperament, the time horizon and risk management, the structure of how we operate, we end up in companies that are considered high quality. But I think it's an important point actually, that in some ways, quality investing is simply investing.
Leandro: I completely agree.
And I think the difficult thing about quality investing probably is that quality is somewhat subjective. And despite many people claiming that there are many high quality companies, actually the best quality investors claim to have investment universes of close to 50 companies. I don't know if that's the same for you, and if it is, what characteristics do the companies in your investment universe have in common?
So what are you looking for in a quality company?
Christian Billinger: Yes, in principle, we can look at any company in terms of market cap, geography, industry, et cetera, but for us, the short list or universe as you refer to, is also about 50 companies. You know, over time that tends to expand a little bit, but call it 50.
And I think the question you're asking really relates to the "how", you know. The previous question I think covered the "what", what is quality investing? And this is a question of how, and the reason we end up with only, if you will, 50 companies in there. Well, there's a few reasons. One of them is we need to, or we feel we need to, be able to understand these businesses.
And so most companies actually fall away already at that stage because we don't feel comfortable analyzing. You know, it's the very well known Buffett's "too hard pile," that Buffett always refers to. So that's where most things end up for us as well. The second reason there's so few companies in that investible universe is because we need, or we feel at least that there should be a pretty long track record, a paper record of performance.
And this relates to the idea of Lindy, right? We also want that track record to be durable or sustainable going forward so that we can actually assess the cash flows and thereby value the business. So even more businesses fall away at that stage.
And then thirdly, and maybe this is a more general point, there's only so many great businesses out there, but by definition they can't all be great or certainly not much better than the average. And so, you know, while I agree that mean reversion is probably a good assumption for most companies, there is clearly a small group of companies that defy that investing sort of law of gravity.
And you know, for us, what does that mean in practice? It means that we look at companies with sustainable earnings growth. Usually they grow top line at say 5% to 10% organically, they grow their earnings at least 8% to 12%. And, over time, and this sort of goes back to the first question, over time we'd assume that we should realize a return of at least the eight to 12%.
In practice we end up in certain industries and types of business models. So for instance, we're, you know, highly exposed to industrials and consumer goods, but that's not by sort of design. That's just, that's a result of the bottom up process we follow and that's just the outcome of the philosophy we employ.
And there's certainly quality investors in technology and in consumer goods, in industrials, in financials, right? So there's many different ways of doing this. I think if you're looking for commonalities, there's probably more commonality when it comes to the business model than when it comes to the industry.
So recurring revenues, flexible cost structures, low or no leverage, et cetera. And I think they also tend to have a un unusual or unique culture, which is difficult sometimes. They're often difficult to put your finger on. But, you know, if I look at our portfolio, we have things like MTU Aero Engines or Coloplast in there, and they tend to be long term, they're very focused on one or a few product segments, their competitors and customers openly admire what they do.
So, you know, so that's perhaps less tangible, but that's another example of why that list, you know, back to your question, why is the list only 50 companies. It's for a number of reasons, really.
Leandro: Do you have a way of prioritizing these characteristics?
So for example, is there something that you look for in a business and you say, "okay, this is a must-have", but maybe you look at another thing and you say, "okay, maybe this company doesn't have this, but that's not like a requirement to be considered a high quality company."
Christian Billinger: I think for us, culture has gotta be number one.
If it's not a business that is characterized by being long term in their thinking, that operates with great integrity, where management is focused on shareholder value, et cetera, then we can't invest in it. So culture is certainly a must have as you refer to it. And I think, the idea that there needs to be something unique about the business is also a must have, right?
So that could be a combination of culture, the product or service offering, the business model, the shareholder structure. So culture and the uniqueness of the sort of mix of aspects of the business. They are must haves.
I think for most other aspects of the business, it's a matter of trade offs. So, you know, one example, I like owning a business that has net cash on the balance sheet. But in some industries where we're invested, it's perfectly fine to operate with some gearing, right? So if you're a consumer goods, you know, if you're a sort of staples company, I wouldn't expect you to be operating with net cash, you know? We're happy with the moderate amount of gearing.
And another example would be recurring revenues. You know, I'd like to see recurring revenues, but in consumer goods, if we use that example again, generally there's no contractually recurring revenues, but in reality, the strength of brands and customer loyalty means that the effect is similar.
So I always think it's important to focus on substance over form. That's key when you're trying to sort of think from first principles.
Leandro: Yep. And regarding what you talked about the financial strength, I think many people tend to look just at the balance sheet to assess the financial position. But actually in the cash flow statement, you also have a great source of financial strength.
So for example, as you said, a company can have a net debt position, but maybe very stable and resilient cash flow. So then actually its financial strength is very high.
I was actually going to ask you what do you put more weight on, whether quantitative or qualitative characteristics, but I think you already answered this question because if culture is something you look at, then I assume is qualitative.
And I wanted to know like, qualitative characteristics are probably the most difficult to analyze, which is I think maybe why there's an edge out there for certain investors. If it was just numbers, then algorithms would rule investing. So I think they require quite a bit of effort to understand and also maybe some kind of humanistic interpretation, so to say, that is probably absent in any quantitative variable.
And my feeling is also that sometimes it's impossible to understand these characteristics in depth unless you have followed the company for a long time, sometimes even years. I mean, there are lots of investors that follow companies for several years before starting a position.
So how do you look for these characteristics and how do you analyze them? Are you one of those investors that has to spend several years tracking or monitoring a position before starting it? Or can you get more comfortable with qualitative characteristics in a shorter period of time?
Christian Billinger: Yeah, that's a great question. And let me just first sort of go back to the first part of that, you know, where you talked about quantitative and qualitative. I guess in one important sense to me, they're just two sides of the same coin. I know often, you know, we like to separate the two as being different ways of looking at a business, but to me, unless the qualitative aspects translate into quantitative, it's pointless.
So whether I think something's a great business doesn't really matter unless that, you know, over time that translates into sustainably high earnings growth. But you're absolutely right, of course, that in terms of the analysis, we're much more focused on the qualitative, right? And I think that's, for me, that's the same thing as saying it's process over outcome.
And we're looking at the underlying drivers as opposed to reported financials in the shorter medium term, right? Because the reported financials can have a large element of noise in there. So for, for instance, if I think back to the years leading up to the great financial crisis, in sort of 2007 - 2009, if you looked at house builders or miners in 2007, and if you only looked at the numbers they reported, you would assume they were terrific, incredible, wonderful, durable, earning streams, right?
Or if you looked at some of the so-called pandemic winners in 2020, you know, whether it's a Peloton or a Zoom or whatever, you could be tempted into thinking they are companies with sustainably high earnings growth. But obviously, I don't think that's the way to sort of go about it if you want to own great businesses for the, for the long term.
And so, so just to address that part of your question, I think valuation matters, right? But the forward PE matters much less for us and many other quality investors, because we're focused on the longer term, right? The long term time horizon, and, most of your returns, if you're a long term investor in great businesses at least, will come from the underlying business.
So what I do want to avoid is buying at levels where it's obvious or almost obvious that we won't fully participate in the value creation, right? So even if you're seeing 10% or 12% or 15% earnings growth and you're buying it at 40 times and that reverts to 20, say 25 times, you know you're not getting 10 or 12 or 15%, you're getting something much less than that.
I would say in reality they tend to go hand in hand. So if you rightly identify a business that continues to outperform operationally, they don't tend to see much multiple contraction, right? So it's still better to look at the business and the qualitative aspects. The other reasons for that are, number one, if it's a great business, the intrinsic value should increase over time.
And two, the valuation part of it is just such an inexact science. We try not to worry about it too much in detail at least, right? So we obviously try to build some sort of model and valuation to understand the drivers, but we're not looking at the decimal points. I'm sorry for that sort of long way of addressing the first part of your question there, Leandro.
I should also say, just to address the second part of it, you know, there's a few reasons I think that these qualitative aspects are maybe often less looked at. And, and as you said, often I think they require you to look at a business for much longer, right? So you can easily pull out the financials in an hour or two and sort of look at the earnings track record and margin progression. Quality takes longer to understand and appreciate fully, I think.
And one reason, in my view at least, is that there's this institutional constraint. So I used to work, you know, for a few different fund management companies, and if you're an analyst at an asset manager, you can't just pitch an idea to the PM and say, this is a great business, right? They want something more specific and they usually want a trigger, because they have to deliver performance in the next 3 or 6 or 12 months, or sometimes even on a monthly basis. So they're not just gonna sort of buy something because they think it's a great business, the qualitative aspects of a business, though, as I sort of alluded to, I think are the ones that drive the sustainably high earnings growth.
Some are more obvious. So if you look at the business model, for instance, and this is coming back to the second part of your question, Leandro, you know, the business model, I think you can figure out more quickly.
So you can maybe have a checklist that looks at recurring revenues, or the cost structure or the balance sheet. But I think when it comes to things like culture, it takes longer to fully understand and appreciate a business. And often you need to sort of, you know, meet with the company or speak to former employees or sort of pick up stories and observe what goes on.
I'll give you an example of a holding of ours, which is Markel. I went to visit Tom Gayner in Richmond, Virginia about a year ago, and I spent an afternoon with him. We had lunch, we went to his office and, you know, just sort of observing the way he interacted with other people and the way he is, suggested, to me at least, that he's someone that I can rely on to be a steward of our capital.
And having said that, I know there's also a tendency in so called "value investing circles" to say that if you're frugal, that means you have integrity and you're shareholder value focused. I don't necessarily agree with that. I know it probably goes back to buffet, but if I look at LVMH, which is another one of our large holdings, there's nothing that is ordinary about Bernard Arnault's lifestyle, but I still think he's an outstanding steward of capital. So it's once again, it's substance over form really.
But, but that, that's sort of how I look at it. You know, when it comes to how quickly can you pick up on these different aspects of a business. So I guess the answer to your question is quicker in some aspects and certainly more slowly in some others.
Leandro: Well, I guess in the case of LVMH, maybe if Bernard was frugal, that would be even like worse!
Christian Billinger: That would be terrifying.
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Leandro: So staying a bit on this topic. I wanna speak a bit about management now that we had Tom Gayner and Arnold come up.
What role does management play in your search for a high quality business? Because we have seen, for example, investors such as Peter Lynch claiming that it's best to invest in a business that can be run by an "idiot" because probably sometime that will happen. Like managers are not forever. I think cultures are forever, but obviously a bad management team can erode a culture.
So what weight do you put on management and on management continuity?
Christian Billinger: Yeah, great, great question. I think in most cases to us, the business is more, to the extent you can separate the two, the business is more important than the management team. But it's similar to the way we look at valuations.
We certainly want to avoid investing with lousy or bad managements, right? Because I've seen too many great businesses or great assets underperforming because of poor execution. And so, you know, a couple of examples of large well known companies that we've been invested in where we feel that that's been an issue.
Unilever (UL) is one of them. You know, I think it's plain to see for most people the extraordinary sort of assets they have in terms of the brands and the distribution network and the emerging markets reach and everything. But execution has not been impressive at all. I mean, it's been very disappointing actually.
Obviously there's management change happening there now, and I don't know to what extent it's Alan Jope's sort of fault and to what extent it's, Paul Polman's who was before him. So that's one example where we feel that, you know, potentially great business, but if there's any doubt, I get to a point where I ask myself, okay, capital preservation is my priority, number one, so if I feel uncomfortable or I'm unsure about this, you know, move on. Just, you know, try and exit and move on because there's so many other opportunities, including our other current holdings or existing holdings.
Another example would be the testing in inspection certification companies, we've been invested in Intertek and SGS for a number of years, but we feel that once again, like Unilever, they're potentially great businesses and in the past they've delivered tremendous shareholder returns, but, partly because of shareholder structure, they've been under investing for a number of years. And smaller, more nimble competitors have been, taking share and, partly at the expense of these large players. And so therefore we've sold out of them. So I think, in cases Leandro, where we see what we feel is sort of obviously poor execution, that would be an issue.
If you look at the upside, on the other hand, yes, exceptional performance will often largely be driven by exceptional people and exceptional management. So, you know, in our portfolio, Berkshire and LVMH would be two obvious examples. I mean, they're obvious. They're probably not great examples, but there's many others.
You know, we're invested in Coloplast, a Danish intimate care business. And, the former CEO and who's now the current chairman, Lars Rasmussen, he really transformed that business. And so, you know, that would probably still have been a good business, but it would have been nowhere near as great a business as it is now is if it wasn't for Lars.
It's early innings for Mark Schneider at Nestle, another holding of ours. But he's showing great promise and I think he's making a real difference there. That would still be a pretty good business, right? So, so I think we passed the first hurdle of not investing in a terrible management, even if we'd invested 5 or 10 years earlier, but now we feel we may be onto something a bit better than that.
And, and another example would be Diageo, where I feel Ivan Menezes has really done a very good job. So, I guess on a more general point we tend to invest in types of industries where great companies will deal well with management transitions.
So we don't wanna sort of rely on another great manager coming in, right? So I guess we come back to this balance between downside protection and upside opportunity.
Leandro: And in this management analysis that you do, how important is alignment and compensation?
So, I feel that, for me, these are two important topics, but it's difficult to make them a requirement, not compensation, but especially alignment, so insider ownership because many high quality companies are like more than 100 years old. So it's actually quite difficult to find a manager, if it's not the founder, that has a significant stake because, well, they have issued shares through the years and insiders have sold their stakes through the decades.
So how much focus do you put on this? And is it a red flag if there's no insider ownership for example in one of your holdings?
Christian Billinger: That's a great point, and I agree with what you're saying that sometimes it's not perhaps quite as straightforward as it might seem when it comes to the often used word alignment, right?
So in principle, I'm all for financial incentives to management and alignment, but I feel that if you can pick businesses where there's, let's call it soul in the game, right? I think that's the best form of alignment as opposed to skin in the game. I mean, skin in the game might be a good sort of second.
I think the best one is soul in the game. So if you have people who fundamentally care about doing a great job, right? And if you have a culture where that tends to be the norm. You could obviously only identify so many of those types of businesses. I'd like to think that many of the companies where we are invested fall into that category.
Often it's because they're family controlled, sometimes because they're founder led. And the only way to identify these types of people and cultures is by spending a lot of time going through different types of companies and industries. So that's, that's my view. I'll take pride and sort of passion in what you do any day over financial incentives, although of course often if it's a founder led business or family control business there's a bit of both.
Leandro: I remember going over Copart's proxy statement, and they actually pay one of the CEOs, Jay Adair, they pay him just in stock. So he makes like $1 in salary. And the, the rationale behind this was obviously to align the incentive with his shareholders, but also because there wasn't like a sum of money that they could pay him so that they could incentivize him because his stake was already like in the billions.
So I think that's something that people tend to overlook because if a manager, like if a CEO has a huge insider's stake, then actually his salary is not going to be as important because it's actually a very small part of his net worth. So I think in that case, for example, the insider ownership takes more of a central role than the compensation structure behind the CEO.
Christian Billinger: I agree with you and I should say, of course, often there's a bit of both. If I look, you know, go back and look at Tom Gayner, or sort of, you know, you look at Buffett again, I mean you could argue that, or Arnold or many of the other people we are invested with, of course they have huge sort of skin in the game as well.
That tends to be the case if you've successfully run a business for long enough. In some cases you look at a Nestle or a Diageo, they're not led by the founders and, you know, management does not have a significant stake in the business in terms of percentage ownership right?
So there, I guess you are ideally looking for good financial incentives to create some financial alignment and you're also looking for people who really care. So I guess usually there's a bit of both.
Leandro: Okay, so now that we have discussed quality investing in general, I mean, we have still some discussion to do, but I want to shift gears a little bit and talk about the concept of "hiding in plain sight."
I mean, many high quality companies have outperformed the market for many years, and this basically means that they were systematically undervalued by the market, even if they enjoyed high multiples, because if they were obviously fairly valued, then you would've enjoyed market returns.
So why do you think high-quality companies fly under the radar so much? I mean many compounders are obvious. Like you can look back at the chart, everyone can look at the past, but few of these companies actually end up making it into many portfolios. This is especially true in the portfolios of professional investors.
So why do you think people choose to "ignore" these companies rather than building a portfolio of companies that have already demonstrated that they are high-quality companies?
Christian Billinger: I agree with you once again. I think often these businesses are, so to speak, hiding in plain sight. I think there's a few reasons.
So number one, institutional investors often have compressed time horizons. And so if you're looking at something on a, say six to 12 or even 18 month horizon, multiple expansion or contraction will play an outsized role for returns as opposed to the earnings trajectory and, you know, most great businesses trade at at a meaningful premium to the market.
And therefore, if you're an institutional money manager and you're worried about the next six or 12 months, you may very well say, "I'm not gonna buy that great business trading at a 20, 30, 40, 50% premium to the market." I know it's a great business and I know that over time it may very well deliver greater returns than any of the other things I can buy into, but over 6 or 12 or 18 months, multiple contraction and expansion is going to be the key driver and therefore I'm going to look elsewhere.
And, you know, I mean, I've had to do this myself when I worked in the institutional world that, when you run your screens, most fund management companies run based on low PE ratios. So that's sort of your starting point. So I think that's one very important reason.
I think institutional investors feel they often need to justify their fees by coming up with these very elaborate and, seemingly at least, sophisticated investment cases, right? So saying that you're just going to buy in on great businesses may not be sort of enough of a pitch when you're in front of clients.
I think thirdly, I think business schools teach this orthodoxy that mean reversion is inevitable and will affect all companies over 5 or 10 years or whatever. You know, for most companies that is true, but there's clearly a group of businesses for which that isn't true.
And I think, we can come back to this idea, but I think if you look at certainly the sell side, and I think often the buy side, most people have gone through that kind of training and they therefore assume that mean reversion will affect all companies they look at. And in some cases, that's clearly not the right assumption to make even before the fact.
I think often these so-called quality businesses are in pretty boring industries, and so they're not on the front page of the FT or even less sort of mass media, but certainly the FT and the Journal and the New York Times and what have you, right? So they're not headline stuff really.
And I guess finally, also when you look at their financial characteristics, they're more middle of the road. So organic growth is, you know, this will vary, but for us, for instance, it's probably usually say 4% to 10% or something, right? Earnings EPS growth might be 8% to 12% or 8% to 14% or something. Clearly they're not slow growing businesses, but they're not super fast growers either. And I think therefore they're harder to label in a way.
So if you're a deep value investor, you probably wouldn't be looking at these. And if you're a tech, well, I don't like the expression tech, but let's use it anyway. If you're a tech or a sort of high growth investor, they're probably not your kind of things you're looking for either.
So I think they're just some of the reasons why I personally feel that of often these businesses are surprisingly overlooked by institutional money managers, despite the fact that I think we can often agree on the qualities they have and the sort of prospect for sustainably high returns.
Leandro: Maybe it has to do with the fact that they don't have a catalyst, like their catalyst is growing for a long time at a steady rate, whereas other companies well...people look for companies that have a catalyst to deliver returns in a one year timeframe. I think I even think that one year is long term for many people, to be honest, judging by the holding periods that we are seeing right now.
Christian Billinger: No, I agree with you and I even think that's large part of the reason why you often get the opportunity to earn above average returns in these businesses, right? The fact that, you know, just what you refer to.
Leandro: So I know that your portfolio is centered around companies that operate in apparently boring industries.
Can you give us some examples of these industries and why they are attractive from an investment point of view? You can choose whatever industries you want.
Christian Billinger: I have lots of examples of boring businesses, tell me when you're bored enough. Let me give you a few that I think are, hopefully not, these are relatively sort of large businesses and leaders in their industries, but I think to the general public and, often to investors, they're not super, super well known.
So, I mean, one obvious example for me would be Coloplast, which is this Danish ostomy, continents intimate care business.
Leandro: Definitely sounds boring
Christian Billinger: It doesn't sound super exciting, does it? But it's a great business. And I'm not suggesting by any means that it's an undiscovered business, but it's certainly not this kind of name you would see on the front page of the newspapers or, you know, see if you're on some online forum, right?
They're meeting a very significant medical need and they're one of the few global players, right? And so in this business there's very high barriers to entry, there's very high visibility, and Coloplast who are effectively family controlled, they have the right culture to capitalize on that. They truly care about patient needs and long-term innovation, in that context enabled by the control of that founding family.
And it's also a really great case study, this industry and how different corporate cultures can result in very different outcomes for shareholders because they have a large competitor, called Convatech. And Convatech has a much more institutional shareholder base, and they've gone through private equity ownership before they IPOed a few years ago. They've really mismanaged their business in my, not just in my view, in many people's view, partly by under investing significantly if you compare to Coloplast.
And like many other great businesses and investment cases, it's also a very focused and simple to understand business and the drivers of value creation are clear. So there's one example of what you would probably call a pretty boring business, but the financials and the shareholder returns are anything but boring.
Let me give you another one: plumbing. That's potentially even even more dull. So Geberit is a holding in our portfolio in that industry. Now, initially they were focused on what, you know, goes on behind the walls, so effectively the sort of actual plumbing, the pipes and all of that. But following some, or especially one large transaction in recent years, they now also offer bathroom furniture. So it's more of a complete offering now.
And, actually culturally, it's very similar to Coloplast in many ways, and they also have an interesting business model where they have this very strong relationship with the installers who often make the purchase decision on behalf of the end user. And another thing we like about it is the fact that it's almost a definition of low technology risk, right? So it's very hard to imagine significant disruption when it comes to bathroom habits, of course.
I have a couple other ones if you're not sufficiently bored yet.
Leandro: No, I actually want to listen to more .
Christian Billinger: Okay. I'll give you two more.
Elevators is is one example, right? So it's a very simple product and service offering and the market structure is very easy to map, which is something I like. So there's four big players and they dominate the industry, there's great visibility on revenues, there's a flexible cost structure. So you get very sort of stable earnings, although I should say in the last sort of five to seven years, it's been an unusual time period for this industry because of the sort of slowdown and downturn, even in the Chinese market.
So it's a great business model, it's an attractive industry dynamic and you get high returns, great balance sheets, shareholder structures in both Kone and Schindler that enable long-termism, because they're effectively family controlled.
The last example I can think of is aircraft engines. We're invested in the German company MTU Aero Engines, and it's almost a definition of a critical component and barriers to entering that business are enormous, right? When I went to visit them in Munich, I've been there many times, and I asked them how many times in the 80 year or something history of the company, have your components been found to have been at fault in any type of incident? And their answer was zero. Not on any single occasion. And I think given the thousands of aircraft that are powered by their components around the world every day, I think it's just a sensational statistic, right?
And on top of that, they also have a very strong position in a highly consolidated market. In terms of business model, there's great revenue visibility, there's limited operating leverage, strong execution. And so that also enables very attractive long term shareholder returns in what seems like a pretty unexciting industry. So there's, I guess, four examples of things that may not seem that exciting at first.
Now, I'm not saying that we necessarily have to look for dull businesses, right? But I think you need to look at the substance of the product or service offering, the business model and the sort of the drivers of shareholder returns as opposed to whether something is called tech or industrial or consumer good or what have you.
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Leandro: I think one of the reasons maybe people tend to invest in exciting businesses, so to say, is because it probably makes it easier to follow or monitor the business throughout the holding period.
Is this something you take into account or are you actually able to invest in like a super boring company that doesn't excite you as much to follow?
Christian Billinger: Well, I mean, ideally we find that we prefer to invest in companies that we find interesting, right? And so one reason for that is, but obviously that's a question of sort of personality and what interests me. But I find that it's much easier, I mean, having mentioned the examples of toilets and ostomy bags, that may surprise you, but the reason is that you are more likely to research an industry, right? And follow and monitor developments.
If you find it interesting, and I think you're less likely to fall for this sunk cost fallacy, ie. I've spent a week, a month, three months looking at this business or industry, I feel I need to invest in it. If I find it genuinely interesting, then I'm less likely to feel that pressure.
And so I tend to focus on things like, you know, we're invested in spirits companies, luxury goods, aircraft engines, et cetera, together with the examples I mentioned. But I prefer just looking at things that I think are fascinating. That's what tends to work best for me.
Leandro: And I have also seen that in your portfolio, you typically hold more than one player in the same industry.
So for example, we've talked about it, about Kone and Schindler. You also hold Hermes and LVMH and then you also have the most classic duo, which is S&P Global and Moodys. So why, why do you do this? Is it because you find synergies in the research? Is it because you don't want to pick a winner and you are betting on the industry?
Christian Billinger: Yeah, so I think it's both of those, and a couple other reasons I should say. If someone I know there, there's lots of people who will say: "look, I like this industry, you know, take elevators or credit ratings and I have a very strong view that Moody's or Kone or whoever will be the winner or or the sort of the outperformer, I'm going to put all my money there", you know, fine. I think that makes perfect sense. Of course if they're certain or relatively certain about something, they should put all their money there. But we're just never that sure of anything.
So the reason we do this is well, you've mentioned a couple of the reasons in terms of researching and understanding an industry. There's significant sort of economies of scale if you own two companies, especially if it's a slightly oligopolistic environment.
So elevators for instance, there's four large companies. If I know Kone, I will have a very good understanding of what drives Schindler's returns, the sort of growth dynamics, the risks, et cetera. And so if you know one company, you often know an awful lot about the other leading players in that industry already. And that also means you're better able to keep on top of industry developments.
It also means that just owning two large companies or leading players in an industry, you can meaningfully reduce the company specific risk. If I had a very strong view or if...I mean, in principle, I guess it's not possible to know what the outcomes will be, but if I thought I knew that Kone, you know, would outperform Schindler, I should own Kone.
So take elevators as an example. Kone has a much higher exposure to China than Schindler does. If I had a very strong view on China long term, I'd pick one or the other, right? But I can see both the opportunities and the risks there, so I prefer owning both of them. And I guess, finally on that point, that gives you owning, say two of the four leading players in an industry. You know, you get very broad exposure to this trend, striving that industry.
So same thing in credit ratings, you mentioned S&P and Moody's. I think this relates to another important point, Leandro, which is that we've talked about security selection so far, but portfolio construction is also an important aspect of quality investing.
And we obviously believe we have 20 great businesses in the portfolio, but I also know that some of them will turn out to be disappointments, either because I've not done my due diligence properly, but it could also be because of these so-called unknown unknowns, right? So company specific risks that can never be eliminated no matter how much time and effort I spend on something.
And we've had these disappointments, at least in terms of mark to market. So I've been investing this portfolio for seven or eight years now. If I look at Kone and Schindler, they're slightly underwater despite the market having had a very strong run for most of that time. MTU is another example.
Now I still believe they're great businesses and I think they'll sort of come right over time, but I need to manage the volatility somewhat at least. And so we own this diverse set of companies that relates to different industries, different geographies, different types of business models, but also, and I think this is sometimes overlooked, factor exposures.
So for us, the probably two largest factor exposures are China, because we have luxury goods and construction businesses that are largely sort of driven by China. And we have duration risk because we own businesses that trade at pretty meaningful premiums to the market averages. And I'm not saying I wanna avoid these two factors right altogether, but I want to be aware of them and make sure that the portfolio is balanced.
So, that's sort of in response to your question. I guess we're trying to eliminate company specific risk to some extent. Plus there's some other benefits when it comes to researching certain industries.
Leandro: Talking about factor exposure, I have noticed that you don't have, I don't know if you have any actually exposure to software in the portfolio or technology.
Why do you shy away from tech? Is it because, well, you talked before about Geberit that doesn't have disruption risk. So is that the reason or what makes you stay away from software?
Christian Billinger: Yeah, I think a few points there. So first of all, we don't intent, you know, it's not technology as such that we shy away from.
I would've no issue investing in companies that are considered to be tech businesses if I thought they were great businesses and I understood them and I had the sort of bandwidth to sort of spend time on them.
I should say specifically with tech, I actually have a slight issue with the way tech tech is often used in the investment community because I look at a business like Deliveroo or Airbnb, and to me, you know, our holdings in Air Liquide or Linde, so these are two industrial gas businesses, or MTU or S&P Global, you know, they offer much more sophisticated technology than some of these sort of delivery firm businesses do. And so in a way, I try not to worry too much about what labels people attach to the businesses that we're invested in, right?
So, to me, Air Liquide is, you know, whether you call it an industrial business or a tech business, I don't worry too much about the semantics. I would say this...so in principle I could, you know, we could invest in some of the more traditional sort of tech businesses, if you will, or let's call them software businesses.
I mean, one limitation is that unless you have a very large team of analysts like say Fidelity or Capital, there's only so many industries and companies that I can cover in any detail, right? So for me, I've ended up looking mainly at industrials, and consumer goods companies. And, I feel I can, I understand a few of them and I find them interesting to follow. But for someone else, technology might be be sort of what, you know, fits all his criteria.
But I think also to what you said, the technology risk. Yes. For us, given that we're looking for long established time tested businesses, so-called technology companies often don't really work. For us at least because they have shorter histories and there's more risk of substitution. So there's a few different reasons.
Leandro: No, I agree. And I think that when assessing the moat of a company, if it's just a technological moat, so to say, and there's no other like competitive advantage, then I think like if the moat is just lines of code written to put out software, then that gap could close quite fast.
Whereas if it's a company that takes advantage of high tech but has other competitive advantages, then that's going to be more stable going forward, or at least more protected from technological developments.
For example, I hold in the portfolio Texas Instruments. That's a company that manufactures analog and embedded chips, but I would not hold, for example, Nvidia or AMD that are designing chips for the leading edge because I think that that sector is much more competitive and tech plays a much more important role in how you do going forward. Whereas analog, the companies are selling products that they manufactured like 20 years ago, so obviously there's less tech disruption.
Christian Billinger: Yeah. And I guess... No, that's interesting. And I think, we, I think in many ways we probably have a similar way of looking at the world or the investment world at least. But we can al also see how we end up in very different businesses. And I always emphasize, people I speak to that, and certainly when I speak to students that I would never suggest that there's a right or a wrong or certainly I wouldn't know which is right or wrong for someone else, right?
So it's just that you find a few industries and types of businesses that suit you and that you find interesting, and you know, that you have enough sort of bandwidth to stay on top of. And that's fine. We don't need to look at everything, right? Like, you know, I'm happy to leave some of these sort of industries for other people to specialize in.
Leandro: Yeah, and I think this is a very important point that you brought up about being, sort of investing in things that suits us. Becuase at the end that's going to facilitate like a long holding period.
And I want to give like a twist to that and talk about how the investment style should suit us. Because I remember listening to an interview with Dev Kantesaria, one of the fund managers at Valley Forge, and he said that a quality investor is actually born and not made. To a certain extent, I actually agree because if you're a very active person with, I don't know, a continuous urge to do something, then quality investing is probably not for you.
Do you agree with him or do you believe one can shape himself to be a good long-term quality investor?
Christian Billinger: No, I agree with him. I think it is a largely at least, a personality thing. So certainly in terms of the analytical tools and the process, I think you can absolutely improve, right? That's what all of us, you know from the time you first sort of become interested in stocks and right 10, 5, 10, 20 years later, you know, most of us have hopefully developed new tools and techniques. But I think, when it comes to your fundamental way of being, I don't think you can or probably want to change that very much, and your investing style ideally should be a reflection of that.
So you can certainly learn key metrics, DCF valuation, checklists, understanding a business model. But, you know, how do you change your temperament? I don't think there's an issue there because some are more suited to a more active style of investing. Some of them will do really well.
Some of them will do much better than myself and other so-called quality investors, right? And that's perfectly fine. I mean, I can't invest in that way and neither would I want to. And I'm sure that goes for, let's call them the other side. So I think that's perfectly fine. You just need to figure out what works for you. Partly what works for you in terms of generating returns, but also what you enjoy doing because you wanna make sure that you enjoy that process if you're doing it for 10, 20, 30, 40 years.
Leandro: I completely agree because I think there are like two steps or two requirements to enjoy if you're a long-term investor, obviously to enjoy worthwhile returns.
One is obviously doing the due diligence and actually investing in companies that are going to do well. And the second one, many times overlooked, is your ability to hold through thick and thin. And I see a lot of investors that actually invest in high quality companies, but they cannot withstand volatility.
And without knowing it, they're investing actually in quite volatile business models and obviously a very volatile business model, even if it's good, then that would lead to a volatile stock price. And then the second requirement is not met because they are not able to hold when there's a 30%, 40% drawdown.
Well, many of them say they can obviously when they're in the middle of a bull market, but when the bear market starts is when reality kicks in. So I think it's oftentimes overlooked how important it is to invest in something you are comfortable with and that you can go to bed without worrying because I see a lot of people worried every day about what they're holding. And for me, I don't think investing should be a journey to suffer. It's actually a journey to enjoy.
Christian Billinger: I agree. I always say that, you know, it's fine not understanding what you're invested in when times are good, but the real test is when things take a turn for the worst and that's when you need to understand what you own and you need to have a style that you're comfortable or invest in a way that you are comfortable with that sort of the lines with who you are.
So I absolutely, I think you're spot on there.
Leandro: Okay. So now that we have pretty much covered a lot of the quality investing framework and also the boring industries and some of your holdings, I want to touch on a topic that we've touched a bit during the conversation, but I want to be more explicit now. It' s controversial across quality investors are probably across the investing community in general, which is valuation.
I mean, I think the fact that high quality companies will trade at a premium is somewhat consensus in the market. But at one side of the spectrum, you have some quality funds that focus much less on valuation and others that focus much more. Where would you say that you lie in this spectrum, and how do you account for higher quality in a valuation model? I mean, do you do it through, for example, a higher terminal rate or through a lower discount rate to take into account that the business is higher quality and obviously there's less risk?
Christian Billinger: Yeah, it's interesting...In some ways, I'd like to answer it by saying I don't care about valuation much at all. And in some ways, my answer is ultimately, in a way, valuation is the only thing that matters.
But I think it matters not in the way that it's commonly perceived by most investors. So I think when quality investors, when they say they're less focused on valuation, I think what they're really trying to say is that they're not concerned about the portfolio being at a premium or even a meaningful premium to the market on current multiples, like a PE ratio or free cash flow yield.
But long term, you have to care about the valuation, right? So, you know, if we go back to the idea of present value of cash flows, what we're effectively saying is that, in principle, high-quality businesses are more valuable because their, you know, sustainable earnings growth is higher. And if you've sort of done a comprehensive...let's assume you have good, a good ability to sort of forecast future earnings and cash flows. Now, that's a big if, but assuming that. that should be reflected, that higher sustainable earnings growth should obviously be reflected in any good DCF valuation.
So, in principle, valuation is what matters. It's just that often, when you then sort of look at what that implies for a current PE ratio that tends to give you, not always, but often a pretty meaningful premium to the market.
Now, as I think I mentioned earlier, we're not looking for great precision when it comes to matters of valuation. And, like most long-term investors, I'm certainly not a big fan of complex modeling, but you know, you have to attempt to take a view on metrics like revenue growth and margins, and free cash flow because they're ultimately what drives business value.
Personally, I'm very comfortable with our portfolio being at a premium to the market on a PE basis or a current free cash flow yield basis because I feel that the superior quality of the companies in there is not fully reflected in their valuations.
I never start by looking at valuation, though. I start by trying to understand the business, figuring out if it's high-quality, whatever that means. And then I usually get to the valuation as one of the last, if not the last, steps in my process. And I should say that the outcome of that process is usually that if I've identified what I think is a truly great business, I find they're almost always undervalued or certainly no more than fairly valued, which is good enough for me.
So if I can get to an expected total return of, say, 10% or more, that that'll do. I was in Omaha earlier this year, and I remember Tom Russo saying at one point that we're not in the business of reaching for the stars, and I thought it was such a great summary of what he's trying to do and, and certainly what we're trying to do.
So, that's my take on valuation. So, I guess the answer is that in some ways, it doesn't matter in the way it's commonly perceived. And in some ways it's all that matters.
Leandro: Yeah. It always surprises me how many investors talk about the PE ratio without looking at the company first, because it's like you're looking at a valuation ratio with no context whatsoever.
And the other day, I wrote an article about the PE ratio because people typically use it just looking at growth, but actually the PE has more drivers to it. So that earnings growth come can come with 100% reinvestment or it can come with 20% reinvestment and obviously, in many cases, only having to reinvest 20% to achieve the same growth is obviously better because you have more excess capital that you can give back to shareholders.
But people only focus on growth and not how that growth is achieved. So for me it's like a bit counterintuitive that someone can go into a valuation discussion without being, let's say, an expert on the company.
Christian Billinger: Yeah. And I, um, and I should say there's other aspects as well, I guess, you know, can impact the PE. So like if you have higher visibility.
Take a business with large share of recurring revenues, you know, all else equal, you'd assume a higher PE because there's better visibility on that earning stream. Or say you have significant amounts of excess cash on the balance sheet, you know, that should also be reflected in a higher PE ratio. So, you know, I also get that it's an easy way to communicate and it's often a pretty good proxy.
But I agree with you, there's certainly much more nuance to it than that. And I think, just looking at the one year forward, or the trailing 12 month trailing PE, is not sufficient when you're looking at truly great businesses.
Leandro: And what do you think... like this companies tend to trade at at premium valuations, but they continue to perform well despite this.
So what do you think the market is missing when pricing them? Is it more the underlying quality or is it more the durability? Because what I feel is that if you construct a, for example, DCF model and you go out five or ten years which is what many people do, or well...if you go 10, you can go 10 years out, but obviously it's a bit impossible to forecast 10 years out, even five.
And then you drop that growth rate to a terminal rate. What you are saying there, more or less, is that the company is going to mean revert by the end of that, 5 year period or 10 year period. So I feel that that's one of the reasons these companies tend to be, well, tend to appear overvalued, but actually are undervalued because they mean revert much, much slower, if ever, to the mean while the market is treating them as they were going to mean revert in the same time frame as other companies that are not such high quality.
Christian Billinger: Yeah, I absolutely agree with that. I was gonna list that as one of, maybe a couple reasons I can think of. But I certainly think that's possibly the most important one. And, I don't know if it's always, I think often it's not be necessarily because people, when I say people, I mean, you know, institutional money managers and sell side analysts, I don't think it's always, or even usually because they can't sort of see that it's a great business.
And, they may also appreciate that it's a durable, competitive advantage, or sort of those earnings growth rate is, the high earnings growth rate is durable. I think it's often because of institutional constraints. So what I mean by that is, to your point, you know, most sell side models and, and I think buy side models and valuations, assume there's significant mean version that you talked about.
Almost every sell side model I've ever looked at will assume in line with GDP after 10 years, right? So say that's 3%, you know, I absolutely get the mechanics of it and why in principle, of course, over to infinity, when you sort of draw these models out to infinity, you have to assume a convergence.
And I think it's also a fair assumption for most companies. But equally, I know that it's very likely wrong for Hermes or L'Oreal, or Coloplast, right? So I'm not gonna assume 8% to 10% growth forever, but I will assume that they'll continue to grow faster than the economy. Even a decade from now and probably 15 years from now and maybe even further out, and therefore they would tend to be structurally undervalued by most analysts and investors.
Now, don't get me wrong, in some cases I will be wrong on that and they will revert to the mean or they'll even sort of be growing slower than, they'll even be losing ground, right? And as I said, I think most analysts and investors probably clearly get that idea.
I'm not for a moment assuming that we have an unusual insight there, but the structure in which they operate, they may be you know, managing an open-ended fund or you're a sell side analyst trying to sort of drum up business, so you may choose to ignore it because these things are too far out in time or it's too vague as a basis to invest for the next 12 months. So I think that's an issue.
I also think that, you know, to your question, what, in a way, I guess, what is the market missing here? I think these great companies tend to surprise on the upside more often than not, and certainly more often than less good businesses. So even if you look at, say, a forward PE ratio, they will tend to be more often overstated for these types of businesses than they would be for the average collection of the sort of aggregate of businesses in the index.
So this short termism n the institutional world and the tendency for these companies to surprise on the upside, I think means there are two reasons I can think of, similar to what you said, Leandro, that they are often, let's call it mispriced or why the value's not fully reflected.
Leandro: And another very important topic for an investor is selling. Well, I think we can agree that in many cases selling is much more difficult than buying because...well I think that when you are buying a company or starting a position, you don't have any long bias on it, but when you when you have to acknowledge that maybe the thesis has changed, then you obviously can be biased because you're already long that position.
So how do you go about selling? Do you ever sell a position for valuation reasons or do you try to avoid doing this?
Christian Billinger: Yeah, I don't think there's any surprises in what I'll say to you that, in that we tend not to sell on valuation alone. And I think I have heard that from countless, sort of long term investors, quality sort of minded investors. I'm sure you have as well.
So, but that doesn't mean we never do. The reasons are the usual suspects. I guess number one, the business is deteriorating. Number two, maybe the business hasn't changed, but I've learned something about it that means that I conclude it's not as good as I thought it was.
Or thirdly, the opportunity cost, ie., there's a better way of deploying capital. So valuation is certainly something to consider, but it's usually for some other reason. And in terms of trading round positions, there's not much of that unless what we perceived to be the extreme.
So like, take the early days of the COVID pandemic in sort of March, April of 2020, you know, we were very active or take the first half... well, the sort of spring of this year, we certainly made some adjustments. You know, we added to some things we owned, we shifted money around to some extent in the portfolio and we initiated some new holdings. But generally speaking, if the business key performing, our general position is to never sell them.
Leandro: Great. And now the last question. It's been a great conversation, I had fun, even if we talked about boring industries.
What books would you recommend for other quality investors that are, well, if you have books that are not well known better, but if not any book, and it can also be, I don't know, some essays by other quality investors.
Christian Billinger: Yeah, I guess, and these, I don't know the extent to which they're well known generally in the investment community, but I always, I always think Quality investing by Larry Cunningham and that he wrote that book with a couple of people from AKO Capital in London, I think is really great in terms of the tools and the sort of principles behind quality investing.
And then equally, I often recommend Investing for Growth by Terry Smith at Fundsmith because there you get much more of the applications, right? So his annual letters and articles and everything. So I think those two books cover much of what we've talked about and I think they're a really great start.
And, I should also say in addition to that, I actually find the, the letters of great quality investors to be the sort of best source of learning and information. So, you know, in my case, that would be reading Tom Russo's letters. François Rochon I think is great, Terry Smith, I mentioned Tom Gayner and looking at great businesses, right? So, as you know, as part of your process of researching and trying to identify and learn more about these great businesses, I think in this case, the best way is certainly learning by doing.
Leandro: I actually have read most of what you have said, so I think that's good on my side.
So thank you very much, Christian for talking with me. It's been great and I think that the listeners are going to have some great insights from the conversation.
Christian Billinger: Thank you, Leandro. It's been an absolute pleasure for myself to speak to you and hopefully chat soon.
Leandro: Thank you, Christian.
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