The Name is Buffett, Warren Buffett

"Concentration does not lead to more risk"

Pavel Begun and Cory Bailey on their portfolio strategy

Published 10 years ago on Jun 08, 2013 9 minutes Read

Their namesake company, co-founded by billionaire banker Jorge Paulo Lemann, made news when it acquired Heinz with Berkshire Hathaway. While the full form of Lemann’s 3G is a mystery, for Pavel Begun, 34, and Cory Bailey, 35, co-founders of 3G Capital Management, 3G stands for good business, good management and good price. Begun’s business streak as a child led him to own multiple businesses in his teenage years. His underdog status drives him and that resolute determination led him to simultaneously obtain a CFA charter as well as an MBA from the University of Chicago before he was 25. As for Bailey, he was born and raised in Union, Missouri. Along with a B.S. in finance and a minor in accounting from St. Louis University, Bailey shares Begun’s penchant for avoiding investment conferences and speaking to other investors. Though Begun operates out of Toronto, their time is mostly spent reading newspapers, annual reports and trade publications. They, too, like their icons — Warren Buffett and Charlie Munger — want to keep working harder and harder at becoming better investors and keep making bold high-conviction investments. 

Pavel, you have always been very enterprising and had started a few businesses in Belarus before you were even 20 years old. How did the move from Belarus to the United States come about?

PB: I initially came to the US back in the early 1990s to attend high school as an exchange student, but returned to Belarus once the term of the program ended. In 1998 I won a scholarship awarded to top students in Belarus to attend a university in the United States (in my case it happened to be Western Kentucky University).  At first I was somewhat reluctant to move — in Belarus I ran a couple of businesses that I thought had a very promising future (a newspaper business and a packaging business). At the same time, I realised that both of these businesses, while exciting, weren’t the businesses that I’d want to be actively involved in until the last day of my life.  The business that possessed such a characteristic was the business of investing, and it was my long-standing dream to be involved in it.  And that meant moving to the US, the most developed investing market on the planet, teeming with the world’s greatest investors.  So, I made the move. 

Benjamin Graham’s The Intelligent Investor has inspired many a young investor. You, too, fell under the spell. How did that come about?

PB: As I started attending college in Bowling Green, Kentucky, I made it a priority to figure out how the business of investing worked and how one would be successful at it. Since Warren Buffett was (and still is) the world’s most successful investor, I naturally sought out to see what he had to say on the subject. In one of the interviews he stated that reading The Intelligent Investor is the best place to start, so I immediately ordered the book online. Once I got it, I put everything I had going on in my life at that point on hold, and didn’t resume until I finished the book. It was like seeing the light — by the time I was done I knew what I would be doing for the rest of my life. The book still sits on my desk and I do go through it every now and then but we have more use for the concepts Graham presents in the book than some of the methods of stock-picking. The biggest takeaways for me are of approaching investing in a business-like manner and making sure you have a margin of safety. 

Can you give us a little background on how you met Cory and on your start in the investing business?

PB: Cory and I met in September 2001 when we joined Fiduciary Asset Management in St. Louis, Missouri, as new hires. The company was short on space and we ended up sharing an office. Neither of us wanted to work for somebody else in the long-term so we were discussing our future plans: Cory said he wanted to do real estate and showed me the numbers; I wanted to do value investing and showed him my numbers. At that point Cory said. “To hell with real estate,” and 3G Capital Management opened its doors three years later in 2004 with about $350,000 in assets under management. Currently, we manage about $50 million — our investment team comprises Cory and myself. Our annualised return since inception through December 31, 2012, has been 16.8%, versus 4.8% for the S&P 500 and 2.3% for MSCI EAFE. Over the past five years — which has been the most difficult period in financial markets in recent history — we produced an annual return of 19.3% compared with 1.7% annual gain for the S&P 500 and an annual loss of 6.6% for MSCI EAFE.  

Given that you and Cory did not have heavyweight institutional backing when starting 3G, was getting in investors tough in the beginning? 

PB: I had a very good investing track record in my personal account since 1999, so potential investors could get a general idea of how our investment philosophy worked out in the real world. Nevertheless, getting investors in the door in the beginning was a tough slog — neither Cory nor I come from wealthy backgrounds, so we simply didn’t know very many people who could have been in a position to invest with us. Our first set of investors included people who had observed us work and, therefore, had faith in us; the first guy who wrote us a cheque was our former boss, Jim Cunnane. Armor Capital’s Boris Zhilin has also been an investor for many years. Currently, we have over 90 investors.

You follow a metric of buying businesses for “8 to 11 times normalised cash flow”. What is so sacrosanct about 8 to 11 times?

PB: We tried to reverse-engineer most of Buffett’s purchases to find out the multiple of cash flow that he typically pays, and it appears that generally he would pay about 10X. And so we ended up adopting that valuation level as our baseline, and we are willing to adjust it slightly based on the quality and growth profile of the specific business in question.

How much cash on average do you hold in the portfolio? Was your cash position very high going into the 2008 credit crisis?

CB: Historically, our cash position averaged about 10%, but it does fluctuate quite a bit, depending on how many good investment ideas we are able to find. For example, in 2007, our cash position was over 25%, as we struggled to locate high-quality reasonably-priced businesses. However, by the end of 2008, our cash position turned slightly negative, as we loaded up on high-quality businesses that were available at fire-sale prices. 

What has been the best investment that 3G has made so far?

CB: Our best investment so far was AG Growth, the largest grain auger manufacturer in North America. AG boasted a stable business as it was selling an essential small-ticket item with a frequent replacement cycle, and the company had substantial advantages over competition in terms of brand name, scale and selection, which enabled AG to generate 25%+ Ebit margins; further, the company carried little debt; the CEO was the founder who started the company from scratch and built it into one of the leading North American short-line equipment manufacturers, and he had 80% of his net worth tied up in the stock. In April 2006, AG was selling for approximately 7.5X free cash flow (FCF) and had a 10% dividend yield, an extremely attractive price by any metric. Little over a year later, we closed out of our position at an annualised gain of over 100%. 

Tell us about some of your top holdings at 3G. How do you address concentration risk?

PB: We can talk about two as they are fairly well known. Wells Fargo, the second-largest bank in the US by deposits, is a high-quality business, run by an outstanding management team, and was available at a bargain price at the time of purchase. It has a unique deposit-gathering system that ensures the lowest cost of funding among its peers, which, in turn, enables the company to grow market share while generating excellent returns on assets without taking undue risks. In contrast to virtually all of its peers, Wells stayed away from toxic stuff. We had an opportunity to purchase the stock at a highly attractive price of less than 7X normalised economic earnings and approximately 90% of book value. 

The other is LSL Property Services, the UK’s leading integrated real estate services provider. The company is a high-quality business, run by an outstanding management team and again, was available at a bargain price at the time of purchase. LSL has strong competitive positions in all of its business lines, such as surveying and estate agency, which enables the company to price its services at a premium compared to the peers. As a result, LSL generates returns on equity of 25-30% in a tough market environment, while employing a minimal amount of debt. It has an outstanding management team that has an excellent track record of value creation, as it turned a struggling money-losing operation into the UK’s leading integrated real estate services provider in little over a decade. We had an opportunity to purchase the stock at a highly attractive price of approximately 7X FCF and a 5% dividend yield.

As for concentration, it does not necessarily lead to more risk — on the contrary, if applied correctly, concentration leads to less risk. You just have to do your homework to make sure the businesses you are buying are solid, and you have to make sure you are paying the right price. And, by definition, you won’t find too many that fit these criteria. So if you decide to concentrate less, you will end up having to dilute your best ideas with mediocre ones, which leads to higher risk. Incidentally, if in the past we had concentrated more, our results would have been much better. 

Has a “value investment” ever turned out to be a “value trap”? 

CB: The only time a “value investment” turns out to be a “value trap” is when you made a mistake in your initial assessment of the company’s value, that is, it was not a “value investment” to begin with. One mistake we made was investing in Pier One Imports, a home furnishing retailer. We misjudged the competitive economics of the business, and incorrectly assumed shoppers would be willing to pay a premium for the shopping experience at Pier 1. Well, it turned out shoppers care about the lowest price, not shopping experience, owing to the commodity nature of the retail business. And in a commodity business, it is the low-cost producer who wins, and a low-cost producer Pier 1 was not. However, since we paid a cheap price for Pier 1, we managed to get out of our position with a minimal loss, despite misjudging the fundamentals of the business.

We put that knowledge to work as we were considering investing in Ross Stores, an off-price retailer. As we established that Ross Stores was the low-cost producer in what essentially is a commodity business, we proceeded to invest in it, and Ross Stores had done extremely well for us, even though we purchased the stock before the market started sliding in 2008.  

You both enjoy playing ice hockey. Are there any parallels you can draw between ice hockey and value investing?

PB: In hockey you have 20 players on the team, but you have to give your first line a disproportionate amount of ice time in order to win. Similarly, in investing, you have to have a disproportionate amount of money invested in your top ideas if you want to have great long-term performance. If we had less concentration in our top ideas over the years, our track record would have been more pedestrian. Also, a good hockey player knows what he’ll do with the puck well before he receives the pass — a good investment manager knows whether a certain business is a buy or not well before its stock
price falls.