The following is a combination of our notes from Mohnish’s virtual talk “The Holy Grail of Investing (December 2020)” at Peking University, where he introduces the concept of “spawner” companies, and our own thoughts. The idea is simple – some companies continue to grow new businesses and business lines (think Amazon) and if you buy them early they are an extremely efficient way to invest from both a time and tax perspective. Investing in “set it and forget it” types of compounding businesses is a concept we have thought a lot about ourselves, and it sure sounds wonderful.

 Mohnish’s original talk is worth a listen. Enjoy!

Choices for an Investor

As a value investor, you can buy two kinds of businesses:

1)     Growing Pies – Set it and forget it. 10-100 bagger possibilities.

2)     Discounted Pies – On a treadmill of activity, etc. Tax inefficient. Difficult to get more than 2-3x returns.

The Path to Multi-Baggers

1)     Focused Mousetraps: Narrowly focused players with long runways (e.g., Costco, Chipolte, McDonald’s, Moutai)

2)     Great Capital Allocators (e.g. Berkshire Hathaway, Danaher, Exor)

3)     Uber Cannibals: Intense focus on buybacks. The pie may not grow, but the share of it will (e.g., NVR, Autozone)

4)     Deeply Undervalued Players/Public LBOs: Turnarounds/leveraged businesses at bargain basement prices (e.g. Tech Cominco, Fiat Chrysler, Rain Industries)

5)     Spawners: Companies that continuously spawn related and unrelated businesses (e.g. Amazon, Alphabet, Alibaba, Tencent, Baidu) (CVI note:

What is a Spawner?

“Staying in Day 1 requires you to experiment patiently, accept failures, plant seeds, protect saplings, and double down when you see customer delight.” – Jeff Bezos

• Company DNA reflects a deep conviction in the importance of relentlessly adding and incubating new businesses that have the potential to be massive growth engines. (CVI Note: You are effectively extending the runway of the Company)

  • Take failures in stride. They expect many failures.

• Uses pre-tax earnings.

  • Very tax efficient. Free loan from the government on easy terms. (CVI Note: Cannibals have to pay tax on their earnings that they use to buy back shares. Spawners are reducing their net income, which reduces taxes).

Types of Spawning – (ways Companies extend their runway)

1)     Adjacent Spawners create related businesses.

2)     Embryonic Spawners acquire businesses and nurture them into much larger enterprises.

3)     Cloner Spawners do not innovate. They copy successful products.

4)     Non-Adjacent Spawners create or buy new, unrelated business areas.

5)     An Apex Spawner continuously deploys the spawning tactics of all four categories.

Spawners Hall of Fame

• Adjacent Spawns - Starbucks

  • Frappuccino bottles. Verismo coffee machine. Starbucks Reserve. Starbucks alcohol.

• Embryonic Spawns - Facebook

  • Instagram. WhatsApp. Oculus VR. Giphy.

• Microsoft

  • Embryonic Spawns: Forethought (renamed and released as PowerPoint)

  • Cloner Spawns: Windows, Word, Excel, Explorer, Surface, Azure, Teams.

Apex Spawners

Amazon

• Adjacent: Music, clothes, marketplace, Everything Store

• Embryonic: Zappos, Zoox, Ring, Audible, Whole Foods

• Cloner: Amazon Food Delivery, WebPay, Fire Phone

• Non-Adjacent: Amazon Web Services, Kindle, Amazon Fresh

Alphabet

• Adjacent: Chrome

• Embryonic: Android, Youtube, DoubleClick, Waze, Nest, DeepMind, Fitbit, Zagat

• Cloner: Motorola, Google+

• Non-Adjacent: Google Fiber, Good Cloud, Waymo

Alibaba Group

• Adjacent: Alipay (Ant Group)

• Embryonic: AliBaba Pictures Group, AliHealth, AutoNavi

• Cloner: AliGenie, T-Head, Aliwangwang (chat)

• Non-Adjacent: Alibaba Cloud, Hema Supermarkets, Alitrip (Figgy)

Berkshire Hathaway

• Adjacent: Berkshire Hathaway Reinsurance

• Embryonic: GEICO, Mid-American Energy, Nebraska Furniture Mart

• Cloner: Three Insurance, BiBerk

• Non-Adjacent: Berkshire Hathaway Home Services

Tencent

• Adjacent: Tencent Comic

• Embryonic: Riot Games, BitAuto

• Cloner: WeChat, Weibo, Tencent Video,Tencent Pictures, PaiPai Auctions

• Non-Adjacent: Future Mobility

Baidu

• Adjacent: Baidu Translate, Baidu Baike (encyclopedia), Baidu Tieba (forums)

• Embryonic: xPerception, TrustGo, Raven Tech, Peixe Urbano

• Cloner: Baidu Maps, Baidu Wangpan (cloud)

• Non-Adjacent: Baiduo Apollo (autonomous cars)

Evolution of a Spawner: Kotak Mahindra

CVI Note: 200x return from 1995 to today. Mohnish bought a very small personal position and sold it prior to any of this gain unfortunately for him!

Non-Spawners

(CVI Note: A lot of companies do not have it in their DNA to become spawners. In fact, there are some companies that we consider to be “anti-spawners”, taking money from a good business line and putting it into terrible new business ventures thought up by management.)

Most businesses are Non-Spawners, including many exceptional ones:

• They have an intense focus on the core business and view ancillary business as potential distractions.

  • If they happen to spawn a great business, they tend to get rid of it too early as it risks serving as a distraction to the core enterprise.

• Amazon owns a gazillion unrelated businesses. But Non-Spawners cannot handle owning even one adjacent business, even if it is a good business with tailwinds.

  • Ford sold Jaguar and Land Rover to “focus”

  • McDonald’s Exited Chipolte to “focus” – CVI Note: They are innovative but inside their core business – think introducing breakfast offerings, ordering improvements, app.

• Non-spawners engage in opportunistic acquisitions or business extensions at the margin of existing product lines, but are unlikely to consider radical new business areas. Excess cash is used for dividends or buybacks or core capex.

  • E.g. Moutai, Costco Wholesale.

Spawning Extends/Hedges the Runway

• GE and IBM would have died decades ago without spawning.

• Microsoft would be a shadow of itself without spawning.

• Virtually all businesses and business models mature and die.

  • Spawning keeps the mothership young and healthy.

• Lower risk than Focused Mousetraps.

The $50 Billion Rule

• There were over 3,700 IPOs in the US in the last 20 years.

• Only 9 business that IPO’s in the last 20 years exceed a $100 billion market cap.

  • Assume that the upper limit market cap of any business you invest in will not exceed $50 billion.

10 Bagger in 10 Years: 100 bagger in 20 Years

How can a business give us a 10x in 10 years?

• 15% a year growth is 4x.

• Multiple doubles and triples.

  • 8-12 bagger in 10 years.

• How can we get a 100 bagger in 20 years?

  • 15% a year growth with multiple expansion is 40x.

  • A few spawners will do better and become 100 baggers.

Pabrai Spawning Rules

1. Assume no business you invest in will ever exceed $50 billion market cap.

   • For 10 bagger possibilities, buy below $5 billion market cap.

   • For 100 bagger possibilities, buy below $500 million market cap.

2. Look at the history of the business.

   1. Does it have strong spawning DNA?

   2. Does it have a great capital allocator at the helm?

   3. No need to make heroic assumptions. The future should be obvious from past behavior and success/failures.

Set it and Forget It

“For the individual or institution really out to make a furtune in the stock market it can be argued that every sale is a confession of error.” – Thomas W. Phelps, author of 100 to 1 in the Stock market

“The truly brilliant investors weren’t investors; they were entrepreneurs that didn’t sell.” – Nick Sleep, Nomad Investment Partnership. (CVI Note: E.g. Sam Walton of Wallmart) In 2013 Nomad was managing $3 billion and was in three stocks – Amazon, Costco, and Berkshire Hathaway. Nick wrote to his investors in early 2014 that he was shutting his partnership saying “ten years from now we will own these exact same three stocks. My partner Zack and I are not going to make any decisions to buy or sell anything and we quite frankly don’t want to write letters to you for the next ten years. We are returning your money and recommend you keep your money in these three stocks and don’t pay fees to us.” They made a couple hundred million each prior to closing and it is mostly sitting in these three stocks. They have probably beaten every professional money manager out there.

•  An entire portfolio composed of 5-10 great Spawners bought at reasonable prices and below our market cap limits is likely to do very well.

• Set it and forget it.

• It is not easy to screen for Spawners quantitatively. Takes work to identify a great Spawner early in its Journey.

  • Worth the effort.

  • Not all will get to Nirvana, but this approach can handle several duds.

When to Get Off the Bus

“The first rule of compounding is to never interrupt it unnecessarily.” – Charlie Munger

• Exit when it is absolutely clear secular decline has started.

  • An exit, at even half of peak valuation, will produce great results.

• Ignore temporary headwinds.

  • Do not interrupt your compounding engine unnecessarily.

Conglomerates vs. Spawners in Emerging Markets

• A scarcity of capital and government-aided cap on competition helps conglomerates grow exponentially in emerging markets.

• This phenomenon is clear in emerging economies across the board, such as the Chaebols in South Korea, or Keiretsu in Japan, and the huge family groups in India.

  • They can be great investments if bought early. E.g. Chaebols in 1980s, Keiretsus in the 1970s.

• A mature conglomerate’s DNA is very different from that of a Spawner.

  • If it has already scaled, it is unlikely to be a 10-100x.

Fake Spawners/Lost Their Way

·        Lost their way – GE, IBM

Fake – cmgi (lots of dotcom companies, bubble burst), Satyam (had a real core business but created online business and valuation got caught up in bubble euphoria)

Virtually Every Public Company Was/Will Be a 100 Bagger

• Early 100x is usually captured by the founders while still private.

• May do another 100x after the first 100x, i.e. 10,000x.

• Walmart had already given the Walton family more than 100x before the 1970 IPO.

  • It gave them another 20,000x after the IPO.

• Getting in early and holding on throughout is key.

  • Uber is unlikely to deliver 100x post IPO as it was already valued at $50 billion at the IPO. (would need to get to $5 trillion.

Canadian Value Investors – “Spawners” concept in practice

As part of thinking through “what is this business worth?”, I ask myself:

·        Is there a history of expanding the scope of their product line, new business lines or businesses, and potential for this trend to continue?

·        How should this affect my valuation?

This is a qualitative factor that affects the overall view of a company and how I compare my potential investing universe. Imagine you only have enough capital to invest in one business and you have two choices. These two businesses have similar risk profiles and similar expected cash flows, and similar market caps, but the second one - Business B - has a history of creating new capital-light businesses, while the other explicitly states that they are going to only return capital to shareholders and maintain their business.

Which would you rather own? Do you need to explicitly value the options Business B has? No, absolutely not. The world is uncertain and it is better to be “approximately right than precisely wrong”. Instead, I would treat this as at least a free option of an uncertain value. Now, this might sound all a bit too academic, but it helps me in practice. For example. when thinking about Vitreous Glass Inc. (see our article here http://www.canadianvalueinvestors.com/home/2015/1/30/2pgwh191i89pm0j8xjgtubjtuj1we2 ), the core business of crushed glass is simple and you can be quite certain that new tangential ventures won’t pop out of nowhere. Management already did that, and it didn’t go well (in their own words), and so are unlikely to be lulled into something because of this. Their historical cash flow is a good proxy for future cash flows, adjusting for changes in population and use of glass bottles. The same cannot necessarily be said of Apple and I argue that Apple is a good example of a spawner. They moved from desktop computers into laptops, then iPods, then online music store, the iPhone, app store, headphones, watches, and on, and on. Comparing just last year’s P/E or P/FCF of Apple and Vitreous and then making an investment decision on this wouldn’t make sense. In fact, if you just did a DCF of expected computer and iPhones sales in 2010 you would have been missing the forest for the trees. Conversely, it is obviously not prudent to have your valuation be based on products or business lines that don’t even exist yet in concept. You would be better off with a dart board and it would be a lot easier. But, it is a qualitative question that can help you decide whether you should pay up a bit for a quality company.