Pavel Begun & Cory Bailey: Investment Strategy Of 3G Capital Management LLC
By Pavel Begun
Published:
Pavel, you are the co-founder and managing partner in 3G Capital Management LLC based in Toronto which you founded in 2004. Tell us more about your background. What led you to found 3G Capital Management?
PAVEL: I was born and raised in Belarus, and despite growing up in what was back then a communist state, I always dreamed of being a capitalist entrepreneur. I started a few different businesses over in Belarus when I was still a teenager, but my eventual shift towards investment management occurred after I won a scholarship to attend a college in the United States. In college I came across the teachings of Warren Buffett and Charlie Munger and the effectiveness and the simplicity of their approach really struck a chord with me.
I started an investment portfolio which I ran according to value-based principles and developed a very good track record over time.
In parallel I got a job in the traditional money management industry, and very soon learned that most traditional money managers don’t really aim for return generation, instead focusing on asset-gathering.
At that time I shared an office with my current partner, Cory Bailey, and it became a daily habit for us to discuss how value-based investing is so much more efficient with respect to performance than the traditional way of doing things centered around asset-gathering. Eventually, we felt we needed to put our minds where our hearts were and in 2004 we started our own firm 3G Capital Management to produce above average performance by applying value-based investing principles. Interestingly, our very first client was our former boss, who had the guts to invest with us even though our investment approach ran counter to that of the traditional money management industry. He did not regret it, however, as his account is now worth multiples of his initial investment!
Can you share with us 3G Capital’s track record? What were the toughest and the best times in its history and why?
PAVEL: Since global strategy inception we produced a return of 14% vs. 7% for the MSCI ex USA Index. The toughest times for the fund were also the best times, as it always is in the business of investing. Back in 2009 and 2014 our fund experienced sizeable declines, in the first instance on the back of the Global Financial Crisis, in the second instance on the back of the emerging markets collapsing. At the same time, these periods were ripe with opportunity, as the plunging markets enabled us to load up on bargains, thus setting up a solid foundation for above-average returns in the following years.
Between the two of you 3G Capital has on a combined basis nearly half a century of experience in valuation-based investing on a global basis. What was your biggest investment mistake? And what did you learn from it?
CORY: By and large the biggest mistake has been following other very smart investors into their ideas. What we have discovered is that our original ideas whose premises we personally explored and deeply understand have produced the best returns for us. In contrast, following great investors who we really admire, into their ideas without necessarily understanding all the inner mechanics of their analysis at times produced not so great returns, or worse.
What is your investment strategy? And has your investment strategy changed since you started the fund in 2004?
PAVEL: We generally look for businesses that satisfy the following criteria:
- they occupy leading positions in their respective industries and those industries have multi-decade track records of leadership sustainability;
- they generate returns on invested capital in excess of 15-20%;
- their debt load as a multiple of free cash flow is below 3-5X;
- they are run by management teams that are both skillful operators and intelligent capital allocators.
- Last but not least, the stocks of the business described above should be available at mid-single-digit to low-double-digit multiple of normalized free cash flow.
- By way of specifics, our current portfolio is selling for approximately 6X EPS and it sports an 8% dividend yield.
In 2022 these businesses generated return on equity of over 30%, on average, with minimal leverage, as over 3/4th of our holdings enjoy debt-free balance sheets. Contrast that with the US market selling for 18X EPS, offering a dividend yield of less than 2%, and producing return on equity of 18% with considerable leverage.
We have changed our approach with respect to the geographic preferences over the years. We initially only invested in the United States, but over time we concluded that to reliably find unusual bargains in high-quality companies we needed to broaden our investing universe. While there is no shortage of intellect in the investment profession, most managers by inclination or mandate don’t even look at the faraway corners of the global markets, which is where we think the most attractive bargains reside.
3G Capital is “long-only”. Why? Don't you think you have been missing out on an opportunity, especially in the technology sector in the last couple of months? Have you ever shorted a company?
CORY: We avoid shorting stocks. If you are right on your investment thesis and go long, eventually you will earn the return. However, when you go short, you can go broke before your investment thesis plays out, as you are forced to put up margin every time the position moves against you.
Does 3G Capital engage in speculative trades? Is there a part of the fund’s portfolio that is dedicated to pure speculation?
PAVEL: We don’t really speculate. 100% of our activities are focused on investing, defined as buying assets at a discount to their underlying intrinsic values.
Last year was very tough due to the situation in Ukraine. What were the biggest/most significant changes in 3G Capital’s portfolio last year? Was 3G Capital’s portfolio affected by the Russia-Ukraine war?
CORY: The biggest change to our portfolio was driven by changes to the valuations of our holdings rather than the Russia-Ukraine war. Last year the Turkish stock market enjoyed stellar performance, and the valuations of our Turkish holdings soared to levels more reflective of their fair values. As a result we opted to reallocate the fund’s capital to other investment opportunities, primarily in China, which offered a much larger gap between prices and values.
You invest globally. Which markets are currently driving your attention most? And, by the way, have you ever looked at Czech companies? For instance, ČEZ? And is there a market you would never invest in?
CORY: Recently we have been spending quite a bit of time looking at markets in China, Turkey, the United Kingdom, and the United States. However, while we are seeing a lot of attractive businesses in these places the prices are still not at the level which we deem attractive. We have looked at the Czech market in the past and identified a few sound businesses. However, so far we have not seen these businesses trade at prices which would make them an appealing investment opportunity, so we are still waiting!
When investing in a company, you are looking for 3Gs: good business, good management, good price. What does it mean exactly? Can you give us some examples?
PAVEL: Let’s tackle the business aspect first. A good business is the one that can sustainably generate satisfactory returns on capital while carrying little or no debt. The businesses which fall into this category are industry leaders operating in industries where frontrunners remain at the head of the pack for decades.
Good management is capable of operating the business in such a manner as to deliver growth and profitability above baseline for a given industry and business type. Furthermore, good management understands capital allocation well, and is open to returning excess cash to the shareholders if the core business does not require capital.
Lastly, we define a good price as a multiple of anywhere between 4X and 11X normalized sustainable earnings. We are cognizant of the fact that one cannot reduce investing to a single-factor formula, so we may at times consider going outside the range if circumstances warrant it. However, most of our holdings’ purchase prices will generally fit within the above range. At the end of the day returns are a function of the price that one pays, so valuation does matter.
How do you assess management quality before buying a stock? What do you believe makes great management? How do you evaluate a CEO for instance? Do you also take into consideration how much the high-level executives are compensated?
PAVEL: There are a couple of angles we consider when it comes to management team assessment.
The first angle is management’s operating performance. We look at management’s actual track record and compare it to baseline, the baseline being what comparable businesses earn on average. We also consider the ‘soft’ data we gather through a variety of sources regarding management’s approach to running the business and make a judgment as to whether that approach makes sense.
The second angle is examining management’s capital allocation philosophy. Do they hoard cash or make dumb acquisitions? Or do they reinvest in the business at a high rate of return and hand back the capital to shareholders via dividends and buybacks when attractive reinvestment opportunities cannot be found? Obviously one should prefer the latter to the former.
Finally, we consider interest alignment between management and shareholders. We examine management’s commitment to the business and also factors such as insider ownership, compensation policies, and insider dealings, if any.
Do you specifically look for founder-led companies?
PAVEL: We do not necessarily look for founder-led companies specifically, but it so happens that a few of our portfolio companies are run by the founders. We do observe that, on average, founder-led companies are better run and their management teams are more motivated. However, investing is not about single-factor formulas, so whether a company is founder-led or not is just one of the many factors we consider in the course of our investment decision-making process.
(Founder-led companies screener)
Your portfolio is very concentrated, 10 - 12 companies, top 5 positions count for almost 70% of your portfolio. Is it a number you never cross?
CORY: We generally stay within those parameters, as we learned from experience that these specific confines offer us enough diversification while also enabling us to source a satisfactory number of investment ideas.
Why don't you have an equally weighted portfolio?
CORY: If every single idea we have in our portfolio offered the exact same expected return potential and risk profile we would! However, no two investment ideas are the same, and the expected return potential and risk considerations will always differ between various ideas, hence we scale our portfolio holdings to reflect these differences.
How long do you usually hold a stock for? And what stock do you hold the longest?
PAVEL: We generally hold the stock for as long as there is a material gap between price and the underlying business value. In our experience this generally happens within a three to five year period. However, at times there are outliers: we had seen cases where prices approached the underlying values within months, but we also had seen cases where it took almost 10 years for the price to catch up to the intrinsic value. An important point here is that it pays to stick with businesses which can grow their underlying value over time, as in those instances you essentially get paid to wait. In contrast, the businesses whose underlying values do not grow much over time offer declining investment return potential the longer it takes for the market to reset price to value.
What is 3G Capita’s approach to managing cash? Do you always have some cash available in your portfolio to use right away for a “quick action”?
PAVEL: We do not explicitly target a specific cash level. Rather, the cash percentage we hold is a function of the amount of investment opportunities available to us. When we are finding a lot of attractively-priced ideas, we will be fully invested. If we are facing a dearth of attractive investment opportunities, our cash position will rise.
How diversified is your portfolio? And can you describe how you diversify your portfolio?
CORY: Our portfolio generally includes between 10 to 12 holdings, with the top five normally accounting for about two-thirds of the total. We try to make sure that our holdings are well-diversified across industries and geographies to minimize the correlations within the portfolio and avoid risk accumulation.
When buying a stock, do you buy the position all at once or in parts?
PAVEL: We normally initiate a full position if we find something we really like. However, if the stock falls substantially following our purchase and our estimate of the underlying intrinsic value is still unchanged, we would generally consider adding to the position.
How do you deal with losses? Do you have any maximum drawdown that you can handle?
CORY: We don’t really use stop-loss strategies, as they tend to focus on stock price movement alone. Our approach is to monitor the gap between price and the underlying business value of a stock and act accordingly. Our decisions as to whether to buy more, hold, or sell are a function of the above gap, rather than a function of a gain or a loss crystallizing.
You usually talk about your strategy as looking for “exceptional bargains”. Seeing so many stocks drop down by almost 80%, it must be heaven for you. Which stock caught your attention the most during this sale season?
PAVEL: I would not necessarily say an 80% drop indicates an exceptional bargain. It appears that many stocks, especially in the United States, are still richly priced despite the recent declines. A business turning into a moderately overvalued one from an outrageously overvalued one does not make it a bargain. Finding attractive investment opportunities in the current environment is still an uphill battle.
You have recently mentioned Kaspi as an interesting investment opportunity. I believe Kazachstan is not a market where most of the investors pay attention to. Can you tell us the thesis behind this stock idea? And how safe is it to invest in Kazakhstan?
PAVEL: KSPI is the largest ecosystem in Kazakhstan encompassing marketplace, payments, fintech, and travel. Generally such vast ecosystems are referred to as ‘SuperApps,’ highlighting their roles as hubs through which consumers engage in commercial interaction with the world at large. A more accurate way to describe KSPI would be to call it a ‘customer experience design company.’
While most companies develop competitively-advantaged dominance within a given niche and stick with it, KSPI takes a different tack. Instead, the company developed a competitively-advantaged approach which KSPI then proceeded to successfully apply across multiple niches. By delighting its customers with superb user experience grounded upon technology-driven innovation and big-data analytics, KSPI proceeded to conquer market after market. Starting 2008 the company grew to become from a standing start #1in fintech, #1 in payments, #1 in marketplace, and #1 in travel, along the way displacing such stalwarts as Visa, MasterCard, and Alibaba. KSPI created tremendous value in process, as the company increased revenues and profits (in USD) by over 35% per annum in the past 10 years with minimal capital investment.
The company should see continued growth going forward as it keeps consolidating Kazakhstan’s market for consumer spending. As a point of reference, KSPI accounts for 1% of consumer spending in its home country vs. 20% for Alibaba in China and 10% for Amazon in the United States.
The credit for the stellar operating performance goes to KSPI’s management team headed by CEO Mikheil Lomtadze who from a standing start in 2008 turned KSPI into the largest publicly-traded company in Kazakhstan with profits exceeding $1 billion.
This attractive business along with the impressive management team was available to us at less than 5X NFY EPS and a 14% forward dividend yield. At the same time KSPI’s international peers were selling for approximately 30X NFY EPS underscoring the stock’s upside potential.
Kazakhstan is safer to invest in than most people realize. On the geopolitical front both Russia and China, the country’s giant neighbors, have a stake in maintaining the ongoing stability. With respect to currency, if the local currency devalues we would expect to see inflation of comparable magnitude across KSPI’s business lines, which would offset much of the negative impact. Lastly, it is unlikely that we will see the Kazakhstani government extracting value from KSPI at the expense of the shareholders given the company’s national champion status and the government’s history of benevolent behavior with respect to the country’s businesses.
How do you manage currency exposure? Reading your past interviews, everyone CAN see that you really invest globally. What would you recommend to others when being exposed to so many currencies?
CORY: Our fund’s base currency is US dollar, so we invest such as to maximize returns in that specific currency. Rather than using explicit hedges such as futures and forwards we focus on businesses whose very business models offer implicit currency hedges. These business-based currency hedges fall into two categories. First category includes businesses which are export-oriented, so that their topline is effectively denominated in hard currency enabling them to preserve dollar-based earnings power in the face of local currency devaluations. Second category includes businesses selling product or service whose price can be easily raised in the event of local currency devaluation to the extent necessary to maintain the businesses’ hard-currency earnings power.
One of the companies you invested in 2021 was the well-know brand Victoria's Secret. What fundamentals convinced you to invest in this company? And what do you think about the acquisition of Adore Me? Is it a smart strategic move?
PAVEL: VSCO is the largest women’s intimate apparel company in the United States, with the market share that exceeds that of the next closest competitor by a factor of over 3X. VSCO boasts significant advantage over the competition with respect to brand image, customer base loyalty, distribution and supply chain, and product line breadth.
As a result, VSCO is able to produce returns on capital in excess of 20% while employing a modest amount of debt and to throw off prodigious cash flow. It is unlikely that the company’s competitive advantages can be challenged by the company’s rivals, who, by and large, are much smaller and lack the requisite resources and expertise.
Indeed, examining the history of the intimate apparel industry reveals that industry frontrunners generally maintain their leadership position and the resultant economics for many decades. We managed to purchase this attractive set of economics which VSCO offers for less than 5X EPS, whereas the company’s global peers boast valuations in the range of 15-20X EPS, indicating highly attractive upside potential.
