For a company to have sustainable cashflows, it needs to have a contract with its customers. This contract can be literal or metaphorical. If you rent out a property and have a long-term contract with the tenant, there is some certainty that you will receive your rental income in full and on time. However, contracts can be broken. Having a literal contract does not guarantee sustainable cashflows. It does however put the odds in your favour.
Metaphorical contracts are rare and harder to break because they are formed out of habits and convenience. Buffett once said, “the chains of habit are too light to be felt until they are too heavy to be broken”. Any company that can tap into these habit patterns is likely to have metaphorical contracts with its customers. Over time, habits passed from generation to generation can create a “Lindy effect”. Coined by the French polymath Benoit Mandelbrot, the Lindy effect states that the longer a story, idea or brand has survived, the more likely it is to survive in the future.
A 100 years from now, it is very likely that students will still study Shakespeare, children (and adults) will still enjoy Disney cartoons and a Patek Philippe will still be a family heirloom worth more than it was in the past.
If Charlie Munger was younger, only allowed to invest in mainly UK stocks and managing a relatively large amount of money, he would have a portfolio not too different from that of Nick Train. He isn’t well known among value investors outside of the UK however his track record is good and he, subconsciously or not, searches for companies whose products are “Lindy”. Over the last 13 years, his UK funds have generated annualised returns of about 12.5% while the UK market has annualised 5.7%. His portfolio is concentrated by UK fund standards with his top 10 holdings accounting for more than 80% of the portfolio.
One of his largest holdings is Diageo which owns well known brands like Smirnoff, Johnnie Walker and Guinness.
Guinness brewed its first ales 260 years ago in 1759. Over the last 48 years, the price of a pint of Guinness has increased by 2,148% while inflation has increased by 1,331%. In this period, the number of competing alcoholic beverages has also increased and yet Guinness has managed to increase prices above inflation without hurting sales. No one is contractually obliged to drink a Guinness, however many people do so regardless – an example of a brand that has metaphorical contracts with its customers. The compounding effect of time transforms this metaphorical contract into the Lindy effect.
Naturally, my next question was to see if the other stocks Nick Train invests in were Lindy and if you can you create a screen to spot Lindy companies or at least companies likely to have metaphorical contracts.
The metric that I think is important for spotting Lindy is companies with stable and predictable operating margins over a long representative time. What do I mean by “stable and predictable”? I mean operating margins with a low coefficient of variation – this is simply the standard deviation divided by the average.
The coefficient of variation is used in pharmacology to quantify the precision and repeatability of an assay. In pharmacology, a coefficient of variation <5% is considered good. Companies however operate in a more chaotic and probabilistic world so I can accept a larger coefficient of variation. A coefficient of variation < 10% is exceptional whereas values between 10% – 25% are good. The “representative time” is a long-time frame, ideally covering a recession, that covers a period in the past that is likely to mirror the future. If we look at Apple for example, 10 years is not sufficient for a representative time because there was no recession in the last 10 years and Apple before the iPhone was released in 2007 is very different from Apple today.
Why are stable margins even important? Stable margins covering an economic cycle tell us that even in bad times, the company can pass on the costs to its customers or suppliers. Companies that are able to do this are likely to have metaphorical contracts.
The Table below shows Nick Train’s largest holdings across two funds that he manages and the coefficient of variation of operating margins. The representative time here is 15 years. I also included the annualised return over the last 15 years. For comparison, a highly predictable company like Costco and Apple have coefficient of variation of 8% and 9% respectively whereas a highly unpredictable company like BP whose value is tied to an externality that is not stable or forecastable has a much higher variation in its operating margins of 118%.
Out of the 15 companies listed which Train owns, 9 have stable operating margins so are likely to have some sort of metaphorical contracts. A subset of these will also likely be Lindy.
The London Stock exchange and Hargreaves Lansdown happen to have high variations in margins. However, they have also had the largest returns over the last 15 years. Does this mean these companies are not Lindy? The London Stock Exchange is certainly Lindy. It was founded 321 years ago in 1698. Stock exchanges have the potential to be Lindy because of minimum efficient scale and the symbiosis between its customers. Minimum efficient scale simply means that the economics only allow a few exchanges to exist – the local market is not large enough for multiple competing exchanges. In the USA, you have 3 major equity exchanges with similar market share for equity transactions – NYSE, NASDAQ and BATS. In China, you have 2 major equity exchanges with similar market share – Shenzhen and Shanghai stock exchange. In India, you also have 2 exchanges – the Bombay Stock Exchange and the National Stock Exchange of India; however, the latter exchange dominates and accounts for almost 90% of trades in the country. In Japan, you have one major equity exchange – the Japan Exchange Group. Similarly, in the emerging markets of South Africa and Brazil, the Johannesburg Stock exchange and the BM&F Bovespa account for more than 90% of all equity trades. Smaller markets tend to have one dominant exchange because of minimum efficient scale. This gives exchanges staying power
Symbiosis between customers occurs in the London Stock Exchange as Investors trading though the LSE attracts more companies to list on that exchange which in turn attracts more investors. This self-reinforcing cycle is similar in companies such as eBay where the presence of buyers attracts more sellers which in turn attracts more buyers and so on. Also, the marginal cost of adding a new customer is negligible. Stock exchanges are Lindy but don’t pass my test of stable operating margins.
This is the limitation of quantitative screening – while it can spot Lindy companies like Diageo, Pepsico, Costco and possibly Apple (time will tell) it can miss out on the LSE. Just like searching for a long term partner, it is entirely possible to find one through a screen (your computer or phone) however, looking away from the screen into the real world also works.
As with any other rule of thumb, the Lindy effect is not perfect. Changing consumer tastes and increased competition through the internet has severed the metaphorical contracts between some brands and their customers. A prime example of this is Marks and Spencer. Just like a tenancy contract, metaphorical contracts can also be broken.
Investing is less about certainties and more about probabilities. A company with metaphorical contracts whose products are “Lindy” does not guarantee success but it certainly reduces the probability of failure.