Suzuki Violin is a method for teaching violin. There is a set of books that contain numerous songs that children learn in order. If you go to an early violin recital for Suzuki students, you might hear 5 different children playing a simplified version of Twinkle, Twinkle because it is the first song in Book One. It forms a foundation for future learning.
Q4 2019 hedge fund letters, conferences and more
If you want to learn about great businesses, Verisign is akin to Twinkle, Twinkle. Every business analyst should study it.
I have written about Verisign three times in the past four years.
Boring Monopoly Still a Boring Monopoly: VRSN Update
Verisign: A Case Study of a Great Business
Short Recap of Business:
Verisign operates the domain name registry for the .com and .net “top-level domains” (TLDs). In short, Verisign operates as a sort of telephone book of the internet for any .com and .net addresses (including a few other domain names). Users pay an annual fee for the right to “park” their website at a specific address, for example, Amazon.com.
The ability to operate this “telephone book” is granted to VRSN through a contractual relationship with ICANN (Internet Corporation for Assigned Names and Numbers), the nonprofit agency that “coordinates” the internet.
If you want .com behind your website address, you will need to pay Verisign a “toll” to be on the internet. Although this is not technically a monopoly (since you can have other top-level domains, i.e. .biz), it is fairly close to a monopolistic position.
Verisign Lessons:
The quarterly update from VRSN is so enjoyable. It takes so little mental effort to realize that this is a great business. Additionally, each quarter, you realize how much heavy lifting is being done for you by the great business.
Verisign as a Yardstick:
Buffett and Munger have both discussed the idea of using a current investment as a yardstick for each new investment. If you own a wonderful business, like Verisign, you can use Verisign as a yardstick against which you compare each new investment.
- Is the new business as simple to understand as Verisign?
- How does the capital allocation compare to Verisign?
- How sure am I about the future cash flow in comparison to my confidence in the future cash flow of Verisign?
Portfolio diversification can create the appearance of a better overall portfolio if you ignore the fact that you are replacing 100% of a wonderful business with a new incoming business that may not be as wonderful as the one you already own. Adding a poor business to a wonderful business does not create diversification, it just gives you a wonderful business and another business with a lot of headaches.
Imagine a new job offer. The first thing you do is compare the new job offer to your current job. Is the new job offer meaningful better than the one you currently have? Similarly, you need to compare each new idea with your current portfolio. If that current portfolio is made up of wonderful businesses, like Verisign, this creates a significant hurdle for each new idea.
Empire Building and Capital Allocation:
VRSN’s management is not interested in “Empire Building.” Management recognizes that they have a special asset. They have what you might call a “golden goose” in their registry business. If management would use the cash flow from the golden goose to go out and buy a regular dairy cow, they would immediately dilute the quality of their overall business. I can imagine the pitch, we are “creating a farm superstore”…but this just means that management wants to raise their profile and build an empire. The examples of companies diluting their great businesses with empire building acquisitions could fill multiple business school classes (Coke buying Columbia Pictures immediately comes to mind). It’s not an understatement to focus on how rare this characteristic is. Most corporations think they can take the incoming $1 of cash flow and turn it into $2 in a few years, but really it ends up becoming 50 cents. It isn’t a bad thing if the only wise decision to allocate your capital back to your shareholders. See’s Candies comes to mind in this area. See’s does not compete in every grocery store aisle with Hershey’s. I am sure Buffett is fine with this result. Some businesses are only great at a certain size or in a very specific business niche or geography. For these businesses, growth is destructive and therefore the cash is better utilized elsewhere. Few managers understand this because their incentives aren’t usually aligned (and by incentives, I usually mean, their pride and occasionally pay package structures). Who wants to be CEO of a great small company, when you can be CEO of a potentially great large company?
To put this discussion into context, Verisign has produced $4.1B in free cash flow in the past 6 years and has bought back $4.1B in stock.
Competition:
Competition is probably one of the biggest threats to shareholder value for any company. The competitive threat from the current landscape of other businesses in addition to the future competitors that don’t even exist now provides a continual concern for shareholders in any company. VRSN is one of the few examples I have ever found that has virtually no competition. The contractual agreement to be the registry for .com and .net provides VRSN a contractual monopoly for their business. Buffett once talked about owning the “one toll bridge from Michigan to Canada” and how great a business that would be. These businesses are very rare and VRSN is such a business. The financial statements of VRSN would look dramatically different with sustained competition.
Patience:
The rarity of a “Verisign” type business doesn’t mean that such examples never come along. Instead, the rarity is an indication of the patience required to wait for a business that is both understandable and truly an excellent business. Certain companies are probably great businesses, but I may struggle to understand a great many of these. Additionally, some very poor businesses are easy for me to understand, but I don’t really consider them to be great businesses. It is rare to find both characteristics in one business. The patience needed to wait till you find a business that combines both of these elements is paramount for an investor.
No Points for Simplicity:
The last lesson of Verisign is one of simplicity. Verisign is a very simple business that is easily understood. When I write about Verisign, I know that I will win zero points for my intellectual gravitas. It’s just not that difficult to understand. However, as an investment advisor, one “unwritten” goal is to convince current and potential investors that the investment advisor is intelligent. If you write about simple companies, you will win few followers and an equal amount of new investors. This is an unfortunate outcome because although “displays” of intelligence are great for raising an investment advisor’s assets under management (“AUM”), I find that there is very little correlation between displays of intelligence and investment returns.
I first wrote about Verisign in August 2016. Verisign has returned 33% annually since that date compared to approximately 16% for the S&P. Keep in mind, this is net of taxes, since you didn’t have to sell during that period to achieve those results. As Buffett has said many times, “There are no bonus points for complicated investments.” Or my favorite: “I don’t try to jump over 7-foot hurdles; I look for 1-foot hurdles that I can step over.
Valuation Matters:
Valuation matters, even for great companies. Terry Smith of Fundsmith, writes about their three core principles:
- Buy Good Companies
- Don’t Overpay
- Do Nothing
Finding the great companies is the first step. The second step is being patient for Mr. Market to offer you an attractive or even reasonable valuation for those great companies. At current prices, it makes sense to wait for the day when Mr. Market will offer Verisign at better prices.
