Spawners - The Capital Allocation Framework at the heart of Multi-Baggers
We look at Mohnish Pabrai's Spawner framework for Multi-Baggers and apply it to my portfolio.
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Mohnish Pabrai is a well-known value investor that has practiced Both value and growth investing over a span of 25-30 years. During his early years till 2000, he was a growth investor. After that, he switched to value investing for the last 20-odd years. Now he has switched his investing style again to growth investing and specifically he wants to focus on finding multi-baggers. During his long investing career he has had success with quite a few multi-baggers and a few select 100 baggers.
He has also written a book, I haven't had a chance to read it yet - https://www.amazon.com/Dhandho-Investor-Low-Risk-Method-Returns/dp/047004389X/
He covered the following ideas in the following youtube video Mohnish Pabrai’s Lecture, Q&A with students of Peking Univ. (Guanghua School of Mgmt.)–Dec. 3, 2020
I feel incredibly lucky to have had access to this mental model/framework early in my investing career. Also, Mohnish recommends that we should just follow this framework and find multi-baggers as this strategy is the holy grail of investing and beats every other strategy out there.
So I will be covering the Spawners framework and my take on it. Let’s go!
Spawners is a framework to identify multi-baggers(stocks that return a multiple of the initial invested capital, ideally 10-100 the invested capital).
Before we move ahead, let's think about this a little, what does a 10-100 times return mean?
Well, a 10 bagger in 10 years and a 100 bagger in 20 years is a CAGR of 25% per year, similarly, a 10 bagger in 7 years and a 100 bagger in 14 years is a CAGR of 38% per year. Aiming for any shorter duration for a 10/100 bagger doesn't make sense to me, but it's certainly possible; I would say we would be lucky to ride one with a shorter duration.
Choices make us who we are
Generally, we have 2 choices for investing, Discounted Pie & Growing Pie.
A “Discounted Pie” is a business in which we can invest for a short time 2-3 years and get a small 2-3x return from this activity. This method is tax-inefficient and you must keep up and keep finding new ideas to invest in.
A “Growing Pie” is a business in which we can invest for a long time 5+ years and get a substantial 10-100x return from this activity. This method is tax efficient and you only a few ideas to invest in.
Mutibaggers are in general powered by two engines of growth, earnings/revenue growth, and multiple expansion. Furthermore, multi-baggers have a path, they have a particular focus on capital allocation, which if you study over a period of a few years, you can tell which path they are taking and if they can make it to the promised multi-bagger land.
The first path is of extreme focus on the core business and having long runways of growth in that core business. Mohnish terms them “Focused Mousetraps” and some examples of this are Costco, Chipotle, etc. These are businesses focused on the core business and their capital allocation strategy is to reinvest in the core business over anything else.
The second path is of “Great Capital Allocators”. I think of these businesses as having an incredible investing discipline and process that is differentiated and results in tremendous success over long periods of time. Among the disciplines of investing & operations, these usually are stronger on the investing side. I would bundle serial acquirers, rollups, consolidators, etc in this group too. Some examples are Berkshire, Danaher, constellation software, etc.
The third path, "Uber Cannibals” is where there are intense buybacks of the outstanding stock. Over time, even if the business doesn't grow your share increases. This is more of financial engineering/hack to use the cash being generated in the business used to buy back stock. Some examples of this are NVR, Autozone, etc.
The fourth path involved buying businesses in temporary trouble that will turn around over time due to some catalyst. The catalyst may be an activist investor, a new CEO, a new owner, or something else. Mohnish also includes deeply undervalued plates here, I think these are mostly depressed cyclical and industrials. Some examples of this are Teck Cominco, Rain industries, and Fiat Chrysler.
The last path, also the most reliable path to multi-baggers is owning businesses that continuously spawn/start/create new related and unrelated businesses. Some examples here are the giants like Amazon, Google, Tencent, etc.
What is a Spawner?
A spawner is a business that always stays in growth mode and tries to find new avenues for growth within its core business relentlessly by adding or incubating new businesses that have long runways. They can achieve this by innovating, copying, and buying businesses in related or unrelated business verticals or horizontals. They are tax efficient as they find a way to keep reinvesting the cash they generate into new ideas. It's more of a portfolio where they know they will have a lot of failures and few successes, but they still pursue those opportunities and have proven to be successful at doing so often. I look at them as a combination of incredible operators and incredible investors/capital allocators.
Spawning is a way to increase the runway of a business. Another great insight Mohnish gives us here is that Spawning businesses have lower risks than focused mousetraps as they will be less affected during downturns(I think it's because these businesses are basically a portfolio of a phenomenal investor and operator).
What are the types of Spawning?
Adjacent Spawners create related businesses in the same domain by creating new products and services. Embryonic Spawners acquire businesses and build them into big businesses themselves(These might be related or unrelated businesses). Cloner spawners copy successful products. Non-Adjacent spawners create or buy new, unrelated businesses. An Apex spawner does all four types of spawning all the time.
The following images show some spawners of each category and most importantly the APEX SPAWNERS.
So what does a spawner evolution look like?
Observe the type of “spawning category/competency” added by Kotak Mahindra over time. This timeline is the most important in identifying businesses with this DNA. If you follow a business and just keep track of if they are developing 2 or more of these competencies over time, get ready, you might be in for a big ride. This is why holding on to your businesses is important; building big things takes time. I usually observe 2 of these competencies on my top 30, and I am watching the other hundred to see if they are adding some more competency to justify an upgrade to the top.
Mohnish made the mistake of selling Kotak in 2000 after buying it in 1995 for a zero gain. If he had held onto it till 2020 he would have had a 200-bagger. That is incredible. If you have a spawner, don't touch the position ever again; no trimming, no stop losses nothing. Let the compounding engine run as long as the runway. Keep watching revenue growth, spawning competency, free cash flow generation, eventual profitability, and a monopoly/oligopoly for a while before eventually if they can't do anything else and they have to rely on buybacks.
What are some non-spawners Spawners?
Mohnish gives a few examples of non-spawners above.
How to think about a 10-100 Bagger in numbers?
So how can we apply spawning to our portfolio as investors?
The first idea is to restrict our hunting ground to businesses below $50B in market cap/enterprise value. This idea is backed by the data from 3700 IPO’s over the past 20 years. Only 9 businesses exceeded a $100B market cap during this time. Doesn't mean this will stay true, but it's a great way to be more successful at finding multi-baggers.
So if you want to get a 10-bagger, you have to buy a business below $5B, and if you want to get a 100-bagger, you have to buy a business below $500M.
Then do the competency checks for spawning behavior in the past.
And Buy & Hold if it's a business that has a long runway, great competitive advantages, an amazing management team, and culture, and incredible products and services.
And then find 5-10 of these businesses and ride them for 5-20 years and keep checking them every 6 months.