A $33 Billion Value Manager Who Has Actually Outperformed | Scott McBride

[00:00:00] If you're willing to think different and be out of consensus, there's actually been a lot of opportunities in the last five years. Our analysts will go to Analyst Days and there's nobody there for stocks we like. And then there's thousands of people on the deep sea in video calls. So they're just not paying attention. When you're thinking about selling when a stock gets a fair value, there can be a bit of an art to that. I just hear so much, what is your catalyst? You know, what is going to unlock value? And for us, you just, you really don't need a catalyst. What you need is to get the valuation right and to get the governance right.

[00:00:28] It's not like what it's going to mean this quarter or what it's going to mean for sediment the stock. It's what it's going to mean for earnings over a long period of time. Welcome to Excess Returns, where we focus on what works over the long term in the markets. Join us as we talk about the strategies and tactics that can help you become a better long term investor. In this episode of Excess Returns, Jack and I sit down with Scott McBride, President and Portfolio Manager at Hotchkits & Wiley, to discuss their value investing approach and what they believe works in the markets over time. As always, thank you for listening. Please enjoy this discussion with Hotchkits & Wiley's Scott McBride.

[00:00:59] Hi, Scott. Thank you very much for joining us today. Hey, Justin, Jack. Thanks for having me. Good to be here. So what got our attention was it was an article I've known about Hotchkits & Wiley for a long time, but it was a Bloomberg article from last year was the end of sometime in Q4. And the title of that Bloomberg article was, how a $33 billion fund manager scored a perfect record betting on value.

[00:01:24] So when I saw a perfect record betting on value, I was like, that was clickbait for me because Jack and I are consistently looking for sort of value strategies and managers that have done good in, let's say, the last five or 10 years. And what was interesting about that piece was it was talking about how of the funds that you run, and now it was a three-year basis and it was through the end of August, but how the firm had 100% hit rate.

[00:01:51] So 100% of the mutual funds for that period of time that was measured in the article had outperformed their primary benchmarks. And so, you know, when we saw that, we said, hey, this is an impressive firm, impressive track record. And we wanted to ask you to join us and talk about sort of value investing and your way of value investing. So we really appreciate your time. Yeah, well, thanks for having me.

[00:02:19] You know, I think the key to success in this business is first, you need to have a great team. And so we've got about 30 plus people on the investment side. Our average tenure for our analysts and PMs is 19 years. This is my 24th year at the firm. So you have to start with a great team. We've got a good group and we've been together through a lot of different investment cycles. And we've learned a lot together.

[00:02:45] I think the other thing you need, which is just as important, is you need to have the right culture. And our firm's been around 45 years and we've built a culture where we focus on one long-term thinking and not around predicting short-term earnings, but really about thinking about what businesses are worth over the long term. I think even more important is we have a culture where we're willing to be different than consensus. You know, you really need to be different to outperform.

[00:03:12] And our team members are just comfortable with being out of the consensus. And if you've been willing to think different and be out of consensus, there's actually been a lot of opportunities in the last five years. And so if you think back to the pandemic, travel stocks were a really good opportunity. The price of oil was zero. And so that created a lot of interesting opportunities in energy. In 2022, there was a big sell-off in tech and there was kind of a panic about some of these tech companies. That created opportunities in tech.

[00:03:40] And then in 2023, we had bank failures and that created a lot of opportunities in financials. So there's been a lot of stress the last five years and that stress creates opportunities, but you have to be willing to think different and kind of, you know, look in areas where others are uncomfortable looking. And so I think that's really what we've been able to do the last five years. Well, that was kind of one of the points in the article is, and this is a quote from you, the market is driven by sentiment. It's driven by emotion.

[00:04:07] And you then went on to say, you don't, when you don't have a lot of folks who are thinking about what long-term value is, it creates an opportunity. And so kind of just flush that out a little bit more. Yeah. So what we're trying to do is we're trying to buy a business at a discount to what the business is worth. And we think that the reason you get that opportunity is because so much of the market is focused on, you know, the short-term and the short-term performance of businesses, short-term sentiment in the economy or in the markets, that drives performance.

[00:04:36] And that creates the opportunity. If you're willing to think about looking at a business from a longer time perspective. And, you know, we try to think about valuing companies on a three plus year basis. A lot of times the companies we're investing in are under earning their long-term potential. So about three years is the time period we think about for, you know, when these, these businesses we think should be able to get back to what we call normalized earnings power, which you could think of as long-term or average earnings.

[00:05:04] But that's what we're trying to do is look for businesses that are, you know, the market's negative about in the short-term because if something to do with the economy or an industry cycle or company specific, and there's reasons to believe if you can think three years or longer, things could be better and you could be getting a good business at a great price.

[00:05:22] You, you had mentioned, um, the opportunities in COVID with travel, but just, you know, that was one type of bear market, but obviously the firm has been through in its history, um, lots of different bear markets. And I think that is a lot of times when investors make the worst mistakes. It's when stocks are down, they have a tendency to sell and then maybe are late to get back in. And so there's a timing component that can really detract from returns.

[00:05:48] I'm just curious, like, what would you, what would you, what lessons do you have for, let's say your average investor in dealing with, um, sort of the bear markets that inevitably come with long-term investing? So we've certainly made our fair share of mistakes, uh, you know, in bear markets and in all sorts of markets. Um, you know, I think the things, uh, thing, thing we've learned is that, uh, there's a couple of really important variables.

[00:06:18] We want to stay focused on when we're evaluating companies. So I talked about price. Of course, we care a lot about the price for patent for the business we're investing in. Uh, we also want to make sure we all agree on the quality of the business, all else being equal. We want to buy the best business. We can, um, can be prices for businesses that, you know, might be, um, a little bit lower quality, but you need to really understand what you're buying and you need to get a great price. So all else being equal, we want to buy the best business we can.

[00:06:45] When you buy a good business and the stock price goes down, you get excited to buy more. Um, and so one is if you're positioned in the right companies, when they sell off, you're excited at that opportunity. I think the other few other things we've learned is one, you don't know when the shocks are going to come. And so you want to have balance sheets that can withstand the shock. Um, we've been through the financial crisis. We've been through the pandemic. You just don't know when they're going to happen.

[00:07:08] You just know they will, and if you find yourself in a position where the balance sheet isn't very good, it is hard to stick with something when times get tough. If you invest in businesses beforehand that have the right balance sheets, you can withstand the downturns. And then the last is you want to have good governance. You want to be invested in companies, um, where there's real alignment with, with shareholders.

[00:07:29] And if you have that, um, um, you know, when, when, when times are tough, management teams can, can take advantage of the downturn. Maybe they take share, maybe they're just well positioned to deal with the downturn. And so those are the things we try to focus a lot on beforehand, before we get into the crisis, which is what's the quality of the business we're investing in. Do they have the balance sheet that can withstand the downturn and what's governance? Are, are we aligned with this management team? Are they going to do the right things?

[00:07:58] On the, uh, the issue of sentiment and emotion that you brought up before, do you think like the market is crazier now than it was earlier in your career? Do you think that creates more opportunities for you? Yeah. So I started my career during the dot-com boom. And so I'd say that was a pretty crazy time. So I think, uh, uh, I don't know if I'd say they're crazier, but there's more and more information available, but that has, does not mean that markets have become more efficient. I think markets are as efficient as they've, you know, excuse me, as inefficient as they've, as they've been throughout my career.

[00:08:27] And, um, you know, that does create a, create a lot of opportunities. I think, um, you know, there's more and more money in passive. There's more and more money chasing, um, you know, strategies that are, that are focused on short-term kind of earnings predictions. And there's fewer people, I think, um, you know, trying to do the long-term valuation work that we're doing. And so I think, you know, there's, there's, like I said, there's been a lot of stress in the last five years.

[00:08:55] There's been a lot of volatility that creates the opportunity. I expect that there will be more going forward and there'll be a lot more opportunities. Yeah. And to your point, we did Cliff Asenus on recently, and he made the same exact point you're making, which is he thinks all of this stuff, not the market's not more efficient. It's more inefficient because of all this stuff. And he thinks that creates an opportunity for long-term investors. Yeah. I guess I would say I agree with that. Again, um, I would point to the examples, you know, we talked about, which is, um,

[00:09:22] you know, there, there's just more stress in the market and more stress creates, uh, opportunity. There's also just fewer people like doing what we do. Um, you know, an example for us would be, um, we had a, uh, one of our analysts go to a buy side, you know, excuse me, an investor day for one of the companies we own. Um, um, this is like a midsize mid cap company, $15 billion. It's one of our biggest investments. He went to the analyst day, which is in San Jose. This is a tech company.

[00:09:51] So it's, it's in San Jose. There were two sales, two sell side analysts and two buy side analysts, including him. So no one's really paying attention to some of these companies. And I would, um, compare that to what's gone on last week with DeepSeq and, and, and the impact. Uh, you know, there was a lot of news on DeepSeq last week. It impacted stock prices. It impacted the price of NVIDIA. And so there were a lot of wall street calls on DeepSeq. Um, there were thousands of people signed up for these calls.

[00:10:21] And so for those big names where there's a lot of interest, there's a lot of attention, but for some of these smaller names, where there's just not a lot of attention, uh, that, that really creates the opportunities for us. That makes sense. We're going to get back to that. Nobody's paying attention a little bit later too, because I think there's a lot to dig into with that as well. Um, but first I want to just talk about value investing in general and how, and how you define value, because we, we talk to a lot of quantitative value investors, which is the opposite of you on the podcast. And they'll talk about, you know, composites of price to book and price to earnings and using these quantitative methods to determine value.

[00:10:51] But I think the way you do it is very different than that. So can you just talk about how you define value? Yeah. So for each company, we want to think about what we think the business is worth. And ultimately we want to buy at a discount to what it's worth. So if you're a capital intensive industry, if you're a bank, a book value might be an interesting stat to think about. Ultimately we want to turn book value into normalized earnings for us and think about what multiple of normalized earnings are we willing to pay for a bank?

[00:11:16] Uh, if you're a software business, you know, we're not going to think about price to books, not really valuable. And in some cases, even price to earnings, if you're a growing software business that's investing through their income statement might not be that valuable. And so for us, uh, where we recognize that faster growing businesses, higher quality businesses should be worth more. So we are willing to pay a higher price for those kinds of businesses, but ultimately we want to figure out what it's worth and we want to pay a discount to that.

[00:11:44] And, uh, we don't want to get dogmatic about, well, it has to be X price to book because again, for some businesses, it doesn't really mean a lot. And we don't really even want to get dogmatic. It has to be a low PE of what it's earned in the past. We're really trying to think about what is this business worth? Um, and then what are we, what are we, what are we getting? What, you know, what price are we paying? And again, understanding that different quality businesses can be worth more than other companies. You alluded to quality there. And there's a couple of things.

[00:12:12] When I looked at your website, you, you talked about some of the key risk controls you follow. And a couple of those get at this idea of quality. And I want to go through each one individually and see how you look at that. So the idea of financial strength in a business, how do you see the idea of financial strength? Yeah, it's really the ability to withstand shocks and downtrends like I talked about. So, uh, for each of our companies, we, we, we kind of rate our companies in a bunch of different categories. And one of them we do is balance sheet. We'll give each company a balance sheet rating. And we want to buy balance sheets again that can withstand a shock.

[00:12:41] And, um, like I said, we've made mistakes in our career where we got the value of the business, right? But they didn't have the balance sheet to withstand the shock. And so, uh, we want to be prepared for the shock before it happens. And that means buying a business that's got good financial strength. And how about this other idea? This is something I had actually heard from another value investor recently is this idea that they see a lot of the protection of the business now, not in the balance sheet, but in the, actually the sustainability of the business itself. So you look at the sustainability of the business model.

[00:13:12] Yeah. So we, uh, again, we rate all our companies on a, on a one to five basis in quality. And what I'd say is if you buy a quality business, um, that means that generally means the business is going to compound value over time. And so that serves as a bit of a risk control. Meaning if you made some mistakes, you know, there's some things that happen to the business that are unexpected, or maybe you paid too high a price, a little bit too high a price. But if the business quality is very good, that's going to serve as kind of a cushion to those mistakes or maybe paying too high a price.

[00:13:41] Whereas if you pay, if you buy a bad business, um, and things go wrong, things can go really wrong. So again, I think we pay a lot of attention to the quality of the business that we're investing in. How do you think about, you mentioned tech companies before, and how do you think about how things have changed for you in the world of these high intangible tech companies? Um, I think that as I referenced before, some of the metrics that traditional value investors would use price to book, um, price to current or trailing earnings.

[00:14:10] In some cases, when you're looking at businesses that have intangible, it's just not as valuable. So, I mean, price to book really for most intangible businesses, price to book really means nothing. Um, you know, for Microsoft, what is price to book ratio as really means nothing about how attractive or overvalued the business might be. Um, for growing, for companies that are growing in investing in intangibles, um, they invest through the income statement.

[00:14:35] So you can find occasionally we found great growth businesses at a great price. And maybe the growth investors have kind of fallen out of interest, fallen out of interest with the business for some reason. And the traditional value people, if you're using price to book or price to trailing earnings, it's not going to look interesting because this is a growth business and they're investing through the income statement. So in those cases, what we want to think about is what are long-term margins when this business gets mature. It's similar to a capital intensive industry.

[00:15:03] We would think about what is maintenance CapEx going to be for a growing business that's spending a lot on CapEx. For a business that's spending a lot on R and D, we try to think about what is maintenance R and D or spending a lot on sales and marketing. What is maintenance sales and marketing? Meaning what are margins going to look like when the business matures? And so I think if you're investing in intangible companies, you have to think about those issues and again, price to book, not very valuable. And you need to make some adjustments to your earnings multiples to really, you know, be comparing

[00:15:32] them to capital intensive businesses on an apples to apples basis. This answer might vary across your funds, but how do you think about the idea of portfolio concentration? I mean, I think you guys are fairly concentrated investors, but how do you think about the optimal portfolio size? Yeah. So we're willing to be pretty concentrated. It depends on the strategy we're talking about. I think ultimately what we're looking for in a stock is what I talked about. Good valuation.

[00:15:57] And then they have a good quality rating in our model, a good balance sheet rating, and then they've got the right governance. So we're aligned with management teams. And if we get all of those things, quality business looks good. Balance sheet is strong alignment with management. And we get it at a good price. Those are the kind of stocks we want to make big weights. And so that's how we think about that's most of what we're doing every day is looking for those kinds of opportunities. When we see them, we're willing to make 5% position in a lot of our strategies and then

[00:16:26] in our more concentrated strategies, maybe even 10 to 15%. So that's how we think about it. When you think about sectors, we're willing to be very different than benchmark weights. We don't talk too much about the benchmark weights. We're willing to have big weights in particular sectors. We're willing to be zero in a particular sector if that sector really doesn't look interesting at all. The norm is not to be zero, but we're willing to do that in cases where we just don't see any value.

[00:16:54] So we're willing to be much different than benchmarks, I guess, is the way to think about it. Let me go back to intrinsic value just for one second before we move on to further. So to get intrinsic value, you obviously have to look at or estimate future cash flows, the future cash flow or earnings stream. How do you guys, like what's the process of doing that?

[00:17:19] Does that vary in terms of maybe the volatility of the firm or the risk of the firm? Or how do you guys, because that's really the tough thing. It's like projecting those future earnings growth rates. And then, you know, and so, yeah, just flush that out a little bit. So we think a lot about normalized earnings power. And again, if you're a cyclical business, you could think of that as mid-cycle. If you're not a cyclical business, you can think of that as kind of your long-term average

[00:17:47] margins or long-term average return on capital that the business can generate. So that's first. We always want to understand what earnings power is. Second, we try to think about predicting five years of earnings power. So we spend a lot of time thinking about what are we paying for five years out, normal earnings. And then we spend a lot of time thinking about, again, the quality of this business. How predictable are those earnings? So you could think of those risk scores I talked about. The quality rating tends to mean the higher the quality rating, the tighter the band is around predictability.

[00:18:15] The lower the quality rating, the wider the band. And so we will think about, okay, what multiple of earnings are we paying relative to the market for this quality business? I'd say only for the best businesses in the world would we be willing to pay like market multiples and think they could be undervalued. That would be very rare. In most cases, we want businesses that are trading at a discount to the market, especially when the market's at over 20 times earnings like it is. So that's the framework we use to think about.

[00:18:42] And we'll talk about what fair value multiple should be and put a number out there relative to normal earnings power. And again, it's going to be based on growth rate, quality of the business. And again, that means the predictability of the business. And this may be a little bit tricky to answer, but do you have any sense of where some of the best performers have come from? Have they come from the names with more variability in earnings or have they come from the names with more consistency in earnings? Or is it not?

[00:19:10] Maybe it's split down the middle and it's about the price that you pay. What would you say to that? I'd say we've made money in stocks that have lower quality ratings. I'll give you an example of one. I'd say the highest hit rate is when we get the quality rating is good and the valuation is really compelling. That's kind of like the, it's really hard to lose when you get that. Those are harder to find. But when you get that, that's when we want to go big. When the quality rating is lower, you want a bigger discount. So we've made money on both, but I would say the hit rate, the hit rate tends to be higher

[00:19:40] when the quality rating is higher. Maybe the upside return, if you get it right, can be higher when the quality rating is lower. So a good example would be in 2022, there were, we owned a fair amount of European banks. And we had a European bank that was about an 18 billion euro company and it reported earnings and it traded for, it was trading at 10 times what it just reported for that quarter. So two and a half times, no earnings, two and a half times actually current earnings, which is about close to normal.

[00:20:09] And it announced they were going to return $16 billion worth of capital over the next four years to shareholders. Again, the market cap was 18 billion. So kind of a stunning value. So it's a European bank. It's not a business that should trade at a high multiple. It's not a business that scores really well on the quality, but it was trading for two and a half times normal. And they were going to give us most of the capital back in four years. And so that was kind of a, those are the kinds of opportunities you want to look for when

[00:20:36] you're, when you're, you know, when you're looking in the kind of lower quality bucket. Again, we want to be flexible. Like we want to be willing to look for all kinds of the great businesses. And we want to be willing to look for the European banks if they're at a discount to what they're worth. On the issue of projecting into the future, when you're thinking about your valuations, one of the things I've thought about a lot recently is this idea of because these huge firms and because of technology have grown at rates, maybe you would not have seen in the past.

[00:21:05] Like, do you, how do you think about mean reversion of growth rates with respect to that? Because it does seem like a lot of us that are like me who are more traditional value guys have thought like these firms can't grow at these rates and they've continued to grow at these rates. So I'm wondering, how do you think about that when you look at valuation? Yeah. You know, I covered tech as an analyst. That's where I, that's where I spent most of my time at our firm as an analyst. And I think mean reversion is a great approach for some industries, you know, for banking, it makes a lot of sense.

[00:21:33] You know, for energy, it makes a lot of sense. For other industries, it makes sense. For things like technology, they're not really mean reverting. I mean, for service industries, they're not really mean reverting. Meaning like if your product falls out of favor, it just falls out of favor and dies. There's no law that says that business has to come back. And then alternatively, some of these businesses that have become, you know, almost monopolies, winner take all markets. Those are really powerful businesses.

[00:22:00] And while there is competition and you have to think about competition and not all of these big tech companies, I think are as good as some are, you have to differentiate. There are some that just are insulated from competition right now, it looks like. And so they just are powerful businesses. Now, I think we'd be willing to own those if the prices were unfortunately in the market environment today. People are just paying very high prices for those kinds of companies. And so they're just, it's just not very interesting for us. That makes sense. Yeah.

[00:22:29] It's something that is a total an aside, but it's something I've thought about a lot because, you know, if you look at the history of the S&P 500 and you look at the 10 largest companies by decade, they almost always change a lot. And I'm kind of thinking going forward, like, will they change? You know, do these companies have an advantage that's different than the past or am I just looking at it the wrong way? You know, I'm looking at this new technology and saying what everyone would have said at those times, which is these companies are clearly going to be, you know, the leaders forever. Yeah. I mean, I think there will definitely be significant change. Could there be some that have longer lasting power?

[00:22:57] Kind of looks that way just based on the quality of the business. But I think for sure I would expect change in the coming decades. When you're looking to sell a position, how do you think about when to sell? Yeah. So, um, so at a high level, it's pretty, you know, it's pretty straightforward. First would be we sell when it gets to fair value and that can happen because the stock went up a lot or it can happen because we just changed our assessment of what it is.

[00:23:23] And we realized we made a mistake and stock's not as, as worth as much as we thought. Could be because we get a, or it could be because we get a better idea. Now I'd say there, when you're thinking about selling when a stock gets to fair value, there can be a bit of an art to that, but I think we've learned over time. And that is when you get a business that is, you know, we'd say like reverting or business that's improving. So we invested in this company. We thought the company was very good, but it was really under earning what it should do. And things start to improve.

[00:23:53] Sometimes you'll be surprised at how much better they get than you originally kind of forecast. And so what we found in some cases, again, it's usually when the business quality is pretty good. When things start to get better, you want to be patient because you'll find out that things are a lot better than I could have imagined. And the tendency can be, oh, the stock is up 50%. We got to sell. I mean, that was our original target, but maybe things are much better than you would have thought.

[00:24:18] So you want to be patient when businesses that are high quality start to see the improvement that you expected. Be patient is one thing we've learned. When you add the positions, do you think typically throughout history, you're more likely to add to a position that's down? So something that's down where you still believe in the business or are you more likely to add to winners? Yeah, we're more likely to do the opposite, which is to add to businesses that are down.

[00:24:43] I think, again, if you go back to, we talked about our culture, our culture is just to be contrarian. And so if we like something and the stock goes down, I think there are some investors who think, oh, the stock's going down, it's not working. I got to get out. This is not how we think. The way we think is, oh, we liked this business and it got a lot cheaper, so we should like it a lot more. That is our natural reaction of the people on our team. Now, we obviously want to make sure that we're reevaluating the situation and we have

[00:25:10] processes to do that to make sure we're not falling in love with a stock and that things really have changed. So we want to make sure that our investment thesis still holds. But if it still holds and the stock goes down, we obviously want to buy more. I think there can be situations where it makes sense, obviously, to buy a stock that's up and we want to be open to doing that too. I think we've done that less, but there can be those rare circumstances where I think that makes sense to do for sure.

[00:25:40] How do you guys come up with ideas? So you have to, obviously, you're doing a lot of deep work on every company you invest in, but then you think about the thousands of companies that are out there. How do you think about getting those thousands of companies down to ones you should actually take a look at? Yeah. So a lot of it is the analysts who have, again, I mentioned 19 years experience that are hunting around. I mean, they're meeting with hundreds of companies every year. They're hunting for ideas. A lot of them, we cover our industries globally, so they know a lot of the companies globally in

[00:26:10] their space and they have views on a lot of them. So a lot of them come that way. And then we have a lot of different screening tools we use to try and look for ideas where the analysts might not see it. And each of our, we organize our group by sector teams and we've got six of them. And each of our sector teams has their own sets of screens that we use to try and look for ideas. And we kind of meet every two weeks to look for idea, to talk about ideas and track our ideas. And we keep track of every idea we get and what our decision is and why.

[00:26:39] So, but I do think a lot of them, you know, one of our advantages is again, having this team that's been together a long time and people who are really deep. We believe in being specialists by industry. And so these specialists have a deep experience in their industries and a lot of the ideas come from them. Most of your strategies and correct me if I'm wrong here. Most of them have multiple portfolio managers on them. So it's not just one person running the, you know, the portfolio. There's multiple.

[00:27:07] So how much of it is like ideas are presented and then it's a consensus type approach or is it like each manager sort of has their sleeves and manages it that way? No, it's a consensus. So the way we do, the way we work is all research is presented in, into teams of like six to eight people and the PMs are embedded in these teams. And what we like about those teams is everything that goes into one of our portfolios is vetted by one of those groups.

[00:27:36] And, um, and so, uh, and those teams kind of stick in their industry groups. So they build expertise. And so the teams vet it, the teams come to agreement on some of the key metrics I've talked about valuation and then the quality balance sheet governance ratings. And then it's up to the PM teams to take the output and build portfolios. And so ultimately we are a team oriented approach. That's what we believe in, but the PMs build the portfolios and whether there's two or three of us, we have to kind of, we have to work to agreement.

[00:28:05] I think each of the PMs comes with different experience. You know, they've worked in different industries. I covered tech people I work with have covered different industries. And so, um, we do bring different strengths, different experiences, but we, we try to work to, to come to agreement. I want to circle back to passive investing, which you mentioned at the beginning, because this is something we've talked about a lot in the podcast. This idea that as passive investing grows, we've got more people systematically adding money to, from their 401ks into market indexes.

[00:28:32] You could make the argument that that is driving up the biggest companies relative to the other companies in the index based on something that has nothing to do with valuation. And I'm just wondering, do you, do you have any opinions on that? Yeah. I think the best example for that is when stocks get added to the, you know, that the passive investing is having this impact is that when stocks get added to an index stock gets added to an index and the stock gets analysis being added. The stock goes up. Everyone's going to buy more. It doesn't really make any sense, right? Like why it's not worth anymore. It just happens to be added to the index.

[00:29:01] And then of course, because the stock is out, the index now has to buy even more of the stock. And so, um, I think that's just the best example I can think of to talk about how indexing is impacting the broad market. I think obviously indexing makes a lot of sense for some folks. It makes a lot of sense when it's a smaller part of the market, as it becomes a bigger and bigger part of the market. Um, you know, we worry that it crowds out, uh, folks like us, but I, again, I think it

[00:29:29] creates the opportunity, uh, for people like us who are willing to, to take a long time, uh, horizon when we're investing in stocks. That's actually what I want to ask you. So do you think one of the arguments, I guess, with this is you could say this creates opportunities for long-term investors, but maybe you have to lengthen your timeframe a little bit in terms of how much you want to, you know, get paid on what you're doing. Like, do you think about it that way? We don't really think about it that way. I know I've heard other investors talk about it. You know, I think our time horizon was always pretty long.

[00:29:54] So if you think about what we talked about, we're, we're really, you know, the opportunities are created because a good business, something's going on with a good business. That's got the market, you know, spooked to the markets really focused on what's going on right now. It could be because people are worried about the macro environment and that might hurt earnings for this stock, or it could be there's an industry down cycle. Um, and that is pressuring earnings right now, or it could be company specific. And so that's what the market's focused on.

[00:30:22] And what we're thinking is, Hey, if you're willing to look three years out or even further, there's reasons to believe, um, that this business, uh, is going to earn a lot more than it is now. And we're getting maybe a business that not only is that a low multiple of current, it's at a really low multiple of long-term normal. So we were always thinking three years plus in terms of time horizons. And I kind of don't think our philosophy has changed in that way. You mentioned something earlier that gets at this next question, which is this idea that

[00:30:50] you have people at an analyst day and there's maybe two or three other people there. This is something David Einhorn brought up, um, in a podcast he was on, which is he, he was talking about this idea that in small cap companies he's investing in, he doesn't think people are paying attention like they used to. And so it makes it difficult for them to go up when there's positive news because there's just nobody paying attention. And he's kind of argued he's focuses more on companies that are returning capital directly to shareholders because he's not thinking about multiple expansion as much as he used to because of this lack of attention. I mean, do you think there's anything to that?

[00:31:19] Yeah, I, I think I totally agree with him. I gave it a couple examples, but you know, our analysts will go to analyst days and there's nobody there for stocks we like. And then there's thousands of people on the deep seat in video calls. So they're just not paying attention. Um, and when we think about, you know, a lot of people will ask us, Hey, do you need a catalyst or do you need, how are you going to unlock the value of no one cares? And I think that's kind of missing point, which is really what you need for a stock to work is a few things.

[00:31:47] You need to be right about the valuation and you need to be right about the kind of the quality and the future of the earnings. I mean, those two go hand in hand, but you need to be right about that. Like, Hey, I'm buying it at X and I think earnings are going to be this over time. If you get that right. And then you get the governance, right? Meaning management team is aligned with you. Then you don't really need anything else to go. I mean, if the stock, if the market doesn't recognize what you recognize, the management team also recognizes it. Management team can take advantage of that low multiple.

[00:32:16] They can pay you a huge dividend. They can buy back a lot of shares every year. So earnings grow every year. If the multiple goes down further, they can buy back more shares. So the earnings grow even faster. So I think ultimately all you need is to get the valuation right. And that means, you know, incorporates the quality of the business and the growth rate and all that. And then you need to get the governance right. If you get those two things right, you don't need catalysts. You don't need to worry about that kind of thing. Do you think this sort of gets back to something I asked before, but do you think we're in more of a winner take all type situation?

[00:32:45] It's just interesting to me, like as someone who runs a value strategy, like, do you think in various industries you look at them, you could definitely argue it in tech, but in various industries due to what's going on with tech and a bunch of other things. Do you think like the leaders have a bigger advantage than they have historically in terms of like being more of a winner take all type situation? I think some of these big tech companies, you have to say do, you know, Microsoft, you have to say it's kind of a monopoly in some of its markets or Google. I mean, they really have a big advantage. Not to say it can never change.

[00:33:13] Of course it could, but some of those companies do as we, as we kind of talked about, we'd be willing to own those. If the price is right today, prices are generally for these large tech companies much higher. Um, and so what that means is, uh, where we're finding the value is in more traditional businesses, you know, that I think where there is no real winner take all, uh, dynamic going on, you know, whether it's banking or energy or industrials or consumer names, there's a lot of competition.

[00:33:42] Uh, there's a lot of companies, um, the business quality is not as high as Microsoft, but almost nothing is. Um, but the valuations you're getting in many cases are, are, are more than making for the fact that, you know, the business quality is as good as some of these, some of these dominant franchises. And again, as I said before, I don't think every large market cap tech company is, is the same. They have different competitive dynamics. You have to really dig into, but I think there definitely are a few of them that you'd have to say they seem to be winner take all kind of businesses.

[00:34:11] Just one more for me before I hand it back to Justin. I want to ask you about AI because that's something I think everybody is thinking about right now from a bunch of different perspectives, but I wanted to ask about it from the perspective of the economy and the market, because you're evaluating businesses, many of which, although you, it doesn't sound like you have a ton of tech names right now, many of which will be affected in AI one way or another. Like, how are you thinking about a big trend like that when you analyze the types of companies you're investing in? Yeah. So I'd say we do like investing in tech. We do have a fair amount of tech.

[00:34:37] We just don't have, you know, we're nothing like the investment in the Magnificent Seven like the market would have nothing like that. We have some other tech names that are big investments for us. So, um, with regard to AI, you know, our, our assumption is that this is going to be something that drives real productivity in the world that it will take time. I mean, these technology waves in the past have really driven a lot of productivity in the world. Again, I think this will do the same. It's going to take time.

[00:35:04] Um, right now there's a lot of hype, obviously on AI in the marketplace. And, um, there's these, there's massive amounts of capital going into pursue some of these AI industries. And for us, we're just really generally want to stay away from making that bet. It's just, are we going to get a return on this massive amount of capital that building these AI data centers? I don't know. Maybe we will. It's hard to know.

[00:35:32] We want to stay away from those kinds of things. The opportunities we're looking at are software companies that we like the software business model. Enterprise software is generally great businesses. And there are a lot of enterprise software companies that today don't really have AI stories, but I think in the future they may, you know, um, in the future they'll have AI products that might, uh, be able to increase their growth rates. And so that's kind of what we're looking for is these businesses that right now, they don't have a lot of capex they're spending.

[00:36:01] They don't have a lot of hype around AI, but we think there's going to be an opportunity in the future for enterprise software companies to sell AI products and, um, you know, that, that might increase their growth rates. And that's kind of where we're looking. So when you look across your portfolio, I mean, do you see, you probably would say like most of the companies are not seeing too much direct benefit from AI right now. They probably have potential for the future, but they're not seeing a lot of it yet. Yeah, I think it's very small. I mean, even the software companies that we think about, can the software companies take costs

[00:36:28] out, are they going to get more efficient at, um, building software? And I think there are signs that that's happening, but it's small relative to the RD budgets of these companies. So I think it's early days and very small. How much do you think about sort of overall market valuation and where we might be in the cycle when building these portfolios, or at least in looking at what stocks, you know, you might be adding to the portfolio. So all we do all day is look at companies and think about valuation. So we think about it a lot.

[00:36:58] Um, again, I think the U S valuation is, is on the high end of things. Um, I think the quality of the companies in the market is definitely higher than it was historically. The returns are higher. So some of that market valuation may be justified, but it's still historically high. Um, but what's interesting for us is if you look at our portfolios that we measure normal earnings or current earnings, even across the portfolios, they're all in about average or even below average valuations for us.

[00:37:26] So if an environment where the market is expensive, um, you know, we're, we're looking at our portfolios and thinking they look okay. They look pretty good. They look at prices. Like we'll be able to generate good returns going forward. And so there's obviously a, a big gap between what we own and what the broad indices own. So curious with like, you guys do so much like bottoms up work. Like how would you incorporate something like the impact of tariffs into some of these?

[00:37:56] Like, do you, is it like that granular where you're looking at like, cause you guys have some international strategies, which we'll talk about, but I'm just curious how you guys kind of would approach something like that. Yeah. So we're trying to think about the long-term impact of tariffs and, um, how companies are positioned, how could they handle it? How could they adjust what's a likely impact to earnings and try to make that assessment. So in most cases, in the companies we own, there could be some impact.

[00:38:23] Ultimately, um, most of the time we think it's manageable. And when the stocks sell off, it's usually an overreaction, but, um, and we're trying to think about what it could mean, but again, it's not like what it's going to mean this quarter or what it's going to mean for sentiment, the stock it's what it's going to mean for earnings over a long period of time. And, uh, that's how we're trying to incorporate it for the, you know, the different companies that we cover. I know this is a little bit wonky, but like, does each company have a spreadsheet that has

[00:38:50] all these inputs and you guys are actually doing like adjustments to figure out like the impact of things? Definitely. Every family has spreadsheets with every company, where they, what their products are, where they do business, where they source them from, what a tariff might mean, how can they adjust talking to management about what they could do if they need to change where they do business and how much it would cost and all of those things. So, and then, you know, what the competitors look like. And so if the competitors are positioned similarly, how much of this is just passed through by the industry?

[00:39:20] What does that mean? So yeah, we're trying our best to model it as best we can. And have you started to utilize things like chat GPT or some of the other LLMs in any of your investment process and analysis? I think we're using them just like everybody else would use them to, you know, improve the way you research, uh, improve the way you document, improve the way you share information.

[00:39:44] So summarizing data before you read a paper, helping you, uh, if you have to do an internal report, maybe doing it more efficiently, you know, um, those kinds of things. Yeah. Um, that's how, that's what we're using too. Everyone's using it kind of in the same way. It's like, there's nothing breakthrough here, but, uh. No, I think it's a tool that is to make yourself better at what you do, but it's not going to change how we invest. Although one of the guests we've had on recently, he is building investment strategies, using

[00:40:13] like a consensus of chat GPT, Gemini. And was it Clyde Jacks? I think it was Clyde. Yeah. Yeah. Yeah. So time will tell if AI can actually produce winning investment strategies. Who knows? Yeah. I think there's a lot of winning quantitative investment strategies out there. So I don't doubt that others will try and use this to create that, to create winning quantitative strategies. You know, I, I, I understand that. So I mentioned that you guys run some sort of us centric strategies, and then there's a few international portfolios as well.

[00:40:43] Um, what are your thoughts? It's been a great time to be a U S investor really since the financial crisis. Um, you know, uh, U S has beat international, but do you, what are your general sort of just thoughts on that? And do you think that the U S fundamentals have been like so much better is like the price commensurate with the quality of U S. Cause that's kind of what you hear a lot. You hear it a lot, like the U S is superior from a quality perspective. Therefore it should trade at a higher multiple.

[00:41:11] And that's the reason why it's outperformed international, but that performance difference is pretty stark over the last 15 years. So do you have any just thoughts on that? Yeah. I think that there's some truth to that. Um, which is a burning growth has been better. And that's been part of the outperformance of U S stocks, but part of the outperformance has definitely been multiple expansion. And, um, for that reason, we think, uh, international stocks offer better values.

[00:41:37] And in some industries, you can look at very similar companies that happen to be one in the U S and one in a different in Europe, for example, with, I'd say very similar business mixes and very similar management teams and governance and just a much, the stocks in, uh, in the U S traded a premium. So in our, in our opinion, for those strategies where we can own both, we're, we tend to be overweight, uh, international stocks. And again, we're really bottom up investors.

[00:42:05] So we're just looking at ideas and digging for ideas. And what that leads us to is to have, uh, more international stocks and less U S stocks. We have both, but more international. And again, I'd say the, the rings growth has been better, but the multiple expansion has been significant. And is there any particular area of the world that looks the most attractive from your, I know it's, I know it's bottom up, so it's might be hard. Yeah. I mean, it's really for us, it's Europe and the UK and that's where we see the most value. Um, okay.

[00:42:35] Um, you know, we have a lot of U S investments too, so I don't want to say we don't, but, um, if you think about relative to benchmarks, at least where the, the U S market has become such a big part of the global benchmarks. Um, we are overweight Europe and overweight, the UK and underweight the U S and those benchmarks. So I would say Europe and the UK combined is, um, you know, is where we see, see the opportunities. And again, a lot of these are multinational companies. They're global companies just happen to be headquartered in, in, in Europe or the U S and

[00:43:04] I'm assuming Europe or the UK. And so, um, you know, you can find good businesses and good valuations all over the world, but in terms of absolute weight in our portfolios, it would be Europe and the UK. Well, it's interesting because a lot of S and P 500 earnings come from overseas, but yet they, they trade here. So they've gotten a multiple expansion benefit, but a lot of European companies also have businesses all over the world and they haven't seen that. So. That's right. I mean, that's, that's, that's my point is the same companies with similar companies

[00:43:34] with similar end market mix trade for discounts in Europe to what they trade at the U S and that's the part that doesn't make sense to us. Yeah. And is there any changes in the process for these international markets, um, that you do, or is it kind of the same methodology? So it's mostly the same. I think there was one big, uh, point of emphasis when you invest outside the U S and that is really governance in the U S. If you have a management team, that's not aligned with shareholders, it's not doing a

[00:44:03] good job and is not focused on creating value for shareholders. A lot of pressure comes to bear often. And that manager management team has changed and in different parts of the world, that's just not true. Um, you know, bad or management teams or governance structures that are not aligned with shareholders. They, they go on for a long time. So when you're investing outside the U S you really have to pay a particular focus on what is the, what is the governance? You know, is this a management team that's aligned with shareholders?

[00:44:32] We've made the mistake of investing in companies that traded a low valuation, but there's really no governance structure in place to return capital to shareholders to, you know, to really care about improving the business. And so we, you sit there with that's that you sit there with a stock that just kind of wastes away. That really is a value trap when you do that. So that means that when you're investing outside the U S you have to pay even more attention to governance, you have to do it everywhere, but, but you have to pay even more attention outside the U S.

[00:45:01] So what are those government? Is it like, you know, share buybacks, paying dividend? What are the things that would be high on your governance checklist? I mean, the number one thing is, are they aligned? You know, so when you look at their compensation, is it aligned with creating shareholder value? When you look at, do they have an independent board? Uh, you know, is it controlled by, you know, a government or is it controlled by shareholders? Um, but really you want to talk to management and understand, are these people that are motivated

[00:45:28] to generate returns for shareholders or do they have, you know, other interests, you know, other stakeholders they care more about. So this has been great, Scott. We just have two standard closing questions for you. Um, and the first is, um, what is something that you believe about investing that you think the majority of your peers would disagree with you on? Yeah. I think I, uh, uh, maybe I already said this, um, uh, again, I'm going to repeat myself.

[00:45:56] So I apologize, but it really is that I just hear so much. What is your catalyst? You know, what is going to unlock value? And for us, you just, you really don't need a catalyst. What you need is to get the valuation right. And to get the governance right. And, uh, you know, as long as the company is going to give you that cash back, you're happy. We're happy to have a low, low valuation. We're fine to set it a low PE for a long time. If the management team does the right thing, that means we get a big dividend yield and they can buy back along their shares and grow earnings really fast by doing it.

[00:46:26] So, um, that's the number one thing I see. Um, people talk a lot about where I, why I don't agree with it. And the last one, based on your experience in the markets, if you could impart one piece of wisdom to your average investor, what would that be? You know, I think a lot of people get caught up in sticking to like, Hey, I've got my one philosophy. I I'm a, I'm a low PE investor, or I'm a, I like to invest in fast growth companies, or I like to find the highest quality. And that's what I want to invest in.

[00:46:54] Um, I would say what you want to be is you want to be flexible as an investor. And, um, you know, I, I live in Los Angeles now, but I, I grew up in the Boston area and I'm a Boston sports fan. I'm a fan of the New England Patriots and our longtime coach, Bill Belichick. He had a way, if I was going to use a sports analogy, there were a lot of football coaches that their focus is, um, you know, their, their belief is I want to have a power run game or I want to have a passing game.

[00:47:21] And that's the, the offensive philosophy I believe in his approach was, I want to be flexible enough to run my offense based upon what the defense gives me. So if the, if it, if this week calls for power run game, I want to be able to do that. If next week calls for a passing game, I want to be able to do that. And I'd say that kind of flexibility, that's, that's how I would think about being an investor. You don't want to just say only buy the lowest PEs because that might not make sense.

[00:47:50] If you could pay up a little bit for a great business, that's what you want to do. So you also don't want to say I only buy the fastest growing businesses because you might pay too high a multiple for those companies someday. Like I think you're doing now. So I'd say you want to be flexible and incorporate the PE, the value and the quality, excuse me, the PE, the growth rate and the quality into any investment decision you're making. And so that's what we try to do. We try to be flexible enough to incorporate all of those things into our investment decision making. I'm a Jets fan.

[00:48:20] So unfortunately I've been on the other, the other side of Belichick's flexibility for a long time. It hasn't gone well for me, but yeah, unfortunately. Great little, great little football analogy to, to close us, close us out here in just a few days before the Superbowl. So any, go ahead. Any, anybody you want to, Scott, you want to take a prediction on the winner of the Superbowl? I'm going to, I'm going to, I'm going to root for the Eagles. So I'll say the Eagles, you know, but I don't really want the Chiefs.

[00:48:49] Chiefs have been a great team, but I'd like to see somebody else win. So I'm going to go with the Eagles. I'm going with the Eagles too, but I've got a house full of females that are rooting for the, for the Chiefs because the Taylor Swift. So most of us have that. So, all right, listen, thank you very much, Scott. Really enjoyed it. Thanks very much for having me on your show. Thank you. This is Justin again. Thanks so much for tuning into this episode of XS Returns. You can follow Jack on Twitter at practical quant and follow me on Twitter at JJ Carboneau.

[00:49:19] If you found this discussion interesting and valuable, please subscribe in either iTunes or on YouTube or leave a review or a comment. We appreciate it. Jack Forehand is a principal at Validia Capital Management. Justin Carboneau is a managing director at Life and Liberty Indexes. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of clients of Validia Capital. Have a great day. Bye.