Redefining Moat Investing with Yuri Khodjamirian

[00:00:00] Welcome to Excess Returns where we focus on the long term in the markets.

[00:00:03] Join us as we talk about the strategies and tactics that can help you become a better

[00:00:07] long-term investor. Justin Carbonneau and Jack Forehand are principals at Illidia Capital Management.

[00:00:10] The opinions expressed in this podcast do not necessarily reflect the opinions of Illidia

[00:00:13] Capital. No information on this podcast should be construed as investment advice.

[00:00:16] Securities discussed in the podcast may be holdings of clients of Illidia Capital.

[00:00:18] Hey guys, this is Justin. In this episode of Excess Returns, Jack interviews Yuri Kajmerian,

[00:00:22] CIO at Tema ETFs. Yuri explains how Tema's approach to identifying modes is different from

[00:00:27] the traditional methods as they look for companies with dominant market share, tangible assets,

[00:00:32] and long-term durability of returns. Throughout the discussion, they delve into the various

[00:00:35] types of modes such as economies of scale, strong network effects, non-replicable physical

[00:00:40] assets, regulation, and high switching costs while also discussing how these advantages apply

[00:00:44] to different industries and how to evaluate potential risks to a company's mode. Yuri

[00:00:49] also shares insights on the firm's investment process which blends quantitative and qualitative

[00:00:53] analysis and how they construct portfolios of these high-quality companies. As always,

[00:00:57] thank you for listening. Yuri, thank you for joining us. Hi Jack, nice to meet you. Hello.

[00:01:02] Nice to meet you as well. I'm really excited for this topic because this is a topic a lot

[00:01:07] of investors spend a lot of time thinking about. It can also be a very challenging thing

[00:01:12] to do. What we're going to talk about today is the idea of modes and durable competitive

[00:01:16] advantages. What I like about what you guys are doing at Tema is you found a unique way to

[00:01:21] do this. There's been some traditional ways people look for these mode type companies

[00:01:25] and you found a very different way to look at it. I think it's really interesting,

[00:01:28] so I'm excited to dig into it today. Yeah, I'm also excited. Look forward to jumping in.

[00:01:34] Before we start, I want to get back to what I just said which is the idea that

[00:01:38] a lot of people are spending a lot of time trying to find these companies that have modes.

[00:01:42] I want to get into why. What are the advantages of investing in these types of

[00:01:45] businesses that have modes or durable competitive advantages? Yeah, so look, I think what a lot

[00:01:50] of people are looking for ultimately is quality companies. Quality companies often have high

[00:01:57] returns on invested capital. The beauty of high returns on invested capital, as one

[00:02:02] great investor once told me, is it does your work for you. A company that has high returns,

[00:02:08] if it can just compound that over long periods of time, well then as an investor,

[00:02:13] you just reap the rewards in terms of the rising equity value of that business.

[00:02:17] It's a holy grail of investing, if you will. Modes are effectively a way to defend that high

[00:02:24] return. Essentially what you get is a set of companies that have high returns on invested

[00:02:30] capital but also have durability and high visibility of those earnings. It makes them

[00:02:35] these beautiful sleep at night type stocks which everyone is out there hunting for.

[00:02:41] And so often what people, when they're trying to say a mode, they're saying defendable high

[00:02:47] returns, high profitability. The other thing is, as we all know, it's like having extra

[00:02:52] money in your pocket. So if you have high profitability, high margins and things like that,

[00:02:57] it's just easier for you to invest in the future,

[00:03:00] defend off competition, it gives you more breathing room as a business.

[00:03:04] And how do you think, before we get into how you think about this a little bit differently,

[00:03:08] what do you think the traditional definition of a mode is? Traditional funds or investment managers

[00:03:14] who try to find companies with modes, how do they do that and how does what you're doing

[00:03:18] differ from that? I think the definition originally,

[00:03:22] if you probably ascribe to Warren Buffett, you talked about this idea of a mode.

[00:03:28] It's a really nice concept. It's this idea that there's this bit of defense that sits

[00:03:32] around the castle of the company. But I think the traditional definition is really just

[00:03:37] barriers to entry of any competition into a particular industry or company.

[00:03:41] And what happens is you have high returns and if you can kind of fight off that competition,

[00:03:46] you can keep those returns higher than the average cost of capital for a long period of

[00:03:50] time and almost beat the fate if you will. Because competition is the force that gets returns

[00:03:56] to come back down to their cost of capital. So if you can find a way to keep it at bay,

[00:04:00] that's what a mode does. So that's the kind of broad traditional definition.

[00:04:06] And in terms of kind of where we're different, I think it's getting more and more understanding

[00:04:12] of what a mode is and its nature. What is really interesting when you start studying this

[00:04:18] and spending time looking at these types of companies is not all modes are the same.

[00:04:23] And that's the bit that probably gets skipped all of a sudden because people

[00:04:26] think it's such an attractive concept. I'm just going to jump in and whatever

[00:04:30] mode there exists, that's what I'm going to invest in. But the truth is there's

[00:04:33] lots of elements that need to be considered that make modes better than the traditional definition.

[00:04:39] And I would think we're going to get into this in a second, but I would think in the

[00:04:41] world of technology, now that technology plays such a huge role in our economy,

[00:04:45] that sort of changes these types of protections businesses have versus what they did back in the

[00:04:50] day. Yeah, exactly. And so we're always looking for types of specific bits of mode

[00:04:58] that if you kind of work them all together, you create a much better subset of mode

[00:05:01] companies. So we're looking for dominance. So companies that have high market shares,

[00:05:05] a lot of traditional mode definitions, they don't really look at market share. They consider

[00:05:12] this a little bit of a sideshow if you will. If you look at some of the announcements that

[00:05:16] Pat Dorsey has done, they say having high market share is not enough and certainly isn't

[00:05:20] enough, but it's a very important feature. And often you have to start with that,

[00:05:24] which is one of the way things that we look at in our shunt. The second bit is this

[00:05:28] point you're talking about technology and what we're focused on is tangibility of that mode.

[00:05:33] The way the economy and the stock market has moved on is that there's this idea that

[00:05:38] modes, intangible value and brands and technology are the real powers of the

[00:05:44] economy right now. And what we're saying is we're sort of trying to go back to

[00:05:47] the old definition of modes. We're looking for real hard, tangible things that you can

[00:05:52] kind of hang your hat on as an investor. And finally, where we sort of are different

[00:05:56] is about the durability. We start by looking at durability and what a lot of investors tend

[00:06:02] to start with when they think about modes is they think how wide a mode is and really how

[00:06:06] wide is the RYC versus WAC. And they think that the wider it is, the longer it will take

[00:06:12] for it to fade. But the truth is what you need to do is use a start by thinking about

[00:06:16] the durability of that particular mode. It doesn't really matter how wide it is because

[00:06:20] compounding is this powerful effect. If I can find just a slim advantage that lasts for a

[00:06:24] very long time, you're actually better off doing that than looking for something that's really

[00:06:28] wide that might just fade over time. And so if you combine those three things together,

[00:06:33] you start to think, okay, that's a different definition of modes. It's more real,

[00:06:37] it's more tangible. It's more about dominance and tangibility and durability of those modes.

[00:06:43] And we can obviously talk about technology as an area where this can be applied.

[00:06:47] So you have a great presentation here you're going to give. And one of the first things

[00:06:52] we're going to look at is this idea of the different types of barriers to entry.

[00:06:55] Because I think this really gets at this idea of defining modes a little bit differently when

[00:06:59] we think about the different barriers to entry that you look at. So I want to go through each

[00:07:03] one and maybe talk about what it is and also maybe some examples of the types of companies so

[00:07:07] people can understand what it is. And the first one is economies of scale. So how do

[00:07:11] you think about that? Yeah, absolutely. I mean, the premise here is that all mode investing

[00:07:16] starts with understanding what are the different types of barriers to entry that exists in

[00:07:19] different industries and different companies. And they're classically a bunch that get defined.

[00:07:24] And we've tried to narrow it down to this set that we think is going to be the most

[00:07:27] powerful in terms of those elements that I talked about, tangibility, dominance,

[00:07:31] and durability of those modes. So economies of scale. I mean, look,

[00:07:35] this was the idea that you can manufacture at scale in terms of really, really high

[00:07:41] amounts of output. Effectively, the average cost of that production goes down so much

[00:07:46] that you're much better than any competitor. So therefore, your manufacturing position is

[00:07:51] very strong. And I think that is really telling with an example of the semiconductor industry.

[00:07:58] What happens in the semiconductor industry is that if you go to a single stab in Taiwan,

[00:08:03] what's amazing is that they manufacture more than any other factory in the whole world.

[00:08:08] In fact, if you take all the factories combined, the number of transistors manufactured

[00:08:12] in one fab is more than all of the things ever produced in the history of mankind.

[00:08:17] And that gives you scale, right? Even though it's down at the microscopic level,

[00:08:21] we're manufacturing so much of it, the individual cost per transistor or per semiconductor

[00:08:26] goes down. And so that's this idea that manufacturing those particular

[00:08:30] fabs gives you that advantage versus a competition. Paint is another really great

[00:08:35] example where the bigger the plants are, the more paint they can produce,

[00:08:40] the cheaper they are relative to their competitors. And they can use that extra

[00:08:44] profit to reinvest in growing or other things. And I think that's another really important

[00:08:48] element that I talked about before, that breathing room, that if you have profitability,

[00:08:52] you have these various entry and create this reading room which management can allocate

[00:08:56] to protect the business in various ways. Yeah, I was thinking about that idea of

[00:09:00] semiconductors. If you think about what it would take for companies to compete with the

[00:09:03] big firms in that area, it is incredibly massive. Even governments are trying to

[00:09:09] invest massive amounts of money to compete with them and they're having difficulty.

[00:09:12] It's just very, very challenging. Yeah, absolutely. It's probably the

[00:09:16] pinnacle of what we've achieved in terms of manufacturing as humans. There's a

[00:09:22] beautiful article written in Wired about this. And it's really understanding what has been

[00:09:27] achieved in terms of manufacturing. And even though we're manufacturing at the

[00:09:30] micro-microscopic level, some of these transistors are down to the two nanometers

[00:09:35] thighs. The idea is that you can manufacture so much of it because you're manufacturing

[00:09:40] such a small scale, that you have a massive cost advantage versus anybody else.

[00:09:44] And there are fewer and fewer and fewer people that are able to do that as every

[00:09:48] year goes by. I mean, even Intel's is dropped out of that race a little bit and

[00:09:53] it's trying to catch up. Yeah, I know it's amazing. Intel was a

[00:09:56] dominant player. I remember back when I started my investing career, Intel was a

[00:09:59] massively dominated player, but not anymore. Yeah, exactly.

[00:10:03] How about the next one? Strong network effects. How do you think about that?

[00:10:06] Yeah, so this is the idea that when you have a network, every additional person or

[00:10:14] entity that's added to that network raises the value of the network exponentially.

[00:10:19] So the best example here is a financial exchange. The more people trade on a

[00:10:23] financial exchange, the more valuable that financial exchange is for everyone that trades

[00:10:27] on it. It's the old saying in finance, liquidity begets liquidity. So the more

[00:10:32] people trade in a particular venue, the more they attract other people to trade at that venue

[00:10:38] and it raises the value of that venue for everyone. And these are beautiful

[00:10:42] businesses because they're very strongly protected by many things. But this

[00:10:47] network effect is really the reason why people coming back to companies like CME

[00:10:50] or ICE over and over again, because they know that the liquidity that they need

[00:10:54] to manage their risk programs or their investments is always going to be there.

[00:10:58] And in fact, it's getting more and more every day. And that's kind of the beauty

[00:11:02] of these businesses. The other example here is payments. If you think about the network,

[00:11:08] we all take it for granted, but Visa is available in like 135 countries and there are

[00:11:14] only 140 countries in the world. So it's everywhere. And the fact that you can walk

[00:11:19] into a shop and your car just works anywhere in the world is actually a huge thing. If you

[00:11:26] look back 40 years ago, that didn't happen. And this network that they've built over time,

[00:11:31] connecting all the different banks, all the different players is immensely valuable

[00:11:35] and creates a very, very strong position. Now again, sort of going back to this idea of

[00:11:40] this creates breathing room, but it really matters what the company does with that

[00:11:44] breathing room. If you see what Visa has done, well it's kept what its take is quite small

[00:11:50] and has given most of the economics to the different banks involved in this value chain,

[00:11:54] which creates a strong system because it said to itself, I'm going to build this network,

[00:11:58] but I'm not going to take the biggest share of this. I'm going to give that away to my

[00:12:02] partners, which will then maintain my monopolistic power, my moat for me. And

[00:12:07] which is exactly what's happening with Visa. Yeah, it's interesting. One of the things that

[00:12:11] struck me right away when you started talking about this is when people talk about network

[00:12:14] effects, they almost always go to something like the social networks. And you've gone a

[00:12:18] completely different way, which I guess gets at the idea that you're looking at this a little

[00:12:20] bit differently than other people are. Exactly. So take social networks. I think

[00:12:25] the problem with social networks is twofold. And again, we'll definitely touch on the topic

[00:12:29] of why we think some of these companies maybe don't have the moats that people think.

[00:12:34] The problem with social networks is the first is time, right? The true commodity that's

[00:12:39] available is attention and time. That's what's sitting on the other side. So it's your time

[00:12:44] looking at a particular screen versus everybody else in the world. And because they've reached

[00:12:51] maximum scale in terms of number of people that they can reach, now it's really about

[00:12:56] increasing ad-lou and all those kinds of things. But the truth is there's a maximum amount

[00:13:01] that they can reach. And that time is competed for immensely by everything else in the world,

[00:13:07] all other kinds of media, Netflix, TikTok, et cetera. And so what we find there is that

[00:13:13] that network is actually a little bit more fragile than people give it credit for because

[00:13:18] it's really hard to compete for time. And so for example, we never really think of media

[00:13:22] companies. Classically, people put Disney and companies like that in the moat category.

[00:13:28] Well, actually if you think about media companies, they're competing for that 24 hours a day.

[00:13:31] That's pretty hard to compete for. And you can break these network effects quite easily.

[00:13:36] The example I would give is TikTok. Look at its rise out of nowhere. And the dirty secret that

[00:13:42] people don't really know about is at one point in the United States, TikTok was taking 25%

[00:13:49] of all Facebook ads on iOS devices for months they were doing that. Think about that. One

[00:13:57] in every four ads was a TikTok ad. They used someone else's network to build where they are

[00:14:03] today. And that to me is a very interesting dynamic, right? So that means that their networks

[00:14:11] are vulnerable because they can be used against them. Whereas if you take like a CME or Visa,

[00:14:16] no one can ever piggyback off a CME to build a competitive CME. It wouldn't make sense.

[00:14:21] And that's these kinds of nuances that people maybe don't think about until they actually

[00:14:25] spend time looking about it and thinking about it. Is this a real network effect or not?

[00:14:29] Yeah, that's interesting. I never thought about that. But I mean, that actually is an

[00:14:31] interesting tactic. You know, just buy up all the ads on a different social network if you have a lot

[00:14:35] of capital and that's probably the exact audience you want. I mean, it probably was very successful

[00:14:38] for them. Exactly. And the reason is that you actually define the market properly. The market

[00:14:43] is attention, people's attention and their time. And everyone's competing for that. And

[00:14:48] so therefore they can use each other or piggyback off each other to go for it. Now people

[00:14:52] like Snap, for example, had a real dilemma in the boardroom. Like do you let this happen?

[00:14:56] Because that's like enabling your competitor. But in the end, the money's good, right? So

[00:15:00] you might take that. And then that's the kind of tension that you get in these businesses as well

[00:15:05] that don't exist in other businesses. So this next one is pretty far from technology,

[00:15:10] which is this idea of non-replicable physical assets. So how do you think about those?

[00:15:14] Yeah. So again, we're going back to the roots almost of what mode investing is about. And

[00:15:20] the ultimate root is the physical world, right? This idea that physical assets are really

[00:15:25] hard to replicate. And the classic example here is railroads. Right now, if you look back in the

[00:15:31] 1920s, there were like 160 railroad companies in the United States. And today there are six

[00:15:36] railroad companies, large ones. And that has happened over consolidation. But what has also

[00:15:41] meant is that the rail network that has been built in the United States is a very difficult

[00:15:47] asset to replace. It has immense value because you're never going to lay that track again.

[00:15:52] I'm not even talking about environmental, but the world, other countries urbanized,

[00:15:56] really difficult to replicate that asset. And so the companies operating on that asset or that

[00:16:02] own that asset are really valuable and have a very unique mode. And as the world moves more

[00:16:08] and more towards digital, we're starting to realize it's the physical assets that are the

[00:16:12] limiting factor and where you're starting to see this kind of modes and dominance come in.

[00:16:17] And interestingly, you say the world of technology, we often try to think of

[00:16:20] technology as relating it to the physical world where we think the real modes are in technology.

[00:16:27] So to give you an example, it can be anything. Semiconductor is a perfect example.

[00:16:32] What is the real constraint? Well, it's the physical semiconductors that you need to build,

[00:16:37] let's say AI and these infinite computing resources that we're building constantly.

[00:16:42] That's the real constraint because it's the physical constraint versus the digital

[00:16:45] unconstraint. Or take a company like Intuit. They do tax preparation software,

[00:16:52] but the real beauty of it is that it's grounded in kind of a physical world of what the real tax

[00:16:58] system is like. And that's people, that's offices, that's kind of paperwork.

[00:17:03] And what we're seeing is that they have a big kind of service business that underlies it.

[00:17:09] Most people see Intuit as a software business, but in fact, you need all of that support and

[00:17:13] service. And that's a physical asset that's difficult to replicate because it's about

[00:17:17] knowledge, it's understanding of the local, each state has its different tax laws, etc.

[00:17:22] And so when we're thinking about like, both for a type of investor, we're thinking,

[00:17:25] is there some sort of real world that I can attach it to that gives it more power and

[00:17:31] more mode? Yeah, I was thinking about railroads. And this may not be a great example,

[00:17:35] but I just think about any time anybody in the US has tried to do high speed rail,

[00:17:39] it has not gone well. And it's been a very, very difficult thing to do to come up and start some

[00:17:43] sort of new railroad type project like that. Yeah, exactly. And it's because you'd be crazy

[00:17:48] to build new tracks. And it's immensely expensive. You think about the environmental,

[00:17:53] just even the land acquisition costs, the value of land is going up so much,

[00:17:56] it's very difficult to build track to where you want it to go. Right? Obviously, if you're

[00:18:00] building it across a cornfield, that's something, but that's not going anywhere that you need to

[00:18:03] go. It's incredible. I mean, the company on the screen here is, you know, one position are fun.

[00:18:09] They're the first ever in the history of the United States to connect all four corners

[00:18:15] of the US and Mexico together and Canada. So effectively, it's got all ports on each side,

[00:18:21] and it's all goes all the way down to Mexico. And it's the first time we've had a North to

[00:18:25] South network under one single operator, which is just very powerful, right? As things

[00:18:32] progress in the future, connecting a whole continent together.

[00:18:37] How about this next one? This could probably be a very strong barrier, this idea of regulation.

[00:18:41] Yeah. So regulation is again, it's kind of double edged sword as we'll get,

[00:18:45] and we'll probably discuss, but regulation provides effectively what are called natural

[00:18:48] monopolies. So the government writes a set of rules and it says, okay, these are the rules.

[00:18:53] And certain companies have the, I guess, almost the license to operate under that regulation.

[00:19:01] And because that regulation is often immense and keeps getting more and more complicated,

[00:19:06] creates this barrier to entry for these companies. The other thing to think about

[00:19:10] in regulation is things like patents as well, which is a form of regulation. It's an idea of,

[00:19:14] can we give you protection around your business to repay you for the innovation

[00:19:18] that you've done? So some of the example of companies here are, you know, pharmaceutical

[00:19:22] companies, which have patent protection. But if you take a company like Thermo Fisher, right?

[00:19:26] They, the, I mean, people probably don't appreciate how much regulation goes into

[00:19:33] manufacture biological substances. I mean, it's under FDA review. The plant needs to be

[00:19:40] super clean. It's literally pages and pages of paperwork that you have to complete.

[00:19:46] And all of these create a barrier to anyone who wants to enter that business.

[00:19:49] Like it's incredible really. And that's the kind of thing that you see in some of these

[00:19:55] sensitive areas where the governments have had to step in to protect consumers,

[00:19:59] but equally gives the power to the companies as well.

[00:20:01] Yeah. Regulation is always interesting to me. And you're kind of seeing it,

[00:20:04] we're getting back to tech again, but you're seeing a little bit in the tech space now.

[00:20:06] A lot of these large tech companies are very anti-regulation for a very long time

[00:20:11] until they get a dominant position. And then they're very pro-regulation because

[00:20:14] they know their competitors won't be able to catch them. And we'll probably see that

[00:20:17] in the world of AI as we go forward. We probably will see that the dominant players

[00:20:21] will probably change their position in terms of how they view regulation.

[00:20:24] Yeah, exactly. You don't need regulation when you're trying to build, but when you're

[00:20:28] trying to maintain your moat, it's a perfect source of barriers to entry.

[00:20:34] We've seen that so much with these large technology companies. Regulation,

[00:20:40] it's a term in industrial policy called regulatory capture. They almost capture the

[00:20:44] regulation and use it as their advantage. And what we've seen definitely in Europe,

[00:20:48] which tends to be a bit more heavy-handed on regulation than in the United States,

[00:20:52] every time a piece of legislation goes out, it just strengthens the position. It's a bit painful

[00:20:55] to begin with, but it just means that no new entrant can come in and build up the power

[00:21:01] that these companies have created already. How about this last one? High switching costs.

[00:21:05] How do you think about that? Yeah, again, so very simple idea,

[00:21:09] right? The idea that switching something out is really, really expensive. And it can be

[00:21:14] expensive in terms of money, but it can also be expensive in terms of time and productivity

[00:21:19] to really switch from one competitor to the other. And the best example here is aircraft parts.

[00:21:25] The fact is that if you're voeing or Airbus and you're building an airplane,

[00:21:28] switching the smallest screw out of a program is, again, reams of paperwork, lots of extra costs,

[00:21:36] redesigning the whole thing. And that is very, very expensive relative to the cost of that

[00:21:42] screw and the advantage you might get by getting it maybe a cheaper competitor.

[00:21:45] And so what you get often with aerospace is these very long product cycles where once you've been

[00:21:52] designed into a particular aircraft, you're probably never going to get designed out.

[00:21:57] And there's really no amount of money that it would cost for you to be able to switch to

[00:22:01] a competitor until you get to the next program. Again, it talks again to my point earlier,

[00:22:05] which is that position gives you lots of profit, which you can then reinvest to get

[00:22:10] into a really good R&D position on the next program. And that's the beauty of these

[00:22:15] businesses. They have this breathing room to be able to keep keeping their position.

[00:22:21] Data providers is another great example. Once you've integrated Bloomberg or S&P into your

[00:22:27] work process, ripping it out is extremely disruptive. So it creates this beautiful

[00:22:32] recurring revenue stream for these companies that often only really get changed if there's

[00:22:37] some sort of change going on in the industry. But that really is very rare.

[00:22:43] That data provider one hits home for me because we're quant investors,

[00:22:47] so everything we do is based on data. And having done it in the past, when you have

[00:22:51] to switch your data provider, it's a big deal. You know everything about your data provider,

[00:22:55] where you need to clean the data, where you don't. You know everything about how it works

[00:22:59] and then you switch and it's quite a shock to the system.

[00:23:02] Yeah, exactly. And so the barrier for you to switch, meaning the benefits that you have

[00:23:07] to get, they're going to be immense. And that's why it's difficult for competitors.

[00:23:11] They're waiting for this entry point, right? Maybe there's a merger or you know, you guys,

[00:23:15] you decide to launch a new product and you're thinking about using a different data provider.

[00:23:19] That's really hard to hunt for and creates this revenue stream for your data provider

[00:23:23] that keeps them there. Now you have some companies that milk that and just sit on that

[00:23:28] and don't invest and build and improve the product until they, you know, their bet the

[00:23:32] benefits of switching suddenly get worse or, you know, get better because competitors have

[00:23:37] invested against you. And so the best companies like, you know, your S&P globals or whatever,

[00:23:42] they take that money and they reinvest in building new products so that you're always

[00:23:46] ahead of the game and really just creates this perpetual monopoly in these places.

[00:23:51] This next chart is really interesting to me because you're looking at different

[00:23:55] competitive advantages and what makes them strong. And on one axis you have the

[00:23:59] durability of the returns and on the other axis you have how competitive it is.

[00:24:02] Can you just talk about what we're seeing here?

[00:24:05] Yeah. So, so I get this goes back to this idea that mode investing is so attractive and it's

[00:24:10] it's a concept that was popularized by Warren Buffett, but actually you need to really dig deep

[00:24:15] and figure out which modes are better than others. As one of the ways we try to present

[00:24:19] this is in this graphic, graphical format, which is start to think about all these different

[00:24:24] dimensions of modes and to see that they're not all made the same. And so what we've done

[00:24:29] here is kind of put two axes, kind of one axis is the sort of level of competition that you're

[00:24:34] seeing relative to each other, all these different industries. And the other one

[00:24:38] is really about the durability of the returns. This concept that I said we always start with

[00:24:42] that. We always think how durable is this business and its returns versus companies

[00:24:48] where the durability returns less. And then we try to plot industries across this.

[00:24:52] As what you can see is that what we are trying to do is we're trying to look for

[00:24:55] companies where there's less competition or industries, there's less competition,

[00:25:00] that there is kind of big competitive advantages, but also where the returns

[00:25:04] are a lot more durable. Companies that we discussed before like data providers and

[00:25:08] railroads, that's where they live. If you think about what you maybe don't want to

[00:25:12] invest in, but it's still in many operations considered to be a mode, especially like

[00:25:17] e-commerce or social media, where the returns are probably not as durable as people think

[00:25:22] and the areas are a lot more competitive. Often these gets supplanted by this idea of brands,

[00:25:28] which is what's supposed to carry you through this. Take for example media. Media is all

[00:25:34] about brands. But the truth is brands can also be broken and they seem less competitive,

[00:25:40] but they're actually a lot more competitive than people give them credit for.

[00:25:44] And so what we're trying to do here is show this graphical presentation that

[00:25:47] even though you might think some of the companies in pink here are

[00:25:52] mode companies, actually once you start looking under the surface, it can become a lot more

[00:25:57] difficult and there are better businesses to invest in if you think about other dimensions.

[00:26:01] One of the things that struck me right away with this chart is this idea we talked about

[00:26:04] before with technology that almost everything related to technology is pink here. It really

[00:26:11] sort of spells out what you've been saying all along in terms of these technology modes

[00:26:14] may not be as strong as many people think. Yeah, exactly. And I think if you look at the

[00:26:18] history of technology, it's about disruption. But I think what's happened maybe since the advent

[00:26:24] of the internet and PCs is that the disruption happens in much longer cycles and it's a

[00:26:32] complete paradigm shift of how computing gets done. So if you think about how we went from

[00:26:37] the PC era to the mobile era and how the players that have won in the mobile era,

[00:26:42] Android, Apple are completely different to the ones that were winning in the PC era.

[00:26:46] If you go back to the 90s, people would have looked at Dell and Microsoft and Intel and said

[00:26:51] that's going to be forever. These are strong companies. They have the best distribution,

[00:26:55] the best technology, the best people. And lo and behold, once the mobile era came in,

[00:27:00] Microsoft was nowhere in the mobile era to begin with. Intel was nowhere in terms of

[00:27:04] mobile chips. It was splattered by ARM and Dell was nowhere there. It was Apple

[00:27:08] and manufacturers that were using the Android ecosystem to build mobile phones.

[00:27:14] Now we're probably entering another era of that kind of paradigm shift, which is AI.

[00:27:18] It's the idea that where are we going here in terms of could this completely change the kind

[00:27:23] of devices that we're going to start to use? So if you went to CES this year, you would

[00:27:27] have seen lots of interesting devices where it's just an AI assistant on a little box.

[00:27:33] Could that be the thing that disrupts Apple? Who knows? But that's what the history of

[00:27:37] the technology business is about. It's almost like the rug gets pulled under them and suddenly

[00:27:43] they have to figure out how to live in a completely different world. Whereas if you're a

[00:27:48] financial exchange or medical technology company, that doesn't happen as much.

[00:27:53] These things, these paradigm shifts don't happen. And that's why we always think

[00:27:58] technology is way more competitive than anyone gives it credit to.

[00:28:02] That's not to say there aren't areas that are less competitive than others,

[00:28:05] but that's kind of our general position. In researching your strategy before we talked,

[00:28:09] I noticed you mentioned this idea of cashflow ROI a lot. Why is that important to you?

[00:28:20] We talk about monopolistic businesses or strong mode businesses. And when we talk about that,

[00:28:25] what is the benefit of this business financially? It's all well and good to talk

[00:28:30] about the qualitative side of modes and analysis of modes. But once you've determined

[00:28:34] the companies that have tangible, durable, dominant modes, what am I going to get as an

[00:28:40] investor? Well, really where you're going to get is this high cashflow return on investment.

[00:28:46] We focus on cashflow because that's the ultimate metric. It's difficult to manipulate.

[00:28:51] It's very easy to understand. It's the cash that comes into the business every year

[00:28:55] relative to the investment that's been put into that business. And it's just ideas.

[00:29:00] You know, the quote says here is it's about consistent value creation over time.

[00:29:05] So if I find a business that has a wide mode like the ones put here,

[00:29:11] they tend to have a high return on industry capital. But to make those a good investment,

[00:29:18] and this is where our approach is slightly different, you need that to sustain for a long

[00:29:23] period of time. This is why I spend most of my time thinking about the durability,

[00:29:26] the tangibility of that particular advantage. And the reason you need it to sustain for a long

[00:29:31] period of time is, and I'm sure we'll get onto this topic, is that also the market's not stupid.

[00:29:36] It can see the high returns on invested capital in these companies. And the only way

[00:29:41] share prices go up is if they consistently beat expectations. The idea is how do you

[00:29:46] invest in this company that has high return on invested capital and get it to beat

[00:29:50] expectations over a long period of time? Well, you invest in one that is very durable.

[00:29:54] That's the idea. And really, it's as simple as that. I buy the subset of the wide mode portfolio

[00:30:00] companies that have higher cash flow returns on invested capital, that have tangible,

[00:30:05] durable dominant modes. And then I sit back and kind of hopefully enjoy the returns from

[00:30:10] these companies if I've done my analysis right. And here what we've presented in the chart is

[00:30:14] kind of, okay, so you're earning 17% on these wide mode companies for a long period

[00:30:18] of time. Well, that beats pretty much all of the returns from even the average of S&P

[00:30:23] companies. So here is a cash flow return of the average of those companies, or MSCR work. And just

[00:30:28] for fun, I stuck in US Treasuries as well. So this is the kind of compound you're getting

[00:30:33] inside the business, which is what will drive the share price over time consistently.

[00:30:37] And that's kind of the idea here with using cash flow return on invested capital.

[00:30:41] How do you think about this idea of people challenging most? I mean, I assume with certain

[00:30:45] types of businesses like railroads, it probably doesn't happen too often. I mean,

[00:30:47] it's very hard for anybody to even attempt to challenge a railroad. But when you see a threat

[00:30:51] to one of your companies, how do you think about analyzing that in this context to think about it?

[00:30:56] Is this a real threat? You know, is this business something that's at risk?

[00:31:01] Yeah. So it's a great question, right? The point is that once you've established a mode,

[00:31:07] you've bought this good company, you really just keep watching it very, very carefully.

[00:31:12] And the way we sort of think about the challenges is we kind of think of like almost

[00:31:15] like a grid, right? Which is you've got your competitors and you've got the company itself.

[00:31:19] And it's about offense and defense. Each of them is playing offense and defense in their particular

[00:31:25] way. So, and then how I analyze offense and defense is I try to use kind of military kind

[00:31:31] of analysis, right? Which is all about source size. Like how big is that thrust coming in?

[00:31:36] Right? How much money effectively is being invested in it? And then I think about what

[00:31:40] kind of strategies are they using to defend or to attack? And then similarly, what kind

[00:31:45] of tactics are they using? Again, also very important in terms of the day-to-day monitoring

[00:31:49] of these companies. And so if you take technology as a great example, now I'm probably get these

[00:31:54] numbers wrong, but we're talking about like 1.5 maybe $2 trillion invested in venture capital

[00:31:59] since 2010. So when I think about source size, like that attack on technology in terms of

[00:32:07] venture investment and all of it is going into technology. It's not really going there chasing

[00:32:13] railroads, right? People are best at what they're going after. And that's force size

[00:32:18] is pretty strong thrust of attack. And then I think, okay, what kind of strategies are

[00:32:22] companies employing against these technology businesses in terms of deploying that capital

[00:32:27] and getting after it? And I'm moving away kind of value destructive business model,

[00:32:31] but there's loads of interesting strategies that people have done to disrupt various businesses.

[00:32:36] Similarly, I think about the company I'm looking at and saying, okay,

[00:32:39] what's this company doing? It's very important that this company has the right

[00:32:44] defense against all of this, like any disruption that's coming its way. But equally,

[00:32:48] and I think also underestimated by market is what's the offense that the company is playing?

[00:32:53] Right? Like what is it doing to maybe get ahead of everybody? Like where is it attacking in

[00:32:59] terms of where is it deploying its capital and spending money? And so when I sit down

[00:33:04] with every company, I'm kind of thinking, okay, what are the competitors doing in terms

[00:33:07] of their offense? It was a strategy tactics, how much money is coming into that? And what's

[00:33:12] my company doing in terms of office and defense? There's also another element of the quadrant,

[00:33:16] which is the defense of your competitors, which can be interesting against the offense

[00:33:20] of your company, if that makes sense. So there's this like interesting balance. And then

[00:33:25] it's a lot of qualitative analysis where you have to make a decision at the end,

[00:33:29] whether it's prone to disrupt or there's a kind of disruption that going to happen or not.

[00:33:34] And it's really the big risk for a lot of these companies. We have to be careful.

[00:33:38] But if I've done my work right on the moats, it should be in really good shape for the core

[00:33:42] business itself. This is more about how the story progresses over time because I need to

[00:33:47] be watching that very carefully. It's interesting when you were mentioning

[00:33:50] 0% rates, I was thinking about, I mean, that might be changing in the future. A lot of

[00:33:53] companies were threatened, their competitive advantages were threatened by 0% rates and a

[00:33:57] lot of money being thrown at stuff. Now the rates are higher. You could argue those

[00:34:01] threats are going to be much harder to bring forth than they were in the past.

[00:34:05] Yeah, so it's like this cost of capital point, which I think is very interesting. But my

[00:34:12] account to that a little bit is this venture money was raised, right? And some of it was

[00:34:16] destroyed and so it was a bad investments, but some of it is still sticking around and they've

[00:34:21] raised quite a lot. And what's also happened and this is kind of, is this progression of

[00:34:26] wealth over time, right? The society is getting wealth, there's more and more investments

[00:34:31] around which are trying to find more and more return. And because venture as a sort of risk

[00:34:37] seeking place has kind of established itself very well, I would say over the last 10 years as

[00:34:43] allocation of investors, I don't think necessarily you're going to see money move away from

[00:34:48] venture. And because they played this trick, right? They don't need to give you a return

[00:34:52] because they say, oh, your money's locked up for 10 years, call us in 10 years.

[00:34:56] That means that it's not going anywhere, right? So it's kind of, I think in the traditional

[00:35:03] world, maybe 10, 20 years ago, the cost of capital mattered because the people were

[00:35:08] directing it, how to direct, you know, how to report against that cost of capital.

[00:35:12] But we're in a slightly different allocation paradigm, I would say,

[00:35:17] which makes it a bit difficult for companies. It'll continue. That's what I think.

[00:35:20] And there's this amount of capital. Now, are they all going to be throwing,

[00:35:25] you know, just the $100 off vouchers at you? And has that era done? Probably yes. But some

[00:35:31] of those strategies work, so they might continue in different ways.

[00:35:33] So this may apply less to your companies because again, you're investing less in

[00:35:36] technology. But one of the things you're seeing a lot now is a lot more stuff going

[00:35:40] on on the regulatory and antitrust side. And again, particularly with the technology

[00:35:44] companies. But how do you think about that? You know, if that's a potential risk for one

[00:35:48] of your investments, how do you think about monitoring that and judging the size of the

[00:35:51] risk? Look, it's the question, right? Because I think it's hopefully I've identified really

[00:35:59] strong modes. The biggest risk of those modes is more like a regulation in the form of

[00:36:05] antitrust and basically the DOJ or the FTC going after these companies or also other

[00:36:12] types of regulations. You know, railroads in the U.S. are regulated very carefully.

[00:36:16] There's labor unions, there's all kinds of other bits of regulation that go after it.

[00:36:20] But antitrust is the most important one. And so what we've done is we monitor it extremely

[00:36:25] carefully. I've built a dashboard that monitors the news flow out of the European Commission,

[00:36:29] the Department of Justice and the Federal Trade Commission to basically try to stay

[00:36:33] ahead of what's going on. Like what are the people there talking about and thinking about?

[00:36:38] What was their academic work like? And I think that's something that we're trying to

[00:36:42] differentiate on. We're trying to defend against those risks so I can try to support

[00:36:46] them better fairly or maybe than the rest of the market because the market is a bit lazy when it

[00:36:50] comes to antitrust apart from merger control where there's an entire industry doing merger

[00:36:54] arbitrage. But I'm going to share a slide which I think is very interesting in terms of just

[00:36:58] the general background of antitrust, right? And again, I think this is like fascinating data.

[00:37:06] This is the number of DOJ investigations by type and this is the number of European

[00:37:12] union antitrust cases. They've gone down massively and this is the thing that I think the market

[00:37:19] made people aren't really aware of. And one of the reasons why we find it so

[00:37:23] been such an attractive strategy to invest in because there's just

[00:37:27] antitrust authorities are doing less and less. And I think this is a nice background as a sort

[00:37:33] of tailwind for the strategy as well and the way of looking for companies that are dominant

[00:37:37] in their particular positions, just less antitrust. It's interesting to think about that in the

[00:37:42] context of like the news flow because I think the reason a lot of us, me included, would think

[00:37:46] this is not true is because if it's Apple that's under investigation, people are talking about

[00:37:51] that all the time or if it's some other big company. So you probably hear a lot of news

[00:37:54] about this in terms of the big tech companies but the reality behind the scenes is very

[00:37:58] different so that's very interesting. Yeah, it's like the classic thing where we're often

[00:38:03] having to fight against the media narrative as investors to be like look, if you actually

[00:38:07] look at the data it's completely different. But the media will write about what it is and those

[00:38:11] are banner cases. I think they're very interesting cases and we'll talk about

[00:38:16] technology in a bit I'm sure and these companies specifically but these companies,

[00:38:22] the cases are not that great. They just create a lot of news and press but I actually

[00:38:29] spent a lot of time reading the actual case documents and we'll see how the core cases

[00:38:33] progress but it's difficult to see what kind of case you can make for these technology

[00:38:37] companies being really that dominant. But yeah, this is what's going on under the surface.

[00:38:43] The DOJ might be doing more big cases like Apple but overall less and less cases over time.

[00:38:52] How do you think about blending quantitative and qualitative in your process? As the quant

[00:38:55] investor, I always have to ask this question but how much of finding a moat can be quantified?

[00:38:59] I think at the surface you could look for high return on capital sustained over time or

[00:39:04] something like that but how much of this is qualitative and how much of it is quantitative?

[00:39:09] Look, I think we can probably do an entire podcast on just this question and as a quant

[00:39:15] investor you probably have a lot of views. I generally think we want to harness the best

[00:39:22] of both things. I think I really subscribe to the Garry Kasparov view that man plus machine is

[00:39:28] probably going to be the best investor there is out there or the best at any particular task.

[00:39:33] We employ quite a lot of what I would call systematic tools to help us guide us in various

[00:39:38] areas and what we did when we set up Temmo was we thought, okay, what areas of the

[00:39:43] investment process do you think systematic approaches work best and what areas do you

[00:39:48] think should be left to human devices? What we generally settled on is portfolio construction,

[00:39:54] as in how you build a portfolio should probably have some systematic elements related to it.

[00:39:59] Fund managers, again, as a fund manager it's hard for me to say, we're not very good at

[00:40:04] sizing positions or putting together the final portfolio and what it's supposed to look like

[00:40:09] but we're very good, better than 100% of the alpha generated over the best fund managers

[00:40:14] at picking stocks. That's what we do. I think what we wanted to do is say,

[00:40:19] can we create a fundamental process around picking stocks using the qualitative side of things

[00:40:25] as much as possible, employing all the classic quantitative tools in terms of spreadsheets and

[00:40:28] models and analysis, getting into the weeds of the companies but leave that to the human side.

[00:40:34] When we think about portfolio construction, for example, can we put in a set of rules

[00:40:38] and systems that help limit the choice a particular fund manager has to harness the best part of that

[00:40:45] stock picking alpha? When it comes to idea generation, I think that has to be free because

[00:40:52] in a way ideas can come anywhere. They can come in the shower, a newspaper,

[00:40:55] whatever you're reading and you don't want to have too many rules around how that

[00:40:59] a particular bit works. Within our fundamental analysis we look at, we use a lot of

[00:41:04] quantitative tools but therefore specific bits of analysis within that particular bit.

[00:41:09] When I'm looking at balance sheets, we have specific scores that we've built based off models,

[00:41:14] based off academic literature that tell us the risk of accounting the statement,

[00:41:18] the risk of balance sheet problems. Often you need to be able to monitor these things from

[00:41:22] lots of different angles otherwise you'd miss things. One thing that I'm big on

[00:41:28] and Tema is the one way to lose money as an equity investor is to get the balance sheet

[00:41:33] wrong with a particular company. Time and time again that's always how you do it and you lose

[00:41:37] money and you never get it back. The company has bad earnings, the likelihood that it'll bounce

[00:41:42] back is pretty high. The company has a bad balance sheet, it's over. Often it's for equity.

[00:41:49] We build a few quantitative tools with specific bits of analysis. We try to use

[00:41:52] quantitative tools for our portfolio construction process and we leave the rest slightly open.

[00:41:57] But this is an interesting idea that you point to in terms of the

[00:42:01] deep mode analysis that we do. Really it comes down to this point that actually it's very

[00:42:07] qualitative. Even if you take the dominance point, just a simple fact, there is no database

[00:42:14] that exists that can tell you the market share of different companies. It just doesn't exist.

[00:42:18] There is no single source like a Bloomberg where I can go and look up any industry

[00:42:22] and they'll tell me the market share and therefore there's no way to screen

[00:42:26] for dominance in the industries. Which of course is kind of crazy to think about,

[00:42:31] right? Like we spend all the time thinking about market share but the data's not there.

[00:42:35] And then when you look at the actual mode analysis, especially the way we do it,

[00:42:38] it's very qualitative and very intensive. You have to do a lot of reading and understanding.

[00:42:44] To your point about blending the two, I mean I think that's one of the things people miss is

[00:42:47] everybody pretty much blends the two. Even people like us who are pure quants,

[00:42:50] I mean somebody has to decide what's in the model. Somebody has to decide when to

[00:42:54] change the model. So this idea that you can completely eliminate discretion isn't true either.

[00:42:58] Every process I think has, it's just a matter of varying degrees but every

[00:43:02] process blends those two things together. Yeah and I think that's the way it is right?

[00:43:06] I think the world loves black and white but the truth is there's always gray,

[00:43:09] right? There's always a spectrum of things that people are doing.

[00:43:14] Similarly with our approach where our ETFs are actively managed but that we have rules on

[00:43:18] our portfolio construction, does that make us more of a passive vehicle? It doesn't really,

[00:43:23] but it's like a continuum and even passive instruments, we rail against them all the time

[00:43:29] but they're making decisions. Index inclusion, exclusion, criteria, all of these things are

[00:43:35] someone's made a decision somewhere that will affect the outcome for the investor.

[00:43:39] I just wanted to ask you briefly about inflation because in theory I would think

[00:43:43] these types of companies might be companies that might do well in periods of inflation.

[00:43:46] I mean they typically have pricing power, they're hard to replace. Do you think that's true?

[00:43:49] Yeah, so absolutely. I think what's quite clear and here what I've done is looked at quality

[00:43:57] stocks. We should think of quality stocks as kind of the bigger subset, right? Modes are

[00:44:02] a subset of quality stocks. There are quality stocks that don't have modes necessarily but

[00:44:07] what we've done here is look at quality in terms of different periods of inflation and how

[00:44:12] it does. And then what's even more interesting is that if you put a value overlay as in like

[00:44:16] you look for cheaper quality stocks, they're the ones that actually do the best on average

[00:44:20] in inflationary periods. And why do these motor quality type stocks do well? It's what

[00:44:25] you said really. It's a lot of their revenues are highly visible. Some infrastructure businesses

[00:44:30] where in their contracts there's like a direct indexation to inflation or even if

[00:44:35] you take some of the aircraft manufacturers, right? They have price escalators built on

[00:44:38] inflation or regulation or indexing. A lot of the times what mode type businesses are is they

[00:44:47] sort of collect a little bit of a toll on like a growing pool and that growing pool is a nominal

[00:44:52] pool. So you, for example, classic mode business from our perspective is ratings agencies.

[00:44:59] Ratings agencies essentially rate debt but they collect the fee of the nominal stock of debt

[00:45:06] and just by inflation that nominal stock of debt is inflating, right? And so we you have more and

[00:45:12] more nominal inflation and you're collecting a fixed percentage or a whole value or even

[00:45:16] a growing percentage that creates the kind of benefit for these companies which then flows

[00:45:21] through to the bottom line. So quality value stocks tend to are performing historically in

[00:45:27] inflationary periods and mode stocks are definitely a part of that. And this is the

[00:45:30] reason why we think that happens. How do you think about valuation? I would think this is

[00:45:33] one of the more challenging things because we know these are all great businesses but they'll say,

[00:45:37] any business at a certain price is no longer attractive. So how do you think about figuring

[00:45:41] out like what you're getting for your money and what an attractive valuation is for these

[00:45:44] companies? Yeah, that's a great question. This is a hard part. In general at Temma what we do is

[00:45:53] when we look at any particular stock we look at four pillars and one of them, one of these

[00:45:58] four pillars is building a valuation case for the business. And it's a very, very important

[00:46:03] pillar because as you say, a great company is not necessarily a great investment. That's

[00:46:07] a classic line in investing and it's really, really important to understand. And so

[00:46:12] it's a bigger challenge for these types of businesses because they tend to trade at either

[00:46:16] at or above the market multiple. And so therefore you're paying up for the quality

[00:46:22] and the protection of our business and the visibility of those earnings. And so what we try

[00:46:26] to do always is look at two things. One is we always look at valuation relative to the

[00:46:31] fundamentals of the business. So I'm talking about the return profile of the business,

[00:46:36] I'm talking about the organic growth rate it produces and the gross rate of earnings.

[00:46:40] That's very, very important to do because what you want to do is ground it in a way.

[00:46:44] And I'm not suggesting you have PEG ratios or anything like that but you need to make

[00:46:49] a holistic assessment of the fundamentals and try to link that somehow to the valuation

[00:46:52] multiple. Often what it also means is an analysis of the company versus its own history

[00:46:57] because these companies have long durability. You can kind of see where it's traded

[00:47:02] versus its own past and what kind of multiples it's gotten to. But I never really build an

[00:47:08] investment case based around valuation as a driver. I'm always looking for the fundamentals

[00:47:13] to do all the work. It's going back to that cashflow return on investor capital.

[00:47:18] That's the thing that does the work and the ability for that business to reinvest

[00:47:22] and compound and grow. And so what I'm trying to do is say, okay, is it fair value or is

[00:47:27] it a good valuation case relative to the fundamentals of that business? And you can

[00:47:31] easily build these cases because a business which has a very long runway because it has a

[00:47:38] fantastic mode of its business, it can keep growing. If it's growing revenues in high

[00:47:43] single digits, expanding margins because you have operating leverage in all of these

[00:47:47] businesses, you're starting to see double digit kind of earnings growth. And if you add

[00:47:52] the fact that often many of them throw off cash which they can reinvest in the business,

[00:47:57] you're quickly getting into this double digit return just from every year, year in, year

[00:48:03] out growth and earnings, which is coming from that cashflow return. And that does a lot of

[00:48:08] work for you as an investor, right? In the marketplace, if I can find the companies that

[00:48:12] are doing sort of 15% IRRs put in the dividend yield of buyback yield plus the earnings

[00:48:17] growth of the business, well that definitely beats the S&P over long periods of time.

[00:48:22] And if I can then do all my work to make sure that there's durability to that,

[00:48:27] I don't need to make any heroic assumptions about the valuation.

[00:48:31] Where valuation is extremely important is the downside case, right? Because it's

[00:48:37] because of the picture I painted you, any nickel, any problem that can spiral into a bad story about

[00:48:44] the company will see a massive valuation discount because there's so much valuation to give up.

[00:48:49] And so that's why I'm spending so much time for example building dashboards looking at

[00:48:53] antitrust analysis because I'm like if that torpedo comes, there's a long way for this

[00:48:58] thing to fall because people might value it at a completely different multiple. So we do

[00:49:02] as every quarter we assess all of the risks, disruption risks which we talked about before

[00:49:07] in terms of office T-shirts of the companies, antitrust risk and any other risk facing the

[00:49:12] company. I don't really care about cyclical risk that much because over long periods of time,

[00:49:17] these companies through cycle are going to be fine. But what I care about are is there

[00:49:22] anything that the market can build into a structural story? And that can be very painful

[00:49:27] for these companies. So that's why I spend, I think valuation analysis comes in very

[00:49:32] carefully. I want to ask you about portfolio construction because that's always one of the

[00:49:35] interesting things is taking all these great companies and how do you put them together into

[00:49:38] a portfolio? How many positions do you hold? How do you size the positions? How do you think

[00:49:42] about sector concentration? Can you talk about that? How you think about translating these great

[00:49:46] companies into a portfolio? So as I mentioned earlier, we had a long think before we started

[00:49:52] Tema about how to do portfolio construction. It basically involves quite a lot of research

[00:49:58] by myself and some of my colleagues in terms of like going and reading academic papers,

[00:50:02] talking to a lot of other fund managers and what they do in practice. And the reason is I wanted

[00:50:07] to really answer this question, right? Like how do you size an equity bet and a position? And

[00:50:12] how do you build portfolios that are the most efficient? And what I alluded to earlier is

[00:50:17] that fund managers aren't very good at this. We're just overall, we generally actually tend

[00:50:21] to lose alpha when we're trying to size positions. And there's a lot of reasons for

[00:50:26] this, mainly related to behavioral biases. And so what we came up with is this approach of trying

[00:50:32] to build different tiers of position size within the portfolios. And these tiers of position size

[00:50:38] are built around conviction, but they're also built a little bit around size, which is what

[00:50:42] the risk managed approach is. Size is actually one of the best variables. And people kind of

[00:50:48] hate hearing that because they always think, well, you're an active manager, you should not

[00:50:52] really care about how big a company is and isn't really the value added from small, medium-sized

[00:50:57] companies better than larger companies. But size is one of the best variables to determine risk

[00:51:02] parameters of a particular business or investment. And so what we do is we have these three

[00:51:07] different conviction tiers. And what essentially when you're managing the money, you're

[00:51:13] trying to move between the different tiers based on your conviction. But within each tier,

[00:51:18] it's equally weighted, the position sizes. Of course, over time, they drift and you want to

[00:51:22] make sure that you adjust those over time. But what this does is it creates a conviction

[00:51:28] portfolio that's kind of risk managed in a way. It restricts the amount of choice you

[00:51:32] can make as a fund manager. And it really focuses you down on that conviction. So you're

[00:51:37] making only really three choices here and really that the stock pick itself is the valuable

[00:51:43] thing, not the position size. So here we've got this foundation position. That's a good way to

[00:51:48] think about it, right? Which is often fund managers have a long tail of smaller positions

[00:51:54] that they're sort of just watching and they bought a little bit. They thought it was a

[00:51:57] good idea. This is actually kind of really detrimental to investors because one,

[00:52:01] that's never going to have a real impact on the performance of the fund because the position

[00:52:05] is often too small. Two, a lot of ideas, despite some managers kind of telling you

[00:52:10] often good ideas, at least moving between ideas, they have a set life, right? The alpha in ideas

[00:52:17] tends to be very high at the beginning, but it actually decays over time. And so what you

[00:52:22] want to make sure to do is that you sign the position right to begin with so that the

[00:52:27] investors actually benefit from that good idea. Whereas what tends to happen is people may

[00:52:31] decide the position too small to begin with, ramp it up at the wrong time when the alpha's

[00:52:36] already gone from that particular idea. The other thing about having tiers is it forces

[00:52:41] some biases out of the process. For example, this bias I just said, which is this idea that,

[00:52:47] oh, just because I have a small position, I'm good. That's a biased view, right? You

[00:52:51] shouldn't have a small position in that particular place. But also it limits kind

[00:52:55] of trading, right? Because you have to make a big decision each time if you have to trade

[00:53:00] 100, 200 basis points of that particular position, you think twice, right? And you do less trading

[00:53:09] when you're trying to tweak things where it just creates costs for investors. And so this is the

[00:53:14] result of the work that we did in terms of understanding what the industry does. A comment

[00:53:21] on the industry is that we're not very good at it. There's not a lot of really good models

[00:53:24] for how to do this and people try lots of different things. But it was a difficult kind

[00:53:29] of balance trying to find what is the easiest way to do this that is most correct from an

[00:53:34] academic perspective, but is also inherently understands that there's a human involved in

[00:53:38] this process as well. To your point in size, I would assume that most companies,

[00:53:42] and correct me if I'm wrong, that meet your criteria would probably be on the larger size,

[00:53:45] because if you're going to have this kind of protection against your business,

[00:53:47] you're probably not going to stay a small company for too long. I mean,

[00:53:50] you're probably going to be bigger. Yeah. So for the fund, you know, focus on deep modes,

[00:53:56] it's really that they're a larger company, but there's relative to size each other. So for me,

[00:54:02] for that particular portfolio, it's much more conviction based than it is really related to

[00:54:07] size. But if you take some of our life science funds as an example, where you have a real stark

[00:54:12] difference between the smaller companies which tend to be pre revenue biotechnology businesses,

[00:54:16] and the larger more established businesses, their range is a lot more stark. And that's

[00:54:22] where size plays different. Remember, this is an investment process in terms of portfolio

[00:54:26] construction that applies across all of Temma's funds and it's supposed to fit kind of the

[00:54:30] different areas all the funds invest in. But within deep mode business, absolutely,

[00:54:35] is really just conviction rather than size that matters because size is quite high anyway

[00:54:39] to these companies. Just a couple more before we wrap up, I want to ask you about international

[00:54:42] exposure because this is something you do a lot of these types of funds typically don't,

[00:54:46] which is you do have significant exposure in the international space. And you do,

[00:54:50] most of us that are in the US will think all the great businesses are in the US,

[00:54:53] but that's not true. I mean, there's some great businesses abroad as well. So

[00:54:56] can you just talk about how you think about this in the international world?

[00:54:59] Yeah, so right now the fund is about 75% US. So it's very much kind of a US

[00:55:03] focus fund. And I think it's speaking to your point, I think really good high quality,

[00:55:09] deep mode businesses, they tend to be in the United States. I think that that is true. It's

[00:55:14] kind of the most powerful biggest market in the world. And I think that's the reason why

[00:55:18] it's bred a lot of these best in class businesses. But that's not to say that there are no really

[00:55:23] good businesses internationally. And so 25% of the portfolio is positioned overseas. About 6-7%

[00:55:30] of that is Canadian rail companies. So as I said earlier, I picked on one of the companies,

[00:55:35] I just generally think they're likely higher quality than the US listed rail companies.

[00:55:41] By the way, they're listed in the US, a huge part of their business in the US,

[00:55:45] as I said, they connect all different parts of the United States. But they're still classified

[00:55:49] as international. But if we start to look further afield, I think one particular area that is

[00:55:55] really underrepresented in the US market that I think is very powerful in terms of deep modes

[00:56:00] is infrastructure businesses. I'm talking about airports, toll roads, businesses that

[00:56:07] own and operate, build, own and operate infrastructure is a very bizarrely not a big

[00:56:14] part of the US listed market. You tend to have a lot of construction businesses that create

[00:56:19] infrastructure, but not a lot of them that own that infrastructure. And so we found the best

[00:56:23] ones tend to be listed in Europe. They're fantastic operators and builders of like Air

[00:56:28] Fords. And these are incredible businesses because really a toll road, if you think about

[00:56:34] it, once you build that toll road, it's a toll that is linked to inflation that has a concession

[00:56:39] of sometimes 50, 60, 70 years that compounds over a long period of time. And they create

[00:56:45] immense value. I mean, one of our companies owns a toll road in Canada. I think originally

[00:56:49] their investment was like 40x their investment just through operational performance, but also

[00:56:56] just compounding over time. They own managed lanes in the US, which is a really interesting

[00:57:02] asset of like dealing with congestion around cities. So creating specific parts of a highway

[00:57:07] where you pay a toll just to avoid congestion. And that's continually a part of, unfortunately,

[00:57:13] the reality in urban centers and people are prepared to pay for it. And that's the kind

[00:57:18] of assets or Air Fords are beautiful businesses as well. Long concession. They are regulated

[00:57:24] on certain parts of it, but lots of it is unregulated. Like the concessions you have

[00:57:28] in the shops, right? It's a captive audience. Travel is growing. They're investing in these

[00:57:33] businesses, but over time they're able to reap these rewards. And so we found a lot of really

[00:57:37] interesting businesses listed in Europe that operate infrastructure, including infrastructure

[00:57:41] in North America as well. They're just not listed in the US. And then you have some

[00:57:45] of the real international gems, companies like ASML, which is a perfect example of a business

[00:57:53] that is just a hundred percent monopoly business with the deepest possible moat.

[00:57:58] I mean, just so people can get a sense of what that business is, they provide a listography

[00:58:03] machines that you need to have that source of light to be able to cut those semiconductor

[00:58:07] talking about to two nanometers. These machines are like six stories high. They cost $300 million.

[00:58:14] They require like 50,000 different suppliers to come together to build it. They have a

[00:58:19] mirror inside them that is so perfect that if you blew up this mirror to the size of the earth,

[00:58:24] there wouldn't be a dent more than a centimeter in it. And this is the kind of like advantage

[00:58:29] this company has. It's the only one in the world that's able to build these machines.

[00:58:33] And you just don't have that in the US. There are amazing semiconductor equipment businesses

[00:58:37] that we own as well, but this is a business that is just quite unique and doesn't exist.

[00:58:43] Or other ones like Novo Nordisk, you know, that's a great business that's developed the

[00:58:47] obesity drug, the Govee and it's just a fantastic company in that sense. So it's just finding those

[00:58:56] really strong competitive businesses internationally. That's what we're trying to do.

[00:58:59] Yeah. I listened to like a long podcast about ASML one time and like what they're doing is

[00:59:03] it's going to be very hard for anybody to compete with that for a very long time,

[00:59:06] it seems like. Yeah. I mean, it's still technology, right? Someone might be able to

[00:59:12] find a new way to do it, but I think it's very difficult to do that. And again, it goes

[00:59:16] down to this technology, but it's in the physical world, right? I'm trying to work a physical thing

[00:59:21] instead of the digital world where the pixels are free flowing, if that makes sense.

[00:59:25] As we close out all our interviews, we like to ask all our guests a standard closing question,

[00:59:28] which is based on your experience in markets, if you could teach one

[00:59:30] lesson to the average investor, what would that be?

[00:59:34] Yeah, great question. There's a lot of things that I've thought about answering

[00:59:39] this question with because there's always a lot of stuff, but I think in my mind

[00:59:44] always drifted back to kind of the simplest things because what I always find is that the

[00:59:49] simplest things, they seem simple, but they're actually really difficult to do in practice.

[00:59:53] And the best lesson that I learned maybe over the last more than a decade of investing is

[01:00:00] just using common sense as a real simple tool. Often what I see with investing is

[01:00:06] people get attracted to things, the fear of missing out, all of these emotions that come

[01:00:11] in. And what I always sort of say is if you just apply common sense, like if something's

[01:00:16] too good to be true, it probably is just because someone else is making a ton of money over here

[01:00:20] on something and you don't really understand it, don't rush into that just because it's

[01:00:25] going up. And so I also kind of give this lesson to a lot of people that ask me,

[01:00:30] what's the number one lesson? If you don't understand it and you can't apply common

[01:00:34] sense to this thing, probably not a good investment over the long run.

[01:00:38] And we've seen that time and time again with the different cycles that happen.

[01:00:42] I always implore people just try to use common sense, try to understand what you're

[01:00:46] investing in and you'll actually come very, very far farther than what the market can do

[01:00:51] as a specific tool. So this has been great. I really appreciate all your time.

[01:00:55] If investors want to find out more about you or about Temma, where can they go?

[01:00:59] Yeah, absolutely. So you can head to our website, which is temmetf.com. There you

[01:01:04] can see all the different funds that we manage, including the one we discussed today.

[01:01:09] And there's lots of information under our insights page. You can subscribe to our

[01:01:12] newsletter as well, where we try to publish interesting bits of research about the

[01:01:16] various parts, including our investment process. So yeah, that's probably the best place to go.

[01:01:21] Well, thank you again. I really appreciate your time.

[01:01:24] Sure. My pleasure.

[01:01:24] This is Justin again. Thanks so much for tuning into this episode of Excess Returns.

[01:01:29] You can follow Jack on Twitter at practical quant and follow me on Twitter at JJ Carboneau.

[01:01:35] If you found this discussion interesting and valuable, please subscribe in either

[01:01:39] iTunes or on YouTube or leave a review or a comment. We appreciate it.

[01:01:43] Justin Carboneau and Jack Forehand are principals at the Lydia Capital Management.

[01:01:47] The opinions expressed in this podcast do not necessarily reflect the opinions of

[01:01:50] Lydia Capital. No information on this podcast should be construed as investment advice.

[01:01:53] Securities discussed in the podcast may be holdings of clients of Lydia Capital.