Value Investing, the Mag 7 and Making Sense of a Changing Market with Tobias Carlisle

[00:00:00] 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. Jack Forehand is a principal at Validia Capital Management.

[00:00:11] The opinions expressed in this podcast do not necessarily reflect the opinions of Validia Capital. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of clients of Validia Capital.

[00:00:22] Hey guys, this is Justin. In this episode of Excess Returns, Jack sits down with our good friend Tobias Carlisle. They cover a wide range of topics, including the recent run in small cap stocks, the future of value investing and the outlook for the Mag 7 stocks.

[00:00:34] They also take a deep dive into Tobias portfolio construction process from the selection of the universe all the way down to issues like portfolio size and sector concentration. Tobias is a deep thinker and always brings an interesting perspective to every conversation

[00:00:45] we have with him. Thank you for listening. Please enjoy this discussion with Tobias Carlisle. Tobias, thanks for coming back on Excess Returns. Hey, Jack, my pleasure. Thank you for having me. I was counting before we just started and I believe

[00:00:57] this is now your seventh appearance, which ties you with Cullen Roche for the most appearances on Excess Returns. Nice. I can only assume that's a very coveted title in the podcast world, being the most frequent guest on Excess Returns. We'll get a little bad at it.

[00:01:11] Put the two of you going. It's a great podcast. I'm honored. Do you remember like the Saturday Night Live that used to do this? Remember it was like Steve Martin, I think, and maybe Alec Baldwin. Yeah.

[00:01:22] When they would host, they would always have this back and forth of who had the most hostings or something like that. So we'll get something similar going here. I love it.

[00:01:31] Yeah. So I wanted to start, we're going to dig deep into how you construct a value strategy as we move on here. But I want to start just with what's going on in general in the market because it's been a really interesting market. I mean, it hasn't been

[00:01:42] like at the index level. It hasn't been that exciting of a market, but behind the scenes it's been a really exciting market. And especially what's been going on with value recently. After that inflation print, we finally seen the surge in value we were hoping for.

[00:01:55] I'm hoping we've seen a lot of false ones over the years. So I'm hoping it's not that. But how do you think about it? What are you seeing right now in value?

[00:02:02] So it seems to have had only over the last few weeks. I don't even know how. It might not even be a month. It has outperformed pretty materially, largely driven I think by the fact

[00:02:16] that it had underperformed up in this year up until very recently. And it seems to be, it's not just value. The market index is float adjusted market capitalization weighted and it's the very biggest mag seven. And then even among the mag seven, it's Nvidia, which that

[00:02:41] the end used to be Netflix. I guess that's Nvidia. I don't know how it works anymore. It's a narrow market, I think, like until until recently, joking or not, I think folks were saying, you know, it's like seven outperforming

[00:02:56] and 493 underperforming. I don't think that's quite right. I think it's about one third outperforming, two thirds underperforming. No idea whether historically that's significant or not. I think you need to go back a little bit though, like clearly value, I think value probably bottomed

[00:03:15] in late 2020 and has been outperforming since but that probably ended a little bit at the start of this year. And then largely the reasons for that performance, I guess would be because it had underperformed so materially for the 10 or 15 years before that, which is a very long period

[00:03:37] of time. There's sort of two things going on right there's the returns to value itself and then there's the returns to the index and neither of them are really predictable or controllable. I think the best you can do is sort of take the opportunity set

[00:03:57] that you're presented with and try to construct a portfolio that whatever happens will do sort of sufficiently well. And so that's what I'm always trying to do on my bias probably towards value, but I don't think it's like a naive bias. I think it's a

[00:04:16] reasonably educated bet based on the historical performance of value and size and various other things. So I think I really have no idea. I think that I probably had more idea five years ago. I

[00:04:32] think the longer that I do this, the less idea I have about where we are and what's happening. I think all you can do is put together a sensible portfolio and maintain that position

[00:04:44] whatever happens. I think the great risk to people is if they chop and change all the time and you get upset with the way that value is performed and throw it overboard along with everybody else

[00:04:53] right at the point that it starts working, but I think that value is a pretty good bet. So I'm glad that it started working a little bit, but I don't know like that could break

[00:05:02] down immediately. It could be a sign of exhaustion in the market or relative to the index. I really have no idea. It's not a very helpful explanation. It's the right answer. There's so much other stuff that goes on in the market and I'm sure there always

[00:05:18] was, but in terms of options flows and I remember Bob Elliott when this whole thing started was talking about hedge fund positioning. There were tons of hedge funds, short IWM who had to cover and

[00:05:28] that was driving part of this. So it's just hard to know when you're sitting in it. Is this the lasting rally or is this... There are a bunch of dynamics going on behind the scenes

[00:05:35] that is making this do this and maybe it won't be lasting. It's just for, at least for me, it's very hard to evaluate it like when we're sitting in it. I always go back to... I think the way that I started investing is I read Buffett's letters

[00:05:47] when I was in university and he talked about look through earnings and he said what you're trying to do is grow your look through earnings over time. So in portfolios that I run, so I

[00:05:58] run to ETF ZIG which is a mid cap essentially value portfolio and deep which is a small micro value portfolio. In both of those what I'm trying to do is grow the intrinsic value of those portfolios

[00:06:15] and the way that you measure intrinsic value is... There are many different definitions of value investing. One is that much more growth year end where you say if you're buying it, if it's growing very rapidly and in 10 years time it's going to be worth

[00:06:31] five times as much then the price that you pay now will reflect that. You'll get the performance when it's up five times and there are other ones where you say well it's at a discount to the sort of

[00:06:43] income and book value right now relative to the rest of the market and that gap should close. They both work at different times of the cycle and I don't think you want to be too stuck

[00:06:54] in one or the other but I do think that the one that I prefer is the one where you're looking at the current discount. But you can't completely ignore growth and so I think that my objective is to

[00:07:10] sort of maximise the rate of growth of that operating earnings, look through earnings which is... So look through earnings for folks who haven't read those letters as you basically look at the earnings of the individual portfolio names that you hold and over time the growth in

[00:07:28] those earnings should ultimately be reflected in the stock prices of the companies that you own. So you're not so concerned about the stock price performance but you're more concerned with the fundamental performance of those names and then the objective is not to overpay

[00:07:46] for that growth. So you have to be a little bit skeptical about very high rates of growth and paying too much for those because growth just tends to attract competition and as a result it slows

[00:07:56] down and falls apart a little bit and then you've overpaid and that's one of the great sins in investing. So I try to be conservative in my estimates of what the companies will do and then to buy

[00:08:07] a big enough discount so that if it doesn't even... even those conservative estimates don't work out you're still going to do okay. That's why before I said, you know, it's difficult for me to

[00:08:18] predict what my own portfolio is going to do even at a business level. It's extremely difficult to predict what it's going to do relative to the index and so I think if you look at what value has done

[00:08:31] over the last 10 or 15 years, it's not been a bad sort of absolute performance. It's just been a weaker relative performance and that's one of the challenges with investing is that you benchmark against an index and really what you should be doing is concentrating more on what you're

[00:08:49] holding rather than that relative performance and it's... but you know, equally it has to over extended periods of time it has to outperform that index and I think the way that you do that is

[00:08:59] sort of the way that I've articulated. You find businesses that'll grow, you try to buy them at a discount skeptical about their prospects and careful about the way that it's constructed, careful about risk, you know, too much debt is fatal, too much concentration at the portfolio

[00:09:20] level can be fatal and all of those things sort of go into ultimately producing the portfolios at the end. Do you think there's anything to this idea that as fundamental investors we have to lengthen our timeframes? So the idea is that whatever that fundamental value is you've got

[00:09:33] what the market's recognizing do you think there's something to whatever's going on in the market that's not converging as much as it used to so we have to be more patient than we did in the

[00:09:40] past? That's a good question. It's not really one I've thought about a lot. I don't know that I don't think that anything necessarily changes, I don't think much changes on a secular basis because I think ultimately the reason for the outperformance is behavioral.

[00:10:01] The argument is always well there's so much more information screening is so much easier so net nets used to be you know you think about the process of finding a net net when Benjamin Graham

[00:10:09] was doing it you had to order us right away for the annual report which was sent to you and then you mechanically calculated that and then you bought these companies at big discounts to the

[00:10:19] liquidation value. And now screening is a trivial exercise you can find free screeners online or show you all of these names and you can put those in and yet it's been a while since

[00:10:30] I've done this exercise but there was an Oppenheimer paper and he looked at the returns over some period of time that sort of escapes me a little bit but I think it was about 25 years

[00:10:43] to 1983 and then I replicate that paper it was 25 years to 2010 taking the period that he hadn't looked at and found roughly the same outperformance even though screening had become materially better over that period of time which makes me think that the real reason for

[00:10:59] values that performance is behavioural people are trying to buy companies have gone up a lot like most people who aren't stock market people when you talk to them what they're hunting for is

[00:11:09] something that's gone up a lot they've got a tip and it's something the reason that they like it is because it's done you know it's like Tesla has gone up a lot it's Nvidia it's gone up

[00:11:17] a lot they buy it because I think it's going to go up a lot more whereas what stock market people are doing you and I probably other investors are trying to find things that are at a discount

[00:11:32] reasonable prospects and so when we're doing that the way that you find things that have reasonable forward returns typically it's something that's a little bit depressed right now and the reason it's depressed is because it just doesn't have a lot of attention or

[00:11:46] something's happened to it and you have to be able to sort of ignore that immediate news but this this that idea is not a new idea like that that idea was comes from a lacosch history

[00:12:01] from visiony paper which came out in 1994 about behavioural economics and they said there are two types of investors there are these naive extrapolation investors which was the first kind I just described they look at stock price has gone up stock price is going to keep on

[00:12:14] going up stock price has gone down stock price is going to keep on going down or maybe another level of sophistication might be earnings have gone up earnings are going to keep on going up

[00:12:22] earnings have gone down and he's going to keep on going down and then on the other side there are mean reversion investors who say well everything exists in a business cycle most things cycle

[00:12:33] not every company cycles but most companies cycle at the top they look great they've had years of earnings going up they're expensive and they've got two things working against them it's expensive share price and probably they're at the top of their cycle but they look great

[00:12:49] they're easy to buy on the other side there are companies with earnings have been going down and their stock price is depressed as a result so they've got two things going for them which

[00:12:58] is that they're more likely to mean revert on a business level and at the same time that big discount to the stock price is probably likely to close and so it doesn't feel very comfortable

[00:13:12] buying them it's a behavioral effort to buy them you kind of have to everybody knows what's wrong with this thing I'm buying it so I'm going to look like an idiot when I buy it but I know

[00:13:24] based on the historical performance of these types of companies that they're more likely to turn around more likely to see that discount close and so they do better and it does seem to be that

[00:13:37] that is actually what happens people who buy these high growth companies they do tend to deliver pretty high growth but not as high growth as they had expected when they put the positions on and as a result the stock price doesn't perform as well as the earnings and

[00:13:55] the earnings don't perform as well as they were expected to and the converse is also true that the value stocks they do seem to disappoint on an earnings basis a little bit but they do a little

[00:14:05] bit better than they were expected to and the stock price does better too and so that's the reason value tends to outperform its behavioral rather than sort of an informational advantage I really don't think there's much of an informational advantage anymore if there

[00:14:20] ever was one I think that it's almost exclusively behavioral but I think that that's an enduring advantage you had an interesting chart you put on twitter that we'll put in the podcast and it was

[00:14:29] getting at some of these points you've been making in terms of we've got the s&p 500 the s&p 400 and the s&p 600 and you can see here how much of the five-year return is multiple expansion versus

[00:14:39] actual growth of fundamentals and and you can see on the on the small side basically all of it is growth of fundamentals and on the large side a huge portion of it is multiple expansion so

[00:14:48] you wouldn't expect that to be sustainable for the long term well I think I think that's a little bit counter to what yeah I think that's a little bit counter to the ordinary expectation

[00:14:57] in the market ordinarily it's the other way around that you get the multiple expansion and value and you don't get the multiple expansion in growth it's the other way around you get multiple compression and growth in multiple expansion and value through the very worst performance of value

[00:15:14] I don't know when it was exactly to say probably starting from 2010 it sort of started underperforming but it was definitely was getting dire it was ugly by 2018-19 and really March 2020 was brutal for value it was wide underperformance

[00:15:32] and then didn't recover as well out of that bounce do you remember that it's sort of the rest of the market you know that was my expectation was all we've had a crash typically value works well out of the beginning of the the renewed cycle

[00:15:45] value should bounce really hard and we're back and it didn't happen at all all of that bounce was in the bigger companies and value kind of missed a little bit and so that last five years

[00:15:57] I think has defied my expectations at least and based on you know looking at all of the data that the pre-existent it's not it's not a you know the data goes back to 1963 point in time

[00:16:09] and then we've got sketchier data going back to 1926 and then sketchier data still going back to 1875 and then like fragments of like data that goes back to 1825 all through that period there are it's there's a clear trend towards value outperforming and the value outperforms over

[00:16:29] the whole period is massive but there are these six periods of time where growth massively out performs value for a sort of extended period of time five to ten years the most recent one was the

[00:16:41] longest period of growth outperforming every single one of them has centered around a stock market boom often associated with some sort of new technology so the 1825 one was steamships and there've been you know telegraph the introduction of the telegraph which was like

[00:17:00] information technology of its day and so when everyone's been associated with like an electronics boom in the 60s the first dot com in the late 1990s and then this most recent dot com 2.0 or the social revolution or whatever the social media revolution whatever we want to call

[00:17:15] this one ordinarily it's multiple expansion for value multiple contraction for growth I think I you know I was I've got a podcast and a public twitter account and one of the criticisms that I saw and I was sensitive to through that

[00:17:40] vast that very long period under performance was well if you're a value investor and you say you care about the fundamentals of these companies isn't it a little bit hypocritical to be looking for multiple expansion no isn't that what the growth guys do like

[00:17:59] they're looking for the multiple expansion here you are saying you're relying on multiple expansion when there's going to be some fundamental deterioration and I thought that was a but I thought that was actually a pretty good criticism even though it's really the way that

[00:18:12] value works it is to find that multiple expansion but I did think that's probably a valid criticism and so I retooled my own investment process a little bit to make sure that whatever happens

[00:18:25] so I when I I did essentially two valuations one is to make sure that it's cheap on what we're currently seeing but also will you generate sufficiently good performance from these names if you have no multiple expansion over the holding period if you just get the fundamental

[00:18:43] performance will it be sufficient to justify putting these positions on and so I think that that was one of the material changes that I made to my process through that 18 19 20 period of value

[00:18:57] under performance I haven't really seen much of a return to value I don't think yet I think it's sort of it's it's worked in fits and starts but still very clearly a growthy large cap

[00:19:12] market and I don't really know why because I think that the the reasons for values one of the reasons that I thought was a pretty valid one was that interest rates were set to zero cost

[00:19:22] of capital to nil marginal project when your cost of capital is nil like it's any any project looks good value has always been a little bit more risk averse you're looking at the downside

[00:19:37] and so many of those projects you know that that risk aversion just didn't count for anything it just didn't it didn't matter when the interest rates are set to zero but here we are in a world

[00:19:47] where interest rates are much much closer to the long run mean of around six percent I think we're at like I don't but I think we're around five or six I think we're getting close to the sort of

[00:19:56] long run mean here maybe just a little bit underneath it and yet it's still you know real estate market has performed very very well the top end of the stock market has performed very very well all sort of assets have have mooned even though rates are up so

[00:20:13] I don't really know what drives it now but I still think that it's a mean reversion multiple expansion market and and I don't really know what turns it around other than just something ephemeral like market sentiment changes or and maybe that's what we're seeing

[00:20:36] now just people get nervous about the fact that the Nvidia is so overextended or Tesla's you know Google's had a Google had a bad not a bad print but the less sort of exciting print recently

[00:20:49] Tesla had a funny earnings print you know it looks like they haven't sold as many cars maybe there's just like a little bit of people getting a little bit tired of those stories it's not as

[00:20:59] exciting as it used to be and you look at other the Russell 2000 some of those smaller indexes maybe they look more interesting I don't really know I think it's it's sentiment or fashion

[00:21:10] and most things are incredibly hard to predict yeah it's it's interesting because we talked to you on a previous podcast about David Einhorn's idea that you know fundamental investing doesn't work anymore and you you've disagreed with him but it's interesting like at the end you kind of have

[00:21:23] a similar conclusion and that both of you are really focusing on companies where you don't need multiple expansion that was his conclusion and that was kind of your conclusion as well

[00:21:30] and what's interesting about it is if you look back you know if you look at Fama and French's migration paper to your point you just said like multiple expansion has been a big part of at least

[00:21:38] the value factors return over time so I mean maybe we're in a world where that that's going to be less of the return going forward I mean I don't know but like that migration from value to those

[00:21:49] other more expensive groupings has been a big part of values returned historically. And for the smallest as well it was always companies would come on in the Russell 2000 and the ones that did very well would migrate up to the mids and then the S&P 500

[00:22:04] and I don't know whether it's just the professionalization the institutionalization of venture capital or it's something like the listing rules are so much tougher with Sabane's Oxley like Sabane's Oxley introduced a huge burden into listed companies of like a million dollars a year

[00:22:21] which for a big company is trivial but for a little company that could be you know a very large proportion of their profits if a company's making five million dollars a million dollars is 20% of its profits which you know on a multiple like that's a very material

[00:22:34] part of its market capitalization and so where previously these companies would float when they were small and grow through it they thought you know let's stay private VC is there to support us all the way up until we're massive companies if the VC

[00:22:50] evaluations to me just astonishing I see these companies I've never heard of before I saw once today I've never heard of it before it's got a 10 billion dollar valuation and you know zero revenue and they've raised billions of dollars at that level because there's some AI related

[00:23:07] play which you know it's a new name that I've never heard of before most people won't know I'm not even going to say this name but it's there's clearly so much VC out there

[00:23:16] that there's no need to tap public markets and expose what you're doing expose yourself to the risk of sub-annoxity and you increase reporting obligations you can just stay private and you're only dealing with the VCs and then you get your big exit subsequently it's like Facebook which

[00:23:31] exited at a huge valuation it was a huge company by the time it it exited and that's been the trend for a lot of these companies so I think that that that mechanism has gone away a little

[00:23:42] bit and it's a shame because it still exists in Australia you know you can list Australia on the main on the main board in the UK they have the aim which is a secondary board for companies that are

[00:23:53] a little bit earlier stage and in Canada they have the TSX venture so companies can come on at smaller less developed stages and then smaller shareholders can participate in that in that

[00:24:08] growth so taking that away maybe that's a reason for small not performing as well and value not performing as well the only thing that I would argue against that though is that there's a pretty

[00:24:21] it's a paper that I refer to quite regularly and it was called the Darwin's darlings or extinct species something like that came out in 1999 so it was pre-Sarbanes oxley and the authors were writing about exactly the same idea you know that all of these companies

[00:24:40] they're small they're doing very well they're family controlled growing earnings very rapidly doing very well like establishing themselves as businesses but they can't get into the index it's like they can't even get into the Russell 2000 so they just can't get a bid and even in

[00:24:58] the Russell 2000 there's so little capital flowing into a relative to the bigger names that they can't and so that they're completely broken down they've got to come up with some new way of getting out of it and I think that was what created the

[00:25:12] activist boom in the early 2000s and the private equity boom in the early 2000s where these really were good businesses and they went private and management teams benefited but they sort of unfortunately the index has missed out on that performance a little bit too

[00:25:27] so it's a it's a it's hard to know I just on the ironhorn thing I just say his his solution to it was that he was going to find companies that were turning their real free cash flows their excess free cash flows

[00:25:46] into buybacks and capital returns and the only thing that I think that my point of distinction was you know there are two sources of return always there's the reinvestment in the business and even if you're not getting multiple expansion you should still be getting

[00:26:01] business grow and you should be largely agnostic to where what you're trying to do is just buy something cheap on a cash flow basis and then what management does with it you know ideally they

[00:26:09] take advantage of the undervaluation but it's not it's not a sin if they don't they're allowed to reinvest in the business and grow the business too and ultimately you know maybe they grow

[00:26:18] the business big enough that you do ultimately see that multiple expansion so I'm just agnostic to it I buy things that my preference is that they have free cash flow my preference is probably that where

[00:26:29] they have that opportunity they they buy back their stock but there's in terms of capital allocation there's a list of things that they can do buybacks are on that list but they're not the first

[00:26:39] thing the first thing would still be reinvesting in the business if they're getting a reasonable return or they fall returns are reasonable. You alluded to how you pick businesses to invest in and

[00:26:48] that's what I want to spend the second half talking about because you've been doing this in the real world for a long time and I want to walk through your process you know from from the beginning

[00:26:55] to the end and maybe talk about how you think about building a portfolio of value stocks so let's start at the highest level so in terms of a universe and I know you run two

[00:27:03] different funds and I think one is smaller cap than the other one but but how do you think about like setting your investable universe and the stocks you can pick to invest in?

[00:27:12] So there are two it's the same identical engine picking stocks in both it's just they're separated into two universes and that's literally one single line of code that is changed in the two and

[00:27:24] otherwise they're identical and that line of code just says for my mid cap so I have one that can buy a mid cap and above but it tends to be concentrated to the small end of mid cap

[00:27:35] currently although that hasn't always been the case when I first started running it in 2019 it tended to buy I felt large cap value was more undervalued then and it was concentrated more

[00:27:46] in large cap value as I've run it it's one of the things that I've commented on before the market capitalization has gone down very material and you can see if you go to the Morningstar Starbucks and you can see the historical it used to be large cap value

[00:28:02] and now I think they call it mid or it might even be small cap value that's a Zeg which is which in my mind it's a mid cap value fund and the way that we screen there is that the largest

[00:28:17] 25% of names but it's sort of much more concentrated towards the lower end now because I think that's where the opportunities are not not because I'm and that's not like a policy decision of mine

[00:28:27] that's just what the outcome of the process I don't have any influence on I'm not directing it there it's just that's where I'm finding the cheapest names right now and that's also true in

[00:28:37] the small and micro so the small and micro is the smallest 75% of the stock market which is actually a vanishingly small it's a very large number but it's a vanishingly small market capitalization they're very small companies in there and you'll see it in the Morningstar Starbucks

[00:28:54] the hinge right it's right it's below the small cap it really is small and micro and so it's the same process in both but it tends to be at the very small end and that's not

[00:29:05] always going to be that way I'm trying to go where the opportunities are and then in there I want so my preferred metric I call the acquirers multiple which is basically the way private equity firms and activists think about these companies because what we're trying to do

[00:29:20] is maximize the operating income that we're buying per unit of our actual front what we're actually spending and so market capitalization is one measure and that's so if you think about a price earnings multiple that's market capitalization to the bottom line

[00:29:41] profit what the acquirers multiple is is enterprise value to EBIT operating income so that's enterprise value is market capitalization but it also looks at the debt that the company has any cash that it has offsetting the debt any preferred stock which is a real cost minority

[00:30:00] interest and other things like that so it's just a more full examination of the price that you're actually paying and on the other side you're looking at the operating income on an accounting basis that it's generating and then I do some other checks and balances to make

[00:30:13] sure that operating income is actually a cash flow they don't match up year to year any given year there might be a divergence between the accounting measure of cash flow which is operating income

[00:30:25] and the actual cash flow that comes into the business but that's because cash flow statements are a reconstruction from the operating from the income statement and it looks like changes in

[00:30:35] cash at bank and various other things over time they should match up but in any given year they don't and I just find that the operating income is the clear is the first measure of cash flows

[00:30:45] of reconstruction so I use those metrics to work out we're trying to maximize the operating income that we hold and the operating income that we'll have in the future and so the way that I think

[00:30:58] about that the second step is to make sure that money that's reinvested in the business will return a greater return than it would be being returned to me so I want reinvested money

[00:31:13] to earn more than a dollar of market capitalization value which means that it has to be earning at a higher rate than I can get myself so that's a complicated way of saying that the

[00:31:28] the S&P 500 the return on equity for the S&P 500 is about 13% which is quite high I think you look at the rate you get for cash is five so money reinvested by the S&P 500

[00:31:41] returning 13 that's a pretty good return well a lot of that is achieved through leverage so that's not a real return on assets so I think about it X the leverage take out the

[00:31:52] leverage look at the return on assets in the future so not the historical number we're sort of making an educated guess about what the future is going to look like will money reinvested generate more than what the market requires for this reinvestment so if you're reinvesting and

[00:32:07] you're getting less than 5% you really want that money paid out if you're getting more than 13% then you want that money retained by the business and in between there's a little bit

[00:32:17] of a decision to be made to over time you want the operating income to grow and you can turn that into a perpetuity you're just looking at what the business you know the normalized

[00:32:30] full business cycle expectation for the return on what is reinvested in the business what it will return how the market will treat those earnings returned and then you can add on to

[00:32:43] that any payout that you get so any buyback any dividend any return of capital and and meb would meb fabled call that the shareholder yield so I can call it the shareholder yield plus the

[00:32:55] the reinvestment the rate of return on the reinvestment those two things together you want to maximize that across the portfolio and so that's what I'm trying to do the way that you achieve that is by paying very modest price being skeptical about growth and

[00:33:10] and being patient sort of giving these businesses enough time to kind of work their way through but it means that my portfolio it's a deep value portfolio the skepticism I think makes a deep

[00:33:23] value portfolio just tend not to pay up for growth but I but I am prepared to pay more for better businesses and I think that that's what the not too much more so it's sort of

[00:33:33] it's very much a deep value small portfolio but I think within that we do pay up a little bit for business and I think that was one of the changes that I've made since I ran the portfolio I thought

[00:33:45] that initially it was just pure multiple or pure price multiple would generate the return to now I think you do need to you can pay up a little bit for some better business and that's what that's

[00:34:00] sort of tried to do across the portfolio. Yeah it sounds similar to what Buffett's done over his career you know starting in the deep values space but then realizing you know maybe bringing a little

[00:34:09] bit of quality to this is a better proposition. Yeah I'm a shameless fan, co-owner of Buffett's methodology I've said this to many people I've been reading Buffett since I was about 17 years old and I've reread those letters probably every five years since and it's amazing the number

[00:34:28] of times that I think that I've come up with an original idea and I go back and I read about Buffett writing about it in about 1983 and then dismissing it and explaining why it's a bad idea and I

[00:34:41] have thought that it was an original idea and a good one and I read his sort of dismissal of it and then kind of understand a little bit better but the first time I read it I didn't even

[00:34:50] didn't even understand the implications of what he was saying I just read through it and went yeah I get that and clearly didn't so I'm yet to sort of get outside of his thinking I'm still working

[00:35:01] on that. It's interesting I also think there's a behavioral reason going back to what we talked about before for adding the quality to it because those companies tend to be a little better companies they're a little less volatile you know and one of the things I've learned

[00:35:12] over my career is you've got to focus on the end investor that's actually using this strategy and that end investor if you're at the bottom of the barrel value stuff that's very volatile

[00:35:20] you know they look at the names in their portfolio and they're like why do I own this garbage like it's very hard for them to stick with that it's probably a little bit easier when

[00:35:27] you move a little bit more towards quality and you get a little bit better companies. Well that's the reason I wrote the book Deep Value because I'd have these conversations with

[00:35:34] people and I'd say why do we use this is crazy if I look at this stuff that you've got in this portfolio and it's a look there's a good reason for owning this stuff you know it is going to

[00:35:42] mean revert or there's some there's a good chance of mean reversion here and across the portfolio that's my expectation inside I used to do that and give that explanation people say there's that's that's not the case but that's also true that there is a great deal of volatility

[00:35:58] you hope that you're on the good side of the volatility but it does cut both ways those little companies when there's some concern about them and then they they you know they stumble and it takes a long time for management teams to fix problems and

[00:36:14] when they don't deliver and that the mood is dire already then they get cut to pieces when they stumble and so it's a it is a it is a concern but I also think it's there's a business model

[00:36:26] element to that and a capitalization like too much debt with a funky business model when they don't deliver they get cut to pieces probably rightfully so so you know you want to be you want to have a bias for better business models but having said

[00:36:44] that everything at a price there's a there's a you don't want you can overpay for good business models even though it doesn't feel I think that that's the lesson that it that everybody has learned it's the wrong lesson is that you can't overpay for some of these business

[00:36:58] because there's you know the compounded style businesses that just grow over time like yeah you make a mistake but just hold on for 10 years and you'll be okay but I think what 2022

[00:37:11] showed us is that you know you could be down 90% which is as good as you know bankruptcy for some of these names like if you if you're down 90% you've got a 10 bag just to get back

[00:37:20] to break even and that's hard to do so I think even though it's not a very popular kind of idea at the moment I still think that sort of conservatism in valuation and skepticism

[00:37:33] about growth keep you alive like that's the perhaps the big difference between me and many other of the growth year compounded type investors is that my objective is not to generate the highest

[00:37:48] return so I can possibly return my objective is to survive first and foremost and so that's that cuts out a lot of the unit a lot of the universe becomes uninvestable for that reason there's either a problem with the balance sheet there's a problem with the business model

[00:38:05] it's just unproven it's too early to say whether it's something that I just can't get enough of an idea about what it looks like through a business cycle to make a decision one way or the other

[00:38:15] and so I think that that makes it uninvestable and you're probably in this out on returns doing that you need to be you know I've I watched a lot of these guys who are the more compounder

[00:38:23] type investors and they would say we you need to buy these companies when they're losing money because they're going to inflect when they become cash flow positive and ultimately profitable

[00:38:36] and you miss out on all that return and that's true it does seem that you miss out on all that return but sometimes you also they don't quite get there and they fall apart and so there's

[00:38:47] and so there's there's risk in that untried business model and so I'm just more of a conservative skeptical investor and it's not it's it's not just personality it's it's because it's based on

[00:38:59] data like I've done a lot of back testing I've looked a lot of research the reason I invest is because of because of those reasons I've looked at the research and I think that it's the best

[00:39:10] way to do it over the long term even though short periods like this where you want to perform are painful they're not they're not it's not a new thing like that's gone on as I said earlier

[00:39:21] where there have been lots of these periods and they go on for an extended period of time and I understand that people can say well 10 or 15 years like that's like half of an investment career or something like that but that's a crazy long period of time

[00:39:33] to be buying value but it's not like this and this is the longest period of sort of under performance but they're not it's not the first time it's happened there have been very long periods of under performance and they've all resolved ultimately to the price matches the

[00:39:49] underlying performance of the business and so that's where your attention should go to the underlying performance of the business rather than the price section. Yeah, Med Vavor has talked about this a lot this this idea that he's talked about like when you're running

[00:40:01] a strategy like value as an investor when you're investing in a strategy like value you really have to think you know in decades in terms of your time frame and so many people are out there you know what's your three-year performance what's your five-year

[00:40:10] performance even you know what's your one-year performance and that's just not the way these kind of strategies work sometimes I mean sometimes you get lucky you invest in your the perfect right time and you get great returns and it's 2000 but other times you invest in it's you

[00:40:22] see the other side of that. It's totally understandable like I can completely understand imagine investing for five years and under performing and saying yeah I still know what I'm doing you know it's it is possible though and that's just the nature of the markets that there's so

[00:40:38] much randomness and the trends can go on for much longer than anybody expects I think that you know there are quantitative strategies there are quantitative momentum strategies that work very

[00:40:50] very well and over a long period of time but I think that they're looking at you know when I say shorter term trends like momentum might look at a one-year anything from much much

[00:41:03] shorter periods three months three to one year and values I think more like a three to five-year type time period so trend certainly works in a shorter term and I think fundamental to work

[00:41:15] in the longer term but having said that I think it's very hard to predict where even a business will be fundamentally in five years time I think that that's the absolute out of limit

[00:41:24] and I think that that's sort of borne out by the research a little bit too when you look at the you can't predict up beyond five years and then the price action certainly is not predictive

[00:41:35] beyond five years so you would expect that if you're going to generate excess returns from from value you do expect them in the first year or so and then it becomes a sort of market return beyond five years and there's this asymptotic line from excess return to

[00:41:52] market return over those five years in the ordinary course so you know when even value guys when they're saying you know I'm going to build these complicated models that go out and predict that

[00:42:03] in the future it's not backed up by the data. How do you think about the number of stocks in your portfolio this is something I've struggled with a lot in my career like I like running

[00:42:14] concentrated portfolios but I also you know have tended maybe early in my career maybe to a little too much concentration like how do you think about getting that optimum number of stocks

[00:42:22] to hold? Yeah I was too concentrated early on too and that was that's Buffett's fault I had read you know Buffett's letters put your best ideas your biggest most amount of money and your best idea

[00:42:37] and use the Kelly criterion to weigh in its edge over odd so your best idea should have the most money in it the most undervalued idea should have the most money in it. I think that's the right approach if you're trying to maximize your rate of return

[00:42:52] but I think that there's it introduces enormous volatility and path dependency and just idiosyncratic risk into your portfolio that's unnecessary. I wrote a book called concentrated investing where I looked at those two ideas concentration versus diversification

[00:43:09] looked at value guys hit up perform for extended periods at time like 25 years and then looked at the academic approach to concentration and invest and diversification and also the practitioner approach from everybody from Graham on one side to sort of probably

[00:43:26] monger and Buffett on the other side where they're much more concentrated. The decision that I made ultimately was that there's something that the academics probably have it right so but the academics are trying for the academic approach to diversification concentration is to replicate

[00:43:40] a market portfolio with the fewer stocks possible because when they were doing it it was expensive and difficult to build out a portfolio of stocks because they didn't you know now you trade virtually

[00:43:51] free with the Rompner hook but back then you had to pay pretty hefty fees to get these names into the portfolio and so that they said you know if you just randomly pick stocks it's actually hard to deviate from the market performance because if you're randomly picking you're

[00:44:08] going to get some winners you're going to get some losers we want to replicate the market portfolio so that's systemic risk so how do we get that market portfolio and they found 30 names somewhere between I think 20 gave you 90 percent of the market return 30 gave you 95 percent of the

[00:44:26] market return and then beyond then you're sort of spending more money than you needed to that's not my objective my objective and the objective of Graham and other investors like that is to outperform the market and so you have to introduce some sort of tilt into

[00:44:41] portfolio and value is an obvious tilt that works quality it's an obvious tilt that works and sizes are is a sort of side effect of probably those two that you can introduce into the

[00:44:52] portfolio to outperform so then the question is how much money can you lose can you afford to lose in any idiosyncratic pick because clearly if you there are no free lunches in the

[00:45:04] market the reason that you're getting something that seems like value at a surface level is because there's some underlying problem with the business and in many instances the market is right and these things deserve to have their discount to what they look like on an earning spaces

[00:45:21] and I found it's about 50 50 half the time the market is over the period holding periods over my quarterly holding period which is a short period of time but you know it's replicated over and over and over again so it is like a long-term window over a quarter

[00:45:40] it's a 50 50 proposition whether a business outperforms or underperforms so in my portfolio what number of names do I have to hold so that I can capture the upside performance and not suffer too much on the downside performance and I found

[00:45:56] 30 is about the right number on the low side and so Zeke has 30 names that equal weight at the beginning of every quarter for my own internal purposes I write down whether I think one will outperform or underperform the index will be up or down and I'm on like 50 50

[00:46:16] on picking which ones are going to outperform and underperform so it's like a coin flip with my small and micro portfolio I have a hundred names the reason is that they just the businesses are a little bit less good as measured by their returns on invest capital

[00:46:33] and their sort of prospects for growth and so on they just tend to be managed by less experienced managers and there's some argument that if they really were better businesses

[00:46:43] they would have grown out of that where they are and so it makes more sense to be have less exposure to each each name but then in addition to sort of just the idiosyncratic exposure

[00:46:55] to names you have to think about things like how much exposure do I want to an industry so the problem is going to be often industries get cheap or every name in an industry gets

[00:47:06] cheap at the same time so there's a problem you know oil something that's driven by the oil price if the oil price goes down all of the majors and all of the explorers and all of the miners

[00:47:18] are all going to be down along with it how much exposure do you want to that industry or that sector and that's a that's a more difficult thing to answer because if you are only interested in

[00:47:32] performance you want to maximize your exposure to that industry but if you're also concerned about survival then you want to minimize your exposure to industries that don't recover and there are

[00:47:46] there have been lots of examples of that in the time that I've been active in the market so one would be for-profit education those for-profit education businesses were all phenomenal businesses

[00:47:58] that had very high returns on invested capital very asset-wide a lot of the money got paid out and stock prices performed very well for very long periods of time and the administration decided

[00:48:09] that they didn't like the business practices of those businesses and so they changed the way that they were remunerated and they all got cheap or ostensibly cheap based on the historical earnings and so you could easily have filled a portfolio with for-profit education names and you ultimately

[00:48:30] would have been zeroed out because every single one of them essentially was taken out or bankrupted down you know 90 percent so that's always in my mind is a possibility that something's not going to

[00:48:45] recover so if an industry is not going to recover how much capital do you want exposed to it just through trial and error I think it's about 20 percent so I tend to have some exposure

[00:48:57] through testing I think it's about 20 percent so I'll have exposure to an industry most instances most industries are going to recover because it's purely cyclical but not in every single case and so on mindful of that ultimately we want to survive more than we want to generate excess

[00:49:14] returns or survival is a precondition to generating excess returns so it has to be survival first so those are sort of things that I think about in diversification concentration I think that concentration is you know you can one way of testing concentration is you just say

[00:49:29] well what if I just run a one stock portfolio what if I run a five stock or three stock portfolio five stock portfolio 10 15 20 30 50 100 and then I can test the performance of all of these portfolios and then just compare them at what point do you generate sufficiently good returns

[00:49:52] with sufficiently mild volatility that the combination of return and volatility gives you you know that's that's alpha or gives you gives you good performance and so I've just found that it falls out it's somewhere between 30 and 100 you can get better performance at 20 but you

[00:50:09] introduce more volatility get very good performance at five but you have massive volatility and at one you you run the risk that you crash into something that goes to zero even though over a long

[00:50:20] period of time the returns are very very good in the future one of them could be a doughnut say one is probably two concentrated five is probably too concentrated but for investors at home I think

[00:50:32] 10 is probably okay you can probably manage to 10 because I manage money for other people I think the number's more like 30 to 100 and I think that that's the best combination of return and volatility idiosyncratic exposure to names and to industries and so on so I think that's

[00:50:49] that's why I run the portfolio where do yeah in the sector concentration thing I agree with you know I've kind of come down on the same way what we had Weston the podcast and he was talking

[00:50:57] about this and he was saying first of all you have to distinguish long short value from long only value you know you and I both use long only value long short value you pretty much

[00:51:04] have to do sector neutral because if both sides are going against you you know that's going to blow it up but like on the on the long only side a bunch of the return comes from

[00:51:11] overweading these sectors so it's about finding that balance you know you don't want to you don't want to own 90% in financials in 2007 or something so you have to have some sort of limits but if you just say we're going to run a sector neutral you're probably taking

[00:51:24] away a bunch of your return doing it that way right yeah that's exactly right and wasn't I test that we were at quantitative value and I think that the I think I'm using this is

[00:51:38] not the way that cliffhassness intended it but sin a little I think is the right idea you know that if it's if sector neutral is not sinning and sinning a little is like

[00:51:49] leaning a little bit more into a sector than you would otherwise do but I do think that in order to generate some return some excess return you really do need a little bit more exposure

[00:51:58] so far for me that has worked out you do want a little bit more exposure to oil when oil goes to zero you you want a little bit more expecting that it'll recover and the names will recover too

[00:52:10] you want a little bit more exposure to to names that have been beaten up they do tend to be in industries that they've all gotten bitten up together so you want to pick the best handful

[00:52:20] of names out of that industry and have a little bit more exposure to it but always knowing that there's a risk that you know so coal is a good example the coal names I thought all got very cheap a few

[00:52:31] years ago but coal has um you know there are political reasons why coal may not recover and coal sort of there are no new coal mines being built yeah some of these some of the

[00:52:44] arguments against investing in the sector but there are equally there are arguments for investing in the sector so there are no new coal mines being built so that means they're probably going to be

[00:52:52] supply constrained but equally they might be putting some of these coal companies out of business but then my argument the sort of the argument on the other side too was that if we're going to be investing in green infrastructure it requires steel it requires coal

[00:53:06] so coal's not going anywhere so that was the argument there but I was nervous about it when I saw those names come into the screen and into the portfolio ultimately because that you know

[00:53:14] there's it wasn't clear which way that was going to go there's some um political pushback against coal and oil and a few of those other things even though I think they're ultimately too important

[00:53:26] to the economy to sort of rip them out but you never know yeah and I think also like people always concentrate on the overweight part of sectors with value but the underweight

[00:53:35] part is really important too like I don't want to be you know if I'm running a sector neutral portfolio I don't want to be forced to own tons of tech in 1999 you know and find

[00:53:42] whatever's the cheapest even though it's not really cheap so I think both of those things I think work in favor of value well that's a great point and I think that that's probably one of

[00:53:51] the reasons that value suffered through this period was that probably we were all underweight tech because tech was sort of was optically expensive but continued to get much more expensive than any of us sort of anticipated but equally like the underlying

[00:54:06] um the businesses were growing so rapidly they're sort of defying base rates these companies like Amazon and Google and Microsoft we've really got nothing like them in the backwards looking data

[00:54:16] where they're that big and continuing to grow at such high rates just I had a look at when when Buffett sold out of the airlines I went and had a look at the size of the airlines

[00:54:28] because I held some at that point I don't have any sort of discretion over whether they get included or not they were just cheap I held some we did ultimately sell out of them but

[00:54:39] like not not for discretionary reasons it's just that they got they didn't form very well and they know are expensive relative to what what they look like but they were all you know 30 billion dollar 50 billion dollar market capitalizations and then you have Google which was close to 2

[00:54:57] trillion and Google was earning that kind of money on a quarterly basis like Google could have bought an airline every quarter through that period of time like they're just the scale was so vastly different for those businesses and it was kind of it was shocking to me that

[00:55:15] they were so much bigger I hadn't kind of quite appreciated how much bigger they were than most other parts of the economy in it and if you look at so Michael Moperson produced those base rate

[00:55:25] those guides to base rates and there's just nothing like that scale that size of businesses that have continued to grow at the rate that they had like a hundred percent growth of Amazon

[00:55:37] when it was one of the biggest companies in the world kind of on a year in a year kind of extraordinary rates of growth and it was nothing to suggest historically that that was possible

[00:55:47] I wouldn't necessarily make a decision one way or the other I'm not considering those base rates when constructing the portfolio but it's just sort of you know Med Faber will produce those

[00:55:58] charts every now and again where he shows like this is the performance of the biggest name in the market after it becomes the biggest name in the market and it's almost always very bad performance

[00:56:07] you know historically over the years that follow but that's not been true more recently that those big names have had huge momentum it's not just stock price momentum it's business momentum

[00:56:18] as well they've continued to grow and it doesn't seem to be any limit to how big they can grow and they're now half of those names are bigger than stock markets around the world they're certainly

[00:56:27] bigger than the Russell's any you know the entirety of the Russell 2000 you know they're vastly huge companies the index is like heavily weighted towards them but it's not like when the index was heavily weighted towards Exxon at one point I think Exxon was 40 percent of the index

[00:56:46] like do you want 40 percent of your portfolio in an oil and in a commodity probably not but do you want 40 percent in Microsoft which has got recurring income or Amazon which is largely recurring income I mean probably like those are still very good

[00:57:01] businesses it's not as much risk having that exposure to them as there is to having exposure to Exxon so there are some questions that we value guys fundamental guys probably have to

[00:57:11] resolve a little bit and I don't know how to do it but it's the market certainly has changed in that respect that's one big difference that we can run these huge businesses at scale where previously that was more difficult it's something I think about all the time because

[00:57:25] if you go back and you people will have those charts of like the top 10 companies in the S&P 500 going all the way back and as you go from decade to decade they're almost always different

[00:57:34] and and I wonder about that like I wonder with these companies is there something different about these businesses where maybe in a decade they're still going to be the largest companies in the S&P 500 maybe with the technology and the advantages to scale you know something's

[00:57:45] changed I don't know the answer to it I don't know if anybody does but it's an interesting thing to think about yeah I couldn't agree more I think partially it's because they're really

[00:57:54] they've got one product that everybody uses and we're also locked in I mean we're very hard for me to use something other than Word or Excel even though I do use the Google alternatives

[00:58:04] but that's not really you know one or the other they're still the biggest names in the market I'm stuck in Gmail I'm never getting out of Gmail I find it hard to believe that I'd you know

[00:58:14] Amazon's just so easy to use I don't even check the prices to see if they're the cheapest and I think my wife tells me they're always they're not they're always more expensive so I should be checking something else but what's the alternative it's like Walmart is the alternative

[00:58:26] so you sort of you there are very few choices for the convenience or the lock-in I could easily imagine them in 10 years time it's still mostly the same names unless it's something

[00:58:38] like you know Nvidia was a little bit of a dark horse it's just for me anyway to come out of sort of largely come out of nowhere and then growing at extraordinary rates particularly considering the size that it's at already I think that it's probably got

[00:58:53] a little bit ahead of itself but the business itself is still incredibly impressive but it's hard to know again because it's clearly it's those other big companies mostly that are consuming Nvidia's chips will they continue to buy at that rate

[00:59:08] one thing that that's one thing that Jake Taylor who's my co-host on the podcast that I have pointed out is that the capital intensity of these big businesses where historically they've been like not particularly capital intensive they are becoming increasingly capital intensive

[00:59:26] and Facebook was one that I was looking at which companies reinvest just in absolute terms beyond their maintenance capex and I was just using his you know if you if you just say depreciation amortization is maintenance capex and then any reinvestment above that is growth capex

[00:59:44] that's not that's not accurate but it's just as a sort of shorthand rough way of figuring it out what are the biggest investors in the market and the two were Tesla and Facebook

[00:59:55] I was kind of shocked by Facebook and that was that was probably when Facebook was spending most of its money on the metaverse but we're still kind of shocking to me that it was you know I would

[01:00:03] think of Facebook as being it's mostly a it's a couple of websites it's a couple of apps but really that the infrastructure is enormous and it's true for Google and for Microsoft as they build out

[01:00:14] the cloud and they build all that back end out it's going to be hard for them to get the same rates of return on those investment that they've had but equally like that it's going

[01:00:22] to be impossible for anybody else to compete with them because no one can spend that kind of money but they're going to be less good businesses in the future so they may not have the same premiums

[01:00:31] you know returns and invested capital that they've had they'll still be very good businesses they just won't be as good they'll be vastly bigger but the business will be bigger and

[01:00:40] they won't be trading at such a huge multiple well Toby as is always the case we have so much interesting stuff to talk about when you come on that we uh don't get through about

[01:00:48] half of it in an hour but uh we'll have to have you back at some point you can maybe take down Cullen's record and we can also uh you can take the sole lead and we can also go

[01:00:55] through the rest of it yeah that was fun that was really great I love chatting to you Jack so it was good I think we think very similarly so it's it's a good chat where could people go if they

[01:01:04] want to find out more about you or about your funds um aquires funds dot com or aquiresfun.com I'm on twitter at greenbacked it's a funny spelling G R E E N B A C K D or you can search

[01:01:17] my name on amazon uh to buy us Carl I'll you find all my books and aquiresmultiple.com we got a free screener it shows the names that we're talking about uh well what I think are the the cheaper

[01:01:31] bigger names in the market and um the two the two funds are Zeg and Deep thank you Toby thanks Jack pleasure as always this is Justin again thanks so much for tuning into this episode

[01:01:46] of excess returns you can follow Jack on twitter at at practical quant and follow me on twitter at at JJ Carboneau 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 you