(Ep.23) The Acquirers Podcast: Eddy Elfenbein – Buy List, Fundamentally Sound, High Earnings Quality

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Summary

In this episode of The Acquirer’s Podcast Tobias chats with Eddy Elfenbein. He is proprietor of the popular investing blog Crossing Wall Street Blog, and he’s also the portfolio manager for the CWS ETF. During the interview Eddy provided some great insights into:

– How To Construct A Buy List
– Finding High Quality Stocks Starts With The World’s Simplest Valuation Measure
– There’s Mean Reversion Among Multiples
– You May Not Think You’re A Factor Investor, But You Are
– The Single Best Metric In Investing Is…
– Why Return On Equity Is So Important
– How Can Investors Spot Warning Signs Of Fraud
– It’s The Second Mouse That Gets The Cheese – Embryonic Industries
– Investors Should Look For Companies That Have A Pseudo-Monolopy

Other Studies/Papers Mentioned

Other studies/papers/articles mentioned in the interview are:

2019 Crossing Wall Street Buy List

World’s Simplest Valuation Measure

Why Return-On-Equity Is So Important

The Single Best Metric: EV/EBITDA

The Elfenbein Theory to Explain the Entire Stock Market

The Acquirers Podcast

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Full Transcript

Tobias Carlisle: If you’re ready, we’ll get underway.

Eddy Elfenbein: Any time you are.

Tobias Carlisle: Okay. Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is aesthete, raconteur, impresario, bon vivant, cognoscenti, recusant, enfant terrible, Eddy Elfenbein. He’s the proprietor of the Crossing Wall Street Blog, and he’s also the portfolio manager for the CWS ETF. We’re going to talk to him right after this.

Announcer: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds or affiliates. For more information visit acquirersfunds.com.

Tobias Carlisle: Hi, Eddy. How are you?

Eddy Elfenbein: Great. How are you?

Tobias Carlisle: Great. I love that description that you have in your Twitter bio. I was going to suggest some additional words that you could throw in there too, so I’ve got ingenue, linguist, boulevardier, flaneur, libertine, entrepreneur, investor, and blogger. You didn’t mention that one.

Eddy Elfenbein: That’s true. The important ones, I left out.

Tobias Carlisle: The most important ones. You’ve been writing your blog since 2006, so you’re one of the longest-lived bloggers that I can find. There are others who started before you, but they gave the game away a lot earlier. So I always think of the Cheap Stocks blog, John Heller, he may have been there four years before you, but I don’t think anybody else has survived as long.

Eddy Elfenbein: I think Barry Ritholtz was before me.

Tobias Carlisle: Barry Ritholtz, yes.

Eddy Elfenbein: Still going strong.

Tobias Carlisle: I think very narrowly, in terms of the value guys who are picking stocks, but that’s exactly right. I always say that value is a very broad church. How do you characterize your own style?

Eddy Elfenbein: I really don’t think of myself as a value investor, and I’m not overly worried about those characterizations. I look for good stocks at good prices, and wherever that takes me, that takes me. Sometimes I’ll get something that would be by conventional metrics overpriced, sometimes by conventional metrics underpriced. I like to sort of remain nimble that way. I don’t think it’s necessary to box myself in by a factor model.

Tobias Carlisle: When you’re deciding whether you put a stock into the portfolio or not, do you undertake a valuation?

Eddy Elfenbein: I do, yeah. I will look at it. It’s always within context of what I think the company is capable of, where historically it’s been capable of. I always want to take the valuation in mind, but it has to be done within the context of other variables.

Tobias Carlisle: You don’t characterize that as, that’s not Buffett style value investing? You don’t think of it as that way?

Eddy Elfenbein: I mean, if somebody wants to call it that way, that’s fine. I don’t worry about it. I do what I do, and whatever people want to call it, that’s what they do. I don’t think investors need to worry about that, need to waste any time. I just focus on what the company is doing and where the price is.

Tobias Carlisle: You have formed a portfolio for the Crossing Wall Street Blog about once a year since 2006. Could you talk us through the process? How do you come up with the names? How does that happen?

Eddy Elfenbein: Sure. Well basically, one of the things I wanted to do with the blog was to show people that they could be good investors by following some basic strategies. And basically the idea is that a lot of people want to make investing far more complicated than it really is. I wanted to show people that it is possible to do well in the stock market. I wanted to say, I’ll even go the extra effort. What I’ll say is, here’s a Buy List for the coming year, and I’ll give you a group of 25 stocks. I won’t make a single change through the entire year, and let’s see how we do. We won’t get bogged down by trading. We won’t get bogged down by the emotions of it. We’ll just choose these names and watch how they do. So that’s sort of how it started. I wanted to show people that you can do well.

Eddy Elfenbein: I actually started with 20 stocks. We expanded it to 25. And each year we add five names and we delete five names. We just do a changeover of 20%, which actually, in terms of the real S&P 500, it’s not that far out from what the actual S&P 500 does. It’s around 5 to 7%, in that area. Some years it’s more, some years it’s less. So we’re just always keeping that 20% turnover.

Eddy Elfenbein: Another important thing about that turnover is, it means that the average stock on the portfolio will be owned for five years. It forces me to sit down and say, when I choose this stock, I want to say, “Eddy, are you comfortable owning this stock for an average, not making any changes, for the next five years?” A lot of people think it’s like a hindrance, it’s a cross I have to bear. I actually find it very liberating, because it focuses your mindset on what the company will be doing over the long term, where their strengths are, will they be lasting? It’s a change of mindset, and I think it really helps me in my stock selection process.

Tobias Carlisle: I’ve heard you describe your process before, is you track around 70 or 80 stocks.

Eddy Elfenbein: That’s right.

Tobias Carlisle: And then how do you narrow it down from your list of 70 or 80 to decide which ones go in the portfolio?

Eddy Elfenbein: I have a watchlist of around 70 stocks. I’m constantly adding and deleting names, things that I find interesting. These are companies that I’m aware of, but I don’t want to say I follow. I can’t sort of go into a detail about them, but I know generally I would consider these good stocks. They pass the mustard. Sometimes the list gets up to about 100 names, which is too big, and so then I’ll bring it back. I think of this as kind of the minor leagues for the Buy List. Basically, I’ll keep an eye on stocks that I think are exceptionally good, and at the time I make changes to the Buy List that look like they’re going for a good price. It’s the farm system, and I want to see what’s been brewing and what I like. And if I like it, then I’ll call it up and bring it to the major leagues. Sorry for the baseball reference for non-baseball fans.

Tobias Carlisle: What qualifies a stock for the minor leagues, and how does it then progress into the majors?

Eddy Elfenbein: I’ll give you a good example. This is a stock I was just reading about, and a stock that was on the Buy List and I unfortunately sold. You can’t worry about this, but it was a company called Heico. It’s H-E-I-C-O. Ticker symbol is HEI. It’s a fascinating company. What they do is, they make aircraft parts, replacement aircraft parts. It’s a very interesting business, because I’m sure not one person in 10,000 ever thinks about this. It’s interesting, it’s a small cap stock. Not many people follow it. And it’s a niche play.

Eddy Elfenbein: Let’s say you are an airline company or transportation company, you have a bunch of airplanes, and a part breaks on your airplane, something in the rotor, something in the engine. You can’t head over to Pep Boys to get this part. You can’t get this replacement part. They just don’t do it. And you don’t want to get a whole new plane, you don’t want to go to the original manufacturer, and so you turn to Heico. They make the replacement part, and they can make a knockoff of it. So it won’t be perfect, but it’s basically, it can get the job done.

Eddy Elfenbein: You always want to be in a business where they say, “Well, just pay the man.” I don’t want to say you’re forced, it’s not a monopoly, but it’s kind of a pseudo-monopoly. They have a very strong market niche. In many ways, I think of it as similar in the dynamics of a generic drug maker. They sort of make the knockoff that gets the job done. Heico is a great company, and I also like that nobody knows about it. It’s not well known. It was on the Buy List, and it did very, very well for us.

Tobias Carlisle: Excuse me.

Eddy Elfenbein: That’s okay. It did very well for us, and I thought it was too pricey, and so I cut it from the Buy List. Sure enough, it’s just gone up and up since then. It’s one of these things, it’s natural to kick yourself and say, “Oh, I made a mistake.” You can’t do that. You have to let it go and realize that you’ll tie yourself up in knots thinking about the ones that you could have made a better investment on. But I am human, so it does aggravate me. It’s a good example. It’s gone from the watchlist to the Buy List, and now it’s back on the watchlist, so I would love to see Heico share price drop significantly so I could add it back. That would be great news. So that’s a good example of the interplay between stocks I watch.

Eddy Elfenbein: And I also bought, I believe, FactSet, which just reported earnings this week. They were on the Buy List, then they went off the Buy List. They went to the watchlist. They’re up about 50% this year for us, and they just had a good earnings report. I think they pulled back a little, so it’s probably in the mid-40s. We’re not even halfway through the year. I have no problem bringing back names that were former Buy List names, because I know something about them, and I can vouch for them. It’s probably just a valuation story, so I have no problem, a company that just is a bit undervalued. It’s overvalued, you get rid of them. They’re undervalued, bring them right back. Heico is very, very richly valued, but a wonderful company.

Tobias Carlisle: Is it fair to say that you’re a business analyst and you’re looking for firms that are going to grow earnings over the five years that you plan on holding them?

Eddy Elfenbein: Yeah, I would say so. There are a lot of different names that people use for this, like investment moats. Warren Buffett uses that term. Companies that have some sort of competitive advantage. There’s a few characteristics. Usually they have strong operating margins. That’s what I look for. Companies where, what they say, the high switching cost. Heico is a good example. It really hits at that. Companies that you can go somewhere else, but why do it? It’s kind of a pain for you, so you want to stay with them. Usually they have a lot of ability to raise prices. They have the cost efficiency. Even if they’re not exploiting that to the most, it’s always good to see.

Eddy Elfenbein: I want to make it clear, this is a generality, so it’s not always true, but when companies get into trouble, usually a bad balance sheet and bad fundamentals are a manifestation of a bad business. And people get that vice versa. You can have a strong business that’s done in by a poor balance sheet, but what’s ahead of the balance sheet, what’s ahead of all the financial metrics, is the business. It’s almost always a reflection of what’s going on in the underlying business. For some reason the customer base has soured on the product, so then you see some financial weakness. That will lead to over-indebtedness as they’re trying to mask the system. So it’s a good example that people confuse the mechanics of the market for what the market really is. As you said, I like to be a business analyst, focus on what the company is doing. Are they serving their markets in a positive way?

Tobias Carlisle: So while you don’t describe yourself as a value investor, you are still exercising some value discipline, though, because you said that Heico became too expensive for you. Can you just walk us through that process?

Eddy Elfenbein: Yeah. Basically, a lot of it’s just judgment. I mean, when I’m looking at something that’s 40 or 50 times earnings, we know that there’s just mean reversion among multiples. Maybe we’ll have a higher mean, but we realize that in a year, so much of your profit has not been through profits but through margin expansion, and you just have to understand that that is not lasting, and that will come back and will bite you. So it’s always great to have multiple expansion. When valuation gets richer on a cheap stock, you just have to realize that you can’t last that forever.

Eddy Elfenbein: There’s not some magic formula that decides what the fair price is. It really is, it’s a judgment call, and my rule is I look at as many numbers as possible, but I’m not absolutely obedient to a single one. I follow all I can, and I try to make my judgment from there.

Tobias Carlisle: It’s funny, because one of the most popular, or one of your favorite articles on your site, is the World’s Simplest Valuation Measure.

Eddy Elfenbein: And to be fair, I say that’s kind of a screening method. But yeah, I put that up there. What I did was, I was working on a very, very complicated valuation method, and then what I wanted to do was find out if I could get a quick and easy shortcut to what those numbers were. That’s what I came up with, was my Easiest Valuation Method. I always find that people, when I say that it’s dangerous, because people want to know exactly precise, down to the halfpenny, what a price should be. I say don’t worry so much about that. Ideally, I want to own a stock for an average of five years, maybe 10 or 15 years. So a lot of those valuation things will fade over time, and you really are investing in the underlying strength of the company.

Tobias Carlisle: Well, it’s certainly worked for you. The returns to your portfolio since inception, in total, cumulative, compounded, 211% versus 164% for the S&P. But in addition to that, I think that what I have observed is that your stock prices tend to be quite smooth. The return for the portfolio is quite smooth. It doesn’t seem to draw down much. It seems to perform quite well. Why do you think that is?

Eddy Elfenbein: Well, I like to focus on high-quality stocks, and so you could get a lot of smart guy, I’m thinking of like Wes Gray and all these people who do factor investing, and say I’m riding the high-quality factor. And I’m sure I am. That does affect the portfolio. Again, I’m not trying to do that. I just go for things I like. Those factors are clearly manifest in the market. When a market breaks, we don’t go down as much. And then our beta on the upside, we don’t go up as much. I think in bull markets we’re pretty competitive with the market. We’re actually beating the market again this year. But we really have made our bones in down markets, where we’ve outperformed pretty significantly.

Eddy Elfenbein: That’s something a lot of people have to understand, that beta is not necessarily symmetrical. We really saw that, actually, in May of this year. We had some of our strongest outperformance in the history of the Buy List. If you want to say it’s a closet high-quality factor fund, I’m sure it is. I don’t try to do that, but I think that’s probably a fair description.

Tobias Carlisle: That’s possibly the outcome rather than the objective.

Eddy Elfenbein: Exactly.

Tobias Carlisle: The objective is to find high margins, high switching costs in the business, at some reasonable price that you can justify. And then the performance is whatever the performance happens to be.

Eddy Elfenbein: Exactly, yeah. By the way, I would say a lot of people, I think, underestimate the world of factor investing. I’ve never put this down. I’ll put this across to listeners, because I think it’s important, but also I’ll stress that I haven’t done the quantitative research. But I would say if any portfolio or index gets large enough, it’s very likely capturing a small group of factors, being value or growth or cyclical stocks or high-quality stocks. I actually think that the list is smaller than people realize. You’re getting those factors or an alloy of a small group of factors. It’s a very sophisticated point. I don’t think a lot of investors understand how true that is.

Eddy Elfenbein: And I have to underscore this by saying that is once portfolios reach a significant size. If you have a small portfolio of smaller cap stocks, you can easily sail around these factors. I’m just saying once it gets large enough, you are almost by definition drawn to be a factor investor at some level.

Tobias Carlisle: I’m glad that you made that point, because that’s one that I make a lot, that whether you recognize it or not, you do have some factor exposure in your strategy, and you should at least understand which one you are tracking to.

Eddy Elfenbein: And those factors correlate with other things, interest rates. You can certainly see that if some risk factor in the market, you’ll see that in high-yield spreads. They’ll be closely [inaudible 00:19:47] and will correlate with maybe macroeconomic factors. Again, we’re talking about the relative to performance of the fund. That’s something that also a lot of people sometimes have difficulty wrapping their heads around. Trotsky said, “You may not be interested in war, but war is interested in you.” The same goes for factor investing. You may not think you’re a factor investor, but you are, and you can’t avoid it.

Tobias Carlisle: Well-known value investor, Trotsky.

Eddy Elfenbein: Yeah, Leon Trotsky, that’s right. You didn’t think you would get a Trotsky quote in this podcast.

Tobias Carlisle: I didn’t. That’s a good one. I’m glad. I haven’t heard Trotsky quoted in a lot of value letters, to the detriment of those letters. It is a strategy that is remarkably Buffett-like, even if you don’t characterize it that way. How do you come to invest that way? What were you doing before you were a blogger in 2006?

Eddy Elfenbein: Well let’s see. I was working for an investment company, a newsletter company in Potomac, putting out investment newsletters. I really enjoyed that job, and it was a lot of fun. I got to work with some well-known investors. People out there know Louis Navellier, has his funds based in Nevada. Learned a lot from Louis. And I just wanted to strike out on my own. I read all these blogs, mostly in the political sphere. I was reading Barry Ritholtz, and I think it was about mid-2005 that I started posting.

Eddy Elfenbein: It was a great time to do it. I remember Joe Weisenthal, he started blogging, and then some other really high-quality blogs came along. It was a very small group, and it was a lot of fun, and then not long after that, the world collapsed, I think, in the later Twittersphere. And blogging is a great tool and medium for investing. You can follow really, really smart people. The news and dissemination gets filtered very quickly. You can hear different opinions.

Eddy Elfenbein: I remember early on, the Wall Street Journal ran an article that I thought was very unfair. It was about how companies, there were insiders, board members at companies, and they got their stock options. And they could change the date at which they got the stock options. And that’s fairly standard. It’s not outrageous. I mean, some places it’s banned. What they did is, after 9/11, a lot of people went and they changed the date after the market plunged. And the Wall Street Journal wrote an article, and it said these were people who were profiting off 9/11. I thought that was a very unfair characterization, and I was able to write about it.

Eddy Elfenbein: I had to sit down to people and say, “Okay, let me explain, if you’re not familiar with these concepts, these terms. Their description of the events is not fair at all.” Before, you really didn’t have an outlet to do that. You could write a letter to the editor, and maybe it’s published, but if it’s critical, they may not. I remember I felt really a sense of liberation, that I could put my thoughts out there. Nobody could block it. And I thought I was adding something important to the debate. I remember that was sort of a key moment where I thought that the blogging really could add something to public debate on an issue.

Tobias Carlisle: Was that on Crossing Wall Street?

Eddy Elfenbein: Yes. Yeah, and I think it got around. I remember Barry Ritholtz, who I admire greatly, I remember he disagreed. He was in very high dudgeon. But there were some other people who agreed with me. I mean, there’s always things. You’re not arguing, you’re not having fun.

Tobias Carlisle: If you’re not arguing, you’re not blogging.

Eddy Elfenbein: Exactly. Exactly.

Tobias Carlisle: One of the more popular posts on your blog is Why Return on Equity Is So Important. I have some views on equity, but I’d like to hear, why is return on equity so important?

Eddy Elfenbein: Yeah. Let me preface by saying there are problems with all financial metrics, and just be aware of them. But I was trying to say investors always want to run after something at the detriment of all others. I said return on equity is a fascinating, it’s sort of the gold standard of financial metrics, because you’re getting the most pure, three lumps go in, two lumps come out. Per unit of X, what kind of return are you getting? And that is really the essence of finance. You want to look at the efficiency in its purest form. Now again, there can be problems. Let’s say you have real estate on the books that’s not properly valued. Well, that can completely throw it off. Let’s say you invest in a minority stake in a company, and that stock goes through the roof, well that’s going to increase your equity base. Or in a certain year, you’re going to have a tax benefit or a tax penalty.

Eddy Elfenbein: All those things are going to distort your return on equity. Inflationary periods will distort your inventory. Disinflationary will have an impact on well. But the idea, the thinking of return on equity, it focuses the mind of investors, saying this is how much I’m putting in, this is how much I’m getting out. In many ways, people understand bonds, because it has yield to maturity. I think of, try to put your stock into a yield to maturity. Again, it’s a intellectual exercise, but I like doing that, because again, it’s telling investors. I’ve worked at a retail brokerage, and people say, “I want something around $20, $25 per share.” Get away from that kind of thinking. There’s a company behind that share price. Find out what they’re doing. Find out what they’re about.

Tobias Carlisle: I agree with you that return on equity is the singular measure for determining the quality or the worth of the business that you’re looking for. And I always say that cashflow return on invested capital is the only metric that you should be using. But if you are going to use that metric, the very next step, the immediate step after that, you have to work out how sustainable that return on equity is.

Eddy Elfenbein: Absolutely. Absolutely. That’s why-

Tobias Carlisle: And that’s… sorry.

Eddy Elfenbein: You’re exactly right. Also, I believe I have a post on this, that a lot of studies have shown that enterprise value divided by EBITDA… or I have that backwards… that’s been the best measurement. But I wouldn’t get bogged down by the differences. They’re all sort of getting at the same thing. As far as sustainability, it’s exactly right, and that’s why a lot of the companies I go for on the Buy List are sort of these tried and true. You know, Hershey is on there. I feel pretty confident. There’s a company called Hershey, Pennsylvania. There’s no company in America that’s keto or low sugar. There’s no company town named after that. But there is a Hershey, Pennsylvania. You realize that chocolate will be around.

Tobias Carlisle: Chocolate’s an interesting one that I’ve thought a little bit about too, because Buffett’s own career is an interesting illustration of that idea, in that he made his first arbitrage money buying the… When Jay Pritzker was liquidating the chocolate factory, the name of which escapes me now, Buffett could take the shares and receive the cocoa beans, because Pritzker had found some tax loophole that allowed him to get some advantage by doing that. And then Buffett would take the cocoa beans and deposit them at some sort of place where you could deposit the commodities. And there was a little arbitrage, and he could make money doing that. And Pritzker had clearly set that up purposefully to encourage people to do that. But that was in a period where there weren’t really very many branded chocolate bars. They didn’t really exist. It’s a more recent phenomenon.

Tobias Carlisle: And then, of course, Buffett’s next famous investment is See’s, which he buys because it has that great brand. And that’s really been the engine room of Berkshire Hathaway, in addition to the insurance and various other things. But it’s thrown off so much money. Even if he hadn’t deployed it very well, he’d still be very, very wealthy and would have done well.

Eddy Elfenbein: I think See’s has been, it’s a small position in the empire, but I think as far as overall performance it’s been one of the best.

Tobias Carlisle: Right, and it’s thrown off an enormous amount. It’s a $27 million investment that in 2011 had thrown off $1.35 billion in cashflow. However you invested that, even back into the S&P 500, he would have done extraordinarily well. Combine that with his additional investments, that’s why he’s Buffett. I think possibly we’re at a turning point where the brands become less relevant, and maybe you say to yourself, I want 60% cacao. I’m going to go and buy Amazon 60% cacao, because I am keto. And maybe brands become less relevant.

Eddy Elfenbein: I heard people talk about that. It’s very possible, but you know, then you wonder, is the brand expressed in a different way? Because it’s a level, you’re signaling to consumers, I’m okay, I’m good. You could be driving with small kids across the country, in an area of the country you don’t know very well, you see golden arches, you know exactly what you’re getting. And so even if the brands, they lose their cachet as the name, it could be, maybe through Yelp reviews or something like that, there’s always going to be a mechanism where a company can say to people, we’re okay, you’re okay coming to us. I don’t know. I don’t know how that will express itself.

Tobias Carlisle: Just to change gears slightly, one of the most interesting posts, I think, on your site is the Elfenbein Theory to explain the stock market. Could you give us the theory?

Eddy Elfenbein: Sure, sure. Basically, this dovetails back with what I was talking about, the factor investing. What I’m trying to say is, and again, it’s a generality, but I was saying that the stock market is overwhelmingly driven by, well I can call it four factors, but it’s really two factors, the positive and negative. It’s the direction of short-term interest rates and the direction of long-term interest rates. You look at the stock market on any given day, it usually follows into one of four patterns. If the short-term interest rates go up or down, then you know there’s a very kind of standard falling out of how different industries will do. Energy stocks versus financials versus consumer stocks.

Eddy Elfenbein: And the same thing with long-term interest rates, how those will affect. Again, a generality. When long-term interest rates move, that’s usually a reflection of the broader macroeconomic environment. When the short-term interest rates move, that’s more of the financial, what the Fed is doing, and inflationary aspects. So there’s overlap between the two, but they’re not exactly two. Now, if you think about these two factors going back and forth, you can put that on a scatter plot, and then you get a quadrant. So you can have short-term interest rates going down, long-term interest rates going down, one up one down, and both going up.

Eddy Elfenbein: Implied in that is you basically have interest rates going up, interest rates going down, or then you have the yield curve widening or flattening, are the two opposing quadrants. I’m trying to draw it in the air right here. And I think a lot of investing breaks down into that. I think these are the factors that rule over everything else. I think a lot of the small cap factors, that’s probably not such a big factor. And I’m sure a lot of it is hard to disentangle from these larger factors.

Eddy Elfenbein: Getting back to the short term and long term, basically the short term, when those interest rates move, it’s a value or growth. When the long-term rates move, it’s a cyclical versus defensive. And you can see, most given days in the market, it’s a battle between those. There’s lots and lots of outliers, and not everything follows that exactly, but I think those are the larger megatrends that govern the market. I prefaced that with a number of qualifications, but I think it is important, and I think that that’s how the market… I think it must follow that system.

Tobias Carlisle: You follow that more out of interest rather than to inform the way that you invest?

Eddy Elfenbein: Right. I mean, I don’t think it’s worth it to make a… For example, I’m asked why I don’t have any energy stocks in the portfolio, and people want to know, is that my view of global geopolitical outlook? No, not at all. I didn’t see anything at that time. I think I have a post, it’s that a lot of people, they see investing incorrectly as top down instead of bottom up. People want to know, “Oh, Trump is going to do this. Oh, China’s going to do that. And the Federal Reserve is going to do that.” Yeah, those are important, but Heico is going to be Heico. Microsoft is going to be Microsoft. That is far more important.

Eddy Elfenbein: I think there’s a natural energy for people who want to go… I mean, I get this in my Twitter stream. When is Trump finally going to ruin the market? What is this trade stuff and the tax cut? Obviously. And it’s like, it just doesn’t work that way. Don’t worry about the top down. It’s the investing from 30,000 feet. Basically, you’re talking about the Fed, you’re talking about politics, you’re talking about international. Talk about the margins at FactSet. That’s far more important. I know Peter Lynch said, “If you want to be invested in a car company, you shouldn’t be reading the Wall Street Journal, you should be reading Road & Track and Car and Driver. That’s what you should be reading.”

Tobias Carlisle: With all of that preface, I’m still going to ask you, do you ever think about the value of the market? Does that enter it? Do you think it’s high or low, or you don’t consider it at all?

Eddy Elfenbein: Only at extremes, like in 2000, but I don’t talk about it a lot, because I just don’t have anything interesting to say about it. I don’t think it’s terribly important. And in fact, as far as the Buy List goes, I actually, with our outperformance, I don’t mind when the stock market pulls back, because I can get values, and I know we’re usually going to outperform. I don’t have much worthwhile to say about the broader market’s valuation. If I did, I’d say it, but I don’t talk about my expertise on Alaskan wines either. I just don’t have anything to add.

Tobias Carlisle: One of the interesting posts on your site, you do have a model for gold there.

Eddy Elfenbein: Yeah, I probably have gotten the greatest impact, greatest feedback, from this. And a lot of people who get into gold get very, very into gold. I thought that gold was a challenging topic, because I don’t think there was a clear way to model the price. So I wanted to roll up my sleeves and take a stab at it. What’s important is, it sort of goes back to the ROE, you want to identify the key factors that you’re looking at. With gold, the key factor is not inflation, but the key factor is real interest rates. Once you get that, then I think everything else falls into place. So that was my factor. My model was based on that, and I wanted to tie that to gold.

Eddy Elfenbein: Now, some of it I did some reverse engineering, and so I took the results and tried to work backwards. Not entirely kosher, but I do believe that… You can be off by a little, but as long as you get the idea. Stocks, it’s the net present value of all future cashflows. That’s all it is. If it’s ROE, if it’s EV by EBITDA. A lot of that, those are rounding errors. You want to get to what it’s at and find out why the company’s doing that.

Eddy Elfenbein: With gold, I got to the direction of real short-term interest rates. In my view is that there’s sort of a level of short-term interest rates, and the Fed talks about this as the r-star in recent Fed discussions, the Wicksellian rate. People have taken an economics class. If the real short-term interest rates is above the natural rate, then gold will fall down. If it’s below that, then gold will rise. That’s basically the idea of the gold model. I wrote that a couple years ago, and every month I’ll get a couple emails about it.

Tobias Carlisle: I was wondering if you tracked it since you proposed it.

Eddy Elfenbein: I haven’t. I mean, I did a couple times, but I haven’t recently. I kind of felt like I’ve said everything I’ve had to say about gold, and so I’ll let that… In fact, there have been a couple economic papers written at university, and the footnote is my blog post on it. I go into some detail about what it is. It’s a fun topic, and I like the idea of trying to crack the code. Maybe I didn’t get it exactly, but I think I got it in principle, what impacts the gold market. And then people will say, “Well, what do you think gold will do?” Well, I put these other variables in, so what I’m saying is I’d have to predict those variables. It’s the same thing, so I wouldn’t predict gold, I wouldn’t predict those variables as well.

Tobias Carlisle: All right, enough macro torture. Let’s go back to talking the stock market.

Eddy Elfenbein: Let’s do it.

Tobias Carlisle: We touched on this very briefly. One of your posts, you were talking about EV/EBITDA as being the single best metric. Possibly that falls out of the Loughran paper or some other research.

Eddy Elfenbein: Yes. Yeah, some research on that has said that.

Tobias Carlisle: You’re not incorporating that into your model either. You’re just observing that that has been the case?

Eddy Elfenbein: Exactly. As I said, any measure of efficiency… Let me go back. I’m a sports fan, and you look at all these numbers that measure sports performance. Some are better, some are worse. Sometimes they forget, what is the player trying to do? You don’t want your center to take a bunch of three-point shots. But as you’re getting anything that’s correlated to good things is going to be correlated to better performance. And so that’s why ROE, you’re getting efficiency. P/E ratio, it’s going to do well as some larger, larger study, because you’re getting to the nub of things. EV/EBITDA, same thing. You’re getting to your superior performance. You’re getting to this level of efficiency. As long as you’re in that, you’re always going to be in the ballpark, but the investor has to take it, don’t mistake the ratio for the answer. You want to find out why the company is getting those numbers.

Eddy Elfenbein: This is a good example. People mistake the mechanics for the market for the market itself. You’ll hear people say, “Oh, the market is being driven by share buybacks or the Federal Reserve.” Those things are important, but that’s not the market. The market is always going to be on corporate profits, the net present value of all future cashflows. That, what it’s about. There’s a company making those profits. Find out why they’re doing it. Did I answer you? I ran wild with that.

Tobias Carlisle: Yeah, that’s great. Any answer’s the right answer. I’m just interested in how you think about these things. If we talk about individual companies, how does one go about spotting fraud?

Eddy Elfenbein: That is a very good question, and it’s one of these things, you’re never going to be 100%. I want to look for companies that I trust. That’s why I look for a good track record. I look for consistency. I generally like dividends, is a good example. You can mask earnings. Once you know about accounting, it’s really frightening how much leeway companies can do, what they call cashflow, what they call different things. But a dividend, you know what a dividend is. If they’re sending you cash money, you can rely on that. And so companies that have long records of increasing their dividends, the so-called dividend aristocrats, that’s always a good thing. I look for management that’s been around for a long time. That’s always good.

Eddy Elfenbein: I also like, when you read different earnings reports or you listen to different conference calls, there are companies that are pretty straightforward. Aflac, I’m a big fan of Aflac. It’s run by the Amos family of Georgia. It’s all the uncles and cousins, and they’ve been doing this. They’re very upfront about what they do. They say, “This is going to be a good quarter. This is going to be a bad quarter.” I remember when the Fukushima earthquake, and they say, “Are you going to have problems with it? Is this bad?” So much of their business is in Japan. They said, “Look this is what we plan for. Monday morning at 9:00 we have very smart people thinking about what’s the worst that can happen? We plan for this, so this disaster, we’re ready.” And that goes a long way with me, saying these are companies that I can trust, I have a lot of faith in.

Eddy Elfenbein: And then you see, oh God, there’s so much crap out there. People will ask me, “What do you think of this pink sheet stock?” I think like 97% of pink sheets. I mean, if you’re serious about your investing, you’re not going to be listed on the pink sheets. So to get back, there’s no perfect way to measure against fraud. Lehman Brothers, that went on. Lots of people didn’t know. And Enron, all these things people didn’t know about. I didn’t catch it either. But you want to go with basically companies that you have a fundamental level of trust in.

Tobias Carlisle: So you’re not looking at it as a minimum level or some particular ratio that they need to get over? More than that, you’re looking for do you believe in management? More Buffett-like in that respect.

Eddy Elfenbein: Exactly. Exactly, yeah.

Tobias Carlisle: It’s one of the things that I’ve considered a lot, because it’s one of the things that traps investors. If you invest for long enough, you’re going to get caught with some fraud, just because particularly value investors, it’s cheap because probably a lot of people have some idea.

Eddy Elfenbein: It’s cheap for a reason, yeah.

Tobias Carlisle: But then you find it, and it looks good, and you can’t work out why. I’ve been caught like that several times. In quantitative value, we looked at several ratios and various other things that they don’t really work. I don’t think any individual one, although you can find examples of one of them capturing an Enron or something like that. I think they work better in concert, but the one that I’ve always found the best is just, if there’s a big accrual on the balance sheet that can’t be explained, I think that that’s a pretty big red flag. And that was something that showed in Joseph A. Bank. I don’t know if you followed that very closely at all.

Eddy Elfenbein: No, I do remember. That was on the Buy List years ago, and I did get rid of it, I think, at a good time. I’ll have to check, but I know it was on the Buy List many years ago.

Tobias Carlisle: It’s extremely hard to tell though, because you get the argument from the company that the reason that they have this big suit inventory is because men like to walk in, buy the suit instantly. The explanation was pretty good, too. So it’s a hard one to pick up, I think.

Eddy Elfenbein: You know, the thing about fraud is, we asked them and they said no. They’re actively trying to hide it from you, so that’s the whole idea. There are people out there who are forensic accountants. There’ll be some way. I know, for example, Tesla has a great deal of interest, and people go right to the county office where you have to submit the plans for buildings. So this is nothing published. Think about that level. They’re just going in just to see if Tesla has filed anything. They changed, they had some tent or some structure on their property, and they filed with the county to extend that. And people ran and got that info. More power to them, but I’m not so worried. With Hershey, I’m okay. I don’t need that level of info. I trust the company.

Tobias Carlisle: I think Tesla’s one of the more interesting examples out there, because the two camps are so set in that they are right. And I think that they’ve both got very good arguments. The longs are right that the car is an object of desire. The demand for it seems to be almost unlimited, at a premium price. That’s a great business. But then the shorts focus on the balance sheet, look at the balance looks weak. And as you were describing your process earlier-

Eddy Elfenbein: And the behavior of some people in the company leaves something to be desired.

Tobias Carlisle: Right. But then again, you would expect that he has a $20 billion fortune, he’s done several incredible things, including shooting rockets into space, making a lot of money at a very young age, so on. And setting up a car company in what has been an incredibly competitive, hard market to compete in. But as you were describing before, good businesses don’t have these problems with their balance sheet. I wanted to ask you about Tesla then, so do you have any further thoughts?

Eddy Elfenbein: Well, the thing is, I can’t say I have any deep knowledge of the company, any more than it’s out there. I’m always leery of companies like this. There were in the 1920s, I believe there were 400 US car companies, and for many decades we talked about the Big Three. So just because you are in an embryonic industry doesn’t mean you will be the winner. As I tell people, if you asked somebody in the early ’80s, I think computers are going to be really big, what should I invest in? You would have been told DEC. You would have been Wang. You would have been told IBM. That’s what to invest in. Probably didn’t work out that great. IBM has done a little bit better, but they certainly had their problems along the way.

Tobias Carlisle: The correct answer was probably Intel.

Eddy Elfenbein: Right, right.

Tobias Carlisle: But you had to know that, with hindsight.

Eddy Elfenbein: Or would you have gotten Yahoo before Google? Google came later. Very often it’s the saying, it’s the second mouse gets the cheese. You see that very often. The de Havilland Comet, that won the race of getting the jet service. Didn’t work out in the long run. Boeing took that. So I don’t know. I’m not impressed by Mr. Musk’s behavior. Also, a lot of his… I’m always suspicious of people who have acolytes. Musk can do no wrong to people. Whenever I criticize him, I get enormous feedback on Twitter.

Tobias Carlisle: We’ll both get some for this one.

Eddy Elfenbein: Yeah, I may, but for me, I can assure you, it is the most impersonal. It couldn’t be less personal when I say these things. I don’t care. If Elon Musk could make me a lot of money, I would have no problem with this. But I would say generally, I raise a skeptical eye. I haven’t been terribly impressed. People I’ve talked to who are more knowledgeable have been more skeptical about Tesla. I can play it either way.

Tobias Carlisle: Let’s talk about some individual names on your Buy List. One is Broadridge, that I think most investors may not have heard of, but most investors should know who they are.

Eddy Elfenbein: Great company. Again, it’s a pseudo-monopoly, but they do proxy voting. It’s one of these things, it’s a headache. I think they have maybe around 50% market share, and it’s one of those things. Better than a monopoly is a pseudo-monopoly.

Tobias Carlisle: Why is that better?

Eddy Elfenbein: Because they don’t have the legal pressure of it. I’ll give you a good example, is Harley-Davidson. I would say that Harley-Davidson is a monopoly. Now, the government’s saying no, plenty of people make motorcycles. The key is, Harley-Davidson does not make motorcycles. Harley-Davidson makes Harley-Davidsons, and they’re the only one who does that. Don’t ask me. Go to a Harley-Davidson owner and say, “Oh, well this is a motorcycle.” “It’s not a motorcycle, it’s a Harley.” So to them, it’s important. Technically, is that a monopoly? Not at all. You can get any kind of motorcycle. Lots out there. And they have the pricing pressure. Harley has actually run into some troubles more recently. But basically, that’s the idea. It’s better than a monopoly, one that sort of acts like one, has the characteristics of one. Switching cost, pricing pressure, wide margins, usually low debt, hopefully low debt.

Tobias Carlisle: The power of the brand. What about Disney? That was one that you’ve had in the portfolio for a little while. It’s come to life more recently.

Eddy Elfenbein: I’m glad you had this, because people always says, “My mistakes,” and this one I got exactly right. And I can say it was a lot of luck. I mean, I’ve liked Disney, but it’s a new stock I added at the beginning of this year. I think in May it was literally their best month in like 30 years. The website Fandango is a movie website I’m sure a lot of listeners would be familiar with, they came out at the beginning of this year. They listed the 10 most anticipated movies of 2019, and Disney owns seven of them. And that didn’t include Frozen Two, which is on tap. And I have a feeling that will make some money. I think Charlie Munger said, “They’re like an oil company that they can drill it out of the ground, make money off it, then bury it and drill it out again and make more money.” And that really is.

Eddy Elfenbein: What you understand is that every Disney movie is almost like a separate business, and there’s a track that it follows, of the international release, going to video, it’ll be streaming, and then they have the toys based on that. And then a big thing is getting the park ride. As odd as this sounds, if they announce a new park ride, they’re such fans that they’ll go to … I believe they said, I hope I don’t get this wrong, but the first park ride specifically about Mickey Mouse. So the thing is, they have this enormous catalog that they can still bring out of the ground and make money off again. They can always use, you know, Frozen Two. You don’t have to spend money. People know what Frozen One is. It’s just a fantastic brand name.

Eddy Elfenbein: Now, for the last several years, they’ve had a lot of problems with cable, with ESPN, some football ratings, some people complaining about the political leanings, problems at ESPN. And fortunately, the stock had done nothing for five years, and so we got it, and I couldn’t be happier with Disney this year. Great company.

Tobias Carlisle: When you construct the portfolio, do you have any top-down consideration of how concentrated you are in any given sector?

Eddy Elfenbein: Yeah, but it’s not really strong. I mean, I just love a lot of medical device stocks, and I got to be careful that I just won’t load myself up with that. I love a lot of consumer names, so I have Church & Dwight. They make condoms, for Christ’s sakes. That’s not going out of business. Great company. Baking soda, Arm & Hammer. Great brand name. So I’m always a little leery. Some of the healthcare. It’s a lot of those defensive names, because you can just see great balance sheets. You can see these consistently rising sales and earnings. So I think I have a bias in my mind to a lot of defensive names. The cyclical names, it takes a greater judgment when you look at the earnings line. You have to understand, yeah, they had a horrible year, but it was just for the economy. You got to adjust for that.

Eddy Elfenbein: The one company I have, Continental Building Products, great company. They make wallboard, so you can have a boom and bust year. So you want to look them relative to the larger economic cycle. I think I have an inherent bias against those names. It’s very tough to do, so I am always cognizant about being overly concentrated in the consumer names and some of those medical device names.

Tobias Carlisle: The portfolio breakdown, the weighting seems to be 30% financials. I think that financials are quite cheap, and I’ve directed more money towards financials too. But you’re not working that way. How do you come to that weighting?

Eddy Elfenbein: I wouldn’t have even known that, because I just think… I have two banks, which is Signature and what’s the new one? Oh, Eagle Bank. Those are the pure banks, and then I have Aflac. And then there’s Fiserv, which is financial services. So in the pure banking it’s just two, and Aflac is another insurance. But I really don’t think of it in those terms. I just of it as companies I like that are well-run and have good positions. I do pay attention to larger… I don’t want to be crazily over-weighted, but it’s not a priority.

Tobias Carlisle: Your newsletter that comes out weekly, how do folks get signed up to that? That’s expensive, I expect?

Eddy Elfenbein: It’s surprisingly cheap. Everybody should stop what they’re doing and go and sign up for it. Just go to my website. There’s an e-letter tag across the top. I think there should be a signup on the side as well, and you can just go in it. But it’s free to sign up for that, and you can cancel at any time. There’s a unsubscribe button. I send it out every Friday. I only take off on Thanksgiving and Memorial Day. Maybe I’ve missed a couple days. I’ve been doing that since 2010. I send that out, and it’s just kind of my thoughts. It’s focused on the Buy List, and I’ll talk about the economy and the market. So it’s fun to do. I enjoy it.

Tobias Carlisle: My hat is off to you. I think you write faster than I can read.

Eddy Elfenbein: My only real talent is I can churn out prose pretty quickly.

Tobias Carlisle: And your Twitter account, which I think is probably one of the best ones out there.

Eddy Elfenbein: Thank you very much. @EddyElfenbein. You can see me out there. I think I’m around 45, 50,000 followers. Twitter’s always fun, and then of course there are lots of trolls and crazy people out there, but that’s what Twitter is. I enjoy. I try to understand Twitter, what it is, but you have a great Twitter feed, a lot of great people. So you follow the great people, you can really learn a lot. I always try to learn from people. Few things are as humbling as being a professional money manager and to see yourself get slapped around and realize that your decision, selling Heico, selling Microsoft, was completely stupid. I’m envious of people in other fields, who can get away with saying absurd things. In finance, your results, you will get smacked around very quickly.

Tobias Carlisle: You are brought to account in Thunderdome, Twitter Thunderdome.

Eddy Elfenbein: Yes.

Tobias Carlisle: Eddy Elfenbein, thank you very much.

Eddy Elfenbein: Thank you. This was a lot of fun.

Tobias Carlisle: My pleasure.

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