(Ep.40) The Acquirers Podcast: Bluegrass Capital – Unit Economics, Incremental Returns And Intangible Capital

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In this episode of The Acquirer’s Podcast Tobias chats with the man behind the pseudonymous Twitter account, Bluegrass Capital. During the interview Bluegrass provided some great insights into:

  • Unit Economics – A Alternative Method For Valuing Companies Today
  • The First Question To Ask When Analysing Opportunities – What Is The Customer Value Proposition?
  • Investors Should Search For Companies Where You’re Getting The Management’s Capital Allocation Skills For Free
  • How To Use The LTV/CAC Ratio – Important eCommerce and SaaS Metrics
  • Are Traditional Financial Statements Becoming Redundant For A Lot Of Today’s Companies?
  • How To Identify Which Companies Have The Best Management Teams
  • The Proxy Statement Can Be Much More Valuable Than The 10K
  • Smart Investors 13F’s Provide A Rich Source Of Potential Investments
  • Investors Should Listen To Company Conference Calls To Ensure Management Is Maintaining Its Core Thesis And Reinvestment Priorities
  • Even Unsophisticated Technical Analysis Is A Very Useful Tool For All Investors
  • Triple Net Businesses And Why Buffett Likes Store Capital
  • Futures Exchanges Are Counter Cyclical And Provide A Nice Hedge For An Investor’s Portfolio

References in this podcast include:

Carlota Perez: http://reactionwheel.net/2015/10/the-deployment-age.html

13F screen: https://twitter.com/BluegrassCap/status/1162170920687083520

Portfolio themes: https://twitter.com/BluegrassCap/status/1096143237658693632

You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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Full Transcript

Tobias Carlisle: All right. Well, when you’re ready, let’s get underway.

Bluegrass: Go for it.

Tobias Carlisle: Hi, this is Tobias Carlisle. This is the Acquirers Podcast. My very special guest today is the man behind the pseudonymous Twitter account, Bluegrass Capital. We’re going to talk to him about some of the valuation methods that he uses and how his own process has evolved where valuation for him is relative to say what Buffett has done what other folks have done, we’ll be talking to him right after this.

Speaker 3: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons he will not discuss any of the Acquires Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquires Funds or affiliates. For more information, visit acquiresfunds.com.

Tobias Carlisle: Hi, Bluegrass, how are you?

Bluegrass: I am well thank you for having me. I was telling you offline, I think we have some different approaches to our investment styles, but I’ve read several of your books, and I’m just really flattered by some of the progress you have and for to be in that company. I’ll try to make this interesting for your listeners.

Tobias Carlisle: Well, that’s very kind. I heard your podcast with Ryan Reeves and he had this little quote of yours right at the start which blew my mind a little bit. And you said at the start, “If something like”, and I’m going to misquote you slightly but, “If I can find a company that invests $1 in acquiring a customer and they can get back $3 to $5 in gross profits, it doesn’t matter to me if the EBITDA margin is negative or positive.” And honestly I was blown away by that and I thought about it a lot since and I now I think I understand what you’re driving at. But can you just describe how you’re valuing these companies when you when you first start out?

Bluegrass: Absolutely. Yeah, we’ll give a shout out to Ryan. He’s a learning machine. I’m really glad to have met him. So what we were talking about there, and the quote you reference is, we’re talking about unit economics of a transaction. So to back up and start broader, what’s the example of unit economics? This used to be a lot simpler for investors to figure out when you had businesses that employed a lot of physical capital, tangible capital. So if Walmart is going to build a new store, and let’s say Walmart has 50 stores now or 10 stores or whatever and they’re about to build one new store. Well you can look at their existing business and you can say, okay, this income statement is a reflection of their 10 existing stores.

Bluegrass: They just told us, they’re going to spend cap X of whatever $10 million to build this store and the returns they expect to get are X, the store will pay back itself in two or three years, there’s going to be a drag of cash going out the door while they build the store. They’re going to have to hire employees and buy inventory before that new store opens. So, if that store wasn’t open, their existing 10 stores would look better on the consolidated income statement, but that new store is going to be a drag for a little while.

Bluegrass: So that’s the unit economics. That’s just saying, okay, maybe the income statement is going to look bad next year or not as good as it would have because this new store is making the other 10 stores not look as profitable as they are. And that’s easy to understand. When you transition that capital model to today’s framework or I should say, what’s more common today, where a lot of currently successful and growing businesses don’t need tangible assets, to invest reinvest in their business they’re not building a Dollar general store, or a Costco store, or a Walmart store, they’re acquiring a customer, they’re acquiring a digital customer. And so you just have to think about differently the unit economics of their business. They’re not going and building a Walmart store, they’re spending money advertising on Google to acquire the customer, but it’s the same exact idea. It’s just, how much money do you spend today? And then what cash flow are you going to get on that outflow in a year, three years, five years, 10 years?

Tobias Carlisle: Okay. So I’ve got you very kindly sent through your little bit about your investment process beforehand. So the first step in your investment process is to start with a customer value proposition. So can you walk us through how you make that assessment?

Bluegrass: Yeah, absolutely. It’s just on the micro level. Before we even get to unit economics, just think, does this product need to exist? Do customers want this? I mean, does anybody want to watch MTV? No. I mean, so it’s like, I think you can just stop your analysis there for various reasons, if that’s what you decide, but you think of other things it’s like, do people want food delivery? Well, yeah, they really do. People really like having stuff delivered to their house via Amazon, or Dominos pizza, or whatever. So the idea of the value proposition is the customer want this so they better off for it? And if they are and they like it, and it’s something they can buy frequently, repetitively, then you start going further down the list of, does this transaction actually make money for the company?

Bluegrass: For some businesses that are good businesses, it does, they have positive unit economics. For some it’s still debatable. Does Uber have positive unit economics? Does Netflix have positive unit economics? Maybe, maybe not.

Tobias Carlisle: And then, okay, that makes complete sense. So you’re trying to work out, does this product or service help the customer in some way? Does it cut some costs out of what they’re doing? Does it provide a service that they’re prepared to pay for? Then you’re looking at, and this is probably most applicable to software as a service type business, is that fair or is this for any business?

Bluegrass: No, for any business. I mean, like pest control. I don’t want roaches and spiders walking around my house. And my wife if she saw one, she’d be really upset with me. So, it’s a small relative cost, whatever $20 or $30 a month or something for the pest people to come by. It’s non-discretionary basically. They raise the prices 3% or 4% every year and we don’t even think about it. I mean, so that’s the value proposition. I don’t cockroaches in my house, you have the specialty chemicals if you’re Rollins or Service Master to do that, and where to spray and I don’t. And I don’t want to crawl under the house, and I don’t want to get onto the roof and put screens over my gutters to protect squirrels from getting in my attic. I’m sorry, I’m just going on too much of a tangent.

Tobias Carlisle: No, I love it.

Bluegrass: It applies to any business. I mean, it’s like, should this business exist? Do people want it? I mean, do people need this service or product? And a lot of companies you can just look at and it’s like, no, or there’s 100 competitors and … or you can do it yourself, there’s no reason to pay somebody else to do it. So it just fundamentally before you even get to the, does this business make money at the unit economics level? Just think to yourself, do I need this? Do I want this? Is this valuable to anybody? If this business just fell off the face of the earth, would anybody care?

Tobias Carlisle: Right. That makes sense. So then you next look at the unit economics. So for all the star companies, let’s say all the star businesses this was a question of building up the store or whatever the case may be, and then what return can we expect on that, and then if we’re building out X number of stores, we’re going to see, at least up front, there’s going to be some investment, there’s going to be negative cash flow depending on how they depreciate, it could be negative income impact. And then you’re saying that some stage they start overwhelming the growth and the payback starts overwhelming the cost to install it and it becomes profitable and that’s the curve that you’re trying to build. So that’s the unit economics. Is that a fair description of the unit economics?

Bluegrass: Absolutely. Yeah. I was probably long winded on the opener. But my favorite example, as far as the physical tangible model, is Dollar Tree. If you look at Dollar Tree, which is a Dollar store operator, competitor of Dollar General, if you look at Dollar tree’s I think it was 1995 IPO prospectus, I think on the cover page, it just basically identifies, they outline their unit economics on the front page. And it’s basically like it costs us $300,000 to open up a new store. And in the first year we generate … No, it’s $150,000. And in the first year we generate $170,000 of EBIT for that open store. So the payback on that store is six months, or eight months, or something.

Bluegrass: And so the thought there is if being you, if we just had a couple $10 million or something, and we could just spend $300,000 or $200,000 to open Dollar Tree stores, you and I wouldn’t care what the profit and loss of the store was on gap. We just knew that if we open one, it’s going to pay us back in six months, and then the store will still be there, and people will still be going to it, and it’ll still be profitable. We’ll just take any profit comes from that store and open the next door.

Tobias Carlisle: So you’re looking for these companies that can grow very, very rapidly and you’re trying to find them at a fairly early stage in their growth curve where the profitability is somewhat hidden by the fact that they’re still growing and reinvesting at a high rate, is that fair?

Bluegrass: That’s a yes. I’m not intentionally trying to look for companies with those characteristics, but the response I would give you is, I do see a lot of hidden value or a lot of misunderstanding in the current market for businesses with those characteristics. I think it was widely misunderstood seven, or eight, 10 years ago. I think it’s a lot more common and understandable now especially as a lot of funded businesses remain private longer. And as we’ve had the proliferation of Twitter and medium and other blog formats venture capitalists share a lot more information about these companies that are still private. So I think they’re helping educate investors.

Tobias Carlisle: Yes. I think you raise two interesting points there. One is, I’d like to get an idea of what your ideal target looks like. So let’s start there and then I’ll go to the next question after that.

Bluegrass: Sure. It’s always fun to think about. Nobody asked me that question, my ideal target. It’s building on some of the things we just said. But you mentioned something a minute ago about, am I looking for businesses that are early on their growth curve? I’m really not. I mean, I’m not afraid of them to invest in. I really like, despite some of the things we’ve already talked about, I really like asset intensive businesses. I know it’s confusing. I like airports, I like shopping malls, I like data centers. But the point I was going to make was, what I’m really most interested in is the reinvestment runway. So I use this example of we can build one Dollar Tree store, it takes us money up front, but then we quickly get our capital back and it’s growing, and it’s spinning off this cash, and we can take that cash and reinvest it in the next store.

Bluegrass: So the reinvestment story, is the company producing cash flow? But if they are, what are they reinvesting it in? That’s really the main thing that I’m interested in focused on when I’m underwriting a business. So, it’s basically trying to understand just what the opportunity is, is management clear about what they’re reinvesting into? Do they educate us on the opportunities that make sense? Is there a big growth runway for them to reinvest? Just qualitatively understanding it and then going in the spreadsheet and saying, okay, they’re reinvesting $1 in what? Are they earning 3% on that, or are they earning 50% on that next dollar they earn or invest, I should say? So, I think that reinvestment and the concept of understanding and looking for it is at the center of my investment process.

Tobias Carlisle: That’s the cool, okay. So the second question that fell out of what you said, and I agree with your … I think that something that has been a change over the last 10 years and it has moved away from, I would say that 10 years ago, Buffett style investors were probably looking for the company has to have a sustainable competitive advantage, high return on invested capital, so on. That’s basically still what you’re saying. But in some ways, this is an extension beyond what he was doing because this is I think a lot more of the value comes from the growth. I’d say almost all of the value in this analysis comes from the growth and you really, just to go back to the quote that you had on Ryan Reeves podcast, that you’re really not caring about the profitability of the company at this point in time when you’re looking at it. You’re imagining what it’s going to look like much further down the road, which means that all of the value is in the growth.

Bluegrass: I do agree that a larger percentage of current valuations are really future growth related as opposed to just the base business. And to tie that in to something you told me offline, which I thought was a great quote, about you’re looking to basically pay a cheap or a fair price for a business that doesn’t factor in the growth. So in essentially you’re looking at the business and you’re saying, if I can pay a valuation that assumes no growth, even though I’m going to get growth and get growth for free, then that’s attractive to you. For me, in reinvestment, reinvestment or understanding the reinvestment opportunities is essentially just understanding management’s capital allocation strategy and abilities. So for me, I’m happy to pay a fair price or even a full price for a company if I think I’m getting management’s capital allocation skills for free, and hence potential reinvestment opportunities for free.

Bluegrass: If somebody looks at a really high quality business, like Brown-Forman, they make your Jack Daniels or just any spirits company, and they say this is trading at a 30% PE multiple premium than SMP 500, it’s like 25 times earnings or 30 times earnings and it only grows 5% a year or something, I mean, that’s a full price. But yeah, my point was going to be growth is baked in there, but if you can bet pay something that’s 20 times multiple, and that basically is valuing a core business that grows at 3% or 4% and in its earnings grow at 7% or 8%, but management’s track record has produced double that, the acquisition, or reinvestment, or whatever management’s track record is actually growing the business 15% earnings a year, you’re effectively getting their capital allocation skills for free. If you’re paying a market 20 times earnings multiple.

Tobias Carlisle: Got you. So Just to change text slightly. In the document you sent through to me, you’re talking about, and I think of this as a more modern way of undertaking evaluation, but this is something that I learnt like 20 years ago or maybe more than that in the run up to the .com boom there was this … And this was more in a venture capital context. And these were valuations that were undertaken typically in private companies in a venture capital style where you had to figure out, what does it cost to acquire a customer? What is the customer’s lifetime value? What’s the total addressable market? I think about that as a venture capital style investment. Is this listed venture capital, is it value in a venture capital context?

Bluegrass: I think I understand your question and I’ll give you a wild ass comment and maybe we can push it together. I think this has always existed. I mean, people understand that if you’re Coca Cola and you’re spending a lot of money to advertise during the Superbowl, it’s not just an expense that has no benefit. I mean, you’re doing that to try to build your brand value, you’re trying to acquire customers and keep your existing customers. I mean, so if you’re the head of marketing, I mean, your job depends on you quantifying the return on investment for your marketing spend. So I think it’s the same concept. I think it’s just a lot of companies that are late stage venture or early public companies that are just growing so fast, they’re just spending so much more aggressively instead of spending a couple of percentage points 2% or 3%, 4%, or 5%, or 10% of your revenue to grow customers slowly. I mean, they’re saying, the lifetime value this customer for Coke it might be 50 years but for our enterprise software customer that lifetime value may be only seven years.

Bluegrass: So, I mean, it’s just a compressed timeframe. So they’re not going to spend 5% of their revenue on sales, they’re going to spend 30% of their revenue on sales, that’s just the way the model looks.

Tobias Carlisle: Can you give an example of that if you apply to say something like Grub Hub?

Bluegrass: Yeah. So, I mean, their acquisition costs for a customer is like $25 to $50, somewhere in there. And they spend it mostly acquiring a customer via Google or offline advertisements like subway billboard type stuff. And for that customer, for 20% ish of their customer base, that customer is ordering weekly, so four or five times a month. And so if you run the unit economics on that, they’re paying $25 or $50, the lifetime value that customer if they last about a year and a half to two years, it’s like $150 is the lifetime value. So if you just think about that way, $150 comes in the door over two years versus up front, you put out $50 to advertise to acquire the customer, that’s a three to one ratio. So that’s a simple example and that’s not exact, by the way, that’s just pulling through comments for management and trying to triangulate around some data. But that’s what LTV versus CAC would look like for a Grub Hub.

Tobias Carlisle: So that was going to be my next question. How are you actually making that assessment? Obviously that’s not something that’s in the financial statements, that’s something that you have to triangulate from commentary, from management.

Bluegrass: Yes. I mean, just parsing through transcripts and reading whenever management team has an industry interview with a magazine or CNBC or something. You just keep notes and every now and then they’ll give you a gem that pushes you in the right direction to understand that stuff. I mean, some of the companies like Zoom, for example, I mean, in their S1 they will actually show these unit economics. But it’s just because they’re so egregiously good, they really can’t hide them. And then they don’t have enough competition to really be worried about it. But you’re right, these are usually things that are not easily to just figure out and these are not metrics that are in a 10K.

Tobias Carlisle: How do you then go from the unit economics that you have building that into a financial model of valuation for the business?

Bluegrass: In a really short answer, it’s just layering them all in. I mean, so if you have 10 Walmart stores and you’re going to build a new one, then you would just have a model that says, okay, here’s our business model or financial model for 11 Walmart stores, what is the revenue going to be per store? What’s the expense space going to be per store? That kind of thing, you just add it all together. It’s the same thing just a lot more or infinitely more complex with thinking about LTV versus CAC, you can just say, okay, the lifetime value is this, versus the acquisition cost is this, you’re going to have X amount of customers come on per year, you’re going to have X amount of customer churn per year, then you just put those things in a spreadsheet and you play around with a variable range of what the output is. It’s just a summary, instead of summarizing a bunch of Walmart stores or Dollar Tree stores, you’re just summarizing or consolidating billions of customer transactions over whatever the lifetime you’re projecting.

Tobias Carlisle: When you’re looking at something like Grubhub, and I think that’s a good example, it seems to me, I haven’t looked at Grubhub closely, but when I, as a consumer of the services, that there’s a lot of competition out there, how do you get comfortable with which is the place to place the bet?

Bluegrass: Absolutely. And the real short answer for me on food delivery is, I don’t. I mean, I’m not comfortable. I look at the competitive set and what I know about it, the dynamics in the marketplace and how they’re competing, and who’s spending capital and who’s funding the capital, and I don’t know the answer. I mean, you can see a good customer value proposition and then positive unit economics, which you Grubhub has, but still not make an investment. I could argue either way basically, but as far as in food delivery right now, so that’s the example we’re talking about, is there a moat that you can point to? I would say, no, there’s not.

Bluegrass: And if you said to me, what do I think that competitive dynamics are going to look like in the food delivery industry five years from now? I would say, I have no effing idea. I mean, those are simple things but they’re the right questions to ask and I think it’s important to be familiar with a wide variety of companies, including companies you might never even invest in because you’re going to learn things about other businesses you own or you may own in the future that you wouldn’t have otherwise figured out.

Tobias Carlisle: Yeah, I agree. There was a great comment on Twitter, something about, how do you define your circle of competence? And I’ve liked your answer to which was … How do you define your circle of confidence?

Bluegrass: I’m glad you brought that one up because that was a flippant response. I do think as investors we need to constantly be pushing ourselves to expand our circle. But as I just tried to demonstrate to you, I mean, you also have to be realistic about what your circle is. And say, I think it’s totally fine, I think it’s actually one of the most important things to just be constantly saying, I don’t know. I don’t know the answer to this. There’s whatever, 15,000 public companies in the world, there’s no reason why we have to … It’s okay to just say, I don’t understand how this works and move on to the next one. But I think it’s not okay for there to be large scale trends and industries that end up driving the majority of growth for the whole stock market. So an example would be technology over the past 20 years. I don’t think you can just sit on your hands and ignore that thing.

Tobias Carlisle: Right. And this leads me to the next comment, you say, investors are overly focused on the gap income statement. This years reported net income is operating on a legacy tool kit that’s not evolved with the current opportunity set in markets. Can you just expand on that a little bit?

Bluegrass: Yeah. I mean, I think we were talking about this earlier. I mean, if you think about how basically how our financial statements, gap financial statements, income statement, balance sheet, cash flow, who made those … what do you want to call it? Who developed the framework for what those look like and what they track? And when did that happen? I mean, this is going back to the 1920s, 30s, and 40s when the primary businesses were railroads. If you think about, if you built a financial model today or a financial statements, I mean, they would not look the same way they do now. We’re operating on just a legacy system. And there’s nothing wrong with them. I mean, they’re not flawed, necessarily. I mean, you have to understand how to interpret them.

Bluegrass: And unfortunately I think analysts get trained from the accountants point of view. And I’m a, what do you call it? A retired CPA so I guess I can talk about this from not being in a mean way but I mean, if you’re taught from an accountant’s point of view, I mean, you’re not thinking about the business the same way an operator would. An operator uses the financial statements in a totally different way and they pull different information out of them than a first year MBA student would.

Tobias Carlisle: What’s the difference? What’s the difference between an operator and an accountant?

Bluegrass: It goes back to this concept of unit economics. I mean, just bridging that down. I mean, somebody can look at this and … If you looked at Walmart’s cash flow statement in the 90s, or the 80s, I mean, they’re just churning through cash, it’s like negative free cash flow. I mean, they’re reported gap net income is going to look really good, but their cash flow it’s going out the window. But we know what the unit economics of a store are, they’re really good, it makes sense for them to build new stores. There’s huge demand all over the US for cheap retail products, high quality retail products, water selection or whatever. So they need to be reinvesting in new store growth, but on the free cash flow statement, it would look like a train wreck.

Bluegrass: Well the opposite is true for a lot of SAS companies. They get paid up front on a lot of their software contracts. So they have deferred revenue. And so they have ginormous amounts of free cash flow, operating cash flow is just crazy. I mean, in a good way, going up, up, up. But if you look at reported EBIT in margin or net income, I mean, they may show a loss. So, both things are relevant and they’re important to understand, but I mean, that’s the example I think of, it’s just if you’re not thinking about the holistic picture of the business, what the unit economics of the business are, why they’re taking capital today and doing something with it, investing it, and what’s going to come back from that investment, three or four years from now, you just may be missing the forest for the trees.

Tobias Carlisle: So that leads to … So management is important in this process. How are they taking the free cash flow that’s been in front of and reinvesting it in the business. How do you assess management?

Bluegrass: Yeah, I think that question and just this idea continues to be, and hopefully it will be a sustaining source of opportunity for investors in public markets because really what you’re doing is you’re doing behavioral analysis on other humans and just trying to interpret the communications they give you. When you talk about a management’s capital allocation skill and how they reinvest capital, that’s not something an algorithm or computer can put it in an ETF, at least I haven’t seen one yet. You have to just listen to the words they give you.

Bluegrass: So one, I’ve got a list of shortcuts here I wrote down by the way, and this was one of them for thinking about some of these topics. If a management team writes a shareholder letter, if they take the time, just once a year, to write a three or five page shareholder letter, that already puts them in the top 5% of management teams. So that’s a quick and dirty cheat or filter to look at businesses and say, if this management team can’t even take the time of an hour on a Sunday in January to write to me their shareholder about the business, it’s like, come on. But in their shareholder letter, usually, that’s where management will spend a lot of time not just talking about the state of the business, but talking about, what are the challenges that they have and what are the opportunities they see? And inside those opportunities, how are they going to reinvest your capital?

Bluegrass: So as far as trying to figure that out, you have to just read management’s words, and listen to management’s words, and on the transcript so they talk about it. And the best management teams are very clear and they articulate it very clearly. They say, our capital allocation priorities are A, B, C and D, and if you look at also some of the best of the best companies, these management teams say the same thing. I mean, it’s like painfully repetitive sometimes, but they say the same thing on every conference call, they say the same thing in every shareholder letter for 10 years, they say, we’re going to reinvest in the business, we’re going to spend this money to do this. And then after that we might do acquisitions. And then after that, if our shares are cheap, we’re going to repurchase shares. And then after that we’re going to give you a dividend as long as it doesn’t take away from our organic growth.

Tobias Carlisle: That seems like a pretty good priority list. Is that is that not a good list?

Bluegrass: No, I mean, that’s the basic toolkit that the good ones say. I mean, those are the only options also or you can also pay down debt or do something with your balance sheet, but that’s basically it. And as far as value creation standpoint, think about it from a shareholder, the different buckets can move around. The lowest risk capital allocation source for shareholder is organic growth. You want the core business to be growing, you want them to reinvest in the business. So if you’re Netflix and you think as a shareholder that they have a competitive advantage in creating content or Disney is a better example, I want Bob Iger to be spending money to reinvest in Marvel to make more Marvel or to make more Star Wars movies because we know people will pay for them, or to build a new Star Wars edition to Disneyland. That’s organic growth.

Bluegrass: But some models it’s a lot higher hurdle rate, and it’s more difficult to accomplish, and it comes with more risk. But some business management teams are very inquisitive and they create a lot of value of the acquisition, and that’s their primary reallocation of capital. Example there would be constellation software, they just buy these $2 or $5 million vertical market software companies and these things hardly grow at all, depending on which side of the fence you’re on, you could say they actually may have slightly negative organic growth. But that’s been very successful for them and there’s this huge universe of, I don’t know how many, thousands and thousands of these small vertical markets software companies, so they take their cash flow and they smartly reinvest it that way.

Bluegrass: And then again, I mean, if you’re like Altria, a cigarette manufacturer, you’ve been paying increasing dividends for 50 years and your core business is slowly dying but you’re just returning 80% of the free cash flow to customers. I mean, to your shareholders I should say, and that’s been a very value creating business. They’re not reinvesting in their business because cigarettes it’s a bad industry, it’s a declining industry. So there’s no right or wrong about how management allocates capital, but there is proven ways that works. And that waterfall went through of reinvest in the business first, then small acquisitions that build out your existing product base, attack the same customers, and then maybe repurchase shares of their sheep, and then pay a slowly growing dividend over time. That’s the main template you see the best management teams use.

Tobias Carlisle: Do you look at how managements incentivize, is that part of the assessment? Do you look at the proxy statement? And how do you account for share based compensation and that stock based compensation?

Bluegrass: Yes, absolutely. So I mentioned that the best cheat sheet to think about capital allocation usually is the shareholder letter. If they even want to write a shareholder letter, usually they’re going to talk about capital allocation. So that’s a good signal. The question you’re basically asking is, absolutely, I think the proximity is as much or more valuable sometimes for the 10K. I’ll say it this way, it’s one thing for management to say, here’s how we’re going to reinvest your capital, it’s another thing to believe them and have enough belief that they’re going to do that to make an investment based on those beliefs. And the best way to have confidence in that, one, is just their track record, have they done what they said? But number two is understanding their incentives. And if they say, we’re going to reinvest capital … I’m sorry. Sorry about that. My dog just woke up. But she’s gone now, a one year old Great Dane.

Bluegrass: If management says in the shareholder letter, we’re going to reinvest your capital to build new stores. And then you look in the proxy statement and it says, 30% of management’s bonus next year is going to come from if they built as many stores as they said they’re going to build. That’s a good incentive and that’s a good marriage of, they’re saying they’re going to do this, I’m betting on them building new stores because new stores have a really high return of capital associated with them. They’re being incentivized to do that. So it’d be stupid, I mean, it’d be crazy, there’s no reason they wouldn’t try to do that. So, I guess that’s the way I would think about that. But absolutely, I mean, it’s probably a longer quote but yeah, understanding incentives is still probably an under utilized framework.

Tobias Carlisle: And how do you think about stock based compensation, how does that factor into your model?

Bluegrass: On a qualitative basis, like a behavioral basis, it’s the same way as incentives. I want all employees to be owners of the business. I mean, my favorite businesses are owner operators, where the founder still runs the business and the founding family owns 20% or 30% of the business because you know they’re going to make long term decisions, you know they’re thinking about their capital that’s employed in the business thoughtfully and they’re not going to do something that’s just going to set capital on fire. So they’re very aligned with you. It’s the same concept with employees, I really want an Amazon employee who’s 25 years old, getting a lot of stock based comp, because I want them to be spending all their time thinking, wow, if I work really hard over the next 10 years, I’m going to be a millionaire because my Amazon stock is going to double or whatever. So I’m all for it conceptually. I’m on the quantitative side.

Bluegrass: I mean, no shareholder wants to see excessive dilution. I don’t want to see excessive unearned stock based compensation. Just like I don’t want to see a bad acquisition paid for an equity that dilutes the existing share base. So that’s the way I think about it that way. I don’t really get too hung up about it. I think maybe part of your question was going towards thinking about, there’s a raging ongoing debate about how you think about stock based compensation inside of free cash flow, is it an ad back, is it something you just ignore? And I think the answer there is just it’s a materiality issue. Businesses I look at just don’t tend to have super amounts of stock based compensation, that it’s even material, that it’s impacting for cash flow. If it is, I think you just want to understand it and say … And in different points in a company’s lifestyle, it’s more natural than others.

Bluegrass: For an early business, you need to give a lot of equity to early employees to attract them to your business because you really don’t have a business. I mean, you just have an employee group with some white paper you wrote on your business and $10 million in the bank from some venture capitalist. So, I guess the summary would be, it’s not something I’m really concerned about, as far as dilution, I just look at it and say, are you diluting my company? As long as it’s not material, I mean, if they’re diluting the stock by less than 1% a year, I mean, I’m totally fine with that.

Tobias Carlisle: How do you find the companies that you like to invest in? What’s the search process?

Bluegrass: I think this goes back to the concept of maybe shortcuts for finding things, a cheat sheet. The best way for me is talking to somebody like you, for example, like you pre-screened somebody and you’re like, yeah, this person is competent and we figured out What our mutual interests are, and we decided, hey, we both really like, like Walmart for some reason or Costco, and you have a frame of reference and you just talk to each other over time and you share notes about the retail industry or whatever. Just having your own network of other analysts, and when that analysts that you’ve already pre-screened as being really competent and good just comes back to you and they say, Hey, you need to look at XYZ business, that’s by far the highest value way for me to spend time working on a company or looking at one.

Bluegrass: Outside of that, I keep a long queue of 10K’s to read and it’s just basically a ever evolving list. I’ve got some 10K’s on there that have probably been on the list for six months and I keep putting names in front of them and never get to them, and I may never read some of them because I just don’t really have interest in them. But it’s companies that already are on the top of the list and it’s their main competitors or potential new competitors. And it’s … Yeah, I’ll stop there. That’s the general summary.

Tobias Carlisle: I think that’s a common way for discretionary investors to do that. A lot of guys who I’ve spoken to who are more discretionary tend to do a lot of speaking to other people. I sometimes think I just wonder if is there a risk to everybody seems to hold the same portfolios? Another Twitter account, Barbarian Capital has a joke that he calls generic value partners and then you go through the list and it’s the same five or six stocks that everybody holds.

Bluegrass: No, actually you built on something to poke fun at myself but also not forgot about this. So probably the best screening tools I use other than having another smart person come to me and say, hey, look at this business is, if you looked at my portfolio, and I’m getting back to the generic value partners or generic growth partners, which I’m certainly guilty of, I’m definitely not afraid to own commonly own names. There’s a lot of similar qualitative characteristics to the businesses I own, if you group them together. One is there’s a lot of owner operators. Another one is a group of investors who I emulate, and there’s 13 F filings when they file their public portfolios, that’s a rich source of screening for me. And I publish my quarterly compound or watch list, which is basically just taking 20 other investors that are really smart, they’ve done this for a long time, that are focused on the same qualities as me, and just aggregating their portfolios.

Bluegrass: And the thought is there, I know most of the names that would be on that list, but once or twice a year there’s two or three new names that Come on because there’s a new IPO, or one company merged with another, or something just changed in the business and there’s a couple I don’t recognize. So, if some other investors that are smarter than me have started buying it, that’s a clue for me to look.

Tobias Carlisle: Who’s on your 13 F list.

Bluegrass: Oh, I should have had it pulled up [crosstalk 00:41:12].

Tobias Carlisle: Just a handful, you don’t have to name them all.

Bluegrass: Yeah. I mean, so Berkshire, Merkel, Tom Gaynor, Fund Smith, SPO advisor was on there but I think they shut down. Alter rock, Sequoia, Rain Cuniff and …

Tobias Carlisle: I’ll put a link to your list in the show notes to this. So, when you’re undertaking evaluation of what you’ve held something for a little while, what’s the clue that something might have gone wrong?

Bluegrass: I’m not making a joke here but the stock chart, literally the stock chart. I mean, I think that’s another cheat sheet or screening tool a lot of fundamental investors don’t pay enough attention to. One of the first things I look at when I’m starting to research a company is I look at its five and 10 year stock chart. And the thought there is, would I have been happy owning that stock five years ago? Because I’m not the smartest analyst, I’m not going to be ever the best investor, we’re all just riding on other people’s coattails, so to speak.

Bluegrass: So, I think you have to have a certain amount of humbleness and you shouldn’t just look at a stock and say, this stock has been flat for five years, I’m going to buy it because it’s super cheap now, and as soon as I buy it’s going to start appreciating. So I just assumed that’s never the case. I assume the trends are going to go on a lot longer than people ever thought they would, and I just want to ride on trends. So stock chart is the first one. As far as how, do you’ve made a mistake or that kind of thing.

Bluegrass: But really, on the qualitative side, it’s just what a management says or does something. First of all, if they have told me something that they’re going to do and then they do the exact opposite thing, we’re never going to make acquisitions in a different sector than our core business. And then I wake up one day and they made this huge splashy acquisition in some new business, that is an automatic sell. That’s a breach of trust, don’t even look at the stock price, I just immediately sell. So, first of all, if they break what they say they’re going to do, that’s the problem.

Bluegrass: But the second one is, if they just say or do things that are not in line with how you judge them. And it’s not necessarily they’re doing something wrong, it’s just I thought the core thesis of the business was A, B, and C, and your reinvestment priorities were X and Y. And now you’re kind of doing that but you’re not. So it’s Just watching for management change in tone.

Tobias Carlisle: Just to go back to the … So I saw there was a question on Twitter about technicals and at the time that I assumed that you weren’t looking at technicals, but you I think that I understand where this question was going, it was something to do with the way that you’re looking at that stock price chart and just looking back over 10 years and seeing, has this compound and grown pretty smoothly over the last 10 years? Is that how you interpret it?

Bluegrass: I’m not sure of the tweet, but I think somebody was actually asking a more about technical analysis and using it in process. And I’m definitely not an aficionado, but I have a huge respect for technical analysis and that community. And I would say, I don’t trade often, but when I say trading I just mean entering a position or closing a position. When I do make trades, I pay very close attention to technical analysis. Just meaning, I mean, with very unsophisticated high level technical analysis, you can analyze a chart over a two or three year timeframe, and you can see where there is support on a chart. You can see where the trends are. And it’s easy to understand below or beneath certain levels, there’s different amounts of supply or demand in the market for the price of the stock.

Bluegrass: So I would just say, I don’t try to time to the nth degree and be cute about it, but if I look at a stock chart and I say, wow, this is really near this support level and they’re having an earnings release coming up, and if the earnings release isn’t exactly perfect it looks to me like I could easily see it an air pocket and the stocks go down 15% to this next support level. I mean, I pay attention to those things.

Tobias Carlisle: I see. What about macro views, do you have any macro view, are you thinking about it in that way or you’re always bottom up?

Bluegrass: No, I’m glad you asked this near the end just because anybody didn’t want to hear me talk as hard you probably already stop listening. I don’t put a lot of weight on macro as far as my investment process. And I think macro is similar to politics in that you get to this emotional state where people have a lot of biases, they’re driven by things that are hard to prove and that are ever moving targets. So it’s really hard to have a right or wrong answer, I guess, is what I say. But I’ll just say it, I mean, if people would know me from Follow me, I think I’m the most bullish person that I’ve ever met that lives. I mean, I’m wildly bullish.

Tobias Carlisle: Yes.

Bluegrass: I think the stock market is about to double in the next three to five years.

Tobias Carlisle: I think that, that’s been part of Buffett’s success is that he’s been so optimistic the entire way through and he’s been right.

Bluegrass: Yeah. I mean, I appreciate you’re not making me justify my bullish prediction, so I won’t necessarily try to. But yeah, I just see there’s the concept … Maybe I’ll say one comment that’s somewhat intelligent, so hopefully it will be useful to somebody. There’s the concept of the Carlo de Perez framework, she’s a professor who is doing a lot of work on the concept of historical market cycles of 30 to 40 year periods where there’s a huge growth wave that’s driven by some new technology. So she goes back to railroads, and then she goes to electricity, and then the creation of telephone and radio, and then in the 1950s it would be, in the US at least, the build out of post war housing infrastructure around the highway system, and the highway bill in the late 1950s, to build a unified interstate system across the US.

Bluegrass: And she calls all these things, an installation period, where we have these huge waves of installation of some new technology or infrastructure. And for a period of time, while it’s happening, there doesn’t seem to be a lot of productivity. Well, on the measured statistics, there’s no productivity growth. People can tell things are getting better and rapidly changing, but it doesn’t necessarily always show up in a GDP type metric. And I believe, and this isn’t an original thought or anything, but I think we are just at the end of the installation period for the internet the last 20 years. I think we are just now starting to walk into a period, post installation, of all this infrastructure connecting six, seven billion people in the world electronically, and now we’re going to be on the start of this deployment period where we connect to the Internet, where we connect people in sensors and people play games through artificial and virtual reality.

Bluegrass: And I think there’s a long lament by economist’s saying, we’ve had no productivity growth over the past 15 years. And then I say, if you look back to periods where there was an installation period for a railroad or electricity, it looked the exact same way.

Tobias Carlisle: That’s interesting. What’s the name of the book?

Bluegrass: I’ll have to look it up and give it to you [crosstalk 00:49:29]. No, it is a book and it’s a series of white papers too, but the economist’s name is Carlotta Perez.

Tobias Carlisle: Carlotta Perez. So I’ve got two more questions for you, open ended questions. The first one is, this is from Twitter, I understand that you’re a real estate investor as well, how does your real estate investment inform your stock market investing?

Bluegrass: Right. And so I guess the feedback there is, I have relatives who are involved in residential and commercial real estate, It’s a legacy family business. So that’s not something I do on a day to day basis but I am close to it just from the standpoint that my Sunday or cocktail hour conversation revolves around a lot of real estate. I think for me the way it informs my public investing is just gives me an appreciation for hard asset businesses, tangible businesses, that I think a lot of other investors that are focused on SAS or software technology will miss. And a good example there would be triple net lease businesses, net net net lease businesses, which by the way, Buffett is the largest investor in one of the public companies, which is store capital.

Bluegrass: Those businesses are basically just the owners of single unit retail real estate like a McDonald’s, or a Starbucks, or a Domino’s Pizza, and it’s just an incredibly good model, the triple net lease business, that’s just one example. And they also own stuff like Dollar stores, they own the physical real estate to a Dollar store, or a Walgreens, or a grocery store.

Tobias Carlisle: What is triple net?

Bluegrass: Triple net just means basically, all of the responsibility and all of the expense for operating the real estate location falls on the operator of the real estate. So if you and I own a piece of triple net real estate and we leased it to Walgreens, the Walgreens employees, they do all the maintenance on the store, they’re responsible and the company itself is responsible for maintaining the building. If it needs a new roof, they pay for a new roof, they pay for all the maintenance, and the pest control, and the resurfacing the parking lot, that stuff. We basically have no ongoing expense, you and I do, as the owners of the building, it’s just straight free cash flow to us.

Tobias Carlisle: That sounds like a good business. So the final question. You can’t talk about individual names but I was just interested to get your views on Futures Exchanges. Can you talk about that industry?

Bluegrass: Oh, yeah. Are we okay on time?

Tobias Carlisle: Yeah, sure.

Bluegrass: Okay. Yeah, sure. Yeah, that’s a business or I should say an industry that I did a deep dive on earlier this year and I was really focused on fixed income landscape and the electronification of going from paper based fixed income trading to electronic trading. But that just led me down the rabbit hole to really dive into the Securities Exchange business overall. And yeah, I think you and I were talking offline, specifically inside of Securities Exchange industry, the Futures Exchanges are a subset of the business model that I think are not widely understood or appreciated for how high quality they are. So I’ll just try to take through a couple of qualities and make this useful and valuable for the listeners.

Bluegrass: I guess the first thing to think about is people say, what’s the motive a Securities Exchange? You can trade a stock on the New York Stock Exchange and you could sell it on the NASDAQ, for example. Some people are like, there’s no moat for Futures Exchanges, there’s this concept called fungibility and non fungibility. So if you open a futures contract on one exchange, you have to close it on that exchange. There’s no fungibility where you can sell it on different exchange. So basically, that creates a lock in, at least for that transaction, and the localized moat but it also has some predictability to it that it gives the business model in that you can see the open interest for an exchange and if investors open a position, that’s half the revenue, and that just means they’re going to have to close the commission and sell it later, which is going to come with an associated commission. So it’s a leading indicator for revenue in the future.

Bluegrass: All Futures Exchanges or all Securities Exchanges have a network effect where the largest liquidity pools are attracted to each other. Customers want to trade on the exchange that has the largest liquidity because it’s going to have the best price and it’s going to have the smallest gap between a buyer and a seller. So they have natural network effects where the largest pools of liquidity get bigger and bigger.

Bluegrass: I think a unique thing other than fungibility that people don’t understand or think about when they think about Futures Exchanges are, you think about gambling, for example, I think it’s what people say, they say it’s a big gambling market. For more than half of energy related and agricultural related futures, the customer is a commercial customer. It’s not just a day trader trying to speculate, it’s a commercial customer that for their business, they are having to basically open a futures contract to hedge against something they’re doing in their business. An example there would be, if you’re Delta Airlines and you need to hedge your fuel cost. That’s something that is a tiny little part of your business but it’s unnecessary, it’s a small little form of insurance.

Bluegrass: So they don’t really think about it, it’s something they have to do and they’re going to do it every year. It’s not like next year’s operating budget is not going to have a futures hedging cost in there. I mean, it’s something that’s recurring and it goes on over time. And it’s the same thing for a Nestle, if they’re creating coffee or they’re purchasing coffee, or they’re purchasing sugar for inputs for the food they sell, they hedge it. So you have this recurring necessary service by these commercial customers that aren’t speculators to use Futures Exchanges. Because of those things, the necessity of the product, of the futures product to these commercial customers, and because it’s such a tiny part of their business and what they’re doing, unlike the other exchanges like equity exchanges, the Futures Exchanges have actually demonstrated small pricing power, a small amount of pricing power, which they raise prices 1% to 2% annually. And the underlying volumes grow basically in line with GDP.

Bluegrass: If you just think about the Nestle example, if people are going to eat more food, they’re going to hedge more stuff. If people fly on Delta Airlines more this year or next year than they did this year, they’re going to have more fuel to hedge. So, volumes tend to grow in line with GDP activity overall at that volume with the pricing growth, and these businesses grow organically 4% to 5% a year. And another nice feature about them is that they’re counter cyclical meaning, when the stock market goes down, when there’s a panic period, when economic activity weakens, volumes in the futures market or any exchange industry market spike. So revenues spike higher when economic activity in the overall economy does worse for these businesses. So they’re counter cyclical and that’s a nice hedge for an investor’s portfolio.

Bluegrass: I guess the last things I would say are, they have basically evolved into an oligopoly. They went through the mutualization wave starting 20 years ago, and they used to be run … they were not for profit businesses, they were run like country clubs basically. They didn’t think about pricing power, they didn’t think about having efficiencies of scale, and automated databases, and electronic back offices and stuff. And now they’ve gone through a wave of three generations of management teams now. And the management teams they have now are very professional, thoughtful, came from other type businesses in the industry like SMP or Visa or like type businesses, and they’re run very professionally, and they’re not competitive as far as they’re oligopolies and they don’t compete against each other.

Tobias Carlisle: It’s interesting that that counter cyclicality that was the natural question I think that came out, that’s that’s really interesting that most of the trading or there’s a spike in trading, of course, when the economy goes through a tough period when the stock market crashes.

Bluegrass: And that doesn’t mean that the stock prices of the Futures Exchanges will go up to reflect that revenue growth, but it is nice. I mean, they do have, as far as paying out consistent dividends or being able to acquire acquisitions, acquire some of their competitors if the stock market goes down, they are in an advantage position.

Tobias Carlisle: And that’s just about coming up on time for us. I want to thank you very much Bluegrass for sharing your wisdom and your process with us. It was fascinating.

Bluegrass: Thank you very much for having me. I hope some of that translated into the conversation okay and people found it useful.

Tobias Carlisle: It was great. I’ll make sure that in the show notes, there’s a link to your Twitter handle and we also need to put a link to I think the white papers by Carlotta Perez and your annual 13 F list.

Bluegrass: Sounds great.

Tobias Carlisle: Once again, thank you very much.

Bluegrass: My pleasure.

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