VALUE: After Hours (S02 E05): Risk Arbitrage, Leonard’s Constellation CSU.TO And The Fundsmith Letter

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In this episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle chat about:

  • High-Performance Conglomerate – Constellation Software
  • Is There A Renaissance Coming For Merger Arbitrage And Risk Arbitrage?
  • Fundsmith’s CEO Terry Smith – Buy Good Companies, Don’t Overpay, Do Nothing
  • Managing Permanent Capital Is A Significant Competitive Advantage
  • Is Paul Singer The Scariest Investor On The Planet?
  • The Pain Associated With Value Investing Makes It Inappropriate For Most Investors
  • The Marriage Of The Left And Right Tail Is Nirvana
  • Watching Bill Slowly Turn Into A Growth Investor Is Definitely My Favorite Character Arc

You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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Full Transcript

Bill Brewster: All right, I’m doing it.

Tobias Carlisle: Take it away.

Bill Brewster: All right.

Jake Taylor: This is always a production!

Bill Brewster: Welcome back to Value After Hours. I’m Bill Brewster, here with my co-hosts, Jake Taylor and Toby Carlisle. Jake, what are you going to be talking about this week?

Jake Taylor: I’m coming to you from a snowy cabin in Lake Tahoe, so apologies if my audio is not great this week, but I’m going to be talking about arbitrage and why it might be a good time to start skating towards that puck.

Bill Brewster: And Toby?

Tobias Carlisle: I’ll be talking about constellation and the giant Mark Leonard, and acquisition as a strategy.

Bill Brewster: And I’m going to be discussing the Terry Smith Fundsmith letter, right after this!

Speaker 4: 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

Jake Taylor: We’ll do it live!

Bill Brewster: We’ll do it live!

Tobias Carlisle: Let’s go. Let’s do it. Do you want me to do constellation?

Bill Brewster: Yeah, go ahead.

Tobias Carlisle: So I’ve got this ongoing theme where I’m looking at companies that basically are set up to do acquisitions, so we looked at Barry Diller and IAC first, and looked at HEICO with the Mendelsons… and then if you’re going to do that, naturally, Berkshire Hathaway is sort of the original gangster; maybe Singleton with Teledyne, maybe that’s the original… Buffett kind of perfected it.

Tobias Carlisle: But Mark Leonard and Constellation is kind of… for me, they’re a little bit under the radar. I’ve known about them for a long time; never bothered to read the letters until this last week. So I read the letters, and I was kind of DM’ing you guys as I was going through them. I’m leery, I’m highly skeptical when I see somebody using Buffett’s language in a letter, because I see it in hedge fund letters all the time. And so, when I first started reading it, I was like, “Well, everybody likes this because he writes like Buffett, but so what?”

Tobias Carlisle: And then I kept on reading, and I kind of… I’m kind of in love with Mark Leonard at the moment. I’m having this long distance love affair with him. Guy’s kind of figured out something incredible. What Constellation does… so Constellation, they target these VMS, vertical market software, and they make really small acquisitions. The acquisitions are typically five to 10 million dollars. When I look back at some of the old articles that came about him not that long ago, five years ago… they’re looking at two to four million dollar acquisitions.

Tobias Carlisle: To put that in context, that company is a 30 billion dollar company. And so, the way that he’s achieving these acquisitions is he has sort of distributed this acquisition. So, it’s not like Berkshire where Buffett’s doing all the acquisitions; they’ve got distributed acquisitions, so they’re getting each sort of downline, does their own… it sounds like an MLM marketing kind of thing.

Jake Taylor: It does.

Bill Brewster: You got your upline and your downline, and then you sign people up!

Tobias Carlisle: When it gets complicated like that, immediately you start getting nervous, but not in relation to Constellation, in relation to MLM.

Tobias Carlisle: So, the background on the guy… there’s not much information, not many photographs of him on the internet. By all accounts, he’s a giant, he’s 6’5″; played rugby; might have come from South Africa or England; nobody really knows. Got an MBA, was a gravedigger at one stage; worked in venture capital until 1995; took some funding, 25 million dollars in funding from O-M-E-R-S. I don’t know what that is. I’ve never encountered that before. Do you guys know who that is?

Bill Brewster: No.

Jake Taylor: Uh-uh.

Tobias Carlisle: So he runs from 1995 until they list in 2006, and so, he lists to give them an exit, I think, basically, because they didn’t take any cash in the listing. That allowed all of their outside investors, the venture funds, to exit.

Tobias Carlisle: And so, they basically take Buffett’s principles, targeting high return on invested capital companies, and then they sort of incentivize them to return that capital back to the mothership, and they keep on deploying it. That’s a conscious strategy of theirs to target much, much smaller acquisitions, because as acquisitions get bigger, you pay a bigger and bigger premium. So, they’ve kind of figured out how to not grow the size of the acquisition, but to grow the whole organization.

Tobias Carlisle: They do lots and lots of acquisitions. They don’t use debt. It’s been a kind of monster run. I’m kind of new-ish to it, so I’m not going to give you all of the great insights… that you guys probably know more about than I do, but I’m a fan.

Jake Taylor: Enjoy that honeymoon period.

Tobias Carlisle: So tell me, what am I missing?

Jake Taylor: I don’t think you’re missing anything. I think the only knock nowadays is that… can they keep doing what they’ve been doing at the same rate, and at an increasing rate to justify the increasing market cap?

Tobias Carlisle: So there’s a couple of… so, Value Investors Club, there’s a couple of write-ups about Constellation in there, and that’s the question that gets asked every time. So they say, or the write-ups say, that there are something like 30,000 of these VMS businesses around that are of that sort of scale… five million dollar-type scale… and if they’re prepared to expand into Europe, then it goes up by another 50 percent, something like that; there might be 48,000 or something like that… between that 7 to 10 million dollar, because maybe that’s the level that they’re at… so maybe they go up a little bit.

Tobias Carlisle: But then the problem… I think their real problem, rather than just that running out of kind of runway to buy stuff, is just the fact that software is a service. Everybody’s figured out that’s a good business, so that stuff is expensive now. So I think maybe you slow down the rate of acquisition, you only hit what you can, and you just wait for the market to come back a little bit. I don’t know.

Bill Brewster: Big time. Big time.

Tobias Carlisle: Big time.

Bill Brewster: Yeah.

Bill Brewster: So, I went back to the scuttleboard bullpen to do a little bit of background on this. Something that I think is really awesome… I’m with you, Toby, right, where I start to see people quote Buffett, and I start to get real nervous. But this is Mark Leonard talking about expensing his own stuff: he goes, “I’ve been President of CSU for its first 20 years. I’ve waived all compensation because I don’t want to work as hard in the future as I did in the last 20 years. Cutting my compensation will allow me to lead a more balanced life with a less oppressive sense of personal obligation. I’m paying my own expenses for a different reason. I’ve traditionally traveled on economy tickets and stayed at modest hotels because I wasn’t happy freeloading on the CSU shareholders, and I wanted to set an example for the thousands of CSU employees who travel every month. I’m getting older and wealthier and find that I’m willing to trade more of my own cash for comfort, convenience and speed, so I’m afraid you’ll mostly see me in the front of the plane from here on out.”

Bill Brewster: I mean, he reminds me of those guys from Fastenal. The management team from Fastenal takes pride when they go to a town and they can stay at their in-laws’ house. Some of these guys are just… they’re cut from the right cloth, I think. And I had told you, I don’t know that I really love the CSU letters as much as everybody else does; I think part of that is I got such a… I was prepared for nirvana, and maybe I had found out I was just reading normal things… so, a bit of, I think, maybe high expectations hurt my perception, but… he really does seem like the real deal, and his track record certainly supports it. It’s interesting.

Bill Brewster: I thought the same thing, can they continue to do it? I talked to Liberty on Twitter about it; he’s pretty active in the name, and he doesn’t think size is going to preclude good things from here going forward.

Tobias Carlisle: One of the interesting things that Leonard introduced me to is… this is Leonard’s term… high performance conglomerates, or HPCs, and then he lists out some HPCs that I will go into over the coming weeks. But that term, I don’t think, really exists outside of Mark Leonard using it, but I think it’s a good one.

Tobias Carlisle: So, I just sort of looked at… if you search that term, there’s not a great deal that comes up, but there are these guys who’ve done a little analysis of HPCs, and so, what separates an HPC from just a typically acquisitive company is… I think it’s a value discipline. But if they just do this sort of top-down analysis about the thing that they say separates good acquirers from bad acquirers… it’s just doing lots of acquisitions.

Bill Brewster: It’s a learned skill!

Tobias Carlisle: Bill shared this with me this morning, this Bain Capital… Bain Capital has done some research, and they find exactly the same thing. I don’t necessarily trust somebody who’s doing a whole lot of acquisitions just because they’re doing a whole lot of acquisitions, but I think it kind of makes sense if you think about… if you don’t pay very much, your payback period is shorter, you should be able to do more acquisitions… you can recycle the capital faster to do faster and faster acquisitions, and then you get some skill in it, naturally, you’re going to get better at it.

Tobias Carlisle: If you’re set up to do acquisitions rather than thinking about them as a sort of strategic think… you’re thinking about them, how can we just maximize the rate of return? I think that it works.

Jake Taylor: Any concern about the… if you have… think about Rome in its heyday, and the further that you kind of get away from the central part of Rome, the more that it breaks down, and the bigger it gets… almost sews its own seeds of destruction.

Jake Taylor: Well, the culture of Constellation… the further you get down,.away from the mothership, away from Leonard… how could it be as tight? Or how can it be as clean?

Tobias Carlisle: It’s not going to work as well.

Jake Taylor: [crosstalk 00:10:29].

Tobias Carlisle: I’m not necessarily advocating investing in the stock. I had a look at… the valuations on any of these companies are just… make you bleed from the eyeballs. They’re just shocking, face-ripping valuations, and my hat is off to anybody who can get comfortable with those sort of levels of valuation… and it’s been expensive for a long time. It’s gone up a lot.

Jake Taylor: Yeah.

Tobias Carlisle: I’m definitely not advocating buying the stock. It’s probably going to quadruple from here because I said that, but I think that-

Jake Taylor: Of course!

Tobias Carlisle: I think that they’re all on 50 times Ps, and they’re probably getting closer to the mature end of their growth, rather than lots of runway.

Tobias Carlisle: I like the distributed model. I think it’s a much better way of managing than that sort of top-down type model, but I think Buffett has said this, too… it just means that every now and again, you’re going to have an absolute catastrophic era that you could have otherwise avoided if the head office had known about it. But on balance, it’s a better way of doing it.

Bill Brewster: Yeah, I think the other thing that was interesting about Constellation was… it appears as though their incentive structure is total revenue growth and return on invested capital. So, there’s a nice sort of… you can send capital back and maybe you can’t make as much acquisitions and grow your revenue, or you could spend a ton and drive your revenue, but your return on invested capital would go down if you get stupid with it.

Tobias Carlisle: That’s smart.

Bill Brewster: So, it’s a nice tension of alignment of interests, and I wonder… the Bain consulting thing that I sent you… I wonder if that’s why they find that consistent acquirers have better results. Maybe it’s because they’re thinking of incentive structures and how to integrate different cultures… and more than just being a learned habit… I mean, it is a learned habit, but it’s almost a way of life.

Tobias Carlisle: Or even don’t integrate them.

Bill Brewster: [crosstalk 00:12:34]. Yeah.

Tobias Carlisle: One of the things that Leonard says that I really like… he’s like, what is culture? How would you get all of these cultures? You can’t. And he said some of them are going, so he says, we just leave the cultures alone at the level of the acquired company, and some of them are going to die out because they’re bad cultures, and some of them are going to be very good and they’re going to learn from each other, and they’re going to get better and better as they go along.

Tobias Carlisle: And I think that’s a pretty good approach. That’s a sort of robust to life kind of approach. That’s the way living things kind of make advances, and I think that that’s… if you want to keep the whole species moving, you can’t… if you have one rule for the whole group of them and that rule is wrong, you’re dead in the water. But if you’ve got lots of little variations, some of which will survive whatever comes next, then that’s a good survival mechanism.

Jake Taylor: Yeah, my understanding is that they’ve been… it seems like they’ve been doing more to try to cross-pollinate some of the… if someone has a good idea. I think there’s been more… I don’t know if management moves it around-

Tobias Carlisle: Do they force it?

Jake Taylor: Like GE, but I remember reading about how they’re trying to get more structure as far as the information cascading between the cultures of things that work.

Tobias Carlisle: It’s interesting. I’m just trying to think in terms of the things that unite HEICO, IAC, and Constellation. The really interesting thing, the one thing that I think that stands out more than anything else… and this was the title of the Forbes article for Diller and IAC… no moon shots. I think that’s really been the key to all of them. At HEICO, everybody… all of these guys are just doing smaller acquisitions, small [inaudible 00:14:20] acquisitions all the time, rather than trying for some sort of monster game-changing acquisition.

Bill Brewster: Didn’t Diller pay like four billion for Match, though? I mean, that’s not nothing.

Tobias Carlisle: But I think, in the context of what that… yeah, that is true, but initially he put in a billion, something like that. I think that they’ve been quite… at the four billion level, it was quite mature. They earned half of it. They might have bought the other half of four billion.

Bill Brewster: Yeah.

Tobias Carlisle: Or whatever they got to, up to 85 percent. Anyway…

Bill Brewster: I think it’s interesting. I mean, Markel is one that’s trying to do it, and the time that it seems to take to get the snowball rolling and… I think that they’ve learned, from what I understand, a fair amount from this CATCO issue that they had last year, where they maybe got into a line of business that was slightly different than something they were comfortable with.

Bill Brewster: There are trade-offs to the acquisition strategy, and you’re bound to have some problems. But one thing that I like about Markel a lot, and where I actually think Liz… that LA Hall forever thread went a little wrong… was when she had mentioned that she didn’t think that culture was a competitive advantage there. I think culture is a massively competitive advantage there, and it’s really, really… it’s not tangible. I can’t put it into numbers. People ask me, “How many acquisitions do you think they’ll do in the future, and how would you underwrite that?”

Bill Brewster: I don’t really know. What I’m certain of is those guys are going to work every day thinking about the right things, and that when there is the chance to pounce, they’re going to do it in what I perceive to be a smart way.

Tobias Carlisle: Is it a competitive advantage, though? Is it just table stakes? Here’s what you have to do to succeed.

Bill Brewster: Well, I don’t think that everybody has the same incentive structures, and I don’t think that everybody-

Tobias Carlisle: But that’s replicable, right?

Bill Brewster: I don’t know, man. You’ve got to set your incentives up the same way, and I’m not sure how many people have the freedom to do that.

Tobias Carlisle: But, I mean, even Leonard says… a few years ago, he said, “I’m going to stop sharing so much detail because there are a lot of imitators out there.”

Bill Brewster: Yeah. I mean, that’s fair. I think it certainly can be replicated. I don’t think it’s easy to replicate, though. It’s one of those things that in a text-

Tobias Carlisle: Simple, but not easy.

Bill Brewster: Yeah, textbook, it might be easy to draft, but the execution of it and actually living it, and being patient enough to wait for the deal that makes sense, and then to execute it when the chance is on the table… I just think it’s a lot easier said than done. But I could be wrong; I mean, I don’t know.

Jake Taylor: Do you guys ever want to be in that position of running a holding company like that?

Tobias Carlisle: I mean, that’s the dream, isn’t it? To be the Buffett-style…

Jake Taylor: Permanent capital.

Tobias Carlisle: Yeah, that’s what every dorky Valley guy out there is trying to get to.

Bill Brewster: I’d be good being a sixth man on that team!

Jake Taylor: That’s the value wet dream.

Bill Brewster: Forget about running it! Call me Rick Fox of that type of company. I’d be totally happy with it.

Tobias Carlisle: Who’s Rick Fox?

Bill Brewster: Exactly!

Tobias Carlisle: Who’s Mark Leonard?

Bill Brewster: Rick Fox used to play for the Lakers. He was married to Vanessa Williams.

Tobias Carlisle: Was he the sixth man?

Bill Brewster: He certainly wasn’t a starter… well, maybe he was a starter for a year or two there, but it wasn’t anything… he’s not the guy anybody knows, which I’d be fine with. I don’t need the glory.

Tobias Carlisle: And here you are with your face on a podcast, Bill!

Bill Brewster: Yeah, well…

Jake Taylor: Exactly.

Tobias Carlisle: Getting dozens of downloads.

Jake Taylor: [crosstalk 00:18:19]

Bill Brewster: I was just about to quote Tupac and say, “All I want is money. Fuck the fame, I’m a simple man,” and here I am on a podcast making no money, so I don’t know what I’m doing!

Tobias Carlisle: But getting no fame, either, so don’t worry about it!

Bill Brewster: That’s right! Yeah, well, anyway…

Tobias Carlisle: Shall we kick on to the next topic? Jake, do you want to give us yours?

Jake Taylor: Yeah. I recently read Kate Welling and Mario Gabelli’s book called Merger Masters, and it was basically profiles of a bunch of guys who have done… or doing… merger arbitrage and risk arbitrage into the ’70s, ’80s, ’90s, even into today. What I found really interesting was that… you don’t hear about that much all these days. Nobody’s really talking much risk arbitrage, at least in my circles, and a lot of that has to do with low interest rates; apparently, that kind of kills that business, because they only earn a couple points above whatever the interest rate is, typically. And the smart ones, then… they move in cycles, and they’ll do risk arbitrage during boom times, and they’ll move into bankruptcy… special situation… after the bust.

Jake Taylor: But what I found… I wonder if we shouldn’t be asking ourselves if there might not be a renaissance of this on the horizon at some point, because it seems out of favor today. And we’ve talked before about different flavors of value, and each of them sort of having their particular time to shine. This might be one that you want to do a little work on ahead of time to be ready for when that season comes again.

Jake Taylor: So what do you guys think about that? Do you want to learn more about it to be ready?

Bill Brewster: We had the mailbag question on FCAU just last weekend, right? Fitbit looks like it’s trading at a pretty discount. I haven’t done the work.

Bill Brewster: I think merger arbitrage is a really interesting strategy. I’ve been fortunate enough to get to know Mario a little bit, so I got to listen to Kate talk about that book. One, I think the strategy is super interesting. Two, the stories in that book are super interesting. And somebody has asked her, “Who is the best or scariest person in that book,” and without hesitating, she was like, “By far, Paul Singer.” That guy does not lose and the people walking through that office are not interested in losing, but it is a terrifying place to work, for, I guess, the right reasons. But that was sort of an interesting tidbit.

Bill Brewster: Yeah, I think it makes sense. I’ve long thought merger arbitrage is a good strategy. It’s not one that I think I’m prepared to execute on my won.

Tobias Carlisle: I’ve done lots of merger arbitrage. I like it as a strategy, but as you say, it’s one of those things that… there are just long periods of time where it’s not a good strategy because the spread is not wide enough. The thing that is different between now and the ’80s is it was hard to track this stuff down in the ’80s. You needed to know how to see the filings, find the stuff, understand what the deal was; now, Google merger arbitrage, there are websites that give you all of the dozen or 20 deals that are on right now with the spread, and they give you what the IRR is… it just calculated, and the sites are out there for free.

Tobias Carlisle: So, it’s a lot less work than it used to be, and I think, as a result, the spreads have closed. You’ve got to get smarter. Having said that, I’ve had some merger arbitrages that were like 100 percent, and I’m not talking about IRR. I’m talking about that were, literally, like 50 percent of the bid, and at 50 percent of the bid, I’m prepared to put in a point or two just to see what happens, because you can get a good return and probably not lose much if the bid doesn’t go through.

Tobias Carlisle: So, I like it as a strategy. I’ve done it in a previous life, and I watch it regularly, but it’s tight now.

Bill Brewster: I played Monsanto. That worked out pretty well. That turned out to be a fairly decent one.

Bill Brewster: I would want to do it where I was somewhat comfortable with the underlying if something busted; like, the Spring/T-Mobile one doesn’t really interest me because I really don’t want anything to do with Sprint if it doesn’t go through.

Tobias Carlisle: What if you long short?

Bill Brewster: Yeah, you could do it that way.

Tobias Carlisle: You’d get both sides. You’d get a little hedge; that way, if it busts and they both fall apart…

Tobias Carlisle: I did it when all of the healthcare mergers were… like Humana… long Humana. That deal ultimately didn’t go through, but in a funny way… the deal took so long. Initially, there was a concern about the deals that were being done to move the head office overseas, to get out of the tax jurisdiction, and the Obama administration put a stop to that. But that deal wasn’t being done for that reason, but it blew open because all of the… I guess all of the arbitrages are in all the same positions, and they’ve got to conserve capital where they can.

Tobias Carlisle: And then it got blown apart because there was a DOJ antitrust, but United was so much bigger, and there was another deal going on that… at the time, that if that deal went through, they’d been number three biggest, and if the deal didn’t go through, they would have been second maybe, still behind United. Took the deal so long to go through that United sprinted ahead of the other four that were still in a deal, and so, when the deal busted, the stock actually went up, because it was held back by the deal! So, that’s a sort of dream arbitrage, and I had a lot of that in my PA and in the fund.

Jake Taylor: You’re right for the wrong reasons.

Tobias Carlisle: Yeah, that happens a lot!

Bill Brewster: Well, you put yourself in the right ponds and good things can happen, even if it’s for the wrong reason, right?

Tobias Carlisle: Get lucky. That’s my strategy.

Bill Brewster: Yeah, well, that tweet that I sent out a year ago just caught fire again today, where I said-

Tobias Carlisle: It’s a good one.

Bill Brewster: The traditional value guys understand the left tail mitigating risk. Traditional growth understands that the right tail can be a lot longer than, I think, value gives it credit for. The marriage of the two concepts is nirvana, but it’s not easy.

Tobias Carlisle: If you can figure that out, yeah… 100 percent. It’s a good insight.

Bill Brewster: And I think what you were just talking about is a good example of how traditional value, I think, sort of wins, in that… there is some price that a lot of bad outcomes are priced in, and that’s where you bet. And then, a lot of things can go…

Jake Taylor: Not wrong.

Bill Brewster: There’s a lot of paths that can happen that aren’t worse than the price you paid, and you can win. So, you don’t necessarily have to be right on the reasons that you’re buying, where a lot of the names that I look at today… I think you have to be right on the path-

Jake Taylor: Really different things.

Bill Brewster: Yeah, and if not three… there is a lot of precision that these… I think prices require, and I think a lot of people are saying, “Well, I’ll just hold longer, and it’s a great business, and over the long term, that’s going to work.” We’ll see. I mean, in 10 years, we’ll have the conversation, and maybe people will say, “See? I told you!” But it gives me an uneasy feeling.

Tobias Carlisle: Yeah, that’s where I am, but that’s what being deep value is… just missing out on all the parties.

Jake Taylor: [crosstalk 00:26:07] after the next.

Bill Brewster: Yeah, well.

Tobias Carlisle: Cinderella sitting at home.

Jake Taylor: Yep.

Tobias Carlisle: Bill, what’s your topic?

Bill Brewster: Well, it’s an interesting segue there, given that I wanted to talk about the Fundsmith letter. And I guess that it’s interesting… I guess the conversation that is going on, or seems to be going on, is there are people that are saying, “Value’s dead. PE multiples are useless, sort of, because it’s crappy businesses that are trading at low multiples, anyway.”

Tobias Carlisle: Same as it ever was!

Bill Brewster: Yeah, well, and I guess that… Terry Smith is incredible. I mean, I think if you look at his letters, if you look at how he approaches the world, I think it’s really awesome. And as I’ve talked about now for three weeks, right, I’m trying to determine whether or not I want more to that game, in [crosstalk 00:27:10].

Jake Taylor: The character arc.

Bill Brewster: Yeah, that’s right.

Tobias Carlisle: Yeah, let’s give the shoutout to the best comment that we’ve seen on YouTube so far. Kevin Zatloukal, Z-A-T-L-O-U-K-A-L: “Watching Bill slowly turn into a growth investor is definitely my favorite character arc on this show.” I love that one!

Bill Brewster: Thank you! I’m glad that me questioning everything that I’ve ever thought is a good character arc.

Tobias Carlisle: I laughed out loud in IRL! That was great, thanks.

Bill Brewster: Yeah. But I think there’s a lot of merit, I just… a lot of the conversation, I think, gets lost in why certain things work and why certain strategies are right for the right people. I mean, I’ve said before numerous times, I think low valuation can work. I think it’s best in an ETF-diversified wrapper. I think that systematically trying to take advantage of behavioral bias makes a ton of sense.

Bill Brewster: For what I’m going through, and discretionarily, I really don’t want to spend the time researching why GameStop can get out of their lease structure, to then go on to the next deep value idea, to then go on to the next one. I don’t know that… I’m going to call it Compound Town, because I don’t know what else to call it, but… sort of those better GARP-y businesses, I think you get more juice out of your time spent in research. It requires a lot of patience, but I think the knowledge base is a little bit more leveragable, given that I think ETFs are the way to play deep value strategies.

Bill Brewster: So, anyway, that’s, I guess, why my character is arcing.

Tobias Carlisle: So, tell us about the Fundsmith letters. What’s the most recent Fundsmith letter?

Bill Brewster: Well, I mean, Terry Smith is a guy out of the U.K. that I would not know about but for Twitter. And what he basically says… we buy good businesses, we pay reasonable prices, and then we do nothing. Now, he doesn’t do nothing, because he sold 3M, but his turnover is super, super low.

Tobias Carlisle: Has that been a mistake or not?

Bill Brewster: Not for him. No, he’s destroying everything.

Tobias Carlisle: No, selling 3M

Bill Brewster: Oh, no, I don’t think so. Actually, I just saw today that it’s apparently getting crushed, but I don’t follow it very much. That entity is sort of in my too hard pile; it’s more of a macro bet than anything, in my limited understanding.

Bill Brewster: So, anyway… he owns things like Estee Lauder. He owns stuff like Philip Morris. His gross margins and his portfolio… I really like how he lays out his portfolio versus the indexes. His look-through gross margins are north of 60 percent. His return on capital employed, I’m pretty sure, is north of 20 percent, probably 30 percent, but I’m not looking at it right now. It’s a really interesting way to approach the world.

Bill Brewster: And I think one of the… I bet he and Russo think very similarly. I haven’t looked at all of his holdings, but they seem to be slower-moving industries that… brands matter, distribution matters, and you can sort of buy and own for the long-term. I’m sure somebody is going to correct me on that, but that’s what it looks like, to me.

Tobias Carlisle: Yeah, I had a look at that letter. I love the way he writes, and I like the layout of that letter, too. He’s much closer to that compounding style than he is to my style, but that’s worked really well for a lot of years now, and I think that it’s going to work in the future, whatever happens to deep value. I think it’s a very robust approach.

Bill Brewster: You know something interesting? When we were talking about HEICO, I said something silly, and it was sort of flippant when I said it. I said, well, it’s 2.8 percent free cash flow yield; it could go down to five. And then I’m sitting around thinking, and I thought, “Well, that is a 50 percent haircut.” So, if you don’t care about the difference between making 2.8 percent or 3 percent, buying today really doesn’t matter if you’re going to hold forever.

Bill Brewster: But the thing that sucks when you’re paying those prices is share buybacks don’t get you much juice, and a 50 percent draw down when you’re looking at a 2, 3 percent free cash flow yield every year… that’s a lot of return. You’ve got to really believe for 16 years, 17 years.

Tobias Carlisle: That was the feeling that I had, looking at all the HPCs, the high-performance compounders that Mark Leonard lists out. I was looking at them like… their returns are ridiculous, and I understand the strategy really well, so I would definitely buy these companies at a price. But it’s just so hard to get comfortable with them when something like… Constellation, I think, was approaching a 50 PE, so you’re getting a two percent yield. It’s growing fast still; it’s still growing in the 30s, I think, which is monstrous growth.

Tobias Carlisle: And then, you look at your yield and you add on the growth, and all of a sudden, it’s an interesting position, but the growth is such a big component of it that you have to be right on that, and that’s where all of the other questions… like Jake’s first question was my first question: How big is this universe of stuff that they can keep on buying? At what stage does the edge of the empire just get too big and start to crumble away? Don’t know the answer to those; got to be right, though.

Bill Brewster: Well, I know I bring it up a lot, but look at 3G. I mean, they had done pretty well, and then they got to size… where maybe both entities are suffering from this; I’d like to think that Bud isn’t, but it could be suffering from a size problem, and now the best brand in their entire portfolio has a virus attached to it, which isn’t great!

Tobias Carlisle: Who knows? It might help. I haven’t seen so much Corona advertising.

Bill Brewster: Well, it’s hard enough [crosstalk 00:33:35] to China right now. I’m not sure we need a Coronavirus!

Tobias Carlisle: I have seen more Corona advertising than I’ve seen anything else for the last few weeks.

Bill Brewster: Good. Jesus, Lord, people, if you’re outside of the U.S., buy some AB InBev products, please. Corona… I don’t care what. And if you’re in the U.S., buy Stella!

Tobias Carlisle: Continental wife-beater, they call it, in the U.K.

Bill Brewster: Stella?

Tobias Carlisle: Stella.

Bill Brewster: Yeah. It’s interesting how brands do that. People have said Stella is just trash over there, in a similar way that Budweiser is here, but then Budweiser is supposed liked globally, from what I understand.

Tobias Carlisle: Budweiser was a premium product was when I was working in the… there’s a drive-through. You guys might not know what a drive-through is, but that’s where, in Australia, someone can drive up and buy alcohol!

Bill Brewster: Nice!

Tobias Carlisle: That’s a real thing! I used to work in one. You had to run around. The Buds were premium products, as they were imports and they were expensive, and so, they were kept in a special locked case so that people couldn’t make off with it.

Jake Taylor: Holy shit. Wow. That’s impressive.

Bill Brewster: It’s interesting how brands can take on different meanings in different geographies. The Budweiser… the Asian IPO documents are pretty interesting to look through, if anyone is somewhat interested. I wouldn’t recommend it. Stay away. It’s bad for your health. Leverage and volume declines.

Tobias Carlisle: Shall we move on to the questions?

Bill Brewster: Yeah, I wanted to give a quick follow-up. Not that people are listening to finance podcasts for this stuff, but I think it was two weeks ago, Jake… you asked what mattered. And the passing of Kobe… I was not a huge Kobe fan when he played, but it’s made me think about how fragile life is. And to the extent that people listen and are engaged with this podcast, and we can add some value to their lives, that’s stuff that matters to me, so anyone that’s listening… thank you. Toby and Jake, thank you for giving me a shot. I was a nobody before this and less of a nobody now, but… it’s been fun.

Jake Taylor: This is a really sentimental moment right now!

Bill Brewster: I’ve been thinking about it a lot, man. I mean, I don’t know. I think one of the reasons that I have thought about it a lot is… seeing how his peers respect him? That’s all I really want out of this game. At the end of it, I just want people to be like, “Brewster did it right.” Now, that may cost me some points in the business category, but that’s what I strive for. So you see, I-

Tobias Carlisle: That’s the only fame worth having. That’s the only fame worth having.

Bill Brewster: I think so, too, right?

Tobias Carlisle: You don’t want to be known by anybody, except for people in the industry who think that you did it the right way. 100 percent agree with you there.

Bill Brewster: Yeah, because that means you actually did shit right. Otherwise, you’re like a marketing guy, and come on… I mean, that doesn’t impress me. Good for you; make your money, whatever. But that’s not what I’m after.

Tobias Carlisle: I’m right here, Bill.

Tobias Carlisle: You know what we didn’t do? We didn’t do Jake’s D.C. Buffett story. You’ve got to tell that story.

Jake Taylor: It’s not ready yet!

Tobias Carlisle: It’s not ready?

Bill Brewster: [crosstalk 00:37:03]

Jake Taylor: No, no, let’s give him a couple of weeks to see what happens, and then we’ll tell the good version of it. How about that? Let’s tease it.

Bill Brewster: That works.

Tobias Carlisle: Okay. You’ll have to tune back in for Jake’s D.C. Buffett story.

Jake Taylor: Yeah.

Tobias Carlisle: Okay, so question… it’s sort of relevant to what we’ve been talking about. EWLee03… I think it was Eric Lee. “Question for next time: do you see managing permanent capital as conveying a significant competitive advantage in investing. Buffett effectively has this and Bill Ackman is also big on the concept”… Einhorn, too; that’s me adding that… “If so, what are the implications for the fact that most managers don’t have permanent capital, and yet, in the case of equities, are investing in long-duration assets?” Good question.

Jake Taylor: Very good question.

Tobias Carlisle: I think we’ve kind of covered that earlier with the high-performance conglomerate question, but yeah, that’s the… the problem for anybody managing money is that when the opportunities arise, all of the firepower gets taken away, and so they can’t deploy, which is why some guys try to carry cash and trim back. That’s certainly the holy grail; it makes you behaviorally a much better investor to know that the assets are going to be there when the market pulls back.

Tobias Carlisle: Gents?

Jake Taylor: I would actually be even more forceful about this, and say that… I am not convinced that value as a strategy is appropriate for most people. I think they just maybe don’t have the capacity to suffer, and it will require that. And it’s not just about, “Oh, yeah, I like buying things with scary headlines”; it’s worse than that. It’s periods like today that just grate on you, day after day, and you’re watching things go up that don’t make sense to you, and you’re not finding enough ideas. That part of value, I think, takes a very special sickness, maybe, to participate in that.

Jake Taylor: And unfortunately, if you’re more of a casual value person, you’re likely to get knocked off the bandwagon right when it’s probably going to start working again, and you’re not really doing anyone any favors by being a value person when it’s easy, so… I guess, buyer beware when it comes to value as a strategy. It’s definitely not easy.

Tobias Carlisle: Casuals!

Jake Taylor: Casuals, I know. It’s kind of a dismissive term, huh?

Bill Brewster: The value tourists.

Jake Taylor: Yeah.

Bill Brewster: I mean, the thing about the permanent capital is… I don’t know that you read the headlines about how great Ackman’s year was this year if he doesn’t have permanent capital, because-

Jake Taylor: That would have been game over.

Bill Brewster: There were some terrible years two or three years ago, and people could have pulled their money. I think… I might be wrong… but I think even he had commented that it was nice to have the permanent equity vehicle.

Bill Brewster: But yeah, I mean, I think that you’ve got… we talked about, is it a replicable model? I mean, yeah, it is, but it’s hard to get there, and then if you can get it, it’s a hell of an advantage, I think.

Tobias Carlisle: Just on the Ackman thing, the bloke I used to work for who’s private, so I won’t give his name, but he likes investing in closed-end funds. He likes investing in things that are trading at a big discount to their net asset value. When he saw that that Ackman vehicle had traded down to a big discount, he was still a believer in Ackman; flew to New York, met with the team; put 20 percent of his net worth into that thing, and I think he’s up like 100 percent, something like that, in pretty short order… in like 18 months or something like that, so…

Bill Brewster: Good for him! A lot of people didn’t believe in Ackman. The best criticism that I heard of him, and I think maybe the most legitimate…

Jake Taylor: Too handsome.

Bill Brewster: Yeah, well, that’s…

Tobias Carlisle: He is a good looking bloke.

Bill Brewster: Somebody said to me, “I think he might not be a great capital allocator,” but in that same sentence, they also said, “He’s by far the best analyst I’ve ever met.” It’s not even close. So, their only quibble is with bet sizes and what positions he took.

Tobias Carlisle: I still think that’s 50 percent of it. I still think that’s half of it, maybe more.

Bill Brewster: Well, that’s a big deal.

Tobias Carlisle: Maybe you put a guy who knows how to bet at the top with a guy who’s a better analyst underneath him, and you get better results.

Bill Brewster: I’m not going to take a shot at Ackman here, man. I dream of having his rep!

Tobias Carlisle: So, let’s move on to the next one. “What are your thoughts on a two percent… almost roughly two percent of personal account hedge by doing a leveraged inverse ETF SPXU, given today’s market valuations?” That’s Alan Sisner. Thanks, Alan, great question.

Tobias Carlisle: Jake?

Jake Taylor: No. No, thank you.

Tobias Carlisle: Why not?

Jake Taylor: My understanding of those type of vehicles is that the decay in them is pretty rough, and so you have to be… they’re much more trading vehicles, and should be handled like plutonium, in only short amounts of time that you should have exposure to them. You don’t want that to be sleeping under your pillow with you.

Jake Taylor: So, I think those are inappropriate for a hedge of any kind of longer duration, and if anything this market has taught us, is that it’s going to take longer than you ever thought. So, to be able to get the timing right and avoid that decay… I just don’t really like your chances of that, so I’d prefer to make everything simpler and view cash as a call option on lots of great things to buy that requires no timing, especially if you’re permanent capital, and don’t have to report against a benchmark. I think that’s probably the smart play for myself. I think it’s more conservative and gives you a better chance of getting to the finish line.

Tobias Carlisle: Bill?

Bill Brewster: Yeah, I guess I have a couple thoughts. One, what’s your forecasted draw down? Because to me, two percent doesn’t really seem like a real hedge. And then, two, to Jake’s point… I subscribe more to the Greenblatt theory where he said, “Pick your ideal allocation, and then if you’re more bullish, you can”… so, say your ideal allocation’s 75/25 bonds/equities, or whatever. If you’re super bullish, you could go to 85/15, and if you’re really bearish, you could go to 65/35, and give yourself sort of a 10 percent range that you can sort of make a market call with.

Bill Brewster: But it ensures that you’re generally around an allocation, and I would rather play a hedging game that way than I would try to get short, because I just… timing matters so much, and I don’t know, I just think you’re sort of over-complicating the whole thing.

Tobias Carlisle: Yeah, that was my thought. Basically, two percent is not enough protection, and you’re probably just going to get that attrited away… I think that’s a word, attrition? Attrite? I have to look that up.

Jake Taylor: It’s Australian. It’s Australian for “losing money.”

Tobias Carlisle: I have done lots of dumb hedging, and that all started in about 2010, so I’m definitely behind on all of it, and I would need… the market would have to go negative 10 or something for me to make that money back! So, yeah, I’m no longer a believer. The timing’s just too hard. You lose too much money on it, and I think that Bill’s got a much more sensible approach, where sometimes you’re going to lose a little bit, but you’re better off, I think, in the long run… compounding over the long run… to keep your exposure up.

Tobias Carlisle: All right, this one’s-

Jake Taylor: Those are nice guard rails. I like that.

Tobias Carlisle: Yeah, those are good ones.

Bill Brewster: What’s up?

Jake Taylor: Those are good guard rails.

Tobias Carlisle: Good guard rails.

Bill Brewster: Yeah, Greenblatt’s a smart guy.

Jake Taylor: He’s no dummy.

Bill Brewster: No.

Tobias Carlisle: This one’s from Patrick Rossi. I think Patrick is in Italy, so there’s one of our listeners in Italy, which is awesome!

Tobias Carlisle: “Do you believe that, as Buffett says, ‘When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it’s the reputation of the business that remains intact?’ Do you guys think that’s still valid?”

Bill Brewster: Every time that I have thought management can overcome the reputation of the business, I’ve lost money, so yes, I still believe that that’s probably right.

Jake Taylor: I’m going to take the opposite view, actually.

Bill Brewster: Mmm! Fading Buffett, how dare you?

Jake Taylor: I know! I know. It’s sacrilege.

Jake Taylor: I think maybe with the increase in the advancement of technological change, that the businesses are just maybe not as mode-y as they were at one point, and now it probably maybe requires a little bit more of a good manager to find the next thing that’s smart to work on, potentially… or even know when it’s time to stop working on it and maybe start liquidating. I mean, I think that’s still a pretty underappreciated and heroic thing that a capital allocator can do, is to recognize that the business doesn’t need to be built into an empire if it’s in a secular decline, and just managing it properly and returning capital to shareholders in a disciplined way.

Jake Taylor: I salute those kind of people, even they kind of get a bad rap as vultures or something. But, I mean, vultures fill a very important niche in the ecosystem of biology, and there’s no reason that we don’t need that, also, in the complex adaptive system that is our economy.

Jake Taylor: So, I think maybe having that smart person might be a better advantage today. Well, let me try to invert it. If you gave… I don’t know, like the Shopify CEO, who is very hot right now; everyone loves him, right… if you gave him a pile of money and said, “Go start a business,” would you want to bet against that? Or would you rather… maybe Shopify’s already a really good business, and you replaced him with someone that’s a bonehead… which of those two would you want to bet on for having longer return outcome?

Bill Brewster: To your question, Jake, I was smiling halfway through because you were reminding me a lot of Munger, and then you went on to go with the inversion take, so you’re officially Munger today!

Jake Taylor: Nice!

Bill Brewster: I guess that… so as far as Tobi is concerned, I think that he’s a guy that could potentially end up like Bezos. It appears as though the stock is priced that way, right? But I mean, that could be one of those unique situations. I still think if you gave me the choice between a bozo running a software company… let’s not make it Shopify, for a second, but like an ERP, or an enterprise software company, something like that… I’d rather take a bozo running that company than a really smart genius in a commodity company.

Bill Brewster: So, I still think that the base rates of the businesses matter, but I do agree that management also matters, if that makes sense.

Jake Taylor: Does it matter more today than it used to… management?

Bill Brewster: I don’t know, but one thing that you had said a while ago that I thought was smart… you had mentioned that a good capital allocator makes a business anti-fragile a little bit, or helps with that, and I think that that’s really true. So, I don’t really know that I’m answering the question, but…

Bill Brewster: Certainly, anything that relied on a distribution mode, or inertia, or whatever… I mean, those modes are eroded more than anything. So, yeah, I guess it matters more, probably.

Tobias Carlisle: I think the sort of proof of that is the cigarette companies. I think it’s hard for cigarette companies to get kind of the best of the best, because it’s just… nobody really wants to be seen to be selling cigarettes, and even Buffett has talked about being uncomfortable investing in them. But those are just unstoppable businesses that, even though sort of nobody really wants to invest in them, nobody wants to be associated with them… and fewer people are smoking… but the underlying growth in the revenues and the profits? They’re just unstoppable.

Bill Brewster: Well, there is one… literally, one… investor that I’ve ever heard that says like, “Well, hopefully, more people smoke,” right? That’s Lawrence… what is it? Lawrence Hamill, right?

Tobias Carlisle: Hampton!

Jake Taylor: Hampton, yeah.

Bill Brewster: I’m like, “Oh, okay, yeah, maybe. That’s an interesting thing to root for.”

Bill Brewster: Yeah, so this is a different-

Tobias Carlisle: That might be libelous. I don’t know if he said that or not.

Bill Brewster: I’m almost certain he said it on your podcast. I’ll listen and send you the minute.

Tobias Carlisle: I’m just protecting myself, Bill. Just hanging you out to dry!

Jake Taylor: You know Toby’s a lawyer by training, right?

Tobias Carlisle: Recovering. So’s Bill.

Jake Taylor: You’re recovering.

Bill Brewster: I don’t know what I was going to say. I lost it.

Tobias Carlisle: I think we’re coming up on time, so let’s…

Bill Brewster: We’ve derailed!

Tobias Carlisle: Before Lawrence comes to sue us for the $1.98 we make every week, gross… see you guys next week! Thanks for listening! It’s always a lot of fun to record these! Gents…

Jake Taylor: See you, boys.

Bill Brewster: Have a good one.

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2 Comments on “VALUE: After Hours (S02 E05): Risk Arbitrage, Leonard’s Constellation CSU.TO And The Fundsmith Letter”

  1. Great show!
    Halma plc may be another hpc – with a formulaic approach to numerous small acquisitions in specific verticals – and not on 50x (yet!)
    Halma is owned incidentally by Terry Smith’s mid-cap offshoot fund, the Smithson Investment Trust.
    Apparently Terry Smith titled one of his final notes to clients as a Bank Analyst in about 1999 “Internet killed the Banking Stars”. Today the global market Cap of the Banking sector is 7$trillion meanwhile the Top 10 Tech stocks are capitalised at 6.5$ trillion.

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