In this episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle chat about:
- Investors Should Be Very Wary Of Financial Market Commentary
- Dark Matter
- Treacherous Markets
- Most Investors Know Very Little About What’s Actually Happening Inside A Company
- TransDigm’s 4000% Gross Margins
- The First Thing To Check In A 10K/10Q
- Half Kelly Position Sizing
- Bill’s Robinhood Statement
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Full Transcript
Tobias: And we are live. It’s 10:30 AM Pacific, 1:30 PM Eastern, 5:30 UTC. What time is it in Chicago, Bill? 12:30?
Bill: We got 12:30, yeah. What time is it in London? Probably 6:30, right?
Tobias: Yeah, so I think with daylight saving, it’s 6:30 PM. Perfect for the commute home on the tube.
Bill: I don’t think people are doing that right now.
Tobias: Yeah, I don’t know. Some people. What’s happening, fellows?
Bill: Just living life, watching the markets.
Tobias: Yeah, wild times.
Jake: I think if my math is right, this is our 30th episode.
Tobias: Oh, this is [unintelligible [00:00:44] together.
Jake: Yay.
Tobias: Feels like–
Jake: Total.
Bill: Not bad, us in the 10, got through–
Tobias: Hey, Port Moresby, [unintelligible [00:00:53], what’s good?
Bill: I think we’re still working on it, Toby.
Tobias: Toronto.
Bill: We’re still out here– maybe by episode 50, we’ll stop announcing all the locations and times around the world. [laughs]
Tobias: Never.
Jake: The good news is you can just forward– [crosstalk]
Tobias: [crosstalk] –you skip forward 15 seconds. San Fran. There we go. I love it. It’s the future, man.
Bill: [crosstalk] –starts his. He’s like, “I shout out all my Patreons, “If you don’t like it, fast forward through it.” Us, we’re telling you the time everywhere in the world. Do you think you can look that up–[crosstalk]
Tobias: Hey, it’s London. 6:30 in London, I’m guessing.
Bill: Hey, shoutout to the guy on the tube. Thanks for tuning in.
Tobias: Ptown. Scottsdale, Arizona, what’s good? Sweden, this is excellent.
Bill: Yo, Scottsdale, what’s COVID like out there? I’m worried about my mom. She’s out there.
Tobias: Bangalore, Sactown, Victoria, BC, Belgium.
Bill: All right, Toby. You’re gonna let me talk?
Tobias: Yeah, brother, you go.
Bill: [crosstalk]–like fucking announcing stuff. What do we think about this COVID cure? I mean, I know that we have no idea. We’re basically three idiots talking about this but–
Tobias: Pump and dump.
Bill: –incrementally good news, yes? Pump and dump?
Tobias: Yeah, I don’t think that’s the– I wanna know how the phase 2 of the trade negotiations are going.
Bill: Dude, it’s infrastructure week, you get the memo?
Tobias: Is it happening?
Bill: I don’t know. They say so. Might as well start this out. This is a Value After Hours. I’m Bill Brewster with my cohost, Jake Taylor. Jake, what are you gonna be talking about this week?
Jake: I have astrophysics and information.
Bill: All right. And Tobias Carlisle, the esteemed, my host and other cohost.
Tobias: O captain! My captain!
Bill: Indeed, yes. Please tell me where we shall sail.
Tobias: I think it’s a treacherous market right now. I think it’s big waves over a coral reef. And I think there are a lot of new surfers out here with us. And I just think that you need to be a little bit careful. I love Davey Day Trader, love that guy. Love every single tweet that he puts out. But you just wanna be careful following Davey Day Trader. This requires a little bit more work most of the time to kind of figure out what you’re doing and that’s kind of what I’m gonna be talking about.
Bill: I don’t see why you would think that it would require more work than thinking Boeing as an airline. That seems like– [crosstalk]
Tobias: I know the seas.
Bill: — sound analysis to me.
Tobias: I know how the fuck rolls [unintelligible [00:03:32] on the water.
Bill: Yeah, no doubt. And I’m gonna revisit my topic from last week. And then, I got something to say at the end of the show. So, I’m gonna kick it off if that works for you guys.
Investors Should Be Wary Of Financial Market Commentary
Last week, I had talked about TransDigm and easy questions at the bottom, or at lower prices I should say. And I wanna reiterate that I think that the decisions are much easier when prices are lower. I think that that’s objectively true. What I don’t wanna minimize is the risk that that entity carries. And a good way to get your head around it if you heard me talk last week and you’re interested, is if you read the Inspector General’s report for the Department of Justice, where they said that TransDigm was earning excessive margins. That is a very good report.
Tobias: What is excessive?
Bill: Man, in that report, they say 15% gross margin– well, it’s profit. I’m pretty sure it’s profit—[crosstalk]
Tobias: What do they mean by excessive, for the customers or excessive for a business of that type? Or what’s that? Or that’s just at peak earnings multiple and so it’s gonna come back from there?
Bill: I’ll just tell you what I think they are talking about is gross profit. And the reason that I think that they’re thinking or talking about that is the margin that they cited, if you back into it, is 61% on the sales and TransDigm margins are mid-50s. So, that’s why I think they’re talking about gross. I could be wrong on that. I was looking more for like the qualitative discussion of the price gouging, or the alleged price gouging.
Tobias: Yeah, that’s what I was trying to understand. Is that what they’re talking about, okay. They’re saying that’s excessive.
TransDigm’s 4000% Gross Margins
Bill: Yeah. And what they’re basically saying is you have to provide the DOJ with the cost of goods that you’re making. But in TransDigm’s case, their argument is, we don’t have the cost. Some of these parts are like very old run, or they’re priced too low, so it’s below the threshold that we have to provide your costs, so there are other ways that we’re going to price our products off of it. One of which is older sales and the other is sales in the commercial market.
And some of the prices are eye-popping, I mean 4,000% gross margins or whatever on a part. What TransDigm’s retort to that is, is it’s a one-off part. We’ve either inventoried it forever, or we have to spin up everything and make it and yes, it is correct that that particular part may look egregious, but in the whole scheme of things, it’s not. Now, whether or not you wanna agree with that argument or not, or I’m articulating it correctly or not, I would encourage people to go to the source information and find out for yourself. What Nick Howley, the CEO, said is like, “We are not a traditional defense contractor. We fund all of our R&D internally. We sell to the commercial market and the DOJ happens to pay the same prices that the commercial market does.”
Look, I think there’s a lot of reasons to dislike that. There’s some reasons to dislike a levered philosophy that somewhat relies on that. The end market is cyclical and some people pitch it as secular. And I just want to be very careful, given some of the events in my current life, to tell people to seek the other side of the trade and not rely on what I may be saying or somebody else.
And just to wrap up, when I was doing AB InBev research, there’s great, great information in the antitrust cases in the US and in the EU. And Buffett has often talked about, “I don’t rely on nonpublic information.” And I think that government reports on companies are like a very underutilized or underdiscussed resource that’s out there that the US taxpayer is paying for and it’s sometimes really good information.
Tobias: Where do you find them? It depends.
Bill: Well, that one–
Jake: Twitter.com
Bill: Yeah. I can think of three off the top of my head. The TransDigm one I was just talking about, just Google Inspector General report on TransDigm, that’ll bring that one up. AB InBev, you can just google like AB InBev SABMiller acquisition antitrust, and then EU and US. And then the other one is– what’s the third?
Jake: So, there’s no repository.
Tobias: Yeah. But my question is, you are actively looking for this stuff open-endedly, how are you tracking it down or finding it?
Bill: Well, it’s mostly by finding the news. So, there was a big 5G report that came out that Sorkin had cited and I just went to the– the source documents are so much better than people’s interpretation of the source documents. Even here, I’m talking about my memory of this thing, and I’m tired and I’ve had a stressful weekend. And so if you listen to what I’m saying, it’s just not the right story.
Tobias: Do you need to be a lawyer to read them?
Bill: I don’t think so. It takes work, it’s like reading 10Ks. You don’t open a 10K and get it the first time but then eventually it clicks. But investing takes work, right? Unless you’re buying the airlines, which is apparently easy.
Tobias: Or the cruise lines, that’s easy too.
Bill: That’s right. I gotta say, I know on Twitter, I took a shot at them or not really. I just think you gotta be really, really careful following Davey Day Trader, but man, his media, he is good at what he does. I gotta give him that.
Tobias: It’s a great follow. It’s one of the best accounts out there if you like this stuff. But yeah, we all talk about a little bit when– I’m not trying to bomb on him at all, I love what he does, I think he’s great.
Bill: No, I’m not either. I just–
Tobias: Just to go back to CDG, isn’t the point of a business to sell the stuff that you sell? So, basically the profit– you’re trying to maximize the profit in the long run. So, you don’t wanna gouge your customers too badly, so they go and get another supplier. But you wanna charge them– I don’t remember microeconomics, but I remember monopolies don’t charge the absolute. They don’t charge an infinite amount, they charge according to some long-run demand or supply curve. I can’t remember frankly, but the theory doesn’t really matter that much anyway, but just the point is, aren’t they trying to charge as much as they possibly can for these things? What’s wrong with that?
Bill: Well, so it’s a razor-razor blade model. So their argument is we invest a lot in R&D, and we start to make money as the products season. And the issue that the DOJ has with them is even the competitive bids, they’re being sourced from TransDigm. So, it’s TransDigm selling to somebody else and then that person selling to the DOJ. I think something like 38 of the 41 parts were actually monopoly parts. And Howley, the CEO, he said, if you don’t—
Jake: [crosstalk] Do you mean DOD?
Bill: Oh, yeah, sorry. My bad.
Tobias: Yeah. Don’t gouge the DOJ. [laughs]
Bill: No, God. Yeah. And I’ve said it over and over.
Tobias: Don’t gouge the DOD either.
Bill: Yeah. Thank you, Jake. My head is in a different place. But, he said, “If you don’t like it, go buy it from somebody else or have somebody else reverse-engineer it.” And I think the point that he’s making is like, “Yes, I agree with you that if you were to look at this one transaction in isolation, it may appear egregious. If you take into account all the investment and warehousing the inventories over time, you’d find it’s actually a pretty efficient method.”
Tobias: Has the DOD looked at the margins on its Microsoft Office? That’s so far as a service, there’s pretty fat margins in that too. What about their cable subscription? Pretty good margins in that business.
Bill: Yeah, well, this is where I think that–
Jake: Three wrongs don’t make a right, Toby.
Tobias: But if you gotta make this stuff each time, you should be able to charge something for it, right? You gotta have a factory. You gotta know how to do it. You gotta do it.
Bill: Yeah. And if it is a one-off part, you have to stop your assembly line, you have to start one up, you got to make it. I mean retooling is not cheap. As a taxpayer, I’m not saying that I loved seeing some of the numbers but I also don’t think it’s as egregious as it may read. There’s nuance in life.
Tobias: When I was a kid, I remember people were upset because there were like $4,000 hammers, $4,000 toilet seats, and things like that.
Bill: Yeah. Now it’s, I don’t know, $1200 latches or something like that.
Tobias: Maybe it’s an important latch.
Bill: That’s right. Well, if they didn’t have to go–
Tobias: Uh-oh. Bill went into the Billtrix.
Bill: Oh, did I?
Tobias: Briefly.
Bill: Am I still here?
Tobias: You are. You’re fine. [crosstalk]
Jake: I heard you talking shit about the government.
Bill: Thanks, Comcast. Anyway, that’s all that I wanna say. I wanna say, don’t listen to people, don’t listen to their pitches and buy stuff. Do your own due diligence and the source documents are the best.
Jake: So, I have a little bit of follow-up with that, actually dovetails into what I was gonna talk about. But Jim Chanos has this really great metaphor of information as an onion. And at the very core of the onion, where there’s the most signal-to-noise ratio are the SEC filings typically, probably also would put government reports like that into that center core of the onion. The next layer out of the onion is the corporation’s interpretation of all of the information that they’re giving you. So those are like their slide decks or conference calls, annual reports.
The next layer out also, by the way, diluting from signal and noise, would be like sell-side research, industrial publications, things like that. And then finally, on the outer layer, you have the rumor mill, Twitter, Seeking Alpha, wallstreetbets, that area. And so, Chanos has said before, and I thought this was interesting was, he’ll read something in an SEC filing and then read almost a 180-degree difference of someone’s interpretation of what he just read on Twitter or whatever. And he just like can’t square those two things. And I think he’s right. If you’re depending solely on the rumor mill for your information, then your chances of catching reality head-on, I think, are pretty diminished. And the worst of it being, if someone’s entire thesis is just stocks only go up, and that’s like what they’re telling you.
Bill: Bye, bye, bye, bye, bye.
Jake: Well, I mean, that’s what we’re hearing right now a lot, right? If that’s the entire thesis–
Tobias: It’s been true since March 23, which is about how long everybody’s been in the market.
Jake: It’s been true since March 2009.
Tobias: Well, that’s true. Are we at all-time highs?
Bill: No, we can’t be at all.
Tobias: I think the Qs were.
Jake: February Qs are, yeah. I think February is still higher.
Tobias: The Qs are everything. What do you mean outside the Qs?
Jake: What are you talking about? [chuckles]
Bill: You know what, one of our listeners said, “I’m saying that I know that I’m gonna lose on this, but I’m keeping on doing it.” I’m not gonna lose on this. Get out of here. Come on.
Tobias: On what?
Bill: I don’t know. Everything. Yeah, all my shit. Please.
Tobias: Do you wanna do yours, JT, continue with your thoughts there?
Jake: Yeah.
Bill: He’s [unintelligible [00:16:19] high as well. Yeah, I guess it makes sense.
Jake: All right. So, I’m switching to–
Bill: Oh, shit.
Jake: –astrophysics mode. All right. This will hopefully be a little bit shorter since we’ve had some feedback that my veggies sometimes take a little too long to cook.
[laughter]Jake: I don’t know if you guys know this, but in the universe, so far what we’ve observed is that approximately 18% of the mass–
Bill: This is cracking me up, real quick. I’m having problems concentrating. All right, let me just regather my thoughts.
***
Dark Matter
Jake: Bill, focus right now. 18% of the matter based on mass in the universe is visible to us and the other 82% is dark matter that we can’t see. So it’s like a 4:1 ratio, which I think is– [crosstalk]
Tobias: We can’t see because it’s too far away, or we can’t see because it’s like– what’s dark matter? That’s another podcast. All right. I’ll look that up myself.
Jake: Yeah, look that one up. I’m sure there’s a tweet about it that’ll explain the whole thing. But let’s think about, is it possible that– when we’re all sitting around trying to figure out the cash flows that are gonna be created by a business over time, is it possible that we might have the visible part? Maybe it is we have about 18% of the information that we would need to know the exact number and the rest of the information is dark matter that we can’t measure, we can’t see it. We won’t know the answer.
Things like, we would never know the managerial squabbles that are happening inside of a company. We would never know if the CEO maybe was sick, and it’s like Game of Thrones happening, and they’re like, who’s gonna try to take over. We wouldn’t know that employees were planning on leaving, especially I think this is exacerbated by big stock option grants that turn, especially early employees into millionaires, and they’re hanging around waiting until they can cash those checks, and then they’re leaving. We don’t really know what’s happening inside of every customer’s head. People try to do like net promoter score and things like that to get a gauge at it, but this stuff is pretty sloppy measurement.
We don’t really know what assessing what the culture looks like from the outside, no different than we don’t know what is happening on the inside of a family from the outside. You could meet some family and think like, “Man, these guys are great.” And the inside, when no one’s around, they’re terrible to each other or who really knows. So, this is very similar to celebrity divorces that just happen. And we’re like, “Oh, they seemed perfect for each other.” It’s a very manicured, textured, or cultivated presentation that they’re giving you, and it’s the same thing with the companies that we’re all looking at. They’re putting their best foot forward for you on a public domain.
On top of that, there are also these external factors that you can never really know the answer to. You don’t know what their competitors are working on and cooking up. We don’t know what’s in some garage somewhere that a kid is working on that’s going to totally disrupt the business model that you depend on all those future cash flows for. We don’t know if the government’s cooking up an antitrust suit against them. We don’t know if there’s environmental impacts, like perhaps a pandemic that you didn’t see coming. Who knew that there was a guy in China eating a bat in November that turned into all of the things that we’re looking at now.
Bill: Fuck that guy. That sucks.
Tobias: Poor bastard. They probably serve them up all day every day.
Bill: Yeah, I do sort of feel bad for him. But this has not been a great year.
Jake: No, it hasn’t. So all of which is to say, if the ratio really is four to one on what you can see and measure to things that you can’t see and measure, I think that that then really, you should take that as like a– you have to be more conservative with your position sizing. You have to be a little bit more intellectually honest about like, “How much do you really know about these companies” I think you gotta back off on your certainty a lot because you think you see the entire universe because you did all the work to see the 18%, there’s a whole other 82% potentially that you have no idea the answers to. I think it calls for some intellectual humility.
Bill: This is where the value school says pay a low price. And then, you are reducing the probability that the other 82% hits you in the face. And that is what value has 100% correct.
Tobias: Or the impact of it.
Bill: Yeah.
Most Investors Know Very Little About What’s Actually Happening Inside A Company
Tobias: So, I got a couple of good comments. Don’t wanna let them slide by. Oracle Brouhaha says, “You really don’t know these things if you’re diversified. If you only own a few companies and you have energy, you can actually do this kind of research.”
Bill: I think that’s probably truer on the smaller ones than the bigger ones. But I don’t disagree with that.
Tobias: You wanna comment, JT?
Jake: Yeah, I’m gonna push back on that. I think maybe in earlier time periods, it was easier to do that. Like how the universe is expanding at something like 46 miles per megaparsec. But what’s happening there is, I think we’re increasingly in a global world and business is done at global scale. And so, I think it’s harder and harder to know more of the answers because it’s gotten so much more complicated. And I’ll give you an example.
Munger has talked about this guy, his name is, I can’t pronounce it well, but it’s John Arriaga, something like that. And this guy bought tons of real estate around Stanford’s campus before it was Stanford, before it was Silicon Valley. And this guy’s now worth a couple billion dollars. And Munger said before that, that this guy never left his little circle of competence. He knew that area and he stayed in that area and he created this really an empire from just knowing that little area. And by the way, I think he’s a Marc Andreessen’s father-in-law.
Bill: Oh, really?
Tobias: Smart.
Jake: Yeah. Anyway, this guy’s worth $2 billion because he stayed in his little circle of competence.
Tobias: And his circle of competence happened to be Silicon Valley.
Jake: Yes.
Tobias: That helps.
Jake: So, there’s definitely some kind of survivorship.
Tobias: My circle of competence is a little country town in the Australian Outback, that wouldn’t help.
Jake: That wasn’t gonna do it. Yeah.
[laughter]Jake: Well, all of which is to say now, I think it’s harder to– the world has gotten so much more interconnected. And really it’s harder to have these little localized markets like that for most goods and services. Most things are competing on a bigger scale. There’s therefore, I think, more information to be able to have to process to get some of these more extreme outcomes.
Tobias: Yeah, I would push back on that a little bit too. I worked as general counsel of a public company and the sell-side research that we always talked to, they had worked out what we were gonna grow to in any given quarter. And to be fair, that was reasonably accurate over time. And I think part of that is sort of being able to take a step back. But being inside the machine that hit those numbers was an entirely different thing altogether, because it was– literally it’d be 430 in the afternoon on the last day of the quarter, and we’d need a material sale to close to hit that target, and it was turning on whether the sales guy and the general counsel could get it done in an hour to finalize that agreement.
So, I sometimes think that the statistics maybe don’t realize how much sweat and effort there is underneath and that how coin-flip some of these things, and it’s not necessarily bad if they miss. It’s not necessarily great if they hit. It’s just randomness.
Bill: Well, and I mean even people within organizations don’t know what’s going on. It’s a function of complexity, size, and how many human interactions there are. When I was at BMO, I barely even knew what our group was doing. I knew what our team was doing, but I didn’t know what our group was doing. And that led up to a group head and that led up to a commercial bank head and that led up to that, you don’t know what the hell is going on for real. You just know the culture.
Tobias: There’s a great line in Sherlock Holmes where he says that, and I forget who he’s quoting in that, but he says that, “Man is basically– no one knows what any individual man is gonna do, but men in aggregate start to conform to some statistical..” I put the quote in one of the books, which is, it’s the way I feel about having seen it from the inside out. There’s a lot of stuff going on all the time. It’s enormously random, what hits and what doesn’t hit, but over time and in aggregate, the numbers do get a little bit clearer. So, I don’t mind that’s sort of the way that I invest, is a little bit step back, not drilling down, because I don’t know that it gives you usable information. Maybe it does, but I think that you can do fine, step back, looking at aggregated numbers, and just being humble and careful about recognizing what the limitations are. And that might mean diversifying a little bit.
Bill: Well, Jake, I mean, you and I have talked about this. And I don’t know if we’ve had the same conversation, Toby. But I mean, that’s why we’ve talked about organizational culture is antifragile. Working on, analyzing– like Markel, for instance, is a group I know. And I just know who those people are and I think they will try to do their best over time. And over time, I think that works out well. I don’t know what this quarter is gonna look like. I don’t know who’s trying to stab who in the back within the organization, if it’s even going on. I don’t know any of that stuff.
Tobias: But you trust them because you can look back and see what they have done as manifest in the numbers that they’ve put up run rather than what they’ve said.
Bill: That’s correct. And honestly, I probably overweight this. I really think the hiring of [unintelligible 00:27:02] that was a lot of signal to me. I thought that that was very out-of-the-box thinking and I think he’s a great addition.
Tobias: Yeah, agreed. Anything else, fellas? Do we move on to mine, we’ve got about 30 minutes before we hit the–?
Bill: Yeah, well, it can be 15 or whatever, but yeah.
Tobias: Mate, I’m gonna hit that mark right dead on the nose.
Bill: I know you’re very good at time.
***
Treacherous Markets
Tobias: So, I just been really enjoying watching Davey Day Trader on the Twitter machine and everything else. Clearly, there are lots of folks following him and I’ve been looking at– you can pull up Robinhood. There’s a robinhoodtracker.net. Basically, there’s a little URL you can tag on to the end of that and the ending of it is, whatever ticker you want to look at, you can pull it up and you can see how many Robinhood holders in each of these individual names. So, I’ve been kind of just amusing myself going through them and seeing what’s getting a bid, what’s not getting a bid. It’s striking– and I’ve said this before, Robinhood buyers are definitely dip buyers and that either makes them value investors or bag holders and we don’t know yet which one it is. But I think you gotta give them credit. They have aggressively bought stuff that’s fallen.
There are places where you don’t gotta give them credit, is things like Hertz and Chesapeake because they’ve aggressively bought into bankruptcies there. And they’ve done the billion-dollar capital raise in Hertz where the debt’s trading at 67 cents on the dollar. That means equity collects nothing. That means that debt takes a 93 or 94 cent haircut, which is a lot. And then—
Bill: Is that a big down? I’m not sure.
Tobias: That’s a lot.
Bill: It’s hard to come back.
Jake: Is that bad?
Tobias: And then the billion that they’ve raised, that goes to the debt holders. That’s not gonna clear the debt because they’ve got to do another one. But while the market’s gonna take that stuff, they’re gonna feed it to it. Now, legally, it’s okay to do it. Whether you like that ethically or not, that’s a question– I think it’s pretty– I wouldn’t be doing it, I wouldn’t do it because I wanna have a good reputation and survive for a long time in this industry. So, I wouldn’t necessarily go ahead and do it, but it is legal to do and it’s all disclosed. They’re telling you right in the document that you’re not gonna collect unless something really drastic happens and they don’t anticipate that happening. They couldn’t be clearer.
So, there’s a lot of guys out there I think who are– it’s very, very easy to trade this stuff. And sometimes the fact that it’s easy to do it sort of masks how much work you really should be doing before you put these on. I got a background as a mergers and acquisitions, [unintelligible [00:29:51] diligence for a decade worked in a public company and I’ve worked in public equities since then reading filings. I’ve read a lot of filings. I’ve done a lot of reps. So I think that for a lot of things, I look at them pretty quickly and decide, when Moderna had its little pump and dump, the moment that I read that I was pretty confident that was gonna be a pump and dump. That’s what they look like. When Hertz was doing its–
Bill: So, you’re saying that 30 seconds of due diligence isn’t sufficient?
Tobias: It’s sufficient to pass.
Bill: Okay. There you go, there you go.
The First Thing To Check In A 10K/Q
Tobias: It’s not sufficient to buy. I think to buy, you wanna be doing a lot more work. So, I’ve built out systems and things. It gives me a– I’m able to cut pretty quickly to the part that I want to look at, and I’m sure that you’re the same. It is hard reading 10 Qs and Ks but if you read a lot of them, you know where you wanna go pretty quickly to see what’s happening. What’s the first thing you check in a 10K or Q? Just interested to know what’s the first thing you look at?
Bill: I like to look at the cash flow statement.
Tobias: There you go. What do you look at, JT? He’s gone to the Jaketrix. How convenient.
Bill: [crosstalk] Yeah, that is convenient. I like to read the IR presentation. [laughs]
Tobias: I just think that when the market looks as easy as this, often that might be disguising the fact that it is a lot harder than it looks. And I think we’re gonna– Jake’s back. You were in the Jaketrix very briefly there, mate. Did you hear the question? Where do you look in the 10Qs and Ks?
Jake: Yeah, I heard everything. I will typically look at a long sweep of the numbers, of the actual financials first, and then from there, I will dig in more to a little more of the qualitative things. I don’t know if you guys know, Buffett, he has a disqualifying checklist. And there are three things that he asks himself before he’ll do any more research on a company. And if any of those three things are a pass, then there’s no balance of any other good things about it that he could learn that will put it back into his funnel.
Tobias: What are they?
Jake: So, I think that’s a pretty good way. I knew you’re gonna ask me that, of course. Let’s see. I think one of them is, does he like the CEO? Another one is, does it have reasonable margins? And then I think the third one is tail risk.
Tobias: Yeah, that makes sense. I always look at the balance sheet. I go to the junkiest, the bottom part of the asset list, and I’ll just look at what they’re including in the assets. And I go to the bottom part of the liabilities list and just look at the stuff there, like the last three entries that you don’t know what they are, that’s always the first place to look because I’m trying to work out what they’re hiding in those parts. Because everything else, like everyone knows what cash is, payables and receivables, inventories. Everybody knows what those things are. It’s the stuff that’s hidden underneath that, that’s some weird thing, that’s where they’re hiding all of the good stuff. I think it’s the same thing on the income statement, what stuff are they hiding down here in costs and at the bottom that nobody’s reading. “Ah, we disclosed it. We just knew that you weren’t gonna read it.”
Bill: I think a lot of the pros that I really respect,they say, I read the audit, and then, I move on from there. Those are the guys that start– that’s the closest thing to the source documents. And even in the 10K, you get to MD&A and you start to get the corporate spin and you start to do the language. I enjoy that stuff. I think if people can communicate what’s going on in the business and a clear manner, it helps me get a sense of who they are. But the audits were the real hard– I don’t know, rubber meets the road, so to speak.
Tobias: Yeah. You wanna be careful of those qualified opinions given how loose they are, I think in most things. I’m amazed that Tesla keeps getting a clean bill of health from PwC. PwC has got a little tail risk there.
Jake: Yeah. Is everyone worried about the AR? Is that what Einhorn has been harping on?
Tobias: You need an accounting PhD to understand that stuff, and even then.
Jake: It’s all too much flexibility right now maybe.
Bill: Stonks go up.
Tobias: But stonks do go up. It does seem that way. I get increasingly uneasy when the market is like this. I don’t wanna be labeled as a permabear. I want the market to go down a lot so I can buy some more and be a permabull again. But the market to me, it just looks, there’s a lot of guys in here who are– If you look at those Robinhood holders, the number of holders in those accounts, they have hockey-sticked up in some of these names that have gone down. And that just means there’s a lot of people with exposure to them and that must be creating buying this, selling that order floater to other folks is my understanding. So there are other folks front-running it [crosstalk]
Bill: It’s in their documents.
Tobias: Yeah, well it’s disclosed. Can’t complain.
Bill: All you have to do is click the user agreement and scroll to page 5 and everybody does that, right?
Jake: Yeah. Page 500.
Tobias: Bill, I’m too eager to hear what you have to say. You wanna take it away, too early?
Bill: No, it’s fine. I can do it.
Tobias: But do you wanna do some questions for five minutes before we jump in?
Bill: Yeah.
Tobias: Folks, you wanna to throw us some questions and then we’ll–?
Bill: I still want to get my head right.
Tobias: Hit us with some questions and then–
Concentrated Investing
Bill: Oh, dude, I got a mailbag from a while back about concentration and position sizing, which I think is a pretty good one given Jake’s topic. And I don’t even know that we can really know right now, but the guy just said that, “In general, there’s a lot of discussions about concentration. Questions kicking around in my brain that I’d love to see you discuss on the podcast. Why is position sizing risk in general portfolio management so rarely discussed? The damning math of being unfortunate enough to oversize losers and undersize winners is in my mind more important than what I buy. Yet, especially in the value space, it seems like it’s almost never discussed. I have to dive into the trading world to really understand a lot of the math and principles. What are your thoughts?”
Tobias: Well, I wrote a book on it.
Bill: Yeah, that’s why I’m asking you. And then you also had that interview. Didn’t you interview the guy that said that, he just equal weights everything because his results were better. Did you comment on that at one point?
Tobias: Well, I equal weight everything because I think it’s extremely hard to work out. When you’re down to 30 names out of 1500, you’re already at the very pointy end. And to say that I think one thing is going to outperform another, I think, is very hard. Having said that, there are guys who can do that. Icahn’s portfolio outperforms an equal-weight version of his portfolio, which indicates he has some skill in identifying which ones are gonna be better and which one’s gonna be worse. I’ve thought a lot about– I think concentration and diversification and position sizing is literally half the battle. Stock picking is one half of the battle. The other half is making sure you got the right positions on– the right size for these positions because you have to understand how much something is gonna—how volatile something is– how much it’s gonna move around. If it’s a zero, you don’t wanna have a material part. If there’s a potential for a zero, you can’t have a material part of the portfolio in it. You gotta start treating it like an option. It’s got to be an option size position, which is 1% to 3%. And 3% is pretty aggressive.
You wanna be more of a Kelly betting type investor to be doing that. Kelly’s really hard to implement for a variety of reasons because the numbers are softer. You don’t include tail risk properly in it, if you include all of the universe and you should, it scales everything down. And Kelly’s the outer limit of what you should be putting on these things, anything inside that still conforms to Kelly. So, you can be smaller and still conform to Kelly. It’s going up more than that, that eventually risks ruin.
***
Half Kelly Position Sizing
Jake: Toby, do you think that half Kelly, which is a pretty popular approach is still– What do you feel like that fits on the risk world? Is that a good approximation or would you even tell people a third or a quarter?
Tobias: I think half. Half, you probably can’t go wrong really. Although I think that when people– the test that you should do for yourself is just to create—so do Kellys in single for a position that you think you should have some portion of your portfolio in. And have a look at how much tells you to put into that position. Then go and include things anything that has a positive expectation bet that you can put on. So, treasuries, corporate bonds, gold, other stuff like that. And fade it into something where it keeps on recalculating, recalibrating until it gets down to the sizing. And you’ll find when you do that, that the position is much, much smaller.
And so half Kelly is a good approach. You’re still not getting enough return for your volatility at that point. Full Kelly is the right mix of return and volatility. But it’s so easy to overestimate Kelly, that you’re much better off underestimating. And the positions are gonna be much, much smaller than you– a 40% position is almost impossible in a properly calculated Kelly universe. They’re gonna be much, much more, like 10% or 5%.
Bill: You look at Buffett–
Jake: YOLO.
Bill: –Well, he’s got that speech where he’s like, I’d have 50% my top name. We said this last week, I get it, but that’s Buffett. That dude is a wizard compared to mere mortals.
Tobias: Plus a little bit of luck.
Bill: Yeah. Well, maybe not a ton of luck. I think he would have been fine no matter what. But there are, I guess, other paths of outcomes where he’s not necessarily Buffett.
Tobias: [unintelligible [00:40:10] financial in a fraud, that can go two ways. He was right, maybe his analysis was just exactly right. But I think–
Bill: I think he might have been. Plus, it was cheap. I mean you get the combination of the events.
Jake: Yeah, but that’s that one man versus the group of people that you can bet more on their behavior.
Bill: Yeah, that’s fair. I mean, that’s really—
Jake: Still a lot of idiosyncratic– and if it’s true to the nature, it’s four to one idiosyncratic of things you don’t know.
Tobias: All right, Bill, it’s time, mate.
***
Bill’s Robinhood Statement
Bill: All right. Listen, to anyone that doesn’t follow me on Twitter or doesn’t want something serious to enter their life right now, please tune out. I had a family tragedy this weekend, and I’m going to attempt to clear up the record, and it involves suicide. So, there’s your trigger warning. And if you decide not to be here, I totally understand. All right. I’ve never had to do this and I hope I don’t have to do it again.
First and foremost, I’d like to thank everyone that has reached out to me since this weekend. I’m glad that I helped some people. And my weekend started out really nice. We were in Wisconsin. And on Friday night, I got a call from my wife’s aunt. And it was the type of call that when you pick up the phone, you know that something has gone horribly wrong. I later found out that Alex, my wife’s cousin, had committed suicide. When I found his suicide note, I was shocked. It read and I quote, “If you’re reading this, I am dead. See suicide 2, for why,” or “See image suicide 2 for why,” I suppose. “How does a 20– almost a million dollars worth of leverage, the puts I bought and sold should have cancelled out. But I have no clue what I was doing in hindsight. There was no intention to be assigned this much and take this much risk, and I only thought I was risking the money I actually owned. If you check the app, the margin investing option isn’t even turned on for me. A painful lesson, fuck Robinhood.”
I was pretty shocked and confused when I read that because Alex, I knew well and he did not have a ton of money to take on a million dollars of leverage. So, when I had phrased my tweet thread, asking the exact question that he asked, how as a 20-year-old with no income able to get assigned. I’ve mentioned $730,000 because I had seen a picture of his account. It was the image suicide 2. Anyway, I get back to what I wrote.
The addendum showed a negative cash balance and buying power of -$730,000. His investing accounts still showed $16,000. I asked what happened. And finally, a person by the name of @actuallyfinance posted an image of the statement that they had that looked the exact same as Alex’s. His tweet read, “Personal Robinhood experience. They supposedly auto-sell in the money options on the day of expire. I ended up testing that one day and instead the options were exercised. By Monday morning, this was corrected and the positions were sold, but it was an alarming sight over that weekend.” So, it appears to me now that Alex died over nothing. My version of events is that he saw the cash balance, thought he ruined his life, and killed himself the next day. And I apologize if I started some fake news about leverage. And I do feel bad for making the leverage story go viral, when in fact, it was a misunderstanding. Sorry.
However, I’m the one that had to tell a six and a four-year old that they had to leave vacation because one of their family members had just died. And I’m the one that has to answer the questions about how he died and why he died and what death is. And I’m the one that has to go to a bodyless funeral because my wife’s cousin threw himself in front of a fucking train because he was so devastated by what he saw that he thought death was his only option. Meanwhile, I see an article about how Robinhood’s app has gamified investing, how the founders are proud of their design features. Well, here’s the thought. How about you design a program that doesn’t make a kid thinks he owes $730,000 when he doesn’t? How about you figure out how to stick whatever that internal settlement number is into the background function rather than showing it on his home screen? Even a more experienced trader referred to it as an alarming site.
So Robinhood, if you wanna write a press release, here are the questions me and my family would like asked. In what world is it okay to show a cash balance of -$730,000 when you know a lot of your users are retail money? His account had $20,000 in it and you’re gonna flash a -$730,000 number in front of him. How is it not just a little fucking foreseeable that that could result in a bad outcome?”
Question 2: Why in the world are kids able to get that much notional exposure, if it is even that? I don’t even understand what the number is. And again, why would you not show net exposure? He thought he was selling covered calls and puts and I think he was.
Question 3: What is it about your product that made my story go so viral? How is it that responses to me have mentioned, know your customer issues, needs for product improvement, glitches and trading execution, and reference the infinite leverage incident. I’m all for financial innovation and democratization of opportunity, but I also recognize that finance is a unique intersection of emotion, math, and strategy, etc. It’s why it’s my favorite game in the world. That’s why it’s table stakes for these platforms to recognize what they are doing and enabling. And the idea that you can flash those kinds of numbers in front of someone’s home screen and not foresee some bad outcome is ludicrous. It’s negligent at minimum, and I’d argue it’s at least reckless.
So this is my message to you, Robinhood, which is opinion based. You name your company Robinhood, obviously to draw some images of helping the less fortunate. You allegedly gamify investing to democratize trading. That’s not good for society. It’s toxic. You claim to enable people by granting access, but you really make money incentivizing orders so hedge funds can front-run clients. That attitude gives finance a black eye and it’s the type of stuff that gives Elizabeth Warren a leg to stand on.
In closing, I apologize for creating a thread that implicated leverage when the real story was interface-driven miscommunication. I was relaying the message of a dead young adult and trying to find answers. I do not wanna do this, but his parents can’t. They can barely get through a conversation without crying.
So that’s been the story of my life since Friday evening. And frankly, it sucked. Now that I have that out of the way, I’d like to have another heavy tangent in case that was not easy enough. If you suffer from any mental illness, I beg of you not to give up. And I realize that’s a little stupid because depressed minds don’t think all that clearly. And I know that because I’ve seen it up close and personal multiple times, but you are not alone. Call a helpline, reach out to a friend or listen to the Quoth the Raven, Sang Lucci podcast when they talked about blowing up because it’s a really good discussion about what can happen in trading when people blow up.
Alex most likely killed himself because his perception of events weren’t the actual events. He didn’t know because he didn’t talk to anyone. And I suspect he didn’t speak out because of shame. And that’s bullshit, and it’s left a world of pain behind. I ache for him and more importantly now, for his family. And if you’d just called me, the whole incident could have been avoided.
Next, a comment for young investors. To anyone that’s listening that doesn’t follow me on Twitter, please be careful in the markets. It’s easy to listen to a podcast like this and think we’re some savants or someone else’s. This is all financial entertainment. It’s not advice, and all of us are professionals. In podcast land, some of us are smart, and others aren’t. There’s no barrier to entry. Don’t fall victim to authority bias. Do not do what we do without thinking about it. Honestly, my best advice is to index and go do something better for society than investing in secondary markets.
But for the love of God, if you do get into investing, you have to understand what you’re doing. Stay away from options and futures. And if you absolutely can’t stay away, trade in lots of one contract until you really understand the risks. The swings can be huge and the emotional fortitude required is learned and rare. So please be very, very careful.
And finally, some of the comments on the internet have been a little disturbing on some forums. The overwhelming majority had been positive, but some have some hate or anger behind them. And to those people I say, I hope you find happiness. Otherwise, life is gonna pass you by. There’s enough hate out there. Don’t be part of it. I got nothing else, guys. [in tears]
Tobias: Sorry, Bill. All right, folks. I think on that note, we’ll end it. And we’ll look forward to seeing everybody next week. See you then.
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