(Ep.80) The Acquirers Podcast: Brian Bares – Moat Master: Moats, Management And Long-Term Growth

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In this episode of The Acquirers Podcast Tobias chats with Brian Bares. He’s the Founder of Bares Capital Management and author of The Small-Cap Advantage. During the interview Brian provided some great insights into:

  • Your Variant Perception To The Market
  • DCF Is The Least Reliable And Accurate Part Of Any Managers Process
  • Why Qualitative Research Is Much More Important Than Quantitative
  • Wide Moat Companies And How To Find Them
  • Investing With Certainty – Moat, Management, Growth
  • How To Spot ‘Red Flags’ In Management Behavior
  • Finding Extreme Winners
  • Early Adoption From 60/40 To The Endowment Model
  • Investors Should Screen On High Price-To-Book
  • How To Build A $4 Billion Investment Firm From Your Spare Bedroom

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Full Transcript

Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest is Brian Bares of Bares Capital Management. He manages $4.6 billion across a variety of strategies. He’s highly qualitative, highly concentrated, we’re going to talk about his process right after this.

You wrote a book, The Small-Cap Advantage. When did that come out?

Brian: 2011, I think. I wrote it during the financial crisis basically. It was published in 2011, ultimately. A funny story about that is that I was paid a $5,000 advance by Wiley. This Q1 of 2020 earned through my royalty.

Tobias: You paid it back.


Brian: I got my first check for $112– [crosstalk]

Tobias: Well, you have a look at the return on investment of Wiley, it’s like 40%. They keep all that money for themselves. It all flows back to Wiley.

Brian: That’s right. They were wonderful. They basically let me do what I wanted. The origin story is actually interesting in that. Pat Dorsey is a good friend of mine. I don’t know if you know Pat but–

Tobias: I don’t know him. I know who he is.

Brian: –he’s built the Equity Research Division at Morningstar, rightly credited with a lot of the moat concept, crystallization in our business, and he’s heck of an investor, and he’s even better guy. I called him one day and I said, he wrote, there’s The Little Book series, there’s The Little Book That Beats The Market, The Little Book of this and that the other thing. And I said, “There’s not a little book of little stocks.”

Tobias: Yeah, good name.

Brian: There should be a book, right? Yeah. He said, “That’s a great idea. Let me put you in touch with my publisher Wiley.” I ran it up the flagpole and they said, “This is a phenomenal idea. We love it, but no one knows who you are. This is reserved for Rockstar-style authors, and so you’re not that,” and so humbling thing. But they did say, “We checked around and you have a decent reputation and the kind of institutional endowment community and that sort of thing. Is there a way you could sort of pivot that into a book about small caps, that’s more a professional book rather than a mass-market book?”

And that got me thinking, “Okay, yeah, check the box, I always wanted to write a book.” I felt like I had some things to say particularly around just how to structure a business and investment management business. They let me choose the chapter list and the content and, other than correcting a few grammatical errors, of which there are plenty. It was the book that I intended to write, and I’m happy.

I read it actually for the first time in about a decade, about a month and a half ago and I was like, okay, to a large extent it still holds up after 10 years. It’s not completely topical and relevant today, but there are some concepts in there I think that were pretty prescient, in particular one about price to book.

Investors Should Screen On High Price-To-Book

I took issue in a paragraph of the book about the Fama-French three-factor model and how price to book was in contrarian indicator of value for so many years. I was like people shouldn’t be paying attention to price to book. There’s just a lot of reasons you shouldn’t pay attention to price to book. And just because it works in Fama-French three-factor model, it doesn’t mean it has underlying validity. And here we are, probably 10 years later from the book, but 15 to 20 years later, it has just stopped working completely. My contention was always derived from– I don’t know if you’ve ever read the book Quest for Value by G. Bennett Stewart.

Tobias: I haven’t. No.

Brian: It’s a great book, and it talks a lot about how leverage can actually be used to a company’s advantage conservatively and increasing returns on equity and that sort of thing. But in it, he has this great paragraph where he basically just says, look, a book value is a measure of the cash that’s gone into a business, but it is not the measure of a value of a business. It’s an arcane accounting statistic. And everything that goes into book value has nothing to do with what could come out of book value.

The value of business is the cash produced in the future. Perhaps, logical or erroneous actions of management is just tucked into book value and then adjusted along the way by accountants and why should anyone be paying attention to that unless the business is in liquidation, or it’s an insurance company or maybe a bank or something like that. But for a normal operating business, we should just all be ignoring book value.

In fact, I would argue you should probably screen on high price to book because it’s indicative of a business that’s markets reasonably efficient, it should produce a list of businesses that are over-earning on their capital base, which is what we all want. Take a little bit of capital and earn a lot of cash coming out of it. The market probably recognizes that. And so, not to get too quickly into our process, but we’re very qualitative in our analysis, and so we don’t do any of that computer screening or filtering upfront zero factor modeling. Anyway, hate to start off by going on a tangent on to book value, but it seems topical given the underperformance of value generally, and everybody’s love of Ben Graham and price to book as a metric.


How To Build A $4 Billion Investment Firm From Your Spare Bedroom

Tobias: What’s the thesis in The Small-Cap Advantage, which is the name of your book? What is the thesis?

Brian: Well, it really is, one, an argument that small caps generally outperform. If you divide the investment universe into deciles, the first decile being the largest cohort of US public companies, the 10th being the smallest, but the 9th and 10th decile typically produce about 2% advantage over the first and the second decile. So, there’s an argument in the book to say that small caps outperform, which isn’t some earth-shattering thesis. Everybody knows that. They see an Ibbotson chart on their local stockbroker’s office wall, and they see that. But they don’t really understand where that performance comes from.

There is an argument to be in small caps generally, but there are also ways that active management can improve on that 2% advantage. You logically think that small caps are the place where stocks go to die and then leaving the public universe through small cap land, so if you avoid those graveyard stocks, you’re going to do well. And then if you structure a strategy around, not necessarily subjecting yourself to certain reverse survivorship bias, and capturing those that are successfully and leave the universe, but there are easy ways that you should be able to even improve on that 2% advantage.

And then, there’s an argument to say, well, individual investor has a little bit more parity in that category with the institutional investor who commits significant time and resources to it, because there’s not a lot of professional participation, especially in that very bottom rung because there are structural reasons why people who are successful elevate themselves out of the space through–

Tobias: Just graduating.

Brian: That’s right. And there are financial incentives to do that. If you build a strategy from scratch, you typically want to make a lot of money. And to make a lot of money, you need asset-based fees. If you are successful, those asset-based fees increase as you either increase diversity of the portfolio and become more like the index, or you get up into large and mega-cap names. There’s an argument to be made in the book about you too can do this if you ply your craft and build a process that takes advantage of some of the structural inefficiencies in the space.

And then finally, there’s some commentary around how to build a professional-style investment management business. I think that my story to the extent that it’s interesting to people really has to do with the fact that I didn’t come from a larger firm. I started my company when I was 27 years old out of the spare bedroom of my condo in Austin, Texas. I think people like that story, maybe they sort of see themselves and that maybe I can do this too. I’ve read the Buffett Letters and I want to be a professional investor and, hey, this guy did it so maybe I can do it too. And so, I didn’t peel out of one of the big Midtown Manhattan hedge funds and have a stable investor base come with me. It was literally me in a laptop and some accounting software, and I was off to the races.

Now, I did have three and a half years behind that of working in the industry. So, I had a lot of confidence around my ability to build out the functionality that I needed to service the types of clients that I was going for. But I think there’s a little bit of resonance in my history with people that are the wannabe hedge fund crowd or wannabe investment manager crowd.


Early Adoption From 60/40 To The Endowment Model

Tobias: So, you launched the firm in 2000. Your first strategy was a small-cap strategy, presumably?

Brian: It was actually micro-cap. So, to even predate that a little bit. I grew up in Omaha, Nebraska, which isn’t really relevant to anything other than there’s a Buffett connection there. And the connection is that when I was a kid, my dad would drag my brothers and I to these business meetings that he had and he was doing some entrepreneurial stuff and it’s real estate and this and that.

So, we got a little bit of early exposure to the business chatter and deals and things like that, and that sparked my interest in business generally. I thought the stock pages were interesting in the local paper and opened up a brokerage account when I was in my teens. And then, found as I was reading annual reports, the Berkshire Hathaway annual letters and said, “Hey, this guy’s in Omaha.”

He was known at the time, but he wasn’t the superstar that he is today. And so, I felt like I had really found something, and that discovery piece was exciting to me. I read everything I could about Buffett, really liked everything that I read, tried to sort of employ some of those principles in my PA when I was in college. I made a lot of the early mistakes every investor does early on and discovered some things that I thought would work, tried to start to separate skill from luck and understand the game professionally.

I studied math and actuarial science at the University of Nebraska, and then right after college, moved to Austin. I started working for a small-cap shop in Austin that was exactly the opposite of what we do currently. It was purely quantitative in its investment sourcing and implementation, highly diversified. It serviced high net worth, it serviced institutional clients through third-party marketers and consultants. It had a 40 Act fund business, so a mutual fund business. I worked there for three and a half years and I got my operational stripes while I was getting my CFA and started to codify my brain what I would do as an entrepreneur in the space. What I recognized was that there were a lot of large institutional allocators that were looking at investment managers, and the landscape was changing. Tt was moving from this 60-40 stocks, bonds kind of implementation, to what is now known as the endowment model.

It was kind of popularized by the Yale Chief Investment Officer, David Swensen. He moved away from 60-40 and said, “Hey, anywhere I can get equity-like returns with little to no correlation to the US equity market, that’s what we want to do. And we are perpetual-time horizon non-taxable, so we have this advantage that we can press.” And so that was really the movement into hedge funds, into infrastructure, into real estate, these illiquid asset classes that could produce equity-like returns, but a smoother line up into the right.


Your Variant Perception To The Market

And so, that’s a long way of saying, I saw that movement happening. I read Swensen’s book upon its publication in 2000. I recognized, “Aha, okay,” the public equity book is shrinking, but they’re ditching these hundred-stock 1% managers where the typical institution in the 80s had 10 to 15 investment managers in their public book, but they each had 100 stocks charging 1%. So, they’re basically paying active fees and getting passive results, which is bonkers, and everybody knew it.

I saw the world shifting to more concentrated, high active share managers that could be real alpha-driving exposures for the public book. Despite the fact there were less absolute dollars going to public equity, the large firms were getting fired, and Yale and others were starting to find firms like ours, where they were highly concentrated. And so, our strategies are 8 to 12 stocks.

So, very highly concentrated, high active share. But it works in a multi-manager context. If you have a handful of managers like us, you can have a perfectly diversified portfolio if you’re the overall tertiary institution. But you have a handful of high conviction, concentrated managers, that’s what you want, you want to focused on just their big swings of the bat that come over the middle of the plate in their process, and so that’s what we offer.

So, when I started the firm in June of 2000, I saw that that shift happening and said there’s an opportunity here to start a firm that could actually have a chance. 27 years old with a laptop, I could compete against all these larger firms because they’re getting fired and people are looking for these hedge fundy like boutiques in the long-only space. And in retrospect, that was the kind of one stroke of architectural genius in my story was that recognition. And here we are today, 20 years later and pretty much most large institutional allocators have adopted this endowment model and are looking for concentration in some capacity.

We’re still a lot more concentrated than most and we started actually in micro-cap. Micro-cap for us, I felt like would be the best chance for us to gain some kind of a variant perception in the names that we were studying against a lot of these large firms that had libraries of research on public companies. Because there still exists, and this was 20 years ago, still today, this vacuum of professional participation in micro-cap, especially in concentration because you can only deploy a little bit of capital in that space before you get too big.

So, what happens is you start in micro-cap, you put up some good numbers, and then you end up owning 50 names or 100 names, so you can accommodate a larger fee-paying asset base, or as we talked about you graduate up into large-cap. And so, we’ve made the accommodation and said we’re going to restrict the amount of money that we take in each of our strategies to stay sized appropriately for the space. So, in micro-cap, we’re still 8 to 12 names. And we closed at $130 million in contributed capital, and we’ve given money back for different times over our history to sort of stay sized in that space.

And then, for investors that like our process and want to grow with us, we’ve launched a small-cap strategy that is bounded by the Russell 2000. And then finally, we introduced in 2014, a mid large-cap strategy. So, as you might expect, the fees go down as you go up because it’s more professional, and it’s harder to produce the sort of alpha that everybody wants as you go up the chain, but we still feel like we have given ourselves qualitative research efforts a really good case for varying perception across the market cap spectrum.

And so, the key to our performance really is the qualitative aspects of the research, which we can obviously talk about, and the extreme concentration. We’ll have a couple 20% positions, if you’re in the teens, I mean, that’s very unusual for an institutional investment manager, because it’s really difficult when you’re wrong. You look really stupid for a while. But if you have a good batting average and a good process that would limit your potential to fall into some of these landmine names, if you get 60%, 65% batting average with a concentrated portfolio, your performance in the index can be pretty significant.


Why Qualitative Research Is Much More Important Than Quantitative

Tobias: Let’s talk a little bit about your process. You said your qualitative and you don’t start with any quantitative screens. So, how do you find ideas and then how do you prove them on?

Brian: Yeah, this is the tough part. It really is starting with A and going to Z in the universe of public companies. It starts with the capture of the public companies in the market cap segment that we’re looking at, literally starting with ruling out the names that we know are off-limits for us. And so those would be– because we have a largely non-taxable, foundation-dominant client base, or people that are allocators that have this exposure elsewhere will throw out things like Reed’s MLP, stuff like that, because typically our clients are getting that exposure elsewhere. They have a real estate manager, they’ll have midstream exposure through their oil and gas managers or whatever. And so we’ll eliminate some swath of the investable universe through just very rudimentary elimination.

We typically don’t do a lot of work in banks and thrifts. In the micro-cap space, when I started one in six companies was a regional banker thrift. Blackbox business is very difficult to get some sort of variant perception. If you do eke out a variant perception and you’re really right, maybe you get sort of 12% returns on equity or something like that, which is fine and it’s great. We’d all be happy with that. But I think we can do better than that, we’ve eliminated those. We’re just looking at kind of real businesses. And once we get that data set of real businesses, then this is where the meat of our process is.

We have a 10-person research team here in Austin. Pre-COVID, we’re very, very active in travel, on airplanes and in rental cars and kicking tires and meeting with management teams and trying to figure out, frankly, what an average company looks like from three qualitative buckets. Key to our process is evaluation of the management team, the moat or competitive advantage of the business, and then the prospects for future growth. Those are the qualitative factors that we focus on. If you think about what we’re paid to do, it really is two things. It’s the discernment between exceptional and average in these three qualitative buckets, and it’s then selection from our prequalified list of exceptional companies, what to put into the portfolio and how much to weight it. So that’s the meat of our process and what we’re paid to do.

It takes a lot of work. One of the benefits of it taking a lot of work is that other people are not really equipped in resource to do it. And so, there’s a little moat around our business as well because there’s a lot of people that look at what we’re doing and say, “Yeah, that’s what I want to do.” Then that means you’ve got to spend a lot of time going to Sioux Falls, South Dakota, or Boise, Idaho, to research the public companies in that area when it’s easier to just sit in front of your screen and trade ideas with your friends and scrape 13Fs. We don’t do any of that stuff. It’s literally get out and meet 100 companies. Once you’ve met 100, you’ll have a good understanding of what an average company looks like from a qualitative standpoint, so that you can more quickly spot exceptional ones.

It’s very much like an institutional allocator would meet managers. So, the good allocators that we know are meeting lots and lots of managers, hundreds of managers a year. My guess is, if you’re a first-time allocator, and you’re right out of college, and you get a job and you meet your first investment manager, you might think, “Wow, they’re amazing. We want to put a bunch of money with them.” And then, you meet 10 more and you say, “Okay, wait a second, they’re all impressive in some unique way.” Then, you meet 100 and you say, “Okay, I understand the game now.” Everybody’s a good salesperson, everybody claims to be different, but after 100, I can actually spot the ones that are different.

The same sort of work applies to junior analysts that come on board with us. We give them the company credit card and say, “Get on the road,” and basically “don’t come back until you understand what an average company looks like,” so that you can more quickly spot that exceptionalism.” Importantly, we think that those qualitative buckets are what drives stock price performance. So, if you think about an average company earning average returns on equity will produce average results.

Back to 1926, the best data we have from Ibbotson shows you you’ll get a 9% to 10% return in the US stock market. That’s probably on average what people are compounding their internal equity. If you think that the stock market is simply a reflection of internal compounding of business value, then to get above-average stock price performance, you need above-average business compounding, and how do you get above-average business compounding? We can’t do it if you have no competitive advantage.

Somebody else is going to open up shop across the street and compete away your economic margin via price. You can’t do it if you have poor management that doesn’t understand competitive advantage and how to press that advantage, and how to reinvest back in the business. And you can’t do it if you don’t have some long runway for growing that compounding. And so, that’s why we focus on those qualitative buckets.

We’re qualitative because the key determinants of value over time are qualitative. So, if we get those qualitative buckets right, we can be a little bit wrong in the price, and with patience, we can still make some money. That’s why we focus our process on those qualitative elements. And it just so happens that it’s hard to do, other people aren’t doing the work that we’re doing.

We’ve had 20 years to build up this cumulative data set of qualitative characteristics that we think press our advantage. And so yeah, that’s the meat of our process. And then if we find something, if you’re an analyst with us, and you come back to the office and you say, “I found this amazing company, and here’s what they’re doing, here’s their management team. And here’s what the prospects look like.” Then, you present it formally to our research team, and we give it the gladiator’s thumbs up, thumbs down. And if we all sort of say, look, it’s the top idea that we’ve seen recently, we’ll add it to what we call our focus list, which is our kind of buy list. Then, we’ll do valuation work.

And so back to your original comment. Screeners use valuation as an input to their process, which in my opinion, leads them into value traps. If you screen on low price to book, low price to earnings, low EBIT, EBITDA, what you end up with is a bunch of businesses that the market has essentially assigned a low valuation to because they’re probably under-earning on their capital base and in some kind of economic decline. And in a concentrated portfolio with 10 stocks, you don’t want those in your portfolio. You want best businesses run by the best people with long runways for growth. We were into this compounding crowd back 20 years ago when it was a little– there were fewer of us, but I think that the database that we’ve built up over 20 years has really led us to just a handful of the most exceptional companies.

If you look at our 13F, and you’re like, “Man, they’re owning some companies that are trading it at 80 times free cash flow,” or something like that. You can misconstrue our kind of valuation discipline, because it looks like we own a bunch of expensive names. When in fact, you actually have to run the DCF, you have to understand what they’re doing, what the tangential growth opportunities are. Maybe there’s some M&A component to their recent history or future that may be misunderstood by other market participants. You really need the nuanced understanding of all this stuff.

When our consultants, institutional allocators look at us, sometimes their eyebrows go up and say, “Wait a second. How can I call you a growth manager, a value manager, with these metrics?” And we say, “Damn the torpedoes, we’re going to buy the best companies we can.” I don’t really care how the statistics sorted out at the end of the quarter or what it looks like on the account statement.


Finding Extreme Winners

Tobias: There’s a very interesting chart in your brochure where you talk about finding extreme winners. [unintelligible [00:25:16] the chart is it shows there’s a rump of companies that fall below the average or near the average. And then, there’s this very long right tail of extreme winners. So, how do you go about finding extreme winners? What’s the differentiator of those companies?

Brian: Yeah, that’s great. You’re referring to a histogram in our company presentation that basically shows that most companies underperform the average and it’s really the performance of the index is driven by a handful of fat right tail businesses. It’s about 7% of stocks that actually power the returns to the index. Those we dubbed as extreme winters which are essentially the long-term compounders that you would probably think of as you run this analogy in your head. You have Starbucks and Microsoft and Home Depot, and these that have compound at exceptional rates for extremely long time. Those are the names that power the returns of the index. Those are what we’re trying to isolate through the qualitative work that we do. It’s like what’s the future extreme winner look like?

As I referred to before, the characteristics of those names are typically that they have some unique competitive positioning, they have some dynamic at the management level where they’re extremely good operators, maybe there’s a founder-owner-operator dynamic, maybe there’s unusual pathways for reinvestment back into the business or maybe there’s just some unbelievable runway for growth where they’re the first-wave mover in that growth dynamic. We’re just trying to isolate those characteristics. There’s a book that’s out there that’s called 100 Baggers, I don’t know if you’ve ever heard of it before.

Tobias: Yeah.

Brian: It’s just chronicling public companies that have hundred times themselves. And that’s kind of the analog for us. It’s like, “What do you do at a high level, Brian?” Well, we try to find smaller companies that get really big. That’s kind of what we do. When I was looking at that book, and the list of those companies, there’s probably a third of them that we would never invest in. They would be companies that are maybe in some kind of binary outcome, FDA drug trial type of a dynamic where either they get the thumbs up from the FDA and it’s a bonanza or to zero. Those are names that we would avoid because we don’t have any PhDs in biochemistry on staff and that’s not our game.

There’s a handful of oil and gas names where they caught the right side of some macro-variable or something like that. Again, those are names that we would not be playing in. Despite being in Texas, we’re not oil and gas investors and aren’t any smarter than anybody else in that area. But there’s probably two-thirds of that list where I said to myself, “Yeah, these are on limits types of companies for us, and we want to capture.” And here we are 20 years later, and I’m proud to say we probably have, I don’t know, a half a dozen or so that would qualify for the current version of that book.

We’ve got names that have been long-term compounders that are on lists of the best-performing stocks over the last 20, 30 years, something like that. We haven’t timed them all perfectly. That’s an almost impossible task. But the longer we do this, the more we realize the right thing is if we find one of these, is just to try and get out of our own way and let the patient compounding work for us. But it’s really difficult when all you do is stare at screens all day long and think about these names. You get almost too close to the tree to see the forest, so to speak.


DCF Is The Least Reliable And Accurate Part Of Any Managers Process

Tobias: Let’s talk about valuation for a little bit. Your favorite DCF– and you have some hedging around that. But you’re like 10% cost of capital, which is reasonably high in the current market. So, perhaps just talk us through a typical valuation, then maybe I’ll just take you through the four names in your brochure.

Brian: I sent you the current brochure, so I hate to talk about current names, because this will be timestamped. Maybe we can talk about some historical names, or I can give you some examples to help–

Tobias: That’s why I didn’t mention them.

Brian: Yeah, [chuckles] thank you. The 10% discount rate embedded in our DCF is really reflective of it being an– First of all, it’s a recognition that there are inherent limitations in the DCF model itself. What we’re trying to do, what’s the point of a DCF is to try and get an approximate valuation of a company. By using 10%, what we’re doing is saying that’s the approximate return of the US stock market since 1926. So, if we come up with a valuation on a name, and we find that it is priced– we find that the appraisal matches the current stock price, we can reasonably say that going forward, we’re going to get market-like returns from this name. Does that make sense?

Tobias: Yeah. Absolutely.

Brian: Trying to use a common size measuring stick for all companies and get a feel for whether something is undervalued, overvalued, or appropriately valued when contrasted with the approximate returns we have seen from the US stock market since 1926. I’m not saying that this is the most perfect way that you can value a company, and I totally get that 10% is punitive, especially in the current environment, and we’ll extend a DCF out much longer than most people.

We will also hold names much longer than most people, even when we feel like the names have raised way past our intrinsic value estimates. The idea is to try and be disciplined on the buy when we have some variant perception, we feel like the name is reasonably cheap and then to say, “Okay, if we’re right about the valuation, and we buy it right, we’re going to get better than market returns going forward,” because that’s the whole game that we’re involved in. So, that’s why the 10%.

Sometimes, you have situations where– this is something that we have done a lot of navel-gazing, especially in the past five years is that, sometimes you have situations where we have approved names for our focus list, meaning that it has actually been one of the most exceptional qualitative names we’ve come across, we’ve approved it for purchase, we’ve done the valuation, and it just seems always too expensive to buy. I think that’s a very common problem in our industry, especially in the current environment. It seems like things are just always too expensive to buy. What’s interesting is if you do some analysis around this, those names have actually in some cases performed even better than our portfolios which themselves have done really well. We sort of say we’re missing out on some of the best names because there’s perennially overvalued.

I have all these war stories where we’ve identified these names, Tyler Technologies and others, where we saw them when they were a couple of hundred million of market cap and we recognized them, we studied them, we approved them, met the management, got to know them, maybe did some user conferences, went to some industry tradeshows, we affirmed the competitive thesis around the name, and we just sat there sucking our thumb as a thing 10 times itself in the market, and we never got a chance to own it.

So, the valuation DCF piece of it is, in my opinion, the least reliable and accurate part of any managers’ process. It’s got artificial precision that everybody puts way too much weight in. It is for that reason that we incorporate a lot of the qualitative assessment of the individual businesses into the portfolio management decision-making itself. Unlike a lot of managers, they’ll say we’re going to rank-order our opportunity set from on price to intrinsic value. We’re going to sell the 100 cent dollars and buy the 60 cent dollars. Wash, rinse, repeat. We don’t do that. Despite my math background, it’s very seductive to have a robust process like that. Your institutional clients would love to hear that stuff because it makes them feel comfortable that you’re not going rogue in any way. There’s a real structure and a process around it. But the sausage is made a little bit more–
Tobias: It’s messier.

Brian: Yeah, it’s a softer process than that. Company X at 80 cents on the dollar maybe a better bet than company Y at 70 cents on the dollar because you have a higher qualitative conviction in the management, in the future growth of the business, or the moat around the business. Again, we’re going back to what we’re paid for, we’re paid for that qualitative exceptionalism and the pre-approval process, but we’re also paid for the portfolio manager judgment in using price to intrinsic value as a piece but not a strict quantitative process in building the portfolio and weighting the portfolio. Does that make sense?

Tobias: Absolutely. There’s two interesting elements to what you’re doing there. One is that you say you extend the DCF out much longer than is typical. So, how long are you doing? What’s a typical DCF term for you?

Brian: Yeah. So, it just depends on the company. This actually goes back to a comment about the DCF itself. But if you have very predictable free cash flow dynamics– for example, we owned a micro-cap company a long time ago that did the dental practice, software and operations and things like that. They had 20-year contracts with their dental practices. They had escalators built in the price. It was just a very, very predictable business. it was a static cost structure. You could map it out and you could get free cash flow dynamics for that business. It was a great business, it wasn’t going to grow super quickly, but you could really be, in my opinion, fairly reliant on the DCF for that business. We actually did a pretty fair job of actually– I think we owned it three times with three round trips in that, were bought at 60 cents on the dollar, sold at maybe 120, 130 cents on the dollar, and did very, very well. Then, we owned a 3D printing company, which was growing at 30% annually, and had just crazy growth dynamics. If you tried to map that thing out past year or three in the DCF, you might as well just be rolling a 100-sided dice. You have no idea what’s happening.

In the former, you could map that out to 10, 15, even 20 years and free cash flow and you can get a pretty reliable number for your appraisal. It’s not perfect, it never is, and lots of things change. But you could just be more reliant on that then in the case of a 3D print printing company. So, we try to keep that in mind. If we have high qualitative conviction and we think that the range of outcomes for growth is not normally distributed, but heavily skewed to the upside and we get a feel for what other people are expecting in terms of valuation and what our conservative appraisal is, we can buy incredibly high growth, dispersed outcome business without doing too much intense DCF work.

On the contrary, if we find a very predictable business that has very static-free cash flow dynamics. Tyler Technologies has software contracts with local court systems and municipalities. That’s a decent example of one where the DCF looks a little bit more predictable. We can extend that out 10, 15 years and we can kind of play with it and get a narrower range of appraisals that we can have higher confidence interval in. Does that make sense?

Tobias: Absolutely. You’re either pushing out the number of years that you know where something’s going to happen and perhaps having a smaller terminal value, or you have a shorter term and you have a chunkier terminal value. How do you think about those terminal values when you’re conducting the DCF?

Brian: Yeah, we try in our terminal value– we are incredibly, probably overly, penalizing companies. The reason why is, I don’t know if you’re familiar with Bruce Greenwald. He has a book called Competition Demystified. He’s Columbia professor. He’s got a great line in one of his books. He says, “In the end, everything’s a toaster.” What he means is, the gravity of competitive dynamics will come to get you eventually. When that happens, your economic margins disappear. In our opinion, that’s what terminal value is all about. It’s like what does the heat death of the universe for this company look like. It’s now going to be average at best. So, that’s what we try to do with our terminal values.

We’re not giving them any magic, grow-forever type of dynamics in there. But again, these are technical aspects of the DCF that I think over my 20-year career, I’ve spent more conceptual time on but less technical time on. In fact, we don’t spend a ton of time thinking about that stuff. We spend more time thinking about what is the competitive positioning in the marketplace? How is that changing? What does the threat of this new entrant mean for the incumbent that we’re investing in? What does it mean when management retires and moves on? What does it mean when they make an acquisition?

These more immediate qualitative impactful things are what we have to really, really pay attention to. And so, yes, we’re updating these DCFs every quarter and anytime there’s something material happening with the business, but our default mode is just stay the course. A buy or sell decision is more likely triggered by– well, a sell decision, in particular, is more likely triggered by a deterioration in one of these qualitative buckets than it is triggered by a something is 120 cents on the dollar in terms of our valuation. We’re getting less reliant on the valuation as a driver for decision-making on the sell side. We still have it on the buy side because we want to be buy disciplined/ We don’t want to overpay for names, but once we hold them, we want to stay married to them. Divorce is going to happen because there’s some serious qualitative crack in the investment thesis.


Wide Moat Companies And How To Find Them

Tobias: Yeah, you slightly foreshadowed where I was going to go next. That was what I wanted to dive into. Let’s talk about competition and moats because I think that that’s possibly the most important part and also the most difficult part of any thesis just for the fact that you’ve got lots of smart people out there trying to break down the moat. What other sort of moats that you look for? What do you like to find in a moat and what do you think that typically received wisdom as being moats, but are probably less moat-y than they appear?

Brian: Yeah, that’s a good question. There’s a lot being written on moats and there are a lot of people that are very smart thinkers on this. What we care about is how long can supernormal economic returns persist? We want to know why that is, how long it can happen, and what could disrupt the applecart. If it falls into one of those Porter’s Five Forces competitive advantage frame. That framework, we have a slide in our deck about Porter’s Five Forces for every single company, and we tease it out. There’s another slide about these more nuanced sources of moat. Lots of technology companies have competitive lock-in and network effects and things like that. So, we obviously prefer seeing that stuff, but I would say, even higher level, all of this falls into just sort of pattern recognition as analysts.

What we’re really trying to do is when we find exceptionalism in economics is to figure out what pattern exists that allows for that to happen. And I think moats fall into that. I think management falls into that. I think runways for growth, reinvestment, M&A to some extent, all of this is just all pattern recognition flowing up to what could allow for exceptional economic returns. We just want to understand that. Our three buckets, moat, management, growth, is an approximate framework for capturing as many of those patterns as possible. It’s not totally comprehensive, but pretty comprehensive.

In the moat bucket, we don’t have a lot to add in terms of the canon. But we’re looking for entire categories of businesses that exhibit just by their very nature moats, and we just tend to shop there. So, there are big swaths of the market which we gravitate to naturally. Information services is a big part of our work. Software is a big part of our work. The SAS model software companies obviously have rich valuations, but they’re incredible business models. They weave their way into your business processes. They’re very hard to kill. They charge you on a monthly basis, as opposed to premise based. You could update the entire code base once and all of your customers benefit. It’s just really, really powerful dynamics. So, we spend a ton of time there and have a lot of exposure there.

We study how businesses get smarter through AI and machine learning. We study through cultural advantages. We’ve made some investments where we just feel like, “Hey, the team of people themselves provide some competitive advantages because of who they are, their background, their history, how they execute, how they structure themselves, how they organize themselves, and self-improve.” There are lots and lots of models here that I think have probably been covered by others as comprehensively as we do. So, I don’t think we have a lot to add to the canon there. I think where we shine is just in the actual boots-on-the-ground reps of actually seeing everything and illuminating what’s actually happening with these companies, and how that could be misunderstood by the market or overlooked.

Just to say Visa and MasterCard have a great moat, of course, that’s obvious to everybody and that sort of thing. But to say that there’s a true network effect there, you have to really study that and get a more nuanced understanding of that and say, “Okay, how can they prevent the rise of Venmo and Cash App and some of these other things? Are the castle walls high enough? For how long can this persist?” And stuff like that. We don’t own either of those two companies. But that’s where we spend a lot of time. So, yeah, I wouldn’t say that. I’ll be writing a book on moats anytime soon. I’ll leave that for Pat Dorsey. But I think he’s as good as anybody about thinking about that stuff. I think we’re really good at that. But that’s just one small part of our overall architecture.

Tobias: What about in terms of negatives, things that many folks believe are moats, but you guys have a different view?

Brian: Yeah, that’s a good question.

Tobias: Where do you feel you can be tricked?

Brian: I think we have been tricked before on the cultural moat. I think that there’s some legitimacy to that and we’ve seen it. Certainly, I’ve seen it. But a phenomenal cultural advantage with a good business system, and good people running it, running up against an average or highly competitive business, that’s a tough thing to overcome. I’d say if we’re ranking what we prefer in moat management growth, we probably would prefer– if the sliders go from 0 to 10 on each of those, we’d probably prefer a 10/10 on the moat rather than the management just because it’s hard for an average management to overcome– great management to overcome no moat, then vice versa.

Then again, it happens all the time. Obviously, Berkshire Hathaway is a great example, commodity and insurance and textile business with great management has turned into a behemoth. We had a lot of success owning a company called Middleby Corporation, which is a commercial cooking equipment company. But it was run by, I would say, a 10/10 manager for better part of two decades. He’s probably the best manager that we’d ever come across. If we ever had to write the next outsiders’ book with– I’m blanking on the name even though I know him. But anyway, if we had to write chapter 1 of the next outsiders’ book, we probably put Selim Bassoul of Middleby as chapter 1. He was just phenomenal. He had the full talent stack.

That’s one thing that we talked about a lot too is, there’s just this stack of talents, that characteristics that a great manager needs to have. There’s no hard and fast list. I mean you need to be a great salesperson. A great CEO can materialize business out of thin air. You need to be a great capital allocator. You need to be a great strategic operator. You need to have a good pulse on the competitive dynamics of your industry in your business. You should have all these characteristics, and Selim was one of those people that was just lights out in just about every category.


How To Spot ‘Red Flags’ In Management Behavior

Tobias: What about red flags for management? Is there anything that you always get– you know there’s potential to be burned there, whether it be incentives or alignment or pay or however you want to characterize it?

Brian: Yeah, there’s a few patterns that we prefer to see. The first would be owner-operator dynamic, which is we want the manager or managers to have significant stock holdings and prefer to think of it as their business and they are doing the best decisions for their stock holdings that they can, and us as outside passive minority shareholders are along for the ride. That’s the best dynamic that we can come up with, I think. The alignment of incentives in the proxy is incredibly important. There’s a lot that we prefer to see. I would say that even with the owner-operator dynamic, there’s always the chance that ego and ambition express themselves in a bad acquisition or something that could be ruinous to outside shareholders. So, there’s no guarantees in any of this. There’s hair on every idea, as we say, in all of these categories. But I would say acquisition is where we have been most surprised to the downside where we own a name with a great moat, great management, we think we’re onto something here, and all of a sudden, there’s the farm acquisition that has come out of the clear blue sky, and it usually relates to some megalomaniacal ambition of the management or something like that. I’d say that’s probably the biggest risk.

I would also add that acquisition when done correctly, again Berkshire being a great example, can be a huge source of variant perception. What I mean is had you just run a DCF on Berkshire Hathaway, the textile mill, with Warren Buffett as the CEO, you would have just completely missed the point.

Tobias: It’s cheaper in net current asset value prices.

Brian: [laughs] Yeah, exactly. It probably would have showed up on your price to book screen. I really think that people are just missing the boat when you have truly phenomenal capital allocators at the helm because great things can happen. The best part about it is they’re unpredictable, the acquisition events themselves are unpredictable, in size and in timing. That is a phenomenal variant perception because the sell-side analysts, it’s suicide for them to incorporate something like that into their models, something that’s unpredictable as an acquisition. And other buy-side analysts, they’re running their normal DCFs and so they can incorporate that so. So sometimes, when you have phenomenal manager with pathway for reinvestment back in the business, huge runway for growth, and there’s this bolt-on acquisition strategy where these are unpredictable, but usually accretive and the outcomes aren’t normally distributed, again, but highly skewed to the upside. You have a really powerful dynamic.

We saw a little bit of that in a name that we own called HEICO, which is aircraft replacement parts manufacturer, where the Mendelsons are these Buffett acolytes and they’re really, really disciplined about the internal capital reinvestment, but also have these opportunities to sort of pay market rates and extract better value from acquisitions. That in addition to kind of the drafting dynamic they have behind the TransDigm and other non-replacement part manufacturers, just made that incredibly powerful dynamic. In typical fashion for our firm, we didn’t capture all of the upside of HEICO, but we got some of that great compounding which is enough to be really accreted to our performance. But that was a big win for us, but I think illustrated a lot of these patterns that we were talking about.


Investing With Certainty – Moat, Management, Growth

Tobias: I looked at several of your names and they are prima facie or optically expensive, which implies that you have high expectations for the future growth, and so the reinvestment runway is perhaps, if not the most important, a very, very important part of the process. So, how do you think about that? How do you get comfortable that they can, in fact, execute on the pathway that you see?

Brian: There are no guarantees, obviously, but the question is, is a lot of the what-ifs. Value investors get, rightly so, very downside focused. What could go wrong with this name? And we’re very much like that. What could go wrong with these names and what could happen? Very few investors, especially in the value crowd think, what could go right if they execute as planned, and what is the potential for them to execute and do we have enough faith in those three qualitative buckets for them to execute? And the answer in many of the names in our portfolio is they could be multiples of their current size. Again, back to that 30,000-foot view of our business, we’re trying to find small companies that can get really big.

I mean, pretty much without exception across all of our portfolios, each of the names has the potential to be multiples of its current size. If we have a 65% batting average, and we get a couple of those right, we’re going to have really, really good performance. That’s the architecture. It’s not VC, but you think about it, especially in micro-cap, small-cap, and to some extent, mid-large, you take 10 swings of the bat, and hopefully, you don’t have any zeros, you have some that just chug along and some don’t execute. You try and reallocate capital where you can, but some execute and crush it. You have a name that goes from 8% to 10% percent of the portfolio to 20%, 30% of the portfolio. You recycle that capital back into other opportunities to the extent that you are still– your strategy is sized appropriately for the space. And any excess capital, you just redeem back to your investors. It’s kind of a VC model in that regard.

We have as much qualitative confidence as we can get by meeting the management market participants, user conferences, tradeshows, all this qualitative work to say, “You know what, this company is uniquely competitively positioned, and we think that position will either strengthen over time or at least stay the same.” And for some very long time, they should enjoy supernormal returns and what does that look like if that happens. We’re not betting 100 cents on the dollar that happens, we’re trying to bet 60 cents on the dollar that happens, so we can be a little bit wrong in the price and still make a lot of money. Of the 10 names, if one or two of them work out, it’s going to work out really, really well for us.


Tobias: It’s absolutely fascinating insight into your process, Brian, appreciate it. If folks want to follow along with what you’re doing, how do they go about doing that?

Brian: We keep a pretty intentionally low profile. Part of that is because we’re institutionally focused. We do get a lot of calls, “Hey, will you invest my $20,000 retirement account?” or whatever. We don’t have any vehicles for that, we’re institutionally focused. The minimum account size for our small and mid-large strategies are in the millions, and that’s intentional. A unique part of our business is that we don’t have any institutional salespeople, we don’t have any marketing people. It’s just 10 researchers and 3 operations people, and we manage $4.6 billion in assets. It’s very, very large single accounts that we manage, and that’s intentional. We want to give our large clients as much time with us as they feel like they deserve and they do deserve, and we want to have meaningful relationships from our standpoint.

We’re trying to continue to build our strategies with those types of relationships. Unfortunately, we don’t have a way or a vehicle of servicing individual clients, so we try to keep those inquiries at bay. But those institutions that do know about us, know how to find us, so pop in the website or shoot us an email or something like that, but, yeah, no Twitter accounts, no social media presence, nothing like that. We intentionally keep a low profile. There’s a small cadre of potential investors that we have that we try to focus on, and they know how to find us.

Tobias: Well, here’s where you pitch your book, and you earn the next $5,000 over the next nine years.

Brian: [laughs] Get another $120 check from my royalties. Yeah, that’s it.

Tobias: The book is The Small-Cap Advantage through Wiley presumably available in local bookstores and Amazon?

Brian: Yeah. You can buy it on Kindle, that’s probably what everybody does. Yeah, I think it’s two cents for me every single time you do it. [laughs] But I appreciate the opportunity to chat and I really love what you’re doing. It does feel as we said at the outset– one of the reasons I said my story, I think, resonates is that there a lot of people in the business that are wondering what it’s like to be an investment manager, how to start up that sort of thing. I really wish I had a resource like your podcast and these videos to feel like I was a part of a community that had some social proof out there that I could do this, and I think that the road is very difficult for people to get from zero to one in this business. But it’s possible and I think that my story definitely illustrates that. So, appreciate what you do, too.

Tobias: I couldn’t agree more, Brian. Thank you very much for your time.

Brian: Yeah, you too.

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