Investment Spandrels

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During their recent episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle discussed Investment Spandrels. Here’s an excerpt from the episode:

Jake: All right, veggie time. In architecture, imagine a doorway and imagine then an arch that sort of connects that doorway. And it creates two little triangles basically. And those triangles don’t exist for any real good reason other than the fact that the things around them create them. It’s almost via negativa. That is called a spandrel, that little area. Architects have taken that and done little designs in there, just to dress up a doorway or cathedrals, things like that.

Well, that term was borrowed then by Stephen Jay Gould and Richard Lowenstein in this 1979 paper, it’s actually about biology, and what they’re explaining there, and I’ll give you the definition their version of spandrel is. “It’s a phenotypic characteristic that’s a byproduct of the evolution of some other characteristic, rather than a direct product of adaptive selection.” So, it’s basically some characteristic about an animal or a plant that has come about as a byproduct of other adaptive pressures.

For instance, we have one– actually, the human chin is a spandrel, in that our faces push back in somewhat based on dietary changes, and it left this little chunk of bone that’s sticking out down at the bottom and now that’s why we have chins. There’s no adaptive reason to have a chin, you’re not using it to defend yourself or like scoop up ants out of a colony [crosstalk] or something right. It doesn’t convey any advantage.

Bill: We’d all look weird without a chin. It’d be weird to– how would you mate without chins? I think it’s a sexual thing. I think it matters. You don’t want a no-chin person to have sex with. Well, that’s my theory.

Toby: There’s a relationship to the chin and hormone that humans are very good at identifying. Excess hormone, not enough hormone.

Bill: Long chin, no chin.

Toby: Yeah, more chin is more dominant, more hormone, which you would know. If you look at big dominant guys who’s got big square head, that’s the characteristic– that’s one of the things that people are looking at. They tend to be in leadership positions. I like the idea of the spandrel, and I like Stephen Jay Gould. I always get a little bit nervous though when people say there’s this thing that we’ve identified and it has no use. What that says to me is, we just haven’t figured out yet what the use is. And so, I get a little bit nervous when I hear them saying, “There’s no reason why we have this thing.” Let’s just pull it out and then you discover a few years later, oh, no, wait, that thing controlled this part of your biology, which was this part of your physiology, which is really important.

Jake: Right, your appendix being a good example of that, where I’ll take that out, it doesn’t matter. Well, it turns out it was a bacteria breeding trap that was helpful for digestion.

Bill: Is that so?

Jake: I believe so. Another related term to this is called exaptation. And what that is, it’s a characteristic that enhances fitness, but it wasn’t built for that originally by natural selection. So, the classic example that Gould uses is a panda’s thumb. And you may not know this, but a panda’s thumb is actually an outgrowth of their wrist bone and their thumb actually slid into become like a finger. And the reason that we know that is the genes that coded for that wrist bone to then become an opposable thumb, also show up in an oversized ankle bone on the panda, because that limb growing that bone worked on all four limbs.

By the way, where I got all of this– some of these things are, there’s this fantastic series– and this is what’s so amazing about the internet. On YouTube– and so far, for whatever reason, I haven’t been murdered by ads on this one for whatever reason, but Robert Sapolsky, who’s a biologist, geneticist, I think, he has these lectures that are from his Stanford class that he teaches that’s called Human Behavioral Biology. And so, you get in there, evolution, genetics, ethology, natural selection, neuroscience, endocrinology, sexual behavior, aggression, language. All of these things explained by somebody who’s a fantastic lecturer. I would encourage you to go check it out if you have time. I’ve been working through the courses because there’s a lot of them. I’m taking Stanford classes, it’s actually from 2010, is when they were recorded, but probably not too much has changed.

Bill: Can I piggyback you real quick while you’re checking that stuff out?

Jake: Buy me dinner first.

Bill: Michael Sandel, I’m pretty sure on– No, Justice is a Harvard course that is on iTunes, I’m pretty sure. That thing is incredible. I think it’s one of the most popular courses at Harvard. So, there you go. You’re welcome, folks. Next.

Jake: There’s some legit great content out there that is free, and you can take it whenever you want. It’s amazing.

Bill: Dude, we’re producing it right now.

Jake: In real-time. [crosstalk] All right. To bring this back to our little world, our little man with a hammer investing, what are the spandrels of your investment process? What are the things almost unintended consequences, byproducts of your investment process? Now, I’m actually going to punt a little bit this week. I’m going to give a couple of them, but I kind of, one, had been doing an experiment anyway to see– I know how smart we have as a listener base. I want to see what things they come up with from their own processes and please tag me on Twitter and tell me what your ideas came out from this. But for me, let’s say, if you were a pure quant, just price to book, Fama-French type of investor, which I think all of those–

Toby: You’re going extinct.

Jake: [crosstalk] Yeah. But what would be a possible spandrel of that? My mind went to– it’s quite possible that you ended up with industry concentrations, probably more cyclical–

Toby: You end up with a little leverage.

Jake: Yeah, debt-laden, all these unintended byproducts that maybe– you originally are just like, I’m looking for the biggest margin of safety of accounting value assets versus the price that I’m paying. And you end up with all of these other little spandrels that you may or may not be aware of. Another one, let’s say that you were a pure momentum trader, what would be a spandrel for that? You may be without realizing it, involved in, like carry-trade type of situations. These self-reinforcing phenomena.

Another one would be, if you were purely a qualitative, pure quality investor, like you’re just looking for the best businesses, it’s quite possible that you would maybe falling prey to some halo effect of management. You just love this guy or this management team, price doesn’t really matter. Or even you might also get some industry concentration as well. If you were looking at, who’s got the most persistent returns on capital over long periods of time, CPG tended to be those type of businesses.

So, without even trying to end up as a consumer products good investor, because of what your process was, you sort of end up getting there anyway. So, anyway, I want to throw that out there for– you guys can start if you have any spandrels in your own process, but I want to see what our crowdsourcing could produce for this one.

Toby: The most obvious one for value guys like me, for deeper value guys, is you end up being short growth a little bit. You tend to be– I can just look at my own portfolio, I can tell you that the top line in the portfolio grows about 6% across all of the companies on average. The bottom line grows a lot faster than that because I do a lot of buybacks. But then, that’s the problem.

Jake: That’s good.

Toby: That’s a bet that I take eyes wide open, mind calm and relaxed. I’m doing it on purpose. Most of the time, that’s a good bit, hasn’t been a good bit recently, goes through long periods of time where it’s not a good bit. But what most investors tend to do is overpay for growth. So, I’m always tending to underpay for growth, is what I’m doing. But I’m short growth, [crosstalk] yeah, trying to pay less than growth.

Jake: 6% though. That’s like two times GDP. That’s not bad.

Toby: Yeah, but what’s real inflation? I would guess it’s probably a little south of real inflation, which is probably why it’s getting punished at the moment.

Jake: Could be. Wearing a tinfoil hat to make that claim?

Toby: Yeah, a little bit but that’s true. That’s exactly right. That’s one of the things I’ve been think about a little bit.

Jake: [crosstalk] cocker spandrel.

Bill: I don’t know, the stuff that probably keeps me up at night a little bit is the amount of leverage that I have in my portfolio. But I’ve outsourced a lot of that to Liberty, and I think they’re pretty good at managing it. So, that’s probably my spandrel.

Jake: Could you say that maybe that unintended spandrel of that might be that interest rates going from 15% in early 1980s to 0 today is a big– you’re just betting that the same trend has gone– You’re making an implicit interest rate bet often in that situation, especially if you’re worried about rolling over that debt.

Bill: Yeah, I think that’s a reasonable question to ask. I think that’s what they’ve done. But yes.

Jake: Let me rephrase it in a different way. How many guys have gotten incredibly rich based on borrowing money that kept getting cheaper over the last 40 years?

Toby: That’s been a good strategy. Almost everyone.

Bill: Yeah. I guess that when you look at what they do though, that’s not– the reason that I believe– this is my thesis and I think it’s supported by facts, but I don’t want to hold it out as a fact. I think the reason that they’re so comfortable with leverage and what they do is when Liberty Media was spun out of AT&T, it was basically just like a hedge fund. It didn’t really have a lot of operating businesses. So, in order to get cash in the door to make other acquisitions, they needed to do things like use collars and issue debt against stock, and I just think it became part of the ethos of how they operate their business. It’s so different than how Buffett looks at the world. I think that somebody like TransDigm, you could maybe say– their leverage target has crept up over time as rates have gone down, so it’s super hard to argue that they haven’t been helped. I don’t know what the answer is. I think Liberty is more than just benefiting from rates. I think they are exceptionally sharp at debt. As do I think 3G is good at debt, not necessarily managing a brand. Don’t come at me, folks.

Toby: Got a good one here from Jerry Maitland just reminding of something from last week. Value has too much left tail protection and shorts the right side. I do agree that value guys just tend to be a little bit too conservative. I don’t know necessarily that that’s– maybe it’s a spandrel, I don’t know. But I think about guys like Tony Deden, Edelweiss. They’re explicitly acknowledging the fact that a lot of the capital that they get is some families, the bulk of their capital and they don’t have any capacity to make more. And so, their idea is, we’re just not going to blow up the capital. We’re going to try to get you like a small real return on top of that. And that’s where I am. My main focus is just don’t blow it up, and then try and get a good return on top of that. So, yeah, I’m guilty of that. That’s fair.

Jake: Yeah, I would say that there’s a little bit of– that’s 10 years bull market talking a little bit too. All of that protecting the downside, that message gets watered down every tick up that we’ve experienced. But on the other side of that, there will be a day where that is an important characteristic as well. Maybe not in our lifetime.


Toby: That’s what I was going to [laughs]

Jake: Our kids, someday [crosstalk]

Toby: For my grandkids.

Jake: –the downside.

Toby: No child can understand that. Child’s like, “This is old stuff, you’ve got to swing for the fences.”

Jake: YOLO.

Toby: That’s it. You’ve held us back. All right, throw your questions in, we’ve got 15 roughly to go.

Bill: That would be my one beef with Berkshire, and I’m not trying to go with the King. I get it. But I don’t know why he hasn’t owned more Costco. I don’t know why he hasn’t owned something like Google. I get Microsoft, he was sort of conflicted out of. Some of it’s underappreciating the right tail in something like Google, but Costco was directly in his wheelhouse. And with that much cash, it’s kind of hard for me to understand– I don’t understand the precision of really–

Jake: Charlie– [crosstalk]

Bill: I know he didn’t, but that’s my point. Once you’re at that size, I don’t know that it makes a ton of sense to me to wait for the cinch. Now, obviously, this is somewhat resulting. I get that. He’s dealt with these questions for a long time. I think that it’s a pretty sophisticated shareholder base, at least the people that aren’t asking the life questions. People have been asking him for a while, like, “Why don’t you do more levered S&P strategy?” Or something like that, at least with a portion of the capital, I think it would have been a better idea, but– [crosstalk]

Toby: If he’s doing S&P, just give it back, he’s not going to do that. There’s enough good stuff out there. He’s shown it with Apple. What have you done for me lately, Warren? Like today, this morning?

Bill: No, but that’s not it.

Jake: [crosstalk] 40% of our portfolio.

Bill: I guess the other way to flip that on its head is, it took Apple to have him keeping up right now. And if you’re going to run a strategy that depends on finding the biggest company in the world, then swinging as big as you can, I’m not sure that’s actually a viable strategy.

Toby: That’s fair.

Bill: I get that it works. But how many times does that work? By definition, it’s only been once. And he did it with Coke too, but you’re just going to capital accumulate waiting for a 25-year swing? I don’t know that makes sense. Dude, I get it. I’ve got a kid down there that screaming like he got murdered, I named him after Buffett. I’m all in on Buffett. I’m not trying to like take shots at him, but I do think that you need to– things need to more–

Jake: Swing– [crosstalk]

Bill: Yeah, well–

Toby: There’s lots of good questions here, guys.

Bill: He beat himself. Keeps swinging on Berkshire. There is a chance right now to buy in shares. I’m sure he’s doing it, but there’s deals out there.

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

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