In this episode of The Acquirers Podcast Tobias chats with David Horn, Adjunct Professor of Applied Value Investing at Columbia Business School. During the interview David provided some great insights into:
- There’s More Than One Way to Be a Value Investor
- Endogenous Versus Exogenous Rates Of Return
- Greenwald – “We Didn’t Get Growth Right!”
- Should Michael Burry Have Been Fired?
- Shorts Allow You To Do More With Your Longs
- Lessons From Paul Sonkin
- Sequoia’s Early Years
- Tesla’s Main Business Is To Sell Stock
- Most Active Funds Are Forced To Change Strategy
- Your Benchmark Is Whatever Else Investors Can Do With Their Money
- Portfolio Insurance
- Get Lucky Timing The Start Of Your Investing Career
- The Agency Problem
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Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is David Horn. He’s the adjunct professor of Applied Value Investing at Columbia Business School. We’re going to talk valuation, methodology, starting and shuttering, hedge fund, and lots of other issues like Tesla and so right after this.[intro]
Tobias: You graduated from Tulane?
David: Correct. ’96, Tulane.
Tobias: ’96. And then, you start as an analyst at Sanford Bernstein, ’96 to 2000. That’s when the dotcom boom 1.0 is absolutely roaring. What was that like being at a value shop?
David: Yeah, I started at Bernstein, I was called an Associate Portfolio Manager. It’s an entry-level job. You’re 22 years old, and they don’t let you analyze things. If you have any separately managed accounts, imagine if you had 2000 of them. At that time, instead of automating the whole thing, you wanted someone to make sure things were in balance. We had a lot of pension funds that maybe didn’t want tobacco stocks and back then, Bernstein was big in tobacco stocks. And so, you had to make sure that things are in balance that they were selling the things they were supposed to do. Basically, that the black box was working properly, so I would oversee that.
What was cool about it was, I got to sit in with the director of research every morning. I’m 22, I don’t really know what I’m doing, and being able to hear those people analyze and talk about the world around us– that was from ’96 to ’99. So, I’m at this famous value shop, and the internet bubble is going on, but they got screamed at and yelled at for being idiots, dinosaurs. They’ve been managing money for 40 years. It’s very eye-opening to me that when you read about, “Oh, values, it’s contrarian, but there’s a reward.” Man, it’s brutal. You have redemptions and you get called names, and these are adults. It’s very hard to stick to your guns. For them, it worked out, although they did sell to Alliance right before the whole thing came crashing down. I wasn’t privy to the conversations, but I don’t know if they decided, “Look, we need to be part of a larger shop. It would have happened anyways.” But right after that, they nailed it, they were dead on, and then they had some great performance.
I didn’t really know value. I didn’t know growth. I remember being in a class, senior year of college, and there was a stock-picking class. One of the activities was stock-picking contest, and someone picked Netscape. And of course, they won the contest. And well, I can’t stand stock-picking contests, because of what it reinforces. It was just funny that–
Tobias: It’s like six weeks or something, right, who picks–?
David: Exactly. It’s literally the worst thing you could– it’s funny, you’re a value investor. But if you had your kid in a stock-picking contest and it was eight weeks long, like, I don’t know, what has the most momentum and can we lever it?
Tobias: Yeah, let’s get the options. Let’s get the OTM calls.
David: Exactly. Yeah, YOLO calls, 50% out of the money that expire in six weeks.
Your Benchmark Is Whatever Else Investors Can Do With Their Money
So, I go to Bernstein, and this is right as the tech bubbles happening– And it’s funny because I think Greenspan [crosstalk] irrational exuberance, that was late ’97. I think it sometimes gets lost in how long that bubble really was, how hard it was to time. So, I’m sitting there at a value shop, and they’re doing good work. I remember they were– the bonds had a decent yield, and they’re buying paper stocks, they’re buying tobacco stocks. Performance is fine, but everywhere else, everyone’s jumping into tech.
I learned an important lesson, which is essentially, if your benchmark is the S&P 500 and you’re not in a big portion of the S&P 500, if you’re underweight or severely underweight, you’re effectively short because what you’re doing is you’re rooting for– if that goes up, you look bad. And if that goes down, you look good. You don’t actually hold it, you don’t lose capital. And there’s this famous saying that “You can’t eat relative performance.” I think that’s actually nonsense because you kind of do eat relative performance because you need to raise capital and you need to hold capital. And if you outperform, you raise more capital. Relative performance does matter. Sadly, it’s a big game we’re playing.
As I was there for more and more years and the bubble got crazier and crazier, basically, we were getting fired. I was there and it was very sharp research. These analysts were really at the top of their game. Pension funds were just upset that they were missing out on private clients and it’s hard, you go to the golf course, and you’re talking with your friends and they’re buying whatever tech stock de jure or IPO de jure. You say, “Well, we bought more International Paper.” Nobody wants to hear that. Eventually, they were right, and they nailed it. That was my first introduction to cycles, sticking to your guns, being a contrarian, how much– Grantham talks about going into a big group of analysts and asking them if any of them think this can sustain itself. None of them did, but no one does anything about it, because of all the career risk. When you read the books, you hear about investing, you don’t learn about any of that stuff. And that was my first-hand view of it. You have to get to the end to essentially be right.
Tobias: When you say you don’t learn about it, you don’t learn about how hard it is to have the weaker performance with everybody making money really easily outside.
David: No, you don’t, and it’s an interesting thing because people talk about benchmarks. What’s your benchmark? S&P. Mine’s the Russell. Your benchmark is whatever else people can do with our capital. If your cousin is on Robinhood and crushing it, at Thanksgiving, they might say, “Well, can you manage my money instead of Toby?” [crosstalk] You don’t want to speak badly about your cousin, but the point is that they don’t– their alternative isn’t just, “Oh, I can put it in an index fund.” And so that makes things very hard, and in a bubble, we see it time and time again, where it’s very tough emotionally. Even Druckenmiller talks about it that he basically he knew better in 2000 and he did it anyway. So, Druckenmiller does it, what’s our hope?
Most Active Funds Are Forced To Change Strategy
Tobias: I love the story that Druck kind of knew that he couldn’t do it himself. So, he got two young guys in there to really rip up the– blow the portfolio up.
David: Yeah, he did that. I guess whatever it was, he jumped in March. He threw $6 billion in and they said to him, “What did you learn?” He said, “I didn’t learn anything!”
Tobias: “I knew not to do it already.”[laughter]
David: I know. We all know this. You think about your business. I put up a Twitter poll the other day, said, “What’s your confidence level that you can outperform over three years if you manage other people’s money?” I don’t know if you saw that one. But about half the people said it’s 50%. And 10% of the people said 90%. I wanted to say to them, “You’re either amazing managers or wildly overconfident.”
Tobias: You’re in tech. [laughs]
David: And I think it’s the latter, and I don’t want to pick on anybody but thank you for answering my poll. But let’s go back to the 50% of people and you sit there you say, “Look, it’s a coin flip. I just don’t know.” But you’ve also structured a business, that’s really bad. So, let’s go to year three and you’ve underperformed three years. And you say, okay, well, how many years realistically speaking, can I ask for someone’s capital? It’s not a decade. That’s not a fair ask. I’ll be right t every decade, but you need more than three years.
But how does your behavior change in year four? Second half of year four, you’re like, “Alright, I’m just going to–” just a little bit of momentum and tweak it a little bit. I went from deep value to have some value. Okay, well, compounders, and, ooh, I’ll buy Apple at 30 times earnings. It’s still kind of value, but the point is, how you performed changes how you behave. And you can see how people– and then it gets to the point where you’re behind, and you have to gun it to basically try to catch up to retain the capital, to make it to the next cycle. Again, Bernstein was my first entree into that.
Tobias: You didn’t really have much of an idea about growth or value before you went in, but then you go to the crucible of value to do your MBA, you go to Columbia. So, you must have had some idea that value was where you wanted to go at the end of being at Stanford.
Lessons From Paul Sonkin
David: Yes, that’s exactly right. I think being at Sanford Bernstein helped me get into Columbia because it certainly wasn’t my grades as an undergrad. I went to school at Tulane, so I think you should have huge, great inflation for simply surviving four years in New Orleans. But I knew I needed to go back to school, and I knew that I didn’t have the analytical chops. So, I was fortunate enough to attend Columbia, and really had an amazing experience there and got more and more exposure to value.
I had an applied value investor professor named Paul Sonkin, who ran a micro-cap and a nano-cap fund, and he was nice enough– After I graduated, it was ’02, and it was right after September 11 and it wasn’t the greatest economy and so I was looking for a position and he said, “Look I’m not going to pay you but you can work with me.” And so, I learned a ton by osmosis. And it was really–
Tobias: Was this Hummingbird?
David: This is Hummingbird, yeah.
David: I was there for about 9 or 12 months. I watched what he did, and it was fantastic, again exposure to a really smart analyst, how he talked to companies. If you think about it, well, what questions do I ask a company? How do I interface with a company? He was very much a suggestivist, which is not quite activist and no threats, but “Look, you’re a micro-cap, and I’ve been doing this, and I can help you. And you can say no to my help, but again, we have aligned interest, so listen.” He had some success with that. And then, I ended up joining up with a long-short fund called Perennial, which has morphed into an RIA. There, I got some exposure to the short side. And that was through– I worked at Perennial from ’03 to ’06, and that was through the housing bubble. And this is where I had a slightly different experience where I actually covered some of the subprime housing companies on the long side.
And they were really cheap, and you could look at New Century and they had these huge dividend yields. There what happened was, we made some good money and then we started to lose money as things started to sort of turn in ’05, and then fortunately, we sold out of them. But I remember coming back from a trip to California to visit New Century, and I was frustrated because I didn’t get it. I was having problems with the financial statements. And instead of saying that– it was so naivety. I wasn’t like, “Oh, there’s something weird here,” I viewed it as a failure on my part.
Tobias: To analyze it properly.
David: What’s that?
Tobias: You viewed it as a failure to analyze it properly, rather than something wrong with their financial statements.
David: Exactly. Look, it shouldn’t be that hard. Businesses aren’t that hard. If it is that hard– And look, you might say, like, “Ah, it’s too hard. I don’t want to do this.” But you have a boss that they say, “You should do this.” So, great experience there, and I said to my boss, “Look, I don’t want to do these sorts of companies anymore.” We had a talk, and he said, “Why don’t you do what I did? Why don’t you go try to start something?” He was one of my first investors and I was about 30 at the time, and I was really excited to do this on my own.
What I realized, through so much of looking at the institution of managing money was that you would have a conversation with someone, and they would talk about how they were investing. And they’d say, you talk about a name, and they’d say, “Well, maybe I put that in my PA. I really like it, but I can’t put it in my fund.” And I thought, “Why don’t I run a fun like a PA? “If this is what I want to do with my capital, I think people want to be in the names where you want to put your capital, not what fits the box for your fund.” I started based on that premise.
I started a fund in ’06. It’s actually quite interesting because I did fine in ’06 and ’07, and it actually performed very well in the crisis. At a long short book, the shorts worked, the hedges worked. And so, this gave me a great deal of buying power in the depths of late ’08 and early ’09. One of the things that really resonated with me at the time was that you would basically see things go bitless. You would see microcapsule go bitless. At the time, Lending Tree– I think it had been a spin-off, it was relatively new to the market and at eight bucks in cash, and I was buying it for between 150 and 3. It’s just sitting there on the bid and I’m like, I haven’t mastered the business, but they’ve got eight bucks in cash, so I’m buying that thing. Again, all of this happened was because– I’ll do a quick tangent.
Shorts Allow You Allow You To Do More With Your Longs
I hate when people talk about a short book in a vacuum, how are your shorts doing? What shorts do is allow you to do other things on the long side. When a selloff, they give you dry powder, but if you’re 70% investment, 30% cash, and I’m 60% invested and 40% short, it can actually– I take that back, if I’m 90% long and 30% short, and my shorts are flat, I actually have more capital at work on the long side than you do. And so, people say like, “You lost 2% on your shorts, you’re always losing on your shorts. Why are you shorting?” I’m like, yes, but you have to hold them against, what did I hedge was the other side of the book. I was able to take more exposure than you were because you only had cash as a hedge. And so, it has to be viewed holistically. That’s frankly, how the portfolio worked. It worked incredibly well.
’09, we come out of the trough and I’m doing great. But something didn’t sit right with me which was essentially that I didn’t see the housing crisis coming. And I should have because I was kind of front and center. A lot of the party lines, we’ve never had a drop in housing nationwide since the Great Depression. I believe that sort of thing. What really frustrated me was that if you go back and you look at some of the things Grantham did at the time, if prices are moving along in a relatively straight line, yes, they don’t fall. But sure, they never fell nationwide, but they also didn’t go up to X nationwide in three years. You have to look at the action before. “Oh, it never went down 50%.” And those aren’t the numbers. But the point is, if you look at the parabola, you have to look at the left side of it. Of course, they came down. While I thrived, I was frustrated because it caught me off guard. You can get things wrong and make money, you can get things right and lose money, and this was an instance where portfolio construction helped me, but I was wrong. I didn’t sense a crisis coming.
Tobias: Do you think that something like that is predictable?
David: Well, so that brings me to my next step, which was, I said, “I missed this. Who am I not listening to? Who called this?” It wasn’t just guys like Burry and people of Big Short, but if you actually go back and you look at some of the cycles, and you look at guys like Grantham, guys like Montier, guys like Hussman. This is where I got into the world of Q ratio, CAPE ratio, market cap to GDP, and you go back, and you look at Buffett. ’99, he’s talking about these things, and you look at that metric. Again, I didn’t read him in ’99. And then, okay, well, what causes all this and this low-interest rates and pushing everybody in TINA and trying to get everybody into stocks. And I said, “Wow, these cycles are predictable,” or at least the risk reward is.
This is what I got wrong. It’s very elegant, and it worked very well two times. And the third time, it didn’t and that’s this time. Now, will it work? I suspect it will. But as far as me managing other people’s capital under that premise? I didn’t do it successfully. I fought it. My shorts were too big, and my hedges were too big, and my longs weren’t in the right places. You try to learn, and you try to do better, and you go back to the lab and look at what you did wrong.
There’s More Than One Way to Be a Value Investor
But it didn’t make sense for me to continue running other people’s money, and it wasn’t doing well enough. I certainly couldn’t raise more. I decided to give the capital back. I was frustrated. I was frustrated, and it’s funny, if you go back and look at Buffett in ’68, and ’69, or ’70, he gave up the capital back, he talks about, “Well, I’m not finding opportunities,” and that’s Warren Buffett. He couldn’t find opportunities. Or if you look at Julian Robertson in ’99, essentially saying that, “I don’t understand this market.” And I don’t think I realized that I didn’t understand the market and I’m certainly not Julian Robertson or Warren Buffett. But the point is what I was doing wasn’t working. When you’re doing it every day, it’s really hard to take a step back.
You’re a deep value guy. You have a book about it, and you have a fund about it. I think the question would be, “Well, what if you didn’t want to be a deep value guy anymore? What if you wanted to tweak it?” Again, I needed a reset. I needed to look at what I did wrong and I needed to say– here’s another great metaphor, and we’ll get to this, but I teach value investing at Columbia to MBA students. In my first year of 2013, 2014, one of the things I was doing, one of the first classes, was that a handout of the IBD, Investor’s Business Daily, Top 20 Rules for Investing.
Some of the rules are don’t look at things like P/Es. Don’t buy stocks under $5. That doesn’t make any sense. As a value investor, you laugh at this. I would say to the students, like, “Look, look, this is what’s out there, this is what’s on the other side of the trade.” Then I went and looked, and William O’Neil compounded it over 20%. Buffett says about value investing, “Look, you either get it or you don’t.” We’re all in this club, and we think we get it and other people don’t, but it’s not really true. There are a lot of paths to heaven.”
Now, value investing still resonates with me and we’ll talk about some of the principles, the framework and the way I think about things, but I think there was a level of– I don’t even want to call it hubris because it’s not that I had a big head, but I guess it was not really being open to other ways of making money and that the other side of the trade isn’t– they might be doing something really smart too. Again, O’Neil, he’s using technicals– By the way, fun fact, Buffett use technicals for six years. So, of course, it’s Warren Buffett, he used technical, that sounds like a joke. He gave his speech years ago to a business school, I can send you the PDF, but the point is, he experimented with them, he decided that they didn’t work. Six years is a long time. But I didn’t feel like I was in a position or had the bandwidth to experiment with anything. If you think about the job of managing money, and how many balls there are to juggle, this is the other mistake I made. I went at it alone.
If you want to do all the things that it takes to manage capital, it’s hard and it’s a mistake to do it alone. I joke the second most important decision after finding your spouse is really finding a partner that has the same vision you do and looks at the world the same way you do because you can start a business with them. Whether it be a sounding board, whether it be someone to take a call, or the ability to step away, and I think I was too deep in and I didn’t have that ability. I think it’s very important, to be able to sit on the couch and think. I got a little too wrapped around the axle, and so I stopped.
Tobias: What year did you finish?
Tobias: And the strategy was a micro-cap value, is that fair?
David: No, it was everything. It was long, short. I had micro-cap, but I went anywhere and did everything, in equities for the most part.
Tobias: And how concentrated diversified were you?
David: I usually didn’t have much bigger than 6% or 7% positions. My joke is that if you are looking at the ticker, it’s too big. It was sort of death by 1000 cuts. There wasn’t one thing– I didn’t have a Valiant, it wasn’t–
Tobias: You didn’t blow up.
David: I didn’t.
Tobias: Just everything didn’t work.
David: I bled out. Yeah, I did not blow up. It doesn’t really matter. When you think about portfolio construction– and here’s an interesting– I like to ask fund managers now, what’s the worst thing that could happen to your portfolio? What world events, the worst thing that could happen? What are you not prepared for? Here the other thing that happened, after the crisis– and a lot of your listeners probably weren’t there for it, but it was terrifying in the sense that Bernanke said, if we didn’t do something, 12 of 13 banks would have collapsed. So, basically, the institutions would have collapsed. You’re raised on- you think that there’s adults in the room, and you find out that there aren’t, and then they start doing all the same policies all over again, and I feel I’m taking crazy pills, but you’re watching low-interest rates, and literally the exact same behavior coming again.
And then as a fiduciary, I’m looking at my investors and saying, “Oh, my God, they have house insurance. They have fire insurance. They have life insurance. They have zero portfolio insurance.” If you mention portfolio insurance to people it sounds absurd, it sounds something that’s too expensive, with something that– and again, all of those insurance, you write the check every year, and you’re not like, “Oh, damn, my house didn’t burn down. I spent all that money on insurance.” You’re happy. Portfolio insurance, a short book– I mentioned this too earlier, but look, I only took a small portion of anyone’s capital. And that’s another thing that was important to me. Look, if you have 75% of my capital, Toby, I’m not going to leave you alone. I’m going to ask you questions all the time.
Why do we have this loser? What’s going on here? Oh, you went away for a week? The market’s down, I’m going to bother you. I have a claim on your time. And It’s reasonable to have a claim on your asset managers time, but that time has to– if you spend two hours a day once a month with every client, you have 30 clients, you start to do that math and you’re doing a disservice to everybody else.
But that money that I did have, I took it upon myself, and I probably shouldn’t have. I took it upon myself and said I want to create a hedge for these people so that when things do collapse, which they will, they have some protection. The portfolio will perform well, just as it did in the past cycle. Whether or not maybe if they wanted that, maybe they would have gone to Spitznagel. Maybe they would have gone to a short-only fund. I sort of morphed in that sense.
Again, it didn’t work and it didn’t make sense. The economics of running capital, it has to work. That’s how hedge funds work. And we can talk a little about that because I think the incentives are a little bit misaligned with your classical– Well, with most asset management, but hedge funds in particular. I guess my point that I would make to that is, I think if you were to match up lockups with incentive– so you come to me and you say, “Dave, I love what you’re doing.” I say, “Listen, let’s say it’s just 1 in 20. My 20 won’t cash out until your lockup ends. Toby, you give me 10 years of money, and we’ll settle up at the end of 10 years sans whatever management fee I need to start to keep the lights on.” And the idea there is, what you see a lot with hedge funds is you’re incentivized to swing for the fences, swing for the fences, you’re up, up, up collapse, you’re back to where you started. LP has made zero money, but you have a [unintelligible [00:25:12]. As a GP, I would love to have long-term money, but again, that’s a tough thing to sell.
Tobias: You managed that portfolio through– it’s been one of the more difficult times for value. I don’t know if you’ve seen that Mikhail Samonov of Two Centuries, says that chart that goes back to 1825 and it shows the current– I mean, this is price to book value. But I think that the narrative about price to book value has followed the more recent performance of it, which has been terrible. And now it’s in possibly the worst drawdown ever because I haven’t seen the updated data since– I think his study goes to May this year, and I think that it did continue to underperform a little bit. But basically, it’s about 60% behind the glamour stocks. We’re traditionally over rolling period it outperforms. The only other time when that’s happened is 1904. That’s equivalent, it’s worse than the Great Depression. And then, prior to that, you have to go back to 1841 to see this level of underperformance. I don’t think that anybody had the sophistication at either of those dates to declare value dead. But that seems to be the– narrative is almost pervasive now that value investing is just a ridiculous concept.
Endogenous Versus Exogenous Rates Of Return
David: Let’s get in a little bit. And this came into– we’ve tweaked a little bit about this, and this was in a chain by, whatever, SuperMugatu. Talking about is value dead, and I know you recently had a pod with with Cliff Asness, and he was talking about the fact that for seven years–
Tobias: It was justified.
David: It was justified. This brings into my question, what is value? We’re defining it by price to book screen. And I guess, to say something, if the stocks weren’t getting cheaper, or if the earnings were declining in line with the multiple staying low, and then the companies were underperforming, then I don’t even know if you call that a trap. I think you call that wrong. So, I think what’s important is– Okay, so let’s dig into, so what’s happening underneath the surface? Unfortunately, I don’t have the tools to do it on a macro level.
But if you just think about– let’s just pick a company, and let’s pick Apple, because it’s A, popular, B, everybody knows it, and C, Buffett bought in 2016. Buffett buys it at six and a half times adjusted earnings in 2016. Cash-adjusted earnings, I’m subtracting cash out. Maybe they had a nominal amount of debt at the time, I don’t think they’re really doing that yet. But those are the numbers, six or seven times. Let’s imagine, you buy a stock and it’s trading at seven times. You put seven bucks out, it’s earning $1. Now, the way I think about valuing, the way that my framework for investing is, there’s two things, there’s endogenous returns and exogenous returns. So, endogenous returns, it’s a type of thing you get maybe from a private business, so you spend $7 on a stock, it’s earning $1. How do you make money? Well, we make money two ways.
One, if someone bids the 7 up, they pay 8, they pay 9, they pay 10. That’s exogenous. That’s someone else doing something to give you returns. But the other way is, you just sit there and collect $1 a year if you’ve got earnings right, and they don’t pay the dividend, but that’s not the point. The point is, if a company is retaining $1 of earnings, whether they pay it out, whether they buy back stock, whether they reinvest it with a positive NPV, the point is that every year they earn $1, essentially, it’s coming back to you as the business owner. I would look at value and say, okay, so you paid $7 for something earning $1. Now it’s at $6, and it’s earning 75 cents. And so, you’re like, “Well, value stinks. This went from 7 to 6.” Okay, well, that’s not necessarily what happened there. Or, did they earn the $1, they’re about to earn another $1 and it’s still at 7? There, and I think this is what Asness is referring to is what’s happening in the past few years.
I still think that cash flows will set you free, if you properly identify cash flows, and you pay– and so now let’s look at what else is happening in the market. Let’s talk a little bit more about those exogenous returns and also the big thing that we hear all the time now, which is TINA. And even Buffett does this, are equities cheap? Well, they’re cheap in relation to bonds, and it’s okay. What’s happening now when you pay 30 times for Apple? They earn a buck, you pay 30. And back to our original endogenous. Okay, you know what? Maybe you’re okay with, I’m earning a buck a year, I paid 30, It’s a 3% yield, treasuries stink, there’s nothing else out there. But it’s almost bond-esque, the arrangement that you’ve set up, you’re going to take, and let’s assume that you just don’t care what the stock does over the next 30 years, you don’t manage outside capital, you’re not taking any P&L risk. The same way with the treasury, you have this– it comes due in a decade. For the bond, and for Apple, maybe you sit there, and you say, “Look, I’m fine with this. I’m fine getting my 3%. And I think Apple’s earnings will hold up.” The problem is, and the reason it’s a flawed investing trope is because buying stocks when interest rates are low, and that being the logic, doesn’t actually hold up historically. That didn’t work until about 30 years ago.
So, if you go back from 1900 to 1970– and Montier did work on this. And it’s basically like the Fed model, which was, as interest rates go down, buy stocks, it’s just correlation is not causation. And what you have to be careful with– whenever I look at a security or think about a security, you have to think– and this– so much of investing is about the crowd and convincing people of other thing and getting them to believe. Instead of it being invested and speculating as X, I actually think you can break it down at the security level. Is this stock cheap enough that I just– Again, outside of mark to market and having to manage other people’s expectations. Am I okay with this earnings stream accruing to me based on the price I pay? I don’t care what anybody else does.
David: This is actually when Ben Graham wrote Security Analysis, and he talked about Wright aerospace, and it was a company trading at $8 with $8 in cash, earning $2, paying $1 dividend. No point, if you can find right aerospace, find a net-net, find decent management, it’s like– again, the market doesn’t have to figure it out. You just don’t care because you’re getting a buck paid out to you, you paid eight, you’ll just sit there all day. Now it’s nice. Going back to Apple, Buffett was right to buy it because he’s already gotten $10 an accrued– this is if you split it just when it was at 90, at 16 now, he’s already accrued $10 in earnings. Now, what’s happened? The market’s figured it out, and they’ve bid it up.
But– this is another thing, and this comes up sometimes when I hear you talk to other managers, we talk about cost to market. It’s like, “Well, I initiated position at 5%. Now it’s 10%.” Who was it? I’m blanking on the name. Steinhardt, when his portfolio wasn’t working, he just sold everything. He blew it up. And, again, think about how hard that is for an institution to do like– what if you wrote a letter and you’re like, “Yeah, guys, we sold it all, wasn’t working. We’re going to rebuild it.”
The point is that if you say 5% of cost or 10% of market, you could all– liquidity aside, taxes aside, we all rebuild our portfolio every morning. Every morning, you walk in, you’re allocating 10% to your 10% name. And if you bought it at 5, but now you’re allocating 10 and it’s got more expensive, again, taxes aside, that doesn’t make any sense.
You’re actively allocating capital. Just because you’re pressing buy on the computer, doesn’t change the active allocation. I do think that’s something that that’s flawed. But the point is that now Apple, now it’s gotten that massive exogenous return, and it’s been bid up to 30 times and so if you want to say– so you say to somebody, “Why are you buying stocks?” “Oh, well, interest rates are low.” “What’s your view on interest rates?” “I’m not a bond guy, fixed income guy, I don’t have a view.” “You have a view. You just expressed a view.” Unless you’re putting on essentially a pair trade, you’re making a relative value bet.
Again, I think that I can’t predict the noise. None of us can, and that’s what we get, “Oh, my God, people are paying–” this is another thing we hear a lot of which is essentially, the market isn’t working. They’re ignoring [unintelligible [00:34:11]. Well, look, does anyone in our business want the markets to be efficient? Of course not. They have no job. So, then they’re inefficient, everybody whines. So, wait, you want them to be inefficient just for long enough for you to get a position on? And then they become somewhat efficient.
Tobias: That sounds fair. That’s exactly what I want.
David: It sounds perfect. But so, the idea right now, so we’re saying, look, growth is too expensive values too cheap. Good, you’re in the mud, you’re in the business of exploiting mispricings.
Tobias: I agree.
Should Michael Burry Have Been Fired?
David: But it doesn’t mean it’s not frustrating. It also comes back to time horizon, it comes back to that institutional mandate, that comes back to monthly returns, that comes back to perceptions of volatility or perceptions of being what box are you in and the ability– and this was a good example from The Big Short, where Burry’s like oh my God, instead of looking at opportunities down here in micro-cap value– maybe he’s doing that again, there’s this massive opportunity over here. And he gets dragged through the mud and fired.
But I could argue that they were right to fire him because he didn’t fill his mandate. I think that’s another thing about this job is that you fill a box. You are a deep value guy. You become a growth guy, maybe people want to be that, but someone probably hired you because they’re looking at this where’s my best deep value guy and where’s my short guy? And so, I think as a portfolio manager, it does help. This is why I say– so going back to teaching, which I haven’t really touched on very much, but I want my students to understand, “Oh, if I have this great idea, and the boss won’t buy it.” Well, are you looking through things through your boss’s lens, and who he or she answers to, and what those LPs expect from the boss? If they step out of their box and lose money, how that might look particularly bad? Oh, you bought puts on Tesla? Since when are we put buyers? I didn’t think we ever did that before. There’s a business behind this, and it’s not just picking stocks. It’s not just whatever duration you want.
Get Lucky Timing The Start Of Your Investing Career
Tobias: Well, let’s just talk– you’re an adjunct professor at Columbia, teaching applied value investing. Let’s talk about the valuation. How are you teaching valuation? How do you think about it? How do you structure evaluation?
David: What we do is we– Bruce Greenwald wrote a book years ago, and now Paul Sonkin and Paul Johnson wrote a new book that touches on valuation. It’s funny, because we don’t go that deep into it. We break down a balance sheet, we break down an income statement, we believe growth out there because that’s your traditional way of doing value. I co-teach with my co-professor, Eric Almeraz, who runs a fund called Apis Capital. The way we view teaching is, you have 36 hours of someone’s attention and 34 of those hours are still going to slip out of their ear when they leave your class. And so, what are a few things that are going to resonate?
What we try to prepare them for is to be an analyst, to understand some of the risks we’re talking about, and to see the different ways of looking at the world. And it’s funny, a student said in my class three this year, he was like, “Wow, there seems to be so much luck involved.” I was so happy because, and again, I don’t attribute to anything that happened. I don’t blame luck for my fund networking. But the point is, yeah, there’s luck. You just talk to– deep value, and you read all the books. Someone comes out of school and launches tomorrow, doing exactly what you’re doing, and tomorrow’s the day it turned, they’re hailed as a genius. And you’re sitting there saying, “Dude, I’ve been doing this for 15 years.”
So, they will get lucky, essentially when the cycle turns, using no different methodology. I think if you look at what’s worked over certain times, you look at some of the growth people today– and again, just to someone that doesn’t know too much, someone that thought Tesla would have $30 in earnings and robotaxis right now, they were wrong, but it doesn’t matter. That happens too. I joked the other day that you’re going to be right and wrong, and you’re going to have good luck and bad luck in your career. But don’t be wrong and have bad luck at the same time.
Tobias: [laughs] That’s impossible.
David: [chuckles] Then, you’re pretty much done, but what I want– Okay, so the first class, what we do is we bring them in and we talk about the tent poles to value. You talk about margin of safety, and I very much– and it’s funny, we talked about value being broken. Value is of mindset, you are a shareholder in a company, you are owning fractional value of a company.
I think that’s something that Graham really talked about, and it hasn’t been lost, because all of us think about owning a business. And at no point, technicals aside, you can even add that in. But the point is, you are the owner of a business, you view that cash if they earn it as accruing to you. I think always having that in the back of your mind– Buffett bought Snowflake or Berkshire bought Snowflake. You can look at a growth name, nut going back to what I was talking about before, look, maybe they think the cash flows– I don’t think that they’re playing a greater fool’s game because I don’t think that’s what they do.
One of the reason I said earlier is talking about how you define value, I mean, Bill Miller was deemed a value investor and is considered a value investment, in the late 90s he was buying tech companies. And so, I think what’s changed is if you’re viewing that, okay, well, I own a business and I want a margin of safety, the margin of safety has sort of shifted.
If you think about a probability tree and outcomes and if you actually think about that whitetail and what a company could become, and even if discount it, you’re still doing a probability trade, it always has been. And the opportunities like Wright aerospace might not exist but these investors who have been able to look at– now you go to business quality, and say, “Oh, wow, they’re reinvesting at this rate, then the multiple, it’s deceiving.” Essentially, I own it, I want those cash flows. I know how they look. I know 25 looks bad, but I also have a good idea or some confidence in how it will look in five years.
Sequoia’s Early Years
We try to expose them to all that. And we also show them. Look, Buffett shuts down the partnership, and he says, “Give your money to Bill Ruane.” And that’s Sequoia. So, if you look at ’71 to ’75, Sequoia underperforms four to five years– actually I have the numbers here. It’s really quite funny, to ask the students about this thing. Starting 1970 July 15, they were up 12, S&P up 20. Next year, up 13, market up 14. Next year, up 3, market up 19. Year four, down 24, market down 15. So, they’re either underperforming or they’re losing more than the market. You’re value guys, you’re not supposed to lose money. Now, you’re down 25 on the market–?
Tobias: If that’s your first four years, you’re in a lot of trouble.
David: So, then what I say to them is that after the first– I don’t know, if it’s 10 or 13 years, essentially Sequoia, they were up 17 when the S&P was up 10, after fees. So, they created 700 basis points in alpha annually. I’m the investing genie and I come to you and I say, “Listen, I will give you a decade,” again, I don’t know if it was decade, or– Yeah, I think from 1984– So, 1970 and 1984. 14 years. “14 years, but you have to play it as it lies. So, you have to have these five years, but you get 700 basis points of alpha a year through 14 years. So, do you want to take your own chances? Or do you want Sequoia’s returns?” And they’re all confused, and they’ll say, “Well, you said I get fired after four and a half years.” I said, “You will.” They’re like, “Alright, fine. I would do on my own.” I said, “You’re all idiots. I just [crosstalk] 700 basis points of alpha and you said no?” But that’s the point.
I don’t want to talk about me. Was Sequoia making a lot of mistakes, or was it just not working out for them? And so, if you look at that– Now, let’s look at a career of 50 years. And so, you say, “Oh my God, I will inevitably hit some bad trough.” Statistically, it has to happen. [unintelligible [00:42:32] had put out a paper and it’s not on their site anymore. But they essentially said if you looked at over a decade at the top quartile of performers, a vast majority of them spent three years in the bottom decile. Again, you’re going to look dumb, and you very well might look dumb for an extended period of time and statistically, it’s going to happen. And so, you need to build a process that keeps you in the game and that keeps you with LPs. I don’t care if it’s growth or if it’s value.
The Agency Problem
And so, then we start to study what works a little bit, and then we go into a little– and this is really fun. We take a company that they don’t know about. The first day as an analyst, your boss gives you a top sheet, you do a quick analysis. It’s not a lot of information, but it’s 10% free cash flow yield, and these are the assets. And then we say, “Would you buy more, hold, or sell?” Someone looks and they say, “I would sell.” I say, “Wait, wait, wait. This is your first day in work and you’ve looked at a company for 10 minutes, and you’re going to tell your boss, you would sell the 3% position?”
David: “I don’t know if I would do that.” I said, “Ah, but should you do that?” So, right now, I’ve created an agency problem where now if we sell it and it goes up and his friend likes it, or her friend likes it, now I’m, “Oh, God,” you’re thinking about career risk. And right on day one, you have to think about career risk. And the company comes out with an announcement, they’re delaying earnings. There’s supposed to be a conference call tomorrow for earnings, and at 3:52 in the afternoon– this really happened, by the way, they announce, “We’re delaying earnings,” so they don’t want the stock. Your boss yells, “What’s going on? What are we doing? Why is this moving?” The hell you know. You don’t know anything. Is that bullish or bearish?
What I’ve tried to shake them out– look, I think we all like to think that Buffett we read, he just sits around, and he reads all day. And you don’t have the screens on, and sure, I think that’s the utopia, but the reality is you’re going to work for someone, and stocks are going to move and it’s going to sometimes happen at 3:52. And you can’t shut your phone down. That’s the reality. Anyways, all the succession of events happen, and they’ll buy stock at 15 and they won’t add 12. And I say, “Okay, well how did your intrinsic value change?” “Well, it didn’t really change.” “But why the heck aren’t you buying more stock?”
Anyways, it’s fun because it’s a very live situation and they get skin in the game. We try to do things like that, which again– that’s why I call it applied value investing. It’s not just theoretical. Anyways, they end up buying it as it goes down and they have way too big position– [crosstalk]
Tobias: It’s evil.
David: [crosstalk] –there’s no money trading place, obviously, but they’re frustrated and some guy– you have a whale with a 30% position– [crosstalk]
Greenwald – “We Didn’t Get Growth Right!”
Tobias: If it’s the Greenwald class, you’re teaching to the Greenwald from Buffett and Graham– [crosstalk]
David: Yeah, we touch on it. But even Greenwald has said, “We didn’t really get growth right, and we’re working on that.”
Tobias: I liked that. Greenwald’s got that methodology where he says, you look at the steady state and you look at the flows from that, which might be the dividends and any buyback yield, and then you’ve got the growth portion, which is basically what you’re reinvesting by your return on invested capital over, whatever your discount rate is. And so, you get some idea, you’re explicitly breaking it into two parts. One is the steady state where you’re getting dividend or the buyback. And then, you’re thinking separately about how it’s growing. And that looks at what you’re reinvesting, the likely return internally to the company. And then, how much cash– from where that’s being priced in the market. That’s Greenwald’s franchise value as far as I can recall. And the nice thing is it breaks into two. And so, you have that thought. It also doesn’t rely on any movement in the multiple for you to figure out where your return is going to come from.
David: Yeah, he talks also about use– break down the balance sheet, you break down earnings power value, and then you look to see if they’re over-earning or under-earning, and I think that’s valuable if you want to be an activist. Look, I think so much of what’s happened is that breaking down the balance sheet, look, it’s very important to understand the balance sheet, but buying it something at a discount to liquidation value is not available too much these days. We like to touch on it, but we segue a little bit from it because we want them to think– once you do the balance sheet work, I don’t think too much of the further work is going to be, oh– again, I’m buying it at a discount to its balance sheet, although understanding how the earnings are working in relation to return on assets, and whether or not this is a good business, those sorts of things do matter.
So, going back to, you said, what are you teaching? It’s not a heavy security analysis class, because what I’m trying to do is expose them to things that they are going to — it’s like the question they ask, “What’s the right sizing?” “What’s your behavior?” “What’s the behavior of that of your LPs?” Anyone will tell you that that your best chance of outperformance is concentration. It’s probably your best chance of blowing up. Look, if you own 500 stocks [crosstalk] and you’re not going to look different than the index. Okay, well, where do I want to fit in? What’s my–? And there’s great funds that are able to own a handful of stocks. But there isn’t a right answer. And look, if you own a couple stocks, don’t blow it. The hurdle– This also goes back to– you sort of thinking about batting average and slugging percentage, and even Soros I think, would say that he was actually wrong more than he was right. But he’s sizing and the magnitude of– The old adage is like, “Well, 90% of options expire out of the money.” But if the other 10% are up 11-fold, then I guess you should buy options?
David: Right. Whether it goes back to sizing or whether it goes back to the framework, we don’t send them out and say, “Go look for net-nets. And if you can find things that trade at discount to the balance sheet, buy them,” because I think that’s true, but I think that they’re going to be looking for other things to do pretty quickly. Hold on, let me just see.
Tobias: I’ve heard that before that Greenwald felt that he didn’t get growth right in the Graham to Buffett and Beyond book and I thought that the more recent– there are a few papers floating around where he talks about this other method that they use is that I think is quite effective because it doesn’t require any– you don’t need to assume– it’s different from a DCF, where you have the gigantic terminal value that basically opaque, so you have no view into– is this thing going to grow faster than GDP for perpetuity? I have no idea at all. I think that’s an impossible decision to make, but the growth portion where you can say, look, this thing, currently it is earning more than the average company in the S&P 500. You can see how much it’s reinvesting. So, you’ve got some idea that there are flows going back into this thing. It seems to have a reinvestment runway. We get an idea about the cash flows that in totality with the going in, so we can come up with a rough estimate.
And then, the number that it spits out is basically an expected return. And so, you’re not really coming up with a hard, intrinsic value. Rather, you’re coming at it more like a Mauboussin approach where– look this thing, the expected return is very, very high here. So, maybe we should be allocating a little bit more capital to this thing.
David: Yeah, and I think that in the framework– it’s funny watching, and Bruce– I think he retired, but he’s still doing some work, and I think he’s working on another volume. I think what’s happening– So, if you go and read that book, they don’t dig too much into growth. Historically, value mean— that wasn’t part of the work because it’s the whole– the upside is free. And I think he did it– well, Buffett did it stealthily. He started buying quality, but it didn’t really become– I don’t know, when that mantra started to take over. But I think what you find is that– Look, value used to be contrarian. How many people go to Omaha every year? And so, when you talk about high screen low price to book, should it work or doesn’t work? Well, should it work? How many people are screaming low price to book? Or does it not work simply because something doesn’t work for five years, and then that just works, right? It’s literally everyone, you even get the value guys that decide that this doesn’t work because I don’t have long enough capital. And so, we all move to where the ball is as opposed to where it’s going. And starting to ask this question more about quality of business and growth– It’s something that, I think, they’re starting to probe a little bit more. And again, when I talked to Greenwald about it, he said we’re working on a better framework for growth.
Tobias: I just wondered if that was the one that he’d been talking about because I had seen that. I think it’s intuitive, it’s good for– The thing that I like about it is it doesn’t require look at a decade and try and figure out where it is in a decade. You look at where it is today. All of the inputs are historical. And then, you just seeing what kind of magnitude of expected return are we talking about here.
David: That sounds right.
Tesla’s Main Business Is To Sell Stock
Tobias: Do you want to talk a name? Do you want to have a quick shot at Tesla? [laughs]
David: Here’s what I’ll say about Tesla. We joked about it turning a lot of people away. I think it would take a whole pod or a series of pods to talk about it. But what you realize about Tesla is, how much narrative matters, and how much storytelling matters. And so, one of the things about class– one of things we touched on are frauds and what I really want them to learn about frauds is that auditors don’t do anything and the SEC doesn’t do anything. They do things after the fact. But if you look at– Yesterday, the LA Times or one of the papers showed a guy in a Model X sitting in the passenger seat, and the car is driving itself. Now, does that guy think he’s being an idiot? Probably not. Or he thinks that look, if this thing couldn’t do what I’m having to do, someone would do something. The NHTSA or– Tesla wouldn’t do that. People don’t sell dangerous products.
I like to say at Tesla, people are like what kind of company is it? Is it a car company? Is it an energy company? The product of Tesla is the stock. They sell stock, and they do whatever they can and Elon does whatever he can to keep the stock price up. And if you look at the way that his incentives work and the way his margin’s structured, it’s all based on the stock. You have to be careful of narratives. There’s this good movie about Facebook and how it’s– what is it called?
Tobias: The Social Network?
David: Right, it is The Social Network. Yes, thank you. But what you realize is that this is happening for investing, too. And so, if you were to pull people and you’re in California, and you say, “Is Tesla profitable?” Did they ever ask– did OSHA ever show up with a warrant to come into their factory and get turned away? Are the products dangerous? Anything like that. Of course, they have a good view, because that’s what’s in the news. And that’s what’s on Facebook. I think the point is that, if you look at Tesla, you think about trading Tesla, what you have to see is a bit of a narrative shift. And as long as these things are out there– Look, this is the only man on earth who can lower the price for his product and have people believe that they’re supply constrained. Why would you lower the price on a product when you make no money if you’re supply constrained? And he’s not supply constrained. But his narratives work.
Again, going back to things like sizing, going back shorts, willing to leave money on the table, I think that’s a very hard thing. Look, in 30 years, your kids will be like, “I can’t believe you were in a market so messed up now. I can’t believe when you were around, you’ve got to short things like Tesla at $400 billion and they didn’t have any earnings.” And you’ll say, “Look, it wasn’t that easy.” Look, it’s fascinating to watch the media around it. I think you have to think about how you– you talk a lot about Nikola, and the things that Nikola is accused of doing with their reveal. And you say, “Well, why is the media treating them differently?” But if they are treating them differently, what’s the fundamental value there? What is Nikola? What’s underneath it? Maybe seeing a narrative shift, and waiting for that narrative shift, which is very hard to do. It’s very hard to wait for that narrative shift. I think you have to do it. Especially on the short side, as far as being careful, trading carefully, limiting your risk, those things are infinitely more important. I mean they’re important on the long side, but even more so on the short side.
Tobias: Yeah, it’s fascinating. David, that’s all we have time for. So, if folks want to follow along with what you’re doing or get in contact with you, how do they go about doing that?
David: Well, Toby, you and I met on Twitter. And so, my Twitter handle is @davidmarchorn. D-A-V-I-D-M-A-R-C-H-O-R-N. And I was saying that my handle is actually The Hard 17.
Tobias: Why is it The Hard 17?
David: So, Paul DePodesta, and I think maybe Moneyball, or one of Michael Lewis’s books, talks about being at a blackjack table, and someone hits a hard 17, they pull up 4, and everyone cheers. “Oh, my God, that’s a great hit.” He’s thinking, “It’s not a great, it’s a horrible hit. What are you doing?” So, we have this obsession with outcome and not process.
Tobias: Right. Yeah, I love that.
Tobias: Well, I appreciate the time. Thanks very much, Dave.
David: Thanks, Toby. Take care.
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