In this episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle chat about:
- Inflation And Value
- Puggy Pearson’s Portfolio
- The Definition Of Value
- Absolute Versus Relative Returns
- Aerospace And $SPR
- Dividends Versus Buy-Backs
- Wonderful Companies At Wonderful Prices
- Big Opportunities In Small Value
- How Inflation Swindles the Equity Investor
- $NFLX And Pricing Power
- Consumer Surplus
- Being Right Once In A Row
- The Value Spread
- $RICK Bombshells
- Black Swan Options
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:
Tobias: Hello, folks. It’s 10:30 AM on the West Coast, it’s 1:30 PM on the East Coast. That means it’s time for Value: After Hours. If you want to listen to it live, go to the YouTube channel. Click the notification, it’ll let you know when we do it. If you want to hear it live, we get a couple of hundred people in commenting, it’s always a lot of fun.
Bill: 10, We get 10.
Jake: More than that.
Tobias: 10 people, with 20 proxies each.
Bill: I’ll tell you what, at 10:30, this is going to seem a little aggressive, but feeling European over here, folks.
Tobias: What do you got? It’s out of the picture.
Bill: Got a little Chardonnay.
Jake: It is after hours, I guess now.
Bill: Indeed, indeed.
Tobias: Are you celebrating something?
Bill: Just the fact that it’s afternoon and I put in a nice morning. So, I figured I’d have a little chard.
Tobias: [laughs] That’s great. What’s up, guys? It’s good. Everybody is–
Bill: It’s a bit of a belated celebration of us continuing to have a fan base. But I figured–
Tobias: Those are strong words, mate. Fan base is just like, people who slow down at a car accident, fans of the car accident.
Bill: That’s a true statement. Some are. Those are our real fans.
Tobias: All right, good to see everybody. And what are we talking about today, fellas? What’s your topic, Jake? I know that you have one.
Jake: Yeah, I’m giving a veggie session that’s probably closer to like that Thanksgiving green bean casserole that’s hardly any really vegetables. This will be a little more fun. But we’re going to talk about investing lessons from Puggy Pearson.
Tobias: What’s your plan, Bill?
Bill: I’m going to talk a little bit of aerospace value chain again. Also, really like Jake’s appearance on the investor’s podcast. I like that Fairfax Africa thing that you broke down. That was interesting.
Jake: Yeah, just see the crazy volume we had at stake?[crosstalk]
Bill: Yeah, and did you move the markets?
Jake: [laughs] No. Well, normally it trades about $200 a day worth of volume.
Bill: There you go. You did due diligence and threw 500 bucks in there?
Jake: Yeah, exactly.
Bill: Nice. Toby, what about you?
Tobias: Yeah, I’m going to talk about value in an inflationary world. I think that’s kind of what we’re confronting here. It’s just been a long time with that much inflation, and I think central banks everywhere are just swinging for the fences like it doesn’t matter. And I think that [unintelligible [00:02:36] even today, he said something, you just about can’t strike out. You can’t do enough. So, that always makes me a little bit nervous. I think that that central bankers in the past might have something to say about doing a little bit too much. So, we’ll see.
Bill: Nah, man, things are different these days.
Tobias: It is, we’ve solved that problem. We’ve reached a permanently high plateau.
Jake: [crosstalk] –trigger warning on that one, Toby.
Bill: I’ll tell you what, I think if the debate taught us anything, it’s that we’ve achieved a higher level as humans.
Tobias: I couldn’t watch it. I just watched the responses.
Bill: It was something. You want to start out, Toby?
Inflation And Value
Tobias: Yeah, I’ll take a shot at it. So, we’ve had this massive crash. We’ve been printing pretty hard, globally, the central banks, Bank of Japan, the European Central Bank, ECB, and the Fed and all the other little ones, the Aussie– Australia has a central bank, and they’re out there doing their best as well. In some, we’ve printed this gigantic amount of money, starting a long, long time ago. We really, really turned it up in about 2010. And we’ve really taken the– we’ve set them to 24-hour printing as of earlier this year, seems to be that at some stage if you print a whole lot of money that turns up. Apparently, you’re not allowed to say that inflation runs through asset prices, but I think that inflation has probably pretty clearly run through asset prices for the last decade or so.
I think it’s probably run through consumer prices as well. But I don’t think that’s been really well picked up by the CPI, which is always adjusted to reduce the amount of inflation that you see. And somehow, they get the benefit of when you get a better television, you hedonically adjust the better TV, better computer, better car, so on. I think we’re probably likely to see some inflation in the future. And that might be a mild understatement to say that we’re going to see some, we might see a lot.
Jake: What would a lot be, Toby, for you?
Tobias: Well, I mean, I think that we see something like a 70s style stagflation, where– interest rates are pinned pretty close to zero at the moment. And central banks can’t do anything about it. The reason that they’re pinned at zero is that government’s got way too much debt. The average consumer’s got way too much debt. The average company’s got way too much debt. If interest rates go up, none of us can afford it. So, interest rates are going to be pinned at zero for a long time. So, there’s no way to deal with any inflation if we get any. And then, on top of that, we’re printing a whole lot of money. The idea, I guess, was that you don’t see the asset price inflation. We’ve had this collapse. We’ve papered over the top of it. And we’ve got no way to deal with it because interest rates are going to be pinned at zero. It just seems to me that the only place where that can blow out in that system is through a whole lot of inflation. So then, what do you do in an inflationary environment?
This is kind of one of the really difficult topics to deal with because in an inflationary environment, low asset-light businesses should do better. So, Buffett talks about this quite a lot in his letters, where he said, “You don’t want a business that’s got a lot of heavy assets in it that need to be maintained and grown.” The only way that company can grow is by reinvesting in its assets and they do so at increasingly high prices. So, on an after-tax, after-inflation basis, it becomes extremely hard to make any money in this market.
There’s a theory going around, and I don’t know if it’s true or not, it’s something that I would like to believe, but that inflation will help value stocks, something to do with the duration trade where that nearer term cash flows become more important than the cash flows that further out. But then, I’ve also got to bear in mind, Buffett’s thinking about low asset intensity, businesses tending to do better well that can maintain pricing power, that’s very important.
In that scenario, it sounds to me like Buffett would favor more of a FANMAG-type portfolio, assuming that he can get the right price, rather than deeper value energy banks, heavy industrials type portfolio, but that sounds more like a value portfolio. So, I think it’s an extremely difficult time to be investing in this market. It looks like you want to be in the asset-light compounders, but then you’ve got to pay extremely high prices for the asset like compounders value, which is been left behind, looks pretty beaten up. But then, that might run really badly through a really high inflationary period. The only thing that I think justifies that is we’re already at that point where perhaps the market has seen that coming and so, the market, with none of us individually knowing that it was going to come, has sort of adjusted itself so that these asset-light compounders are overvalued or are expensive, because that’s where the returns have been and they can deal with inflation, and all the stuff that’s going to struggle with inflation is already very cheap.
In short, I’m confused, and I’m scared.
Jake: [chuckles] Well, if you weren’t confused, you wouldn’t know what’s going on. I agree. I mean, I think it’s incredibly difficult to untangle all these different moving pieces because there’s some where it seems like that would hurt, some where it would help. You don’t know the magnitude of the impact. Yeah, I mean, you raise– if rates go up at all, that seems one of those good outcomes for a value basket potentially for all the same reasons that you said. But, yeah, if it’s high capex, expensive capex, replacing capital to keep the cash flows coming, those businesses do relatively poorly.
Now, I’m not so sure, like– now about this pricing power idea. I think there’s more pricing power in the world when credit creation is on steroids because you’re just like, “Well, I’m just going to borrow the money.” But if you actually had to come up with the cash, you might be a little less willing to pay the vendor, you might drive a little harder bargain. Everyone’s looking to chisel a little bit harder on everyone else. Maybe there’s not as much pricing power out there, as everyone assumes.
How Inflation Swindles the Equity Investor
And if you haven’t already, I would suggest reading– Buffett has an article I believe from Fortune, that’s called How Inflation Swindles the Equity Investor. And it’s dense, it’s a little tough to get through because it’s– I don’t know, because he’s so damn smart. But it is chock full of all– it’s a master class on how to think about this. And I try to read it like once every six months or so, just to put it back into the memory banks and even still, that might not even be often enough. So, give that a read.
Tobias: Can you give us a quick– what’s the quick summary of what he says?
Jake: You would do that, wouldn’t you?
Bill: Don’t make us do the work.
Jake: He goes through how businesses are impacted, basically like what we were talking about, like depending on how much capital you need to add to the business to keep the future cash flows coming and how that changes based on it. And the different levers that a business has to pull to produce more. So, I’d be doing a disservice to try to– this is like, “Hey, summarize the Bible,” or something. Okay, thanks. Give it a read.
$NFLX And Pricing Power
Bill: I have no idea on this stuff at all. So, I have nothing to add, in Charlie’s words. The only thing that I was thinking about today is, I just think there’s so much consumer surplus out there and that low rates lead to that kind of incentive like it just really enables people to– I mean, like Netflix is, I guess, you make it up in scale, and I sort of get that, but what should that product really be priced at? Probably higher. I think when people can push out their time horizon that far, and just say, “Well, the cash flows on the backend,” lower discount rates seem to favor that kind of method of thinking.
Jake: Would you pay 2X for Netflix right now?
Bill: Well, now we’re getting into a different issue. Right?
Jake: Well, that’s pricing power, right? If today they said, it’s 30 bucks or whatever a month, would you keep it?
Bill: Well, I mean, I barely keep it where it is. But I guess that–
Jake: [laughs] So, where is all this consumer surplus you’re talking about?
Bill: Well, I think I guess it what it has done is it’s created a lot of pressure on legacy bundle producers. And they’re like– on a go-forward bases I think that ecosystem has got to unravel. So, maybe it’s one of these short the horses type things.
Tobias: Yeah, that’s where I’d get to. In that area, particularly, whatever that is video-on-demand or streaming video on the internet, or whatever it’s called, there are lots of options there. HBO, if you want the really high-end stuff. YouTube, if you want to just reach into the bargain bin, but there’s some good stuff in there, too. This podcast, obviously, is right up there, of the free stuff.
Bill: You can get it without ads, if you pay.
Tobias: It’s us and Game of Thrones.
Bill: Pretty much exactly what people flip between.
Tobias: I think Netflix is going to be fine. But I always look at that, that’s a lot of debt. And I’ve used all that debt to go and buy inventory that ages like food. If you watch any of those old shows– I get there’s some classics out there.
Bill: [crosstalk] You need to watch Cobra Kai.
Tobias: But that’s manufactured nostalgia, right? That’s for dogs like– [crosstalk]
Bill: That’s [crosstalk] nostalgia.
Tobias: But it’s manufactured in the sense that they’ve remade it for today. If it was real nostalgia, you’d be watching the original Karate Kid.
Bill: Well, now I’m going to, which– I then got to thinking how long should I make my kids wait to watch Cobra Kai. You should not be able to watch Karate Kid and then just go into Cobra Kai.
Jake: That’s got to bake for like a decade, probably.
Bill: That’s what I’m saying. I mean, a while at least. I don’t know. Maybe I’ll just mentally torture my children to accelerate the feeling of the time. I’m not sure. I’ve got to figure this one out. I admit, that’s not a fully baked thought.
Tobias: There’s a lot of consumer surplus out there are. A lot of it’s driven by our buddies on Sand Hill Road funding stuff like Uber. Thanks so much for the cheap taxi rides everywhere. That’s been great. And lots of other– [crosstalk] I’ll take more of those, not that they’re that much that useful to me at the moment. But assuming I ever leave the house again, that’d be something that’d be useful.
Bill: Did you guys ever have, what was it, Via out there? It was boundary restricted, but it was a car service. It started in Manhattan and you could get it from like the East Side to the West Side. And then, they came to Chicago. That service, the whole thing was, they wouldn’t drive directly to your doorstep. They would–
Jake: That’s called a bus.
Bill: No, no, it wasn’t. It was a black Tahoe. And you had to walk to the– it would only stay on the main roads. Well, I’ve got to ride in Chicago who’s probably– I don’t know, like 16 blocks and you had to say like, “Oh, I’ll pick somebody up,” but not enough people were in the service to ever pick anybody up. It was like a limo for 16 blocks for three bucks. It was crazy.
Jake: Pretty good.
Bill: I also have absolutely no loyalty to either of those apps. You just give me the cheapest ride. It’s a freaking car that’s coming and who cares.
Tobias: Let’s get back to Netflix and its pricing power. Isn’t that same thing? Are we talking about the same thing? What I do these days is I switch it off, and then the moment that a show comes that I want to see, I turn it back on again.
Bill: Yeah, I agree. But I guess that that’s almost like my version of consumer surplus. You just have so much choice and the capital markets are funding it, and I think that the low rates enable people to look through something through such a long duration lens that they almost– I don’t know how to separate my feeling of like, this price is irrational, from also saying, “Well, if you do get the scale of 3 billion users,” or whatever, it makes sense, I just don’t know–
Tobias: Modest the ambitions.
Bill: –how to separate those things. [crosstalk]
Tobias: The total addressable market is everybody who is alive, there’s 7 billion people on the market. That’s what we’re going after.
Bill: No, I know, it was it was a big exaggeration.
Tobias: I know, you’re joking. I’m joking too.
Bill: Hyperbolic, sir. I’ll have a little more wine, thank you very much. But I don’t know, I think that line of thinking is happening, until of course, the stock price goes down and then people worry about tomorrow and not 20 years from now.
Tobias: That’s it. It’s easy to raise money now and there’s this rush– because whenever there’s a boom on, there’s a rush to submit your footing in the market, which is why the only search engine that can succeed is the first search engine out of the gate, the 20th search engine out of the gate has no chance at all. No, that’s Google. That’s right, mate. They had a different approach.
Jake: No, wait a second, [crosstalk] I think.
Tobias: But there’s this– the booms create the urgency, and then the urgency spread a whole lot of money around and that has second-order effects too, it makes advertising base companies look a whole lot better than they might otherwise be in, and lots of other ways that we can’t measure. There is an enormous amount of consumer surplus, and that’s very, very good. Part of that’s delivered by the internet.
You get one homepage you’ve got to look after for each little product, rather than servicing lots of different– you don’t just set up a physical location. Lots of reasons why there’s more surplus for everybody in the chain. But it doesn’t eliminate competition. Anybody else can come along and compete with you. I realize that there are some that have some genuine competitive advantages, but I just wonder if at some stage, do we stop projecting these things off to these imaginary TAMs and just start looking at what they’re earning now. And so, you’ve got to put up or shut up, and that kind of happens when the market goes down.
Bill: Yeah, I was going to say when the stock stops going up.
Jake: Also, at what point– how do you think that all of these grow and don’t fight each other at some point? Like they’re all–
Bill: Well, they will.
Jake: –just in their own little ecosystems making all the money. Or no, is it going to leak into each other’s when competition shows up?
Bill: Well, this is the Greenblatt’s saying. Some of these names are going to be the names that you know for a fact 10 years from now, but they’re all priced as if they are– or many, I shouldn’t say all. So, you’re going to read about the survivors. And you’re going to read about the managers that pick the great ones, and you’re going to read about all the survivorship bias problems that make up books is what is going to be, but let’s just make sure that we remember all the people to get their faces crushed.
Tobias: That’s a lesson I’ve learned after The Big Short. When I first heard that, I was like, “Look at these geniuses out there.”
Bill: I’m aware of the event.
Being Right Once In A Row
Tobias: The book, look at these geniuses out there who figured out the fact that all of these things are happening. Of course, house prices can’t keep on going up, there’s all this leverage. And then since then, I’ve spoken to so many people who knew that, it was just common knowledge in the industry. And lots of guys had set up funds beforehand, they just bled to death because they get unlucky with the timing and then the guy who gets lucky with the timing and the idea, he becomes a household name. He’s right once in a row. Everybody else’s right no time in a row everybody– but you watch the guy who did really well, he hasn’t been able to replicate that. Paulson hasn’t been able to replicate it. It’s a tough game.
Bill: You’ve just got to be right once and be levered.
Tobias: That’s true.[chuckles]
Bill: Good point.
Jake: Yeah, that’s fair.
Tobias: What should we do? Do you want to eat some veggies?
Puggy Pearson’s Portfolio
Jake: All right, let’s do it. So, hat tip to my boy, Mike McCoy for, I think originally introducing me to Puggy Pearson. Here’s this guy born 1929, I think, Northern Tennessee, Hardscrabble. Nine siblings, dirt poor, gets a fifth-grade education, joins the Navy at 17, comes back, and eventually turns into one of the most successful gamblers ever. His first big win in 1971, he won the World Series of Poker, the seven-card stud event. 1973, he wins three World Series of Poker bracelets, including the main event, the Texas Hold’em, no limit. Also, not just a one-trick pony though. Top 10 pool player in the world, and also apparently took like $7,000 off a golf pro on the course gambling. He’s the original– I don’t know if you guys ever watched any of those shows about the guys who are like high-limit gamblers and–
Tobias: The prop betting.
Jake: Yeah. They’re actually probably more like degenerate gamblers. They bet on every single thing. You just hang out with their friends and be like, “I bet you $10,000 the next car that drives by is red.” “No way. All right, I’ll take it.” It’s all day for them, money just flowing back and forth. But this guy, he painted on the side of his RV, it said, “I’ll play any man from any land, any game he can name for any amount I can count, provided I like it.” He’s just going to take action if he thinks he is– I have three quotes for you from him. And we can sort of like work through these and think about what the implications are for us who pretend like we’re doing something more important than gambling. “Ain’t only three things to gambling, knowing the 60-40 end of a proposition, money management, and knowing yourself.”
Tobias: There you go.
Jake: So, in that, we have, bet when the odds are in your favor. We have position sizing, maybe a Kelly formula. And we have investor psychology and Graham’s observation about being our own worst enemy. All in one sentence from a guy who got a fifth-grade education.
Tobias: Universal laws of gambling, speculating, and investing.
Jake: I think that’s fair, right?
Tobias: And that sounds right to me. That’s what you’re trying to do as an investor.
Jake: Yeah, when you got the 60-40.
Tobias: You want to get the right odds on a position that you’re putting on. What’s the next one?
Jake: Money management.
Tobias: Yes. So, position sizing.
Jake: And then, knowing yourself.
Tobias: Yeah. That’s the hardest part.
Absolute Versus Relative Returns
Jake: So, the quote number two is even a little bit more elaboration on that last part. “The first thing a gambler has to do is make friends with himself. A lot of people go through the world thinking there’s somebody else.” So, in my mind, that’s like, “Alright, just own up that you’re either growth versus value, or absolute versus relative,” which I think is ignored a lot in this– I don’t know why, but absolute versus relative to me is even more ignored than most things.
Tobias: Let’s talk about that a little bit. What is absolute versus relative?
Jake: I think it’s somebody who wants to actually make a positive return on their investment over a long– [crosstalk]
Bill: [crosstalk] that’s a little harsh, sir.
Jake: –that time. The other one is more like, “I want to beat the market, over whatever time period.”
Bill: I think that’s harsh.
Jake: You think so?
Bill: Yeah, I do. I think absolute saying, I want 10% three years out, no matter what. And then relatively saying, if these two assets are trading at a certain price relative to each other, they’re in the same space and this one’s maybe a little bit growth here, but a little bit cheaper, so I’m going to buy this. That’s how I think of the two of them.
And then, I think you’ve got probably a blend is the answer where you have a sanity check, where you’re like, “Okay, maybe if I’m comping things at 50 or 60 times sales, it’s got a little bit out of control, and I should not quite be on absolute.” That said, if it’s really small, I understand small and expensive if you really think it can grow. [crosstalk] –expensive is a bad combo.
Tobias: Even an absolute investor has to be looking at the other opportunities. So, your opportunities might be, you sit in cash until you find something that gets over your hurdle. But you should be reducing your hurdle if the return that you’re getting on your cash is lower, shouldn’t you? Or is that a– [crosstalk]
Bill: [crosstalk] -you think. [crosstalk] Buffett does, I don’t think.
Jake: No, the way I think about it is that the first dollar in the portfolio is the easiest one to part with, and the last dollar in the portfolio has the highest hurdle to me. It’s a sliding scale that moves from low to high. So, as you get out–
Bill: Dude, I don’t want to be your first army soldiers. You’re sending them out there to die. “Yeah, we’re fine. We got more.”
Tobias: That’s what the pawns are for.
Bill: That’s right. Yeah.
Jake: It’s pawns versus protecting your queen later. You want your queen when the chips are really down.
Bill: That’s fair.
Tobias: I always find that relative absolute debate– I frankly don’t fully understand it because I think that even absolute investors must be looking at–
Bill: Yeah, I mean, so I was listening to the 7 Investing podcast that they were talking about, I think it was chips. And the guy that was being interviewed, he said, “There’s no more absolute valuation in this space. It’s mostly relative.” And I think his point was like– [crosstalk]
Tobias: Everything is expensive?
Bill: Yeah, that was my sense from him. And if you’re going to continue to buy, what you’re buying on now is more, okay, I’ve accepted that this space is rerated up within me accepting that. I think that this is a good bet, relative to the other bets that I could make. That’s how I interpreted his statement. But he also may be wrong, my interpretation of him may be wrong.
Tobias: You must be exposed to those businesses. You have to have some exposure.
Bill: I don’t know, dude, I think some people just want to own stuff that’s in a secular growth-type industry, and it’s easier to own and maybe it’s easier to sell the clients, and maybe don’t give a shit because you can keep assets and you can tell people you’re doing something intelligent.
Jake: Or maybe you have to keep up with some benchmark in order to keep those assets. And so, you’re more of a relative investor.
Tobias: Yeah. That’s fair., I’m just trying to work out–
Bill: Or maybe you believe it. I mean, that’s possible, too. Right?
Jake: You don’t have to.
Bill: Yeah, but you could.
Tobias: I mean, that might be true. I’m just trying to understand the basis for the rationale. That’s what I’m trying to understand. Are you like, “Yeah, it’s all expensive”? But because we got to do it, this is the one I’m going to do it because this is the least egregious or this is the best opportunity of the lot. Or is it somebody else is like, “All that stuff is now really, really expensive. I’ll get it later when it comes back to Earth if it’s a bit cheaper,” or not, because I don’t have to hold it.
Bill: I mean, my personal opinion of what’s going on, and I was happy to hear Modest Proposal say it as well, I think that people right now are willing to pay up for business certainty because it’s either easier to stomach emotionally or it’s easier to sell to their clients. I think that it has created an opportunity set in the market that if you’re willing to do the work and have the stomach to deal with some really shitty quotational indigestion in between and if you can truly be long term three to four years, I think that there’s some interesting swing trade opportunities out there.
Tobias: Swing trading?
Bill: Yeah, well, like an intermediate swing trade? I mean, that’s basically what– I’m going to talk about Spirit, that’s basically a swing trade. It’s not an asset I want to own for 20 years, but guess what? Everybody talks about 20 years, y’all are full of shit, your investment horizon’s like four to five years max or until March. I don’t want to hear 20 years. That’s fucking nonsense.
Tobias: Three to five is right.
Jake: Like 2020?
Bill: Yeah. “Oh, mine’s 20 years or until the shit hits the fan, then I’m out.” Okay, thanks, go back to Twitter.
Jake: All right, quote number three.
Jake: Bill’s going to be in rare form in like 15 minutes, so let’s– all right.
Tobias: Provoke him.
Bill: I think I just got provoked. That does really bother me though. All these ROIC discussions. Everybody’s “Oh, well, you can pay a ton, you just have to extend your time horizon.” Yeah, that’s cute in theory, dumbass. I watch people capitulate. That’s exactly what capitulation is. It’s people no longer believing when it was easy to say when your duration was forever. So, unless you’re one of the people that was buying in March, I don’t want to hear that shit out of you. It’s my personal opinion. More wine, and nice.
Jake: That’s fair. All right, back to Puggy. “I believe in logics, cut and dried, two and two ain’t nothing in this world but four. But them suckers always think it’s something different. I play percentages in everything.”
Tobias: Here we go. A quant or a value guy.
Jake: Quant? Fifth-grade education– [crosstalk]
Tobias: Fundamentalist rather than a quant.
Bill: I see somebody asking for life advice, you want life advice? Don’t ask us for life advice. Next.
Jake: That’s Puggy. [chuckles]
Bill: The thing about the odds and I had said it, I don’t know if I’d said it on the show or not. But for so long, I think I like really fucked up how I looked at the world by– I had this thing in my head, look down, not up. And really the thing that I should have told myself is think about the skew. It would have been a much more useful framework for my brain because I had turned off the ability to see the odds because I didn’t allow myself to get creative enough on the upside. It was a mistake.
Tobias: Do you think that–
Jake: That’s [crosstalk] in every bull market, though.
Tobias: Yeah, that’s what I was about to say.
Bill: I don’t know.
The Value Spread
Tobias: I think that you should be, you should invert your thinking right, you should be thinking about the risk at the very top of the market and you should be thinking about the opportunity at the very bottom. So, don’t write the obituaries for value at the tail end of a bull market. Wait until there’s a collapse. Don’t write your long think piece about why value is busted in a market that’s unfriendly to value. Wait until– this is just my advice to all the young guys out there writing those thick pieces after five years in the market. Have a look at what the opportunity looks like after you go through a full cycle. Then, think about it in those terms.
Bill: Dude, I was listening to our– I’ve been working on the store, folks, check the store out. I’m proud of how some of that turned out. But I was listening to some of our old episodes to come up with different sayings and maybe ideas for artwork. You guys were talking, I think it was like May 27th maybe, I don’t know, maybe I’m off, whatever. Anyway, you were breaking down how few of the opportunities there have been for value as a factor in the past. Sometimes when you guys get into this factor conversation, I sort of can’t follow in real-time or whatever. And I was thinking about it, I was like, “Man, that is crazy where we are and how wide the spread between quality or growth and value is.” Some of it makes sense. Some of it doesn’t make any sense.
Tobias: What do you say are the opportunities? You mean when the spread gets wide like this? What do you mean– like the parts, the periods of time when values sort of outperformed?
Bill: No. I mean, like when the spread is so wide. You were citing, you were down to like four other times that the spread had ever been as wide in the conversation that we were having. It’s just going back among some of the conversations and listening, I was like, “Oh, man,” I know I talk to you every single week but–
Jake: [crosstalk] 200-year study.
Tobias: Well, there’s a couple. On the data that we have, you can run a backtest back to 1963 for point in time data and you can see there’s about four or five opportunities through that period. And they’re all legendary bull market peaks, like they’re cyclical Shiller P/E monster peaks. There’s like 2000. And then, you got to go back to 60– there’s one in ’66, there might be one in between that I’m just forgetting about at the moment. But basically, the market– it’s hard. I have a little bit of trouble, sometimes it sounds like such a dumb idea to go and buy something that’s cheap on a ratio but it’s like I get that, it doesn’t sound like something that makes sense. It’s so easy for everybody to do it. But if you go back and look at it through history, it has worked really well on multiple occasions.
And at times when it didn’t work really well, looked like right now. The spread was really, really wide and then it had a really good run on the other side. I’m not advocating– Don’t go and buy something on a price to book value basis. I’m not saying that. I realize that there’s a big difference between the book value of a bank and a minor in a tech company. I’m not saying use price to book, it’s probably a useless metric. It doesn’t really make a lot of sense. But EV to cash flow, with a little bit of growth in there, you tell me that if I buy something cheaply on an EV to cash flow basis, that’s not going to work across enough opportunities? Come on. That’s going to work.
Jake: [laughs] Gauntlet thrown down!
Bill: No, and I think that’s probably true the bigger you get also because– operating leverage can start to work against you and you get some innovators dilemma bull– not bullshit but stuff. But on big basis of cash flow specifically, the multiple starts to matter much, much more than small basis because it’s harder to grow and shrink.
Tobias: Because they’re more stable.
Bill: Yeah, that’s right. So, low price, big basis are probably a decent place to fish. If you trust the capital allocation coming back– [crosstalk]
Big Opportunities In Small Value
Tobias: The only thing to say now, though, is that there’s clearly more undervaluation in small caps than there is in large caps. If you run that French data, you can see it’s all concentrated in the little stuff. Small value is the big opportunity at the moment. Big value is a second opportunity. And then, I don’t think there’s much else out there. Unless you’re like EM or something like that.
Bill: Have you not seen Qurate, bro? Come on. [crosstalk] Tobias: Well, that’s big value, mate, that’s in my screen. I’m not anti-Qurate. I’m pro-Qurate. I ain’t against it, I’m for it!
Jake: That’s not big, right? That’s more like mid-cap.
Bill: That’s true.
Tobias: What is it, $2 billion? How big is it?
Bill: 3.1 now. Hello! Not that I look.
Tobias: That’s somewhere between small and mid. It’s not a big company.
Bill: It’s approximately 3.3.
Tobias: I saw somebody the other day saying that they were looking for software-as-a-service opportunities. They had a market cap below $100 billion. Our definition of big and small has changed a lot recently.
Jake: That’s your asset inflation.
Jake: We found it!
Tobias: It’s all in the multiple too. I mean, there’s some– I get that, that’s not true. It’s not all in the multiple, but a lot of the gainers in the multiple, and that can reverse, so be careful.
Bill: Well, like fastly. I don’t even know what the– I think maybe it’s $600 million in sales, I don’t even know, it’s like a $9 billion company, $600 million may be way high. Don’t even listen to me for this. The point is, I don’t care if it’s $600 million, I don’t care if it’s $150 million, whatever it is, you can grow a lot off of that revenue base in theory as a software company. Some of these like big, big multiples on really small bases, I understand how people can get there. Big multiples on big bases make me much more uncomfortable. I’ve had a lot of people– Rick’s come into my feed from some of the people that I talk to.
Tobias: Rick? R-I-C-K?
Bill: Yeah, I think– [crosstalk]
Tobias: Good [crosstalk] on capital management.
Bill: Yeah. Then somebody blew up. I guess, how many inner family lending. I guess, he lent his girlfriend money out of the entity, he’s lent his brother out of the money out of the entity. One of my friends that likes it, he pitched it to me. He said, “For the industry, the guy’s good.” I was like, “Yeah, I’m just saying that’s a big qualifier, man.” But I don’t know, Bombshells, it’s not what I thought it would be. It’s a pretty interesting concept. So, I like Tilted Kilt if you’re from Chicago. I could see why it could do well in Texas. It’s like a new Hooters, but big. And everything is war themed.
Tobias: War themed?
Bill: Yeah, it’s Bombshells.
Tobias: Oh, I see, okay.
Bill: But it’s not a strip club. I thought it was a strip club, tt’s not. I wouldn’t call it family establishment, but it’s maybe somewhere that some people take their families, I don’t know.
Tobias: That must have been disappointing, mate.
Bill: Yeah, it wasn’t the deep dive I was expecting.
Tobias: Do you want to do your bit? Is there more Puggy Pearson?
Bill: I don’t really care if people want to hear it or not.
Jake: No, we’re good. We got enough out of Puggy.
Tobias: Sorry, Puggy.
Aerospace And $SPR
Bill: I’m back. I don’t know why I’m just messing around with some of the aerospace stuff again, because I can’t get it out of my head. I don’t know if it’s Spirit or Hexcel, I don’t know what the answer is, but Spirit Aerosystems to me is intriguing enough. I have like a small bet. But it’s not like meaningful, it’s mostly enough to get me interested. That’s an entity, I understand it’s not the best business in the world, I understand maybe Hexcel is a better business, according to my pea brain, the correlation’s 0.8, which means they’re about 80%, the same bet. It’s one of those that for the past five years has traded north of $7 billion and today is a $2 billion company, and they appear to have the liquidity to get through this thing.
That’s what I’m talking about, short-term swing trades. We went from, this is a super cycle that will never end, to travel is going to stop for a while. There are currently New York Times articles about people that are flying to nowhere. They are literally buying tickets in an airplane to get up to land in the same spot that they left.
Tobias: Because they all like the experience so much. There’s nothing like flying cattle class in a plane.
Bill: Yeah, it’s super bizarre, but I think it’s pretty hard to deny that. The fleets are going to be smaller, no doubt, but there’s going to be demand there. Europe is not very– they don’t love flights a whole lot. They don’t love the pollution. There’s a lot of pressure to upgrade the fleets. Ryanair is negotiating a big purchase, a 737 Max. This plane gets flying again, I can just see it being, eight years from now, people being like, “Wow, Spirit was a really good investment from that low base. Imagine that.” It’s like, yeah, that’s because that’s how this shit works. I don’t know what to tell you, folks. It got blown up by the 737 Max, then you had the pandemic. They’re able to implement some changes in their production lines that they otherwise couldn’t because production has stopped. So, maybe it comes out of this on the other side, just a little more efficient and more right sized and super tight from organizational structure. I don’t know, worked for Domino’s Pizza.
Tobias: Who’s there end customer? It’s all the airlines– [crosstalk]
Bill: You know what I mean? [crosstalk] –stocks. What?
Tobias: Spirit’s end customers are really airlines, right?
Bill: Well, I mean, that’s your end market. It’s Spirit Aerosystems, SPR is the ticker, not Spirit. The airline– [crosstalk] They make the fuselages and the wings and some nacelles for the airlines. It’s basically a derivative play on the Max.
Tobias: Well, it’s certainly a bombed-out sector, and it’s a bombed-out airline.
Bill: Yeah. Well, that’s the thing. Is it a mispriced security? Probably not. I don’t know how mispriced it is necessarily. There’s a huge dispersion of outcomes that’s going to be an overhang on the multiple. I think what I can confidently say is in five years, the uncertainty is going to be lower and the outlook is going to be better subject to another pandemic. And if you don’t think that that doesn’t result in a higher cash flow and a higher multiple on that cash flow, then you and I don’t speak the same language.
Tobias: Makes sense to me.
Bill: Probability of it losing money over the medium term is pretty low. Is it the best investment out there? I don’t know, [unintelligible [00:41:10]. No, I was not all in on Bed Bath & Beyond. Get out of here, fucking nonsense. I don’t know that I should say that out loud. McMurtrie did call it at the bottom, by the way. I don’t know if he did it publicly. But he wrote me, he’s like Bed Bath & Beyond is going to rip from here and he was right. So, credit where it’s due. But I did not play that train long shot. Thank you very much.
Tobias: Yeah, we talked about it on the podcast. He was buying a lot of bath bombs. No, McMurtrie and I talked about it. He was buying a lot of bath bombs at the time to– [crosstalk]
Bill: Just sitting there in a bubble bath.
Tobias: Every night, has a bubble bath.
Bill: With his Chardonnay. Here you go, Dan. Cheers. [chuckles]
Definition Of Value
Tobias: Let’s throw in some questions. I’ve got a good question here. What’s your definition of value?
Bill: I don’t know, dude. Buying something for less than it’s worth.
Jake: Whatever it is, it’s joined at the hip with growth.
Bill: I mean, look, what I like to buy is situations where I think that there is a lot of unwarranted pessimism and a stock that I can fathom a scenario where that pessimism disappears, and people get it turned into optimism. That’s what I like to buy. I tend not to buy stories that I think I have to be the most bullish guy in the room. I think that the probability of finding decent values in those stories is low and my personality is pretty freakin’ stodgy, so I’m not the guy that’s gonna be there. But, I mean, people that bought Zoom or whatever, in the beginning of this pandemic, that was actually good value. I would have laughed at it at the time, it wasn’t. They were right. The cash flow that it generated. I think that the opportunity set that the pandemic opened people’s minds up to, if you were early to see that, that can be your definition of value. It’s just not where I like to play.
Tobias: Hang on, Zoom was good value at the beginning of the pandemic?
Bill: Yeah, I think in March, you could argue that. My man, Kevin Zatloukal, he texted me and he was like, “Yo, there–” I even put it on the Twitter machine that their distribution was like Henry Schein like. They’re in all the classrooms, they’re going to blow up. That kind of insight can be a value insight, you’re buying something for less than you think it’s worth over the long term. It’s just not where I find what I play it.
Jake: Agreed. I think there can be longer-term-based value and shorter term, and when is the value realized? Sometimes, there’s value today and purely just the assets that you’re buying. What can I get it for? Can you get a bunch of shipping containers or something for cheaper than what the market price of those is? Or it can be the business value growing into what you think is a reasonable outcome and paying less for that and skating to that puck. And I think either one of those is perfectly valid. I think they have their times where one does better than the other. A lot of that has to do with how much do people value the future versus the present, as expressed by interest rates. But one is not necessarily better or different than the other, they’re just sort of different flavors of the same idea.
Bill: On TransDigm, when I bought that, people were calling me asking me liquidity questions on an entity that didn’t have a liquidity problem. I had a pretty high degree of confidence that that was value. Given that and the price action and what I knew about the entity and where it had traded and how it was trading, and the questions I was getting, I was like, “This feels like good value to me.” Here? Maybe. I don’t know, I’m not going to sell it. But it’s not my game to be more optimistic about how we come out on the back end of this recovery. It’s not what I find interesting about investments or where I think I actually have an edge. I think I feel more comfortable in carnage.
Jake: What’s your definition, Toby?
Tobias: Yeah, it’s pretty simple. There’s two components to value. I get that they’re joined at the hip, but there’s a yield and there’s a growth element. And you don’t have to be positive in both of them, you can be positive in one or the other to generate your return. To your point, though, being positive on the growth side of the equation has been a much better bet over the last 10 years. And being positive on the yield side of the equation has been a losing bet that’s gone backwards. So, I tend to be more conservative, I tend to be more on the yield side, but I don’t think that you can ignore– I want the business to be growing roughly inflation or better because I think that gets you out of a lot of the value trap type things that are just going backwards. It’s how you buy them at a discount and then you get your–
Jake: Time is your friend a little bit more than–
Tobias: You buy the ones that are going backwards, and they’re always cheap, and they’re always cheap all the way to zero. And that’s a disaster. I’ve played that game enough times in the past that I don’t really want to play it anymore in the future. What I like now is just I want cash flow coming in, some potential for reinvestment that will grow a little bit faster than inflation and reasonable yield, maybe a yield in the near term that’s sort of approaching the 10 year or something like that. That’s a very, very simple valuation method. And that will tend to be cheap on an enterprise, multiple acquirers, multiple bases, because they just tend to cluster down. I think if you pay more than 10 times on an enterprise multiple basis, you’ve got to have a really, really good view of how you’re going to get that money back. Historically, that’s been a bad bet.
It’s unsophisticated. It’s a particularly unsophisticated method of investment. But it’s simple for an idiot like me to understand and so that’s sort of what I try to do. If you’re talking about a reinvestment runway that requires very high returns on incremental capital for an extended period of time to justify the price that you’re paying for it now, you foresee it being so much bigger in the future. I have a lot of trouble getting comfortable with those types of valuations. There’s something inside me that– or maybe I’ve just seen them fall over enough times and not be realized, maybe it’s because I’m Australian, and there just aren’t that many of them in Australia. So, that’s sort of where I get to, at the more conservative end, and it’s been to my detriment.
Bill: But I also don’t think that you would sit there and say to somebody that’s making that pitch to you and saying it’s undervalued based on these assumptions. I think you might say to them, “I’m not comfortable making the same assumptions that you’re making. But if your assumption set is correct, I agree that’s value.”
Tobias: That’s true. I include that in my definition. The things that I don’t look at– if it’s purely a growth, if it’s purely a revenue growth basis and there’s not much margin, and there’s some of these around. I would have trouble with an Uber, for example. At some stage, that’s got to get profitable to justify it, and maybe they can learn and expand, and it becomes a monopoly, and then they can jam up their pricing, I can’t see, I can understand how that happens. How you value something like that? Impossible for me to know.
Bill: Yeah, I think you’ve got to build it up from the user base and then you got to think of the operating leverage. It requires a lot of exponential thought.
Tobias: And then, you got regulation on top of that.
Jake: You have to be right about unit economics that are a decade from now and it’s very, very difficult to know what unit economics are of supply and demand of something when there’s so much that can change.
Bill: Yeah, which I guess is why I don’t begrudge people that try to play that game. Personally, it’s not the game you’re going to find me playing.
Jake: Got to know yourself.
Dividends Versus Buy-Backs
Bill: The other thing sucks [crosstalk] about a lot of these– A lot of these long-duration names is, then they end up like, so you got this company, it’s got like these high returns on capital or whatever. And then it’s buying back its shares at a 3% free cash flow yield and it’s like, “What the fuck are you doing?” Just dividend it back to people. But then people like it because Buffett once upon a time said, “I like to own more of Coke.” But that proved to be horrible. I just don’t understand why people are so averse to the taxes that they favor buybacks at high multiples. It doesn’t make a whole lot of sense.
Honestly, if you’re in one of these great companies or whatever, and they weren’t buying back from, I don’t know– let’s not even ping them for March, like through April. If they weren’t been buying back in April and May–
Jake: Which they weren’t.
Bill: –it’s horseshit. And I got problems with– [crosstalk]
Tobias: Well, they had liquidity problem, some of them.
Bill: [crosstalk] he loves that stuff. [crosstalk] You can’t feed them enough shares under four.
Tobias: It’s a liquidity issue. This is the thing that annoyed me so much through 2008, 2009, that there were companies that were very, very cheap that went buying back stock for the reason that they had no liquidity. So, I try to remember that lesson this time around, try to avoid those things [crosstalk] liquidity.
Jake: That’s my problem with debt. The debt you’re taking, you’ve already basically cashed that chip in ahead of time and so you’ve limited your optionality of survival.
Bill: You’ve got to keep the liquidity on your balance sheet. You’ve got to manage that stuff. The problem with debt, at least from what I have seen, if you were reasonably levered on a cash flow basis, that usually doesn’t result in catastrophic problems. I think when you start to get stretched on a cash flow basis and you start getting into loan devalues, that’s when you start to get into a game where stuff can flip quick. Because then if your bid gets soft, all of a sudden, your LTV goes through the roof, and you don’t have the cash flows to support it and then banks start to get really nervous. That was a lot of the problem with the big housing crisis. It was not really income based. It was a whole bunch of value based and value is just as much as the next guy is going to pay, and that works until it doesn’t, especially when it’s leveraged so much.
Wonderful Companies At Wonderful Prices
Tobias: Not that Buffett is the only way of doing it. But I do like Buffett’s approach to investing where he says wonderful companies at fair prices. But what Buffett actually means is wonderful companies at wonderful prices, he’s trying to pick the eyes out of the market and then he’s waiting for the opportunity to bomb a whole lot of money into it. You see that with Apple. Yeah, Apple is a great company. But he didn’t buy it until it got really, really cheap. And then, he went bananas on it. I think that that’s part of his secret sauce, has been that he is buying these companies that are much, much better than everything else around in the cheap bucket. But he’s waiting until it gets in the cheap bucket. That’s a really hard thing to do. I don’t know how to do it other than buying a lot of the stuff in the cheap bucket and hoping that some of it works out.
Bill: You also have to swing. I mean, I know I keep saying.
Jake: We’re being absolute investor instead of a relative investor.
Tobias: Well, I’m not criticizing either. My question is about the definition a little bit. Even the absolute investors are relative investors, in my opinion because what are you looking at? You’re looking at the 10 year, you’ve got to put your money somewhere. If it’s sitting in cash, then–
Bill: You got opportunity cost somewhere.
Tobias: Yeah, you’ve got the opportunity cost.
Bill: Yeah, that’s fair.
Tobias: I think it’s a perfectly valid thing to say, “I’m only going to buy companies that have a sustainable return on invested capital higher than the S&P 500 average. And I’m going to pay a multiple at a market multiple or better.” Therefore, you’re buying better quality companies at below-average prices.
Jake: You should describe the magic formula.
Tobias: Well, it’s not quite, but I think that would be a perfectly valid– it probably falls at roughly the same way. But it’s a slightly different way of thinking about– or you can do the reverse. You say, “I’m going to buy companies that are much, much cheaper than average. And I’m going to try and get them at a roughly the same quality as average.” And I bet that works just as well. I think that all of those strategies work over time. How they go in any ten-year period, I don’t know.
Jake: Bill, what would you think about the– you said you don’t like to see a high return on capital business that then does share buybacks?
Bill: Well, like higher prices?
Jake: Yeah. At high prices. I think I would be in favor of them plowing more money in even if it lowers the return on capital down to something, I don’t know, like 10%, but a bigger than absolute value of– or bigger magnitude of cash flows because of that even though the return– the return on incremental capital is falling, but down to some level, rather than buying back expensive assets that they’ve already created, which is one way of looking at a share buyback.
Bill: Yeah, at the share buyback level, you’re not– Yeah, you’re buying it usually at a pretty high multiple to replacement cost. I just rather have special dividends. If I had my druthers, that’s what they do. They just give you the dividends.
Jake: Not if it’s a good management though. Don’t you want them to hang on to it and keeping for it?
Bill: There’s a lot of these companies don’t need that much money. I mean, no, I don’t want it to be in some glass box that you’re never going to see as a minority shareholder.
Jake: You’re talking about Buffett right now?
Bill: Sometimes, yeah. Whoever said that they think I think I’m smarter than Buffett, I don’t. I just think a lot of the people that ask them questions are idiots. That’s the difference. I think Buffett’s core thing is, think for yourself. And if you’re not thinking for yourself, you’re doing a disservice to what he teaches you. So, if you’re coming at me for thinking for myself, I’m going to come at you for how you’re thinking.
Tobias: And he’s got a bit of Chardonnay on board too.
Bill: That’s right. I will finish this off now.
Tobias: You can catch those fists.
Bill: That’s right.
Tobias: You’re limiting yourself to one glass a day, mate? that is a gigantic bucket. I could do a few laps in that one.
Bill: It’s not that big.
Black Swan Options
Tobias: I got a question. Do you think a 2% to 3% Black Swan option allocation is worth it at this point in the cycle? Lots in that question.
Bill: I don’t know.
Jake: I don’t really know what that’s priced at right now because it seems like you’d probably be paying a pretty healthy premium for that insurance at the moment, because it’s not exactly like, the cat is in the bag still, as far as–
Tobias: It’s a hard question.
Jake: Shit could be a little wild here coming up. Who knows?
Tobias: Yeah, that’s a really hard question for that reason that I think that it’s all expensive, but you might get a payoff on it, too. That’s a funny thing that Chris Cole used to say to me is that the best opportunities involved [unintelligible [00:56:19] a little bit elevated, that’s when you make a lot of money because usually like March aside, because that came off a very low VIX that when the vol is elevated, that’s the back end of the crash, like you’re in the late 2008 part of the crash rather than that Q4 2007 when we probably still didn’t even know that we’re in a crash at that point. And so, vol was elevated, but then vol went really crazy. I’m not saying that now is equivalent to Q4 2008. It’s nothing like it at all. We’re clearly at a new all-time high. So, that’s a very, very tough question to answer there.
Bill: There’s so much liquidity right now, too. I just don’t know how you get the really catastrophic downside without everything failing, and then good luck collecting on your Black Swan bet. Then, you got counterparty risk.
Jake: Probably not the two pennies that you’re putting in the pot for that. If you’re– [crosstalk]
Bill: Yeah. Honestly, I’d rather just like buy some gold because I just don’t see winning unless the whole system collapses and then I’d rather own gold.
Tobias: In your own personal safe or would you hold it in paper? Would you hold it like an ETF?
Bill: You got to have the physical, but then like I said, my beef with that is whoever’s stronger than me ends up owning it.
Tobias: Yeah. If you got the fizz, then you need to back it up.
Bill: [crosstalk] –guns.
Tobias: Yeah, that’s it. [chuckles] Any more questions, folks?
Bill: Looks like one of Mohnish’s 10 Commandments. There is no shorting. I only listen to Biggie Smalls’ 10 commandments. Thank you very much. [chuckles]
Tobias: Mohnish. Yeah, I believe in shorting. It’s a real thing. It helps portfolios.
Jake: He’s not Santa Claus. [laughs]
Bill: All right, well, I think we’re running out here.
Tobias: Thanks, folks. We’re going to call a little bit early today. That was fun.
Bill: Have a good one.
Tobias: If I can figure it out how to press the button. All right, guys, ciao.
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