VALUE: After Hours (S02 E42): Mauboussin And UFO Cults, Small And Micro Value And Thematic Investing

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In this episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle chat about:

  • Thematic Investing
  • Mauboussin And The Rise Of Intangibles
  • UFO Cults – When Prophecy Fails
  • David Gardner – Don’t Sell Stocks
  • Capital Cycle Theory For Software
  • Small Value Is Really Cheap
  • Buffett Caught The Perfect Wave
  • Software Replacing Banking
  • Tobias’ Crazy UFO Theory
  • Network Effects Are Not New $T AT&T
  • Buffett Actually Owned A Toll-Booth
  • Stoic Or Visionary Investing
  • $NFLX Cheap
  • Energy Reduced To A Rounding Error In The S&P500
  • Cold Fusion SPAC
  • Value Investing, Inflation, And Interest Rates
  • Zoom Phone

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

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Full Transcript

Bill: We live?

Tobias: We are live.

Bill: Is it Value: After Hours, Melt-Up Edition?

Tobias: It’s 10:30 AM on the West Coast, 1:30 PM on the East Coast. If you want to watch it live, you’ve got to go to The Acquirers Podcast YouTube channel. Click the notifications. Just in time for the Melt-Up Edition. What’s happening, fellas?

Bill: Inning two, the top of–

Jake: Well, that’s better than inning one, I guess.

Bill: What was the bottom, couple of strikeouts?

Tobias: When do we get that stimulus deal, then we’re really going to go bananas.

Bill: The stimi is going to be pretty dope.

Tobias: Do you reckon we’re getting a stimi before the election? [crosstalk] If I was the Dems, there’s just no way I’d be running stimi before the election.

Bill: Well, I don’t know, man. We’re about to get [crosstalk] us.

Tobias: Folks in the house.

Bill: Pelosi actually, she dropped her opening offer a long, long time ago. So, now I don’t know what she’ll do. It’s going to be great. Melt-up stimi is the best.

Tobias: Not that it makes any difference to the fundamentals. Throw the stone in the pond for a few days and watch the ripples and everything goes back to normal.

Bill: It changes the fundamentals some, it changes the consequences, right?

Tobias: Yeah, I don’t know. I haven’t seen the content.

Jake: It shifts the fundamentals–

Bill: That’s correct.

Jake: -between companies. It picks winners and losers is what it does.

Tobias: Oh, kids.

Bill: I just want to pick the ones I own.

Jake: Losers.

Bill: Yeah, that’s true.

Jake: We’re doing so much winning right now. We’re taking all the winning from the future and putting it into the day.

Tobias: That’s it.

Jake: [laughs]

Bill: We’ll see. Just make sure you win today. You don’t want to be left out now.

Tobias: Geez, don’t be a value investor in this market.

Bill: Melt-up. All right. Let’s get this thing going. Gentlemen, I am one of your hosts, Bill Brewster, along with my cohosts, Jake Taylor and Toby Carlisle. Jake and I are just living in Toby’s world but we’re fortunate to do it on a weekly basis.

Jake: I am paying rent.

Bill: I’m just not getting paid. I don’t have to pay rent– [crosstalk]

Tobias: I’m not getting paid either!


Bill: I don’t know. They say all these Google ads are sending you a bunch of money.

Tobias: Yeah, $100 a month.

Bill: So much! By the way, buy some merch. I know I need to get more out there. Anyway, Jake, what are you going to talk about today?

Jake: I have a little piece I’ve prepared that I’ve been calling UFOs and Michael Mauboussin’s new white paper.

Tobias: That’s cool. I’ve been watching a few– been reading a little bit around UFOs. This is definitely going to go deep on UFO conspiracy theories this time around.

Jake: Maybe.

Bill: Toby, what are you going to talk about today> other than UFOs?

Tobias: Yeah. Well, this is a similar sort of thing. Unidentified small and micro objects are closer than they appear. I don’t know. That’s terrible. Small and micro, silly cheap. Small and micro value, silly, silly, cheap. Something’s got to give.

Bill: It’s not the size that matters.

Tobias: What are you doing, Bill?

Bill: I’m going to talk about a little bit of where we are in the market. I’ve been thinking about a lot of things, some of thematic investing versus fundamental and whatnot. And I’ll start that off right after this. [fake intro] Also, where’s the chard? Not every day is a chardonnay day, folks. Sometimes, Diet Coke is my drink of choice.

Jake: With some rum.

Thematic Investing

Bill: So, I’ve been spending a lot of time thinking about some of what I perceive to have worked recently, what people missed. I guess that I think that we’re at a point in time– maybe Twitter is not the best place to have nuanced discussions. I will admit that, but it seems to me that some of the earlier thematic guys really thought–

Jake: What does that mean by the way, what’s thematic mean? Like Zoom, we’re having [crosstalk] therefore buy Zoom?

Bill: I’m going to getting there, bro. No.

Jake: Okay, sorry.

Bill: Dude, Geez! God! Your smart-aleck comments.

Jake: That wasn’t smart aleck. I actually don’t know what it means.

Bill: No. So, when I think of it, I think of it closer to like, this is a trend that is definitely coming and the rest of the world doesn’t recognize how big this trend is going to be. Therefore, if I’m earlier than many, recognizing the potential, I’m going to end up doing very well over time. It’s very, very similar to the rule breaker philosophy, at least how I’ve mentally chewed on it. The rubric of– [crosstalk]

Tobias: This is the [crosstalk] full one, right?

Bill: Yeah, that’s right. I think that there’s a lot of merit to that strategy. I think it’s actually very smart. I think this market has particularly rewarded a strategy like that. But I think that, generally speaking, if you marry that strategy with small on a market cap basis, I can really get down with that. And it’s somewhat VC in public markets. My aversion to that method right now is I think everyone is looking for a platform. So, I’m not sure how many unique insights like I’m actually going to have versus other people. And I think if you’re applying VC from a high valuation, the outcomes are probably less good than maybe backward-looking outcomes are.

But I think that people should listen to David Gardner and really chew on that philosophy. He did a podcast with Consuelo Mack. He did one with Patrick O’Shaughnessy. I think it’s something that’s interesting to contemplate. I didn’t expect yesterday to open up a YouTube to see Mohnish Pabrai discussing the merits of compounders and focusing on business quality. I think that is an interesting thing to happen at this stage of where we are in the market, I don’t even think he’s wrong. I don’t want to come off in that way.

I think that what is going on right now is there’s so much pressure to go into the compounders. I’ve heard– I have not watched the ARK Invest video, but I’ve heard that they’re just like dunking on value guys, and I think that they have a point. I also think value guys have a point, but it’s gotten to the point where the traditional value guys voices are mocked and that’s how rotations into different asset classes outperform and others lose. I think this is what– I don’t want to say like tops look like because I really do think we are about to approach the melt-up. But I think this is a really interesting time and there’s a lot of merit in the VC strategy and looking for young companies that are doing things differently at small valuations is a very rational strategy to me.

As far as Pabrai goes, I just think it’s really interesting because I never thought that I would hear the words come out of his mouth. So, yesterday, I just didn’t expect for him to go into compound town. But welcome. Welcome to the club. [unintelligible [00:07:52] been saying this forever, man.

Tobias: Let’s just leave Pabrai to the side for a moment, I will come back. I just want to ask a few things.

Bill: Please do.

Tobias: What you’re describing, is this some sort of top-down approach?

$NFLX Cheap

Bill: I think it is. Yeah, it’s got to be. I think where it works is companies that have entered industries and have approached it in a different way. So, I don’t know that it necessarily has to be top-down. For instance, Netflix in the media industry, is offensive to a lot of fundamental guys, because they’re looking at today’s cash flows. There’s a world where in 2026, Netflix has a ton of cash that it’s printing. You’ve got to believe some things, but I don’t think it’s patently silly to believe those things. I think you can have a debate about whether or not the assumptions are realistic. But I think that in the past, I would have been served better by looking at these crazy high valuations and thinking like what’s the bet the market’s actually making here rather than dismissing it?

Jake: How much debt does Netflix have in that scenario where they’re printing money in 2026?

Bill: It doesn’t matter, dude. I mean, if you get to–

Jake: [laughs]

Bill: Jake, it doesn’t matter. If you get to $70 billion in revenue, what do you think they’re actually going to spend on content? Like $30 billion? How much corporate overhead are they actually really going to have in a maintenance scenario, right? They’re no longer investing. The game today is use the accommodative capital markets to absolutely destroy all of the competition. If that works, dude, that’s going to be worth a fuck ton. That’s an actual technical amount that I did on the back of the envelope. Then, you end up with like an NVR, AutoZone, it could be a really interesting outcome. Once they start chewing themselves, it’s a lot of cash flow.

Jake: Everyone in your scenario died off though, right?

Bill: Yeah, you’re going to have a lot of distribution die. Yes.

Jake: I’m not sure that is a safe assumption.

Bill: Well, that’s fine. That’s the debatable assumption. As is churn, as is ARPU, I mean, I get it. Look, it’s easier at a $250 billion market cap to say this is crazy. If you were betting on it at 100 billion, makes a lot more sense. That’s where I think some of the VC mentality can make– like really thinking that long out. But I think when you marry that with Buffett-style concentration, I think you can really get yourself into some problems because your hit rate is probably going to be quite a bit lower. So, you’re playing with skew, I think, more than letting the right tail run.

Tobias: We’re using this top-down approach to identify– I like the idea of if you’ve got something out there that’s got a very high valuation, then they turn around and use that valuation to soak up a whole lot of assets. That’s a really smart move. We’ve all said previously on this, if I was Tesla, what I do is, I’d raise. Firstly, go and raise a whole lot of cash. Second, I’d gone by Fiat, Chrysler, or something like that. And then you’ve got all of your manufacturing, all that other stuff, just kind of distribution, all that stuff sorted out. But this is a slightly different thing here. What we’re talking about is identifying a theme, and then trying to figure out how that theme is going to play out over a decade or something like that. And then, we’re going to invest on the basis of where we see that theme going. And we’re going to kind of ignore the present fundamentals or the–

Jake: Present valuation.

Tobias: Fair enough. Present valuation. But the valuations still project out what you’re currently seeing 10 years in the future, but you’re saying something different from that. You’re saying, ignore the current financial statements of Netflix and think about it when it gets to a $70 billion run, right?

Bill: If you believe it can. If you don’t believe it can, then you’re not.

Tobias: What is it now?

Bill: I don’t know off the top my head. I just know that I had this conversation last night and we were talking about like– I think that’s what Rich Greenfield has baked into his forecast in 2026. Now, he’s the most bullish on the street and the street’s fairly bullish but I’m just saying–

Tobias: Is it 200 million subs get there? No, it’s– [crosstalk]

Bill: Yeah, I mean, I don’t know how he broke it down between ARPU and subs. But I guess what my real point is without having the data in front of me to have the conversation is, yes, I think that the game that people are somewhat either missing or choosing not to play, but I think choosing not to play is different than missing it, is thinking far out about what a terminal value could be. And being a terminal value investor rather than a cash flow investor, historically, I have had a real aversion to that. And I’m not sure that I want to adopt that strategy, because in my view, you really only have one way out. The nice thing about cash flows, it provides a couple of outs if things go wrong.

But look, I have gone at him about this before, I’m not trying to go with my hero, but Buffett should have bought Costco a long time ago. And I think he still could, I’m not really sure why he doesn’t. I think part of it is his assessment of the probabilities is quite a bit different and the style that he likes to invest in is quite a bit different. And that’s totally fine. He’s like the GOAT. So, that’s awesome, but I do think that there are other strategies that can work for people. I’ve been listening to David Gardner speak a little bit more and I think I understand what he does a lot more than I used to. And I don’t think it’s crazy.

Tobias: I think in some ways what you’re describing is the way that I understand. I spoke to Ian yesterday, he might– I don’t know if he’s on listening or not. In some ways, I think this is what the micro-cap guys are doing when they’re thinking like P/E or VC, more VC than P/E, where they’re looking at these companies. And they have an idea, they have the management team largely in place. And you’re just looking to see can these guys actually execute on this idea? Or, can they get what they’re proposing to do done and you judge it over? The short period of time that you have to look at them, and then you think, how big is the opportunity when they get the– I think it’s a very, very difficult thing to do. But it’s not unachievable. Lots of guys are out there doing it and doing it really well. But I just think folks underestimate how hard that is.

Bill: Well, what I’m saying is we’ve been in a market where I think that method of thinking has been rewarded.

Tobias: That’s true.

David Gardner – Don’t Sell Stocks

Bill: Probably more so than it should have. I think that there are more entities that have been rewarded with the story than warrant that rewarding, if that makes any sense. I also think that there are some that merit it. One of the things that Gardner says when he talks is, he’s like, “Look, my hit rates probably going to be somewhere between 40% and 60%.” I think he says 40%. But at the end of the day, if he bought Amazon at three bucks, and he still owns it, that can take– you can eliminate a lot of losses. So, then the question becomes, do you actually have the stomach to never sell? And that’s where I am not sure that people actually have the guts when– like Wells Fargo for a while was a never sell. Now, it’s a never own. If you own a stock– like Amazon at one point was a never own too. So, if you really think that you can never sell, then never sell. And David Gardner actually says like, “I don’t. I hold them until they are thrown out in the basket. I hold them longer than anyone.” That’s not easy.

Tobias: That’s the only way to sell, just like eliminate your ability to sell. You just not allowed to sell stuff. And if you’re wrong, it just becomes a smaller and smaller part of your portfolio, and you just have to ignore it. But that was one of the funny things about the story that Fisher tells at the beginning of my version of Common Stocks and Uncommon Profits, is that when he found his dad’s portfolio, he had hundreds or maybe even 1000 little names in the portfolio because he just buys a lot of things. And then if they work, then it takes over the portfolio. If it doesn’t work, then it diminishes to zero. But he’s not selling is the point. You know what I mean?

Bill: Yeah, you’re coffee canning basically. In the past, I have dismissed a little bit because of the church that I prayed to that approach. But I think that there’s a lot of merit in it, I just don’t think that I would be comfortable allocating like 10% of my capital to strategy like that, because 10 bets doesn’t seem like a sufficient number to catch a real wave to rise.

Tobias: How did Fisher size, does anybody know that? Anybody at home know how Fisher sized?

Bill: Same with Lynch, right? How did Lynch size because he had a lot of this stuff in his portfolio and then let it grow.

Tobias: Part of Lynch’s success is investing from ’77 to ’90.

Bill: Yeah.

Tobias: Good returns through there, but also very fair tailwinds for value guys through there.

Jake: For everyone.

Buffett Caught The Perfect Wave

Tobias: Buffett’s really run into– Buffett’s unlucky that he’s– I mean, he’s very lucky in the start of his career. He didn’t catch the Great Depression like Graham did. But then, he’s come out just on the closure of Graham-Newman. And he’s ridden it all the way basically until 2005 when we’ve had the first real value armageddon type event. And there are lots in that 200 years of Two Centuries data that Mikhail Samonov put together, but you can really see Buffett is– I’m not trying to take anything away from Buffett, but it does help to have a value tailwind at your back instead of a value headwind. And you can see him with a valley headwind. He’s a pretty ordinary investor with a value headwind.

Bill: Oh, how dare you go with the GOAT? Dang! On a value path!

Jake: Hate mail, send it to Toby.

Tobias: [laughs] It’s funny, the older I get, the more I want to be like Buffett. The more I think there’s a lot of– and just to disagree with– not because I disagree, this is what I think. The older I get, the list I want to take shots on things have the potential to go both ways. I think the older I get, the more I want to be– I have this preference for quality in the stuff that I bought. I want it to be really, really cheap. And the only way you get something that’s cheap enough is to go sort of down into deep value world where it’s not well picked over. But then, once you’re down there, you’ve got to find stuff that can survive, like you need a cash-rich balance sheet, you need some cash flows, you need management that’s buying back stock that’s cheap because that’s the only signal that they can send. I think that you can get that– that game is so much easier over the long run than trying to pick themes.

Bill: I guess. I think something that Jake said a long time ago that– or maybe not all that long ago, but when we were offline that made a lot of sense is, some of it too, is like what– there’s doing what’s optimal, and then there’s doing what’s optimal for your investors, and sometimes something that’s optimal for your investors is actually suboptimal in theory. And the reason that I bring that up is I agree with you in my PA about value. I know that this is people are going to dunk on me for it, but I actually think Qurate and Wells are not shitcos. And I actually think this skew and those, if you actually think long term, is pretty interesting if I’m right on those businesses. Now, I don’t know how you call up an investor that is investing with you and say, “Yes, I realize that Zoom and Teladoc and all this is up 3X, but boy, I really like Wells Fargo here, they’ve got some change under the hood.

Tobias: That’s the business. That’s what you do.

Bill: But it’s super hard.

Peter Lynch In The Streets, Warren Buffett In The Sheets

Tobias: So, what you’re saying is, you’re Peter Lynch in the streets, Warren Buffett in the sheets.

Bill: No. I don’t run the spray and let it run portfolio. That’s not what I do. But I see the merit in it more than I once did. That’s all that I’m saying.

Tobias: I’m teasing a little bit. But aren’t you saying that you’re more reckless– What you’re saying is you’d be more reckless with the public stuff and less reckless with your own stuff?

Bill: No, I think that there are– I think that if you look–

Tobias: Reckless is the wrong word. Sorry, I didn’t mean reckless, but I mean, more aggressive.

Jake: There’s exciting to own and then there’s scary to own.

Tobias: Yeah.

Bill: Yeah, I guess I don’t know that I would be more or less aggressive with either, I would just hope that the investor base that I had understood what I was trying to do. I don’t run outside capital. So, I’m fortunate to not deal with this. If I did, I think I’d need to have a long discussion about what the appropriate strategy would be for the assets in that portfolio because I don’t think that a lot of people would want my portfolio, which is fine. That’s why I think it’s going to work.

Tobias: But that’s value isn’t it? You’re always buying– The reason I wrote Deep Value is because people will look at the portfolio and say– fair enough, it’s been a shit run, but people will look at it and say, “This is scary stuff to own.” I’m like, “That’s the point. You’ve got to buy the scary stuff.” But that’s not been the case.

Stoic Or Visionary Investing

Jake: The question I would ask myself is, is it easier to see the future 10 years from now and skate to that puck? Or is it easier to control my emotions now and buy that scary portfolio. Neither one is going to be easy, but which one do I feel like I am particularly wired to handle? For me, personally, it’s a little bit more of the stoic than the visionary.

Bill: Yeah, that’s fair. I think that makes a lot of sense. My personal market prediction, even though I think we’re in inning two with the melt-up, is I think some things have already melted up. And I think it’s going to be interesting to watch some of these shareholders that I perceive to have already benefited from some of what’s about to come, I think it’s going to be interesting to see how long they own those businesses if the stocks go nowhere for a little bit. It would be interesting to watch. And maybe I’m wrong. Maybe all these stocks become trillion-dollar companies, and it’s fucking awesome. In which case, please buy me some good champagne, because you’d be super-rich.

Tobias: I have no idea what’s going to happen.

Bill: I’ll be sitting here drinking that cheap chard.

Tobias: I’ve just had the fuse burned– [crosstalk].

Jake: Yeah. What’s the [crosstalk] cost in that world?

Tobias: I can’t tell anymore. I’ve got no idea. Nothing would surprise me at this point, up 50% or down 50%. It’s just both are equally likely, in my opinion.

Bill: I was looking at my portfolio. I mean, obviously, I have endowment bias on it, but I don’t think there’s that much stuff that’s crazy. I think stuff’s got a long way to run.

Tobias: But the criticism would be, don’t hold bank because banks are–

Bill: Well, by the way, I tax law sold that bitch.

Tobias: You punched out of Wells Fargo?

Bill: Yeah, well, for 30 days. You give me a scenario where people buy that in the next 30 days, and I’ll be pretty shocked. I’m not trying to pay taxes. All my idols avoid taxes.

Tobias: Fair enough. Not advocating for or against it at all. I don’t know. I don’t want to get in trouble.

Bill: I’m not going– I don’t know– [crosstalk]

Tobias: Not investment advice or tax advice.

Bill: Yeah, well, the idea of not tax law selling is sort of silly, in my opinion, especially given the earnings call that they just dropped. I do not think they’re going to catch up in the next 30 days. And if I’m wrong on that, I’m wrong on that.

Jake: Yeah, get a little wash roll, get back in there.

Bill: That’s right.

Tobias: What is the wash roll? 31, okay.

Bill: There’s some other entities that could provide similar exposure. I do still like this [unintelligible [00:24:49] Wells.

Tobias: The only wrinkle to that is, in 2016, the market started rocketing on the first day before the election. A lot of folks think that it started on the Tuesday, the day of the–

Bill: I’m started laughing because I think you think if the market rockets, Wells going to rocket?

Tobias: I don’t know, run. It was value more than anything.

Bill: [crosstalk] Wells isn’t even value. Wells is unownable.

Tobias: That’s deep value.

Bill: I know.

Tobias: The island of broken toys. Should we do JT’s?

Bill: It was not the earnings call they needed, at least not to get people hyped up.

Jake: No.

Bill: I think it was a good one, by the way, but you know– [crosstalk]

Tobias: Just an arc very quickly. I’d be careful if I was– it’s just not my personality. I wouldn’t be doing a victory lap if I’d had a really good long run. I’m too scared of the market gods just leaning down and smiting me for my hubris.

Bill: I see. Greg says, “I’m pushing Wells to dump it.” Nah, that’s not what happened.

Tobias: Pumping it?

Jake: Yeah, I mean, I thought that video was pretty funny.

Tobias: Yeah, it was good.

Jake: I mean it was good, but I agree. You are absolutely tempting the gods there. Just tip your cap that you’ve had a good run.

Tobias: Spectacular run. To give a credit, the returns are redonkulous. It’s like 75% this year on $6 or $8 billion AUM. Incredible.

Bill: Yeah, that is a hell of a year.

Tobias: And a very long run.

Jake: Yeah, they went from $1 billion to $10 billion like a year.

Tobias: Yeah. They’ve done 36% compound for the last five years or something. I think that was in that article. Those numbers might be wrong. But something like that was pretty very impressive.

Bill: As a quick tangent, back to Wells real quick. One thing I think is funny is everybody’s like, “Oh, you’ve got to think long. You’ve got to think long. You’ve got to think long.” The whole reason I like Wells is like five years out from here, I think it’s going to be in a lot better shape than it is today and everybody’s like, “You’re a fucking idiot for owning Wells now.” I’m like, “I get what it looks like right now.” You’ve got to be a moron not to see what it looks like right now. But it’s an entity that I don’t think people are thinking long on, or I’m just completely wrong, which is very possible, because Buffett doesn’t like it and he’s smart in financials. He’s not smart, he’s a genius.

Tobias: Is it not him liking it or is him trying to send a little message about can’t do anything where there is any kind of ethical misbehavior? Maybe Solomon, I don’t know, kind of–

Bill: Yeah, I don’t know. Buff Dog, hit me up. I’ll always take your call.

Tobias: Hit him in the DMs.

Bill: Yeah, that’s right. Slide in, dude, I’m always on Twitter. Well, actually, less so now. But whatever.

Tobias: Sorry, JT. Let’s get the veggies in.

Mauboussin And The Rise Of Intangibles

Jake: All right. Well, Mauboussin has this white paper that came out, it’s probably a month ago now, I don’t know. I was a little slow to getting to it, finally. But it’s called One Job: Expectations and the Role of Intangible Investments. If you’ve read a few other books like Capitalism Without Capital and The End of Accounting, they talked about this, and how intangibles have changed really the accounting treatment. How accurate is accounting compared to reality? And so, these intangible investments are– [crosstalk]

Tobias: What’s the issue? You have to expense your IP rather than capitalizing it.

Jake: Correct.

Tobias: And depreciating it over time. Okay.

Jake: Right. So, it ends up showing up in investment in intangibles, ends up showing up as an expense in your SG&A, and it doesn’t show up on your balance sheet then. So, what really the problem is, is it makes historical comparisons very difficult. And really, there’s sort of like five things that are impacted. So, earnings end up being understated when there’s heavy intangible investment because all of the expense is showing up in year one. Book value ends up being understated because it’s not being capitalized on the balance sheet. The invested capital then ends up being understated, which means that return on invested capital is overstated. The actual how you produce cash flow and returns looks like it’s on a smaller base. And then, the important thing too, is that that he free cash flow doesn’t end up changing. So, if this is really an accounting thing and therefore a lot of academic impact on– if you just go look at price to book or something. But it has made a pretty material impact. 1977, tangible investments were 1.7 times intangible. And then 40 years later, intangibles are 1.4 times as much as tangible. So, it’s definitely shifted quite a bit. It’s material.

So, the adjustment that they that some have made to try to clean this up a bit is to amortize R&D over a six-year period. So, we’re just going to straight-line depreciate R&D over six years rather than recognizing it upfront in SG&A. And then, taking some of the expenses that are involved there, especially in software with sales, marketing, general, and administrative and doing it over a two-year period instead of just one year. An accounting professor did a study of this, and by reclassifying some of these intangibles, it ended up actually shifting 40% to 60% of stocks from a value or glamour bucket. You do change the composition of what value or glamour would look like if you change some of these things.

Tobias: If you’re using price to book as your metric?

Jake: Yeah, but even P/E can be changed too if that’s what you’re using because earnings are clouded by too much expense being recognized in year one. So, they do a little theoretical example of Microsoft and walk through that. And it ends up being that NOPAT, which is net operating profit after taxes, ends up being bumped up by about 15%. And then, the invested capital ends up actually going up by 70%. So, return on invested capital drops then in Microsoft from 52% down to 33%. But by the way, 52%, on that big of a capital basis is frickin’ astounding, right?

Tobias: Ridiculous. Yeah.

Jake: Yeah. Anyway. Another thing that they point out is that stock-based compensation, which we’ve talked about this already a little bit on the show, but it ends up being 15% to 20% of cash flow from operations and for the S&P 500 tech sector, and the smaller the business, the worse that that stock-based compensation impact is.

Tobias: So, does that balance it out? Because you said that there’s a– you’ve got a gross up their earnings a little bit for the impact of R&D, SG&A, and then that’s about 15%? And so then instead of running that portion of compensation through the income statement, they just run it outside that and so that kind of balances it out, roughly, 15% comes.

Jake: I don’t know if that– that 15% that I cited earlier on NOPAT was just Microsoft specific. So, I’m not sure what the adjustment is across the entire tire bundle there. Another–

Tobias: Are you guys getting a phone call?

Jake: Bill is. I don’t know– come on, man.

Bill: Oh, dude, you know what happened? I’m having technical difficulties. That’s why we switched, it came back, my audio–

Network Effects Are Not New $T AT&T

Jake: All right, we’re just going to keep going and pretending that you’re on top of it. One of the funny points in the white paper was that he’s talking about how 1908, AT&T’s annual report is talking about network effects and how having multiple phone lines creates a big difference in the value creation. So, everyone who thinks that they’re onto some new idea with network effects and that you’re a genius for discovering it, it’s been around a long time, let’s just say.

Tobias: Well, 1904 was the last bottom of the big value drawdown, that was 59% bottom then, we’re at 59% in May. I don’t know exactly where we are now, but probably fractionally worse. Network effects is the cause of value underperformance.

Jake: That’s what it is. It’s come back again.

Tobias: Damn!

UFO Cults – When Prophecy Fails

Jake: One of the things I was thinking about– well, let’s talk about the UFO part of it, and this ties back in a little bit too to Bill. So, this guy named Leon Festinger, I think that’s how he says it. He studied cult members, and they had these– people were waiting for this UFO to come. And they had a date, and the date ends up coming and then passing. Obviously, they didn’t get picked up by the UFO and taken anywhere. He studied these people and interviewed a bunch of them. And this is actually where the work on cognitive dissonance came from. He found that people would claim that the event still happened, but that we just couldn’t figure out– we just can’t see that it happened. It becomes a non-falsifiable hypothesis.

What they say is that oftentimes what happens is that there’s a shift to more sophisticated and nebulous models when someone who is personally and ideologically committed to a theoretical approach is clearly failing. So, what happens is if whatever you’re doing is clearly failing, you look for– it becomes more sophisticated, it becomes more nebulous. We start blaming intangibles, we start blaming information arbitrage, we start blaming the Fed. There’s a million reasons why you start looking for why, whatever it is, isn’t working anymore.

Tobias: It just reminded me of– there is a study, and I don’t know if I stuck it in one of the books or not, but I read it. I think I have talked about it before where they get two people, and they put them in front of slides of cells, and they have a button where they can indicate whether they think the cell is healthy or unhealthy, or they’ve got some pathology. And the wrinkle is that one person is getting real feedback and the other person is getting feedback that is based on the first person’s feedback. But basically, it’s randomized. They don’t know if they’re getting their own determination of whether something is sick or pathological, doesn’t yield them any useful information. Their responses don’t give them any useful information.

So, what ends up happening is the person who gets the concrete feedback, gets the accurate feedback, they start getting reasonably good with no pre-training, they start getting reasonably good at telling difference between sick cells and healthy cells. And they come up with these pretty simple concrete rules for what makes something sick and what makes something healthy. On the other hand, the person who gets the scrambled feedback, they start coming up with these increasingly elaborate theories for what is going on in the cells. And they get to the end, they’ve basically got this very elaborate nonsense theory for what is driving the difference between healthy and sick cells just because their feedback is terrible. So, if you get good concrete feedback in, you get good concrete rules. If you get bad feedback, you get amorphous rules. Same phenomenon, I guess.

Jake: Yeah, I love it. It makes perfect sense. [chuckles] So, maybe the feedback mechanism has not been particularly good lately and we’ve got to come up with a bunch of reasons why. And I get like, obviously, the world has changed between tangible and intangible, it’s undeniable. I guess part of the problem is some of the rigidness of academic versions and definitions of value, which I think all three of us maybe don’t particularly subscribe to.

Tobias: The reason they make it rigid, though, so it makes it testable. You have to be able to have a concrete– and then you have to make a lot of simplifying assumptions and so on. I think that I understand why they do what they do. I understand why there’s criticism of what they do. But I don’t think I could come up with a better way of doing it.

Capital Cycle Theory For Software

Jake: Yeah. So, the last thing I want to talk about, and this is just sort of more throwing it out there free form, but do you think that there’s anything to the idea of like a capital cycle theory, but for software? And different time periods maybe will have– like spending the money will produce more value, versus other times, or whether you’re just plowing a bunch of money into an idea of what a software can do. I think about– I had this friend who was a very early programmer at Microsoft and he said that you have to realize that software back then was so much better than any previous way of doing what you were doing. So, something like Lotus 1-2-3 replacing– or Excel a little bit after that, or a word processor, or Windows itself, or Netscape Navigator, all these things, because they were so new and they replaced something that was just so bad before, the value creation of them was monstrous. So, you were early spender in that environment, but if you’re a late spender, maybe a capital cycle theory, diminishing returns to the job to be done by the spend of that software dollar. Are we may be thinking that these things are more valuable than they are because of that and they’re plowing so much money in here? Just like we would say if you were spending a ton of money in 2007 in oil, peak oil time to bring it on, maybe there’s not going to be as much yield for you later, we’re going to have too much supply of that.

Bill: I was talking with somebody about Twilio today. He was saying that it’s fully embedded in his code now. I don’t know how many tangential opportunities they can create, but I think that’s what a lot of SAS investors would argue as going on today is that they’re laying the next iteration of the internet’s infrastructure and if you have that opportunity, you go out and spend and you get it. And I think some of these businesses are going to be around for a really long time, and they probably are the next utility. I just don’t know which ones. If I did, I wouldn’t be here.

Jake: [laughs]

Tobias: Yes, you would.

Bill: I certainly wouldn’t be messing around with Wells Fargo.

Jake: On a shitty value podcast.

Bill: No, I like the podcast. I have fun here. But I wouldn’t be fucking around in banks and stuff occasionally.

Tobias: It’s hard to know. I think that there’s reasonably good arguments for having a portfolio that looks something like the economy. There’s still a lot of money going through banks. You need a little bit of exposure to that.

Bill: Yeah, I don’t know if you do or not. I like it.

Software Replacing Banking

Tobias: How is software going to get rid of a bank? That’s probably the comment that’ll just get replayed to me for the rest of my life.

Bill: Well, yeah, I don’t know that they’re going to. I’m not fumbling. Shut up, Greg. Anyway, I don’t think that software is going to eat a bank. I think a lot of fintech is going to help banks get more efficient. My entire thesis on big banks has always been that the small banks are going to get absolutely strangled by regulation and now low interest rates.

Tobias: Small banks, yeah. Fair enough.

Bill: Yeah, I might be wrong. I like the big banks in general, because I don’t know how if you’re subscale, you’re going to make it through this. Unless you’re taking shitty credit risk to earn a little bit higher spread, and that game doesn’t end well. One of the questions that I have is, a lot of these fintech startups seem to have partner banks. Those partner banks, I believe, tend to be located in rural areas, because it’s somewhat harder for them to attract assets anyway, so there’s more incentive to go out and partner with these fintech. What the hell are they doing with the deposits? What are those banks doing? Are they just like some skeleton crew that’s buying mortgage-backed paper and then, they’re basically Charles Schwab? I don’t know.

I’d like to know why are those banks making the deal that they’re making, but this is what I posted on Twitter. I was like, “Can we stop arguing that fintech is going to take deposits because all of the big banks have grown deposits over the last six years.” And that’s when FinTech’s exploded. I know it’s a nice feeling to have that it’s happening, but the data actually doesn’t support it. And if you think the FDIC is lying, then please show me that argument.

Tobias: Two quick things. I just want to go back to– when you were talking before about the increasingly amorphous rules for the term– just maybe thinking of that. Remember AQR, in one of Cliff Asness’s pieces, AQR talks about this little study? I don’t know if his blog post or if it was the paper, but they talked about a little study that they did. You assume that you had next year’s forward earnings, and then you make a valuation on that basis. And they just found that ’99 and 2000 had the lowest– had an inverse relationship between forward fundamentals. The reason that they do it, they acknowledge that it is cheating. The idea is that you’re feeding the system knowledge that– you’re giving it an advantage so you can see how close the relationship is between the returns and the fundamental data. That’s the whole point of doing it.

Most of the time, if you have the forward earnings projection from a year, you do really well because you know what’s winning and what’s not, so that makes total sense. But in ’99 and 2000, it didn’t help at all. In 2019 and 2020, it didn’t help at all either, it was reversed. I just wonder if it’s one of those another example of that amorphous feedback making us all come up with crazy theories for what’s going on. And I want to get some UFO talk in.


Tobias’ Crazy UFO Theory

Tobias: Who wants to hear my crazy UFO theory?

Bill: I’m in. Does it end in small value is undervalued?


Tobias: It does now. This is the way it goes. We don’t know if aliens are from another planet– we don’t know we’re seeing aliens from another planet. They’ve released the footage online of that naval aviator seeing a UFO that disappears out of his radar range really quickly, and they released that just to see how everybody reacts to it. There’s no great reaction from the public. So, they go to the next stage, which is you get the pilot interviewed on Joe Rogan’s podcast, which is like a fringe podcast. And you can say, after that comes out– you just wait and see, like, how do people react to that. If they react really positively to it, then you say– then you don’t disavow. If they come out and everybody’s starts panicking, then you say, “Well, this guy is disavowed, and that’s a fringe podcast, so don’t worry about it.” And then, nobody reacted badly to that. So, then they had this New York Times write up a piece about all of the discoveries that people have made.

They got some guy from Aerospace Corporation to talk about, they have some method for retrieving stuff from off-world craft that’s the kind of words that they use. All the pull quotes in that New York Times article are really make you think that we’ve found aliens and we’re pulling stuff out of the craft. But if you actually then go in and read it, there’s nothing like that in there at all. It’s a really anodyne kind of article. I just wonder if we’re being just softened up a little bit for when they come out and they say at the end of 2020, when everybody’s so exhausted from all the stuff that’s going on, yeah, we found aliens. And it’s like the 10th most interesting thing that happens in 2020. And then everybody– now we all know, and we can all get on with our lives. That’s my theory.

Bill: And the aliens are shorting value, those fox– and they’re buying growth.

Tobias: When aliens come out, that’s the signal of value runs.

Jake: They could see 10 years into the future. They’re thematic investors.

Bill: That’s right, bro. They’ve already mined gold in space, so they already get the proposition.

Tobias: And gold’s a [unintelligible [00:47:05] if that’s the case.

Bill: No doubt. That would suck, that would really suck for all the people that are like run into gold as a safe haven against the dollar if we just start mining a shit ton from space. That would be funny. I would feel bad for you for losing a lot. But I would laugh also.

Tobias: What works in that scenario, the mining company?

Bill: I don’t know.

Tobias: We don’t really do anything with gold. So, it doesn’t really make much of an impact on the economy, right? It’s literally just the–

Bill: Some of these options package is what works in that scenario, and it’s not going to be mine.

Tobias: So, there’s going to be some SPAC is going to absolutely crush it.

Bill: The interesting thing about Mauboussin’s white paper that I don’t think he touched on and if he did, I didn’t hear it, but was when he talked about stock-based comp, I think he said this, if he didn’t say it, I’ll say it. You should assign some sort of cost of capital and then embed that in the interest expense. So, your implied cost of capital is maybe lower than reality because of dilution. Now, I think some people just say, “Well, I’m just going to be diluted,” or whatever. But I think to be theoretically correct, the employees are lending equity to the company, so what is their cost of capital for that? I thought that was an interesting– I haven’t gotten to that place on my own. But when I read it, I was like, “Oh, that’s freakin’ obvious.” But when you’re trading it 50 times gross profit, what’s your cost to capital? It’s all funny money, anyway.

Small Value Is Really Cheap

Tobias: Throw your questions in, folks. We will have a shot at them. The only thing I was going to say is that small value is really cheap, but I think that that’s only a little bit more believable than we already know about aliens. So, hit us up. I do think that small values are very cheap, though. I think that you don’t need a multiple rerating for valuable work at the moment. Small value to work, that’s the thing– I think it’s now so squashed that there’s enough yield and underlying growth that even if the multiples stay the same, it’s still outperforms. This is assuming that multiples don’t continue to get squashed, which is entirely possible, but at that point, I don’t really care because the underlying growth should outperform.

Jake: You say you don’t care.

Energy Reduced To A Rounding Error In The S&P500

Tobias: But I can hold now, so there’s no urgency. I mean I care I guess, but it’s that the stoic line where– I think it’s Aurelius who says, “Can you endure?” “And if you, then can shut up,” basically. That’s where I’m at. I can endure it, so shut up. Here’s a good question. Energy looks risky with pipelines are historically cheap. Would this be an area you’d invest in? Bill?

Bill: Yeah, if I hated myself, which I do, so I might.


Bill: Sometimes, when I feel life is going too well, I look at energy and I think like, “Maybe I just need to punch myself in the face.”

Tobias: It’s a rounding error in the S&P 500 now. It’s crazy how small it’s gotten.

Jake: God, do you remember when Exxon was the biggest company in the world? It wasn’t that long ago.

Tobias: Right. I think it’s in the last 10 years, wasn’t it?

Jake: I think so.

Bill: I’ve mentioned before, I think Kyler Hasson, he’s the guy that’s written the most about it, as a generalist. I think Enterprise Products and Magellan Midstream are interesting. I don’t know enough about how you can get really screwed within the corporate structure, but they’re pipelines. And from what I understand those assets are really freaking good. And I do not think hydrocarbons are going away anytime soon. So, do your own due diligence. And I might sell it for a tax loss, so don’t cry if I do. I don’t own it right now. But I might buy it just to lose money just to sell it.

Jake: Well, I would say that there’s– this has kind of been true for a while already. So, there’s been a fair amount of value guy blood spilled on that sword. So, who knows–

Tobias: Including mine.

Jake: –when it will start working again. But I agree, it’s hard to imagine that the world is off of hydrocarbons as a thing. I don’t care how ESG untouchable they become.

Tobias: When do we get some fusion? When do we get cold fusion? How far away is that?

Jake: It’s always 10 years away.

Cold Fusion SPAC

Tobias: I can’t believe that there’s no Tesla out there working on cold fusion, that’s just an obvious–There’s a billion-dollar business–

Jake: SPAC! let’s do it.

Tobias: SPAC. Yeah. You don’t have to actually do it. That’s the thing that– you just have to say you’re working on it.

Bill: The Golden Age of Selling Dreams, that’s where we’re at.

Tobias: [crosstalk] all the time.

Jake: Pre-revenue.

Tobias: Pre-revenue, we’re pre-technology. That’s what we’re working on. Cold fusion.

Jake: We’re pre-reality.


Tobias: That’s what Nicola was, they’re pre-technology.

Jake: We’re pre all the hard work of actually making us– [laughs]

Tobias: Trevor Milton’s got a $35 million ranch in Utah. That’s real.

Bill: Yeah.

Jake: Damn it.

Tobias: So, I’m just announcing right now that I’ve got a startup, it’s going to be cold fusion. I haven’t thought of a name yet, but it’s going to be– if Nikola Tesla has a middle name, that’s what it’s going to be called.

Bill: Is our ticker going to be FU?

Tobias: The ticker is going to be something T-S-L-A-N-K-L-A something, something L-A?

Jake: Q.

Tobias: [laughs] Yeah, that’s right. Not yet.

Bill: I think that Buffett’s deal in the pipelines probably ends up very good. Look, those assets you need– like the Magellan assets, from my understanding, if you are going to get gasoline from a refinery to the endpoint of a gas station, you need the assets. So, I think you’ve got to ask yourself, like, “Are those the assets I want to own?” And if the answer to that is yes, it’s probably an entity worth doing some due diligence on. I think those are interesting assets. I don’t own it, but I can understand why people like it. I don’t think cars are going away tomorrow.

Buffett Actually Owned A Toll-Booth

Jake: I think it’s a tollbooth-y experience. I was just reading– have you guys read that– It’s called Cap Allocation and it’s about the Berkshire’s financials basically from 1955 to 1985, something like that?

Tobias: No, I haven’t seen that one.

Jake: If you’re a big Berkshire nerd, it’s pretty fun to read, to just go through all the different numbers, see what Buffett was looking at in real-time. But one of the early, early deals that was very small and kind of wasn’t– I haven’t really heard it talked about much was this company that literally owned a tollbooth like– they owned a tunnel in Detroit or actually is a bridge in Detroit called the Ambassador Bridge, I think. And he owned a literal tollbooth at one point that they bought–

Bill: The Buff Dog. He’s the man.

Jake: He’s good. Toby’s wrong.

Bill: Yeah, it’s messed up that you don’t like Buffett, man.

Tobias: [laughs]

Bill: Messed up.

Tobias: Okay, I got a good question for you. How do you think value performance in inflation/stagflation environment? This part I can ask. The second part, I don’t know the answer to, created by Banking for All Act. I don’t know that Act. Sorry. Do you guys know Banking for All?

Bill: No, I haven’t read it. I pulled it up real quick, but I don’t know what the hell it does and I only saw like six paragraphs which is not enough for any act to actually be, so I need to read it.

Value Investing, Inflation, And Interest Rates

Tobias: How do you think value performs in an inflation/stagflation environment? Then, don’t worry about the second part.

Bill: I don’t know, how does any– I mean, I have no idea.

Tobias: We kind of talked about this a few weeks ago, it made me– I think there’s this sort of narrative at the moment that what value needs is inflation. But I don’t know that that necessarily helps just because the nature of it at the moment seems to be this– Well, it’s not always the case but there’s a bit of heavy industry in there at the moment and there’s that great– There’s some Buffett commentary on it including his paper, How Inflation Swindles The Equity Investor, where he talks about reinvesting in heavy industry. It makes it hard. I sometimes wonder if the reason that the market looks the way it does at the moment is because everybody is actually anticipating inflation or if the market is already positioning itself for inflation that we aren’t necessarily measuring.

Bill: Yeah, I think that’s fair. The nice thing about software, if you’re a software investor is, I’d argue a lot of the inflation’s already in it because your inflation is going to come through the cost structure. And it’s not as if engineers are not in high demand right now. So, I don’t know that you have to be quite as concerned about inflation in that way as you do like if your machines are more expensive to replace, you know what I mean? There’s a lot of scenarios that I can argue that I’m like, “Oh, software wins.” It’s just not the valuations that I think make much sense at the moment. But I’ve been wrong and will continue to be probably.

Tobias: How about you, JT? Do you want to want to get some more [unintelligible [00:56:35] hate mail?

Jake: Yeah. I don’t know. There are so many different things you can pile up on either side of the scale that I don’t know which weight is heavier, so which way it tips. Yeah, of course, software could be– if it has pricing power especially, could certainly see pretty dramatic earnings in an inflationary world, potentially. But you could tell me that 3D printing becomes this amazing thing and at the cost of actually producing an atom where you want it in the structure that you want it, completely changes the cost structure of that. And now all of a sudden, maybe heavy industry is not as disadvantaged. Software eats that part of the world. Okay, well, that’s– I don’t know now. All of these things are very hard to do– I think if interest rates go up quite a bit, then all the reasons that terminal values have been inflated, work backwards somewhat, and cash today will be more valuable and cash flow more temporally close to today will be discounted less than the cash that’s even further out. And therefore, that is a value versus glamour argument at the moment.

Bill: Except maybe you could argue that there’s less potential dollars to enter the market if there’s a higher opportunity cost of capital. The certainty of your position may actually increase. But I don’t disagree with you. I’m just mentally masturbating here.

Tobias: Plus, you’ve got the cold fusion generators everywhere, making energy abundant and free, essentially.

Jake: Too cheap to meter.

Zoom Phone

Bill: What I wanted to say before we derail. I watched the Zoom Investor Day, that was pretty interesting. When you think about what people may be seeing, as far as Zoom as a platform, and then the phone and how– Zoom phone, how it can displace all the telephones and everything that’s in the enterprise right now, it got me thinking to one of the discussions that we have a lot. It is obvious to me how that product really hurts the incumbent phone provider, to that enterprise and enterprises in general. The people that provide the hardware and all of that excess costs that you can suck out of the system. It is much harder for me to understand why Zoom is the beneficiary of that over the amount of years that I think you have to have that view right now.

To me, part of what’s awesome about Zoom is how easy it is to use. If software is that easy to use, it seems easy to switch. And maybe that’s stupidity in my mind, but I just worry how do they not get outflanked by somebody else with this valuation. That’s where I think our conversations end up and just kind of getting to this point and we say [crosstalk] melt-up.

Tobias: Folks, that’s all we got time for this week. In closing, we’re all long Zoom.

Jake: [laughs]

Bill: That’s not true. You can’t say that. Also, nothing we say is investment advice and don’t get your panties in a bunch if I sell something.

Tobias: See you next week, amigos. This was fun. Thank you.

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