(Ep.92) The Acquirers Podcast: Matthew Peterson – Structured Value: Options And Volatility With Buffett-Style Value

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In this episode of The Acquirers Podcast Tobias chats with Matthew Peterson, Managing Partner at Peterson Capital Management. During the interview Matthew provided some great insights into:

  • Value Investing Using An Options Framework
  • Structured Value
  • Capitalizing On Opportunities Too Small For Goldman Sachs
  • Buying LEAPS To Generate Outsized Returns
  • Position Sizing Using Notional Value
  • What Investors Are Missing On $DJCO
  • Why Dhandho Is A Long Term Hold
  • The Tax Consequences Of Options Selling
  • $COST Missed Opportunity

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Full Transcript

Tobias: Hi, I’m Tobias Carlisle. This is The Acquirer’s Podcast. My special guest today is Matthew Peterson of Peterson Investment Funds. He’s got an absolutely fascinating implementation of value using options, typically option sales. He calls it Structured Value, we’ll be coming up right after this.

[intro]

Tobias: When did we first meet? I think I might have met you at an Idea Dinner hosted by Alex Rubalcava.

Matthew: Was that it? Or– [crosstalk]

Tobias: When he was a value investor.

Matthew: Yeah. Was it maybe a–

Tobias: Through Ben Clayman? Possible too.

Matthew: Like 2011 or probably–

Tobias: Something like that. So decade, let’s say a decade.

Matthew: Yeah, probably a decade.

Tobias: And honestly, that night, when I heard you describe your investment philosophy and your strategy, I was like, “This is amazing. This is genius.”

Matthew: Thank you.

Tobias: Describe your strategy, how do you implement your strategy?

Value Investing Using An Options Framework

Matthew: Okay, well, let’s start. So fundamentally, we’re a long-term value-based fund. All of the standard protocols you would affiliate with a value fund, you would affiliate with our fund. But what I think you’re referring to is the small nuance where we sort of buy and sell in a little bit of a different manner than, I think, most traditional funds, and it’s an enormous advantage. I spent a lot of years only talking about it very privately because I was afraid that if I went public, it would get exploited. But what I’ve discovered, actually, is that very few people– people are reluctant sort of to put it into practice, and there’s a couple extra steps, but out of all your listeners, there might be a few that go out and try it. And there will be a few that stick with it.

What we do, essentially, is once we discover, and we can walk through a process or whatever, but once we identify a company that we’d like to own, and we have a very concentrated portfolio, so we’re talking like, maybe 10 positions is a good amount. When we find a new position we’d like to buy, I want to figure out the best way to acquire that exposure. And so, what I discovered years ago on Wall Street, is that by basically selling a put, a lot of times in the value space, when you want to buy a firm, it’s fallen out of favor, maybe there has been an event that’s caused the price to decline into a place where you’d like to own it, oftentimes, it’s high volatility. And high volatility impacts the prices of put and call contracts. Most people are somewhat familiar with puts and calls.

Call allows you to buy the shares, put usually allows you to sell the shares. But if you invert it, and basically, instead of being the buyer of a put, you become the seller of a put, people are paying you to protect their shares. And should the shares decline in price further, they then put them to you into your portfolio. And so, it’s just one extra step. So, instead of going to the New York Stock Exchange and buying, say, shares of whatever we want to own– unfortunately, I didn’t check recently. But Tesla is always a good example, because it’s so volatile. But instead of buying– Toby, do you know what the prices today of, say, Tesla?

Tobias: I don’t. Is it 400 bucks?

Matthew: Yeah, let’s say it’s 400, you could likely go in through the Chicago Board of exchange, instead of paying $400 for it, commit to buying it for $400, over a period of nine months or so, and someone’s likely to pay you about $100 for that commitment. And so, what happens in the scenario is, instead of buying through New York Stock Exchange, we go through Chicago Board of exchange, we write these put contracts, we’re committed to buying the shares. They are priced, basically, through quantitative assessment, there is no qualitative assessment, that’s underlying the Black Scholes model, for example. And so, we pick up a large premium and we use this as a tool to own the equity. So, we’re not just trying to pick up premium, we’re not picking up nickels in front of a crusher, whatever the analogy is, but we’re basically looking for an opportunity to buy shares and looking to move in as cost-effectively as possible and as cheaply as possible.

And so, this allows us by writing these puts, it allows us to pick up a premium before we buy. And then when we do buy, we’re paying far less than the market price for the securities and that’s a huge advantage because it lowers the denominator throughout the entire holding process then of the position.

Tobias: Let’s look at one of those transactions. When you sell a put to get into a position, you have the same downside profile as someone who has bought the stock. So, if you’re a value guy, and you’re already prepared to underwrite this particular stock, you’re already prepared to accept the downside of something that you’re buying into. What you’re saying is by selling a put and capturing hot, a lot of volatility, you’re in fact getting a lower purchase price in the event that the stock falls that point. Even if it falls to your strike, you’ve got some premium embedded in it that you’ve paid an even lower price than that. So really, the risk for you is that, it’s a sin of omission where it’s something that you want to own and it never falls the price where you in fact get it put to you and you get to buy it. Is that fair?

Matthew: That’s absolutely fair, that’s absolutely correct, and that is very much the way I look at it. So, if we took a really basic example, like, Berkshire Hathaway, which everybody’s very familiar with, and it’s not the best example, by the way, because volatility is not usually very high with Berkshire. But we can talk to it easily and all the nuances, but there’s basically four outcomes to any scenario. So, once you sell the put, the worst outcome, of course, is that the shares go to zero. And like you said, it’s the same position you’d have if you are a value fund owning the securities. Of course, it would be terrible for it to zero. Berkshire B shares, I think, are around 210 or so. If that went all the way to zero and you hadn’t sold a put, you would lose $210. Maybe if you sold the put with a strike of 200 and you picked up $20, you’d lose $180. So, it protects you a little bit.

The second scenario is the ideal scenario. And that is where you want to own a security for the long term, you’re using this put process, this cash-secured put as a tool to own the shares, the shares dip a bit, they get put into your portfolio, you’ve captured the premium, and now you own Berkshire at $180, the shares maybe went into the $190s and now they’re at $300. And you’re looking and feeling great.

The third scenario is also reasonably attractive. Basically, shares don’t decline much, maybe they’re flat, maybe they’re up just a little bit, but you’ve picked up enough premium that you’ve sort of offset the waiting period. Maybe the security is probably theirs– they may still be very attractive, maybe more attractive. But once these contracts expire, you obviously keep the premium and you just go about your business so you could resell more contracts. So, the third scenario is the shares stay flat or go up a little bit.

And then, the fourth scenario that you describe is the worst scenario, where– although it feels painful for us, but it’s not like LPs or other folks complain, because it looks like the third scenario to them. So, the shares rally, you missed a multi-bagger position and you’re back to the drawing board, you have to find a brand-new idea, and you’re totally right, but you missed it. And so that is the risk, that is the real risk.

Tobias: Do you buy the equity at the same time to sort of mitigate that risk a little?

Matthew: These are great questions. We can go into depth on some of this. There’s a few things that you can do. In fact, my approach has evolved a bit over time naturally as you get more experience and so typically, — let me put this framework around it. We’re such long-term holders that we may wouldn’t– I like looking at things a decade out or so. And I would love to own compounders that continue to grow at high double-digit rates for that a period of time, very happy to own securities that way. So, what that means is, typically, initially, I don’t, to answer your question, I just sell the puts. And that’s usually the approach that we take. Sometimes, if it looks like maybe there’s a lot of operating leverage, and it’s really going to move quickly, or there’s some sort of catalyst that’s changing things fast, you can– and this is a step further, so I don’t want to really confuse your audience. But I have and you can take a small piece of that premium and buy some out of the money calls so that if it truly rallies, you do capture that upside. It actually becomes in a way like a free call option, if it’s done well.

I tend to do that more than buying the shares, but ultimately what happens is you own the stock. And once you own the shares, it becomes quite interesting what you can do, because you’ve become so familiar with the security, when it dips, you can buy, sell some puts. If it rallies, you might be able to sell some calls. And if those have the same expiration dates, the price can only be in one place on that final date. And so, you can start kind of capturing multiple premiums around a long-term position that you hold.

Buying LEAPS To Generate Outsized Returns

Tobias: The Greenblatt Yellow Book, How to be a Stock Market Genius, he includes in there this discussion of buying leaps where he says if you’ve got a position where the downside could be unlimited, it might be a zero, but you like the risk-reward of the position that you could then go and buy a leap, which is a long term equity, anticipation, security, something like that.

Matthew: Yes, that’s right.

Tobias: Something odd. Basically, it’s just a–

Matthew: I think the definition of a leap is simply an option that’s out longer than a year, I believe.

Tobias: Yeah, that’s what I understand too. So, you can buy a call in something that expires in 2020. I think they’re currently traded now for a lot of stocks, 2022 January or 2023 January might even be available at the moment. Do you ever do any call buying of that kind of nature?

Matthew: So, it’s a really good question. And these are all great strategies. Given the exact scenario that you’re mentioning, it’s something we would consider. But at the fundamental level, what I’m really looking to do is– so how can I say this?

Tobias: You prefer to be a vol seller than a vol buyer?

Matthew: Yeah, I prefer cash coming in, rather than cash going out. So anytime you buy a call, you are at a risk of the timing being wrong. And so, that’s what’s most challenging for me, is that markets can be irrational and if you happen to be in a recession or a pandemic, or there’s something going on, and the prices aren’t where they really rationally should be, you just automatically lose 100%. So certainly, if you took a basket– I can see a scenario where you have a basket of securities that might play out, and you can maybe call that one position, and it actually is 10 underlying securities. And maybe there’s really a symmetric upside, but it could be a zero. It might be a winning strategy, it’s not something that we usually do. We’re really focusing on capturing the long-term securities through the sale of these puts, and we just use it as an entry price. But other than that, it’s pretty plain vanilla.

Tobias: So, you tend to be a vol seller rather than a vol buyer. So, let’s talk about selling a position and the reverse of selling a put is selling a call, which is then giving you the– if you hold the underlying security and it gets to your price, then you become– yet that’s a way of exiting and capturing some of the volatility on the upside. Is that a strategy that you employ?

Matthew: Right, that’s exactly what we do. So, if we had a hypothetical situation where there was a security that fell from $100 to $50, and we thought maybe the value was $200 and now it was so attractive, that we wanted to make it a position, instead of buying at $50, we might sell puts at $50, pick up $10 in premium and ultimately pay $40. As they start approaching $200, and this could be 8, 10 years later, they’re approaching $200, we’ve now made 400% almost, and we then go to sell a call, that call then would pay us premium. And by the way, as the shares have risen, the call price has become more expensive. So, we pick up quite a bit of premium on that side as well. I’m just hypothetically using 10% or so but if the shares are appreciating, and they’re out $190, we might sell a $200 call, strike, pick up $20 for that, and should they rise above $200 now, we’ve exited. Instead of going from $50 to $200, we’ve now gone from $40 to $220.

And so, it actually makes a meaningful difference to your IRR. Even over a 10-year time horizon, you end up adding multiple single-digit but solid single-digit percents to your holding throughout a long period of time.

Tobias: So, the positions that you are writing the options on, if you’re underwriting the downside in one of these, you have to be reasonably confident that this is a solid thing that you’d like to own, so what’s the process? Just ignoring the buy, the actual mechanics of buying and selling, let’s talk about the qualities of the businesses that you like to buy. Where are you focused and how do you think about them?

Matthew: Yeah, it’s a really important question. And it’s similar, again, to holding the underlying equity. So, I have a very straightforward framework that I just a little mental model in my own mind that I think– that I try to adhere to. And it’s basically I’m looking for the greatest business models and the greatest management, and then a fair price. And if you can sort of get into that intersection, I think you have a– you increase your odds of weathering any unforeseen storm, because you have a great business model and you have great managers, and you’ve paid a good price. So, that’s something that is always very helpful. But I’m fundamentally looking at all the same metrics that you’re looking at. I think I bend a little bit more to some qualitative aspects, but I want to make sure that the multiples are within proper ranges, and I’m not overpaying some EBIT, EBITDA, or whatever. I really care about cash flows.

I’m evolving, as I think everybody does, and I used to care or look carefully at book value and underlying assets. And now, I’m questioning some of these legacy philosophies that I had because cash flows can come with no book value. And so, cash flows are much more important to me. But what I’m really looking for is clear quality assets that sort of underwrite the firm in general, if that makes sense. And a lot of times, what I really appreciate finding, and oftentimes I think this is where deep value is, is I’m finding value that is somehow off the financial statements. So, that could be super high-quality management, or some moats or brand that’s not really apparent in the financials because I find if it’s really obvious in the financials, nobody’s missed anything. And the markets are usually pretty efficient. But I really try to find something that is creating a floor to this position that we’re looking at, for example.

Tobias: Right. That makes sense.

Matthew: Did that make sense? I’m not sure if that was– [crosstalk]

Tobias: Yes, as a volatility seller– and this is not something that’s unusual to value guys, but you think about the downside a lot, that’s the first step in the process.

Structured Value

Matthew: Before I’m even looking at how volatile anything is, I’m identifying the position. And there are positions where the vol is insufficient to use the– I call it structured value. So, the vol is insufficient to use any structured products, because if you’re going to sell a put and pick up a 12-month 5% IRR, it’s just not worth doing it. If the position has a possibility of doubling, you’re better off just buying the shares. So, I will take the more conventional approach if it’s a better approach.

Tobias: So, let’s just talk about a little bit about how you structure. Do you have a preference for– Are you looking at a quarter when you’re selling an option, are you looking at a week? Do you prefer to look at a year? Do you have some sort of IRR that you want to get over before you put it into the fund?

Matthew: So, there’s a couple of good questions bundled in there. Quite often, I’m only hesitating because it’s changed a little bit in the current situation. But quite often, we’re not only selling vol, we’re also selling time, we’re writing all of the factors. And so, I don’t mind if we’re getting sufficient IRR going out, I actually prefer to go out very far. So, I will write contracts in Jan 2023, and that will be– I will be so comfortable and confident that the firm, whatever catalysts or uncertainty exists today will be gone in 2023. So, I like going out very far. The challenge is you do have to get sufficient IRR to make it worth your while. As a rule of thumb, if I’m not getting double digits’ IRR, then I will look at other ways.

Now, the thing is to consider, we actually, in reality, when we’re building these out, we build them out over time, just like somebody purchasing equity and buying a position in their portfolio, might buy over time and they might have some strategy, they’re going to own 2%, and then 5%, or whatever it’s going to be, we do the same thing with our contracts. And so, we can get different expiration dates and we can have different strike prices. And so, what that means is, it ultimately looks like, you can almost create a little matrix where you have a bunch of different prices, where things are expiring. And what that means is you might sell some that are in the money and some that are out of the money and some that are at the money. And then, you might do that for different strike prices. And then, you might also continue to do that over time. And so, you end up with this kind of a complex matrix where some you buy and some you don’t, but in all of them, you pick up premium, and your ultimate position, you’re basically– I’m building into the size that we’d like over time. So, yeah, we’ll go out usually really far when we’re doing something like that.

Tobias: That’s interesting because I’ve noticed that you tend to get higher IRRs the nearer term that you’re buying. But then you’ve also got to balance that against the fact that you’re typically collecting less premium when you’re doing that, too. I found that the sweet spot is sometimes about a quarter or two out that that’s where the highest IRR, plus sort of a reasonable amount of premium for the amount of notional risk that you’re taking.

Matthew: Yeah, so the idea being, because quite often the shares, you’ve researched a great idea, and then shares appreciate a little bit and then you miss it. The challenge is, you have the ability to rewrite the puts at that point and then you can capture it again, but the world might be different. So, I was writing a few months ago that we are probably in the most uncertain time in the history of most of our lives. We have political unrest, pandemic, recession, political uncertainty, etc.

Tobias: Don’t forget the aliens.

Matthew: If aliens showed up tomorrow, I think, yeah, it’s 2020. So, at this point, it seems– I think it would be foolish to expect volatility to be so high a year from now. So, to write a nine-month put and think, “Oh, I’m just going to capture the premium again if I don’t buy it.” The IRR might be significantly lower nine months from now on that same security with the same new duration. And so, that’s another sort of balance that you have to make. So, you can write them short term and you do capture more but then the world can be different and the vol can shrink and so, you may have to just buy the shares.

Position Sizing Using Notional Value

Tobias: How do you think about sizing because you can clearly sell– you can get a very levered position by doing this. But then, you also run the risk at some stage, worst-case scenario, armageddon, every single one of your positions gets put to you, you need to be able to take them while you’re out of business. How do you think about sizing? Do you think about the notional as you’re putting it on? How do you do it?

Matthew: That’s exactly how I do it. You calculate the notional. So, you’re basically looking at what’s the strike price and the quantity that we’ve sold, and an option represents 100 shares of stock. So, you look at the notional, you look at the strike price, and then you multiply times 100. And you say, “Okay, if I sell this amount, I’m going to be buying $5 million worth of XYZ shares.” And you need to calculate where that fits into your portfolio. So, it’s a great question. I run a really concentrated portfolio, probably more concentrated than most. I think four of our positions make about 65%. And they didn’t always start that way. They grow into those sizes and things, but the way that I typically move into a security is I start relatively small, with say, a 2% position, and then I give myself a couple of more chances to get it up to 10%. So, we’ll go 2%, 5%, 10%.

Tobias: Are we talking notional? Or are we talking premium?

Matthew: Of notional.

Tobias: That’s notional, okay.

Matthew: So, I’m calculating notional, and I’m saying, okay, well, let’s take a– for easy math, you have $100 million and you just say, “Okay, I’m going to take notional of $2 million, then I’m going to take notional 5, and then I’m going to take notional of 10.” And then as things expire and unwind, we can add to that position and continue to put it to the proper size. So, typically, that’s how I think about pricing things. It’s all based on notional and everything’s cash secured. So, we’re ready to buy. We’re only selling contracts on positions that we want to own.

The Tax Consequences Of Options Selling

Tobias: Right. Understood. The tax consequences for options selling, I think it’s treated as ordinary income.

Matthew: Yeah, these are really good questions, great questions, in fact, because most people don’t go into this step. So, there’s so many little nuances that that are worth exploring. So, yes, they are treated as short term. However, when you buy the securities, there’s no tax liability at that point because there’s been no realized gain. So, they’re just sort of embedded in the security. So, you can delay that for quite some time. There’s another interesting aspect that happens when you do the call selling for an exit. So, to answer your question directly, anytime that you’re shorting, the gains are treated as short term. And so, even if you hold a two-year leap and maybe someday– the laws will change, but I’m not waiting around for that. So, it all is treated as short-term capital gains. Of course, the holding of the security is still treated as long term capital gains.

What I’ve recognized, it took me a little while to realize that this was happening or possible, is that, especially in a place like California, where you have high state tax, there’s a really interesting tax arbitrage that exists if you use long-dated, covered calls as an exit strategy. And a lot of times when you do long-dated positions, a lot of times it’s just a January expiration that exists. You go out to the kind of the next year and it goes to January. And then, if we waited till September of next year, then it’d suddenly be January 2024. So, if you’re out a year or two, when those are deep in the money, you would take a little risk of the position price movement, but if you end up with a security where you’ve sold a call, and then it’s rallied, you have captured a long-term capital gain on the equity and then you have a short term– Sorry, and then you have a gain on the options, on the call options as well.

Tobias: Because you’ve sold it in the money.

Matthew: Because you’ve sold it, I apologize, I’m rambling.

Tobias: In the money. No, I’m just trying– you’ve sold it in the money and then it’s continued to rally. So, you own it–

Matthew: Only sold it out of the money and it’s rallied right through the strike.

Tobias: And you’ve got the premium in it. Okay, so you got two sources of gain, you’ve got the premium and you’ve got the capital gain and the underlying. How are they treated for tax purposes?

Matthew: So, the capital gain in your underlying position as long term if you’ve held it for more than a year– and what’s happening now is the call that you sold, let’s just say you sold a call for $3, the shares have rallied and now it’s $30. And that’s actually a loss and it’s a short-term loss. And you can put time value into it by instead of just letting it all unwind in January together, the shares get called away from you and you’ve exited your position as planned, you can actually unwind that call in December and capture that whole short-term loss–

Tobias: In that tax year.

Matthew: For this year. And then the next year, you just liquidate or sell a one-month call, I would still sell another call probably, on the underlying security that has this long-term bet in capital gains, that then gets taxed the following year. So, you take a short– a large– in Cali, you’re like 40 something percent tax all right off, and then you pay 20 plus state or whatever, so it’s still not that low, but you pay your long-term capital gains a year later. So, you get deferral and it’s arbitrage. There’s a little bit of tax arbitrage.

Tobias: What’s the timing of this? If you sell a put, what’s the timing? Let’s say you get the premium in January and then it expires in the following January. What is the timing for tax purposes? Is it at the point of sale or is at the point of expiry?

Matthew: Great question. Directly, it’s the point of expiration when the tax liability occurs, and of course, then you pay the following year when you file taxes. But it’s a really interesting question because if you basically are– so you can plan accordingly. It’s better to have things expiring in January or so, but what’s interesting is, the way the execution, I think, people often misunderstand it. I was talking about, you can buy in New York Stock Exchange with Chicago Exchange, what I will do is, when we’re interested in selling contract on position, I’ve watched people try to emulate what we do and they make this mistake, they’re like trying to force a position through. I literally write it and leave it like a limit order, sometimes for months, just waiting for a flash crash or some event, and they happen very quickly.

If you’ve been around a while you see every few years, there’s just something that has a sudden 10% swing in a bunch of stuff and a 40% swing in something you liked. So, we have positions that sit there waiting to be bought from us. And that helps us immensely in getting a large price. So, these option prices swing quite widely. So, if you’re interested at $4, I might write it for $10 and it’ll sit there for three months, and the day it gets bought, we pick up the cash. And I’m always very surprised, it’s a great day when someone’s buying our contracts because they’re very mispriced.

And at that point, just for your viewers and listeners, it’s interesting. We don’t have any IRR on that day. We pick up cash and then on our fund balance sheet, we have a liability, we have an obligation to buy the shares for that price, and that obligation is a liability. Let’s say we brought in a million dollars, we now have an offsetting $1 million liability on day one. And what happens is that cash doesn’t change value, that’s cash. What happens is the liability goes up and down with the market. And if we’ve done things right and it appreciates, it will asymptotically approach zero. Liability will go to zero, and then it will expire and we’ll still have the cash.

What Investors Are Missing On $DJCO

Tobias: Well, that’s great. I think that’s a pretty good overview of the option. So, let’s go back to the positions a little bit. Do you want to talk about individual– Let’s talk about the names and the quality of the names. This should be fairly familiar to most folks, but Daily Journal. Do you want to talk about the opportunity in Daily Journal?

Matthew: Yeah. And then again, I know like– I’ve spoken a little about Daily Journal, I actually really liked Daily Journal. Typically, I don’t go through every portfolio position, but I really don’t mind. It’s like this is a long-term Fisher compounder. If anything, I’d like to bias myself not to sell it, I think that’s– I’m more at risk of selling a good compounder than I am at not buying something of great value. So, let’s see, I can start at any point with Daily Journal. Why don’t I start by saying the framework of the management and the business model and the values? The management is Charlie Munger and a lot of his good friends Peter Kaufman, Salzman and a bunch of others. Unfortunately, very sadly, Rick Guerin passed away a few weeks ago. Rick Guerin and Charlie Munger actually bought originally the Daily Journal newspaper 43 years ago. It’s sad to see him go. He’s a lived a great life and was a big part of the company.

So, the business model, everybody thinks is a newspaper and it’s actually this SaaS core software system, called eSuites. And so, the business model being aaAS means, very low book value, very high cash flow, and they have a lot of special features where they’re implementing things like major deferred gratification where they’re giving quarts like a seven-year lead time before they start billing. And that just completely changes the dynamic where it’s not showing up on the financial statements, but they certainly have many tens, hundreds of millions owed to them from municipalities and even countries like Australia around the world. Management is wonderful. The business model is fantastic as well. The newspaper business we just put at zero because that’s not a good business model anymore. It’s probably not worth zero, but it’s not worth counting.

And then, what’s very interesting is they also– we talked earlier about having this sort of underlying floor for security. Daily Journal in 2009, Charlie and Rick Guerin went and they pushed about $50 million into– I think, they bottom ticked to the day, the financial crisis. They bought mostly Wells Fargo and Bank of America. But this equity portfolio they have has now appreciated to $200 plus million. And it’s all part of this umbrella, which is a $350 million market cap. So, people are really– I don’t think very many people understand what’s happened in the space, in the technology space. And so that’s given– presented a really good opportunity.

Tobias: Yeah, I’ve embarrassingly bought Daily Journal [unintelligible [00:36:12] about $70 and then I think I sold at about $95, somewhere between 2009 and 2010 because it came into– it was like a net-net or net cash to those securities so.

Matthew: Well, it’s not too late. Look, I can share with you a couple of details and ask anything you want and if it gets too long at Daily Journal, we can move away from it. One interesting aspect that I think people probably don’t recognize at all, if you look through their 10Ks, you’ll see they have this equity portfolio, but two of the securities are international securities. And so, the only way to kind of figure those out is to find somebody who’s figured it out or to start mapping possible securities and try to identify exchange rates and what can they possibly own. And as it turns out, one of their big positions is BYD.

And so, BYD just today is up another 16%. And I don’t know where it’s going, but it’s suddenly become worth in excess of $100 million, just the Daily Journal, a piece of it. So, there’s a $350 million market cap. One of these little hidden securities happens to be BYD and that’s tucked in there. A lot of people come to me and they say, “Well, are you worried about the financials?” Well, guess what? BYD is much larger than the financials in that portfolio. And so, that creates this very solid floor in my mind, where, if the– so what we’re looking for is true asymmetry in the risk-reward profile of these firms, and I think this fits it so well. I actually spoke about it last year in Switzerland, and I called the presentation hiding in plain sight, because it’s right in front of everybody. I mean, it’s Charlie Munger.

A lot of people know about the Daily Journal meeting, attend the Daily Journal meetings, a lot of people don’t own the security. And it’s because nothing’s very obvious, nothing’s apparent, even though it’s right there. And so, this equity portfolio is going to grow into the current market cap of the business, today’s market cap, over let’s say, five years. And sure, the market cap could be below the equity portfolio of the business, but that would be pretty wrong. And so, I look at that as a really solid floor. You can buy in today and five years from now, if the whole SaaS business fails, you get all your money back. That seems really secure to me.

On top of that, you’ve got these unbelievably– these business minds, running this software firm that has potential in my view to at the end of this decade have about $100 to $150 million per year in revenue. And so now you have to think about how do you value SaaS and then revenues, and then do you want to figure out what the cash flows would be, but if you slice it a bunch of different ways, it sort of looks like a billion-dollar business. And so, I look at this as you’re buying something for 350, you may get– you’ll definitely get your 350 and you might get one and a half billion or more. So, that seems very attractive and very safe.

Tobias: Yeah, good risk-reward profile in DJCO, run by the kind of guys, and not to sleep on Peter Kaufman either because he’s business genius in there too, not a lot of folks know that.

Matthew: That’s right. There’s only about 300 or so employees, maybe 350 employees at Daily Journal, and Charlie’s been there for 43 years. So, you can imagine he’s worked or maybe possibly interviewed quite a few or I think– the culture is going to be among one of the better cultures, I think, in sort of, among modern corporations. I think it will be there to last far after Charlie’s gone, for example. And I think that’s really valuable to have sort of 300 minds that sort of understand and respect the Kauffman and Munger philosophies.

$COST Missed Opportunity

Tobias: Do you want to talk about when you exited Costco?

Matthew: Sure. Well, that was so– Thank you. You probably picked that up from the annual report.

Tobias: I did. Yeah.

Matthew: We sold puts, and Costco increased and we missed the opportunity to buy. And at the time, it didn’t seem that terrible because Costco wasn’t one of these firms that was just screaming cheap. It was just such a great business model and run by great people. And it was good. But actually, it’s a really good example of the sort of step four, where we didn’t buy in and then the shares over the next sort of 18 months, I think they almost doubled. I can’t remember all the numbers you’re looking at, but we’ve probably sold with strikes out 150 or so, and I think they’re above 300 today.

Tobias: Yeah, I was just wondering what the reason for selling, was it valuation-driven sale?

Matthew: We wouldn’t have sold if we had been put the shares. So, it would have just been a nice compounder that we would have had in our back pocket. But the shares were not put to us, the shares did not decline below our strike. So, when we– again, I don’t remember the– [crosstalk]

Tobias: So, you sold the call to get– and that was–

Matthew: No, we sold a put [crosstalk] a tool to enter, but I still write about those in the report. This was an attempt to own this position, we picked up the premium, we earned the adequate IRR, we didn’t– And then– a lot of these contracts will go out– if we’re writing contract today, it’s very likely we’re going to January 2022 at a minimum. I’d like to get through all the uncertainty if possible, and maybe even 2023.

So now, it’s kind of with us for a while, and then if we don’t buy the shares, we still call it an exit. So, that was the exit, but that’s exactly the scenario described earlier, where the shares rose and we didn’t buy them, and then they went up considerably, in large part due to the pandemic and a lot of other things.

Why Dhandho Is A Long Term Hold

Tobias: Got it. What about one of your private holdings? Do you want to talk about Dhando?

Matthew: Yeah, sure. Again, normally I don’t talk about all these but I don’t mind. It’s more about the commitment and consistency biases, but you’re picking good opportunities. Dhando, we will hold for a really long time. And so, let’s talk about that. What is Dhando? First of all, are you familiar with Dhando at all?

Tobias: Only from speaking to you over the years? I know a little bit.

Matthew: Let’s start at the beginning. Dhando, it wasn’t intended to remain private, but we had an opportunity to buy into a private vehicle that was being run by Mohnish Pabrai in 2014. And so, there were shares available. The idea was to kind of create a little mini Berkshire and things have pivoted a bit since then. But the shares were $10 a share. It went into a business and then that was used to sort of get things up and running. Ultimately, Dhando now is like a secret in our portfolio. It’s just amazing what we hold. So, the idea was to IPO a couple years in, which was going to sort of resolve us with this sort of painful quirk in our portfolio, because it’s not really designed to have a private entity. But we do have this. The IPO didn’t happen for a number of reasons. Mohnish bought an insurance company that had a little bit of trouble, try to be moved to Puerto Rico, do a few interesting things, and ultimately ended up selling but it wasn’t possible really to do an IPO because there was no cash flow. And so, the IPO wouldn’t have been a very successful IPO.

So, remain private, ultimately, because interest rates and fixed income have been so low. It’s hard to have a really good return in a bond portfolio from an insurance entity. So, that was sold to Francis Chow. And ultimately– Mohnish calls it putting the toothpaste back in the tube. Money was spent. It didn’t quite work out, but I think from here, it’s going to work out quite well. So, what he’s done is basically, over the last few years been distributing back some capital. So, the original 10, we’ve received about seven and a half. We hold it in our portfolio at book value, by the way, and what has it become?

Mohnish has basically launched, the largest part now is an India-focused fund. And he’s raised about $100 million for that fund. So, we own the fund, we’re not invested in the fund. So, there are a few pieces left. The insurance company’s gone, there’s a little bit of an equity portfolio, and then there’s basically this hedge fund, and there’s a little– [crosstalk]

Tobias: The Manager, is that what you’re owned? You own the part of the Manager?

Matthew: We own the Manager. We own the business, and then the business manages the fund, Dhandho Funds. The main Dhandho fund is an India-focused fund. It’s invested in all sorts of interesting companies over in India. It’s probably going to do very well. It’s been really volatile. Will receive cash flows, I think, very inconsistently, but we can handle that. What’s interesting is that in our portfolio, because back in the day, we needed to track it– we needed a way to track it and so we determined with our auditors, the best way is to just use book value, and we receive audit book value statements from them on a regular basis quarterly, audited annually. And so, we just consistently mark our books to book value. But as you know, the book value of a hedge fund is zero. I mean, it’s like some brains in a computer or something. So, we hold this at book value, which is the book value of the legacy stock holdings that they have. It’s actually $2 a share. So, we bought it for $10, we’ve been paid back seven and a half, and we hold it at two. And this started a large position, and over six years, it’s down in our portfolio.

But in that $2, there’s a sliver, the piece attributed to the hedge fund is actually, I believe, seven cents. Seven cents of this position is $100 million hedge fund in India, and that is growing, by the way, it’s only a couple years old. So, it’s quite a nice position to have actually. I treasure it, and I can imagine a few years from now with a few hundred million and some good years in India, we can have some nice dividends coming from that position. But it has taken a lot of patience from a lot of people, including a lot of our LPs to understand we own this, and it’s a really valuable asset.

Capitalizing On Opportunities Too Small For Goldman Sachs

Tobias: Just to change pace a little bit, how did you get your start as an investor? And how did you come to marry the options with the more traditional sort of Buffett-style value investing?

Matthew: Yeah, great question. My background very briefly, I grew up in the Midwest in Minnesota, and studied economics and math at a small liberal arts school called the University of Puget Sound, which is near Seattle. And from there, I basically went out to Wall Street. I went to China for a little while and then I went out to Wall Street. And I spent a whole bunch of years consulting for investment banks, primarily Goldman Sachs. So, seven years, I was kind of between London and New York, and two of them, I officially lived in London, doing all this stuff with Goldman. And there was a period that was very interesting for me, and it was about 2005. I don’t know maybe this is too much information. But there was this Basel II implementation that was going on at Goldman and my team was helping with the risk management group. And we were trying to justify to the SEC, that Goldman was so advanced in their measurement of risk that they didn’t need to abide by the SEC requirements, we could create our own requirements.

And so, to do that, we had to model out every product that Goldman was working with, and I was one of the people responsible for create– I was primarily responsible for creating that model validation documentation and submitting that to the SEC so that we could get approval to take on more risk, basically.

And I was also studying for the CFA designation at the time. And so, there were a lot of things that were sort of connecting in my mind, where I was recognizing, you don’t really need to buy– I was actually looking at different desks, trading desks at Goldman. And I was realizing that these siloed traders were netting out positions that they were taking, and it was seemed inefficient. And when I brought it to like the MDs that I was working with, it was sort of not a significant point for them. But I recognize that you could actually make a very high IRR, may be 20% or so, just by writing puts on these things that they wanted to buy. So, it was during that time that I recognized that was really possible and I started experimenting with it myself, and it was really working.

And I actually did bring it to Goldman, and said, “We should have a desk that’s doing this.” And we did a quick analysis where we said, “What’s the market size?” At that time, I think it’s grown since then. Certainly, we were looking at only a few securities, but the market size, you’re saying, “Well, maybe we could do this with $250 million.” And then it was like, “Oh, so we’re going to make $50 million.” And then, at Goldman $50 million doesn’t–

Tobias: Doesn’t move the needle. [laughs]

Matthew: Yeah, now we got to write about it, we got to get space for all these guys. So, we got to pay the team. Goldman guys aren’t cheap. So, they said, “Yeah, I mean, it’s great. It’s 50 million.” Doing all that it was very interesting and I realized, “Well, I can do this.” And I was sort of setting up the block to run my own firm anyway. But certainly, that was the sort of period where I said, “Okay, this is going to be how I buy securities,” and it’s how I buy securities all the time. People sometimes ask, “Well, do you do things differently?” and like a PA, I mean, most of my PAs in the fund anyway, but even in my PA, I always sell puts as a tool, even if they go out a week or a month or whatever, I don’t rationally see why I wouldn’t take the premium [crosstalk] again.

It’s interesting, it’s part of the reason the market’s not that efficient, because, I mean, I tried to bring it to Goldman. And they said– there’s two reasons that, that they leave this market for people like us, and it’s that, one, most prop traders, most employees have an annual review and bonus cycle. And we’re looking at an 18-month contract, and that’s the start of a position. And so, very few people are willing to have that sort of patience, when they’re going to be evaluated December 31, no matter what’s going on with this underlier, and then they’re going to have to justify some sort of strange holding that they have. Part of it is the employee culture of the review and bonus cycle. And the other part is that the market is insufficient to move the needle, and so they don’t participate. And that leaves this space where there’s a lot of inefficiencies and I think irrationality, a lot of emotional trading. People are in there on Robinhood. That was sort of a lot of that background.

And then in, let’s see, around December 2010, I left my consulting firm, I left Goldman and I basically was– my fund was set up, we were getting ready to launch in 2011. And we did a little analysis where we want to live and ended up moving out to the West Coast and setting up in Los Angeles, and we spent nine years there. So, that’s kind of the very brief background.

Tobias: How did you discover the value side? How did that come about?

Matthew: The value side was so much ingrained in me. I don’t know when that moment was, if that makes sense.

Tobias: Was it a parent or a grandparent who was–?

Matthew: Certainly, my parents are, I think, generally very value oriented and just frugal in nature. My father’s an attorney, my mom’s a pharmacist, but just the way that they handled their assets and money– it was very much a value-based sort of framework, if you will. So, I sort of always knew I wasn’t going to overpay for anything. And I grew up at a young age doing very interesting entrepreneurial-type jobs. I set up a can recycling thing in my father’s law firm when I was nine or something and I’d get five cents a can and then I quickly had 500 bucks, and I realized I had enough to start buying CDs at the bank rather than just getting the interest, and then I started trading the CDs. And I was like 12 trying to do without my parents and the bankers were getting frustrated with me because I cared about $3 and they didn’t have the time to deal with it or whatever. So, it was always very much part of who I was.

I remember very clearly, I was riding a train in New York in 2003. And I was trying to tell my good friend that he should be buying Berkshire Hathaway stock. And then, he brought up the annual meeting, and I had never been, and it occurred to me I could just go. I think it was April 2004 was the first time I went to the Berkshire annual meeting. And that was a really great life-changing experience I’ve been. Other than the two years I lived in London, I’ve been every year since. Some of my best friends come with me. A few of my current best friends I met at the Berkshire meeting. So certainly, that was a big piece of it.

Tobias: Well, that’s great. We’re coming up on time, Matt. If folks want to follow along with what you’re doing or get in contact, how do they go about doing that?

Matthew: Yeah, great. There’s a lot of information on my website at petersonfunds.com. And folks can email me if they want to talk further. It’s matthewpeterson@petersonfunds.com. Twitter @MattPetersonCFA. And, yeah, I’m happy to speak with folks about any of these topics and more.

Tobias: Oh, that’s fantastic. Matt Peterson, thank you for your time.

Matthew: Thank you, Toby. It’s a pleasure.

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