VALUE: After Hours (S03 E12): The Risks And Rewards Of Concentration, PG’s Axioms And Neversell

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

  • The Risks And Rewards Of Concentration
  • Paul Graham’s Axioms
  • If You Were Born 15 Years Later Would You Still Be A Value Investor
  • Price Is Not A Valid Reason To Sell
  • Never Sell Was The Best Way For Value Investors To Hold The Best Businesses
  • Value Gurus Versus Value Studies
  • Hedging Portfolios With Competitors
  • Moats Don’t Help That Much
  • Avoiding For-Profit Colleges
  • Valuation Disparity Between Europe And The U.S
  • How To Know When It’s Time To Get Out
  • Malevolent Mr. Market
  • Symmetry In Investing
  • Does The Lindy Effect Work?
  • Good Design Is Timeless
  • $TDG’s Moat

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: Oh, yeah. That would be pretty cool to watch.

Tobias: What’s up, amigos? It is Value: After Hours. It’s 10:30 AM on the West Coast. 1:30 PM on the East Coast. It’s 5:30 PM UTC. 5:30 AM Australian Eastern Standard Time. We are live. If you want to come and watch us live, go to the YouTube channel for The Acquirers Podcast and click to get notifications, it will let you know. What’s happening, gents? It’s our one-year anniversary of the bottom.

Jake: Generational buying opportunity, one year ago today.

Tobias: Crazy. This is the best that your 12 month lookback’s going to look, so screenshot it.

Jake: [laughs] It’s all crap from here.

Tobias: Pump out all the marketing material today.

Bill: That’s right.

Tobias: Get it out.

Bill: That’s what I’m doing.

Tobias: Good luck with the tech. Thanks, fingers crossed everybody. [unintelligible [00:01:01]. I’ve got a good topic for today. It’s JP Morgan has this article, The Agony & The Ecstasy. It’s about concentrated stock portfolios and how many businesses fail, how many companies fail, in the Russell 3000 came via The Irrelevant Investor. I appreciate the link there. What are you guys talking about today?

Bill: I’ll probably just piggyback on you and then talk about the power of doing nothing.

Jake: Hmm. How’s that fit into your epic rant that is on deck?

Bill: I don’t know how epic it will be. We’ll see.

Jake: Let’s find something to get you wound up. [laughs]

Bill: I’m plenty wound. I just don’t know how wound I want to get.

Tobias: It’s 4:30 AM in Melbourne. Sorry, I might’ve got those times wrong. I guess you’re on your own. Don’t listen to me.

Jake: All right. I have a little piece prepared. Did I say that right? Piece prepared for that’s called A Beautiful Portfolio. This is going to be talking about some of Paul Graham’s work.

Tobias: Good name.

Jake: Maybe.

The Risks And Rewards Of Concentration

Tobias: I’ll take it away, because I’ve got the conch and I’m always lazy and I finally prepared something, so here I guess. It’s a nice bit, the JP Morgan paper, The Agony & The Ecstasy, the risks and rewards of a concentrated stock position that looked at the Russell 3000. Basically, 40% of Russell 3000 companies have negative absolute returns. You’d have been better of holding cash, in that instance. The reason that I wanted to highlight it, because I think this is potentially something you could put into your list of just stuff to be careful of. They listed out what are the primary reasons for business failure?

The first one is commodity price risks that cannot be hedged away. We probably already knew that, so just be careful of the commodity businesses. Government policy. This is a really long one, but that just about anything that they can change can hurt you, including regulation and deregulation. When the federal government’s moving around, you’ve got to be a little bit careful there. Intellectual property infringement by domestic or foreign firms. Foreign competitors whose market share is magnified by governments subsidies. The impact of patent trolls. Changes in US or foreign government tariff or trade policy. Fraud by nonexecutive employees. A shift in buying power to the firm’s customers, resulting from consolidation. Unconstrained expansion by competitors. I don’t know how useful that list is, but it’s just an interesting– everything that can go wrong. [laughs]

Jake: D, All of the above.

Tobias: I don’t know how much of that you could identify prospectively, maybe be careful of commodity businesses, maybe be careful of businesses that are heavily regulated or not regulated at all. I don’t know. I don’t think there’s anything that–

Jake: Or somewhere in between. [laughs]

Tobias: Or somewhere in between. Be careful of patent trolls, which means that you are the copyright infringer. Also, be careful of infringing– of having your copyright infringed.

Bill: Yeah, it sounds like businesses that aren’t particularly moaty can go out of business, sort of my takeaway.

Tobias: Well, how do you assess a moat? That’s a good question.

$TDG’s Moat

Bill: Well, I spent the morning reading about TransDigm. This person was talking about how they generally in aerospace, if you own the IP, that’s a pretty good place to play, and one of the things that makes it tough for a lot of people to compete in aerospace, is you need to be able to invest the money today in anticipation of the backend. The upfront development costs on the platform are not where you’re making much of your money at all, so you’re making it on the backend. But then if you own the IP, and you’re the sole source, that’s pretty moaty, I would think.

Tobias: What’s an example of that?

Bill: Well, TransDigm?

Tobias: Just specifically, what are they doing?

Bill: Well, they’re making like small–

Tobias: They’re aftermarket, aren’t they?

Bill: No. That’s where they make a lot of their money, but they integrate themselves in the supply chain up front, and then on the back end, they’re the people that own the IP, and they tend to be the sole source of small-ticket item, small-dollar value, [crosstalk] single-source, highly engineered parts.

Tobias: When the OEMs are developing their thing, they come in and they say, “We’ll help you” but they are integral to that process of developing whatever it is. “We’ll supply the parts,” and then down the road–

Bill: Yeah, they make little antennas, they’ll make the little seatbelt buckle stuff, they’ll make something that you put wires through that goes in the cockpit and whatever. It’s little stuff that doesn’t make a whole lot of sense to– once it’s already on a plane, and certainly it’s long into the lifecycle, it doesn’t make sense to stand up a secondary manufacturing plant that then you need to have go through all the FAA regulations, and it’s not so easy to copy. I think HEICO goes after easier-to-copy parts. TransDigm focuses on stuff that’s more highly engineered and smaller ticket size.

Sugar Prices

Jake: A bit like sugar in the US where we pay 2X the world’s normal price for sugar. Mostly, I think due to some kind of tariffs or something, but nobody notices or cares, because it’s like, “What’s your annual sugar budget?” It rounds to zero. No one cares.

Tobias: Does that support high-fructose corn syrup or something like that?

Jake: I’m thinking of actual real granulated sugar.

Tobias: It isn’t that– one’s a substitute for the other, so you keep sugar expensive, and it makes the other one competitive? I don’t know. I’m just asking.

Bill: I’d be interested to see a list of the companies that went out of business.

Tobias: It’s 40% of the Russell 3000. [laughs]

Jake: It’s a long list.

Bill: Yeah, I understand. I guess what I’m saying is, we talk about, “Oh, well, the Russell is trading at a cheap valuation relative to the NASDAQ,” I would be interested to know how many of those companies are tech? Maybe those companies–

Tobias: Well, that’s 3000, not the 2000. It’s all of them. It’s the top 3000. It’s not necessarily a small cap versus NASDAQ. NASDAQ is quite big these days.

Bill: I guess, I just want to know, which of the companies– I’d like to see a list. I know it’s a long list. I get it, 1200 companies–[crosstalk]

Tobias: Long and distinguished.

Bill: I would be interested to know what the multiple was before they went in? Sometimes–

Jake: I’m curious to see how moaty they were at one point in their lives.

How To Know When It’s Time To Get Out

Tobias: Kodak.

Jake: Big moat.

Tobias: At one stage. Yeah.

Bill: People make joke of that. How long could you have invested in Kodak? Yes, I agree. The last year would have been bad. Kodak had a pretty good run. If you were early in Kodak, I don’t think that you were, “Oh, fuck, it went out of business eventually.”

Tobias: It was the NIFTY 50.

Jake: Monster.

Tobias: Isn’t that saying, when you fall out of a high window, it’s not the fall that kills you. It’s just that last little bit where you hit the ground at the bottom.

Bill: Yeah, I don’t know how much of this is, could you own businesses and monitor them, and then see some of this coming. Yeah, you’re going to take a markdown at some point but-

Tobias: What would you look for?

Bill: I don’t know. You got to look at KPI’s, I guess. For TransDigm, you certainly wouldn’t want to see a secondary player into the market, that busts the whole thesis. For cable, I think you want to see how they’re taking share of other customers, and if people started to take share from them, I probably wouldn’t stick around to see why with all the leverage. I don’t know. I think every situation is pretty different. I think with beer, probably people would have said, when the volume decline started, you didn’t want to really hang out, especially in Bud. I did, but it was a loser.

Tobias: Buds is a tough one. Buffett bought some Bud in 2005, I want to say, before the acquisition. When did beer really start being a declining industry? Or macro beer started being a declining industry?

Bill: When he bought it, it was already declining.

Tobias: That’s what creates the opportunity. But then, you’ve got Sam. I looked at Sam, was cheap, maybe two years ago, something like that. Sam’s had a monster run since then.

Bill: Yeah, well, truly took off, too. That helps.

Tobias: That’s [unintelligible [00:11:02]?

Bill: Yeah. Well, I don’t know if it’s done it. I think that’s some of what’s going on there.

Tobias: I think there’s a lot of more randomness in it.

Bill: You’ve got to monitor this stuff. How do you know anything?

Moats Don’t Help That Much

Tobias: Well, that’s kind of my position. I thought there was a question about Dan Rasmussen saying that moats don’t help much. That’s my view. For most companies, 96% of companies, there’s no real decent moat in there. There’s a 4% that they seem to be pretty persistent. I think they’re almost each one of them is like a unique situation. I don’t know how much of a lesson you can draw from it. It’s each one is unique for its own.

Jake: Have you been on Twitter? There’s moats everywhere. Every company has moats. They’re all moaty.

Tobias: It does look that way. There are some moats out there though, I just don’t know if you can draw broad lessons from it.

Jake: If you disagree, it’ll check the stock price.

Tobias: That is true. It’s been a good run for moaty businesses. All right, I feel we’ve thrashed this one to death. What do you got, JT?

Jake: Have we? I don’t know.

Paul Graham’s Axioms

Jake: Paul Graham. Do you guys have much experience with any of his work or ideas?

Tobias: When I was a tech M&A lawyer in San Francisco, someone gave me his book, just the name of it escapes me at the moment. It’s been a long time since I’ve read it.

Jake: Is it Hackers & Painters?

Tobias: Yes, that’s the one. I’ve got that back there somewhere. I love the book. I read his website, when he puts up in USA. I found that to be pretty insightful. He’s an interesting thinker.

Bill: I have no idea who he is.

Jake: Good. All right. Well, just as a little background then, for Bill’s sake and everyone else maybe. Paul Graham, he’s a computer scientist, essayist, and venture capital guy now, he was one of the founders of Y Combinator. He’s probably doing okay, but he has this book Hackers & Painters, and it’s quite good. I mean, some of the talk about programming languages might not be as interesting for someone although, there are some cool– [crosstalk]

Tobias: He advocates Ruby on Rails over C++ or whatever it was.

Jake: That not quite right, but yeah. [crosstalk] -this one called LISP, is the programming language that he likes.

Tobias: LISP. Okay. It’s been a long time.

Jake: In Chapter 9 of the book, it’s called Taste for Makers. It’s actually available on his website too, if you want to read that section. He’s talking about, how mathematicians will call good work, beautiful, and it has its own meaning, and other domains have also adopted the idea of beautiful. Whether it’s scientists or engineers, or musicians or architects, designers, writers, and coders. He looks through all these different domains, and tries to draw out the similarities of really, “How do you make good stuff?” I thought, well, all right, we can start with where the different domains that he saw, and how do they make good stuff there, and he took it to then computer programming, and we can then take it one step farther and try to apply it to a portfolio or investing more broadly. He has 14 different axioms about what makes something beautiful. We’ll pick out a handful of them and see if we can get through them and see what interesting things come out of it.

Number one. Good design is simple. In math, a shorter proof is always better. Good computer programming is very tight. Good writing is concise. Hemingway wrote like at a fifth-grade level.

Writing For Five Year Olds

Jake:Toby, maybe we talk a little bit about some of your experience with writing and simplification.

Tobias: Yeah. My first three books were written, probably where I normally write and then Acquirer’s Multiple, I read in the– after the Second World War, they discovered that a lot of the guys who were on the naval boats, couldn’t read the manuals, because they’re written by engineers, and the guys who are expected to operate them in many cases were unqualified to some degree. They went and they standardized writing to work out what are the indications, if someone can read to a fifth-grade level or a 10th grade level. Basically, it’s the number of syllables in a sentence, the number of syllables in a word, the number of words in a sentence, and they have different scales of measuring it. Basically, it determines how complex or how complicated your writing is, and how many years of education you need to be able to understand it.

What they then found is they’ve gone and looked at famous writers and see what level they write to. There’s a pretty strong correlation between the lower the grade level and the more commercially successful your book. Harry Potter is written to a very low grade level, it’s one of the most successful books around. Dan Brown writes to fifth grade reading level. Ernest Hemingway got a Nobel Prize for Literature to a fifth grade reading level. I find Ernest Hemingway a little bit hard to read. Dan Brown, it’s a page turner, they’re very short chapters. Basically, the more complex your writing, the fewer people who can read it, the less commercially successful you are. I found that to be true too. Acquirer’s Multiple is much more successful as a book. It’s also cheaper, so there’s that. [chuckles]

Jake: I think the good writing has a crispness to it as well. There’s an economization of words that really– the English language is rich enough that you can– there’s almost a right word that you can pick, that will eliminate two to three other words that would be descriptive to help try to craft the sentence. Taking this to an investment context, a good investment thesis is simple. It’s kind of back of the napkin, doesn’t have a lot of moving parts that can– If any one of those links in the chain breaks, and it destroys your whole thesis, that’s a lot more fragile than a very simple back-of-the-envelope calculation and an idea. Which is why I actually find a lot of macro things really compelling, but also, I’m very cognizant of the fact that you need 12 different things that all happen in the right order for this whole magical puzzle to pop out, here’s how you would win.

Tobias: Jason, who runs Mutiny Fund. I said to him, the problem that I’ve always seen with macro is that the idea might be compelling, but it’s all in series, this needs to happen, this needs to happen, this needs to happen. By the time you get six things in series, where it’s just a coin flip, the number of possible outcomes is so huge, it’s really hard to get paid. He said, “Yes, but that’s the way to make the bet really convex.” I was like, “That’s interesting,” that you can put on a more blunt version of it, and probably be more likely to get some return. If you put on that one, if you can narrow it down to like– I’ve got this thesis that something’s going to happen in Japan, so I want to be short JGB, vol, puts or calls or something, whatever they’re trying to– if they’re doing it to that level, that’s because– Kyle Bass says, “This is the most convex trade I’ve ever seen in my life,” like that kind of stuff.

Jake: You get three sevens in a row on your slot machine.

Tobias: That’s it. Get all the cherries. All the cherries came up.

Jake: [laughs] Bill, Any thoughts on simplification in your investing world?

Bill: Yeah, I just think a whole lot of hard needs to get you to the simple part.

Good Design Is Timeless

Jake: Hmm, we’ll get to that a little bit more. Next thing, good design is timeless. In math, every proof is timeless, unless it has some error in it. Almost by definition, good proofs are timeless. Kelly Johnson, who was a manager and brains behind the skunkworks projects that produced the U-2 and the SR-71 said that an airplane that looks beautiful will fly beautifully. If you look at the SR-71, to me that’s a really timeless looking airplane. It still looks badass even though, it’s what 60 years old or something?

Tobias: Didn’t they say about those things, that there are two problems with them. I might be wrong about the SR-71, that’s the Blackbird, right? I can’t remember which ones which. I read that book too. He said, “There are two things that really bothered him.” They were designed at some sort of pressure. They assume that they’d get up into the air and all of the metal would expand, but basically all they sat on a tarmac, they just leaked all over the place. It may not have been the SR-71. It might have been the later stealth fighters, but he said basically, you can’t fly them. You need a computer to help you fly them, because otherwise, they’re just not aerodynamic. They just fall through this. They’re like rocks that fall through the sky that a computer flies for you.

Jake: All right. Well, they still look badass. Don’t ruin that part for me.


Tobias: I think that’s also true. I don’t know what I’m talking, but it’s interesting.

Jake: One of the nice things about being timeless is that, it’s a way to evade fashion. He doesn’t call it the Lindy effect, but it’s a little bit like that. If you design something that would appeal to someone in the 1500s, it has a better chance of appealing to someone in 2500. A good drawing, or a good painting–

Tobias: Ruffles around the neck. [chuckles]

Jake: [laughs] Right. That’s a little bit more fashion. For me, the timelessness in an investment context and a portfolio is really a well-run long-duration-minded business and really focusing on cash flows, and actually cash. Cash sometimes is important in the investment world, and other times it doesn’t matter as much but I think that is a bit of a fashion as well. I think over the long term, you can anchor to the fact that, good cash flow producing business, in 2500 is still going to be important, just like it was in 1500. Although we forget about it occasionally, it’s more fashionable to be not really worried about cash sometimes but I think it’s always a touchstone for me to come back to.

Does The Lindy Effect Work?

Tobias: Let me play devil’s advocate for a moment because one of the great articles that you did your veggies on a little while back was the– how long something had survived, and how long it was like– this is the Lindy test. Somebody had done this analysis, and they had said that basically the length of time that something has been alive is like an irrelevant factor for how long it continues to survive. So, Lindy is not right.

Jake: I think Lindy, if we’re being strict about it, is that, if you know nothing else about something, you have to assume that you’re somewhere in the middle of the life of it, just statistically speaking. The odds that you’re at the beginning or the end are probably less likely, which leads you to the middle, which then means that it’s about half of its life right now.

Tobias: Damn, that’s good.

[laughter] Jake: All right. The next thing is, and this goes back to you, Bill, good design is hard. In math, the difficult proofs, they require a lot of ingenious thinking and solving, ingenious solutions. A small budget is what will produce a really elegant design. A lot of times the constraint is what creates the creativity. That’s not easy. The best art has always been the painting of people. You could paint a tree, and if one of the arms of the branches of the tree is off by 5 degrees, no one’s going to notice or really care, because it just like, “All right, well, that’s just what that tree looks like.” But if you paint someone, and you’re off by 5 degrees as far as where their eyes are, that’s very noticeable. That’s not easy to do, obviously. The other thing too is wild animals, he says, are beautiful because they live hard lives. Which I think is a nice thing to say, or it’s interesting.

In this investment context, and you guys can fill in more here, but to me, it requires a lot of research to understand a company. It’s not always easy, it’s hard. If this game is too easy to you, I have to wonder about do you really understand some of the risks that you might be taking. Of course, your psychology is always going to be tested in this, maybe like few other pursuits. It really is you against yourself a lot of times.

Tobias: I think, it’s always you against yourself. There’s nothing else there.

Malevolent Mr. Market

Bill: I like Elliot Turner’s concept of a Malevolent Mr. Market.

Tobias: Malevolent or benevolent?

Bill: Malevolent. Yeah– I’m getting tongue twisted, but he is a bad guy-

Tobias: The evil one.

Bill: -he is trying to get you to act the wrong way.

Symmetry In Investing

Jake: Yeah. All right. A good design uses symmetry. A lot of this is like repetition and recursion. You see that a lot in nature. There’s a lot of repetition that’s used, kind of fractal patterns, things like that. If you look at the Eiffel Tower, it’s actually a tower on top of a tower, and that’s a recursive idea. For me, in the investment context, that is– I think a lot of times sort of pattern recognition, you’ve done a particular investment, or you recognize something about a business, and it looks similar to something else that you’ve been successful with, or maybe not successful, and you learn that lesson and you learn to avoid it then. I think there’s also maybe an interesting argument to be made there with symmetry about equal weighting of positions and the humility of that. Thoughts on that?

Bill: I don’t know. I’ve never bet big and lost yet. I’ll let you know when that happens.

Jake: [laughs]

Tobias: [laughs]

Jake: Gauntlet thrown down.

Bill: No. I’m not trying to be an ass about it. It’s just I bet big a couple times. I bet big on TransDigm in March, I bet big on Qurate when I told everyone I was doing it. I haven’t bet big and lost. Maybe, if I take a big loss, then I’ll change my opinion. Thus far, my higher weighted bets, I bet big on Charter, things have worked out when I bet big. It’s not easy for me to understand the concept of an equal weighted portfolio, if I’m spending all this time to try to figure out when a bet is worth making.

Tobias: Symmetry is tough. I can’t really imagine how you apply that at this point. I’ve got to think about that a little bit more. Maybe that does make sense in a portfolio. Maybe that is symmetry in a portfolio.

Jake: Well. Let’s see. Toby, your long/short is symmetry in some ways.

Tobias: It’s a little bit unbalanced to more favor the long, because the long tends to go up more often than the short goes down, and the short goes up. I think that equal weighting is just what you so when you get down to that– you’re already at the very pointy end of a big data set, and you’re just saying, out of all of these positions, I don’t know which of these at this pointy end are going to be the better ones. I think it’s hard going through that list. I’ve done that many times, looking back historically, to try and work out, not knowing what worked. It’s hard to figure out which ones are the ones that are going to work. If you went through and cut out the tech, well, then you miss Microsoft, and you miss some of the big winners. Retail, you miss Ross Stores. If you have some rule for things that you miss, I think possibly everybody else is doing the same thing. I don’t know. That’s why I get to equal weight.

Jake: Yeah. That was Joel Greenblatt’s observation, when people were given discretion over the magic formula picks, and they all underperform just the unconstrained version of it.

Tobias: It’s tough. I don’t know if that continues to apply, but it was a fairly short time period. That was the only thing. My two cents only ran for about 20 months.

Jake: Yeah. Next thing. Good design resembles nature. This one is obvious, based on– if you’ve listened to this show at all, and our incessant use of nature for trying to explain things. But at the end of the day, it has to do with it– Nature has had a long time to optimize and had a lot of– It’s a very large end. You get that big of a population size and that many observations, you can start to trust that whatever comes out of it is true. I don’t need to really belabor the nature part of it, because we do that every week.

The next thing I’ll just move on. A good design is redesign. Apparently, Leonardo da Vinci basically invented sketching. It was a lot of writing over things, moving a line a little bit. It’s just constantly reworking it. As you know, Toby, I’m sure you can speak to this on writing, but good writing is just– it’s total crap when it starts out. Your first draft is such garbage, and it’s just the meticulous working it over and over the materials until you almost hate the material as the author. That leads to eventually good writing. You’re just sketching and then just relentless pressure on it to turn it into good writing.

Tobias: Yeah. It might even be Paul Graham who said something like, “When you start out, you have better taste than you have skill. “The first thing that you write down,” and this is through a career as well, but the first thing you write down is or to draw, or paint or whatever is terrible, and then as you get better, your skill matches your taste.” It’s also true for each individual thing that you do. The first draft is diabolically difficult to get up. It’s really easy to go through and edit and rewrite. Not really easy, it’s easier than the first draft, because the first draft is impossible. You’ve got to get the first draft out and down as quickly as you possibly can, because it only starts getting better from there. So, even if it’s bad, it’s better to have it out.

Jake: In the investment context, I think sometimes people are guilty of, getting the idea into their portfolio, and then they stop thinking about it. They stop sketching, and they stop redesigning, they stop rewriting. It’s just, “Well, that’s one of my positions, let’s go look for another one.” To go to Ian Cassel’s point about– he spends 80% of his time on the things that he owns to make sure he understands it, that’s sort of the writing equivalent of rewriting in the investment context. You’ve sketched it out at the beginning but once you’ve owned it for a while, that’s your actual rewriting over and over, resketching, and doing a better job of matching your understanding with reality as you go. It’s probably a pretty helpful idea to keep in mind.

Hedging Portfolios With Competitors

Tobias: Yeah, I really like that one too. I like Ian Cassel’s idea, is you just keep on– the longer you hold it, the better you know it, so you’re not going to sell out precipitously if something happens in it, that if you studied it closely enough, you would have known that was coming anyway, there’s some small change, it’s not really material. Sort of what we were talking about earlier that you just need to follow the things that you own closely enough so that you can see if there’s some change. I don’t know if you can pick those things that are potentially game ending for those businesses. Maybe you can, I don’t know. If you think there’s something that’s going to be– If there’s another competitor that’s potentially game ending, maybe you hedge it by taking a small position in that competitor knowing that by the time that competitor gets big enough to really damage your business, you’ve already got a stake. So, you’ve got a big enough size in each.

Jake: Yeah. That’s the what if of why didn’t Sears buy just 5% of Amazon when it was an early competitor just to have a little bit-

Tobias: Blockbuster.

Jake: -of their own [crosstalk] Blockbuster.

Tobias: Taking a little bit of Netflix.

Jake: Sure.

Tobias: As an investor, you can do that. The business doesn’t have to do it for you, you can do it externally. Hedge your Blockbuster stake with a position in Netflix. That’s an interesting topic all by itself, I don’t know if you can– I might have to think about that one. How would you hedge all the positions in your portfolio with the competitors?

Bill: Yeah. I don’t think you want management running a hedge fund on your behalf.

Tobias: But they have earned some sense on that.

Jake: Who knows the industry better–

Bill: Sears got fucked because Sears sucked. Sears didn’t get screwed, because they didn’t take a position in Amazon. They got screwed, because they stopped investing in their business. You could walk through those aisles. They were full of shit. They got under-inventory. They invested a bunch of money in a crap app. I’m sorry. I don’t think a 5% position in Amazon was going to save them. They just would have spent that money in a bad way.

Tobias: It wouldn’t save them but it might save you as a Sears investor or the Sears family.

Bill: Probably not, [crosstalk] Lampert probably would have taken out some loan and put the shares and leaned them up against ESL investment trust. That’s what he did with all the good real estate, why wouldn’t he have done it with the shares?

Tobias: Now what I’m saying is, you as an investor, don’t have to ride Sears all the way into the toilet.

Bill: You can buy it.

Tobias: You can externally, you can say, “Well, Amazon’s a real threat to this thing, I’m not prepared to sell out, but I’m going to buy this little thing over here.”

Bill: Yeah, but I don’t want my management teams doing that.

Jake: What would you, hedge your REIT with Zoom? Is that like a play?

Tobias: Maybe? [chuckles] I think it’s an interesting way to approach the problem.

Bill: I said that I haven’t taken a big loss on a big position. I guess the airlines were a big position. I did take a loss. I wonder if Zoom had cut in over time, would I have been able to notice that I was in a melting ice cube? I don’t know, that’s a harder question for me to answer. I guess it was easier this time around, because when the world stopped, I was just like, “Oh, this is clearly different.” I guess I don’t have a good answer, simply because I don’t have one.

Jake: All right. Well, I’m all done. I shot my wad. Whatever you guys want talk about now.


Price Is Not A Valid Reason To Sell

Bill: Yeah. Well, I think it’s interesting. I agree with what Ian is saying, but then, you’ve got Charlie and BYD. He’s basically like, “Yeah, I’m just going to hold it.” So, when do you act? It seems as though, among most of the investors that I admire, price is not a valid reason to sell. That seems to be a very, very consistent theme. Then, you get to the question, “Well, who are all of the investors that held and then everything bombed out underneath them?” I mean, Acry, Buffett– Malone flipped stuff. Munger said straight up, “I don’t understand, why BYD is valued this way? Are you going to sell?” Probably not. They’re good at what they do. I don’t know, it seems to me that prices is valid reason to buy, and the more and more I read people that I seem to respect, now maybe this is just like a market cycle top. You’re talking about Buffett, Munger, Jake. If you don’t like them, then who’s your role model? It’s not as if I’m just pointing to some crazy tech bro. I’m talking about Munger.

Tobias: There’s a good quote from Bill Gurley that I had put up today, where he says, “The power of compounding for these platforms is so huge, if you invest in an Amazon or whatever, the hardest thing to do is close your eyes and forget it.” There’s a little bit more to it than this, but his point is, the only thing analysis is going to cause you to do is to sell a stock. He’s like just close your eyes and just keep on holding.

Jake: Yeah. I don’t think you’re wrong. If most of the returns come from a few huge winners, and you go and truncate those winners by doing too much analysis and selling too early, and when those business results come out that you could never have imagined in your wildest dreams, that is what turns into those outcomes. It makes it really hard not to trim something that maybe you’re better off ignoring and letting happen. But I do think it’s got to be a lot of dead quiet evidence and survivorship bias in this analysis, right?

Bill: I don’t know. I’ve been talking about David Gardner for almost a year now. This is how his theory works. I think he probably looks for a bigger addressable market than I’m maybe used to pushing myself to think too. I think he swings at things. He thinks, he can really, really win, and then he holds them. Then he just lets math takeover. If you’re upside is a $2 trillion company and your downside is zero, then you can mitigate that with a bet. But if both are 1% going in, and the upside on one is, whatever percent infinite basically and the other is down 100, as long as you can keep taking shots on goal, it’s not the craziest strategy. I don’t know why it outperforms an index, that’s hard for me to wrap my head around.

Tobias: I have been doing a little bit of that, trying to work on some never sell ideas. I’ve been doing testing just as far back in my data set as I can go just run the screen and see what happens if you hold it today. That’s what happens like you have, it starts looking more like a VC-type portfolio where you have a handful of monster winners. You have plenty that go to zero. If you think about the– I’ve discussed this a number of times, but high return on equity, high gross margins, high operating margins, all those things that we would all agree basically indicate a company or business is doing very well. When you run those screens, you still pick up stuff like you would have bought a whole lot of profit colleges, when they got cheapest before they got wiped out. How would you avoid those sorts of things?

Bill: The for-profit colleges?

Tobias: Yeah.

Bill: I’ll tell you when I got interested in them was when they got cheap.

Tobias: Yeah. Me too.

Valuation Disparity Between Europe And The U.S

Bill: This is a tangential thought, but it’s somewhat similar. I was listening to Cobra Global on the Twitter machine. He was talking about Europe. Everybody’s– Well, not everybody, but I’ve seen people citing the valuation disparity between Europe and the US. First of all, trigger warning to people that think that I’m some crazy crony capitalist or socialist from last week, because you all can’t listen, that’s not my fault, that’s yours. He was like, if you look at the EU, a lot of the countries can’t actually stimulate, because they’re bound by EU restrictions on what their deficit is allowed to be. Then, the EU is trying to get cute with how much they’re paying on the vaccines. Now, they’re going into lockdown, and they’re going to be austere, and we have the vaccine and we’re not. To all you that said that I don’t know what I’m talking about, guess what? We got a test case. If I’m right, you can go fuck yourself. To anybody that said that, I had a big head-


Bill: I want everybody to know that, I, 100%– Oh, Toby and Jake, everything, and you can go fuck yourself too.

Tobias: I thought you meant physically a big head. Don’t worry about that, mate. Your head’s proportionate.

Bill: I know I’m pretty decent looking, that I’m aware of. I’ve gotten into trouble when I’ve let valuation start to drive my research. That’s when I really started to get myself in trouble.

Tobias: That’s the reason, that’s the cause of you’re looking at something?

Bill: Yeah. I think when I’m on the fence, and I’m like, “Ah, but it’s cheap,” that’s when I really get myself in trouble.

Tobias: Here’s my question, that’s a phenomenon of the last kind of– since 2010. Basically, since 2010, value hasn’t been much of a contributor to return. It’s been at the bottom of every– when you do an attribution of returns– this is sad, but when you do an attribution of returns in any given year, valuation, it’s not there. Historically, that’s a little bit unusual. Most of the time value does pretty well.

Bill: Yeah, but that’s in any given year, right?

Tobias: Well, that’s over– [crosstalk] last 11 years since 2010, mid 2010.

Bill: Yeah. I guess what I’m saying is, I fully understand in a wrapper that is mechanical of why valuation would be a valuation-first decision. In the more discretionary portfolios, I think you’re almost betting that– I guess that maybe I’ll just say what it’s done to me, and we’ll see, there are some other people that it doesn’t do it too, but I think that if I look at valuation, I underweight business quality. I think that there are a lot of places more that I know more about the market that cheap really indicates a lot of problems. I don’t have a good answer.

Tobias: I got someone’s thrown a Cassel quote from the Business Brew podcast. Some of the best buy and hold investors had their best performance come in high turnover years, Buffett had 80% turnover over 20 years, same with Lynch, Greenblatt 200%.

Bill: Yeah.

Jake: I think I would–

Bill: I had some pushback from a pretty smart person on that, but I’m not ready to– I haven’t done the work, but this guy is pretty smart. I’m going to follow up with Ian.

Avoiding For-Profit Colleges

Jake: Let’s go back to the for-profit college idea. I think if you’re going to be a never sell mentality, which is sort of what we’re talking about again, I think you have to really have a business that has long, long sustainability, a lot of resilience. I would argue the for-profit colleges were not playing fairly with all constituents in the ecosystem, which would eventually have led to some defection and problems for them. When you get into that, I don’t think you can hold those forever, especially regardless of valuation. Whereas if you can find a cleaner shirt business, that to me makes it more likely of a candidate to be in your never sell pile.

Tobias: The problem for the for-profit colleges, they were basically subsidized by the government. They were getting as sort of all universities are, as all colleges are, that were subsidized by the fact that you can take out a big loan to buy these things. My thought process at that time was to go through and try and find the ones where basically they were learning a trade– ESS, which is Los Angeles, that’s the ticker– the name of it just escapes me, it was pretty well known at the time. I asked my wife about it, because she’s an LA local, she’s seen them advertised on television forever. I thought, well, they help people get trades, become a mechanic, become something like–

Jake: Welding. Yeah.

Tobias: If there’s anything that’s going to survive this, it’s going to be ESS. No, ESINQ, I think it is that.

Jake: Yeah.

Bill: Oh. Yeah, because it’s bankrupt.

Tobias: Yeah.

Bill: Yeah. The whole education industry in general is a racket. Sometimes, I wonder if the average college is public and under the scrutiny of short sellers, whether or not it would still exist.

Tobias: You get those times where it’s a great business, it’s quantitatively a great business and here’s your opportunity to buy it at a good valuation. That’s what I perceived Buffett to be doing. He’s trying to buy really good businesses when they just get that moment. The last example is Apple, but just for whatever reason, it traded down. I think it was on like 10 times EV/EBIT, something like that. It was just too cheap and he buys it. That’s what he does. These are not wonderful companies at fair prices, these are wonderful companies at very, very cheap prices. But he’s still buying wonderful companies out of their bucket. He’s not buying the–

Jake: [crosstalk] [laughs]

Bill: I don’t know if that’s not really true, because he says in his private– I don’t know, I wonder if Pilot Flying J was a really wonderful price.

Jake: It gets harder, I think, when you get bigger to find the wonderful price.

Bill: Yeah. He used to do it with crappy companies that he could take over control of too, which– I wouldn’t want that life. I just spent some time talking to Kyle Cerminara, and he seemed to go through some stuff that I’d rather not go through. Turnarounds of inherited dog poo-poo is not exactly my idea of a great existence. I think you’d argue it’s not his either.

Never Sell Was The Best Way For Value Investors To Hold The Best Businesses

Tobias: I got a good comment here. Never sell was a way for value investors to hold on to the best businesses at 30 times earnings when they initially bought in at 10 times. I kind of agree with that. The way that I justify it– I don’t do this. I’m trying to think through if I had something more discretionary, this is something that I might do. The way that you get the right tail, is you have to be in these things that start running and for whatever reason, the business quality gets better over the time that you hold it.

I always give it– the best example of that, I think is Microsoft, because Microsoft in 2010, 2011, 2012 that kind of time, they were pitching at value investors’ congresses, and it was 11% free cash flow yield with one year of earnings, revenue declines run by Steve Ballmer, stock hadn’t gone anywhere for 13 years. It wasn’t a compounder-type stock at that point. And Satya Nadella just taken over so. He was unproven. Since then, Satya Nadella is probably a business genius. They’ve turned it into a software as a service type business and it’s run a million miles. Probably, it’s still roughly fairly valued, even though it’s up a lot and the multiples gone up a lot.

Bill: Yeah. Here, I’ll say something that triggers people. Maybe value investing is the disease that gets people to sell that thing at 20 times earnings to buy the next thing at 10 times earnings that turns into some Brookfield property situation where you get taken under. I think these rules are so difficult. I’m dealing with it right now with some of my portfolio. It’s trading it at valuations that I’m not particularly comfortable with, but what am I going to do?

Tobias: Well, congrats to everybody who’s got long-term capital gains. Long-term capital gains tomorrow.

Jake: Today, woo.

Bill: It’s like, what are you going to do? I sell it, I’ve got to pay taxes, then I’ve got to come up with another idea. Nothing is cheap right now. I don’t know what you do.

Value Gurus Versus Value Studies

Jake: I did a little study at one point where I looked at the value gurus versus the value studies. The idea was to try to figure out, is the simple model really the floor and not the ceiling of what’s possible, as some have argued? What’s interesting– and a lot of this has to do, I think, with liquidity differences in a back test model that just looks at, okay, buy this, sell this, and it’s not as constrained, especially if you got bigger, and you’re Buffett and you’re trying to do things, you just don’t have the same universe. Regardless, the punchline is that the models trounce even the gurus, but why?

One hypothesis I had was actually that if you think about the value guru participating in the irrationality of the intrinsic value being below price and catching the runup, and then selling at intrinsic value, perhaps the model, participates in that part of the spectrum, but because it mechanically holds for a year or two years, or whatever, and it doesn’t really care about what happens in the interim to valuation, it might participate on the upper half of the irrationality when something runs past intrinsic value and goes up to something that the value guy would have never been able to hold. Maybe that’s where that extra premium comes from in the mechanical study. I know it’s a hypothesis. I’m not sure if it’s true or not, but I find it an interesting idea.

Tobias: Yeah. The same thoughts occurred to me, not necessarily just against those guys, but that’s a reason to hold on– you definitely have some things that run well beyond where you would buy them, and part of it is a multiple expansion, and part of is I have a good earnings sprint because they turn around and so they’re much, much more expensive, then you would buy them or hold them. But you don’t have a rebalance that coming up, so you sit in them. Graham has that rule where he says, “I hold on to it, if it’s run up 50%, or I’ve held it for two years.” I think, it’s one of the few Graham rules that’s a really bad one, because what you want to do is hold the things that run up for two years and really– sorry, hold the things that have run up for 50%, because you’re truncating those winners, and then the two-year holding period is meaningless. If it’s still cheap, you should still be holding it probably.

Bill: Yeah. That guy is not a guru when he was born in the depression. It makes sense that maybe his rules are slightly–

Tobias: He wrote some books that are all right.

Bill: [crosstalk] Even Munger and Buffett have said they had to morph from them. I don’t think that the notion of the guy wrote a book, so it’s timeless wisdom. I think the method of thinking is very timeless. But I don’t think that you can be, “Well, it worked in the 50s, so it’ll work today.” That doesn’t make sense to me.

Tobias: It’s the same idea. You could look at John Maynard Keynes, he describes a method of investing that basically sounds like what Buffett does today. He says, “Look for the compounders, only hold a handful of them that you fully understand.” You can read him, and it sounds like Buffett. Buffett’s quoted him and it sounds like Buffett.

Bill: Buffett also learned from Graham, and then Buffett morphed. I think that there’s different things for different personalities.

Tobias: For sure.

Jake: What’s Value 3.0 then?

Tobias: Compounders, software as a service.

Jake: Oh, that was 2.0, compounders.

Bill: I don’t know. I think long/short is probably a pretty good strategy going forward.

Tobias: Bless up.

Jake: Just because it’s sucked ass for so long.


Bill: Well. I just think it seems to be one of the things that’s uncorrelated. I don’t know somebody said, it’s new 60:40 and I think that makes sense.

Jake: In the wrong direction.

If You Were Born 15 Years Later Would You Still Be A Value Investor

Tobias: Well, it’s definitely uncorrelated. I can attest to that. I’ve got a question here. JT and I’ve talked about this a little bit but interested to hear what you think that. If you’re born 15 years later, would you still be value investors?

Jake: Probably not.

Tobias: I’ll say this, I discovered value investing in the late 1990s and it was a full-blown tick. Similar to what we had last year, I guess, when dotcoms were teeing off. That didn’t make any sense to me and value made sense to me. So, yes, I certainly would still be, because 15 years later probably coincides with this current dotcom 2.0.

Jake: I think I would have also, just because, my whole life up until I knew even what value investing stood for, I always liked getting deals on things, and I hated paying retail. I was always looking to arbitrage something and feel like I was getting away with something. I always probably would go more towards cheaper than quality in whatever I was doing. When I heard it described as doing that same idea, but for the partial ownership of businesses, it just made perfect sense to me right away, that inoculation took. So, I think I still probably would have fallen into the value bucket, even if it was 15 years after.

Tobias: I don’t think Graham necessarily defined value as cheap. What I got from reading the Intelligent Investor was that you should approach it in this sort of business-like fashion, you should approach it like you’re looking– you’re not trying to buy cool products or cool companies, you’re trying to buy streams of cash flows.

Jake: Did he actually say dog shit?

Bill: Yes, but dude-

Tobias: Did I say that? [laughs]

Bill: -then everybody says the cheap. If I offered you a Ferrari, like an F430 at 100 grand and it was mint, most people would agree that’s value, but for some reason, most value people are like, “No, I want the Pinto for two grand.”

Tobias: [laughs]

Bill: Okay, but really rich stuff can also be value. But then when you pitch that, people are like, “Oh, you’ve abandoned your roots.” It’s like, “No, I just think that’s good value.” Scarcity accrues value over time, scarce assets tend to trade at higher multiples, you can find value at higher multiples. God forbid, you say that. People are like, “Oh, did you even read, dude?” Yeah, I did.

Tobias: Then, Buffett says that too. Low multiples aren’t necessarily value and high multiples aren’t necessarily expensive.

Bill: Yeah, well, people might benefit from listening.

Tobias: The problem is that– the difficulty is this, when you look at the cohorts of stocks, the cheaper cohorts do tend to do better than the more expensive cohorts, but the lottery tickets come out of the most expensive cohort. If you’re the kind of guy who can go through the most expensive one and pick out all of the Shopifys and the Amazons and Micro– well, not Microsoft, because it was cheap, but anything out of that group, and you can identify the ones that are winners, then you are well and truly paid to do that. If you’re not able to do that, and I’m not able to do that, then you need to be going through the stuff where your base rates a little bit better.

Bill: Dude, you say that, but I bet that the strategy that you’re thinking of running on the side where you’re the invincible investor, where you are waiting for temporary hiccups in moaty businesses, I bet you could run that.

Tobias: Yeah. I think so.

Bill: This is basically rule one stuff. I’m just not sure that I’m fully on board with the bet size that he preaches.

Tobias: The only thing that I would say to that is, this is what I’m trying to talk about it now. How do I avoid stuff like the for-profit colleges? I just don’t have a rule for avoiding that stuff.

Bill: I think something that I’ve learned from Elliot and McMurtrie a little bit is they like to talk to people that are short. I think both those guys are good at understanding the case against what they own. I think if you really force yourself to write that out and to say, “Okay, well, how would I argue the short side of this?” I think that might be a good exercise-

Tobias: That’s fair.

Bill: -and make yourself– not even just a premortem, no. If I would short this, why would I be short? What would I be looking at that would make me not like this?

Jake: I think Amazon or something, you could have written a very compelling short of Amazon for multiple years. It almost went bankrupt a few times. It’s not like it was even– this isn’t a hypothetical, and yet, there’s these survivors that turn into these absolute monsters. I don’t know, it’s really hard.

Bill: Yeah. Dude like Nick Sleep probably knew that short case and didn’t think it was right. Maybe Nick Sleep isn’t quite the investor that everybody thinks he is if AWS doesn’t come out, but he probably still retires.

Tobias: You could have bought a cheap, too, it fell 94% from– it’s fallen 90% plus a few times, like you got it in the early 2000s down 94%, maybe you’re just like, “This thing is better than it looks here, and I’ll just grab something here.”

Bill: Yeah. David Gardner–

Jake: [crosstalk] -see what the metrics look like though at that point. What were you actually preparing– [crosstalk]

Bill: [crosstalk] -any of us would have seen it [crosstalk] e-commerce bookstore would have been like Barnes & Noble is going to kill that– [crosstalk]

Jake: What was the cheapest, it’s ever traded on price to sales or something– [crosstalk]

Tobias: I’ll pull that data up, and I’ll tweet that out in a moment. That’s time, amigos This was fun. It was a good chat.

Bill: Yeah. Indeed.

Jake: Sorry. We didn’t take more questions.

Bill: I’m not. You guys got a good combo.

Tobias: We got some in. Thanks, amigos. We’ll see you next week. Peace.

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