VALUE: After Hours (S03 E13): Adaptive Radiation, Undervalued Quality Resurgence, Big Hwang Blows Up

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

  • Adaptive Radiation
  • Original Value vs Expected Mean Reversion
  • Undervalued Quality Resurgence
  • Implied Rates Of Change Are Mispriced In Today’s Prices
  • Big Hwang Blows Up
  • X ROE Is Highly Mean Reverting
  • How To Run A 8-10 Stock Portfolio
  • SPAC Boom Signals Top
  • AQR Quality Minus Junk: Factors
  • Carnage In Weed Stocks
  • Scott Galloway ‘Cowish’ On WeWork
  • Verizon: Network As A Service

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

Toby: Good morning, afternoon, amigos. It is 10:30 AM on the West Coast, 1:30 PM on the East Coast, 5:30 PM UTC, I think it’s 3:30 AM Australian Eastern standard time. If you want to watch Value After Hours live, you need to go to the YouTube page for The Acquirer’s Podcast and click to get a notification, and then you’ll be able to come in. What’s happening, fellas?

Bill: Just loving life, [crosstalk] got some retail friends telling me, I don’t know, there was some IPO that popped 50% yesterday, they want to get in and out real quick. I said, “I’m not an advisor, but I don’t think that’s a game that you really want to play.” They were like, “Yeah, but it went up 50% today.” That’s still out there.

Jake: That’s good. Keep some froth on.

Bill: Little bit of risk on.

Jake: [laughs]

Toby: Is it Buffett’s birthday today? Happy birthday, Buff Dog.

Jake: No. August 30th.

Toby: Oh, I’m sad that you know that, brother. [laughs]

Bill: It’s nice in a way.

Toby: I’m just teasing him. I think JT, you’ve got some good veggies for us today. What are you talking about today?

Jake: Yeah, I might. I’ve got a little segment prepared on adaptive radiation. We’ll see where that takes us.

Toby: What about you, BB? What are you doing?

Bill: I may adapt my conversation after hearing Jake’s stuff. I was thinking about shouting out some ideas that I think are worth doing some research on.

Toby: I like that. I’ve seen a couple of things– I think we probably going to have to talk about how the ARK goes, I don’t know how you say it [unintelligible [00:01:57] and Wang have–

Jake: Not going to trade anymore.

Toby: Total return swaps to get $15 billion of equity up to $80 to $100 billion in some of these high-flying names, but maybe they’re helping if squeezes GME, and being a notable one and then Viacom, I guess, and Discovery. What do you guys make of that?

Bill: I told you guys that I didn’t like Viacom, and Discovery’s 20, 25 multiples last week versus Netflix, I think, so it turns out that was right. [laughs]

Jake: Winner.

Toby: Well, like GME, the funny thing is those were all undervalued. Discovery, and Viacom, and GME were all sitting in my screens for a while. It’s a little bit of a change that the big runs now seem to me to be coming out of deep value. I can’t hope that that sustains for a little while, but my topic is going to be on quality in a little bit, and I don’t think they do very well on the quality metrics.

Bill: Yeah, I guess the only thing that I would say is, undervalued implies some terminal value certainty that I do not have in those names.

Toby: In Discovery?

Bill: Yeah.

Toby: It’s just a content maker. They’ll just find another way of distributing their content. We’ve discussed it before. I know this, it’s not– It might not be the–

Bill: Oh yes, [crosstalk] Look, it can work. Malone’s behind it, I got love from Malone. I’m not a Zaslo fan. I’ve been on the record, but he’s done some good things, the Scripps acquisition made sense. I may be too bias negatively on that one. I’m open to that criticism.

Big Hwang Blows Up

Toby: The story is wild. He had criminal charges brought against him for insider trading, and then he’s not been– That’s why he’s converted into a family office. He’s still able to get $80 billion of leverages– I mean $80 billion on $15 billion of equity. I’m a little bit envious, honestly.

Bill: If this is how he’s trading on inside information, you’d want to lever that up, wouldn’t you?

Toby: Ah, that’s fair.

Bill: He’s probably going to make his money.

Jake: I’m not uncertain about it. If you guys–[crosstalk] [laughs]

Bill: I don’t know what’s going on. I’m not trying to get us in legal trouble.

Jake: Is this guy Bobby Axelrod, or is he playing? I’m not sure who’s who at this point. You guys ever watched Billions?

Toby: I saw the first episode but I just–

Bill: I like Bobby Axelrod, good character.

Jake: Yeah, I think the first three seasons are available on Amazon right now. They’re pretty fun. Wife and I have been watching them, which even to get her to watch something even remotely finance related is a big win for me.

Toby: Is it finance? Is it too close to home for you?

Jake: No. I do explain a few things here and there to her, but you don’t need a ton of finance background to really– it’s still just about characters at the end of the day, right?

Bill: Yeah.

Jake: But the guys who wrote it are the same guys that did Rounders, if you like Rounders, which I do.

Bill: Oh, are they the same guys?

Jake: Yeah, Brian Koppelman– [crosstalk]

Toby: Rounders was good, having played a little bit more poker, Rounders is a little bit cringe worthy now. Taylor said, “He’s like twisting the biscuits open and licking the cream out of the middle,” not going to last very long. [giggles]

Jake: We call those cookies here not–[crosstalk]

Toby: Cookies.

Bill: They are not biscuits, bro. They’re Oreos made by Mondelēz, owned by Bill Ackman, who you quoted today.

Toby: Ack Attack, is that right?

Bill: At least it was one time, yeah.

Toby: I like that quote from Ack Attack. I’m going to talk a little bit about Ackman and quality when it’s my segment, but I think that JT’s got the conch.

Jake: Let’s wrap up that conversation on this– Really, I guess it’s you’d call like derivatives, that are using to get extreme exposure.

Toby: I don’t think there’s anything that’s—

Jake: What is SEC doing, if not reigning this kind of stuff in?

Toby: I don’t think there’s anything necessarily wrong with using total return swaps for this sort of stuff. All they’re doing is saying rather than us going and trying to trade this stuff, which would be a nightmare, you go and put these positions on for us and give us the benefit of– we’ll take the move in it, you get a fee, you can offload your exposure to other people on the other side who want to get on the other side of this. I don’t think there’s anything necessarily wrong with the tool that they’re using. But if there’s insider trading going on and they’re using it as a method to disguise beneficially from those things, then that’s a problem, which probably is better.

Bill: They were unrelated claims. Nobody’s saying this guy, he was using, well– or, are people saying that he was using inside information to get this leverage.

Toby: I think the saying it was a squeeze, which is manipulation, squeezing like GME squeezing Viacom.

Bill: My sense is this, there was a secondary factoid of the story, was not the primary factoid. But I don’t really know. I don’t pay much attention.

Toby: The fact that they’re using the swaps?

Bill: I’m very happy not to be. No, the insider trading allegation.

Toby: I don’t know– he was criminally–

Bill: Yes. It’s just some old stuff.

Toby: It’s not that old.


Bill: It’s old.

Toby: If we forgive very quickly, I guess.

Jake: What crimes have you done for me lately?


Bill: Well, how old is it?

Jake: I don’t know.

Toby: The family office is only a couple years old.

Bill: Well, I’m just saying that doesn’t have anything to do with his current position.

Toby: No, it doesn’t. That’s fair. It’s just a pattern of slightly unethical to criminal behavior.

Bill: Yeah. I’m glad I don’t have a SEC settlement or whatever. But I don’t know anything about the background of this. Happily, so I have not paid much attention to this.

Toby: I’m just blown away by the scale of it. He’s got $80 billion, that’s nuts.

Bill: Yeah, I don’t know. Is it?

Toby: He’s still rolling around with that leverage, that’s bananas.

Bill: That’s a lot of money. Some people like the game, man.

Toby: Yeah, but play the game with the $15 billion, don’t play with the leverage.

Bill: Says the guy who doesn’t have $15 billion– [crosstalk]

Toby: That’s true. [laughs]

Jake: He didn’t get to $15 billion.

Toby: As we always–

Bill: Easy to say from the peanut gallery, bro.

Toby: 100% true. It’s always the case when we’re talking about Roaring Kitty. Whatever he topped out at, $48 million. I don’t know if it’s all over yet. I’m just saying. I think that was the highest number that I saw that he’d made. Everybody’s like, $48 million in GameStop, take it off. People were saying that to him at $24 million and they were wrong, at $12 million they were wrong, $6 million, $3 million–

Jake: $2 million.

Toby: Yeah, I would have taken it roughly 250.

Jake: Thousands?

Bill: The thing about his position is once it hit that value, then you can actually get out of it. I bet he was a big percentage of the open interest– [crosstalk]

Toby: –because he had the liquidity. There was liquidity there.

Bill: Yeah, that’s right. I mean, I don’t know what he did, but it would have been a smart time to at least get out of some of it, because you can.

Toby: Well, he’s got the diamond hands, mate. You don’t get there if you’re shipping it.

Bill: Yeah, no doubt, but you also don’t get there, if you think you own something, and then you go to sell it and there’s no bid.

Toby: Yeah, that’s the value strategy, buy it when it’s illiquid, ship it when it gets some liquidity.

Bill: Yeah, that’s how value arbs liquidity?

Toby: I think so.

Bill: The old liquidity arb?

Toby: I’ve done this before, it takes you weeks to soak up a position in some terrible little net-net, and then something comes along and it gets a little bit of attention, and all of a sudden, there’s some liquidity in it. If I was smart, that was when I would have sold it, rather than when it went back down again.

Bill: I bought something that’s pretty illiquid, and I’ve been sitting out there just waiting to sell it, it doesn’t sell, so I own it, whatever.

Toby: You’ve got to be patient. That’s the name of the game.

Bill: Yo, I don’t care.

Toby: It’s [crosstalk] forced patience.

Bill: I do care, otherwise, I wouldn’t be trying to sell it, but whatever. I’m fine owning it.

Toby: Let’s do a topic. What do you got, JT?

Adaptive Radiation

Jake: Today’s veggie segment is on this idea from evolutionary biology called adaptive radiation. I’ll read a couple of definitions of it that might help start us. One definition is, it’s the diversification of a group of organisms into forms filling different ecological niches. Another one is a relatively fast evolution of many species from a single common ancestor, particularly when a change in environment makes new resources available.

In a common era, a very static environment, nature rarely will have two types of species that are occupying the same niche, because one will be a little bit better adapted than the other one, and it will drive it out, and you’ll reach this static equilibrium of this particular adaptation, this species is better suited for this environment the way that it is. Now what ends up happening, those niches then become homogenized by one species.

But when you have a lot of change, then it can create these disruptions where then all these new niches open up, and you’ll see a large radiation of adaptation, hence the name ‘adaptive radiation,’ that allows lots of strategies to be successful in the environment.

Okay, after the dinosaurs died out, there were a bunch of really weird animals that came around at that point. You had these giant carnivorous birds that look like huge ostriches, you had apparently like hoofed carnivores that were almost like cows, but they were like hunters. Giant land crocodiles, these giant cat and dog looking hybrid animals. And of course, eventually, you had mammals, which had this huge explosion in functionalities after the dinosaurs.

You often see this adaptive radiation occur in an island setting, because it’s sort of its own little niche, and you’ll get one species that will come in, and it will suddenly find– it’ll evolve rapidly to fill a bunch of niches within that island environment. One example of that is the Hawaiian honeycreeper, which is actually 17 different species that came from one original species probably, but it has all these different beaks that are adapted to fit the environment and take advantage of a particular resource. You have ones that are insectivores, ones that are nectivores, which means eating nectar, ones that are seed eaters, they have really flat bills for crushing the seeds, and then you have these ones that are kind of more generalists. So, you have this rapid adaptation to fill a particular niche. Toby, you look like you got a question?

Toby: Oh, I was just going to say something like niches get stitches, but I couldn’t find a place to stick it in sensibly, so keep going. [laughs]

Jake: Okay, thanks. Solid contribution.

Toby: Thanks, brother. That’s why I didn’t say anything.

Bill: Yeah, that was awesome. Appreciate that. We’re all– [crosstalk]

Jake: [laughs] In nature, any kind of disruption is what creates opportunity. I think it’s obviously similar to, I think, economic environments as well, and maybe markets. Our mutual friend of the show, Rishi, sent me a recent letter from Rob Vinall who’s RV capital, and also a couple follow up posts that he had about his letter. It’s pretty interesting how it ties in with this. He’s talking about investing is really about forecasting future cash flows. We all agree that’s the game to be playing, discounted back to today, and you want to be as accurate as you can about what those future cash flows are going to look like. The problem is that you can’t really avoid making assumptions about what the world might end up looking like to make these cash flow predictions.

Original Value vs Expected Mean Reversion

Jake: One approach is what we might call original value, which is really like, I’m understanding the company’s history looking backwards, I know everything about it, I have to assume that the future will look something similar to what the past looked like, and that there’s then an expectation of reversion to the mean of, what the business is going to do, what the multiples that the market was willing to pay for the business, all these things are going to revert back to the mean. That’s really the bet that old school value has been making for 100 years. You think about Buffett with Amex, and the salad oil scandal. That was a temporary problem, the reversion of the mean of a good business he was expecting, and he did really well with that.

The other approach, potentially, that you might call newer value, would be taking advantage of rapid and widespread disruption and changes, and focusing then more potentially on TAMs, focusing more on network effects, growth rates, and really more ignoring the past, because you don’t think it’s a good prologue for what the future is going to look like, really ignoring the base rates and reversion to the mean and really focusing more than on the future and optionality that these businesses might create.

I think both of them have their season, and understanding what is maybe the next to come, might tell you which way to lean, whether more towards old reversion of the mean, or more towards traditional value– towards the newer value, optionality. One way to reframe this conversation is to talk about explore versus exploit. I think we’ve talked about this on the show before, but it’s really interesting to see actually, ants, through the use of their little simple minds, the way that they’re programmed their brains and pheromones, they’re able to mathematically solve problems to do this explore versus exploit trade off. What researchers have found is that they actually will tune the amount of exploration versus exploitation based on the rate of change within the environment. The more change there is in the environment, the more the ants evolve towards more exploration, because that is what is rewarded. But the more static the environment, the more the ants fall back towards exploitation.

Toby: How are they making that determination?

Jake: It evolves from the very simple, just machinery inside of the little algorithm in their little ant brains that has just a few yes, no, on or off type of synapses that will then emerge into this very intelligent behavior.

Toby: What are the criteria on which they’re making those decisions? Maybe I could use them in my investment strategy.

Bill: I like to see IPO valuation.


Jake: Right. I don’t know if I have a good answer for that. I’m going to punt on that one. But I’m going to keep going instead and following my own agenda.


Jake: The more the change there is, the more that they do exploration. The more static, the more exploitation. Well, I think what’s really interesting about this is that if we have to remember that in markets, it’s horse race betting. What is the mispriced bet? It’s not just what is likely to happen, but if everybody knows that’s what’s likely to happen, the pricing can get messed up there. I think it’s probably reasonable to say that 10 years ago, people sort of assumed too much reversion to the mean, especially if you were a value investor. These businesses grew in ways that we never really would have predicted. There were lots of places where reversion in the mean was just dead for the last 10 years.

Toby: Would you say it’s as long as 10, I’d say just even 6?

Jake: All right. I mean, perhaps that’s–[crosstalk]

Toby: 2015. Let’s come back to this in a moment, but I think 2015 is the date.

Jake: When it sort of changed?

Toby: Yeah, when it split.

Jake: We have the actual rate of change, that ended up occurring versus what was sort of, we expected. I think that there was an error made often by a lot of value investors, probably me included. The other part of that too is the skewness of the distribution. If you have a very fat tail, especially on the right tail, a right tail skew, the outcomes can be so big that you can underappreciate what they would look like. It’s not even just the probability, but also times the magnitude, which is captured by the skewness of the tails. With that said then, today now, let us try to think about… what optionality for the next 10 years appropriately priced, or have we all sniff this out now, and people are potentially overpaying for that optionality. Perhaps if the next 10 years are not as different, then the right bet to make is the back to the reversion of the mean, the old school expectations, looking backwards more, and not so much looking forward as where to focus your efforts.

That then brings us to looking at things like Carlota Perez’s innovation and diffusion, and technological revolutions. They have this explosion phase, and then typically an installation, and then it becomes a utility, and then there’s something else that comes along and disrupts it. Where are we on that? This also gets into arguments about, take Ray Kurzweil’s asymptotic approaching of just this runaway–

Toby: The singularity.

Jake: Yeah, the singularity and these nonlinear exponential technologies, versus Peter Thiel holding up an iPhone and saying, “This is not the equivalent of putting a man on the moon, and maybe that we’re not as advanced as far as maybe some of us think in certain realms.” I don’t have a ton of answers.

Implied Rates Of Change Are Mispriced In Today’s Prices

Jake: But I think it’s an interesting question to think about, is the rate of change that’s implied over the next 10 years mispriced in today’s prices?

Toby: Almost certainly.

Jake: [laughs] I’m glad you have an answer. [laughs] That was easy.

Toby: Here’s my theory. I’m clearly being a little bit facetious. I think that in 2015, and I always point out the article that you wrote in 2015 about dispersion of valuations being the pretty good predictor of how one side of the distribution will perform. What happened in 2015 is the dispersion of valuations got very tight. Junkie companies were as expensive as potentially high-growth, high-quality companies. You could see that if you went to the Morningstar style dashboard, where they have that little grid, and they show size, and value and growth on the different axis. Everything was basically the same P/E, whether it was small or large, whether it was growth of value, and that doesn’t make sense.

The faster growing better-quality companies deserve a higher multiple than the other stuff. The result of that was, as that distribution went back to a– not normal in the sense of a normal distribution, but the more ordinary, the more usual course, we saw the higher growth stuff outperformed massively and the value stuff stumbled for the last six years at least. But I think now we’re at the point where the distribution is very, very wide, which, if you can think about it another way, what that means is that the high growth stuff is extremely expensive, and the lower quality value stuff is roughly around its long run mean. But on a relative basis, you would expect the cheapest stuff to do better than the more expensive stuff. I think that’s probably what happens over the next 5 or 10 years. I’m talking my book a little bit, but I think the lesson that I learned in 2000, I didn’t learn it in 2015, took a few years after that to learn it. I do think that’s the lesson, and I feel that the reason that growth stuff works so well is because it was unusually cheap, and we can look at anything like Microsoft in 2010. I guess that’s 2010, 2011, 2012, a lot of those things we’re just cheap. That allows you to not pay much for the optionality which creates the huge returns.

Jake: Billy, what do you think?

Bill: I don’t know. I guess in Toby’s talking, he’s talking about buckets. I understand that argument. One of the things that I think that you can do with some quality companies that you can’t do with the companies in cheaper buckets as well, is underwrite to what you think base cash flows are. I think a lot of the cheaper bucket coming into coronavirus to expose how cyclical those businesses are. Business like booking, it was able to flex down its cost structure, commensurate with its business and survive, as opposed to the airline. There’s just no world that those two businesses should ever trade at the same multiple.

I guess you could say, “Well, if I’m just going to harvest all the cash, then what do I care as long as my through cycle analysis is correct?” I think that’s somewhat true. Also, I think that that ignores how the world actually works. I just think a lot of the times like class A real estate versus class C real estate. Some apartment complex in Kansas City is never going to trade at the cap rate of New York City apartments, but every once in a while, in New York City apartments is going to get whacked. If you own those at the wrong time, you’re going to get whacked with it. Expecting your entry cap rate on an A class building to mirror your C class, I just don’t think you get that many opportunities in life. If you want to have the strategy of, “Well, I’m just going to wait,” then that’s cool but then you have to actually be willing to wait. That means sometimes having a 10-year underperformance.

Toby: You’ve got some risk and liquidity problems in there. If you flip it around and think about– efficient markets as a theory, I don’t think works very well, but as a– or sorry, empirically, it doesn’t work very well. but theoretically, I don’t mind it as an idea that you get compensated for risk. That’s almost certainly true. You get compensated for illiquidity. Class A building in New York in Manhattan, I’ll bet you can ship that pretty quickly. Class C building in a third-tier market, I bet you that’s a really illiquid thing, and so you would expect that you would get a higher return, you’d expect that you’d be stuck in it for longer, and you have no guarantee what sort of price you’re going to get if you want to get out, you should be compensated more for that.

Bill: Yeah, but I’m going to argue one more fact in this. I would also argue to you that, if you lose a tenant in your class A building in New York, you can replace that tenant much easier. Your underlying cash flows are, I would argue more stable, in a normal environment. I understand that’s been an odd time to have this discussion in COVID, I get that.

Toby: In the ordinary course, that’s true.

Bill: Let’s go back to 2019.

Jake: I did see that office vacancies were as high as back to 2003.

Scott Galloway ‘Cowish’ On WeWork

Bill: You know what pivot I thought was interesting today was, and I don’t listen to him as much anymore, but Galloway, I turned on the Recode podcast today, and he was actually like, he referred to himself as cowish, not bullish, but no longer bearish on WeWork. He was really negative on WeWork. His point today was now you’ve got a completely different dynamic in commercial real estate, you’ve got actually a brand, and it’s no longer run by a lunatic, it’s actually professionally managed. I don’t know, that’s an intriguing idea. I guess it’s going public via SPAC.

Jake: Imagine if they could have held their bullets until right now to have fired at buying all this real estate up to convert into WeWork’s? They’d look like geniuses.

Bill: I guess. The other side of it, though, man, is they created this brand. I get that what they did was crazy. But would they have been them, if they waited? I’m not sure. Somebody else in theory has the dry powder, go get it and do it. The one thing that is not scarce right now is capital.

Toby: I do think that idea of outsourced office space, clearly that’s got to be a theme that’s going to work for a period of time. Not everybody wants to work from home, but not everybody’s going to want to build a head office either. There must be some like, I want to go to a place where I have an office and there are other people working in a building around me. I don’t necessarily want them to be in my business. I just want them to be nearby. I’m at home with three kids trying to shout at me while I’m trying to record a podcast.

Jake: You want someone else to cop on you for a while.


Toby: That’s it.

Bill: Well, that’s what Galloway was saying, and he’s like, they have a brand, and they’ve got an ability to– they’ve got this forward-thinking feel, and people may end up outsourcing a lot of their office decisions to them. I thought that was an interesting pivot.

Toby: It make sense.

Bill: Usually, when people go that bearish to cowish on an idea, it can make some sense to pay attention.

Toby: I’m not entirely convinced that WeWork is the vehicle that gets you there. I think that theme is a good one. I think that if you’ve got some way of building a network of these offices, so if I go to another city, I can just check into that office, and I can rent an office for the day so I can sit in there and have a place to meet people with, that’s a great idea. That’s got to be something that will be around in the not-too-distant future.


Jake: They had that forever, like Regus.

Toby: Yeah, but Regus is garbage.

Jake: Well, but the concept is not new is what I’m saying.

Toby: Certainly, there’s a big difference between WeWork and Regus, Regus, you just want to– they’re dark and they’re awful, whereas the WeWork’s really pretty. There is a big difference in between the two. Somebody will figure that out and say, “Look, it’s an app on your phone that you can check in anywhere, and we can just bill you easily or it’s recurring revenue,” or whatever it is. There’s some solution to it that is a good one.

Bill: Yeah, I think that’s right. There’s no difference between Starbucks and a coffee shop in theory, but in practice, there’s a huge difference.

Toby: Offices that turn into coffee shops, coffee shops that turn into offices. That’s the direction we’re going to go. You either pay for your office space and get your coffee for free, or you pay for your coffee, and you get your office space for free.

Bill: You think those are the only two outcomes?

Toby: That’s the only two possibilities. There’s no–[crosstalk]

Bill: I like it. Office Max is trying to lease you office space and hope you buy a printer. I don’t think that’s going to work as well.

Toby: I don’t think that will work as well. Maybe.

Bill: They might though. Who knows? Maybe they just let you come in print–[crosstalk]

Toby: Free paper. That’s it. [laughs]

Jake: Jesus.

Bill: Bend you over on the ink.

Toby: Well, they already do, don’t they?

Bill: Yeah. What if they subdivided the ink and ended up charging you even more? That would be just terrible.

Toby: Ink as a service. [crosstalk]

Bill: Yeah. Yes, I like it. I think there’s something there, man.

Jake: These printers nowadays are so disposable, they’re practically printing as a service.

Toby: The printer cost less than the ink does. They just give you what, but printers like the razor/razor blade model.

Verizon: Network As A Service

Bill: I’m pretty sure I was reading Verizon’s investor day, and I think that they referred to their network as a network as a service.

Jake: Oh, Jesus.

Bill: I just thought that was the service. I didn’t realize–


Toby: We’re throwing the telephone calls for free.

Jake: Service as a service.

Bill: That’s right. Books, reading is a service.

Undervalued Quality Resurgence

Toby: All right. Let me do my silly topic. I saw this tweet this morning, pretty interesting, that quality has been beaten up– everybody knows that value has been smashed up, because I talk about that all the time. Quality has also been smashed up. I think most value guys out there are not pure value guys. Nobody’s just buying on price to book multiple and hoping that works out. Everybody’s doing some additional work. Quality is relevant to most value investors too. I don’t have a great graphic to show everybody, but I thought it was an interesting– I’m going to hold this up the screen, so if– whoops,

Jake: High tech.

Toby: Yeah, isn’t that amazing? Look at that.

Jake: Yeah, that’s a pretty good drop.

Toby: Who’s listening at home and those who couldn’t see when I held it up, basically, that’s long top quality, short stocks, short low-quality stocks. Everybody might be aware last year, bad quality had this exponential run, massive run out of the bottom. Most of the time, it’s not a good thing to be long low quality stocks and low quality in definition is stuff that’s not turning its earnings into cash flow, stuff that has debt on its balance sheet, stuff that’s not particularly profitable, is low quality. If you own good quality stuff, typically it does better than low-quality stuff. If you add a value tilt to that as well, you do very, very well. Value and quality work really nicely together, unless you get into a market like last year’s where any fundamental worked in– and I’ve talked about this a little bit in the past, AQR did a great study, where they showed that the fundamentals were reversed in 1999 or 2000. Fundamentals were also reversed in 2019 and 2020, kind of amazing symmetry of what a coincidence between those two things.

More to your point earlier, Jake, I do think that we’re setting up for a really nice value-quality run here over the next 5 or 10 years. I think that’s not necessarily to say that– so within the tech stocks, I think there are some incredibly high-quality, reasonably valued things in there. I think some of those will do quite well. The things that don’t look like that though are going to struggle. I think that there’s going to be less equity capital around for a lot of these companies, it’s going to make it a little bit harder. I think that being having that already on your balance sheet or generating in your business, that’s going to be useful in a time of scarcity, which we’re probably going to come into over the next few years, I think for a variety of reasons which we can get into to too. Any thoughts on that?

Bill: What are your reasons? Let’s get into it.

SPAC Boom Signals Top

Toby: There’s been this huge demand for equity over the last even nine months, which is what has created this SPAC boom, that they’re just– [crosstalk]

Jake: Or, NFTs.

Toby: NFTs, but SPACs in particular because I think that SPAC is like– we’re so hungry for equity, if you give us cash, we’ll give you back equity to the value of your cash, and people prefer that. Here’s what we’re going to do with the equity. We’re going to go and buy something that looks like the way we describe it, and when we find it to buy, you’ll get the opportunity at that point to say yes or no, and you can probably get your cash back, if you say no. That’s appealing to a lot of people. It’s an unusual market where we’re so hungry for equity that we’ll enter into an arrangement like that. Most of the time, it’s a little bit harder than that you need someone who’s a pretty well-known investor at the helm, who’s got a good track record in the particular thing they’re trying to acquire. I think the same thing that happened in 2007, 2008, 2009, where busted SPACs get arbitraged, is the more likely outcome so people go whacking those things for the cash in them rather than just buying them, thinking they’re going to get a big pop, and they announce an acquisition.

Jake: Yeah, piñatas.

Bill: Isn’t IPOE right around trust value? I think that’s [crosstalk] say that.

Toby: I think there are few of them.

Bill: I think [unintelligible [00:36:27] said the other day. That would be interesting. [crosstalk]

Toby: If you weren’t expecting a huge pop, what’s the reason for doing these things?

Bill: Yeah, but you are. Chamath’s like a freaking promoter. You’re buying in near trust value, and then you get the option of him doing the hype machine.

Toby: I see Virgin Galactic’s done about 53% from its peak.

Bill: Yeah, bro, but it mooned before it went down to 53%.


Bill: Nobody’s saying, “Oh, I’m looking to own the operating company,” when they say, “This is trading next to trust value,” and you get the option of him promoting it. That’s a totally different statement.

Toby: I understand that. That is what happening, but is that what should be happening?

Bill: [crosstalk] -why do you want to make money, you nerd?

Toby: [laughs] I want to be right.

Jake: The rocket ship is going to be blow up, but it might get you to Mars first. We don’t know yet. It could blow up.

Toby: It’s not the reentry into the atmosphere that kills you, it’s the impact. At the moment, all we’ve done is reenter the atmosphere, so there’s no problem with this rocket launch yet, is what you’re saying.

Bill: No, here’s what I’m saying. Let’s say that Virgin Galactic had $15 in trust value, which I don’t even know if that’s true or not, but let’s just say it did. You bought it in March of 2020, you’re up 2X. I agree that if you bought it on February 3rd when everybody was all hyped up, you got screwed, but the longer-term people are still up 2X. I just don’t know. I know it’s frustrating to say it that way, but it’s also [crosstalk] true.

Jake: I have seen some SPAC base rates though, and they’re not good.

Bill: Yeah, I’m not saying go out and buy a bunch of SPAC.


Toby: We’re definitely not saying that.

Bill: I’m saying there may be one that’s close to trust value that’s got arguably the best promoter in the world at a time where promotion is being very highly rewarded. To me, that seems like a downside/upside that makes some sense. Now, I understand value people be like, “Isn’t that close to speculation?” No, it’s not close, it is. I acknowledge it, but that doesn’t mean that you can’t make some money on it.

Toby: I think that game’s almost played out. I don’t know how many times. I think it’s almost there.

Jake: We need an inning update.

Toby: [laughs]

Bill: I told you guys, I just got an offer on land, that’s not even on the market that I bought in September that somebody almost doubled my value. I don’t think that we’re at the point where capital is scarce. Until capital is scarce, I think yield is going to be hard to come by, and when yields hard to come by, I think people do really dumb shit. I don’t see why this ends. I get that’s what everybody says near the top, I get it. I totally understand that there’s a lot of froth.

Toby: I don’t think we’re near the top. I think we’ve gone past it. I think we’re on the other side already.

Bill: Maybe. I don’t know. The fucking markets flat and up this year, so it’s hard for me to see how we’re past the top. Definitely in some of those names, there’s been some things that have corrected 50%, but, okay, there’s always stupid stuff.

Toby: It’s all coming from one particular area though. Doesn’t that make you a little bit kind of–

Jake: [unintelligible [00:39:38] [laughter]

Bill: I don’t think it’s coming from one particular area. I think it’s coming from everywhere.

Toby: No, there’s a concentration in the– stuff that did well last year is suffering this year. The stuff that suffered last year is doing a little bit better this year.

Bill: Dude, it was up 4X.

Toby: It’s not over yet, Bill.

Bill: Yeah, pulled back a little bit.

Toby: A little bit? 53% is quite a lot.

Bill: Help me with this math. If you’re up 4X and you’re down 50%, you’re roughly up 2X in 12 months.

Toby: Fair enough.

Bill: Definitely got pretty good return.

Toby: How many of the people who bought it, and who are up 4X and are down on the 53%? I’ll bet you that if you look at the flows into that thing, the vast majority of the people on [unintelligible [00:40:24] basis are down.

Bill: Yeah, well, that’s why people should listen to us.

Toby: Those are trading sardines, mate. Those aren’t eating sardines.

Bill: Yeah, well, I don’t disagree there. I just don’t think that we’re past the top, but I’ve always said I don’t know how to ring the bell at the top.

Toby: Nobody does. I’m being facetious. I think that when the speculative stuff starts falling over, then it’s close to the end. Ninth inning, bottom of the ninth.

Bill: I guess, dude. Gun to my head, I’d take duration here.

Jake: Grantham says that, “The day after the peak is just a little bit less optimistic than the peak was,” just a touch.

Bill: As Bill may say, “If you’ve been wrong for 10 years, you’re just a little closer to being right today than you were for the last 10 years.”

Jake: That’s true.

Bill: No. People have sent some good ideas, things that I think are worth research. One, arbitraging time, Legacy Housing. I thought that’s an interesting idea for people. Jeremy Raper was out there talking about some Polish trash company that’s trading at 13 times earnings. I pinged my father-in-law, because he’s Polish about that. If I get any good scuttlebutt from over there. If you get outside of some of the SaaS compound accounts, there’s some people that are pitching some pretty interesting things right now. Like Yarn, that I do think, if it is true, and I’m attributing it correctly, if I’m not I apologize, but he goes by one main capital, or that’s what he runs. If it’s true that there is a Chamath’s SPAC that’s close to trust value, I think that’s a bet that could be worth making for the right part of a portfolio.

Jake: Is it the guy that looks like Tony Romo in his Twitter?

Bill: I don’t know, man, but he’s a sharp dude. I’ve been fortunate enough to talk to him a couple times. I like how he thinks of the world. Look out there. There’s some good ideas out there, regardless of how much froth there is.

Jake: That’s good advice. You should never turn it off.

Bill: Yeah.

Jake: You should always at least be exploring.

Bill: I mean, shit, even Biglari ripped.


Jake: Anything is possible.

Bill: [laughs]

Toby: If you believe anything is possible–

Jake: Magical thinking.

Bill: I was having a conversation with an insurance broker. I know the guy. He strikes me as thoughtful, and he places like business risk. He was waxing poetic on Markel. Those insurance names, I think there’s a lot of good stuff out there. Don’t let some of the headlines scare you away from doing work is sort of the takeaway here.

Toby: I’d say that undervalued quality– that quality and undervalued quality probably once in a cycle opportunity right now. Definitely don’t be not doing anything, just be hunting in undervalued quality. That’s where you want to be right now.

Carnage In Weed Stocks

Bill: Yeah. [crosstalk] It’s an interesting carnage in the weed names, too.

Toby: It’s not a sector, I know. Well, what do you like in there?

Bill: I don’t know that I like anything. I just think it’s an interesting thing to be looking at. I think some of this risk-off appetite has taken some flows out of MSOS, and MSOS has been constructed through turnover total return swaps, and it’s creating some selling pressure. I do think people are going to be smoking a lot more weed in the future than they are today. Then, you’ve just got to figure out all the hard questions between that conclusion and which one to invest in. So, good luck. When you find them, let me know.

Jake: I’d buy the whole complex for a certain price to asset value, if that was to be available.

Toby: Meb Faber has a good white paper on it, when he launched his ETF TOKE, T-O-K-E. He wrote a white paper about looking at the growth of marijuana as a new industry and he looked at the growth of alcohol. I think it was post prohibition. All of the brands came in and he said that the entire industry did about 20% a year. That article is now few years old, so you get an opportunity to see how that has all held up since he did that. If you’re interested in it, that’s probably a good place to start and have a look at Meb’s piece, and then an ETF is an easy way to play that thematically. Not financial advice.


Toby: The price to book on it? I don’t know.

Bill: Book doesn’t matter– It matters, but the issue is like, if you’re paying– I think that you have a couple questions to figure out if book matters. One, is interstate commerce going to be mandated? Two, if so, can these states still have some licensing program, because if so, then if you paid 30 grand for a license and you have an exclusive right to sell an estate, book value doesn’t mean shit. If they can’t have those licenses, then your book value might matter a lot, because then you’re getting closer to maybe what your distribution and replication costs are.

Jake: There’s a price to book level for it, where I don’t care about the answer to that.

Bill: Yeah, but there’s probably going to be some other stuff going on. But I don’t disagree.

Toby: Are any of them making any money?

Bill: No, they pay everything out in tax.

Toby: Yeah, the top lines are–[crosstalk]

Bill: Their tax obligations are insane. That’s why everybody cites EBITDA.

Toby: The notepad is gnarly.

Bill: You pay tax on gross profit, you can’t even deduct any operating expenses. That’s rough.

Toby: Yeah, that is rough.

Jake: Punishing.

Bill: I guess that’s why I’m intrigued by the idea, because I do think that there’s thousand reasons to say no, but there may be reasons to say yes. As those reasons to say no become less and less obvious, you would think valuations have a reasonable probability going higher.

Toby: Throw your questions in, amigos, if you have any. We’ll take a swing at them. I think we forgot to do that last week, so we’ll do it this week.

Jake: And amigas.

Toby: Well, amigos is the collective– just both.

Jake: One amiga. [chuckles]

Toby: If it’s five girls and one boy, it’s amigos. If it’s five girls, it’s amigas. That’s the language.


Jake: Geez.

Bill: Dang. Toby loves the man.

Toby: Which man? [giggles] Just the MAN, all caps.

Bill: Yeah, just in general.

Toby: Yeah, here’s a good question from VSG. This might be one for you, Bill. How they’re getting around the fact that can’t use the banking system? I thought they had to do most things in actual cash.

Bill: Yeah, they do. It’s a big problem. The other side is, if they can’t get access to the capital, then the people that actually can figure out how to operate should be able to expand their moat a little bit before– I think that the biggest risk to the entire thesis is, all of a sudden, they all have to compete on an interstate basis, the licenses aren’t protected, and capital just floods the industry, and that to me is just a catastrophic outcome for equity.

Toby: When it happened to alcohol, the thing that helped the booze companies succeed was the best brands, like you wanted to be in a brand. I think it’s probably true here as well. I don’t know any brands in the space, but if you need the Smirnoff or you need the Jack Daniels, you need that protection, something that everybody recognizes.

Jake: Yeah, but where did that come from? I think, Bill, you probably speak better than this, but it was a scale game, which allowed you to then spread your advertising over more a bigger people which created the brand, which allowed you to charge a little bit more.

Bill: Yeah, I think that’s right. I also think booze is heavier to– I think there were local boundaries that created brands, like St. Louis was Budweiser, and up in Chicago was Miller Lite. I don’t know why those actually–


Toby: It’s going to go all macro, this terrible macro, I really prefer it when it was the artisanal small supply, the wheat flavor.

Bill: Yeah, it will end up with [crosstalk] craft wheat.

Toby: Craft wheat, there you go.

Jake: Shitty Bud.

Toby: I want the Sam Adams.

Jake: The Bud of Bud.

Toby: It’s called Bud.

Bill: Wheat is a whole lot easier to grow than moonshine is to make. Plus, probably, I don’t know. I haven’t had moonshine in a while, but I suspect the you’re not going to have all of the– I bet there’s more illicit weed in your mature state than there is illicit alcohol.

Toby: Mississippi moonshine’s like fortified wine. It’s like 14% alcohol.

Bill: Really?

Toby: Waste of time. [crosstalk]

Bill: Yeah, that is a waste of time. What about that Appalachian moonshine?

AQR Quality Minus Junk: Factors

Toby: [laughs] Yeah, that stuff’s rocket fuel. What metrics do we use to hunt for quality? There’s a good paper out there by Cliff Asness, AQR, really recent one, where they’re talking about quality, and so they go through in detail all of that ratios in that, but it’s basically a more cash on the balance sheet than debt, cash flows rather than losses, higher returns on equity than lower returns on equity. That’s a little mean reverting for my taste–

Jake: [crosstalk] -all that bullshit.

Bill: More cash than debt.

Jake: You can see it why it’s underperforming—[crosstalk]

Toby: It didn’t work last year. It definitely didn’t work last year. It was inverted last year. Inverted, like in, where is my camera—

Bill: Like Top Gun?

Toby: Yeah, Top Gun.

Jake: What do you think of Novy-Marx?

X ROE Is Highly Mean Reverting

Toby: Yeah, Novy-Marx, so that’s gross profits on total assets. I think that anything else, it has some marginal utility. It does seem that there is a relationship– We run quantitative value, we use the Novy-Marx metric as a substitute for return on invested capital, and we use price to book as a substitute for EV/EBIT, just to create an academic version of the magic formula. It does all right, but all the returns are still driven by the value side. Novy-Marx does seem to add something at the edges, as a quality metric it does well. I don’t want to go and buy quality absent value. I want to buy undervalued quality, that’s what I’m trying to do, and I define quality X the ROE metrics. I like cash flows, and I like cash-rich balance sheets, and I like management doing something about it. I think that’s a better– [crosstalk]

Bill: Why X ROE?

Toby: It’s highly mean reverting. For most stocks, it’s highly mean reverting. It’s literally 4% of stocks that seem to resist the mean reversion in return and equity. I don’t know that you can identify them prospectively, or I think it’s extremely difficult to identify them prospectively. Having said that, it does seem to be that there are some that exhibits some persistence, so if you buy those ones with the persistence aware of the fact that they can lose it at any point, and you just need to be Johnny-on-the-spot when that happens, I think you’re okay.

Bill: I don’t know, part of the issue is buybacks ruin the equity.

Toby: Oh, you mean they make the calculation difficult?

Bill: Yeah.

Toby: That’s the case with something like Maccas.

Jake: [crosstalk] -make it less relevant to reality.

Toby: Just a bit more difficult calculation, I mean rather than–

Bill: Like super hard to do it on cigarette companies for instance.

Toby: Yeah.

Bill: Pretty sure, they all have negative equity.

Toby: Yeah, anything that’s been doing buybacks, and paying dividends for a long time, doesn’t have any capital left in their business. Is quality hidden from financials– oops, let me pull this up. I don’t think so, I think you can do it quantitatively. Is quality hidden from financials? You have to go open and go deep stock by stock A to Z. I think that it’s in the financials for the most part. I think you can do it quantitatively. I think when you’re looking at the 4%– when you’re looking at the mean reversion, when you’re looking at– sorry, mean reversion return and equity, I think you need to find another reason why they’re not going to mean revert, that’s not quantitative. I think that’s a qualitative exercise. I think it’s extremely difficult to do. I don’t know that there are any people out there necessarily who– I think there are more people who think they’re doing it than are actually doing it.

Jake: If I remember correctly, CPG as industry has really resisted that ROI mean reversion better than others, and I can’t help but wonder if that wasn’t just a glitch in the matrix for a period of time, and there’s a lot of guys that were really high-quality investors that tended to get into CPG, and they rode that to incredible results and career-making results. I’m a little skeptical that you could repeat that.

Bill: Pretty rude to say that about Buffett.

Jake: I know, he’s one of them.

Toby: I think, a lot of that, it was a scale game. There were supermarkets that had finite space and lots of distribution. If you’re big enough, and you could pay to get your products prominently featured–

Jake: Free TV channels-

Toby: Free TV channels.

Jake: -showed all your ads continuously.

Toby: That was a good strategy for a long time, but now I think that a lot of people are shopping in different– shopping through Amazon rather than shopping at the supermarket. I think that’s why there’s a resurgence in craft beer, boutique, anything. People want better quality, small batch stuff rather than the mass stuff. That’s going to be a much more difficult game to play. I think, we’ve already seen that in– a lot of those names are starting to look cheapish, and I don’t know if that’s because they actually are cheaper if this is just a new future where they’re going to earn less and grow slower. Maybe that was the problem with Kraft Heinz acquisition, as a ground zero for that.

Bill: Yeah, I think they’re definitely going to grow slower. Maybe not something like Nestle. Nestle is big in EM.

Jake: Yeah, that’s what you need is, you have to win outside of the US now.

How To Run A 8-10 Stock Portfolio

Toby: I’ve got a good question here. Probably, Bill, you might want to have a swing of this one, too. A hypothetical question. If you were to run an 8 to 10 stock portfolio, how would you do it? Carefully. [laughs]

Jake: Buy 8 or 10 companies.

Bill: Yeah, I’d find 8 or 10 companies at good prices and buy them.

Toby: There you go. That’s helpful. I think you want to be careful of diversification, something like that. You don’t want eight oil companies. You want to have pretty solid diversification. I think you want higher-quality businesses in that instance, because you don’t really want too much in the way of cyclicals unless you’re on this stuff all the time. So, I’d be looking for a more traditional Buffett-type portfolio, I think would work better for that. Make sure you got good diversification. I want geographical diversification, industry sector diversification, because you just can’t really have more than one thing– You get blown up if you’ve got too much in one place.

Bill: Yeah. I think it depends on who you are. My man, Mike Mitchell, he does it, but he does it with a lot of liquidations and stuff, so it’s a different risk profile. My buddy, Francisco, he does it with media assets for the most part, but that dude can dance circles around most sell-side people. He really knows his shit when you talk about media with him. I don’t know, you got to be able to out-argue the other people that are in the industry. I don’t have that confidence in myself to run eight names.

Jake: I would say that you probably want to skew towards really protecting your downside more to be that concentrated and less chasing that optionality. There’s a reason that VC baskets are 100 companies, and you have to make sure that you capture that one true outlier that’s going to drive all the performance. Whereas if you do it on an 8 to 10 basis, boy, you’re really rolling the dice that you’re going to be able to catch one of those high optionality, high right skew outcomes. I think you almost want to go back to the other side and be more concerned about the left side skew in that much concentration.

Bill: Yeah, I think that’s right. If you talk to Francisco, he’s got a huge position in Charter, but he has that position from way, way back. If you look at his portfolio weighting today, it grew into that weighting. It’s not like he’s like, “Oh, that’s my weighting out of the gate.” I think, it’s is a skill to hang on. Greenblatt has said in the past, when you’re that concentrated, when stuff really starts to run on you, that’s as much of a learned skill as it is taking the punches.

Toby: I think one of the things that Michael Mitchell said in our podcast, and we discussed it more recently, and I think that’s one of the underappreciated things that Buffett does is, Michael Mitchell got his– and you as well, in Qurate. Michael is getting his capital back inside one or two years, and I think Buffett did that as well, with BNSF, he was getting almost all of his capital back pretty quickly. That’s underappreciated. They’re getting their investment back, and then whatever sitting in there, you feel a little bit more comfortable letting that run. I guess you can engineer that by selling half your position, once it’s gone up 100%. I think Buffett would say, “It’s not the right thing to do, but somehow getting your capital back from a company, that gets you past that rule,” or something like that. I don’t fully understand what the difference is, but I need to think about that one a little bit more.

Jake: There isn’t one.

Bill: Yeah, I don’t know. I was happy when it was selling off. It caught a bid which kind of sucks.

Toby: Still in my screen. It’s still cheap.

Bill: Yeah, I like it under 10.

Toby: That’s full time, amigos. Whistle’s blown. We’re on injury time right now. That was fun. We’ll see everybody next week.

Jake: Cheers.

Toby: Peace.

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