In this episode of the VALUE: After Hours Podcast, Jake Taylor, Bill Brewster, and Tobias Carlisle chat about:
- Value Investors Misunderstand Leverage
- Investing Lessons From Scott, Scurvy & Vitamin C
- The El Farol Bar Problem
- Are You A Good Investor Because You’re Getting Results?
- Forward P/E Underperforms
- Rising Short Interest In Consumer Durables
- Forget Macro Predictions & Focus On Companies
- Chasing Yield
- UnitedHealthcare Giving Members Free Access To Peloton
- Lower Your Expectations
- Private Equity Is Not Independent Of Public Markets
- If Rates Got To 6 Everything Collapses
- Templeton: Keep Changing Your Methods
- Swedish Match
- Fear & Greed Index
- The Lumber Pump Obsession
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
Tobias: All right, here we go. Live streaming. No idea what happened then, but here we go. We are live.
Bill: Hey.
Jake: [imitating random intro sound]
Tobias: [giggles]
Bill: There we go.
Tobias: Apologies, folks, the little man on the wheel in the back is running flat out. All right.
Jake: [chuckles]
Tobias: It’s a little bit after 10:30 on the West Coast.
Jake: [chuckles]
Bill: Yeah.
Tobias: It’s a little bit after 1:30 on the East Coast.
Bill: I took a nap while we were waiting. So, I’m fully rested.
Tobias: For the first time in a long time, I’ve done a whole lot of preparation. I got veggies that are actually fruits. What’s happening, fellas?
Bill: Ah, look at that. Franks and beans? Ah, not much. Today, Jeff Bezos went to space in what looked like a giant penis. That was interesting.
Tobias: Looked sharp.
Bill: Yeah, he looked good. Look, man, I [crosstalk] he’s pretty cool.
Jake: Thirsty.
Bill: I’ll tell you, what was amazing was the cameras.
Jake: I haven’t seen any of the footage of it. Is it good?
Bill: Dude, you could see the whole thing. I don’t know how many feet, 360,000 feet in the air, and you can watch the whole thing happen. It’s crazy.
Jake: Almost like I don’t have to go up there myself. [laughs]
Bill: They seemed like they were having a lot of fun up there. I would go up there when tickets are 400 bucks.
Jake: [laughs]
Bill: So, we’re going to need to work on the technology a little.
Tobias: What are we talking about today, fellas? What’s your topic, JT? You’ve got some veggies?
Jake: Of course. I wouldn’t show up if I didn’t.
Tobias: [chuckles]
Jake: We’re going to be tackling the El Farol problem.
Tobias: Ooh.
Jake: So, we’re getting complex systems going.
Tobias: I don’t know what that is. What do you got, Bill?
Bill: I’m probably just going to listen to Jake, and try to figure out what he had to say. And then, if it comes to me last, I don’t know, we can talk about PSTH blowing up or some other thing in the value world.
Tobias: Yeah.
Jake: We need an innings update too at some point.
Bill: I don’t know, man. There’s a lot of cheap stuff out there.
Fear & Greed Index
Tobias: Yeah, it’s funny. I’m kind of have that view too. I’m in a little bit of two minds, because I tweeted this out yesterday. Fear and greed dropped below 20 historically, not going back very far. The data only goes back to serve post 2009. It’s 2010 or 2011, at least according to the Wayback Machine. It’s been a pretty good indicator of when to buy. I appreciate how silly that is given we’re 3% of all-time highs, and it’s giving you that little signal. But it’s done that before. It did that in 2013, and anybody can take a look at 2013 is a pretty good year.
I don’t know that any of this stuff is particularly helpful. I’m just interested in this indicator as an objective way of saying how nervous everybody is about the level of the market. I don’t know what it means that it’s come off so little over– It’s showing so much fear given it’s come off so little. Probably that just speaks to lack of volatility in the market that it’s been such a good market now for whatever it is, 15 months or something.
Bill: Well, it just seems to me like– [crosstalk]
Jake: Months or years? [chuckles]
Tobias: Well, yeah, particularly 15 months, but 13 years before that had been pretty good, too.
Bill: Tech had its sell off earlier in the year. Now, value cyclicals are having theirs. This just feels normal shit to me. I’ve been buying some stuff.
Tobias: Yeah, when I run my higher quality screen, it looks to me like there’s an unusually large amount of pretty good stuff in there. So, there’s undervalued, high-quality stuff in abundance.
Bill: I found bitcoin not catching a bid interesting.
Tobias: Where is bitcoin right now?
Bill: I think it’s under $30,000.
Jake: Below 30.
Bill: Yeah. I don’t know. I had the whole. If you assume, which I don’t, but let’s just assume that the headlines are correct, and the market was actually selling off because of the delta variant, this is my attempt to get us demonetized yet again.
Jake: [laughs]
Tobias: Lambda.
—
Bill: Then, you would think that– I thought that maybe a logical conclusion would be more stimulus which would mean weaker fiat which means bitcoin should catch a bid, but I was not right.
Tobias: That’s macro, mate. It’s really hard.
Bill: Yeah, well, that’s why I don’t mess around with it for the most part.
Tobias: Once, you get to that second, which means you’re in trouble.
Bill: Yeah, that’s fair. We should have macro people on the show. It would really help ratings.
Tobias: It does. That’s true.
Bill: Yeah, people love macro.
Tobias: People love the macro.
Bill: You’ve got to look at the company that’s taking Whitney Tilson’s newsletter.
Jake: Stansberry?
Bill: Yeah, not like him, particularly. There’s six or seven of them. The data on the macro newsletters that they write is crazy. Crazy.
Tobias: The thing about macro is, it’s a lot like politics. It’s just your political views inform your macro views, and I don’t think that’s a particularly good way to invest.
Bill: Yeah.
Tobias: I’ve been this macro– [crosstalk]
Bill: That’s a decent way to write a newsletter, though.
Tobias: Yeah, it is. It’s a fun way of writing. I’ve been to some macro conferences as Chris Cole’s plus one carrying his bags, and they’re fun. The macro is practiced by the big boys. It looks more like special situations.
Jake: Well, since time immemorial, there’s been demand for prognostication, whether it was the chicken guts, or– [crosstalk]
Tobias: Oracle at Delphi, the Pythia.
Jake: Macro calls. That’s just people have always wanted to think that someone else knew what the future was going to hold. I don’t think that’ll go away either.
Bill: No, it’s unfortunate.
Tobias: You’ve got to be careful of eclipses, earthquakes, plagues, all those sort of things.
Bill: My kids are watching-
Tobias: Ominous.
Bill: -YouTube, and some creepy guy came on and said that, the end of days is near in November. Everyone was going to die. He was in a ski mask.
Jake: Wow.
Bill: Thanks, YouTube.
Jake: That one’s after Peppa Pig? [laughs]
Bill: That was fun. Yeah, dude. No. Not Peppa. Peppa’s G.
[laughter]Bill: You can’t mess with her. It’s some silly ninja kids or whatever. The kids are watching. You know what I like about that? They’re like, “Why does that kid’s dad play with them?” Well, maybe because he’s paid to, you little shit. Shut up.
Jake: [laughs]
Bill: I’ve got a job.
Tobias: Because he loves his kids.
Bill: I need to go on a podcast. I make no money for– [crosstalk]
Tobias: I don’t feel it’s strongly– [crosstalk]
Jake: [crosstalk] to work really hard.
Bill: That’s right. [laughs] That’s not very nice.
Investing Lessons From Scott, Scurvy & Vitamin C
Tobias: I got some veggies. So, I’m going to take away with some veggies. I think there’s an interesting lesson on this one. I backed into this after a conversation that JT and I had last week. This is an old article from 2010. I’ll link it up in the show notes. But it’s on Robert Scott– [crosstalk]
Jake: No, we won’t. [chuckles]
Tobias: [laughs] Yeah. No, we won’t. But you can search Scott, scurvy, and something else, and you probably find it. Robert Scott had a run at the South Pole in the early 1900s, about 1911, 1912 which is basically modern history because they were doing it– Thinking that they were pretty modern like. We basically sold scurvy in 1747, James Lind, who was a Royal Navy surgeon pointed out that people who had citrus fruits didn’t get scurvy on these trips, and it took about 40 years. Then, the Royal Navy… all of the ships carry some citrus in it basically solved scurvy, because scurvy is caused by a lack of vitamin C. This is 1911. So, long way afterwards.
They had this conversation with another– The trip was ill fated. Half of them died. The ones who didn’t die, did something a little bit that– Not to give the whole thing away just yet, but basically, they headed out on the ice. They had scurvy before they headed on the ice. They all died of scurvy, including Scott.
They recorded the conversations that Scott would have or other people would have with the surgeons on the ship about their views on what was causing the scurvy. The funny thing is that we thought that we’d solve this 100 plus years earlier, 200 plus years early, and it turned out that we hadn’t. All we figured out was that there was this association between citrus fruits and scurvy.
We knew that if you ate it– but we’d known that for a very long time. All James Lind did was codify that information. Before that, even Vasco da Gama knew it, when he hit it out on his voyage in 1497, that they should take some citrus with them. It had been known, but the exact mechanism wasn’t known. We didn’t know it was vitamin C. We didn’t know about vitamin C. The Royal Navy mandates this citrus– It was sort of an advantage that allowed their ships to stay out on a blockade of Napoleon for years at a time where the other navies couldn’t do that, because they didn’t know about the citrus fruit protecting you from scurvy.
What happened in this 1911, 1912 trip that caused these guys to all die of scurvy given that we’d known about it for so long beforehand? There’s been a variety of things, confounding factors in between. One of them was ships got faster and faster. In the early 1800s, mid-1800s, they became steam ships, which were very, very quick. It would take a couple of weeks, and you don’t get scurvy in a couple of weeks. It takes longer than that. So, it was unnecessary to have vitamin C at all on the ship, because you’re getting fresh fruit– before you left, you get fresh fruit when you get to the other side. You don’t get scurvy.
That’s the reason why these other things started happening, because we just didn’t know that was superfluous through this period. Lemons were difficult to get hold of. They had an abundance of these limes, and they thought that the association was acidity. It was a lack of acid in the blood that was causing scurvy, and so you had these limes, and they’re more acidic than lemons are.
But the problem is that they’ve got about a quarter of the vitamin C of lemons. In addition to that, they stored them in these– You don’t want to take the whole wine with you, so you juice the wine, and then you stick it in this open-air pot, and there are copper piping taking it from one place to another, and the copper piping denudes the lime of its vitamin C. It’s already got not much vitamin C. So, basically, they eliminated all the vitamin C, but it didn’t matter, because they were getting everywhere so quickly that nobody was getting scurvy.
Now, fast forward to 1911. They are following all the things that they should do. They’ve got their lime that’s been stripped of all of its vitamin C. They head out. Already, people are getting the telltale signs, a little bit of white around the edges of the gums a little bit of red, starting to see old sores open up. They’re stuck on the ice in the dark, half of the party heads off…
Bill: Wait. What did they try to do, you froze up for me? Did he freeze up for you, Jake? I was like in this.
Tobias: They are trying to get to South Pole.
Bill: Okay. All right. Okay.
Tobias: They’re making their assault on the South Pole. They head out on the ice. The ones who stay back on the ship, they start losing their minds, and they decide they’re just going to eat whatever they can get their hands on. They eat polar bears, they eat whatever– I don’t know if they’re polar bears on the South, but whatever, they get their hands on– [crosstalk]
Bill: Yeah, South Pole, I’m going with it.
Tobias: I don’t know. It might just be. I forget. That part, I might have just added that. It doesn’t destroy the story. Basically, if you eat fresh meat, you get some vitamin C from the fresh meat. So, they didn’t get scurvy. They didn’t really know, and it was a terrible expedition. All the guys die, including Scott. Half of the crew gets back, and they tell the story.
Once again, they have to go back to the drawing board and figure out what is the connection between citrus and scurvy? That’s when they figure out that it’s in fact, vitamin C. But they had these other theories, because we just become aware of bacteria. Is it bacteria in the blood and therefore the acidity, that should kill the bacteria?
Is it [unintelligible [00:12:43] poisoning, is it this mysterious kind of poisoning that everybody’s getting? It turns out that it’s vitamin C, and if you get that, you just don’t get scurvy. But if you don’t get that even as someone who’s on land, if you don’t get enough vitamin C, because you don’t eat enough fresh fruit, you can get scurvy to this day.
I just think it’s an interesting illustration of how there had various confounding factors combined together to make us realize how little we actually know. It’s one of the concerns that I always have when I’m looking at a company, going through the valuation process. What are we actually trying to find, what do we know about these things, and what can you learn from even reasonably long periods of time in the market, 10 plus years? That you know to be true, that are just confounded by all these other factors. So, what do you guys think of that?
Jake: I definitely don’t want to get scurvy.
Tobias: [chuckles]
Jake: It sounds like an awful way to go. [laughs]
Bill: Yeah, that doesn’t sound fun at all.
Tobias: They detail it in this thing. It’s pretty nasty. They describe the death as a welcome death by the time we get to the end of it.
Bill: Oh, that’s terrible. I don’t want a welcome death.
Jake: It is amazing. The diffusion of information and how slow it was back then, and you had to keep relearning the same lessons.
Tobias: Well, we knew that was vitamin C, and it had just been like old wives’ tale, but just received wisdom that people knew that if you ate the– Vasco da Gama in 1497, so 413 years beforehand, he knew that if you took fresh fruit, you’d be okay. But as just they try to refine it down, make it more efficient, and then refining it down, and making it more efficient, they completely removed the thing that was keeping people safe.
Jake: There is some interesting parallels there with fragility and Lindy effect of what’s worked for a long time, and then you think you understand why, but maybe you actually don’t understand why, and therefore, you end up creating a much more fragile situation for yourself.
Tobias: Yeah, I think that’s right. I also agree with the person who says that the cure for scurvy is stimulus.
Jake: [chuckles]
Bill: Clearly.
Jake: Yeah, you could print scurvy away. No problem.
Tobias: All right, fellas–
—
Are You A Good Investor Because You’re Getting Results?
Bill: Yeah, I think what you’re somewhat drawing a parallel to is, you take a risk, you have an outcome. Are you right for the right reasons, are you right for the wrong reasons, what do we actually know that’s going on within companies, what do we actually know that’s going on anywhere? I have no good thoughts on this. So, you’re welcome for my comment. But I can tell you it’s something that I struggled with a lot over my break or whatever. I don’t know. I’ve said to people recently, I don’t know if I know what I’m doing at all, and I think people think that it’s a cute thing to say, I honestly, mean it. I don’t know how much I can say it to people until they listen, but I’ve had a year–
The whole reason that I left the bank, the entire fucking reason is because I didn’t want to sell at the bottom. Not only did I not sell at the bottom, I traded a macro event pretty well. Am I a good investor because of that? I have no fucking clue, man. I have no idea whether or not what I did was replicable, I have no idea whether or not I should theoretically be proud of it. Somebody asked me the other day, because I bought some more Qurate, they were like, “Well, is it the best stock in the market?” I have no idea. I can’t answer these questions. I leave that shit to the pros. All I know is I’m trying to make money in the market when I see blood, or when I see an opportunity that I see.
I have a lot more trader in me that I wish I did. I wish I was more of an investor. Guess what? I’m not. I like to fancy myself one, but I’ve got a long way to go. Is that wrong? I don’t know. There’s a lot…
How many do I actually know? Sometimes, that’s why I have an itchier trigger finger than I otherwise would, and sometimes I get into things before they’re fully diligenced. But sometimes I think you have to in the market. In case you don’t know, I can tell them. I’m very conflicted about a lot of big things that I’ve been thinking about, and to your point on what do you know, what do you know you know? I’m not certain. So, you’re welcome for that mind dump. Is that what you were going for [crosstalk]?
Tobias: Yeah, look, I think–
Jake: Toby’s not going to be happy until you’re crying. [laughs]
Bill: Oh, it’s going to take a while.
Tobias: What we’re all trying to drive that is to come up with the best conception of value, or this is what I’m trying to. I’m try to come up with the best conception of value over probably the nearish term, the next three to five years. If you think in those terms, then that gets you out of the stuff that’s sort of– I think it gets you out of the value traps a little bit, because you’re looking at stuff that should be still growing on a revenue basis, and it probably gets you out of stuff that’s of value too, because you’re still trying to look out for three to five years and work out where you’re going to get to.
If you do that, the problem is, it’s very difficult to tease out over shorter periods of time, what are in fact the drivers of value it does change over time that. The whole market has thought it’s various stages. It’s the leveraged buyout value can go onwards combining all those things together like that. Our view of it has changed. I don’t know if we’ve landed on the correct one now. I just don’t know. Like you, I spent a long time looking at this stuff, and I don’t know if I’ve advanced any from where I started out.
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Value Investors Misunderstand Leverage
Bill: I will go to my grave saying that, for now, value investors misunderstand leverage. That is one place that I think that value investors massively miss underpricing of common equity because of leverage. I think that maybe the reason is that their bibles were written when debt had covenants, and it actually mattered, and-
Jake: [laughs]
Bill: -it doesn’t now. The interest rates are somewhat nonexistent. So, you have no covenants and very low rates. Can it go wrong? Sure. It can go wrong. I don’t know. Today, I was looking at Teva which I’m not saying to go out and buy, I don’t know shit about generic drugs. But if you look at that cap structure, McKesson just settled, do you think they can settle? I don’t know. You can have some pretty interesting outcomes when you have that leverage on business on the market cap, like on the common equity.
Now, a lot of that’s going to be encumbered. The enterprise value to free cash flow to the firm’s not screamingly cheap, but the common equity is compressed in a lot of situations. I think TransDigm was one of those situations last year. But I don’t know. It’s so great. TransDigm worked. Is that because I’m smart, or did I just get lucky buy a bailout? I don’t fucking know, man. It’s a question I’ll never be able to answer. But what I do know is that it was a fortunate bet.
Tobias: Part of the problem with making any prognostications or drawing any final conclusions on the significance of debt or otherwise, or discount rates or otherwise, I think that we’re in– this is going to be my bias, but I think that interest rates are probably below where they would otherwise be freely floating in the market.
Now, does that mean that you use that discounted interest rate where it is, in your model, which gives you these fantastical values? Clearly, that was the right thing to do for the last five years. It was to use this very aggressive discount rate– or not very aggressive. That was the alternative in the market. Do you assume that it goes back roughly to where it was over an extended period of time? Because we’re valuing these things on 10 plus years of earnings.
Does that mean you think it over that period? We’re going to have some mean reversion back to roughly what it has been in the past? If you do, then, you’ve undervalued these things. I don’t know what the right answer is, but I do think that part of it, I think that if you hit the system like this, you pin those interest rates too low, it makes everybody go crazy.
It makes people borrow more money than they otherwise would. You’re incentivized to do that. Borrow a whole lot of money and buy back your stock that’s going to make– particularly if you’re a CEO of a big company, and you get paid on that basis, yeah, you do what you’re incentivized to do. So, you’re going to carry a whole lot of debt, and it hasn’t mattered yet.
Bill: To be fair, though, the 30 year right now is at 186. I don’t understand not issuing the shit out of bonds, especially when credit spreads are tight. Because there’s no way that you can argue to me that 30-year equity capital costs less than 5%. If you’re interested in maximizing the value of the firm, especially when you have no covenants, I just don’t understand why you wouldn’t push the debt markets as hard as you possibly can.
Tobias: In the context of the prevailing interest rates and equity risk premium, it makes complete sense. But that’s the point that I’m making that it’s completely sensible inside the context of what you’re doing now. But the question is, if those interest rates move out, and you have some floating rate, or you have to make that bullet payment at some point in the future with more expensive debt, that’s a different consideration, right?
Understanding Leverage
Bill: Yeah, but I think that there are a couple answers to this. One, I think you really have to look at how the debt matures. You don’t want a huge debt maturity in three years with a business that could undergo some cash flow problems in the interim. Because then you get cross defaulted if you can’t refi. But I guess that I just have this conflict in me, that’s like, “Okay, I hear what you’re saying.
But also, there is no evidence to me that there’s any shortage of money looking for deals.” Whether or not that’s because it’s a government– it has their finger on the scale or whatever, I’ve got to play the cards as they are. To me, the answer may be something like, “Okay, well, I’m going to address this in my asset allocation.” It’s not. I’m balls long equity right now, which may be a big mistake at a top or whatever.” I’d fair exited to get some– [crosstalk]
Tobias: It’s only it goes down from there. [chuckles]
If Rates Got To 6 Everything Collapses
Bill: Yeah, well, fair criticism to those that say that that’s a mistake. I internally think about that a little bit. But maybe the answer is to hedge something in a different way, because if you’re going to argue that rates are going to go to 6 or something like that, then I’m going to tell you everything collapses. The housing market’s gone, your pension funds are fucked, your equity markets are down. The world doesn’t work. Maybe there’s a different hedge there. But within an equity allocation, I don’t think that you can put money out the door and assume that rates are going to mean revert to anything north of 3 and get anything done.
Tobias: That’s right.
Bill: Yeah. So, what I mean is– [crosstalk]
Tobias: Are you buying low-quality companies?
Bill: Yeah, which that violates what Buffett said about debt. Don’t go out on the risk curve to get more yield. I would argue the same thing for equities. This is what Charlie’s been saying to people forever, like, “Bring your expectations down.” Now, they haven’t done it at Berkshire, so that begs a different question.
Jake: Other than that, how is the play, Mrs. Lincoln? [laughs]
Bill: Well, I don’t know. I think it’s a really interesting conversation. How to deal with this is a really tough thing to answer.
Jake: Very difficult. Financial repression is real.
Tobias: Yeah.
Bill: Yeah. What does that mean? What does financial repression mean?
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Chasing Yield
Jake: It means if you can’t get a reasonable return on your asset in less risky ways, you have to go looking for it other places, and you then bid up the price of those things to the point where you’re chasing yield right off into much riskier situations than what the price of that. So, S&P 500 at 3% yield, you might be able to argue as chasing a bit even if, and because, Treasuries are at 1.8% or whatever for 30 year, and if you think about equity as a 50 year, let’s say bond maybe 3% slots in with that, but does that mean that’s right? I don’t know.
Bill: Well, what’s going to cause the 30 year to go higher than where it is? Because if it’s growth, that’s not that bad.
Tobias: Inflation.
Bill: Yeah, that could be a problem. But I don’t know. The debt market’s not buying the inflation story. Even though labor is super tight, you would think that inflation is not implausible off that, even though, I had been in camp– [crosstalk]
Tobias: Can you read what the debt market is doing? Is there a signal destroyed by the fact that the Fed’s in there with his finger on the scale?
Bill: I just don’t think that they can move that big of a market. In the 30 year, the 10 year, I don’t buy the Fed thing. I think that’s people want to have a tinfoil hat on. Maybe, I’m wrong. I’m open to that. I attribute it more to– [crosstalk]
Tobias: But it’s their explicit– what does the FOMO do? FOMC, what does the FOMC do?
[laughter]Bill: Yeah, I don’t know how deep the market is, and how deep the Fed– [crosstalk]
Tobias: It’s all at the margin, right? It’s all at the margin.
Bill: Yeah, but I don’t know. I don’t know what I’m talking about in this. I really don’t. So, I’ll just stop talking.
Tobias: Either the Fed has an influence or it doesn’t. If it does have an influence, then it’s not a conspiracy theory to say that it’s influencing the market, right? [chuckles]
Bill: Yeah, but my conclusion to that is like, “Why in the world did that influence ever go away?” I don’t understand– [crosstalk]
Tobias: You might lose control of it. If inflation does in fact pop up, then they can’t be having negative– They’ve got negative rerates now, but at some point, you have to lift it. Otherwise, there is going to be some refusal to participate in that market.
Swedish Match
Bill: Okay, well, I guess that the other way that I would maybe say that I think about this is, I’ve been looking at Swedish Match a little bit. You know anything about Swedish Match?
Tobias: I just know the original story written by Frank Portnoy. [laughs]
Bill: Well, they have this product called ZYN. ZYN, my degenerate friends [unintelligible [00:29:10] If you’re listening, shoutout to you guys. I love you guys, but you are degenerates with this stuff. They’re these nicotine patches. They have no powder, they got no tobacco, they got nothing. Highly addictive, tastes great. My friends rip them like they’re going out of style. I put one of my mouth on the golf course. I won’t do it again. I couldn’t even swing a golf club. I don’t need another addiction in my life. No, thank you.
But that company to me, the probability that rates destroy wealth in that investment given the fact that I think that they could probably grow mid-single digits for 10 years generating 70% gross margins and 30% net income margins, I guess I could keep cash rather than that or something like that. It doesn’t have to be that bad.
But I can’t run from a boogeyman that I’m afraid of and still keep up with the wealth treadmill. Maybe, that’s the exact problem. But, man, that’s a huge opportunity cost. If you missed out on these 10 years, you really have to be right on the back end. I don’t know that would put me specifically in the right frame of mind to make cogent decisions going forward.
Lower Your Expectations
Jake: I think that’s right. If there are good deals to be done, I think you still have to do them. It’s just more of a general gestalt of, are we to expect headwinds or tailwinds from here? I personally think you could make a pretty reasonable argument that people should be lowering their expectations, and expect some headwinds from here for, either we have to grow into this valuation or we have to reduce the valuation.
One of those two things has to happen from this level. So, it’s not clear to me which one we’re going to have, but if you have good deals to be done on an individual basis, I think you have to keep pulling the trigger, regardless of what else is happening. The world is big enough that there will be smart, interesting things to do, regardless of whatever else is happening with all this macro stuff.
Bill: Yeah, I guess that I’m not sure that the market would eventually solve the outcome that I’m going to describe. But something that worries me is, what ends up happening is the government starts to try to say, “Well, look at the wealth inequality, and we’ve got to figure that out,” and then, you get some stupid top-down economy, and I hate to call out the socialist card, because I debate this with my in-laws all the time. But fixing the problem could cause more problems than the problem. Then, you would think that that could create some rerating downward, and that would be a pretty bad scenario. Because the wealth gap is unacceptable.
Jake: It always was. [laughs]
Bill: Yeah, well, yeah. But I don’t know. I’m going to go back and forth on March, but I think the government did the right thing last year.
Jake: Let’s do your veggies, JT, because we’re going to run out of time otherwise.
Bill: This was a good conversation. Good topic, Toby.
Jake: Yeah.
Bill: You bailed me out of talking PSTH.
Jake: It’s going to be surprising how well this is going to tie together, almost as if we planned it, which assuredly we did not plan. [laughs]
Bill: No.
—
The El Farol Bar problem
Jake: This is the kind of famous at this point, El Farol problem. E-L-F-A-R-O-L. If in case, you want to look it up yourself and actually learn about it as opposed to my version of it. But El Farol is this bar that is in Santa Fe, and it used to feature Irish music on Thursday nights. There’s this economic professor at the Santa Fe Institute, his name is Brian Arthur. By the way, if you had a time machine, and you could force yourself to go back to, I think it was 1998 when he wrote this paper on increasing returns of scale. If you could have gone back and read that and said like, “Listen, this one’s important. Forget all this other stuff. Read this. Make sure you read it.” Like you were Biff with the sports almanac?
Tobias: [laughs]
Jake: That would have been a very, very lucrative idea for you to have internalized in 1998. Anyway, so, Brian Arthur, he wrote that paper. He’s from Belfast originally, and he likes going to hear this Irish music of his youth at El Farol, this bar. However, he doesn’t like going when there’s a bunch of drunk lunatics at the bar, and it’s too crowded.
Suppose 60 people are considering going, but none of them want to go if more than 60 people are going to be at the bar, because it’s an unpleasant experience then. But less than 60, it’s quite pleasant. We pretend that over the past 10 weeks, here are the number of people who have gone. 15, 18, 83, 66, 45, 76, 67, 56, 88, 37. So, we have five good nights and five bad nights over the last 10 weeks when you two have gone to go see this Irish music.
Well, now, these 100 people who are deciding, “Should I go to the bar or not on Thursday evening?”, they all have their own model of what might be the right reason for them to go or not. Maybe, some people would use just last week’s and say like, “Oh, well, it’s 37 last week. Therefore, it’s likely to be below 60 this week. I’m going to go.” Now, what if some people said, “Well, I’m going to take the average of those last 10 weeks which happens to be 55,” and they decide, “Well, I’m going to go. That’s below 60.” Or, maybe there’s some people who maybe take the average of the last four weeks, which would have been 62, and they decided, “Well, I’m not going to go.”
Well, there are different methods of prediction end up in this ecology of prediction. All of these prediction models are competing with each other for accuracy. Some of the models will live and some of them will die based on how accurate they are. People, they’re evolving their models with new data to try to figure out what’s the right thing to do.
The thing is if they all shared the same rational model, what would end up happening? It would end up negating itself, because everyone would end up predicting that few people would go, and they would go, and that would be wrong. Or, they’d all be predicting that too many people are going and no one would go, and then, it actually would have been a good time to go. They have a way of canceling themselves out. Each model is affected by the prediction of other people’s models. Really, you end up with chaos in this complex adaptive system.
This happens to basically describe how the market works as well. People have their predictive models, and everyone’s competing against each other with their models, and there’s an ecology of models out there competing with each other to try to figure out, “Is this a good time to go to the bar or not, right? Is this a good time to buy or not?”
Actually, Merrill Lynch did this study for a long time, and then they got acquired by BofA. The last publication of it I could find was from 2019. But what they did was, they survey institutional investors to see what factors are they using basically, like, what model are you using to decide whether you want to go to the bar or not?
Forward P/E Underperforms
Jake: The forward PE has been the number one model for 14 years in a row as of 2019. By the way, it’s underperformed by 46% over the last nine years. So, everyone’s using the same model, and then, therefore negating themselves out, and it’s not working.
Tobias: Say that again. The forward PE has been the most popular model, but it’s also been– or it hasn’t performed very well?
Jake: Right. Exactly. Perhaps, probably because everyone has been using it as their number one factor. They have tons of different factors in here like earnings surprise, dividend yield, beta, size, return on equity, PEG ratio, relative strength, all these different– machine learning all this other stuff. Since 1991, earnings revision as one of the factors has been underperforming by 1.4% per annum, when years, it’s in heavy usage by everybody.
Tobias: [laughs]
Jake: But the time when it’s not in heavy usage, it’s plus 4% per annum. The average model in 2019, they used 18 factors, whereas in the early 90s, it was 7 or 8. John Maynard Keynes actually described this problem a hundred years ago, when he talked about this beauty contest, where you are trying to come up with what you think the average person is going to guess is what they would say is, what they would pick for the for a beauty contest. Then, you start to think like, it becomes recursive where each layer down, you’re thinking, “Well, what’s the average person thinking that the average person is going to think that they’re going to pick for the beauty contest?” It becomes a total mind scrambler to try to–
Really, all they’re trying to figure out is, it’s really a very complicated form of greater full theory, like, is someone going to pay me more later compared to– am I using the factor that’s going to be the one that’s the winner who’s going to allow me to pick over this time period the thing that someone’s going to pay me more for? What do you guys think of the El Farol problem to start?
Tobias: Yes, that’s a good summation of it. You’re not trying to come up with a valuation. You’re trying to pick which ratio best predicts the next 12 months.
Jake: That’s probably accurate, I would say. It might be generous to say 12 months, but [laughs] are we measuring quarters or days?
Tobias: Quarterly, yeah.
Jake: I don’t know. [crosstalk]
Tobias: It’s going to be noisy, because– I don’t want to say confounding factor, but the thing that influences what other people are doing like, did cheap stocks on a PE basis all of a sudden become popular in which case there are fewer of those, because everybody’s trying to buy the cheap stocks. If your approach was to try and figure out which one best predicts where the underlying business will be in x period of time, do you still run into the same problem? Probably, possibly. You still get booms and busts in that scenario, right?
Jake: Well, it always goes back to what is everyone else imagining, and are they bidding that factor up to a level where there’s nothing left for you except maybe even under performance? You don’t know what everyone else is doing a priori. It’s almost as if this would be telling you that all of the [chuckles] machinations of trying to figure out where the hell this thing is going, and what’s going to work is perhaps wasted CPU cycles.
Tobias: Yeah, so what’s the solution? What’s the answer?
Bill: Wait, I’ve got two quick thoughts. Ken Fisher, even though you’re not allowed to speak his name, he who shall not be named, he used to do this when he would do his market predictions. He always would admit that he’s cheating but what he would do in order to come up with it is, he would look at what everybody else has predicted after the big money poll has closed, and he was like, “All right, that’s what’s priced in. So, that’s what’s not going to happen.”
Then, he picks the slices outside of that, which I thought was interesting. Then, the other thought that I had was, I just think forward PEs hasn’t worked, because there’s a very real possibility that we are in the middle of a huge global asset grab for the next layer of basically internet infrastructure.
There’s really rational reasons to reward people that are spending a ton of money if that thesis is correct and their businesses are sticky. They would have more losses right now, because gap requires it. It makes sense to me. Now, whether or not that assumption is correct is debatable, but I can at least understand it.
Tobias: Ken’s dad, Phil, who wrote the book, Common Stocks and Uncommon Profits. There’s a similar story in the start of one of his books, but it’s not looking at where the big money goes. It’s just one of those competitions, and I think the prize was a color TV or something. Back when, that was a big deal.
Jake: Whoa.
Tobias: [chuckles] They just got everybody’s prediction for where the stock market would close the next day, and everybody predicted plus 0.5%, plus 1%, minus 0.5%, minus 1%, and then, he just picked plus 3%. Of course, that turned out to be the right thing, and he won the TV. The prediction was not on the basis of that’s what he thought was going to happen.
He just knew that he’d be the only one out there predicting that it was just a wild move one side or the other, and everybody would forget the correct answer in the years to come unless it was of a wildly divergent answer. So, that was why he picked it. He was pretty smart. So, he is playing the game more than he’s trying to figure out what’s happening.
Bill: Yeah.
Jake: Yeah. I think that Bill gave us probably the correct answer earlier, when he named an individual security and situation that he thought made sense to him, and-
Bill: Just makes me happy. [laughs]
Forget Macro Predictions & Focus On Companies
Jake: -took him away from all the macro predictions and trying to factor in what factors are going to be the winners over the next period of time, and instead just focusing on the business, focusing on the price that you’re paying. The odds implied of the business results from the price that you’re paying, do they make sense to you, or are they aggressive, or are they conservative? If they’re conservative enough for your threshold of what you feel comfortable with, then you proceed. I think that’s probably the smart way to play the game. That’s really the way that Buffett and Munger have been playing the game the whole time.
Tobias: The only criticism that– Let me play devil’s advocate, because I’m a deep value guy, and this is one of the things that has occurred to me, is that by virtue of the fact that you’re always digging around in things that are conservatively valued on a conservative basis, are you missing out on some of the stuff that is very, very good, and you should in fact be paying what is an optically high price for it in the moment given that it might have this behavior down the track? The only thing is that’s a very, very difficult game to play. Historically, forward PEs don’t work.
Bill: It is, but– [crosstalk]
Tobias: In fact, growth doesn’t pan out.
Private Equity Is Not Independent Of Public Markets
Bill: But dude, the other side of that is, think of how much money has gone into private equity. Some of the cheaper companies that are smaller, I really think you got to be able to articulate why hasn’t private equity bought this yet. They get to see under the hood on a lot of these things. Going back to what we don’t know, I would not be shocked, if a lot of things that are optically cheap or truly shit shows under the covers.
That’s tough. I know it always has been, and I’ve realized that that’s how value works, and I get all that. I’m just saying that, as this market evolves, and more and more and more money goes into private stuff, some of these companies that made me scratch my head and be like, “Why is it public?” I’m not saying there’s not a reason. There’s plenty of good people doing smart work that say there’s a reason, but that would be top of my check list.
Tobias: The thing is, private equity is looking at the market too. Private equity is not doing this independent of where the market is. They’re looking at, “What can I flip this back onto the market?” Private equity doesn’t have to be stuck in that. They’re also influenced by what’s happening in the market.
Jake: There’s a sell to the next dumb PE guy, if you can.
Tobias: That seems to be most of them. Yeah, for sure. It seems that a lot of companies now are just permanently private equity from one fund to the next, or from one firm to the next.
Bill: Yeah.
Templeton: Keep Changing Your Methods
Jake: There’s a great quote from Templeton that draws it all together. “If you’re going to be successful in selecting investments, you have to keep changing your methods.” Don’t have to change your principles, but you have to keep changing your methods. Keep getting better at what you’re doing.
Tobias: I like it. Do you guys want to take some questions? I think we’ve got some tip that was in euros. I thought it was in euros. So, thanks very much for that– I missed the name. Sorry, it scrolled by while we were talking, but thank you very much for that.
Jake: [chuckles]
Tobias: I’ll spend it on booze.
Jake: [laughs]
Tobias: Ah, looks like we’ve devolved into some arguments.
Bill: Yeah.
Tobias: [laughs] [crosstalk] was in the comments. That’s great.
The Lumber Pump Obsession
Bill: That guy, he’s obsessed with this lumber pump. It’s the second week he’s been saying it. Ah, look. Here’s the thing. Since I know some people who happen to be involved in talking about lumber on Twitter, the fact of the matter is I don’t think anybody, especially that came out of the Itasca crowd, was arguing that you should underwrite lumber at 1200 bucks.
I do think that when prices moon like that, it gets more attention. But if you underwrote $1200 lumber, you’re an idiot. Welcome to the market. That was your first education, and you should learn to be more conservative in your underwriting. If you bought it because it was going up and you saw it on Twitter, also not the smartest decision in the world. Welcome to your first education in trading.
Now, why aren’t people talking about it now? I don’t know. Maybe when it’s being painted red and fore-selling is occurring, it’s not the most fun thing to talk about. That doesn’t mean it’s a pump and dump. People are trying to exercise the rights right now, and there’s no bid under the stock. So, that’s my two cents on what’s going on there.
UnitedHealthcare Giving Members Free Access To Peloton
Bill: As far as the United Healthcare-Peloton deal goes, I have no thoughts were sharing except for the fact that it’s probably a pretty interesting deal. Peloton has got an interesting– Some of what has come out has proven devaluation to be less absurd than I thought it once was, and I’ve seen the operating leverage in that business. You’ve still got to believe it’s got a long way to go, though. I think, I might be wrong.
Jake: What would you handicap the odds that United would overpay for that asset?
Bill: Well, I don’t think they’re like– I think they’re just giving subscriptions to their members.
Jake: Okay.
Bill: There’s a very real possibility that Peloton– where my opinion on peloton shifted last year was when I realized that it might actually be very affordable personal training for everyone. That’s when I started to be like, “Oh, okay, I get this.” When I thought that it was more of a high-end equipment company, I was much less interested. I was close to buying it with that recall. I didn’t, but I was close.
Rising Short Interest In Consumer Durables
Tobias: I got a good question, and thanks to Colm Moore, “Well, spend it in an Irish pub. We’re going to get three Guinnei in Omaha next year.” This is the question, though. Any thoughts on the rising short interest in consumer durable companies on the view that the cycle is over, and everyone is overearning? Restoration Hardware, for example, is becoming a popular hedge fund short. BB, that’s probably you man.
Bill: Yeah, look, what the hell is Restoration Hardware trading at? $7 billion or something like that right now? I get shorting it there.
Tobias: I saw one of the clubs inside– [crosstalk]
Bill: But valuation shorts are fucking terrible ideas in my book. Oh, my God, 13. Jesus, Lord. That’s actually $15 billion enterprise value. Yeah, I don’t know.
Jake: [unintelligible [00:50:05] short it. [laughs]
Bill: No, I wouldn’t. That’s exactly why I wouldn’t. Exactly what I just said. I would never short that company. Gary’s got unlimited ability to do whatever the heck he wants. People think, he’s a genius. He’s maybe actually pivoting the brand in the right way. It certainly appears to be. I don’t know. You want to get in front of that train? Enjoy it. There are easier games to play in my book. I’d short it after it rolled over maybe.
Tobias: I think they’ve got the club, the Restoration Hardware Club, whatever they call it. I think there’s one in Beverly Hills, Hollywood. Had a look. It’s pretty cool.
Bill: Yeah, they’re sweet. Look, man, he’s doing a good job with the brand.
Jake: Yeah, club like you go there and drink?
Tobias: Yeah, it was closed though on a Saturday night. So, maybe it’s just too early, because I’m old [laughs]
Jake: Yeah, okay.
Bill: Yeah, that’s a big part of what they’re doing, dining and experience. It’s a way to get people to be habitually introduced to a furniture brand that they otherwise would come back and make a purchase every five years or something. You are actually brought in and you’re constantly reminded of Restoration Hardware.
Jake: It’s just like when I go to IKEA to get the meatballs?
Bill: No, it’s a lot different, but similar.
Jake: No, okay. [laughs]
Bill: It’s much more akin to Starbucks roasteries, which I think are smart.
Tobias: I think it’s a great idea that– [crosstalk]
Bill: Basically, [crosstalk] the advertising cost.
Tobias: There’s a whole lot of mall space that’s basically empty these days. The only reason you need to go out there is for the experience. You don’t need to go and buy something anymore, because it’s all delivered on Amazon. So, you go out and hang out in a Restoration Hardware mall, and while you’re in there, you’re like, “This stuff is pretty cool. Wrap it up. Send it home, I’ll take it.”
Bill: Yeah, Nordstrom was, I think, probably the pioneer in doing that but they messed up where they put their stuff. Their dining rooms are in the back. Gary had the idea to make a lot of these dining rooms the focal point. If not the focal point, somewhere that people want to go. If you go to the one in Chicago, when you enter it’s right off to the left. If you go to New York, it’s got this sick roof top. It’s smart. It’s a good idea.
Tobias: All right, team. That’s time. That was fun. Next week, the lumber king himself is back.
Bill: To pump. Greg, you can come directly at him.
Jake: Yeah. [laughs]
Tobias: And BB is on vacation, and then, it will be around some time after that. All right, gents, that’s good.
Bill: All right. Have a good one.
Jake: Cheers everyone.
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