In this episode of the VALUE: After Hours Podcast, Jake Taylor, Bill Brewster, and Tobias Carlisle chat about:
- Acquirers Multiple All-Time Spread
- When ROE Matters
- Mauboussin – Underestimating The Red Queen
- Why Deep Value Works
- How Apple Is ‘Watching’
- Facebook’s Latent User Intent
- This Is a Rate Rally
- ARKK Blow-up
- People Get Too Confident In Their Ability To Predict
- Facebook – The Value Tech Stock Got Wrecked
- Technological Obsolescence
- The ATT Update Is Damaging Small Business
- Maintenance CapEx v Growth CapEx
- Measuring Incremental Revenue
- Japan Performing Better
- The Problem With Net-Nets
- Energy Is Rocketing
- Instagram v TikTok
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: 1:30 PM, oh, it’s still setting up. I’m not sure if we’re live or not.
Jake: We’ll do it live.
Tobias: Yeah.
Jake: It says, we’re live on mine. So, let’s do this.
Tobias: It does. All right, then, we’re live. It’s just getting a bit slow, man. Here we go. This is Value: After Hours production quality-
Jake: Through the roof.
Tobias: -top podcast production quality as always joined by Jake Taylor, and Bill Brewster, and Tobias Carlisle. We talk about value stuff in an afterhours format, even though we record it during hours.
Jake: It’s confusing.
Tobias: It is confusing.
Jake: [laughs]
Tobias: Indicates that it’s a more relaxed atmosphere, we can talk about things that you might otherwise here on an investing podcast.
Jake: Not around polite company?
Tobias: Not in polite company. What’s happening, fellas?
Jake: Bill, you got the doggy visiting?
Bill: Yes.
Jake: New dog, huh?
Bill: Yes. Oh, good. You laying down. All right, excellent. Yeah, I got a new baby in the house. So, that’s exciting.
Jake: Very exciting. How are the kids? They’re loving it?
Bill: No, they’re actually the hardest part of it. I don’t know. My four-year-old has got some attention stuff. He needs to stop being a bitch.
Jake: [laughs] Well, they’re not paying attention to the dog or what’s the problem?
Bill: No, he doesn’t like that the dog’s getting attention. He’s got to get over it.
Jake: Oh, okay. Got it.
Tobias: Corey Hoffstein is looking for [crosstalk] financial advice. He says, “Should I put 100% of my money in value now?” The answer is yes, always.
Jake: [laughs]
Tobias: If you’d asked me that five years ago, I’d have said yes. Still, yes. Value is evergreen. It just seems to be cyclical in its performance. But the idea of buying for less than something’s worth that makes sense to me. Everything else is too hard.
Jake: Not investment advice. [laughs]
Tobias: That’s not investment advice. Although, I spent some time over the week looking at some of the factors. Interesting. I don’t know what to make of it, but I’m going to throw it out to you guys. See if you can chew it over with me.
Jake: We know if robo-advisors were bailing on it that probably it’s about time to work.
Tobias: I clicked through and I had a look at what they’re actually doing. It was at Betterment. Betterment says, “We’re no longer using value because it sucks too bad.” And everybody’s pointed out that ringing a bell, that’s the bottom their value can run, again. What they were saying was the actual definition value factor price to book. That’s fair enough. They don’t like the particular metric.
Jake: Is that what they were using before? Who’s–
Tobias: Evidently.
Jake: Okay.
Tobias: I don’t know if anybody would actually other than academics would suggest that, that’s a good way of doing it. The way the academics use it, though it makes sense the way that they do it, but yeah, there’re better metrics out there.
Jake: Intangibles, bro.
Tobias: Intangible’s word. You’ve got to work out how to bring them onto the balance sheet evidently. Was it Wealthfront? Sorry. Thanks, Hoffstein. [laughs] It’s good having the fact check is fact checking this live.
Jake: Yeah. It decreases our stupidity by about 12%.
Tobias: We’re stupid for about the lag. Somebody else takes to figure it out in a minute or two.
Jake: [laughs]
Bill: This is correct.
Metaverse About To Trough
Tobias: Yeah. Everybody’s talking Meta that used to be called Facebook. No idea what a change that it’s going to be. I think that name, Metaverse, that’s going to age like stuff that goes off really quickly, because remember when virtual reality was very uncool for a period there when it went through the trough of disillusionment on the Gartner hype cycle. I’m guessing that Metaverse is at about the trough of disillusionment anytime soon just like the stock price.
Jake: Yeah. It’s little bit rough right there.
Tobias: It’s interesting to hear at some point.
Bill: That was the point.
Tobias: That was quite a day when it was down 25%.
Bill: Yeah, well.
Tobias: Cheeky $100 billion or whatever. It was wiped off the market cap [crosstalk]
Bill: I think it’s not more than that. I think it was two.
Jake: It was two hundred, I think.
Tobias: Two hundred.
Bill: Yeah.
Tobias: $100 billion used to be a lot of money.
Jake: Yeah. [laughs]
Bill: Indeed. Well–
Tobias: [crosstalk] I think you have Netflix, who tore up hundred. Who knows? Wow.
Bill: I don’t know. It’d be interesting to watch. We’ll see.
Tobias: Indeed, we will see. What’s happening, fellas?
Bill: I think a lot of the commentary maybe unsurprisingly is not correct, but whatever.
Jake: Wait, Twitter with a hot take that’s not your favorite?
Bill: Yeah. But what do I know?
Tobias: What’s not right about the commentary?
Bill: I’m not sure that there’s actual evidence that TikTok is taking share of Facebook. I know that that’s what Zuckerberg said. But I don’t know. If you trust alt data, it’s not. If you trust what everybody wants to believe it is. I actually think there’s a reasonable possibility it’s more likely that it’s taken share of YouTube.
Jake: Ooh, spicy.
Tobias: None of it’s appearing in the data that was like, YouTube’s taken over Netflix in terms of time watched and TikTok’s taken over from Instagram, hasn’t it? What’s wrong about that?
Bill: Well, the actual data that App Annie puts out shows that average time spent per user on Instagram and Facebook is actually slightly up over the last two years.
Tobias: I thought the argument was just that TikTok had overtaken Instagram in terms of people that were using that more then. I thought that was the only take.
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Instagram v TikTok
Bill: I don’t even know if that’s supported by the data. I think Instagram is still bigger than TikTok, but I could be wrong on that. But per user, one of the issues that Instagram has is reels is cannibalizing Instagram. Your ad load on reels is lower than what it would otherwise be. But I think everybody wants to believe that Facebook’s dying, but the unfortunate thing for that belief is that the data just doesn’t support it. Then again, don’t let data get in the way of a good narrative.
Tobias: What about YouTube over Netflix?
Bill: Ah, I haven’t seen those. I only had a couple of slides shared with me. So, I can’t actually speak to that.
Tobias: I’m not looking at the data. I’m looking at slides that are shared on Twitter. [crosstalk] if they’re not right, then it’s not right.
Jake: [laughs]
Bill: Yeah, TikTok is bigger than Instagram.
Tobias: Here we go.
Bill: Yeah.
Tobias: JT, what have you got on deck today?
Jake: I got a veggie piece on a recent white paper by The Man, The Myth, The Mauboussin.
Bill: Only thing that I would ask on average– sorry, average monthly users or average monthly hours spent per user on TikTok is a lot higher than Instagram. I’d like to know the age skew. Young people have a lot more time to sit around and look at their phone.
Tobias: If you got a younger skew then that would be better, wouldn’t it?
Bill: That depends what you’re selling. I would like to sell advertising to people that have money not people that stare at their phone all day.
Jake: Have their parents’ money.
Bill: Yeah.
—
Tobias: Sorry, JT. What’s yours? You got a paper from Mauboussin?
Jake: Yeah.
Tobias: What’s he talking about?
Jake: We’re talking about actually the scale, which– Well, we’ll get into it. I don’t want to spoil it [crosstalk] early.
Tobias: All right. What have you got, Bill?
Bill: I was going to riff on whatever you guys did, and then Meta was going to be my background or my backup plan.
ARKK Blowup
Tobias: All right, cool. Well, I got a few just the factors what seems to have been going on at Facebook implosion. So, we can talk about that. It’s coming up on the one-year anniversary of ARKK topping out, which is coincidentally the one-year anniversary of all of my stuff starting to work.
Jake: [laughs]
Tobias: I watched that fairly closely. I didn’t set out to be the anti-ARKK and I’m not SARKK or anything like that. But that seems to be the way that it’s going. Value and quality are inverse to ARKK, go figure. And then, energy rates inflation, is that starting to work its magic? I saw the 10 years creeping up towards 2%, which just seems to me to be an incredibly low number, but who knows. Maybe that’s the pin that pricks the bubble.
Jake: I saw that’s–
Bill: It’s peak rates.
Tobias: Peak rates.
Jake: Peak rates or whatever.
Tobias: Peak rates for this cycle.
Bill: I honestly, actually believe this probably peak rates.
Jake: Oh, I think [crosstalk] I’ll take the over on that a bit.
Bill: [crosstalk] You’ve been waiting for rates to go up for a long time.
Jake: [laughs] I have.
Bill: I wouldn’t expect that to stop today.
Jake: No, I would–
Tobias: If the Fed had its way, it probably would be peak rates for the cycle. It’s just the inflation, and energy, and few other things going. I don’t know what the Fed watches– I’ve got no idea what the Fed watches, housing markets just as hot as the surface of the sun. Stocks have been up a lot. Doesn’t seem to care.
Jake: Food prices, energy prices.
Tobias: Yeah.
Jake: Just stuff that you would want or need.
Tobias: Just stuff that you eat and live in. But don’t count the stuff that you live in.
Jake: By the way, I saw an interesting statistic. What do you think the average mortgage rate was in the US in 1990?
Tobias: When do they top out, 1980?
Bill: Yeah.
Tobias: It’s 16% in 1980.
Bill: Yeah, it was probably 7 or 8.
Tobias: Oh, that’d be– Yeah, I’d guess something around there, 6%, 7%, 8%.
Jake: 10%.
Tobias: Why was it so high?
Jake: Like you said it was 17% in 1982.
Tobias: 10%?
Jake: 10%. Imagine what your house is worth in a 10% mortgage rate environment. That was 1990. We’re not talking about 1937 or something. It wasn’t that long ago.
Tobias: Ancient history.
Jake: Ancient history.
Bill: No growth.
Jake: From 1990?
Bill: Well, just now. I don’t know. You got tech deflation, GDP is not hot. I’m talking long term. I don’t know about this year or next year. Who the hell knows?
Jake: Yeah.
Tobias: Let me just quickly–
Jake: Yeah.
Bill: The money hasn’t recirculated to the rich and stopped flowing around. It will soon.
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Acquirers Multiple All-Time Spread
Tobias: I just have been interested like value’s the thing. My definition of value, The Acquirer’s Multiple has been sucking wind a little bit for since about May last year. I was just interested to know what happened because we keep on hearing as the spread is wide. What does that mean? The spread is wide. So, I just looked at a combination of these things sales, cashflow, book, earnings, and EV/EBIT, which is The Acquirer’s Multiple. What’s interesting is sales, and book, and cashflow have all come in pretty significantly the spread since cashflow didn’t really ever get that blown out, but sales and books certainly did. That’s why you come back in the spread.
Jake: You mean top decile versus bottom decile difference?
Tobias: Yeah.
Jake: Okay.
Tobias: Exactly. Thank you for clarifying. I should have said that.
Jake: it’s okay.
Tobias: They’ve come in pretty materially since September 2020. But the two that have blown out and consistently blown out and I don’t know why they would be so different. Because I can understand why book doesn’t work and cash, I don’t know. But sales and there should be a pretty strong relationship between sales and EBIT earnings eventually. The EV/EBIT has blown out much, much wider than it was in the dotcom peak. Much, much wider than it was in 2007, 2009. It’s basically the widest we’ve seen.
The interesting thing about US EV/EBIT is, it is comparably wide to the rest of the world which is not true of the other value factors. They all seem to come in while there’s other ones have blown out. Typically, wider spreads mean better returns are coming in the future. But I’m just interested to know. What do you guys think? Why would those two keep on blowing up while the other two would come in so consistently?
Jake: We have a hypothesis on what’s the difference between P/E and EV/EBIT? Really, it’s-
Tobias: Debt.
Jake: -debt.
Bill: And taxes.
Jake: And taxes, but if there was an interest, I guess, too. On the debt side, I think we’ve seen a junk rally if you will, and I noticed comparing one particular ETF that you might be familiar with Toby, that you might even manage compared to RZV, which is just a small cap general value index. Yours is a little bit higher quality cut relative to maybe a little higher debt loads for some of the RZV. It’s been interesting to watch how they move a little bit different from each other, and I noticed the debty ones did a little better, and I wonder if it was from existential crisis of 2020, if you have a heavy balance sheet, and then there’s a little bit of question marks about what you’re going to survive, you’re going to get crushed. Now, it’s like, “Okay, they’re probably going to survive” and you see that bounce back. So, therefore, a less aggressive EV/EBIT than does maybe relatively not as good because they were never as in much existential crisis.
Tobias: There’s a composition element, too. There’s a lot of energy, and heavy industry, and there’s others I guess, particularly book.
Jake: Yeah.
Tobias: Book’s going to look a lot healthier when energy spikes financials, too.
Jake: Yeah.
Tobias: I don’t know. It’s interesting. I think it’s good news, because I think there’s a lot of returns coming and we’re very, very early in the cycle to the extent that the spread might not even have started closing.
Jake: Yeah. So, early. It’s not even started. [laughs]
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Energy Is Rocketing
Tobias: Next cab off the rank interrelated. Energy rates and inflation, so, energy has been rocketing recently. That’s probably part of the reason we’ve seen some of the uptick in inflation among other things and then rates seem to be behind the curve. It seems every time Powell has a presser, he says there are going to be some rate cuts coming but just not yet, because everything’s too fragile. Then every market estimate of how many rates or rate cuts rate increases. Every single market estimate, there seemed to be saying between four and seven increases over the course of this year. Is the market always too optimistic in these things?
Jake: Above my paygrade. I don’t know.
Tobias: Because the two years has been in a relative context. I know we’re still talking about sub 2%, but it has been running pretty hard. I think I said mid last year that there was– I saw, I forget who he was from, but could have been Goldman Sachs or something like that interviewed on Bloomberg and said, they thought 2% by year end and it didn’t quite get there.
Tobias: I’m guessing they just took a ruler and put a line through the trend and figured out where the intersect was at the end of the year. But here we are. They’re not that far wrong. We’re only a few weeks into the New Year. All of that, does that eventually– I mean, I guess we’ve already seen a lot of the high fliers had a lot of wind come out of them, but are these the nails in the coffin?
Bill: No.
Tobias: Care to elaborate?
Jake: [laughs]
This Is a Rate Rally
Bill: No, I don’t have any thoughts other than it seems people want it to be the nail in the coffin. I don’t know. If you look at where rates are, if you just draw a trendline from 1985 debt to today, we’re basically bouncing up against what would be resistance. So, this is a rate rally. I really do think, whatever laugh at me, I think rates are not going much higher. I think if they do, you’re going to squeeze growth, and then if you squeeze growth, they’re going to come down. I think the thing that’s hard for me to understand is, what does the 10 and the 30-year imply on actual growth? You do have people locking up paper. Now, I guess they trade and you lever it and whatever. But the 30 year is 224.
Jake: Insane.
Bill: That would imply that people are buying that kind of duration for that kind of a yield. I don’t know. I tend to think that the deflationary forces that were pre-COVID continue. Stuff like college will go through the roof, because it’s not a free market.
Tobias: Does oil take it out of the hands of the Fed? Does oil just sort of do it, oil acts as a big handbrake on the economy? Is everything [crosstalk] expensive?
Bill: Yeah, until it doesn’t. When’s the last time that high oil prices haven’t led the lower oil prices?
Tobias: Yeah. But in the interim, you get a 2007, 2009-type scenario.
Bill: Maybe. I don’t know.
Tobias: That’s how you get back to those low oil prices.
Bill: Yeah, I guess, I don’t know.
Tobias: Since I’m focused on equities, that’s what I’m thinking about.
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Why Deep Value Works
Bill: I think that that’s a really short-term focus on something that’s supposed to have a 30-year duration plus. I don’t care much what happens in the next two years and I need to position my asset allocation accordingly. So, whatever happens, I can get through it. But within an equity allocation, I think worrying about stuff like this would cause much more harm than good but there are plenty of people smarter than me that disagree.
Jake: Yeah, tough game. So many moving pieces and it’s not always clear which– They don’t always matter the same at different points. Sometimes it matters, sometimes it doesn’t, sometimes this data point is the important thing, sometimes it’s not, it’s such a complex system one wonders why you try to predict what it’s going to do next.
Tobias: Well, it’s unpredictable and we’re interested in talking about it because this is Value: After Hours. This is not how I invest. Just fun to talk about.
Bill: Yeah. The thing is inherently equities are super long duration instruments. Everyone that I’ve ever studied and respects think long. I’ve never heard anybody be like, try to predict oil prices and position yourself accordingly along with what your forecast of rates is. There are some macro guys that do it, but I can barely pick a stock much less the rest of the stuff.
Tobias: But I’m not necessarily suggesting you do that. If your estimate goes up 30 years, then what discount rate are you using over 30 years? Are you using 2%? Because I think that’s going to be too low over 30 years. I think that you got to normalize over 30, you go back to six.
Bill: I don’t think we’re going back to six, man. Throw a six handle on this economy and tell me how the debt serviceable.
Jake: [laughs]
Tobias: Yeah, it’s not.
Bill: Okay. So [crosstalk] then what happens?
Tobias: That’s exactly my point and that’s why I want to talk about it.
Jake: Okay, but then I think you need to be in cash for that portion that you’re worried about. I don’t think that, I just fundamentally disagree.
Tobias: [crosstalk] deep value stuff that doesn’t really matter.
Bill: It’ll matter, I promise. If rates go to six, your deep value is not going to be safe.
Tobias: I don’t think anyone is going to be safe. But I would much rather be in some stuff that’s going to earn more than 6%, and it’s not heavily levered, then stuff that’s projecting out 10 or 15 years at exceptionally high rates of growth– [crosstalk]
Bill: I think where you and I fundamentally disagree on that statement is, I don’t think you’re going to earn more than 6%, because I think your implied earnings base underlying your 6% assumption is going to be screwed. So, I think everything is coming down. That’s why I think you have to– if that’s your view, I think you hold cash to offset that risk.
Tobias: I think everything’s coming down.
Bill: Yeah. So, that’s a cash issue. But I don’t think you hide in value stocks. I think you get out of equities. I really do fundamentally think that picking a place to the market to hide is the wrong way to play that trade.
Tobias: I think deep value is just about the only way that you’re going to be able to go through it. If you look at Japan, you look at what happened in Japan over 1992 to basically today, it’s still below where it was in 1990 or 1992 whenever it topped out. The only thing that has worked is a thing that where you buy it at a very deep discount to what it’s worth, and then as it runs up, you sell it and replace the basket with a cheaper basket. I think that sort of ratcheting effect is the only thing that will work. I don’t think you can rely on underlying growth in the businesses to drive returns in the portfolio, because if you overpay for them, which I think that we’ve just– what we’ve done is overpaid for everything. That’s how you get 2000, 2015-type scenario where really, really good businesses keep on performing but the stock price is getting nowhere.
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When ROE Matters
Jake: Yeah. Well, it’ll be very interesting to see, one of the big differences in that analogy is the returns on equity of the businesses. Japanese businesses over that time period were very anemic when it came to returns on equity. The longer you hold, the more return on equity matters for your expected return. So, if you are trading more like a value guy on a shorter term, like, active turnover of a portfolio, ROEs don’t matter as much. But you’re playing a relative kind of cheapness spread. But if you’re longer-term holder, then ROEs start to matter. US businesses in the last 30 years have had phenomenal ROEs and especially relative to other time periods.
Actually, Buffett was talking about it in 1998, 1999 and saying they were shocked at how high ROEs were even then, and I think they’re climbed, I think they’re higher than they were back then. If that’s the case, well, one, it’s hard to imagine getting another bite of that Apple of the ROE Apple. We’ve seen taxes come down a bunch, we’ve seen intangibles and the growth rates of intangibles, I guess that could keep going for longer and that’s possible.
It’s hard to imagine taxes getting lower on businesses from here. I don’t know whether levers you have to pull more debt, the companies have levered up a fair amount already as it is. I don’t know how many more levers there are a pull in this equation to get higher ROEs from here. If anything, you have to fade that a little bit I think if history is any guide, but it will matter materially over the next 20 to 30 years what ROEs look like.
Tobias: Do you know what Japanese ROEs were like peak cycle?
Jake: In 1989? What were they like?
Tobias: Oh, yeah.
Jake: I don’t know what they were in the 80s. I have to imagine they were pretty high because there was– You are just like, everything’s working, every real estate thing you’re buying is going up and marking your mark to market your book. So, your book values are growing like crazy. I have to think they were looked good. That’d be my guess, although, I don’t know the answer to that.
Tobias: Because I thought the issue was always that all the cross shareholdings bit made it hard for anybody to take them over and to shake them up, but it also probably you’re holding stuff is not really economic yet. You’re probably overpaying for it and eventually that’s going to suppress ROEs.
Jake: Right. If there’s no cleansing bloodletting bankruptcy to really, actually transfer capital from the hands of those who made poor decisions to the hands who will make better decisions, then you end up with, I think, zombie companies and low ROEs.
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Japan Performing Better
Tobias: Japan has done increasingly better. They’ve been a lot of stories over the last 10 or 15 years about Americans moving in and practicing, initially starting out, it’s like American style activists, and then becoming more collaborative or changing the way that they did it. But whatever process they used, eventually, getting that message through that cross-shareholdings don’t help, and you need to free up capital, and you need to get out of stuff that’s not earning enough on equity. I think that they have slowly improved, and that’s probably why they’re starting to look a lot better than they have. It could be a lot of the reason why it’s performing a little bit better more recently.
Jake: Yeah, it’s possible. I think the other part is the pension funds, who recognize like, “Oh, my God, we have unfunded liabilities that we have to meet with this basket of assets that we have. If that basket of assets is not earning very well and not growing, we’re going to have a hard time meeting these liabilities. So, we need to do something structural to fix this.”
Tobias: Well, we’ve resolved that issue.
Jake: Yeah. What’s next?
Bill: The only thing that I disagree with is, you were saying, if your value and your trading more ROEs don’t matter, but I don’t see how you can have an accurate view of whether or not you’re buying value without a view of ROE.
Jake: A net-net, I don’t need to know what the ROE is.
Bill: Yeah, but okay.
Jake: That’s what you were buying in Japan, though, is net-nets? That was what Toby was referring to.
Bill: Well, no wonder it didn’t go anywhere. You’re rewriting to cash, and then you got nothing else to do, then you got to sell a security and go find something.
Jake: Yeah.
Bill: That’s a one thought.
Jake: But that worked, right?
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The Problem With Net-Nets
Bill: Yeah. But unless there’s another net-net to go read–. The risk you’re taking with net-net is reinvestment risk and some agency problems. If the people in the net-net pay themselves too much and your cash turns into illusory cash or the security rewrites, and now you got your cash value, and you got to go find your next net-net, and you got to pay taxes, and then you got to go do it again, right? [crosstalk]
Tobias: I think Jake’s just making the point that the longer your holding period, the more important return and equity becomes versus buying at a discount.
Bill: Yeah, but I don’t see how you can buy at a discount without having a view on your long-term ROE. You can’t do evaluation without that.
Tobias: Well, you can assume that it stays where it is and you can see that’s subpar. Take energy, for example, over the last 12 months. Energy looks worst at the bottom of its cycle. Low prices for oil, all of your fixed costs are the same, you’re not making any money. The returns on equity look terrible. Paradoxically, that’s the best time to buy energy because that’s when it gets cheapest. The other side of the cycle when they’re earning lots of money on equity. Then, now they’re expensive and now everybody knows, and that’s probably the time to be exiting energy.
Bill: But as you just said, the spread between EV/EBIT has widened a whole lot. I hear a lot of commodity pitches as it’s one times EBIT. Well, guess what, the markets telling you that EBIT is not underwritable.
Tobias: Yeah.
Bill: So, that could be part of the spread extending, where people are like, “These EBIT numbers on some of these commodity companies, they’re just garbage.”
Jake: That used to be true of car companies back when they were just metal benders and you could never get more than four or five times multiple on it, because everybody knew that it’s still just a car company. [laughs] But now– [crosstalk]
Bill: But I think there could be some of what’s going on. There’s a lot of shortages, there’s a lot of short-term pricing power that’s in some of these businesses. The market may just be like, “Look, this a onetime puff.”
ROE Is Not A Great Metric
Tobias: Yeah, historically, it has been the less you pay for your flows or the assets, the better you do and return on equity has not been a great metric to build a portfolio on because it’s highly mean reverting. When it’s high, it’s coming back down, when it’s low, it’s going back up. So, systematically, it’s not a great metric. If you’ve got a better view of an individual company, then that’s a different matter. But I invest on base rates. I’m always worried about what the base rate is going to do for stuff that I’m holding.
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People Get Too Confident In Their Ability To Predict
Bill: For the 2000 to 2010 period, Gavin Baker was on O’Shaughnessy’s podcast, and he said that, “The real reason that that outperformed was earnings growth.” Do you guys have a view on that? Because I don’t know.
Jake: What outperformed? Value?
Bill: Value. Yeah. It really had a good run because that was when the Bricks came out and the commodities really ran, and it was a ton of earnings growth that propelled it. Ever since I was reading Drew Dixon’s analysis of growth pummeling value for 30 years, I just wondered– One answer is rates. But I’m wondering if there’s another answer that I’m blind to or whether or not his piece, no offense Drew but I haven’t checked it, but whether or not is piece is missing something. I just don’t know. But when Gavin said that, I was like, “Oh, that’s interesting. If that decade was supernormal earnings growth in the value factor.”
Tobias: Yeah. It’s existed outside of that time period too, like, what’s the explanation for the full dataset and across different factors?
Bill: I don’t know.
Tobias: Across different regions? He’s cherry picked a seven-year period out of a– Not sure. He’s trying to be misleading and I just mean that. The answer could be it was compositional. That was just junky value had a whole lot of commodities, and energy, and financials, and all of those things read through that period. The book factor would have done quite well, because it was picking up all that stuff.
But then you’ve got to answer the question for other factors, EV/EBIT, EV/EBITDA over the full set in different countries, and it gives you the same answer, and that’s not going to be necessarily fluttering in financials. Because in quantitative value, we excluded financials and we excluded utilities. The effects still persist. So, it doesn’t answer the question.
I think the real answer is that people get too confident in their ability to predict what these businesses are going to do. They prepared to pay up prices, and they just disappoint, and there’s stuff at the other side. When the baby’s thrown out with the bathwater, often that the worst part of the cycle. Then, as it improves on the other side, if you’ve already bought something cheap and you get that improvement, then the market had priced it for the dustbin, and now, it’s going to rerate on a rising business cycle. That’s how you get the take the move.
I think that that’s what the O’Shaughnessy paper shows is that, the growth year stuffs maintained its growth rates. It just gets multiple compression. Ordinarily, value does see the earnings of a one-year holding periods, but the multiple expands because it’s already too low. It’s an imperfect answer, but I think pretty much that’s reality. I mean that’s what I have seen.
—
Bill: Yeah. I wonder how much massive private equity changes the whole equation.
Tobias: I think private equity is cashed up and is doing business but it doesn’t seem to be showing up in small cap indices particularly.
Jake: We’re all the take outs of small cap.
Tobias: Yeah.
Bill: That’s the question that I’m asking is, do we honestly think that they haven’t scoured the earth for small caps that are good value?
Tobias: What are they doing with the cash? They just re-trading stuff that they’ve got to fund that bought something. They’ve got an exit, so they just exit to other private equity or exit to another fund. I mean, that’s possible. I have thought about that. They’re just trading all these things around. It’s pretty stable.
Bill: Yeah, there’s some of that. Ironically, there’s a public market discount. So, exiting the public markets is not exactly exciting.
Tobias: Is that right?
Bill: Yeah.
Tobias: Crazy.
Jake: Well, people, they pay a premium to be locked up, so they don’t have to ingest quotational brain damage.
Tobias: Yeah. Munger pointed that out, right, too.
Bill: Yeah, I think that’s right.
Tobias: Thanks for that tip, Jason. 50 bucks from Jason Hirschman. Thanks, brother.
Jake: Whoa, that’s inflation there. [laughs]
Tobias: [crosstalk] hot drinks.
Bill: Yeah. Thank you.
Jake: All right. Should we do some Mauboussin?
Tobias: Yeah, let’s eat some veggies.
Jake: All right.
Bill: Next time, Bitcoin.
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Mauboussin – Underestimating The Red Queen
Jake: [laughs] This white paper that Mauboussin has out, it’s called “Underestimating the Red Queen.” We actually have discussed already what a lot of this paper is based on. This is the theoretical physicist, Geoffrey West’s work, which his book, Scale that we talked about actually, Season 2, Episode 49, which was December 17th of 2020.
Tobias: Remembered that well.
Jake: We’re front running Mauboussin research. Just kidding. It talks about Kleiber’s law. What that was if you remember from our segment was that, basically along the x-axis there’s a log scale of an animal’s body mass. It’s like one, 10, 100, 1,000. Then on the y-axis, there’s a log scale that is the animal’s metabolic rate. That’s energy used per unit of time. There’s this nice upward sloping line along this logarithmic scale, it’s about three quarters rise over run.
We can plot out how much does an animal weigh versus what’s their metabolic rate, and we see this nice line. What’s underlying that explanation is really how nature dissipates energy throughout a network. It explains the rate of blood flow, the number of heartbeats, longevity and growth. This is what the most important thing is. In the context of this white paper, and I don’t know if you guys have ever really stopped before to ask yourself like, “Why do we stop growing at some point?” There’re some living things that grow continually until they die, like, Peloton.
Tobias: [laughs]
Jake: Too soon. But there’s a reason for this. Nature is figured this out. It’s allocated to the growth of new cells as well as the maintenance and repair of the old cells. When you’re born, most of your energy gets directed towards that growth. But eventually, after you’d become a certain size, all your energy has to go towards maintenance and you stop growing.
This similar phenomenon exists for businesses. In a corporate context, financial capital serves as what like nature’s energy is, so there’s an analogy there. Growth stops at the point that maintenance needs are consumed by the available incoming energy or capital effectively. Understanding the growth of the company means that we have to understand the difference between growth CapEx and maintenance CapEx. This is something we’ve talked about on the show before, but this paper dives into it a little bit deeper.
It’s possible that a lot of the growth that you’re looking at is maybe not quite as shiny as you think it is because it’s possible that they’re spending more on maintenance than you imagine. This is where the Red Queen effect comes in. If you remember in Alice in Wonderland, the Red Queen says it like, “You have to run twice as fast to just stay where you are.” This is a little bit of Buffett’s talked about standing on your tippy toes at a parade.
There’s lots of different analogies. Matt Ridley, who’s my favorite author has this book called The Red Queen. It’s basically, how that relates to biology. There’re these arms races that happen in biology, especially around immune systems, which is interesting to go back and reread given our last two years of experience with COVID and all that.
Tobias: Oh, we just got demonetized, probably not.
Jake: Ah, shit.
Tobias: You’re allowed to criticize it now.
Jake: Oh, okay.
Tobias: It’ll be okay.
Jake: It’s all good. There are two complications that impact this conversation. One is inflation and the other is technological obsolescence. So, the first one, inflation, when prices are rising, the CapEx exceeds depreciation even in a stable business because the new CapEx that’s being funded is at an inflated rate, and when you’re depreciating it that’s based on older historical costs. An opposite in the case of deflation, Moore’s Law type of situations, the CapEx gets cheaper over time, and depreciation then is overstating the maintenance CapEx. Sometimes, the first movers actually don’t have much of an advantage compared to the followers because their costs can be higher than if the costs are falling.
Technological Obsolescence
Jake: The other one is this idea of technological obsolescence. What’s happened there is that, it’s increasing the chances that you’re overestimating the useful life of an asset. A write down is really this sudden recognition of the loss of the usefulness of this asset. Of course, there’s another kind of bifurcation here that makes it complicated and that’s tangible versus intangible. If you remember some of our conversations, like, for tangible assets, depreciation tends to understate maintenance CapEx.
This might be because the tangible part of the economy is almost like this mature, fully grown adult as compared to a younger growing company where they– Because it’s newer, more of the capex is likely going towards growth as opposed to maintenance. I can’t help but wonder about David Einhorn’s observation, maybe last year when he was talking about how a lot of basic industries have been starved of capital recently, especially in the last decade. I think he’s referring to energy largely.
Anyway, this younger part of the economy is more based on the tangibles, so, more energy is going towards growth maybe than maintenance. Mauboussin found through research that, “firms with higher intangibles have faster growth rates, but they also have higher standard deviations.” When something breaks, it’s a really long way down to find that next thing of value. You can’t reuse computer code for very much. Think about Blackberry or something like, what’s the next use of it? It’s like, “God, it’s miles below what we were valuing it before.”
This actually goes back to our– Remember, we’ve talked about Eugen von Böhm-Bawerk about his subjective value and the different bags of grain that he was going to decide, like, what to use them for. As you remove grain, you don’t just satisfy your needs that much less. You cut off whatever the least useful thing was for you and then that’s the next where the price is set as to the value of something. So, it’s all just like at the margin.
When you compare to, let’s say the tangible economy where physical machinery has scrap value or real estate that they have could be used for something else. There’s another layer down where obsolescence isn’t quite as far of a cliff compared to intangible world. The rest of this white paper, Mauboussin is walking through a bunch of examples, and it’s probably better to read it than to hear me talk about the specifics because there’re numbers and it starts to get confusing.
But one thing that was interesting was, there’s this accounting professor named Peddireddy. He did a study where he looked at companies from 1974 to 2016, and he looked at all these different industries, and in general, he found that maintenance CapEx exceeded depreciation and amortization by about 20%. Of course, there’s a lot of variation between industries and therefore there’s probably even more variation between companies within industries.
But in general, 20% overstating, that could be material. To give you a little idea of some of the numbers of this, in 2020, Amazon, Google, and Microsoft, all changed the useful life that they were using for their servers from three years to four years. All of a sudden, earnings got boosted by about $2 billion each from just a simple accounting change for all three of those companies. In the case of Amazon, I think about a 10% increase to earnings, just non-economic changes. It’s just purely, we’re going to say that that these servers that are running are good for four years now instead of three years.
Bill: Amazon, Google, and Microsoft?
Jake: Yeah.
Bill: You mean the three big cloud providers?
Jake: Yeah, exactly.
Bill: So, maybe they’re actually worth more for longer than people anticipated because the cloud’s a really big thing?
Jake: I don’t know if that’s the takeaway, but there might be.
Bill: Okay. Just throwing out an alternative reality.
Maintenance CapEx v Growth CapEx
Jake: Okay. It could be. What’s actually ironic about all this is actually the energy companies, none of the companies report their maintenance CapEx versus growth CapEx. It’s quite possible they don’t know the answer to that. I bet most CFOs don’t really know the answer to what dollar should be considered growth CapEx versus maintenance.
But ironically, energy companies do this because the way that just the dynamics are that because they start with a certain amount of reserves and they know that they exist with some certainty, and that they’re accessible by today’s technology, they go and tap those reserves, they therefore know how much like they need to buy or go and find to replace those reserves, so, they can see actually what maintenance CapEx is based on production level. So, ironically, energy’s already been doing this and it would probably be helpful for investors if more companies tried to give us some of those numbers rather than us trying to back into them. But anyway, great white paper, stand on the cutting edge of research as Mauboussin does and I would check it out if I were you.
Tobias: How do you divide the CapEx up into maintenance CapEx and growth CapEx?
Jake: How do I personally?
Tobias: Yeah. What’s the simple rule of thumb for doing it? Or, there is none.
Jake: I think it’s so industry specific that it’s really hard to give a simple rule of thumb. I think there’s a lot of art to this, and maybe almost to the point where it’s theoretically correct, but operationally almost impossible to execute in a way that you wouldn’t– Incredible amount of chance of tricking yourself probably in this, because it’s so hard to determine.
—
Tobias: Before you said, there’s a reason why we stopped growing at some particular point, but there are other animals that have grown bigger. So, why does any individual species or individual stop growing at some point?
Jake: I don’t know the exact answer to that. I think it has something to do with the amount of calories available. Energy above a certain point, as we’ve talked about with, oh shoot, who was it that wrote the paper a long time ago, it was something it had to do with the size of animals and actually the physics of capillaries and how blood can move across membranes only to a certain size and therefore you can only get to be so big. But anyway, I don’t know the real answer. I don’t have a good prepared answer for that but I think it has to do with above a certain size, you just can’t get enough energy and diffuse it throughout the entire system to have it live. But why a pygmy shrew versus an elephant? I don’t quite understand.
Tobias: It’s interesting to think about big businesses now that one screen facing a variety of customers. Where in the past, they had to go and do that individually. For each individual customer in some ways that solved that problem, where the energy diffusion is, it’s a shorter step. So, they’re able to– Energy diffusion might not be the right analogy, but they’ve just got a tight, a closer relationship with the customer. You just work on one piece of code where it is pretty safe to do that [crosstalk]
Bill: OpEx has to go up because of a change, because they don’t have the direct relationship with the customer, because Apple cuts them off. Some goes to Amazon, arguably, some’s going to go to TikTok or is going, some goes to Apple, you got to spend. So, what’s your maintenance spend versus your gross spend? It all comes back to Meta.
—
Measuring Incremental Revenue
Jake: How do you try to figure that out, Bill? How do you decide what part of SG&A would you count as growth versus maintenance? What part of R&D because I think actually R&D a lot of it is, especially for bigger tech companies is needed to keep the system up and running to keep the cashflows of today’s customer running? It’s not as discretionary as it sounds.
Bill: Yeah. I think you look for margin inflection and I think for SG&A looking at incremental SG&A spend incremental revenue is a reasonably good idea to figure out whether or not the salesforce is getting incrementally more productive.
Jake: So, you look at the change in revenue versus the change in SG&A over the year?
Bill: Yeah. It’s not perfect, but I almost figure like, “Okay, well, last year’s workforce got paid this, how much did the additional pay change the additional revenue?” Like, “Are they getting more productive or less productive over time?”
—
Tobias: “Cold-blooded animals keep growing. Vasanth, thanks for that. Crocodiles, for example, grow all their lives just like Peloton before they die.
Jake: [laughs]
Bill: There you go.
—
Tobias: Apple and Amazon have huge problems with supply chains. Google and Microsoft don’t care. Yeah. That’s right. Chamath had that– they’d been doing victory laps because he had that spread bet last year where he said, was it long–?
Bill: Long Google, short Facebook, he’s going to do victory laps over that when you look at his SPAC performance.
Tobias: Knows, too. But he had a spread– [crosstalk]
Bill: He incinerated retail capital and he’s going to joke about some spread bet that he theoretically laid. This guy gets better and better each time I hear it. How’s Clover doing? Let’s see. What else did he take?
Jake: Not great, Bob.
Bill: 276. All right, let’s see Space.
Jake: We need percentage changes.
Bill: It’s 71%. That’s okay. Oh, boy. Except it apparently came out at 56%, hmm. I don’t know. I have to check out IPO A and B also but I think maybe a little humility would go a long way.
Tobias: When I watch the little clip, I don’t think I go all the way through it. But all I saw was him. They said, watch him explain why it’s going to happen and I was really interested to see what the mechanics were like, why– [crosstalk]
Jake: What’s the logic?
Tobias: Yeah. The logic underlying. All that I saw was him explaining what a spread bet was.
Bill: No, I think he was right on ATT and how it would drive incremental dollars to Google. I do think he was right on that.
Tobias: But what was the thesis? But it was too. Yeah, it was long Google and Microsoft, short the other FAANGS. Thanks, Lorenz.
Bill: Was it short all the other FAANGS? I thought it was too long.
Tobias: Oh, [crosstalk] Netflix and– [crosstalk]
Bill: I thought it was long Microsoft and Google and short for other ones.
Tobias: [crosstalk] something else, Netflix, maybe.
Bill: Yeah. if it’s true that it was Microsoft and Google, then you got to explain Amazon to me. But at least Facebook versus Google, I think he was right on. I think it has [crosstalk] attribution.
Tobias: But [crosstalk] stumbled by that point, though. What do you mean?
—
Facebook’s Latent User Intent
Bill: Well, Facebook specializes in ads that, shoutout to my man, Devin. latent user intent. Stuff that you don’t know that you need, but you do want. That’s what Facebook’s specialty is.
Jake: What does that mean? I didn’t know that there was an Ice Chest with a stereo in it and now I want that.
Bill: I have stopped drinking for the most part and I am interested in non-alcoholic cocktails. It’s not something I’ve ever looked into in my entire life. Facebook started to serve me ads for non-alcoholic wine and non-alcoholic cocktails. [crosstalk] I’m actually pretty happy that they’re doing it.
Jake: [laughs]
Bill: Whatever the laughter is, they’re objectively serving me relevant ads and it’s probably the most relevant ad that I’ve gotten in a long time. Google on the other hand specializes in, I’m typing in non-alcoholic wine, and then Google– [crosstalk]
Jake: Yeah, [crosstalk] the tension is revealed there.
Bill: Yeah. It’s more alike you know what you need and you’re doing. It’s also why Amazon’s growing so much. There’s only so much shelf space on Amazon. When you type in a search term into Amazon, it’s a bidding war to get noticed now. It’s beautiful real estate to charge for.
Tobias: That sounds more useful. That makes Facebook somewhat useful and Google doesn’t. So, why would that be the thesis for long Google, short Facebook?
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How Apple Is ‘Watching’
Bill: Well, Google is not just search. You got YouTube, you got GCP. Well, the issue is when Apple’s tracking came out, Facebook can no longer– I talked to a guy, who manages spend for small business, and it’s why I sent out this tweet about Facebook helping business. But the alarming thing that he said to me is, he said, “When Facebook used to be able to track people across iOS, you’d have green shoes and red hat say that you’re selling. You would know the click through rates on green shoes versus red hats. Now, that’s gone completely dark.”
Now, rather than pouring fuel on your marketing spend for green shoes because it’s got more attraction, you continue to have the shock on. He said, “It’s going back in time where you have, half your marketing spend is wasted. You just don’t know which one or which half.” The concerning thing that he said to me is he used to be able to, pre this change, have a t-shirt shop, just an idea in your garage, and basically scale it on the back of Facebook ads. He was like, “I don’t think that’s possible anymore.”
Jake: Would you say to track you and iOS, what does that mean?
Bill: They watch everything that you can click through. So, that’s what Apple turned off.
Jake: When they are in Facebook, then they can see what I’m clicking on or [crosstalk] see everything?
Bill: No, they could see everything. Now, Apple’s allowed to watch. I actually turn that on for Facebook, because I don’t mind the ads. So, I don’t mind if they watch what I do inside other ads. It’s actually made my Twitter ads more relevant, too.
Jake: Tell me your long Facebook without telling me your long Facebook.
[laughter]Bill: Well, I actually don’t mind. I think I have a one-person allocation. It’s nothing. But I do think it’s interesting. Apple, you can click on advertising and Apple does the same thing. By the way, anyone that thinks they don’t is out of their minds. But you can turn it on and it’s called advertising. Then if you turn it on for all the other apps, it’s called tracking, which is a distinction without a difference. But that’s the nice part of owning the customer relationship.
Jake: That’s pretty gross, though, isn’t it, that they could just see whatever you’re doing, when you’re in your email or whatever?
Bill: Yeah. I don’t really care as long as you serve me good ads.
Jake: I care.
Bill: Look, if the government can do it– [crosstalk]
Jake: How about that, too?
Facebook – The Value Tech Stock Got Wrecked
Bill: This is what’s going on. My default assumption is there’s no privacy anymore. I don’t know. That’s just what I default to. If you want privacy, do something on paper.
Tobias: Given the problems that Facebook’s got there, are you allocating post the blog?
Bill: No, I’m not. I don’t know if I’m going to. I don’t know, we’ll see. I think that it’ll be interesting to see what happens with that company. Here’s something I think is interesting. They did a big buyback right before this quarter. They have better internal data than everybody. I find it odd that they did a big buyback with better data than everybody else has and everybody else is convinced that they’ve lost it.
Tobias: But then why not wait for the 25% drop and spend less or buy more.
Bill: I don’t know. That’s the question that one has to ask themselves.
Tobias: But that would indicate that is not that good, wouldn’t it?
Bill: It depends on your conclusions from your question.
Jake: Well, that assumes that they know what the markets going to do, too, which is no one really knows that.
Tobias: Yeah. Maybe Ray Dalio.
Jake: If they knew that, they’d be running a hedge fund and not a rising company.
Bill: Yeah, I don’t know. Look, there’re a lot of theories, a lot of people are convinced. It’s a peak Facebook, we’ll see.
Tobias: Yeah. I don’t know. I think it’s much more interesting down here. Who knows? At some point, I don’t have any plans to buy it. I’m just saying that, down 25%, and it was already cheapish relative to the other ones.
Bill: Ironic that the value tech stock is the one that got racked.
Tobias: But it wasn’t. I wouldn’t have said it was so cheap that it either had that free optionality embedded in it. It was reasonably priced.
Bill: [crosstalk] Dude, it was 18 times core earnings.
Tobias: What’s that mean in context with anything else like? You think that the reason that got wrecked is because it was the value tech stock or what’s the–? [crosstalk]
Bill: No. I just think it’s interesting.
Jake: You put value on anything, it goes down. [laughs]
Tobias: Yeah.
Bill: I think that it is an interesting thing where the tech stock with the lowest multiple got destroyed out of the big ones. I think that’s interesting. It’s almost as if the market knew that something was coming.
Tobias: Yeah.
Bill: But a lot of people got caught offsides, because you don’t go down $200 billion and have the market. No, but I do think that as a discretionary investor, if you’re just looking at multiples, I agree with it in a portfolio context 100%. But I think if you’re picking something and your reason is, “This is relatively cheaper than this,” then the next question that you should be able to really articulate is why and it’s something that when I was younger, I didn’t understand.
Tobias: Well, they’ve had a few problems. One of them is the big change to Meta and pursuing this new strategy. It’s totally, maybe it’s distinct from what I’ve been doing before. I also, a lot of us who used it in the past don’t use it anymore.
I still use Instagram but there’s clearly there’s other things going on it is complicated, but know that you’re not going to get anything deeply undervalued without some hair, and that’s the entire handicapping point of what we’re trying to do. I’m not trying to find the best thing, I’m trying to find something reasonable that’s discounted at a price where basically if it gets up tomorrow morning, it’s going to make some money. Like, I don’t need to be winning all the time.
Bill: That’s Facebook.
Jake: In all fairness, it wasn’t the big pops from Google and Amazon that happened, took them to new all-time highs, either.
Bill: Yeah. That I think actually if you wanted to be bearish on the markets the best argument to make.
Jake: That’s a little troubling if you’re– [crosstalk]
Bill: Yeah. When your beats create lower highs. I think that would be my technical observation.
Jake: Is that a cup and handle or what’s the–?
Bill: No, it’s lower high.
Jake: Oh, okay.
Bill: You don’t want lower highs and lower lows, especially in the stocks that drive the market.
Jake: What’s 25% of the market anymore?
Tobias: I was surprised that Facebook was 5% or whatever it was. 25% drawdown, that’s 1% of the S&P 500 right there for the next day, and then the market was up 1.7%. That’s a pretty modest move. That didn’t worry anybody else. I guess, the problem is to say idiosyncratic to Facebook, but it doesn’t matter.
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The ATT Update Is Damaging Small Business
Bill: It worries me. I’m worried that small business is materially hurt by this change. It’s actually, probably one of the most concerning things that I’ve seen that I– [crosstalk]
Tobias: Which change? The lockdown or the–? [crosstalk]
Bill: No, the ATT thing. The stuff that, if small business is not able to target consumers as well as they have been in the past, then I think one has to wonder what small business formation is going to do. We’ll see, I don’t know. But the reduced efficiency– Oh, phone. The reduced efficiency of Facebook spend is concerned.
Jake: The targeting now mean that you spend less or do you have to spend more to get the same?
Bill: Well, this guy that ran ad campaigns said that it hurt the businesses that he advertises on behalf of. I can’t think that that’s good.
Jake: Were they slashing their budgets then because of that?
Bill: No, but you can spend more on a particular ad if your conversion rate is higher. It’s not your cost per impression that matters, it’s your cost per conversion. So, at least that’s how he looks at the world. He says that this is bad for the businesses that he advertises on behalf of and I’m going to take his word on it.
Jake: I believe that. I’m saying, though, is it bad for Facebook? If they’re still spending the same ad budget even if it’s not as effective, the revenue is still coming in.
Bill: Yeah, well, I think if you– Look, they’re guiding to single digit growth. Anywhere as low as three, I think anywhere as high as 11. If you look at a three-year stack, I still think that they’re growing 20% per year. I don’t know. I know it’s a dead business, but it’s pretty good dead business.
Jake: Still growing, even though, it’s dead? [laughs]
Bill: Yeah.
Tobias: All right, dudes. That’s time. Thanks, amigas.
Jake: Cheers.
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