Todd Combs on Buffett & Munger

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In their latest episode of the VALUE: After Hours Podcast, Brewster, Taylor, and Carlisle discuss Todd Combs on Buffett & Munger. Here’s an excerpt from the episode:

Bill: We were talking, Jake, about the Wechsler interview or wasn’t it Todd? Who was that?

Jake: Combs. Todd Combs.

Bill: Yeah, Combs. Ted, Weschler, anyway. What were we talking about offline? It’s the 15 PE-

Jake: Oh, yeah.

Bill: -that’s going to grow over the next five years? How did he frame that?

Jake: I’ll pull up my notes real quick, so that we can– [crosstalk]

Bill: I think that’s what he was saying.

Jake: Get the real one.

Bill: You solve for stuff like cyclicality. What probability [crosstalk] way that this is going to be higher?

Tobias: Yeah, I wish we would discuss that. Let’s do that.

Bill: I think that’s the test that Facebook potentially fails, because I think everybody in the world is concerned about duration risk. So, even if all the data can show you, right now the core business is pretty stable. I think in the back of everyone’s mind is like, “Yeah, but it could be the next MySpace.”

Whereas to Jake’s point over the past years, something like energy, you can argue that there’s going to be some EV transition or transition to electricity over time. But oil is going to be here. Or refining capacity, for instance is something that looks like it’s going to be pretty constrained for a while so maybe when that gets really cheap, you can bet that a little bit harder, then you can bet when it’s something that’s maybe as amorphous as– [crosstalk]

Jake: Something low Lindy like Facebook?

Bill: Yeah.

Jake: So, Combs recalled the first question Charlie Munger ever asked him. What percentage of S&P 500 businesses would be a better business in five years? Combs believed that it was less than 5% of S&P businesses. Munger stated it was less than 2%. So, that’s the first little thing here, which is kind of surprising. You would think 2% in five years, I feel that might not be the base rate. What do you guys think about that?

Tobias: Well, as soon as I read that, I thought immediately of the Mauboussin research that he does, where he looks at the buckets of return on invested capital. And he’s been doing this for a long time now. So, it’d be interesting. He’s probably done it for more than 10 years.

So, you can probably actually look at that initial crop. But every year, he updates it and he looks at just ranking every company in the S&P 500 or Russell 1000, whatever it is, by return on invested capital, to create five buckets so that the highest return on invested capital is in the top bucket. Worse return on invested capital, which is typically negative return on invested capital in the bottom bucket. And then, you wind that forward over 10 years and you can see that there’s this incredible mean reversion. So, that is the pervasive– [crosstalk]

Jake: Yeah, they are just fall like–

Tobias: The really bad ones get better, the really good ones get worse. They don’t actually ever return [unintelligible 00:49:54]. It’s kind of asymptotic. So, the best ones are still better at the end of that. But then, that’s not discussing the valuation in there. But the thing that stands out to me from that, there’s 4% of businesses that are in that top bucket that don’t mean revert. They tend to sustain those pretty high returns on invested capital. So, I would have thought that 4% is probably statistically the number. But whether they’re better or not, I don’t know. So, possibly Munger’s right. Off the 4%, only half are better after 10 years or 5 years.

Jake: So, Munger goes– or Combs goes on, “You can have a great business, but it doesn’t mean it’ll be better in five years. The rate of change in the world is significant, which makes this exercise difficult. But this is something that Charlie, Warren, and Todd think about. When Combs started at Berkshire, they had a 7 out of 10 confidence of the business’s outlook for the next five years. The nature of the world is that things are constantly changing and Todd said that they are right on maybe 1 out of 10 predictions.” So, that should have been a headline to me. When they first started, he felt they were good 7 out of 10 predictions. But the world has become so hard to predict that now they think they’re only on a 1 in 10 batting average.

Tobias: But you got to be surely 50:50. Surely, it’s not– 1 in 10 means that you’re actively wrong. 1 in 10– surely the base rate is 50:50.

Bill: I think it depends how specific you want to get with why you’re right.

Tobias: Oh, fair enough. Well, it’s like a Tetlock type thing, right?

Jake: Yeah, it is.

Bill: yeah.

Jake: This is probably their entire population of predictions-

Tobias: Yeah, fair enough.

Jake: -even the ones that are on the low confidence interval. I think if you asked me to guess what they would have said for that number, I would have never come up with 1 in 10. I would have been maybe coin flip.

Tobias: Yeah. I learn that the strike rate and back test for various things that I do. It’s 50:50. And you’re hoping that you get a bigger payoff and the stuff that works than the stuff that doesn’t work. But that’s not always the case. It cycles.

Jake: So, Bill, here’s what you were referencing. Combs goes to Buffett’s house on many Saturdays to talk. Here’s a litmus test they frequently use. Warren asked, “How many names in the S&P 500 are going to be 15 times earnings in the next 12 months? How many are going to earn more in five years using a 90% confidence interval and how many will compound at 7% using a 50% confidence interval?”

Bill: Hmm.

Tobias: Has he just told you his formula there?

Jake: Well, Combs said that this rubric was used to find Apple since at the time the same three to five names kept coming up. So, in this exercise, you’re solving for cyclicality compounding an initial price.

Tobias: Yeah. When he says 15 times in 12 months, what does he mean by that? Which way? It’s going to be reverting down or reverting up? What’s the directionality? Which way is he going with it?

Jake: Probably down, I had to guess.

Bill: I don’t know, you could do both.

Jake: You can. 15, that’s the matter which way the elevator’s going. [laughs]

Bill: Yeah, they just bought Louisiana-Pacific. What’s LPX’s trading multiple? Like three or something ridiculous?

Jake: Going to 15.

Bill: Yeah. That’s because the E is going to go down.

Jake: [laughs]

Bill: I wonder they say, “Okay, well, even with that fade, do we still think that we can make 7%?”

Jake: Yeah.

Bill: You get yourself somewhere that you need to go? I don’t know. Ask a follow-up question, somebody that’s got access. Holler back. The 10 are strong.

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