In their latest episode of the VALUE: After Hours Podcast, Bill Brewster, Jake Taylor, and Tobias Carlisle discuss:
- Only 1 Tech Stock from the 1999 Dotcom Bubble Beat the Market by 2007
- The Munger Approach to Selling Stocks & Marriage
- The Drivers Of Stock Market Returns Over The Last 10 Years
- Value Studies Outperform Value Gurus: A Study of the Long-Term Returns
- How to Avoid Disasters in Investing by Learning from Sailors
- The Relationship Between Price to Cash Flow (P/CF) and Stock Returns
- How to Profit from the Lag Effect
- A Guide to Man Overboard Investing
- Buffett’s Early Investment Strategy: How He Aimed for 10% Outperformance Over the Dow Jones
- The Challenges of Finding Value in Today’s Market
- Is It Time to Invest in Small Cap Value Stocks?
- The Economic Impact of Student Loan Repayments on Millennials
- Inflation Driving Up Insurance Premiums, Especially in High-Risk State
- Why is the Chip Industry So Boom-Bust?
- Accounting Is Not Always a True Representation of a Company’s Financial Health
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:
Tobias: This meeting is being livestreamed. It’s Jake Taylor and Tobias Carlisle on Value: After Hours. Just the two of us today, JT. No third wheel.
Jake: Oof. Boy, we removed the safety net.
Jake: Stretch it out already. [laughs]
Tobias: Add more. I got to try to find where this is being streamed. I can’t see the questions.
Jake: Oh. YouTube, I think.
Tobias: YouTube? YouTube, you say? [unintelligible [00:00:31] available on YouTube. So, what’s been happening? You’ve been traveling?
Jake: Had a bit of some travel. Yeah, we can go through that.
Tobias: Stretch. Talk about travel. I try and find this–
Jake: Okay. Yeah, last week, I was in London, obviously. So, I broadcast from London. And then this last weekend, I went to Greece for the weekend on the way home and had a nice little trip. And now, I’m back stateside, and slept in my own bed last night for the first time in a while. It was glorious. Felt so good.
Tobias: I think getting home after a long week on the road.
Jake: Yeah. Good to see the family again. See how many inches the boys had grown while I was gone.
Tobias: How was Greece? What’s Greece like?
Jake: It’s lovely. First time there. It was really pretty. The water is nice and warm, like, 80 degrees, probably Fahrenheit.
Tobias: Visit any of those crucible of civilization type spots?
Jake: No, not really. It was a pretty quick trip. Next time, I’ll have to add a little bit more time and actually do some proper sightseeing. I did see the Temple of Poseidon though. That was the closest thing to history that I got.
Tobias: Where’s that?
Jake: Call it like 45-minute drive south of Athens.
Tobias: Did you see Port of Piraeus?
Jake: No. I saw literally nothing except that one thing and some water. A little bit of Mediterranean.
Tobias: Let me give a shoutout. I’m going to give 10 minutes of shoutout– [crosstalk]
Jake: Yeah. Where’s everybody from?
Tobias: We got to stretch this out.[laughter]
Tobias: Santo Domingo, Dominican Republic. First in the house. What’s up? KS US? Is that Kansas? I’m not sure.
Tobias: Milton Keynes. Stockholm, what’s up? Panama. Kirchheim, Germany. Las Vegas. Atlanta. Lewes Delaware. Toronto. I skipped somebody there. Tallahassee. Lots of Toronto’s. Edmonton. Mós, Portugal. There we go. Living the dream.
Tobias: Toronto. Nashville. Valparaiso. You win. IN. Hang on. That’s not in Chile. Augusta. Turku, Finland. It’s a good spread. What’s everybody up to? Good to see everybody.
Jake: How’s the market treating you, TC?
Tobias: How is the market treating me? It’s been fairly kind, I think, for the last– It’s funny. I don’t know what you call them, factor style analysis.
The Relationship Between Price to Cash Flow (P/CF) and Stock Returns
Tobias: It seem to suggest that value is having a– it’s back to sucking again. I produced one last week. I went and looked at the French data library. It has lots of different data series. The one I pulled up was price to cash flow, because if you run price to earning, someone says, “Well, what’s the cash flow look like?” And if you run price to book, someone will tell you, “How old that is?”
Tobias: So, that doesn’t work anymore. So, I just cut to the chase. I do cash flow. I do valuate cash flow, which is market capitalization.
Jake: I thought you’re going to go the other way and start just going price to sales.
Jake: Or, just eyeballs. [chuckles]
Tobias: Eyeballs. Clicks.
Tobias: So, price to cash flow. I do it on a valuate basis, because the question is always, is this the size thing? Is it the smalls? Is it the equal weight? In this instance, it’s value weight. So, it’s market capitalization. I looked at the most expensive 10%, the glamour decile, the expensive decile, the growth decile, whatever you want to call it, the growth portfolio.
Tobias: Versus the value portfolio, the cheap ones, the low price to the fundamental. Over the full data set, growth– So, this is 1951 to present rebalancing on annual basis. Each portfolio is about 200-ish names, and it’s the top 2,000 names. So, it’s a reasonable spread.
Jake: All right. I like the setup of that.
Tobias: Value has outperformed growth over that entire period by 20 times.
Jake: I don’t believe you. [laughs]
Tobias: Here’s the interesting thing. If we had stopped that analysis in August 2014, value had outperformed growth by 80 times. So, since 2014, August, 2015– [crosstalk]
Jake: Wait. 80 times, like a full 80X compounded difference?
Jake: [laughs] Okay.
Tobias: It was a very smooth chart too. It was quite consistent outperformance. And so, since August 2018 to the very bottom, which was about March 2020, the drawdown was 76%. It’s not a drawdown, it’s underperformance. So, value has underperformed glamour since August 2014 by 76%, which means that you go from 80 times outperforming to 20 times over the full data set by adding on the additional 10 years at the end. That’s a very long period. It’s a very long drawdown. See, I think you could be forgiven for looking at value over the last 10 years now and saying, “This really doesn’t work down a lot.”
Tobias: Can’t afford to lag by that much.
Jake: Really [crosstalk] epic collapse, really, in the data set, right?
Tobias: There’s nothing like it.
Tobias: There’s nothing like it to the point where you probably should be asking, is this fundamentally broken? I don’t have a really good answer other than my instinct intuition that it’s not. But I kept on going with the analysis. So, I looked at the comparison, I looked at the drawdown, and then I looked at the yield across those portfolios. So, the yield in the glamour portfolio is about as low as it has ever been through the entire day. It’s basically just squashed down over the full set. And the yield on the value portfolio is a little bit over. It’s better than average, but it’s not– [crosstalk]
Tobias: It’s not as high as it has ever been. It’s better than average. But value relative to growth is– [crosstalk]
Jake: What are those numbers are we saying there? What’s the yield roughly on each one of those ballpark?
Tobias: Let me look at that. It shouldn’t be that hard to find, but it’s– I was surprised, actually. It wasn’t quite as stretched as I thought it was going to be. Let me pull this one up. So, the growth portfolio is like 1%.
Tobias: Value, I would say, is about 13%, which is– [crosstalk]
Jake: Wow. It’s [crosstalk] than I would have guess probably.
Tobias: But the differential probably– We’re probably in the top five, in terms of differential. I still think 1999 was the broadest, and then 2000 was third. So, 2021 was second and now we’re in one, two, three, four, five, six out of 72 years. So, we’re in the-
Jake: Top decile.
Tobias: -top 5%. Yeah, top 5%, I would say. This is all US data too, by the way.
Jake: Interesting. So, the general lay is that top end pretty dang expensive.
Jake: Yeah, more expense than it’s never been.
Jake: Kind of average-ish.
Tobias: Yeah, maybe a bit better than average, but yeah, average-ish.
Jake: A little better than average, but not like, “Oh, my God, you’re getting absolutely a steel, relatively speaking–”
Tobias: I think relatively speaking, you’re doing pretty well. On relatively basis-
Jake: Yeah, relatively speaking. Yes.
Tobias: -you want to be in value. But on an absolute basis– I still think you probably get slightly better returns than average, but not like– I don’t think it’s going to be a 2000 where both gets crushed and value just massively outperforms through that period.
Jake: So, what’s your base rate outcome then from here?
Tobias: Well, here’s the thing. [crosstalk]
Jake: Is it negative for the glamour? Let’s say 10 years from now we have this conversation. Is it zero, slightly positive or negative for glamour? And then the value basket, do you put it at slightly positive or reasonably positive?
Tobias: So, that’s a good question.
Jake: Or, only down a little and the other one’s down a lot?
Tobias: Even having accounting for that drawdown, the underperformance since 2014, the outperformance of value over growth over that full set is 5% a year, which is a big up. That’s massive. It’s like 15 versus 20.
Jake: Yeah, that’s an insane number over a compounded series.
Tobias: And so, I would say now growth is–. Is it negative? I don’t know. But that yield is so low. It’s hard to see how that multiple expands much from there. If anything, it goes the other way to go back to its long run average, which might be 4% or 5%, something like that.
Jake: It is hard to imagine that there is– What levers do you have left to pull from here? I don’t know.
Tobias: There’s no quant value person out there who’s just pulling on price to a multiple. Nobody’s doing that. It’s just that that’s what they call value, the value bucket, to distinguish it from other measures like quality, which are returns on invested capital, and the conversion of earnings into cash flows. Then what they do at the cash flows once they come in? Do they buy back stock? What do they do? So, that quality metric, which you can split out, that’s been helping people outperform. Quality is looking historically pretty good. I think the forward mirror for quality is looking pretty squashed as well. I think it’s had such a good run. But then I don’t know, is that merely by virtue of the fact that that’s describing a lot of the bigger end of town-
Tobias: -and they’re caught in there? It’s a funny time. I looked at Acquirers Multiple. Sorry, Not Acquirers Multiple. On the Alpha Architect site. They’ve got all the different value metrics there.
Jake: That dashboard.
Tobias: EBIT/EV, it hasn’t been updated yet. It’ll be updated in the next few days. EBIT/EV continues to be the widest spread, but price earnings is also a widespread at the moment. Cash flow is actually– It looks to me like it’s long run average, not massively stretched.
Jake: I wonder what’s that a symptom of. I’d have to have a think through the accounting, why that might be.
Tobias: I can’t figure that one out, either. I have noticed that in back tests that the cash flow portfolios have done a lot better over the last, particularly since 2020. Cash flow portfolios have done well, whereas operating earnings portfolios have not. I don’t know why. Sometimes, it’s just randomness. That just happens in the data.
Accounting Is Not Always a True Representation of a Company’s Financial Health
Tobias: Jim O’Shaughnessy, famously, when he first came up with what works on Wall Street said, “Price to sales is the king top of the income statement.”
Tobias: So, on and so on, cleanest. And then changed his mind subsequently to an EBIT/EV type metric, and then changed his mind again to a combo saying, “Use them all because there’s just noise in them.” I don’t know, if it just– They pick up a sector that’s hot.
Jake: Yeah. That makes sense. I would say that the other issue is that accounting, It does its best to try to reflect what is happening in the real world in economically. Sometimes, some companies, their accounting is much closer to reality than other companies, just the way the GAAP treats things. As Buffett said, lots of times like. “The accounting is a place to start, not necessarily a place to finish.” So, if you’re doing more deep dive analysis.
Tobias: Let’s do some questions. We got some good input. We’ll be referring to the questions a lot.
Jake: Yeah, it’s a special mailbag episode of Value: After Hours.
Tobias: “Does the same breakdown occur ex-US? or does the factor hold up better?” So, I’m not sure about that, because everything looks to me like value versus the index. So, emerging markets look like value versus the index. Probably value emerging markets are destroyed. Anything that’s not S&P 500 looks pretty sickly at the moment. S&P 500 is just incredibly– If you’re small, if your value, if your quality even, I think hasn’t done as well. Nothing.
Jake: It’s a beast, huh?
Tobias: It’s a pretty good portfolio, when you look at the top names in it. It’s not like in the 1980s when the top name was like Exxon or something like that. The top name now is, whatever it is, Apple,-
Tobias: -Google, Microsoft.
Jake: Yeah, those are okay companies.
Jake: They might have–
Tobias: They are better than average.
Jake: They might have a little franchise going there. I don’t know. [laughs]
Is It Time to Invest in Small Cap Value Stocks?
Tobias: Yeah, “Value. Small cap value.” So, I just did this a little analysis today, just looking across my portfolios. I think small cap value is getting close to about as high forward return as I have seen. Mid cap values– [crosstalk]
Jake: [laughs] Performance has been that bad?
Tobias: I think it’s– [crosstalk]
Jake: That’s another way of saying that.
Tobias: It had this very, very brief run from October 2020 to April 2021. I would say, like, April 2021 or May 2021 is probably the peak still for those indexes. Small and value.
Jake: The problem is is that you just never can’t tell when it’s going to close that gap. It can happen so violently that there’s no timing it, right?
Tobias: No. Well, I don’t think you can time it. I think that’s the answer. You have to be there for that when it happens, but then you probably endure the– It’s not always the way. I could easily see that at some point, this all reverses and will be 10 years down the path with SPY having made no progress, and probably still looking pretty expensive at that point, potentially.
Jake: Well, all depends on what the underlying does. It depends on the turnover too. Over 10 years, you can turn over a lot of the companies out of there that are the companies that are working now. It is an evolutionary process within SPY.
Only 1 Tech Stock from the 1999 Dotcom Bubble Beat the Market by 2007
Tobias: That’s a good point. Meb had a tweet today.
Jake: How are you, Meb?
Tobias: “How many of the 10 most valuable tech stocks in the world at the peak of the dotcom bubble beat the market by the time of the next bull market peak in 2007?”
Jake: Oh, gosh.
Tobias: I’ll give you the name. See if that helps.
Jake: Yeah, that’ll help.
Jake: Ooh, maybe.
Tobias: No. IBM? No.
Tobias: America Online?
Jake: That one’s an easy.
Tobias: Oracle? No. Dell Computer? No. Sun Microsystems? No. Qualcomm? No. Hewlett Packard? No. None of them.
Tobias: All right, here’s the next question though. “How many were ahead at the end of 2022-
Tobias: -fully 23 years after the dotcom bubble crested?”
Jake: All those same names?
Jake: Oh, gosh. Microsoft?
Tobias: That’s it. You got it.
Jake: [laughs] I’m glad you stopped me before I added more wrong answers. [laughs] Wow.
Jake: You can’t be real enthusiastic about those odds, right? Like, bellwether best and all those. In 1999, you would have given me totally logical and very, very believable reasons why all of those were dominant companies for the next 20 years, right?
Tobias: Yeah. In that list, there’s Cisco and Oracle.
Jake: Intel, 95% market share at that point. What other company do you know has an entire huge industry locked up at 95% market share?
Tobias: Hewlett Packard, Qualcomm, Sun Microsystems, Qualcomm, Dell Computer, Oracle, America Online.
Jake: You would have told me network effects, first mover, advantage, ability to outspend on R&D compared to everyone else. You could never catch them. All of those would have been like very– No one would have laughed you out of the room at that point.
Tobias: You could have held them all. I think one of the things it really demonstrates is that no one knows what’s going to happen. Businesses, when they look really– If the lever that you’re pulling on is the quality of the business, it’s hard because they often look good because they’ve had that cyclical tailwind at their back for a period, which they had– Cisco is the one. Some people have made some comparisons between Cisco and Nvidia, because Cisco, there was that panic for internet routers at the end of the 1999, 2000, and everybody front end loaded five years of buying.
Tobias: It helped Cisco out, perhaps in the same way people have front end loaded five years of buying for Nvidia. I don’t know. I’m not close enough to it, but it just wouldn’t surprise me.
Why is the Chip Industry So Boom-Bust?
Jake: It’s really hard to say. But if you do look back at just chips, in general, that industry has been so boom bust over the years. Just absolute annihilation of companies over time.
Tobias: Why is it so boom bust? Why is that?
Jake: Huge fixed costs. Long lead times in getting ramping up. So, you’re planning– Let’s say, I wanted to be able to service my customers with a bunch of more chips. Well, I needed to start probably five plus years ago building that factory to be ready. So, you’re always just hoping that the future is going to be as bright. When you have huge fixed costs and you show up, you still have to move some units to just even try and cover your fixed costs, but you’re eating your marginal costs or you’re eating your flexible costs at that point. You end up with an absolute bloodbath.
Inflation Driving Up Insurance Premiums, Especially in High-Risk States
Tobias: I got a question here. I got a few. What do you think of the reinsurance market? Are you following that at all?
Jake: A little bit. I’m following more general, the insurance industry, not reinsurance quite as closely. But I know insurance has been pretty firm lately. These companies are, I think, getting pretty good pricing right now.
Tobias: There seems to be some difficulty getting insurance in California and Florida, but just my kids soccer like, they had to move everything around because they couldn’t get insurance on some of the fields. Strange.
Jake: Yeah. Well, inflation finds its way into a lot of places, including insurance premiums. When you have cars that ran up 50%, when you have basic materials that are much more expensive now, so the repair costs are higher. GEICO is not going to eat that. They’re going to pass it on the next time that the contract comes up in a year. So, yeah, I mean premiums– Or, let’s take Florida and storms. If it’s going to be expensive to solve that problem for you that occurred that you were insured for, it’s going to be more expensive the next time you come around to have to buy that same coverage.
Tobias: California does something weird too, where they don’t allow them to reinsure some of the stuff, or they don’t allow them to include the cost of reinsurance. I don’t fully understand it. I saw a CBS news article on it that reinforced some of my prize.
Jake: Oh, yeah.
Tobias: Wasn’t as critical as it could have been.
Jake: [laughs] Oh, that’s part of the fun, that confirmation bias.
Tobias: All right, here’s one. This is one that I don’t really know either.
The Economic Impact of Student Loan Repayments on Millennials
Tobias: This is borderline economic, but how big an impact does the student loan repayments starting have on the economy, on the marginal consumer?
Jake: Well, that one’s too easy for me, so I’m going to let you take that one, TC.
Tobias: [laughs] I have nothing further to add. You know, I don’t know either. I don’t know. Some impact. I have no idea. Millennials and their avocado toasts out.
Jake: [laughs] Of course, we can all paint the pictures of that, where it’s like, “Well, yeah, all the disposable income that was going to Pelotons, and I don’t know whatever else– Yeah, avocado toast gets soaked up now in student loan payments. But these government led things, especially in election years, they have a way of being the can getting kicked even further down the road. How many years do they keep renewing the electric vehicle subsidy programs, and renewables, solar, and wind, credits, all that stuff? They come due. There’s always a question of, “Oh, are they going to put them back on?” And then last minute, they put it back on again. So, I don’t know. These things are really hard to– I’m not sure how much of you can depend on it for any real investment thesis. If that’s your thesis for something like, oh boy, I don’t know, try to find something easier to figure out.
The Challenges of Finding Value in Today’s Market
Tobias: When your idiosyncratic discretionary value, so you’re not trying to manage to any given exposure, you’re just going to buy something when you find it cheap? Otherwise, and you’re sizing, so you’re not too concentrated. I don’t know exactly how concentrated you get in client accounts, but not too concentrated. So, below 10%, something like that. I don’t know what you get. 5%, something like that.
Jake: It depends on how well I know it. I can go higher than that.
Jake: But yeah.
Tobias: “How hard are you finding it to find positions now? How do you feel about the market at the moment?”
Jake: Yeah, it’s harder, for sure.
Tobias: Harder than when? October last year?
Jake: No, harder than– Yeah, well, maybe that, but I’d go even further back before I would say– It’s harder than during COVID, harder than 2020. Probably, not harder than 2019 though, and 2017 and 2018.
Tobias: I can’t remember between– Yeah.
Jake: And 2019.
Tobias: Can’t remember.
Jake: Those felt harder. Let’s just say, I had more cash than I do now. But a lot of that is things that I bought a couple of years ago feel fully priced, and I just haven’t sold them. But I’ve been letting them run a little bit more than probably normal, because I don’t have a lot of great things to replace behind them. I guess, my prospective returns from today’s portfolio don’t feel quite as strong as they did probably, certainly like two years ago or two and a half, three years ago. But that’s because a lot of the names have run up in the meantime. That’s just the nature of it.
I don’t always love talking individual names, but when I bought Fairfax three years ago, it was like, I don’t know, 0.6 or something half, 0.5 price to book at that point. That felt like there was a lot of meat on that bone that was available. When I bought energy companies, when oil prices were negative, I just needed them to survive at that point.
Jake: I felt like there was a good chance of ROEs coming back off of zero to be pretty strong at that point. I stand to earn a lot of that ROE, plus the multiple expansion that comes from when you get out of completely blood in the streets. But that doesn’t really describe today’s case anymore. They’re making pretty decent money still. They’re retiring shares. They’re doing dividends. They’ve been reasonably okay, at least like some of the majors on Capex, not getting too crazy with it. But you’re at quite a bit different multiples than when I bought. The spring doesn’t feel as loaded as it did when I was buying them, for sure.
The Munger Approach to Selling Stocks & Marriage
Tobias: Implicit in what you just said. There’s the distinction between buying and selling, right? So, you buy, and you’re looking for everything to be lined up perfectly correctly, and then holding is a different question. You’re like, “Now, how close are we getting to my imagination?”
Jake: Yeah. I agree with Munger at when he was, I think, 1997, when he said, “I’m still figuring out my sell criteria.”
Jake: I think his words on marriage actually apply reasonably well to this, which is, when you go into the marriage, you should have your eyes wide open. But once you’re in it, you should have your eyes, a little bit closed.
Jake: I think that same could be true for your portfolio, where have your eyes wide open on valuation. But as you own it over time, I think being too strict with valuation sometimes can make you sell too early and then what, especially, if you don’t have anything readily to put into it at that point. Or, said another way, I think being a value buyer and a bit of a growth holder might be a reasonable thing to do.
Tobias: I say quality holder.
Jake: Quality. Yeah, sure.
Tobias: But also, obviously, you can’t ignore the valuation either. You can’t have it.
Jake: No, but I think maybe forcing it to an extreme– Having your bar a little bit higher up like, I would never buy here, but I can hold here for a while. Maybe it grows into that. Maybe it doesn’t. I’ve been guilty in the past, certainly of punching out of something too soon and not when you get a win earlier, and then you leave a lot of money on the table, potentially. Especially, if it’s to just go into cash and you don’t have anything readily available to put it into, that seems super.
Tobias: Yeah. I had some holdings last year in the home builders and a lot of adjacent stuff like Williams Sonoma, which I continue to hold, like, that kind of stuff. Boise Cascade, which I also continue to hold. It’s all adjacent or not a builder, but it’s selling into that same market. As it’s run up, there’s no discretionary element to me selling some of these things. There has to better opportunities in there. But I don’t know. At any given, you shake the opportunity set every time you rebalance.
Tobias: I always hope for those things that something else comes in and pushes them out, because– [crosstalk]
Jake: It feels like you already kind of rung that the– [crosstalk]
Tobias: So, my discretionary– [crosstalk]
Jake: Squeeze that lemon.
Tobias: They’re good businesses. They’re pretty good businesses, but they’re not great businesses and they’re definitely cyclical.
Tobias: It feels to me [laughs] close to the end of that cycle. I really want to get out, but they’re still in there. So, I just keep on holding.
Jake: Yeah, it still must be reasonably priced if they’re still in there, right?
Tobias: It’s been good fortune for me that I haven’t, because they’ve continued to work, even though I just, like, along with everybody else, was just completely shocked that they continued to do that.
Value Studies Outperform Value Gurus: A Study of the Long-Term Returns
Jake: Yeah. Well, part of this too came from a little study that I did back when I was teaching way, way back in the days. It was an examination of all of the value studies. Comparing that to the value gurus and looking at them in a longitudinal study of like, “Okay, in this year, how did the studies do? Aggregated? How did the managers do?” And then just running through in time. Of course, all of the caveat emptor in this world of studies where it’s like, transaction costs, trading costs, and taxes, all these things that people cite for why you can’t fully depend upon these studies. That’s fair. By the way, the studies absolutely trounced the managers, the gurus. It just killed them across every single time period.
One of my hypotheses as to why this might have been was that if we think about taking advantage of some behavioral bias, I think we would all agree that the market can undershoot and also overshoot. Both of those extremes are illogical from the actual price, when it’s price and value matching each other. So, the value studies, because they’re so mechanical, they buy when it’s cheap and they hold for a year or two years or three years, whatever the prescription is, and then they sell, and then they trade up. Well, it’s possible that they because it’s a time-based effect, it’s not necessarily valuation based, they might participate in capturing both the inefficiency to the downside as well as if it runs up to a stupid amount that the guru would have sold out of. And so, they’re not capturing that upside inefficiency.
Jake: I don’t know how true that is. It was always just a hypothesis.
Tobias: That makes sense to me. Of course, you can definitely see it. Some things just get hot for whatever reason and they run up way beyond what anybody.
Jake: You never would have held it, right? If you had discretion over that, it would have felt like you were taking a really stupid risk at that point. You’d already won, you would want to punch out to lock in the gains. Like, every single psychological thing would be making your finger want to push that button to get the hell out, right?
Tobias: Particularly, because the nature of these things is they do tend to return to Earth. They’re not like the compounders where– [crosstalk]
Jake: Very rarely do you catch Apple as a net-net and ride it to the [crosstalk] land.
Tobias: Look, it’s fine to overpay for that stuff. There’s such good businesses, eventually they catch up. That’s fine. Don’t worry about it. I’ve never bought anything like that in my life. [laughs]
Tobias: That’s not true. I bought plenty of them and sold them when they got to-
Jake: Got to like a reasonable price.
Tobias: -fair value.
Jake: Yeah, exactly.
Tobias: Bought them at half book, sold them at book.
Tobias: Then ran to 10 times book.
Jake: Well, if we think about the return profile, a lot of times, it is a couple of names that will drive the entire outperformance of the portfolio, a power law type of outcome. If you trim those extreme return profiles, boy, you really truncate the total portfolio return at that point. If everything else is just, call it, a bunch of okays and then a few dogs out of there, you really might be giving up a lot of that potential total return from an aggregated basis.
Tobias: The VCs always used to say our portfolios have got parallel distributions. That’s why we have 10 positions and one or two [crosstalk] all of the returns.
Jake: Well, 100 positions.
Tobias: Well, that’s Y combinator. That was there. They said, “You get such good right tails, you can’t afford to miss the right tail. Therefore, have many more smaller positions and you’ll get more money into increase your chances of catching one of those. Given that any one of them can return the entire value of the portfolio, you might as well be in as many as you can to catch it.”
Tobias: There must be– [crosstalk]
Jake: Spray and pray, they call it.
Tobias: That must be true across. I don’t know why that would be different for listed portfolios as well. I think it is all fairly similar. It’s just over. People don’t hold for those periods of time, you’re selling all the time. But in those long studies that I have done where you just tell the system not to sell, just to hold everything, so it’s not real. You don’t get any of the capital back. It’s imagining that you’ve got this unlimited supply of capital to invest to, although you do end up getting about a third of the portfolio capital back over five years, which is extraordinary. To me, that it’s as much as that.
But it actually makes sense, if you think, if you’re buying on a cheap on a free cash flow basis and free cash flow yields like 10% after three years, that’s 30% of the cap of your starting capital has been plus some growth.
Tobias: It does make some sense that that’s what ends up happening. I think it would be hard to run a portfolio on that basis, unless you were explicit at the start like we’re doing a Y combinator, we’re going to buy 100 positions. We know that there’s going to be a lot of dead weight in here and the median stock might not do that well. But the payoff on the right tail is so huge, we don’t know which ones it is. That’s the funny thing. I go back and look at them. I have no idea. Prospectively, some of the names I recognize, that’s a bit of a cheat, but many of them I don’t.
Jake: I think if we compare time periods too, I think that’s important to realize the opportunity sets and the way that they’re structured. So, Buffett in 1950, it was a continuous conveyor belch mortgage board of inefficiently priced securities. And so, every single time you were trading up, you were just keeping that edge sharp on the portfolio. Like, buy something, it would run up, trade up into the next thing that was cheap. Two years later, that had run up. That’s how he made his best returns was basically just always keeping that cheapness edge on his portfolio. You had a nice run rate that you could just continually keep recycling into.
I think now, it’s possible that the inefficiencies come in punctuated time periods now where it’s like, “Yeah, the market’s a hell of a lot more efficient over most periods of time, but then occasionally, it just gets stupid one direction or another.” So, you have to wait around that whole time period when it’s mostly pretty efficient. And then when those things come, you have to be willing to swing big. So, that’s much more of a Munger Daily Journal management approach. Like, do nothing for a really long stretch and then feast when it’s put out for you. The industry is not really structured to capitalize on that style of opportunity set and flow. I think it’s much more the little continuous version always turning the portfolio over. That’s sitting on Treasuries for eight years, like, Munger did before you load up completely on three names. I don’t know if you can run a business that way, right?
Tobias: If you’re in an industrial and you have businesses that you’re ostensibly running, even though you’re not necessarily doing anything, you’re at the top making sure that the capital is not being reinvest, they’re not making silly acquisitions and doing things like that. You probably can do that, just that you wouldn’t expect an ordinary operating business to be making an acquisition every single year or every few years.
Jake: No, of course not. You would know that cyclically, there will be times where your competitors will be weakened and you want to have the resources available to take advantage of that, whether it’s taking their customers or their best employees or buying them out completely. That’s what a good anti-fragile operator is always thinking about.
Buffett’s Early Investment Strategy: How He Aimed for 10% Outperformance Over the Dow Jones
Tobias: I think also it’s worth pointing out with Buffett, who’s quite a good investor.
Jake: Is he all right? Sorry.
Tobias: For that period of time when he was running the Buffett partnerships, he was holding three names in stuff that was incredibly illiquid. Just impossible to get in– [crosstalk]
Jake: I think he was more diversified than that, wasn’t he? I would have guessed it was more like 10 to maybe even 15, because he had three different buckets going. He had like workouts, which is like an arbitrage thing. He had going concern type of more like buy and hold those.
Tobias: In generals.
Jake: Yeah, generals. So, I would imagine that it would have been a little bit more diversified than three.
Tobias: Pretty concentrated though.
Jake: In the grants, yeah. Compared to the average investor, he was pretty concentrated.
Tobias: And then he regularly says in those Buffett partnership letters, “I’m aiming for 10% outperformance over the Dow Jones over 10 years.”
Jake: Oh, my gosh. 10% compounded.
Tobias: I think it was 10% over 10 years. I don’t think it was compounded.
Jake: Oh. No, it had to have been higher than that.
Tobias: That might have been what he achieved. What he said was 10%. Maybe it was over five years. He was saying, “For you to tie up your money with me, I’ll give you this is what I think is a reasonable premium over what you can get in the index for less.” It’s very modest.
Jake: Huh. Well, he did better than that.
Tobias: He did. He actually did better than that.
Jake: He under promised and over delivered on that one. Shall we bang out some vegetables?
How to Avoid Disasters in Investing by Learning from Sailors
Tobias: You’ve been coasting so far, JT. Time to carry this podcast.
Jake: Yeah. [laughs] All right, all aboard. So, I found myself this last weekend in Greece, like I said, on a boat in the Mediterranean as one does.
Tobias: Look at this guy.
Jake: I know. Who are you?
Jake: It’s silly.
Tobias: Who are you?
Jake: I know. I don’t even know, either. But this boat that I was on was, it was kind of a big boat and it was with some actual real experienced sailors. Like, this wasn’t just a little dinghy or anything. Being such a serious operation, even just going from one island and pudding to another one and anchoring for a swim is, it’s a real experience. It’s not just like, you got to really be paying attention. These are high consequences. So, I was hoping that we could– I watched this captain and asked him a bunch of questions to– I like to just learn about like, watching anyone in their mastery moment and talking to them is always interesting. And so, I was hoping that we might find some business and investment parallel implications from, and hopefully they’re relatively obvious, but– [crosstalk]
Tobias: Let this be a lesson. JT never sleeps. He’s always looking for podcast content.
Jake: Shit, man. You have to. Otherwise, how else can you keep the streak alive, right? You got to be like Cal Ripken. You can’t miss practice either. All right, so, these are three lessons from serious boating. All right, so, number one. Planning before you move and maintaining a margin of safety. So, first thing is, you’re always charting out your course before you even get started. You don’t just take off and then be like, “Oh, we’ll figure out on the way where we’re going.” And you have to make sure that you aren’t traveling over any path that you might run into trouble that you might have been able to avoid, like, reefs or sandbars or whatever. You really have to understand your boat, and what it’s capable of and not capable of. Like, what size waves can it handle, what depths are safe, what wind speeds are safe to be in. There’s so much that you have to really understand.
Then you also have to just keep a margin of safety in all of those things, all these parameters. If it’s only good for 3 meters, let’s say, of waves, you don’t go out when it’s 3-meter waves. It’s like, you keep away from the line. This is literally Munger’s advice about figuring out where you’re likely to die and then not going there. This is an– [crosstalk]
Tobias: That’s good advice.
Jake: Yeah. It’s not theoretical in this case. You might actually die if you mess this up. All right, lesson number two. While you’re underway, you’re looking for markers and waypoints on the path towards your destination to make sure that you’re not deviating from the course of where you think you’re supposed to be. And the investment equivalent of this is, I think, thesis signposts. So, any investment you’re making, you should be able to set signposts that would either confirm or deny where you are and are you going where you think, is this proving true or not? Like, confirming or disconfirming evidence, making sure you’re on the right track.
Then at that point, when you’re sailing, you have to be constantly monitoring the weather, the wind, the waves, currents, and making sure that those conditions. Because they’re always changing, how is that changing with what your thesis? Of course, obviously the same is true for markets. Bigger ships can go less places and obviously, AUM is like a performance anchor as Buffett has said lots of times like, “You can’t bring a big old ship into a little bay and then try to get to close to the beach” Turning takes time. They were telling me that a full-size container ship like one of those really, really big ones cruising along at 10 miles an hour, if you were to throw it into reverse, full reverse, it would take still 1 mile to stop.
Tobias: You can just say a day.
Jake: No, but a mile. Picture like how far a mile is from offshore. Like, if you were to heading towards something you were going to hit and you went full reverse, a mile is a lot of ground to still cover or sea to cover. There’s such serious inertia at work here. You really have to plan ahead. This reminds me of Bezos– when he would be congratulated on a great quarter, he would then say, “Well, thank you, but that quarter was baked three years ago.” I think it’s always like that. I think this is really especially true in the investment world is that the outputs from the inputs are so badly lagged. Like, you do the work and then you set your course, you set your investment thesis. A lot of times, you won’t know if you’re right or wrong and you won’t get paid for years in some cases.
What ends up happening is, you have to be very careful to not continually over steer and have too many inputs. It was really interesting. I was watching the captain steering this boat, and as you’re drifting a little left or a little right or porter starboard, I guess, they call it, he would start turning the wheel, and then 10 seconds later, the boat would start to go in the direction that he turned. Then by the time were already moving that direction, he’s already starting to steer it back the other direction for the next 10-second increment. I think that there’s something analogous in the investment world where you want to figure out a little bit like where the puck is going and skate to where it’s going and not be chasing everything. Like, if you can get out ahead of it a little bit, I think you’re a pretty big advantage.
Lesson number three is around resilience. Mother Nature is obviously very unforgiving. As one of my friends said, “It’s all left tails in the ocean.” No right tails out there. So, to improve your chances of responding to a challenge successfully, you have to have procedures for every contingency that you can imagine. That response has to be executed coldly, coordinated, and without much surprise, if you can help it. You want it to say like, if X happens, then we do Y together and we know our roles. We’ve discussed this man overboard moment and procedures before on the pod.
Actually, UTIMCO, The University Of Texas Investment Management Company, their endowment, they have a pretty nice example. They had this slide that I found that it’s a liquidity plan for a -60% market correction. They basically are like, “Here’s how we’re going to reposition the portfolio, if that happens.” Including a -20% single day collapse, like, these are the moves that they’re going to make, so that they’re not just completely caught flat footed by a market panic. And so, this is yet another call to action to you, if you are an investor, to get your man overboard procedure ready before you’re in the middle of the storm. We’ve already asked you to do this a few times, but here’s another one. But of course, there’s always going to be surprises, and you can’t plan for everything. Because of that, these ships have redundancies for every system that’s on there.
Tobias: Coffee maker.
Jake: What’s that?
Tobias: Coffee maker.
Jake: Oh, yeah. That can’t go down. You have to have– [crosstalk]
Tobias: That’s the most important part of the ship.
Jake: That’s right. Well, it fuels the team. Obviously, communications and radios, they’ve allowed the exchange of information with other ships in the shore. It’s huge. It’s such a better system than what was before, but yet, there was still this bank of like, I don’t know, call it, 25 different flags that were all in these little slots. I asked them like, “What are all these flags for?” You can spell out like, they’re letters. The flags represent letters, and so you could spell out with someone and communicate with them in an old school fashion, if all for whatever reason like radios were down. They actually keep a wide range of basic materials on hand for problem solving like welders, and machining, and steel plates, and paint, and epoxies, and all this stuff. You have to be able to fix things when you’re out there, because things are going to break that you maybe couldn’t have planned for necessarily. So, there’s an element of creativity that’s required and responsiveness.
So, in investing, I think it helps to have multiple tools at your disposal like this. Maybe it’s the ability to understand capital cycle theory or maybe you have to understand SAS growth dynamics or maybe it’s arbitrage or activism, or convertible debt, or options, or hedging, or factor analysis, different asset classes, whatever it is, all of these things are just like different tools in your tool belt. And the chances of you finding intelligent things to do increase, I think, as you add more tools and give you more flexibility on how you express intelligent things to do.
So, part of increasing your resilience is a constant battle with entropy. Like, every system in the universe naturally decays due to entropy. The only solution to fighting entropy is you have to constantly add energy, information, or materials from outside of the system into the system to fight entropy. So, the maintenance of a big ship like this is just absolutely constant. We’ve done a segment on this already on sailing ship maintenance. I think it was in August of last year, if you want to go find it. It’s an interesting story. So, you’re doing continuous maintenance.
But every five years, they’ll do, what they call, a special survey, which is they take the ship out and they basically go through every nut and bolt in it. It’s a complete overhaul of the boat. It’s not a bad idea, I don’t think, to periodically do a special survey of your own portfolio and assess like, if you need a complete overhaul of it. It’s really easy to allow these barnacles to accumulate over time. It’s rusty bits of your portfolio that could probably use a little scrubbing and a fresh coat of paint, maybe re underwriting thesis. I think it’s important to do that periodically and clean out the deadwood.
So, next thing is that technology can actually remove critical thinking by creating abstraction and increasing fragility in a system. So, a lot of times, technology is about turning sensory input into numerical terms, and it’s creating models out of what’s happening in the real world, so that you can have an approximation of it. It’s like maps that are approximating the territory. Like, a map is a technology to help you understand the territory. This George Box quote about, “All models are wrong, but some are useful.” It’s very easy to be just staring down at your instruments, and then not looking out at the actual ocean.
There’s lots of precision in these instruments, they give you answers down to a decimal place, and they make you feel like you’re being exact in your awareness. And of course, GPS, depth finders, all those things are game changers for understanding the environment that you’re operating in. But often what can really sink your ship is found by just looking out into the real world. Sometimes, the risk doesn’t show up in your instruments. So, you have to keep a first principles based, level headed awareness of the investment world if you can, like, looking out. Not only are you doing accounting stuff or spreadsheets or SWOT analysis, but you could spend too much time in there. Sometimes, just getting away from your desk and looking out at the real world can protect you from these obvious risks that aren’t captured in your spreadsheet.
I think a lot of times, mathematical rigor is often substituted for simple basic holistic understanding of what you’re trying to do, similar to how if you’re staring by instrument instead of just actually looking out up at the real world, you can lose sight of important fundamental things. So, those are three lessons from serious boating that I picked up over the weekend, and hopefully, maybe there’s some good investment parallels for you there.
How to Profit from the Lag Effect
Tobias: There’s some good lessons in there. The lag one I think is interesting. Lag is tough, particularly in business because what’s being reported is the last quarter. So, any changes that are made may not show up in the next quarter or the one after that. It takes a long time for the business to turn around. Often, what appears to be moving in front of the reporting is just someone who’s got a better idea of what’s actually happening on the ground and vice versa. Maybe that’s one of the reasons why value has worked so well buying mean reversion and those things just having a better idea. Cheapness alone, just front running the lag.
Jake: Yeah, I’ve been around long enough now to watch reasonably up close, like, full business turnarounds. I’ve even participated in a few private ones. It’s amazing how long these things take to play out. It really does not match our human conscious timelines that we stay aware of. I know we can all think in years, but actually live through years of watching something slowly turn is a completely different experience than just imagining it hypothetically. It’s a lot more painful to wonder, “What the hell is taking so long here?” But in the real world of business, it turns out it’s actually hard to do these things.
Tobias: When I used to mess around a lot more in options, I always used to find that, just the strike beyond the next quarter, that was the one that was like most people didn’t give a shit about that one, because a year out people are thinking about that. A quarter out, people are thinking about that. But the strike beyond the next quarter is just like that one doesn’t exist.
Jake: It’s a dead zone?
Tobias: Yeah, you don’t need that one. Don’t have to worry about that one. So, that one’s often mispriced, underpriced.
Jake: Huh. It’s like, soft analysis being done on that one by other participants?
Tobias: Yeah. The lag is real in economics too. We have coincidental indicators and we have leading indicators. I saw something today that said that, “The lag between when the Fed starts hiking and when it starts showing up in results is five quarters,” which is a long time.
Jake: Well, it makes sense. We’re talking about the transmission of interest rates into every nook and cranny of an economy. That’s naturally going to take time to filter out and transmit throughout a system.
Tobias: It does makes sense– [crosstalk]
Jake: Every little decision at the margin is being done with a new part of information and it’s going to take a while.
Tobias: It does make sense, but there’s also this idea that the market is so forward looking that it reacts almost immediately to every new bit of information that comes in. For some things, that’s true.
Jake: Yeah, I don’t think so.[laughter]
Jake: No, I do. Obviously, it’s true in some ways, but– The efficiency, I think, is mostly there, but it’s not completely there, and that changes then all of the math that’s done from there. You can throw a lot of the math away at that point and favor common sense instead, in my humble estimation, obviously. Do your own philosophical work there.
A Guide to Man Overboard Investing
Tobias: What do you like for a man overboard? Do you have a list of names that you’d like to own and a rough price that you’d like to own them?
Jake: Yeah. I try to maintain an inventory of companies that I feel like I understand, but maybe the price just isn’t there for me to feel like I’m getting the right risk reward. A lot of times, it’s easy to buy more of the names that you really already own and understand when they come in some. Yeah, it’s difficult, because ideally, you should be measuring opportunity cost of every single dollar at every point in time. And so, that would mean then taking a very flexible approach to it. Like, you don’t know what industry is going to go on sale. You don’t know, have you done enough work to be comfortable to buy it? What asset class might puke for whatever reason? So, to be opportunistic, that implies a flexibility.
Berkshire has been run this way where it’s about the individual day when they show up, like, what’s the smartest thing to do with each new dollar. I think that’s the right way to do it. But it is difficult when you want to try to put some structure around it, so that you stay in your spots where you know you’re smart as well. There’s a constant tension, I guess, between the pre-planning and the ability to be flexible to do things as the opportunities arise.
The Drivers Of Stock Market Returns Over The Last 10 Years
Tobias: Why do you think it was such a weird decade for value?
Jake: You got to save that one for therapy couch there, buddy. [laughs]
Tobias: No, I’m going to ask you now. Why not? Why do you think it was such a weird decade–? Because I always say like, you wrote that great article showing that the dispersion between the cheap stuff and the expensive stuff was as tight as it has ever been. If I’d have been smarter, I’d have said, “Well, then, what does that mean?”
Jake: Yeah. And now what?
Tobias: It means that quality is probably on sale. You can buy good, better-quality stuff for cheaper. That’s the arbitrage. Now, it’s the other way around.
Jake: Alas, you and I were not smart enough to take that next step.
Tobias: I read that article. I processed it. I put it up on my side.
Jake: Understood it.
Tobias: Understood it. Didn’t ask the next question.
Jake: Then started sucking my thumb, basically.[laughter]
Jake: I don’t know. I mean, there’s interest rate arguments. Low rates make these future cash flows not as discounted. There’s economies of scale that work affect things that are on some of these big businesses that allowed them to scale without much new capital. Like, the difference between growing a Facebook versus growing a standard oil and the amount of capital that you would need to drive business is just different beasts. So, recognizing that.
Tobias: I think interest rates has got to be a big part of that, hasn’t it? That’s the most glaring– The reason I ask before I say that, if we can’t diagnose– [crosstalk]
Jake: Tell me the answer before you ask me the question.
Tobias: Why don’t know the answer.
Tobias: But if we can’t diagnose the last 10 years, then what hope have we got of being appropriately positioned for the next 10 years? That’s my wild thought.
Jake: Oh, yeah. So, we can’t diagnose. So, where did the returns come from? That 16.6% annualized return of the S&P 500 from 2011 to 2021, where did that come from? Revenue growth was pretty normal. Share count shrunks somewhat.
Tobias: Is that unusual?
Jake: No, I think it was a little bit more than normal. But if I remember right, it wasn’t extreme. Margins expanded some.
Tobias: That was unusual. Margins have gone well beyond where they had previously been reverted.
Jake: Right. And that could be some of the explanation of, well, corporate taxes were lower. That’s going to help your margin. Employees share of GDP didn’t really go a lot of places. So, that’s going to help your margins, if you’re a business– Labor was cheaper. Labor lost.
Tobias: You think that’s because labor got paid with a lot of equity?
Jake: I don’t know.
Tobias: Is that 15% share based compensation in the service sector?
Jake: I don’t know.
Tobias: White collar rather than service?
Jake: Yeah, I was going to say tell that to all the baristas– [crosstalk]
Tobias: Or, meant to whit collar rather than– [crosstalk]
Jake: Yeah, perhaps.
Tobias: If you’re a big tech employee, you’ve done pretty well in the SBC.
Jake: Dividends were pretty standard. And that leaves then multiple. And multiple carried a huge chunk of that. So, what’s driving the multiple? The enthusiasm and interest rates drive a lot of the multiple.
Jake: So, we can lay the foundation of where did it come from. That’s not really so much like value versus something else, but that’s just where did the market’s returns come from. So, where the next 10 years? Which of those levers are you going to pull to get another great decade? Is it going to be revenue growth? Oh, by the way, if we remember back to when we talked about this, 2011 to 2021, revenue grew actually slower than 2000 to 2010, which was a lost decade for stocks. So, top line was actually worse in that decade where everyone crushed it in the S&P 500. So, I don’t know what the next 10 years necessarily, but it’s hard to imagine that it’s not going to be– You are get 5%, right? Maybe you’ll get GDP or 2%, I don’t know.
Tobias: I thought 3.2 from using– But that assumes that we end the decade at the long run average multiple. So, we end the decade at 16 times, 17 times on a PE multiple basis.
Tobias: That doesn’t account for any margin contraction, but 3.2%, 1.7% of that is dividends, the other, whatever that is, 1.5% on the index.
Jake: So, revenue is likely to come in at normal. Share count, I don’t know how much more you can borrow and buy back shares, again. Dividends are probably going to be relatively normal. Share count might actually grow. Companies come up short and have to get money in the door, they issue shares, and that will hurt you. Like, you actually add to the total share count. Margin, again, with these really high margins already, is that going to grow from here? Gosh, I’ve been very wrong about the ability to keep growing that. But at some point, you got to run up against some ceiling of what corporate America is allowed to take in this whole system.
Then that leaves multiple. And you start off with a high multiple. I guess, you can go to a higher multiple, but how much of your return are you pulling forward with a high multiple already? Ah, it’s just doesn’t leave you real enthusiastic, does it?
Tobias: On that cheery note,-
Tobias: -we made it.
Jake: We made it.
Tobias: I don’t know what we’re doing next week, because JT and I are both at a conference. We got to figure it out. We may be broadcasting with a special guest from there, and we may just be off, but we’ll let everybody know.
Jake: Yeah, we’ll track somebody down and try to do the live session from there. We’ll see.
Tobias: All right, fella–
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