In their latest episode of the VALUE: After Hours Podcast Jake Taylor, Tobias Carlisle, and Kyle Mowery discuss:
- Value Investing in Industrials with a Growth Twist
- Everything Is Falling Off a Cliff!
- Higher Incomes, Lower House Prices, or Lower Interest Rates
- Unit Economics: The Root of Free Cash Flow and Quality Investing
- The Power of Compounding: How 13 Rabbits Became 10 Billion in 66 Years
- The Return of the Small Cap Value Cycle: Invest in Darwin’s Darlings
- The Risks of Commercial Real Estate Exposure for Banks
- Triple Threat to Businesses from Rising Interest Rates
- What Happens at the End of the Longest Yield Curve Inversion in History?
- Calumet Specialty Products: A Refining and Renewable Fuels Business with a Bright Future
- Is IWN Underperforming Because of Secular Trends or Cyclical Flows?
- The Challenges of Normalizing Business in the Post-COVID Era
- The Short Selling Game: Kyle’s Approach and Sizing Strategies
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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Transcript
Jake: First try.
Tobias: Hey. This meeting is being livestreamed. It’s Value: After Hours. I’m Tobias Carlisle. I’ll joined, as always, by Jake Taylor. Special guest today is Kyle Mowery of Grizzly Rock Capital. He’s the PM. We’re going to find out what he does right now. Hey, Kyle, how are you?
Kyle: I’m great. Yeah.
Jake: [laughs] Segue.
Tobias: Amazing.
Kyle: I’m right in. Yeah, appreciate the time. Long time listener, first time caller, back to the radio days.
Tobias: Yeah. Welcome.
Kyle: Thanks.
Jake: Welcome back.
Tobias: So, tell us a little bit about you and Grizzly Rock. What’s the philosophy? What’s the approach?
Kyle: Well, like yourselves, I was afflicted with the value bug.
Jake: [crosstalk]
Kyle: Yes. And then, I managed to start a firm that focuses on value investing, when value as a factor stopped working.
Tobias: You did. Welcome to the club support group.
Jake: Yeah. [laughs] To the support group.
Kyle: Yes, exactly. At least, yeah, this is a safe space. Yeah, we’re fundamental investors focused on free cash flow. Unit economics died in– I hate know compare. I would never compare us to Buffett, Munger, but in that train of thought, single stock analysis. Our strategy is long-short, but you make more of your money on the long side over time because markets go up, except this fall. Yeah. No single name small cap focused generalist. We do a lot industrials, materials, consumer. We’re generalists, but we have to be able to understand the business.
Jake: How did long-short work out last year for you?
Kyle: Pretty good, obviously. I wish I could get into performance, but I can’t.
Jake: Sure.
Kyle: Let me say it this way. We’re in year 12, so we’re still around.
[laughter]Tobias: Hey, surviving is 100% of the game.
Jake: Yeah. The other half is putting up good return. [laughs]
Tobias: I’ve never seen that. I don’t know what that’s like.
Kyle: I invest a lot in the value game or in the value circles, like, why do you short? If you’re going to make most of your money long over time, why short? And the answer is staying power. It gives you the cash to invest when things are really cheap. Now, you can do staying power a lot of different ways. Berkshire is the best example because there’s cash that comes in every day. But how do you have that or how do you develop that if you’re running your own portfolio or some version of staying power, if you’re long only got to have really good clients? That’s a great way of having staying power. But sometimes, things change, especially in the institutional world. So, staying power and putting points on the board is the answer of why I’m sacrilegious and an evil short seller.
Tobias: Talk to us about the shorts. How do you size? How do you identify shorts and so on?
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The Short Selling Game: Kyle’s Approach and Sizing Strategies
Kyle: Yeah. Well, I wish it was as easy as inverting a long process, but it’s not because it’s very easy to find an overvalued security. It’s very hard to find an overvalued security that’s actually going to trade down on the time frame that you think or trade down without trading up a whole bunch more and you having to take that loss from a risk management perspective. So, it’s all about finding catalytic paths really on the long side and the short side, but catalytic path on the short side is usually numbers. The numbers are going to miss the street expectations over the next one quarter to three quarters, much shorter-term. You got to trade it. You got to be willing to trade it actively to put the points on the board and are people going to care.
Your last episode, last week, you’re talking about some of these meme stocks. It doesn’t matter if you trade on fund if you, the short sellers, trading on fundamentals of people are not. A lot of really smart short sellers are out of business, as you covered well last week. But with respect to what we do, when we saw that, we just got out of anything that was related to meme. So, a lot of our shorts are very boring businesses. COVID over earners were really good for us because it was pretty obvious that, “Hey, look, from an economic perspective, COVID is over, the street is extrapolating it, and you can just go and steady the business, steady the industry, and have a sense that numbers were going to miss, and then try and make 30%, 40%, and move on to the next.” So, it’s very much an 80:20 game on the short side and being willing to trade it, as opposed to the longs, where you can have a multi bag.
Tobias: How do you size?
Kyle: Smaller than we used to.
Jake: [laughs]
Kyle: When I got into the business, we used to do 20 shorts, like, point, point and a half. Now we’re more like 40 shorts, 45 shorts, 50 basis points to 150 basis points. So, if you get them right, yeah, it’s nice. Puts points on the board. But if you get them wrong, then you’re not sitting there taking a ton of pain and having to cover based on a squeeze.
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Tobias: Let me give a shoutout to the crew. Santo Domingo, Dominican Republic. What’s up? Toronto. Gulf of Mexico, welcome back. Bangalore. Petah Tikva, Israel. Good for you. Filthadelphia in the house. Lewes, Delaware. Antigonish, Canada. Norberg, Sweden. Essex. Stirling, Scotland. What’s up? North Miami. Kennesaw, Georgia. Perth, Australia. Good for you, Stuey. Early stuff for you. Utah, Cardiff. Winter Park. “Toronto. Value never stopped working.” It’s just sleeping for a little bit. Mérida, México.
Jake: [laughs]
Tobias: [crosstalk]
Jake: Took a little performance nap. [laughs]
Tobias: Edinburgh. Vestavia. Bakken oilfield in Canada. What’s up? [crosstalk]
Jake: Oh, worldwide.
Tobias: Worldwide. Nashville. I got a shoutout before that I was going to try and read. Did anybody click on that name, see how hard that name was to say? This is it. Llanfairpwllgwyngyllgogerychwyrndrobwllllantysiliogogogoch. That’s in Wales. That’s one name.
Jake: [laughs]
Tobias: Welcome. I’m sweating profusely have to say that.
Jake: [laughs] Oh.
Tobias: So, Kyle, talk to us about the longs. You like industrials. What’s the attraction of industrials?
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Value Investing in Industrials with a Growth Twist
Kyle: Well, in this business, you often end up in things that just make the most sense to. Actually, if you look geographically on the country, a lot of financials in New York, tech out west, oil down in Houston. But I live in Chicago, transplant from LA-ish. Yeah, I just started doing industrials. It’s funny, you can get a lot of cheap prices of businesses that are, either cyclical or steady-ish and you can just understand where you are in a cycle or understand what the earnings power of the business is. And yet, there’s a lot of these businesses that are being overlooked and they have latent and growing free cash flow profiles because of new product innovation.
There’s a lot of innovation actually in the energy sector. Materials on decarbonized products or environmentally friendly products or just different ice to EV transition. There’s a lot of things to do there that fit our time profile, which is one year to three years, two years to four years on the longer-term. So, where you can study the unit economics and buy what looks like a value business, but it also has this sort of growth engine underneath the hood, and that’s a good way to get a re-rating.
Jake: So, you have an existing cash flow business inside and then also a higher upside internal?
Kyle: Yeah. Or, you can underwrite 40% to 50% higher EBITDA out two years, but you’re paying a traditional value multiple, five times, six times EBITDA, and maybe 10% to 15% free cash flow yields, net of growth CAPEX. That’s a pretty good set up, even when IWM just goes down 30% in two years.
[laughter]Jake: Yeah. Right. Just goes one way. [laughs]
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Tobias: I looked at IWM and then I pulled up IWN this morning. Gee, there’s some pain there. IWN is pretty close to its five-year, like, zero return for five years. So, it’s looking a little bit like Ark in that respect. It’s tough out there. Why do you think they’re undiscovered in industrials? Why do you think you get those profiles? Because that sounds pretty attractive. Reasonable growth, reasonable multiple.
Kyle: It is attractive today, but because of all the things that we all know, the fund flows just aren’t there. There’s not many small cap focused managers anymore. If they are, they tend to have gravitated towards tech, because that’s put the points on the board. In the end, return and relative return are all that matters in this business, absolute return being number one. So, I understand why a lot of folks have gone in that direction, but then a lot of those folks have gotten hit last year, then it’s not really coming back.
So, I think there’s just a lack of appetite in terms of some of these underfalled boring businesses. But I think that now that capital has a cost and these businesses are generating cash, I don’t know when there’s going to be the right time, but there should be a time in the next handful of years where there’s some very, very nice returns out of these companies, because they’re real businesses, they’re not going away and they’re priced with extremely high free cash flow yields.
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The Challenges of Normalizing Business in the Post-COVID Era
Jake: Are you seeing onshoring or friendshoring, all that kind of stuff showing up in the numbers?
Kyle: Yeah, for sure, definitely. It’s coming in chunky fashion now. It’s like, “Oh, this facility comes up or it is how things are being routed.” Yes, and it takes time. I think it takes a lot longer than we all realized. I was just starting to invest professionally in what’s the China price like going offshore back, what, 15 years, 20 years ago. Now it’s coming back. It takes time. There’s issues with supply chains, and a lot of these supply chains have gone bump for, either COVID or inflation or timing or demand. It’s been a really unusual cycle post COVID because of these changes. So, I don’t know, Jake, what are you seeing on that?
Jake: I just see a lot of difficulty in trying to normalize most businesses and arrive at a reasonable number. There’s just been such booms, busts shortages, prices moving around, prices not coming down, some prices not coming down. It’s like trying to put like– I don’t know how far back you have to look to find normal again. Maybe there is no–
Tobias: Well, I was going to say that. You’re reaching back past like 2020 in 2023. That’s three or four years. Even 2019 was a little bit of an unusual year. I felt like it was more end cycle. Yeah, it’s a very hard period where you’re looking back beyond that to get a normalized, whatever that means.
Kyle: Yeah, that’s for sure.
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Is IWN Underperforming Because of Secular Trends or Cyclical Flows?
Tobias: What do you think is the reason for the weakness in IWN? Do you subscribe to that flows going to? Is that a secular that’s just going to go on forever, that’s everybody’s set up that way the bigger companies are always going to get the flows? Or, is that a cyclical thing where they’ve been doing well, so they’ve been getting flows, and if we get a reversal and the flows will follow that too?
Kyle: I think it’s a little bit of both. Now, as a small cap manager, clearly hoping that small caps ever get flows again. But let’s be honest. Some of the Mag Seven are some of the best business profiles on the planet. We can compare it to NIFTY 50 and say, “Oh, those were good businesses too.” Yeah, but you’re Google and Facebook, you basically define the advertising market. If people have product or service to sell, they’re going to go there and it’s going to be for a while. So, they are extremely high-quality businesses, and there is staying power, and that’s why they’ve been growing the way that they have.
I don’t play in large caps, so I don’t have a lot of very specific answers. But in small caps, whether it’s underinvestment in a certain that Bob Robotti’s style of underinvestment in a certain industry for a long time, or things like The Inflation Reduction Act, which are dramatically impacting how a lot of energy transportation is procured in this country. And that affects a whole bunch of different things. So, there are a lot of changes that should be attracting capital, and I would like to think that it’s coming. The capital usually comes later than the early performance. So, hopefully, we’ll be selling some of the things we’re currently in a couple of years down the road to folks that see, are they continued growth. But that’s always the way of it for stock pickers now.
Jake: Are the companies doing buybacks? Are they turning these low multiples into earnings yields?
Kyle: Yes. I would say the majority of our top positions are doing buybacks. The ones that aren’t have a lot of financial leverage. Anything with a lot of financial leverage, as you both well know, has gotten absolutely hammered this year. But there’s names that have fixed in their interest costs, and they know exactly what it is. You can run the math, and you can understand interest costs, and where the industry is, and you can see a line of sight to reasonable leverage. I actually grew up before– I went to business school and started the fund, I was in high yield, so I have done more. I was in high yield during the [unintelligible [00:15:18], so that was exciting.
Jake: That’s fun.
Kyle: Maybe another reason I’m an evil short seller half the time now.
Jake: [laughs]
Kyle: [laughs]
Jake: Looking for [crosstalk] things.
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Tobias: When you look at the high yield landscape, what do you see now? Are you a subscriber to this? There’s a credit event coming?
Kyle: Credit event? Well, I don’t know. Credit spreads haven’t blown out. Credit is still available. This will probably get some of my friends throwing things at me.
Tobias: Yeah. Let’s go.
Kyle: But if you didn’t read the last Marks note, it actually is worthwhile reading. I’ve read most of what Marks has written over his career, but a lot of it’s been similar in nature. This note was basically like, “Look, if you could make 10% in high yield, just go make 10% in high yield implicitly. Don’t mess with private equity in a rising rate environment. Don’t mess with equities in a rising rate environment.” I told some of my clients, I’m like, “Yeah, he’s not wrong.” If you can make 5% on a two year, or you can make its 10%– [crosstalk]
Tobias: 5% of the 10-year.
Kyle: Yeah. Well, yeah, almost. Yeah, I don’t know where it is today.
Jake: Or, not.
Tobias: It was 5% last week, but it’s right there. [crosstalk]
Kyle: Yeah. That’s a real return, if you have a piece of– 60:40 has gotten slaughtered two years in a row now. But at some point, the strategy makes sense. But anyway, yeah, what’s the demanded risk profile for an equity, if you can make 10, 11 in high yield? It’s obviously higher than that.
Jake: It’s not 3%. Like, the S&P right now is an earnings yield, right?
Kyle: Yeah.
Jake: Somebody’s offsides. I’m not sure which one. [chuckles]
Kyle: Yeah. So, in small caps, look, 24 numbers are going to come way down, r small caps are going to go way up. A lot of these companies, the price and the earnings profile in 24 are not analogous to one another. So, small caps are telling you we’re going into recession. They’re down, what, 17% in two months? 17 odd percent in two months, three months. I don’t have the exact numbers, but it’s a significant amount. It’s clearly signaling the recession is either imminent or not. Toby, you’re the expert on a 10:3 and whatnot.
Jake: [laughs] Yeah, give us an update.
Tobias: I don’t know, if you can be an expert on the 10:3, but I watch it enough.
Jake: Cam Harvey begs to differ, sir.
Tobias: [chuckles] Yeah. Cam’s an expert. Cam’s the expert. I look at the same thing that everybody else looks at, and it says to me that when there’s an inversion pretty quickly after there’s a recession, and there’s no recessions that I can see without a preexisting, without an inversion beforehand. The length of time from the inversion to the declaration of the recession is 12 months on average, which is like that’s tomorrow.
Jake: The call is coming from inside the house.
[laughter]===
What Happens at the End of the Longest Yield Curve Inversion in History?
Tobias: But this is the longest inversion in the data, and that’s likely because COVID required a lot of liquidity, fiscal and monetary. And so, to suck that liquidity back out, they’ve put interest rates up faster than they ever have before. We don’t really know what happens at the end of that. I think the yield curve inversion always sounds very technical to people who– It sounds like I’m discussing the bearish harami or something like that, but really all it is just the Fed. The Fed influences the short end of the rates, and the whole curve has come up now. So, they call that a bear steepener.
I had to look that up the other day. I didn’t know what that was, but a bear steepener is when the later dated yields come up rather than the front curve coming down. And so, people want to distinguish a bear steepener from a bull steepener, I guess, when the front comes down. But there’s no indication in the data that makes any difference whatsoever. So, I don’t know, if that makes a difference or not. We’re going to find out is my view on it. I think there’s a pretty strong correlation.
The logic makes a lot of sense to me, but I don’t think it’s like a certainty once it happens. But I’m watching because I want to see. I want to know what happens here along with everybody else. It’s like that there’s this joke that– this guy goes in to get his trucking license and the guy gives him these increasingly ludicrous scenarios where inevitably it ends in a crash, and the guy manages to get around all of them and finally gives him this one, “You’re on a cliff, sheer cliff to your left, cliff wall to your right. There’s two trucks coming out of the way. What are you doing?” He says, “I wake up my brother, Luigi, because he’s never seen a really good crash before.” And that’s how I feel. I’m at the point where I’m just watching and waiting to see what happens. I don’t know, if it’s going to happen, but it seems like there’s this inevitability to this thing.
Jake: Am I Luigi in this scenario?
[laughter]Tobias: I’ll wake you up, brother. Don’t worry. I’ll let you know.
Jake: Oh, no.
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Everything Is Falling Off a Cliff!
Tobias: Everything I look at, every single data series that I look at, it looks like it’s falling off a cliff. IWM, I’m less interested in– That’s the market’s interpretation of what’s going to happen. Although, there’s a lot of weakness in those IW– All the underlying of the IWM, they’re all carrying a lot of debt, they’re cyclical, they’re looking weak. Like, the prices coming down there don’t surprise me really coming into this. Where are you going to hide? Magnificent Seven are fully valued rich to fully valued the rest of the market. Somebody tweeted out yesterday that, “If you back out the Magnificent Seven out of the 3,000, you got 2,993 stocks that are down.” It’s not quite as dire as that, but it’s pretty close. It’s like 86% of stocks are down on that top 3,000.
Jake: Wow.
Tobias: Something like that. There’s 14% that are up that are carrying the whole market.
Jake: Year to date.
Tobias: I think that’s year to date. Yeah.
Jake: Okay. That’s impressive. That is not much breadth, is it?
Tobias: But we are then close to the bottom of it. Not close to the bottom of a drawdown, but we’ve been drawing down quite a lot. Like, we’re coming up on where we were about 12 months ago in October last year, which was the low for the last 12 months. So, I don’t know. Fear & Greed gets to extreme fear, which becomes like a short-term bounce because everything’s oversold, whatever that means. Or, you blast through it and you get a 2007, 2008, 2009 type scenario. But I don’t know. I’m not predicting anything. I’m just looking at this stuff.
Tobias: The other side of the coin, Bill Wabuffo would say, “The consumer looks really good. The inflation reduction act is massively stimulatory.” Those deficits are gigantic. The deficits that we’re running now look like 2009 at the very bottom.
Kyle: Yeah.
Tobias: That clearly has to show up. When you back out the government stimulus, the economy is on pretty shaky legs, where is I don’t know what happens if you actually take that out. It looks pretty nasty.
Kyle: But the 24 numbers, they’ve come down a lot for many of the businesses we track, but they haven’t come down nearly as much as the price. It’s a really interesting world.
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Triple Threat to Businesses from Rising Interest Rates
Jake: That Marks piece, he asked like, “What’s the most significant financial event in your career, basically?” People say like Lehman or GFC more generally, typically, but he says that it’s a 2,000 basis point decrease interest rates from 1980 to 2020. That’s like, “Damn, that’s a big movement.” It’s a lot. [chuckles]
Tobias: There wouldn’t be many people invested- [crosstalk]
Jake: It’s a different world.
Tobias: -pre-1980 left in the markets.
Jake: No. That’s his point is that, no one’s really seen interest rates going the other direction.
Tobias: Do you think it helps though to have seen that? What are you going to learn from interest rates going up? Every year, everything’s cheaper than it was the year before.
Kyle: Toby, the thing that I’m struggling most with and I’d love, Jake, your opinion on this too is the time that it takes the interest rates to roll through. For us, we pop it in a spreadsheet and call it good. But for these companies, they’re struggling with it and they’re working through the post-COVID phase, but they’re also making decisions day by day, week by week, month by month, and the cost of capital just keeps creeping up. It feels like this rolling slowdown. It’s slower than I probably would have guessed. That’s what I would ask someone who was managing money back then. Jake, what do you think?
Jake: Yeah. I think it’s a little bit of that like a boiling pot. If you’re watching it, it never seems to boil. The interest rates take a long time to penetrate into every nook and cranny of the economy, but I think eventually they do. I think you’re right. If you’re watching it every day, it’s really hard to see the little changes. But over a broader swath of time, I think they clearly happen. I think there’s also some nonlinearities there where it looks like nothing and then all of a sudden, it’s like, “Holy shit, how’d that get so big?”
Tobias: It hits three parts of the framework. It makes it multiples come down. If interest rates go up, multiples come down. That’s just the gravity of that’s what happens. When interest rates go up– [crosstalk]
Jake: Limiting belief.
[laughter]Tobias: There you go. That’s been what’s holding you back. Then, it makes financing the business more difficult because there’s plenty of charts going around. Small businesses are financing at 10% rates. We haven’t seen that since 2007. But clearly, before then they financed at higher rates and there wasn’t always a giant crash in there. That’s worth noting that 10% for small businesses is tough.
Jake: They’re the only ones who have seen interest rate expense increase so far.
Tobias: So far. And then there’s the customer who finances big enough, whatever that thing might be. A lot of customers finance the things that they buy. It’s a big difference from a 0% world to a 10% world. Well, that’s just the marginal sale doesn’t happen.
Jake: Yeah.
Tobias: So, that’s three key parts of the business. The multiple that you pay for lower earnings that are supported by more expensive capital. To me, that says that there’s a lot of compression that should happen, but we’re seeing it in IWM. We’re not seeing it in– And maybe that doesn’t apply to the Magnificent Seven. Maybe they don’t confront those problems because they are much– [crosstalk]
Jake: They don’t require much capital.
Tobias: Yeah, don’t require much capital. Customers basically paying tens of dollars a month to access their stuff. Yeah, the multiples, they trade on maybe a free cash flow multiple that’s close to the risk free rate, something like that. They’re still above that though.
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Kyle: Yeah. One of the things that’s been interesting to me in this whole sell off this fall is that the VIX hasn’t spiked.
Tobias: The VIX has just stopped working.
Jake: [laughs]
Kyle: Yeah. Death by 1,000 cuts rather than one fell swoop, because we all know how to trade the fell swoop.
Tobias: Yeah.
Jake: But this slow-motion kind of thing, it’s a lot harder. When do you be aggressive? That’s what we’ve been talking around about inside our shop. Like, “When do you be aggressive?” Haven’t really started to deploy cash. We have cash. We have investments that we really like, and we have a long list of prospective investments we really like. But it’s like, “Well, if we just wait, it’s 2% cheaper tomorrow. So, let’s just be patient.”
Tobias: The things that get cheap are a little bit impaired. That’s what I’ve noticed. The things that get cheap do have real questions about what they look like over the next few years for the reasons that I just listed, like, higher rates impact the customer. So, now you got to work out what’s the customer going to do with slightly impacted rates. I guess, you should just be creeping a little bit longer all the time rather than on-off. I think that’s the mistake that I’ve made in the past.
Jake: I think setting an absolute return hurdle for what you expect is a good way to mitigate some of this timing risk. I think that’s what Berkshire does. If he’s pretty certain, he’s going to get a 10% yield on it, then he’s not really going to ask too many other macro questions before pulling the trigger.
Kyle: Yeah.
Jake: That’s probably smart.
Kyle: You just have to be honest about your time frame.
Jake: Yeah, that’s true. Because you can be really wrong [laughs] in the interim, right?
Kyle: Yeah.
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The Risks of Commercial Real Estate Exposure for Banks
Tobias: It’s funny to see the impact of these higher rates on some of the—So, the banks. Bank of America has this $130 billion hole in its balance sheet that– It doesn’t mean they’re insolvent. It doesn’t mean nothing’s going to happen. All of those securities are held to maturity, so it doesn’t create an issue for them other than it’s a hole that has to be filled in as you go along.
Jake: There’s no issue as long as the asset side never requires the liquidation of the liability side, which is probably a–
Tobias: I think they said they can flip it to the Fed at par. I think the Fed has said, “You can do that.” I think that’s the truth.
Jake: I think that is the truth, actually. It’s a good gig if you can get into it.
Tobias: Yeah, it is. I slightly forget why I was saying that. What was the last thing we talked–?
Jake: [laughs] Sorry.
Kyle: Banks are funny, right? So, banks, it’s so easy to think about them in a broad swath. So, take small caps. So, KRE, everybody knows, is down, what, 35%. And on the region’s call, Friday, I think it was Friday, it was last week, they’re talking about rolling commercial real estate issues, NIM contraction, and they had some fraudulent checks, which is pretty funny that here management try and talk their way out of how they let check fraud happen in 2023.
But I’m not a regions investor. I listened to the call just as a proxy for some of these commercial real estate exposed banks. But there’s other banks, say, take Pathward Financial. Basically, it’s like half a payments business, half a commercial bank. But they don’t have any real estate exposure. Their average loan is repriced every four years. So, you’re going to quickly get your NIMs back up to where they should be. Oh, and by the way, because of their payments business, they fund debit cards. So, if you’re sporting goods with a holiday card or your Walmart, you want to pay your associates who are non-banked, how do you pay them? With a debit card. The cost of funds is zero there. So, there are interesting rifle shot approaches on the banking side where you don’t have to take these giant commercial real estate exposures, but it sure seems like a slow-motion car crash to me. It might be too small for a lot of the shorts. Excuse me, too slow for many of these shorts to actually work– [crosstalk]
Tobias: Gradual dependence and then suddenly-
Kyle: Yeah.
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Tobias: -is probably what happens with all this stuff. Yeah. I do remember, the point of the Bank of America thing was that and just on the 10% hurdle rate, part of the challenge is it wasn’t that long ago that we were all seriously arguing whether the US would go into negative rates, because the rest of the world was negative rates. Rest of the developed world was negative. It seemed– [crosstalk]
Jake: it seemed like the next spot. The most likely next destination, right?
Tobias: We talked about that quite a few times, like, what happens if when rates go negative, like, what’s the correct multiple for a stock in a negative rate? Well, it should be like infinite or it’s riff.
Jake: Infinite.
Tobias: I don’t know.
Jake: Yeah. [laughs] [crosstalk]
Tobias: So, you can forgive some of these banks, SVB, FRC, and Bank of America that they looked at those like the two-year getting some yield on the two-year and said, “Well, that’s better than negative, and rates are going negative. So, if you hold that, that doesn’t make that much sense.” And then all of a sudden, we’ve decided that it’s a 5% world, and they’ve all been caught, and that’s where they’ve all been hurt. There are these bank charts that do the rounds that show how much all of those banks have lost. It’s extraordinary. It’s more than they’ve ever lost at any point in time, going back in the data, which I don’t know how far back it goes, like, to 1980 or something like that.
Jake: No big deal.
Tobias: I don’t know what the impact of that is. Is 10% your absolute return in that world with negative rates? It starts sounding a little bit like that the conversation that we had about Gotham saying we’re in the 95th percentile of cheapness for value. Are you waiting for the 99th percentile? Are you going to get here at 95? Is 10% just being too much of a hold up? It turns out, no, that was the right thing to do. But I think some of these decisions are hard to make.
Jake: Buffett’s talked about this in the meeting when rates were super, super low, and he was saying that like, “Yeah, it would probably be justified to go below our internal 10%, but we just don’t feel comfortable doing that, so we’re not going to do it and we’ll just sit out.” But I think he’s saying mathematically, it would make sense given where the world is. If rates continue to go lower, then that especially would make sense. But then I think he also probably– But they also have said like, “We’re as surprised as anybody to see where rates have gone. We never would have predicted that. So, don’t put much stock into what we say about where rates are going from here.”
Tobias: It might not be over. You got to hike a little bit, so you’ve got some headroom when you get a little bit of weakness, so you can cut into the weakness.
Jake: What if we did go negative after this? Would it surprise you?
Tobias: Did Japan go negative? Obviously, it must have been negative at some point, right?
Jake: I think so.
===
Higher Incomes, Lower House Prices, or Lower Interest Rates
Tobias: I think it’s bad for society. It’s bad for business, but it’s also bad for society. I think there are a lot of markets around that have got this same quite– not quite, but characteristics. The housing market is one example where housing is on record unaffordability, because you have house prices that haven’t quite got the message that rates are up, because everybody expects rates to go back down. And so, either incomes have got to go up 50%, house prices come down 35%, or rates go back down to 2% or something like that.
I think, Kyle, you said something like that similar in relation to those small caps. It just doesn’t make sense to have the prices where they are and the fundamentals where they are. At some point, there has to be this equalization, but you got to work out which side moves. I think it is prices tend to be the easiest thing to move. But who knows? What do you think?
Kyle: Well, housing, I am surprised that prices are where they are and we’ve quite frankly been avoiding most of the housing sector, because it’s a little bit in the too hard pile for us. But there’s smart people on both sides of that one. There’s a lot of millennials and Zs that are trying to build households. There’s not that many houses out there. It’s not much land being, at least where I live, certainly down south and whatnot out west, mountain west or whatnot. But I don’t know. Too hard.
Tobias: There’s short-term rentals impacting that market, I think, a little bit. I follow some of the housing bears. They seem to think that there’s a lot of that short-term rental like Airbnb and so on is influencing that market. A lot of people have been using those. That’s not a bad small business. You put up some hundreds of thousands of dollars, get control of something, and run it as a little business that throws off some money. But it requires that you get the bookings, which–
Jake: Yeah. [chuckles]
===
Tobias: In a work from home world, there’s a lot of them, but fewer in a– If you’ve got to go back to the office– What about return to office? Is that impacting any of the industrials? Are they getting everybody back in?
Jake: I don’t think they left. [laughs]
Kyle: No. Yeah. No. Downtown Chicago is an absolute zoo on Tuesdays and Mondays. It’s like a ghost town. It’s pretty funny, actually.
Jake: Is that right?
Tobias: Everybody’s back in the office on Tuesdays?
Kyle: Yeah, it’s bananas. I ride the metro, the large suburban train. I ride it all at one stop. But today, it was standing room only. Yesterday, there was no one on there. Yeah, it’s definitely bifurcated. I don’t know how that doesn’t hurt commercial real estate over time. But when? I don’t know. When is the question on that one.
Tobias: The figures in office just seem to me to be apocalyptic. It’s like 50% occupied. And the 50% that is occupied, they’ve all got– It’s old leases where those are half occupied or a quarter occupied. So, they’re all going to be cutting space.
Jake: Desperate to get out of it, kind of. [chuckles]
Tobias: The buildings are all indebted. So, it seems to me like there’s going to be some office impairment at some point, or they get turned into some other– Maybe they get turned into residential, but evidently, that’s pretty hard to do too.
Jake: We’ll fix it over time. I just don’t know if it’s the same owners will be the ones that have the assets at the end of the day.
===
Calumet Specialty Products: A Refining and Renewable Fuels Business with a Bright Future
Tobias: Yeah. So, what’s undervalued? What’s exciting? What’s interesting?
Kyle: Well, the things that we’re focused on, I think just broadly speaking, are these businesses that trade at value prices but have growth elements in them. I’ll just give you one. It’s a bit of a small cap hedge fund hotel. It’s Calumet Specialty Products. So, half the business is down south. They make refined fuels, refined waxes and oils, like, very, very classic industrial. They call it specialty half specialty, half commodity, probably at best. But that’s a seven times multiple business. These refineries, there is a reason for these products to be used, et cetera.
But then the other half of the business up in Montana, they have this old heavy oil refinery that they’ve flipped to making renewable diesel and sustainable aviation fuel. And sustainable aviation fuel back to what we were talking about with the IRA or what not, this is a geographically focused market that can easily access anywhere near the Puget Sound. So, sustainable aviation fuel is going from Montana into Portland, Seattle, and Vancouver, and at really, really good rates in terms of unit economics and profit.
So, this business, long story. I’ll spare you the backstory in terms of there’s a family involved. It was 10 times levered. There was a whole bunch of different financing options. But this summer, the company finished the renewable diesel and SAF transition in Montana, and they flipped this business on its performing to spec, and it’s four times levered. You had the IRA come in, there’s other states that are putting SAF credits on top of what the Feds have put out. So, you have a reasonable sense for what the unit economics of a gallon of sustainable aviation fuel is. You have an offtake with shell.
Actually, today, Calumet at Great Falls, Montana is the largest volume producer in North America of SAP. So, you have this business. It’s levered. Yes, it’s still levered 4 times, but it’s now levered 10times, and now it’s going down because of cash generation and free cash flow. Management is actually trying to monetize it, which is why it’s catalytic in the relatively near term. So, you talk about a business, you put a 10-ish multiple on that business. Management would argue 12 to 16, but if you put a 10 on that business, you’re basically putting– It’s up and producing, but they’re going to essentially double the capacity. So, now you’re closer to $400 million of EBITDA there. Put a 10 on that, that stock gets you to in and around $35 to $40 a share. It’s a unit. It’s actually an LP. It’s an MLP, which they may or may not address also.
So, talking $40 of potential value with a reasonable multiple on line of sight on volumes and unit economics that are well known. The stock is at $16 today. So, this is the type of thing that it’s cheap, it’s free cash flowing, and it has a catalytic path to something that’s going a lot higher. That’s one example. But it’s endemic of what we’re looking for, things that control their own destiny, either buying back stock or expanding EBITDA considerably through the use of technology or growth CAPEX.
Tobias: What’s the ticker?
Kyle: CLMT? It’s an MLP, which is the wrong structure. They actually lit a whole bunch of capital on fire by overinvesting, which is funny. They spent all this money at Great Falls for this giant facility, and that was the reason that the marginal economics to flip to RD and SAP were so good because they had a lot of capital already in place. So, if you run the math, like, if you take the math that the company is giving you, it seems too good to be true, but that’s incremental capital. They’re not counting all the capital that already is in the ground that they converted from fossil cracking to what’s called lipid hydrogenation. They’re cracking fats and oils and you’re making fuel. That’s what it is.
Tobias: Nice one. What’s the reason for the MLP structure? It was a [crosstalk] vehicle for–? [crosstalk]
Kyle: Legacy– Yeah, it’s legacy family.
Tobias: Yeah.
Kyle: The family that’s behind this actually just sold Heritage Crystal Clean. I don’t know if you know that. It’s like a little industrial Midwestern like parts cleaning business. Good business, somewhat cyclical with margins, but pretty easy to– Well, now it’s gone from the market. But it used to be easy to trade because you could have a sense for– It was a classic margin reversion to the mean story. So, you could trade it long, trade it short at the right times in the cycle. But it’s gone. It’s out of the markets. And so, the rumor is that the family may or may not be out of public markets in aggregate. They’ve had bankers in on Calumet for a long time. There’s a couple really well-respected bulls in this story. Not me. I’m hoping to jump on for a bit of a ride here.
Jeremy Raper knows it well. He’s a pretty smart guy. Ryan O’Connor, my friend at Crossroads, knows it well. The biggest knock on that one, probably, is that it’s a small cap hedge fund hotel, which I usually try to avoid. But this one, the catalytic path was so interesting that it caught our eye.
Tobias: How hard is it to de-MLP?
Kyle: It’s doable. It’s just a matter, of does the family want to pay the tax?
Tobias: Oh, there’s a tax impact. Okay.
Kyle: Yeah. But if you think about what’s going on in sustainable aviation fuel and the oil majors, the oil majors all know it’s coming. Most of the oil majors were late to renewable diesel. There’s really only Valero. So, now that SAP is up in terms of the policy is more or less set with respect to the subsidies in the US, the line of sight to how the fuel is going to be created is still– I won’t bore you with the details, but there’s a path that works, for sure, and that’s the fats and oils refining them the way that renewable diesel is being done now. But there’s a bunch of other paths. So, the oil majors are sniffing around, and I would be surprised, if it’s not a consolidating industry. Oil and gas is a consolidating industry. Just even yesterday with the Hess steel, Chevron and Hess, you’re seeing consolidation. These guys, I think it’s coming in the SAP world too.
Tobias: Yeah, I was going to mention that earlier. I had seen a little bit of that. JT, we should do your veggies before we are up against time.
===
The Power of Compounding: How 13 Rabbits Became 10 Billion in 66 Years
Jake: Yeah. Toby, I’m going to need your help on this one because it has some Australian– You tell me your lived experience of this. The goal of this veggie segment is to try to get at a real lesson in compounding and help build some intuition around it. It’s a concept that were, I think we all understand, but at a deeper level. It’s actually very difficult to understand. I think humans in general are pretty terrible at it.
So, our story starts in 1859. There’s this wealthy settler named Thomas Austin living in Victoria, Australia. He had 13 European wild rabbits sent to him across the world. Naturally, he let the rabbits roam around free on his estate. It doesn’t seem like much, but this little act set in motion a chain reaction that impacted an entire continent, mostly in a negative way.
So, five years later, after 1859, there’s a little over 100 rabbits at that point, no big deal. 10 years later, it’s still less than 500. Like, there’s hardly any cause for concern. You wouldn’t even notice that they’re there. 20 years later, 1879, they’re still less than 10,000 rabbits. Again, spread that out over the continent, you hardly would even see them. 35 years later, they’re still under a million. This is a non-issue. This is a relatively long time and it still seems like absolutely nothing is happening.
All right. As you guys know, rabbits are capable of producing, I think it’s four litters a year and two kits to five kits, which is what a baby rabbit is called, per litter on average. By 1904, we’re 45 years into this post event, and the rabbits, there’s 17 and a half million at that point. Okay. Well, now it’s starting to become something. By 1925, this is just 66 years later, there are 10 billion rabbits in Australia-
Tobias: [laughs]
Kyle: -and they’re wreaking havoc on local flora and fauna. They’re devastating crops. And so, Toby, do you want to inject here at this like, what growing up in Australia? Like, what was the sentiment around rabbits? What was happening when you think of rabbits in–?
Tobias: I think, to be fair, the problem had been solved by the time I was a kid. Not so much solved as in–
Jake: Mitigated.
Tobias: I know how the story ends. Yeah, it’s a well-known story in Australia that somebody introduced an invasive species, and it took over pretty quickly. Yeah. I don’t want to steal your punchline. But that’s a well-known story. Yeah.
Jake: So, 150 years, the Australian government has had these efforts to try to control the rabbit population, and that has included building fences. Like, apparently, there’s some giant fence in Western [crosstalk]
Tobias: Rabbit-proof fence.
Jake: Yeah, apparently. I don’t even know how you do that. But poisoning them, trapping them, shooting them, even releasing these flies that had this rabbit specific deadly virus in it– [crosstalk]
Tobias: Was that the myxomatosis?
Jake: Yeah.
Tobias: The myxomatosis wasn’t successful?
Jake: It was okay. The rabbits evolved to–
Tobias: The ones did survived, didn’t–
Jake: Yeah, they had restraint or they evolved to have whatever antibodies or whatever that kept them, they were resistant to it. Anyway, actually, what’s worked best, apparently, is that farmers will go and destroy the rabbit warrens, which are like these series of interconnecting tunnels that they live in. It takes away the rabbit’s safe place to breed and raise their young. And so, that puts pressure on that prolific breeding by taking away that warren.
Two big surprises for this that I think we should highlight. First is that, we understand that compounding produces these huge numbers. And to get to $10 billion is like, it’s just insane to think about over enough time. But it’s still surprising to go from 13 to 1 million rabbits in 35 years, and then basically double that and you go from 1 million to 10 billion. The second thing is, and this is probably more surprising is that, compounding is barely perceptible at first. And for a long time, it doesn’t look like anything is happening. It’s really hard to notice. And then it just comes on in these huge waves.
So, I think when we’re trying to compound our wealth, we’re trying to compound our knowledge, our relationships, it takes a long time to bear fruit. We have to be patient. It doesn’t look like anything’s happening for long periods. And then all of a sudden, everything happens at once. It just gets to this– You have to do that early, boring work toiling away to become that overnight success and have that deserved steepness of the curve later. Like, you have to put in the work. Anyway, there’s hopefully adds a little bit of more intuition around compounding by thinking about Australia’s example with rabbits.
Tobias: Should have named the fund after rabbit, whatever that rabbit was.
Jake: [laughs] Yeah. Prolific.
===
Unit Economics: The Root of Free Cash Flow and Quality Investing
Tobias: How long have you been in business for, Kyle?
Kyle: This is year 12.
Tobias: You say you launched right at the peak of the– Yeah. So, what’s year 12? 2011?
Kyle: Well, I just launched when I graduated business school. It was I didn’t try and time. I timed the entrepreneurial risk rather than the value cycle.
Tobias: How have you found it investing through what’s been a pretty–? You’ve had a headwind anyway, not to say that you couldn’t have outperformed, but you’ve had a headwind.
Kyle: Definite headwind. I think that unit economics is the root of free cash flow, and I think unit economics took me a while to get there, but willing to take some duration. When you’re looking at a business, really great business, out a couple of years, I think so many value guys, they get into the game. You’re trying to find a net-net, and then you’re trying to find a classic value cheap on free cash flow, cheap on earnings. I don’t think I’ve gone as far as down the quality spectrum as many, especially those who have grown their businesses a lot in the last five years, six years. But I do think with the focus on unit economics, you do pick up a little bit more of the quality factor. As we all continue to try and grow and improve our skills throughout our careers, it’s been helpful. It hasn’t been panacea or silver bullet, but it’s certainly been helpful to get, so you’re not completely fighting tech or quality.
Jake: I, sometimes, wonder from an evolution process of markets and what’s worked and the winnowing of– The more that you leaned quality as a “value guy,” you got to make it to the next round evolutionarily. It makes me wonder then, “Okay, if everyone who’s survived is quality, does that leave the opportunity then back to the guy who’s looking for back to price to book?” [laughs] We’re back to the old days again.
Kyle: I’m incentivized to say yes, because that’s the business I’m running. I have a friend. He does smaller things and hairier things than I do. He dubbed it The Last of the Mohicans. He’s like, “There’s only a handful of shops that even look at the way–” If I said replacement cost to a professional allocator now, many would just look at me funny where when I got in the business replacement cost. That’s a very standard value investing like, “What’s the replacement cost?” I literally had a client tell me that he never wanted me to say that word again about five years ago.
===
Tobias: It’s a downside measure, right? Anybody who’s been looking at the downside, you’ve been looking the wrong way. It’s been an upside market.
Jake: Yes, but if you do it right, you’re still compounding. You’re just not compounding at Mag Seven rates.
Tobias: JT talked about it a few weeks ago. There are two variables that you can hit in the future value one plus R to the N. You can either hit the R, get the R, pump that R right up, or you can focus on the N. You can make that N as big as you possibly can. To lead on from the rabbits, it’s the last few years of compounding that really make a big difference. The longer you can hang in there, the better you can do. But that is more of an adverse selection approach, isn’t it? You’ve got to be surviving each period rather than necessarily winning in each period.
Jake: We just did another segment on type one versus type two errors. God, it’s like it all fits together.
[laughter]Tobias: I had a question for you just before we were at pre-replacement cost. Yeah, it’s gone. Sorry, it’ll come back to me in a moment.
Jake: Come back to you like in about a half hour? [laughs]
Tobias: I’ll ask it next week.
Jake: Yeah.
Tobias: What were we talking about then? Re-replacement cost.
Jake: Quality tilt. Who’s left? Last of the Mohicans.
Kyle: Yeah, there’s a few. Yeah. There’s a few. It’s funny. In small cap or anything cyclical, the apathy in the market– I was trying to explain this to a management team the other day. I’m like, “You’re not fighting some intangible monster. You’re fighting apathy.” Like, no one cares. It’s not just me saying that. That’s just like their return on invested capital is going up, the CEO is buying stock, the company is buying stock, they have a growth project and they’re trading at 5.2 times for a business that’s supply demand imbalance towards them, the supplier, and they’re just tearing their hair out.
I’m like, “Guys, it’s apathy. You’re not understanding what you have to do. You have to tell the narrative. You have to be crystal clear with it. You got to allocate capital in that way, and you have to make it understandable and digestible.” They’re like, “Well, you figured it out, why can’t the other people figure out?” I was like, “Because I’m the only knucklehead willing to spend this many hundreds of hours figuring it out.” Quite frankly, it was a terrible return of time.
Tobias: [laughs] So far.
Jake: [laughs] Yeah.
Tobias: So far.
Jake: Yeah.
Kyle: So far. Yeah. We made money, but not return on– The metric I want my legacy to be if I add a metric, R-O-A-S, return on analyst stress. ROAS.
===
The Return of the Small Cap Value Cycle: Invest in Darwin’s Darlings
Tobias: There was an article that came out or a report that came out from Piper Jaffray in 1999, which one of the reasons that I got into this business, because I was interested in buyouts and private equity at that stage and not so much value. I had read security– not security analysis. Sorry, I had read the Roger Lowenstein book on Buffett that came out.
Jake: Making of an American Capitalist?
Tobias: Yes, that one. But this research report was the thing that was the one that I like most. I’ve republished it a few times on my sites, but it was basically they call it Darwin’s Darlings or The Endangered Species Report. They said there are all of these companies that sit basically in the Russell 2000 or a little bit below that have these incredible metrics, they’re all growing pretty quickly. They’re still controlled by the founding CEO family. They’re still being run in there. They’re doing really good stuff. They just got this secular crush in multiples for years and years and years, because there’s no interest in them. And then they had an update the following year.
Then I think that that’s what created the little activist private equity boom that followed on in the early 2000s, just that there were so many of these companies around that had these high-quality characteristics that were just being completely ignored. I see a very similar situation today that there are lots of these little industrials around it. They’re pretty high quality. They’re pretty good. They’re undervalued. There’s no obvious catalyst is part of the problem. But they’re cheap.
I think the forward returns and that stuff, all look pretty good to me. I don’t know how nasty this whole period gets with—Clearly, they’re being impacted by higher rates in their businesses. But many of these don’t have any debt stuff that I look at. I think it’s obvious to me the next 10 years is like a small cap value cycle. But I am talking my book a little bit when I say that. But I also look back over long periods of data. JT sent me the article in 2015 that I completely ignored or didn’t think through. The spread is wide now. The spread was tight then. It does make a big difference to returns. I know everybody laughs at the three things that I always talk about, but it drives the returns. That’s why I look at it. What do you think?
Kyle: The challenge is, when we come into our professional day, every day, and you look and it doesn’t change, it doesn’t change, it doesn’t change, right? Then you just have to know when to pull the trigger. I think the best example of that is Munger buying Wells Fargo. I think it was like March 9th of 2009 or thereabouts.
Tobias: Pulling off the 405 or PCH or whatever he was in [jake laughs] on to make the call.
Kyle: But he didn’t do anything in the fall January. You guys remember what that was like. January, February, it was like we don’t even know if there’s going to be a financial system.
Tobias: Well, that’s why I was doing net-nets, because when they get liquidated, you get some money back, whereas these other business, you don’t know.
Jake: Quality. There’s no qualities when you’re in the beyond the Thunderdome. [laughs]
Tobias: Hey, Kyle, we’re coming up on time. If folks want to get in contact with you or follow along with what you’re doing, what do they do?
Kyle: Yeah, kyle@grizzlyrockapital.com. I’m very open. I like talking names. We also have a co-investment arm of our business. It’s @covestselect on Twitter. We actually take really unique single names to the institutional market as single name co-investments. We’ve built a fund for it registered. We have a full-time investor communications person. So, if you have a great idea, hit us up, and we pay managers cash. So, I know we didn’t talk about that much today, but that’s our public profile @covestselect on Twitter. kyle@grizzlyrockcapital.com.
Tobias: Are you on Twitter? What’s your Twitter handle?
Kyle: The CoVest is the right Twitter handle.
Tobias: CoVest. Okay.
Kyle: Yeah.
Tobias: Just say it one more time.
Kyle: @covestselect.
Tobias: Got it. And JT, folks want to get in contact with you, same old, same old?
Jake: They already know. It’s fine.
[laughter]Tobias: Kyle Mowery, Grizzly Rock Capital, thanks.
Jake: Thanks, Kyle.
Kyle: Appreciate you guys’ time.
Tobias: We’ll be back next week. I think we’re going to be doing a Halloween show next week.
Jake: Oh.
Tobias: I will see you guys then.
Kyle: Guess I’ll dress up.
Tobias: [laughs]
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