In their latest episode of the VALUE: After Hours Podcast Jake Taylor, Tobias Carlisle, and Chris Pavese discuss:
- In This Market Focus on Base Hits, Not Home Runs
- GLP-1 Hype vs. Reality: Analyzing the Winners and Losers
- Tech Cycles Through the Ages: From Telegraphs to EVs
- Self-Serving Bias and Ant Mills: Are We Trapped in Mental Death Spirals?
- Value Investing in the Face of FOMO: Are We Slow Learners?
- Small Cap Companies’ Looming Interest Expense Crisis
- The Surprising Trends in Market Returns
- Yield Curve: Unpredictable Lags and Real-Time Signals
- Value Investing and the Misfit Underdog Mentality
- Tax, Interest, and Market Returns: A Comparative Study
- Apple and Microsoft: Dominating the S&P 500 with Just 2 Companies
- Nintendo’s Promising Future: Examining Catalysts and Creative Culture
- Focus On Businesses With 10K’s Under 100 Pages
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
Tobias: Hey, this meeting’s being live streamed. It’s Halloween.
Jake: Happy Halloween, everybody.
Tobias: This is Value: After Hours. I’m Tobias Carlisle, joined, as always, by Coach Prime, Jake Taylor. Special guest today is Chris Pavese, his Broyhill Asset Management. We’re going to find out what that is right now. How are you, Chris?
Chris: I’m good, Toby. Thanks for having us.
Jake: Welcome, my friend. Good to have you on.
Chris: Good to see you, Jake. Or, I’m sorry. Good to see you, Prime. I feel underdressed with you two here. I didn’t get a heads up, but–
Jake: Are you going as Marc Andreessen as Halloween? [laughs]
Chris: I’m going as a midtown New York hedge fund manager. That work, I can show the best.
Jake: There you go. [laughs]
Tobias: What do you guys think? Is this an exciting market or is this there’s not much going on at the market at the moment, or is there–? What am I missing?
Jake: What market?
Chris: Things are getting interesting.
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In This Market Focus on Base Hits, Not Home Runs
Tobias: What’s interesting? What are you seeing that’s interesting?
Chris: Well, I was listening to a few of your calls before this. I know you guys talked a bit about small cap, right? Small caps have gone nowhere in five plus years.
Tobias: I think it’s like 25 years.
Chris: You could say the same for China. I think MSCI China, since inception, is basically flat, or at least it was– Last time I looked at it, it might be down now. Who knows? With markets, what was interesting is, well, it’s a little bit different now with the S&P up, what, mid-single digits this year. But there was a point where NASDAQ was up, I don’t know how high at the peak, but all driven by a handful of stocks, and the rest of the market is eventually flat to down. So there’s things to do, there’s things to buy, there’s still plenty of fluff out there if you’re not careful, people get run over every day.
I think the name of the game, good example of what Charles Ellis called Winning the Loser’s Game. I think this is the type of market where you don’t want to swing for the fences. Just focus on getting on base, and not striking out and not making too many mistakes is name of the game right now, which is a lot different than the game that people have been playing for the last decade or so.
Jake: Yeah. Buy[?] every dip.
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Tobias: Chris, tell us a little bit about Broyhill and your background.
Chris: Yeah. So Broyhill started– Well, before it was a family office, it was an old southern furniture manufacturing business. So brand was popular. I’m dating myself here, although I wasn’t around back then, even back then. I think it was the prices, or one of those old school American game shows that popularized the brand and made it more of an American household name. Family sold the business in 1980. So the family office has been around since then. I joined the family office in 2005 after a stint in New York with JPMorgan, hired down to run one of the family’s internal equity portfolios.
Long story short, appointed CIO in 2011. And then last year, it was a big year for the firm, where we effectively spun out the investment management arm of the family office, which is Broyhill Asset Management into a separate entity. So the Broyhill family is still our single largest investor, but they are one of a handful of investors today, as opposed to me being one of a handful of their employees.
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Focus On Businesses With 10K’s Under 100 Pages
Tobias: What’s the strategy?
Chris: That’s probably to a detriment that I don’t have a short focus, crisp, clean answer to that. That’s largely because we don’t really fit real nicely into a box.
Tobias: Family office background? Let’s talk the equity strategy then. Let’s do– [crosstalk]
Chris: Yeah. No, even still, I’d say we’re global opportunistic value. But all those words mean different things to different people. Today, the portfolio is about 50-50 US, non-US. We’ve owned things as small as several hundred million. We’ve also owned things as large as Google, Meta, Microsoft in the past. The other weird thing is, to a value investor, at least, I think a lot of us have grown up a bit over the years. But value to us isn’t a statistical construct. It’s not necessarily always looking for extremely high-quality businesses or compounders. It’s looking for mispriced assets. So it’s looking at a future stream of cash flows, discounting that, and trying to buy it with a margin of safety. It’s typically looking at things we can understand, which are generally pretty simple businesses.
If you had to put a gun in my head, I think our favorite setup is a mid-cap equity with a single line of business, 10-K under 100 pages, as opposed to greater than several hundred. Nintendo is a good example. I don’t know, if Nintendo is technically a mid-cap today, but that’s the first 10-K that jumped in my head, that’s probably 60 pages, 70 pages. We like special situations. We’re not merger arb guys, but we play occasionally in activists and event driven investing. So our largest position up until a couple of weeks ago for the last year plus was Activision.
We’re attracted to spin offs, and catalysts, and that type of thing. Depending upon your definition of classic value, it’s what we’d call classic value investing. It’s concentrated. It’s 10 names, 20 names. I’ll say long biased. We don’t short individual names, but we will occasionally hedge when we can find cheap, creative ways to do so.
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Tobias: Cool. Let me give a quick shoutout to all of the listeners. We have pretty good spread, usually. Santo Domingo. Are you always first in the house, Danny.
Jake: How’s does he do that?
Tobias: I feel like Dominican Republic. I feel like that’s always up there. Nashville. What’s up? Antigonish, Toronto. Gulf of Mexico. What’s up? Scott from Scotland. Durham.
Jake: Easy to remember. [laughs]
Tobias: Dino from Townsville. What’s good? Savonlinna, Finland. Always in the house. Castleford, England. That’s a good name. Northern Great Plains. Dublin island. What’s up? Minneapolis. Tallahassee, Guatemala. Brandon, Mississippi. Kennesaw.
Jake: How can it be?
Tobias: It’s crazy. I saw Lad Vegas somewhere there too. I don’t know if that was a typo, but I thought that was funny. Bangalore. Skipped over you. Sorry. Lad Vegas. There we go. Bendigo.
Jake: Toby, Get us updated on all your various metrics that we have to keep a weekly tabs on.
Tobias: I’m a nightmare. Thanks for asking, JT.
Jake: [laughs]
Chris: [laughs]
Jake: I thought you’re just happy to see me. [laughs]
Tobias: Yeah. This is when value gets cheap.
Jake: Yeah. [laughs]
Tobias: We’re still inverted spreads. Still wide. I think last time I looked at the Gotham website, which has the–
Jake: Yeah.
Tobias: Is this a good time for value question. I think he’s looking at like 1,400 names. Top 700 out of 1,400 largest, looking at the earnings yield, EBIT on EV across those names. And then he has a two-year forward return. So when the 60s–
Jake: Based on his data set of-
Tobias: Based on his data set.
Jake: -when it’s been this cheap, here’s what it went on to do.
Tobias: That’s right. So I think it only goes back to 1998 or something like that. But he says 66 percentile towards cheap, which means that there’s only 33% that are cheaper.
Jake: These are wild swings. When we were talking about it– [crosstalk] .
Chris: Whose site is this, Toby? What’s the data–?
Tobias: gotham.com.
Jake: Yeah.
Chris: Yeah. Okay. [crosstalk]
Jake: Greenblatt’s proprietary data set.
Tobias: Greenblatt’s. Yeah.
Chris: Yeah.
Jake: But it went like 92 percentile. And then I feel like we checked it again and it was at 40 percentile, and now it’s back at 66 percentile?
Tobias: It was over 90 percentile. It was in the 90s. Do you remember?
Jake: Yeah.
Tobias: But that was March. Can you believe that? There’s not been a great deal of value performance over that period from March to now. It’s been below 50 percentile, and it’s at 66 percentile now.
Chris: I’m surprised that his metric knowing how he thinks– We know the Gotham products a little bit. I’m surprised it swings around that much relative to [crosstalk] a more normalized earnings metrics that I wouldn’t expect to move that much even in a year as volatile as this one.
Tobias: There’s been some weird stuff. The Alpha Architect tracks the spread. Again, it’s a funny metric because it’s the median stock out of 1,500. So it’s the 750th stock versus the median stock in the value decile, which is the 75th stock. So it’s 75 versus 750. It got out, I think, this year in June or something was as wide as it’s been, and it’s closed pretty materially since then– [crosstalk] .
Jake: What was it? Like four? Blew out to three or four, wasn’t it?
Tobias: I don’t know what the number was, but it was wider than it was in 2,000 at the peak. It was wider than it was in 2009 at the trough, which were two extremes.
Chris: Yeah.
Tobias: It’s not delivered a great deal of performance, I wouldn’t say, over that period of time, but it’s come in a lot, which might be energy getting caught in that bucket and energy earnings falling materially would be the only thing that I can think. I just don’t think there’s much going on in that area. Sorry, Chris. Go.
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Value Investing in the Face of FOMO: Are We Slow Learners?
Chris: I was just going to agree with the valuation spreads really for the last several years is something we’ve been writing and talking about consistently for a while. It seemed like it was to no avail up until 2021, 2022, when we were like all value investors jumping up and down about people ignoring these big cash flowing boring businesses trading at close to single digit multiples or double digit cash flow yields, and instead buying things that had somewhere close to zero probability of ever earning money over the next 10 years, 15 years, 20 years. That’s changed.
You look at some of the valuations and some of the market caps of these businesses that are still unlikely to earn anything over the next 5 years, 10 years, 15 years, 20 years. There’s billions, if not tens of billions of capital still making those bets. I guess we’re all, as a group, we’re slow learners.
Tobias: I think there’s a fair bit of bloat to still come out of the market, to be fair. I think there’s a lot that’s come out. I think we’re a long way from, like, if you think about 2009 at the bottom or 2000 through that [crosstalk], I don’t know why you call the bottom there, because value is a different beast through there. It doesn’t feel like that to me. It doesn’t feel like screamingly cheap valuations, even though we’ve been in a pretty prolonged bear market now, it’s coming up on whatever it is 22 months or something.
Chris: Yeah. I think in some cases, the valuations are probably there in certain names and certain pockets of the market. For me, it’s more. So sentiment is just not even close. You go on Twitter, and everybody’s back posting their quarterly numbers. [Jake laughs] We’ll see the next few quarters of that– [crosstalk] .
Jake: If I got quiet there for a little bit.
Chris: Right. Posting their top 10 names and it’s just like if you were dating myself again. But 2001, 2002, 2003, that was like death by 1,000 cuts. After two years, three years, nobody wanted to be anywhere near equals. Like, the value guys were happy, but everybody that was buying the NASDAQ and all those tech names, they were gone. If they were around, they just weren’t vocal. They weren’t talking and they definitely didn’t have the confidence they had one, two, three, four years, five years prior. These investors are as confident as they were before they lost 80%, 90% with certain managers last year.
Jake: [laughs]
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Tobias: It’s been quite a run for the seven. Nothing much else has done anything. There’s some stuff that has performed underneath, but it’s mostly the seven– I’ve seen some statistics that say that it’s the other 2,993 stocks are down. I don’t think that’s quite right, but it’s not far wrong most of the performance on market cap waste basis anyways in those seven.
Chris: Yeah. You guys looking at anything interesting these days? Where are you guys spending time?
Tobias: I got a big chunk of energy. I got some basic materials. It’s highly cyclical stuff that I think is cheap.
Jake: I haven’t really found anything that’s felt justified in displacing something that I already owned and feel like I know and feel comfortable with so far. So, the hurdles have been high to get into the– So, I haven’t been doing very much.
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Nintendo’s Promising Future: Examining Catalysts and Creative Culture
Tobias: How well either of you guys know Nintendo? Because you raised it before, Chris.
Jake: Played a lot of Super Mario Brothers.
Chris: [laughs] And Zelda.
Tobias: Saw the movie. Chris, is it one of your holdings?
Chris: Yeah. It’s a core name for us. It’s funny. [coughs] We first started looking at it several years ago right around the same– Around the time, you had a handful of bullish calls that were absolutely correct on the Switch. We spent several months on it then. I’m not sure what it was, but there was something that held me back from doing anything. I think it was maybe just thinking that I had this nostalgia like bias to my view that I was afraid was going to cloud the thinking. But it seemed really obvious then when you run the numbers, and even under typically when we model, we model a bear base and bull case for everything. Even in our most aggressive bearish assumptions for Nintendo, if the Switch was anywhere remotely close to what it turned out to be– It looked like a home run, and that just made me feel like and that was under bare case scenarios, and that just made me feel like we were missing something. So, we ultimately didn’t do anything and just kept following it, kept following it.
I mentioned Activision before. So, we’ve been following gaming for a while, looking for an entry point there because I think the secular tailwinds there, whether– I’ll use a funny name. Whether it’s the Metaverse or whatever you want to call it. I think that’s the one place where metaverse can actually be monetized. Yeah, the secular tailwinds in gaming are super interesting. The fact that the software providers were moving the digital, so margins were going from similar to what we saw in music with streaming right from low, boring, cyclical to very high recurring cash flow generating.
Recently, this year on the pullback that we got involved finally. That was largely because I think people just got stale on the name like the Switch got stale. It’s year seven, the company always has not given any guidance or expectation in terms of when the next gen is coming out. So Wall Street’s just written it off and said, “It’s dead money until then.” Meanwhile, in year seven of a console cycle, they can put out numbers like they did this year with the launch of right.
With the Mario Brothers movie, it seems like you’ve got a number of catalysts lining up over the next couple years, whether it’s new Parks launching the Mario Brothers movie, and them basically signaling that for the first time, maybe they’re actually going to do something to monetize this-
Jake: All this IP.
Chris: -unbelievably valuable IP they’ve got– Well, Disney is probably not the best analogy right now because Disney is in the doghouse. Another great example of like, it’s amazing how quickly sentiment goes from one extreme to the other in this business.
Jake: Oh, man.
Chris: Disney was on everybody’s wish list of forever business– [crosstalk]
Tobias: Streaming.
Jake: Yeah.
Tobias: 10 plus years, and now nobody will touch it. That’s one that’s been on our list to start revisiting for that reason. Back to Nintendo. Yeah, I just think it’s one of these cultures where it’s counterintuitive. So, a lot of times people will punish companies for not pandering to Wall Street or not having a shareholder first mentality. But there’s so many examples. I think the one that comes first and foremost to mine is like a Valiant, which is really extreme, where that shareholder first mentality can get you just into so much trouble. It’s the difference between that and a customer or stakeholder first mentality.
Then you can look at Amazon. I’m sure there’ll be a point in the future where Amazon will be in the doghouse, but right now, Bezos, in terms of the customer obsession, could do no wrong, could look at Costco, the scale economic shared model, and both those examples. I think Nintendo, the culture there is so unique, and I just I think it’s impossible to replicate anywhere else this day and age. All they want to do is create fun games for kids, families, and just drive this creative culture, and do things just for that reason. If you just do that and if your sole focus is taking care of your customer, you have to believe that ultimately, that’s in the best interest of shareholders.
Even if Wall Street wants you so badly to focus on what you’re going to do next quarter, when are you going to roll out this console, and it’s just like, “Listen, we’re going to do it when we have something that’s worth rolling out, and that’s it. That’s all we’ve got to tell you, guys.” You go back decades and decades, and the company’s always operated that way, and it’s been the right way. You can argue it’s been the right thing to do.
So when you find a business like that, we’d love to own a portfolio of businesses like that. I don’t think there’s that many, and I don’t think there’s rarely that many that you can get at the right price. For Nintendo. For us, it’s somewhat of an exception. I’d say every other name in the book. We’ve got pretty close to what I’d consider pinpoint estimates on what we think the business is worth under multiple scenarios. I did an interview recently with Value Investor Insight and this was I think a little frustrating for John over there, because he wanted to talk about Nintendo so bad, and it was the one where it was like, I don’t really have good numbers. Sometimes, it’s just enough to know that this isn’t the right price.
Under so many scenarios, it’s so hard for us to envision money or envision losing money, where it’s like, if it’s the right business, you can just feel good that over time they’re going to make you plenty of money. So if you just focus on the downside, and I know that’s cliche in our business today, but I think that’s a great example where sometimes trying to sharpen your pencil, and get real granular, and get real precise on something that’s just a guessing game at the end of the day. Not being able to do that isn’t always a reason not to make a decision or not to make an investment. But it’s rare for us, and Nintendo is a good example of that, where again with the next gen Switch One, we don’t know when it’s going to be released. We think it’s next year, but that’s just a guess. And then two if it’s released, the range of outcomes there is so massive.
Jake: Yeah.
Chris: Yeah. We’ve got numbers, but the numbers are almost meaningless.
Jake: Yeah, you’re almost betting more on emergent properties of a system than you are on predictions.
Chris: Yeah, and they’ve just got so many levers they can pull right. We don’t know how aggressive they’re going to get in monetizing the IP. We don’t know the economics shared economics with Universal and the Parks and how much they’re going to make. We don’t know. We can estimate what they’re going to make with Mario and other movies, but it’s back of the envelope and we can fool ourselves by putting multiple decimal points into Excel. But at the end of the day– Yeah, we know the business, we like the business, we like the management team. We think they’ve been sending all the right signals over the last couple of years, I’ll be still probably not enough to make most investors happy, but it’s pretty clear to us, when you look at the history of the business and the history of the management team. They’ve come a long way in the last couple of years just in terms of how they’ve thought about creating and monetizing what they’ve got.
Tobias: Good balance sheet too.
Jake: Yeah.
Chris: Yeah.
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Apple and Microsoft: Dominating the S&P 500 with Just 2 Companies
Jake: I got a wild stat for you guys here. Apple and Microsoft together represent 14% of the aggregate weight of the S&P 500. The energy, real estate, utilities, and materials sectors represent 12% of the S&P 500.
[laughter]Jake: Four sectors against two companies.
Chris: Yeah.
Tobias: Do you think that that is wrong as a reflection of its impact on the economy?
Chris: Question for me or Jake, Toby?
Tobias: That’s an open question.
Jake: I’m going to let Chris take this easy one.
Tobias: [laughs]
Chris: No thanks, man.
[laughter]Chris: It’s tough to say wrong. I think it’s a reflection of where the markets have been– I think it might not be a reflection of where we’re going. Toby, I would tend to think, put a gun to my head. I think you’re probably right. Being focusing on energy and cyclicals and that type of more cyclical, real aspects of the economy. Our hit rate there is lower than elsewhere. The last year or two we’ve been looking and poking around those markets. We haven’t done a whole lot because our own hurdle to get involved has to be higher, just because I know our hit rate is lower, if that makes sense.
Tobias: Yeah, it’s a tough area to invest. The only reason I ask is when you put together a market cap chart or even just a revenue chart looking at the size of those businesses relative to other businesses.-
Jake: Huge.
Tobias: -they are on a different scale. They’re so much bigger than everything else that’s around there. When the airlines fell over, when off it punched out of the airlines, I remember looking at the airlines, they were like– I can’t remember now– [crosstalk]
Jake: Round a zero,> You feels like it?
Tobias: They were like $30 billion market capitalizations at that point. That was against like Google was at $1.7 trillion, something like that. I was like, “Google could go through and buy all of the airlines with its free cash flow in a year just on a different scale.”
Jake: Yeah.
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Tech Cycles Through the Ages: From Telegraphs to EVs
Chris: I think there’s a great chart, and I’ve got a letter keyed up that I wrote. I actually wrote it for our midyear letter back in June and decided our midyear letter was already way too long, so I cut it out. I was saving it’s called AI insanity. There’s a chart there that we borrowed, I forget where we “borrowed” from somewhere else. I forget where we borrowed it from, but it shows– There’s that classic chart of stock market cycles that shows buy the dip and where people puke and where all in, all in, all in, and then it’s like the trough of delusion.
There’s a similar chart on tech cycles, and I think going back again to 1999, 2000 makes sense, where the Internet stocks peaked in March 2000. That was the peak of expectations for the internet. But the internet didn’t peak in 2000 by any means.
Tobias: Right.
Chris: When people look at that today and say, “There’s no way AI is going to be smaller today than it is,” or “It’s not going to do all these great things.” They’re probably right, but that doesn’t have any– The correlation between that statement and the valuation of the underlying stocks is zero, if snot negative. There’s a period where the stocks are going to get like you saw on Internet, where it takes multiple years for that just sentiment to be washed out. But in the meantime, the technology is progressing and the use cases are progressing, and it’s a multiyear transition. There’s a great book, and I referenced this in the write up, and of course, I’m completely drawing a blank right now, but it’s the– [crosstalk]
Jake: Carlota Perez, probably.
Chris: I’m sorry.
Jake: Carlota Perez, the history of financial innovation. Technological iInnovation.
Chris: It’s similar to that. It’s a different name though. I’m going to have to circle back with you, Jake. I’m going to forward it to you. But that’s basically the premise. I think I’m thinking of a different one. There’s tons of books on market manias and bubbles, from [unintelligible [00:26:51] to Ed Chancellor to Mackie, but then this is the combination of that with tech innovation, which sounds similar to whatever book you’re talking about that maybe I need to read as well.
Jake: It sounds like you already read it.
Chris: It goes back hundreds and hundreds of years, none of this is new.
Jake: Right.
Tobias: Yeah. Mikhail Samonov has a great 200 years of value. You can see in that introduction of the Telegraph in 1844 had a pretty impact. The steam engine had a pretty big impact. All of those were like tech cycles, they look exactly the same.
Chris: Newspapers, radio, cars. rail.
Tobias: 1690s was the electronics–
Chris: Auto was a broke market for how long. It’s an awful business, and somebody’s got to tell maybe certain other people in the EV industry the same thing.
Jake: [laughs] They’re finding out.
Tobias: Are they?
Jake: Oh. I don’t know.
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GLP-1 Hype vs. Reality: Analyzing the Winners and Losers
Chris: So I’d love to talk. If you guys don’t mind, I’m going to use this time to pick your brand a little bit too. We’ve been head down for a good two weeks, three weeks now. So this is technological change. It’s somewhat pharmaceutical change, but looking for opportunities to fade the GLP-1 craze, which seems to be almost as extreme as the AI hype in both directions. Both the perceived winners and the perceived losers. Going back to relative valuation and the relative extremes in the market, it’s mind boggling. Wondered if you guys have spent time there.
Jake: Do you guys know that meme that’s from Mad Men, where-? I forget which the guy was, but he’s in the elevator with Don Draper and he says like, “I feel bad for you.” And then Don Draper says, “I don’t even think about you at all.” Then someone took that meme, and then they put GLP-1 is like, “I feel bad for you,” and then McDonald’s like, “I don’t even think about you at all.”
[laughter]Chris: Jake, you got to send me that because I may need it for our letter, if we want to do this.
Jake: Yeah. It’s hilarious. I guess, McDonald’s reported pretty strong this last quarter. I haven’t looked at it, but I think that was the takeaway of the joke.
Chris: Yeah.
Tobias: I actually haven’t spent much time thinking about it. I don’t think you can tell even which way it will impact—Say, GLP-1, I know that it has these properties where it makes people eat less and evidently it makes you able to study better and do a few other things like it gives you a little bit of a little bit more will or something like that, which is interesting. I just don’t know that you can tell necessarily whether it’s going to be a net negative for junk food or a net positive. Like if you can get the weight off really easily, why would you be disciplined about your diet?
Jake: Yeah.
Chris: Right.
Jake: Let’s lever the system up, right? Yeah. [laughs]
Tobias: I feel like you could go a lot harder through the winter months now.
Chris: I like. It.
Tobias: Halloween, Thanksgiving, Christmas run through there. Just don’t worry about it.
Jake: Yeah. There’s a pill for that. Yeah.
Tobias: January, feast of [crosstalk]
Chris: I hope you’re right, Toby, because I’m ramping up in that same spot right now.
[laughter]Tobias: Yeah, it kicks off tonight. Silly season kicks off tonight.
[laughter]Jake: You want to get nuts? Let’s get nuts.
Tobias: Yeah. I don’t know. What do you think? What’s your view? What do you think there?
Chris: So we’ve spent more time on the healthcare side of the equation. It’s probably been 10 plus years since I’ve looked at this space. But historically, a lot of these big medical device companies have been viewed at, or at least at one time or another were viewed at high-quality businesses with secular tailwinds in terms of growth drivers, operating depending upon what market, and relative oligopolies limited competition. Some of them are starting to look interesting. You’ve got businesses– I’m going to try to shy away from mentioning names because we’re actively doing work and beginning to establish positions. There’s medical device businesses that traded at historically mid-20s type multiples that are approaching double digit cash flow yields. I just don’t know, it’s really like–
So this is another example where it’s tough to model out because even the GLP-1 data is still so early. We don’t know the long–term implications. You see forecasts for this being like $100 billion market in six years effectively. You can back into that based on pricing and what that implies with population, and then back into the impact on the addressable markets of those related companies. It’s like doing that. It’s hard to get to how hard these businesses have sold off.
Jake: Really. Even if it was pretty bad for them, it wouldn’t be as existential.
Chris: It’s also not clear. Everything else, there’s positives and negatives, and I’ll give you an example. So we haven’t spent any time up until recently on some of the companies in the dialysis market, one of which is Berkshire owns 40% of.
Jake: Yeah.
Chris: That is treatment for kidney failure. And historically, that market has grown, I think, at 2% to 4% annually in terms of population of kidney failure. Let’s just look at the US. GLP-1 has a great impact on reducing type 2 diabetes, which is one of the leading causes. It might be the leading cause of kidney failure. But you know what? It’s not the only thing. It’s really only about 40% of the people that need dialysis, right? So first thing you can do is go, “Okay, let’s just cut that growth rate in half, and let’s just say they fix type 2 diabetes.” But there’s still the other half of that volume growth that has been there that has been unrelated to type two diabetes has nothing to do with anything that GLP-1 is going to address.
So right off the top, you can just say, “Okay, what’s it worth if the volume gets cut in half?” That’s worst-case scenario. But then there’s other factors, like, during COVID, these businesses got hammered because mortality surged. This is all coming from my knowledge of the healthcare system and pharmaceutical space. I’m not at all qualified to talk about this, but we’ve had this conversation with our Director of Research–
Tobias: It’s a podcast, you’re allowed to do it.
Jake: Yeah. [laughs]
Tobias: PhD in organic chemistry, worked for Big Science, worked in clinical diagnostic labs. This is where I geek out on financial, she geeks out on this stuff, and I have to back her up and be like, “Okay.” So, it depends like that. What does that actually mean for the stock?
Jake: Yeah.
Chris: But the reality is, GLP-1, in addition– So it’ll keep some people out of dialysis, which is a good thing. I learned this recently. Kidney failure isn’t something you fix. So if they’re on it now, they’re not going to come off it. Even if they came off it temporarily, they’re going to come back on it at some point. So that’s one thing. The second thing is, I think the mortality rate is something around like 18%. And so if GLP-1 can keep those people alive longer, the back end of keeping people on dialysis longer may actually be more of a tailwind to volume than the slowdown on the front end, if that makes sense.
Jake: Right.
Chris: We don’t know any of this yet, but that’s the point. You can model out different scenarios, and you can back into what’s implied by the stock. Davida[?] dropped, what, 25% on that last Novo test a few weeks ago? Literally, it wasn’t that. It was trials. They stopped short, because it was clear that their endpoint, it was better than expected. And so there were stocks that dropped 25% on that day, but not a whole lot of information about what that patient population is going to look like 10 years, 15years, 20 years from now. We’ve had people on these drugs for a few months.
Jake: Yeah.
Chris: I just think it’s super interesting. There’s other impacts too. I don’t know, obesity is a massive problem in the US. So we start cutting that back. What’s the first thing someone does after they cut 10 pounds, 15 pounds, 20 pounds, or 30 pounds, 40 pounds, 50 pounds? They probably look to tighten up some of that extra weight. Maybe go to the gym. Maybe start giving– [crosstalk]
Jake: I was going to say divorce attorney. Sorry.
Chris: [laughs] We haven’t gone there yet. Are they publicly traded–?
Jake: Second order effects. You got to look a little deeper into the– [laughs]
===
Value Investing and the Misfit Underdog Mentality
Tobias: Chris, these are very long-term trends. It’s almost like the VC macro kind of—I’m trying to predict something that’s really, really long way out in the future. Is that part of your process? Is that how you work through it? You think about AI, and where that’s going and GLP-1 and where that’s going? Is that how it works?
Chris: Not necessarily. I guess, to be clear, we typically look for our turnover is relatively low, maybe 15% to 20% annually. We typically hold 10 names to 20 names, so maybe that’s a new idea, or two a year, or sometimes quarter if we’re lucky. We’re typically modeling out three years, five plus years, and our turnover is pretty consistent with that time horizon. But we’ll also look at things where if we model out three years to five years and we get that price in 6 months, 12 months, we’re happy to take it and move on to something else.
I’d say not necessarily, we’re not always looking at uber long-term trends like this. I think the commonality is we’re looking for some sort of dislocation where the market extrapolates that out forever or longer than we are comfortable extrapolating it out. AI and GLP-1 are good examples of that where because there’s still so much uncertainty in terms of picking winners and losers or the extent of the winners and losers, we don’t have to necessarily better than anyone else or try to better than anyone else at forecasting out that far. It’s just a function of trying to understand what’s in today’s price and what’s reasonable or likely relative to– It’s like anything else. It’s just where are the odds in our favor, where if things stretch too far, and where we can be comfortable fading the popular narrative.
Jake: Yeah. One way to classify value investing would be that you’re generally betting that the world is not going to change as much as everyone is predicting. So I wouldn’t be surprised if you were able to assemble a basket of GLPp1 impacted securities. It would probably not be a terrible bet to make to just belong that as people realize like, “Oh, yeah, maybe this does change things, but it’s going to take a while.” It’s going to take longer, and there’s going to be a lot of cash flow between then and that day that the companies will realize still. You paid a cheap multiple for it, and maybe you get a decent return because you took the other side of the bet.
Chris: For whatever reason, I think it’s just personality and personal preference. You could argue the other way too. You could argue that like, “Listen, these names haven’t run nearly enough. There’s so much potential here, the market is missing.” When we model this out 5 years, 10 years, even our worst-case scenario, the stock’s multiples of where it is today even after jumping 50%. We could occasionally get there too. I think we’ve got this misfit underdog mentality. I think probably that’s common for value investors, where I’m much more comfortable looking for the other side of that. Talking to primetime over here with the Colorado flags in the back. We’re a lot more comfortable looking to fade than looking to bet something’s going to be even more extreme than the consensus thinks.
Tobias: Yeah.
Chris: Not saying we won’t do that, but that just tends to be more our style.
===
Self-Serving Bias and Ant Mills: Are We Trapped in Mental Death Spirals?
Tobias: JT, do you want to do your veggies before we–?
Jake: Yes, sir.
Tobias: Chris, we have to do the vegetables-
Jake: Obligatory.
Tobias: glorious nation for us to-.
Chris: All right. Let’s hear it.
Tobias: -learn something.
Jake: So today’s episode is entitled The Self Serving Bias and Ant Mills, and we will tie these together. So the self-serving bias is this tendency that we all have where we tend to evaluate things in ways that protect our own self-image. Like, when we succeed, we attribute it to our own abilities or efforts. “I knew what I was doing. I’m smart. I worked hard.” But when we fail, we tend to blame it on external factors, like, my boss had it out for me, or, “That test was unfair, or I was just hungry and tired, I’m not–” [crosstalk]
Tobias: [crosstalk]
Jake: Yeah. I’m not an asshole. Yeah, the Fed ate my homework. So, I was reading Shane Parrish’s new book. It’s called Clear Thinking. He had a section in there that I liked. He says, “If you got some result you didn’t want, the world is telling you one of two things. Either one, you were unlucky. If that’s the case, then you should probably keep doing what you’re doing and it’s likely to start working. Or, two, your ideas about how things work are wrong.” Most people don’t want to hear that they’re wrong. It’s a blow to our self-image. It hurts our egos. Instead, we tend to ignore what the world is telling us, and we keep doing what we’ve always done, and getting these same old bad results.
And so tying that together, I was on a long car ride with my 12 year old this weekend to a baseball tournament. He was telling me about this thing called ant death spiral, and I was like, “Okay. Well, hold on a second. You saw this on YouTube probably. So, it’s probably bullshit.” So I was a little skeptical, but I did a little bit of my own digging when I got home. It turns out that it’s a real thing. But scientists call it ant mill. It’s an observed phenomena where in a group of army ants, they get separated from the main foraging party, and they lose the pheromone track, and they begin to just follow one another round, and form these continuously rotating circles, and the circles are called death spirals. It’s because the ants eventually will just march themselves to exhaustion.
The largest ant mill ever discovered was 1,200ft in diameter, which in each ant, it took about two and a half hours to complete the circuit for each ant. And so when we think about ants, their brains are– they’re almost exactly one one millionth the times the size of our brains, some of you more or some of you less. The human brain is 1.1 liters to 1.2 liters, typically, and the ant is one microliter. So ants have this very simple input output functionality that’s wired into this limited number of neurons. And of course, we are much more complex. But it feels like we actually exhibit some of the same kind of ant mill behavior where we keep making the same mistakes over and over again and not learning and adjusting.
We get in our own little mental death spirals where we’re just circling around and following each other. The ants, they stop asking themselves like, “Are we doing something wrong here?” and trying to check. They’re maintaining this status quo of just following the ant in front of them. Shane has this pretty good quote in here that, “If you want to see whether your thinking is wrong, you need to make it visible. Making what was previously invisible visible gives us the best chance of seeing what we knew and what we thought at the time the decision was made. Relying on memory won’t work because the ego distorts information to make us look better than we actually are.”
So I think we’re all a little bit guilty occasionally of running into our own little ant mill where we just circling around and we’re not stopping to check our assumptions and check, are we doing the right things? A lot of times, it’s because our ego is holding us back.
Tobias: Good one.
===
The Surprising Trends in Market Returns
Chris: Super interesting, Jake. I got ant book recommendation for you. Have you read any of E. O. Wilson’s stuff?
Jake: I have. I’m a big E.O. Wilson fan.
Chris: Of course, you have.
Jake: [laughs]
Chris: All right, I’ll leave it at that. I pulled up while you were talking, which it was driving me crazy. Engines That Move Markets. That was the book I was thinking of.
Jake: Oh, yeah. I don’t think I’ve read that one. I have heard of it. We had somebody asking on Twitter about Mauboussin white paper and the total shareholder return question on they had, what was it, it was the S&P 500 growth versus S&P 500 value from 2007 to 2021 annualized. This is like a decomposition of returns exercise. I don’t know. Did you guys get a chance to look at that little table at all before? Toby– [crosstalk]
Tobias: I did have a look at it. Yeah, but I need to pull it back up again.
Jake: Anything surprising there?
Chris: How much of it was multiple expansion and compression on both sides?
Jake: So multiple expansion for value accounted for 1.6% of the 7.6% total return. On the growth side, it was 3.6% of the 13.3%.
Chris: All right.
Tobias: So it was an extra two points there for– The one that the shares outstanding–[crosstalk]
Jake: That’s the one that surprised me.
Tobias: So that means that the value have been net issuers.
Jake: Yeah.
Tobias: The growth– [crosstalk]
Chris: Over what time period?
Tobias: 2007 to 2021.
Chris: I wonder how much of that is banks following the financial crisis in terms of dilution.
Tobias: That’s a good guess. Possibly– [crosstalk]
Chris: That’s all it is. It’s just a guess, but that’s where my head went.
Jake: I think you’re right. There was some equity issuances in energy too, wasn’t there? They were raising a lot of capital [crosstalk] in 2014-2015.
Chris: Commodity businesses don’t have a great track record of capital allocation.
Jake: You don’t say. [chuckles]
Chris: I didn’t notice any. In Thorndike’s book, The Outsiders. I might be misremembering, but I don’t remember many commodity businesses there.
Jake: Yeah. So 2% return profile for the growth from basically reducing shares. And that must have been like Apple and some other things that have just eaten a crazy amount of their shares back, I have to imagine. I bet if you stripped out some of the outliers, I bet that probably looks a little bit more normal. Yeah, that was my biggest surprise too that value was on the issuance side and growth was on the retirement side.
Tobias: EPS growth was, as you’d expect, much more healthy for growth than it was for value. I guess, the share shrinkage contributes to that as well. But it was a big margin, 3.3% versus 8%.
Jake: But the net income difference wasn’t that much. It was like 5.2% for value versus 5.9% for growth. That’s almost a push.
Tobias: You clearly needed– Yeah, net income. That’s not growth. That’s just net income. So it was net income, 5.2% for value, 5.9% for growth. So does that mean that growth was cheaper than value?
Jake: No. You had the same amount of, call it, business results-ish, but then the number of claim tickets chasing those business results reduced on the growth side and increased on the value side, which then gives you EPS differences of 8% and 3.3%.
Tobias: But they’re saying net income 5.9% versus 5.2% for value. Doesn’t that mean that growth was cheaper, 5.9%?
Chris: It sounds like that’s net income growth. No? That would just be my guess.
Tobias: It splits out growth.
Jake: No, it’s change in net income that’s attributing to the return.
Tobias: Okay.
Jake: That’s what I was trying to say. Yeah.
===
Tax, Interest, and Market Returns: A Comparative Study
Chris: I’ll flip it to you, guys, after this call, and I presented it to our board last quarter. I think it was one of the Fed banks that published it that showed a return decomposition. Now, this wasn’t value growth, but it’s somewhat related. It was a return decomposition from the 1960s through the 1990s relative to the 1990s through today, or something of that. I’m sure I’m butchering the time period, but what it showed was– The returns over the two periods shown were almost identical.
I’m going months and months ago go from memory, but it basically showed how the biggest driver of the return delta over those two time periods was, one, declining interest expense and two, declining tax rate, corporate tax rates. But when you looked at the EBIT growth, the sales growth and the EBIT growth over the two periods, the lesser period from a return perspective actually grew sales and EBIT faster, but all of the difference was in the decline in tax and interest expense-
Jake: Right.
Chris: -which fast forward today–
Jake: Can it go that any further in that direction? [laughs]
Chris: Just the opposite. We’re absolutely going in the other direction. Not to mention that’s even before we get into unit labor costs right.
Jake: Yeah. Margin pinch.
Chris: Then you look at change in valuation over that time period, and then look at where we are today and where you think we’re going to be in 10 years. It’s hard to make a real bullish case for being long spies here.
Jake: Yeah. Has Fed been reading Chris Bloomstran’s work? Is that what’s happened?
Chris: [laughs]
Jake: It wouldn’t surprise me at this point.
===
Tobias: Did you guys catch Munger on the Acquired podcast. Not The Acquirers Podcast. Thanks to everybody who sent me the congratulations for getting Munger on– [laughs] [crosstalk]
Chris: Oh. Obviously, so hard.
Jake: He picked the wrong one.
Chris: Yes. [laughs]
Tobias: He probably got confused, or his mind has got confused. That’s a VC podcast. Why would he go on that?
Jake: Yeah. Here, we’ve been praying at the altar for years.
Tobias: [crosstalk]
Jake: [laughs]
Chris: No. Any big takeaways there?
Jake: I haven’t listened to it yet. I got it queued up, but I haven’t had a chance.
Tobias: To me, it sounded like he’s playing the same old songs. I like the stuff that he plays. I like it when he gets up and he plays the classics. He played the classics, but there wasn’t much new stuff in the– I like it when they get up and play the classics. I’m not going to lie. I go to my bands to see the classics, not the new stuff.
Jake: Yeah, I don’t need your new stuff.
Tobias: Save the new album up. Wait until it’s been released in five years.
Chris: Hey, that’s our Universal music thesis in a nutshell, man. Thank you for that.
Tobias: People like the classics.
Chris: That’s it.
Tobias: I like remixes of the classics, but I still want to hear your classics.
Chris: Yeah. As long as it’s not Taylor reproducing them ourselves, we’re happy. We’re fine with remixes too as long as we get paid on those.
Tobias: Does that not feed back into Universal?
Chris: If she reproduces an album, and it’s played on Spotify, and you listen to that album or that song that she’s produced, no, we do not get paid as Universal shareholders. But if that new album drives physical sales and stuff and people to listen to her older stuff or stuff that’s still under Universal, then, yeah, it still benefits us. It’s not nearly as strong as her being directly tied to the label anymore.
Tobias: Taylor’s the only thing keeping the economy in the black at the moment. She was 6.9% of the– [crosstalk]
Jake: GDP.
Chris: Unreal.
Tobias: No.
Jake: Yeah.
Tobias: Not quite. She’s probably only a point of GDP at this point. Still like a billion dollars.
Jake: I have to say I’m surprised. So my dad took my nieces, who are the perfect Taylor Swift age to go see the movie. He was raving about it. He’s like a 65-year-old man.
Chris: [laughs]
Jake: He loved it. Although, apparently it was a little long, but apparently, it was quite good. I was shocked when he told me that.
Chris: Yeah. I’m still curious to see the impact on Kelsey’s performance.
Jake: It’s got to be down, right?
Chris: I think it’s too early to tell. There’s no statistical correlation.
Tobias: I thought they had some stats up that show that he’s only won since she’s been there. He’s better when she’s there.
Jake: They lost this weekend, so he must–
Tobias: Oh. Was she there?
Jake: I don’t know.
Chris: [laughs]
Tobias: Maybe that was what was holding him back.
Jake: If nothing else, you got to have a little less vigor in the tank, right? [laughs]
Chris: I’m not touching that one.
Jake: Yeah. All right, go ahead.
[laughter]===
Small Cap Companies’ Looming Interest Expense Crisis
Tobias: So what have we got? What are our prospects for the rest of the year? How do you like the setup, Chris?
Jake: Strong to quite strong, Toby.
Tobias: Is it cheap enough to–? There’s some stuff around. I still don’t feel like we’re quite at the–
Jake: Wake me up when the high yield spread blows out.
Tobias: Yeah, we haven’t had that. We haven’t had the panic yet. VIX can’t get out of bed.
Jake: No.
Tobias: Old man.
Chris: Yeah. That’s been the biggest– We’ve talked about all these divergences and discrepancies. Like, chart bankruptcy filings this year, and then look at credit spreads– [crosstalk]
Jake: It makes no sense, right?
Chris: Somebody explain that to me. You saw in 2008, and then COVID—COVID was even on steroids, but you had this massive spike in defaults to 10%, 12% the last two cycles. We’ve been saying for the last year or two. I think this is going to be a great environment for the distress guys that have been lipping their chops for the past 15 years.
[laughter]Tobias: That’s right.
Jake: Yeah.
Jake: Yeah.
Chris: Yeah. I think we have two years, three years of high single digit. I don’t think we get the 10%, 12% spike. Maybe I’m wrong. You got to have some sort of financial accident to get that. But even without that, I think we just have multiple years of rolling high defaults, and that just seems inconsistent with where equity markets are. Not necessarily small caps. The thing that’s interesting about small caps, I don’t know if you’ve got seen this, but if you plot– So one interest expense. People are surprised intuitively that interest expenses across S&P 500 or S&P 1500 really hasn’t increased-
Jake: Fairly [crosstalk]
Chris: -given the backup in rates. But if you break that out by market cap, interest expense at small cap companies and micro-cap companies is absolutely through the roof. The large cap guys have refinanced and extended everything out and termed everything out as long as they could when they could, small caps are going to be crushed. We’re going to be dealing with so many bankruptcies for the next several years. That’s going to be an interesting opportunity set. But for your point, yeah, until you see credit markets wake up to this, I think equity markets have a long way to go too.
Tobias: The bond markets are clearly in some agony. Bond markets are down.
Jake: Yeah. Have you looked at TLT?
Chris: Don’t do that.
Jake: Don’t do that. [laughs] Make sure you haven’t eaten recently.
Chris: It looks like a meme stock.
Tobias: At some point, that’s a reasonable long. I don’t know where it is. As a hedge, I don’t want to be the first one in.
Chris: Even so, risk free at five? When was the last time like–?
Jake: Been a while.
Tobias: 2,000. You got to go back to something like that.
Chris: 5% seems pretty nice.
Jake: But if interest rate cycles are 25-year to 40-year phenomena, we’re in–
Tobias: 40. Yeah.
Jake: Yeah. This is like the first pitch of the first inning. Are you ready to push it all in already? [laughs]
Tobias: [laughs]
Chris: Yeah.
Jake: Okay.
Tobias: I got some interesting stats. I collect a list of these just little tweets that have got little funny data points. So commercial loan demand has–
Jake: This is recession indicator stuff, Toby?
Tobias: Yes, recession indicator. Commercial loan demand has slumped to the point that’s consistent with past recessionary periods. Here’s a weird one. Cardboard box index is used to gauge consumer goods production. The output of boxes is believed to be an indicator of future production of consumer goods, since it’s so common for packaging and shipping. According to this index, a US recession is lingering. We’re still in one. There’s a few of these funny things around. LMI, Logistics Manager Index, hit an all-time low. Quiet implosion of activity occurring in the freight sector.
Jake: Yeah, Berkshire’s, like, BNSF’s volumes are off. I think they were off 10% or something. That’s pretty material.
Tobias: There’s been a freight– I don’t know what it is, but there was that freight company that collapsed last week. Pretty big.
Jake: Oh, yeah. Convoy’s.
Tobias: Convoy.
Chris: Yeah. Trucking employment, transportation eEmployment. You look at temp staffing has fallen off a cliff. You look at job openings have fallen off a cliff. Everybody points to labor and employment as such an indicator of strength. It’s such a late cycle indicator, but there’s leading indicators under the hood of employment, all of which are just completely tanking.
Tobias: Right.
Jake: Housing.
===
Yield Curve: Unpredictable Lags and Real-Time Signals
Chris: The other thing that’s interesting, Toby, you mentioned the yield curve when we got started. There’s data that shows the magnitude and duration of inversions correlates nicely with the magnitude and duration of recession. On both those measures, this has been one of the longest and deepest.
Tobias: Yeah.
Chris: The other interesting point is, when it inverts, that’s been probably the single best predictor of recession historically, if you had to point to any one indicator. But the lag is totally unpredictable, right?
Tobias: Right.
Chris: What’s more predictable is, when it reverts like it’s doing now and you go from deeply inverted and it starts shooting straight back up, that’s a much closer real time indicator, which is kind of scary now that everybody has completely written off the– Earlier in the year, it was like 100% certainty. We’re in recession now. There’s every single buddy you talk to is soft landing camp.
Tobias: It’s [crosstalk] something happen.
Jake: Yeah. Be careful. You’re going to give Toby, a full horn there.
[laughter]Chris: Am I singing your song over here?
Tobias: That’s my song. Folks, that’s full time. We made it to the end.
Jake: How they get in touch with Chris if they want to?
Tobias: Yeah. Chris Pavese, Broyhill, how do folks get in contact with you if they want?
Jake: Yeah. Well, first thing you should do is go to the website which we just relaunched after spinning out. So that’s just broyhillasset.com. I’m also on Twitter periodically. I don’t even know what my handle is, but if you look up Chris Pavese, I’m sure it’ll come up somewhere.
Tobias: Perfect.
Jake: Cool. Good seeing you, buddy.
Tobias: Yeah, thanks, Chris.
Chris: Yeah. Thanks for having me, all. This is fun.
Tobias: Pleasure. We’ll be back next week.
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