In their latest episode of the VALUE: After Hours Podcast Jake Taylor, Tobias Carlisle, and Scott Weber discuss:
- How to Build a Diversified Portfolio with Factor Investing
- The Druckenmiller Algorithm
- The Magnificent 7: How Digital Ads Have Destroyed Other Forms of Advertising
- Why Fairfax’s Stock Price Has Tripled in Three Years
- Microsoft’s Transformation: Phenomenal and Unbelievable
- The Energy Sector: A Monolithic Monster or a Hidden Opportunity?
- The Problem of Too Much Debt in a High-Rate World
- The Credible Case for Investing in Energy Stocks
- There’s No Place To Hide!
- The Fed Needs to Stay Disciplined, Even if It Hurts Stocks
- The Straw That Breaks the Camel’s Back Could Be Credit Distress
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: This meeting is being livestreamed. I am Tobias Carlisle. This is Value: After Hours, joined as always, by my cohost, Jake Taylor. Our special guest today is Scott Weber. He’s the Senior Portfolio Manager at Vaughan Nelson. He runs a concentrated large cap portfolio. We’re going to talk to him right now.
Jake: Welcome, Scott.
Scott: Thanks, Jake. Thanks, Toby. Good to be here. Great to break the fourth wall here.
Jake: [laughs] Well, funny enough, so Scott and I are both in St. Louis right now for an event. I don’t know, we’re maybe four doors down from each other in different hotel rooms. Yeah.[laughter]
Jake: But it felt like it was going to be too crowded to try to jam in front of one computer, so we opted for this.
Tobias: I think it’s a good idea. Let me ask you, Scott, what is a concentrated large cap? What does that mean to you?
Scott: That’s a good question. To us, concentration means less than 30 names. We feel like that gives us the ability to express the conviction and the work that we do. It frightens some folks because it sounds like it’s too concentrating of diversification is held over your head like the Democrats, and it turns out that mathematically, you don’t need to own 100 names to be diversified. You can have ample diversification. We would argue better diversification than the S&P 500 through factor work, et cetera, through careful consideration of what really moves a stock. And of course, large cap is going to be determined just by relative framing on what’s available in the world. So, we’re not buying small caps necessarily. We’re hired to beat the S&P, essentially.
Tobias: So, what’s a big position at inception?
Scott: Well, big at inception would be kind of full 5%[?].
Scott: Not often do we do that. Classic example, and here we go right into the compliance gauntlet with naming names– [Jake laughs] back when it was called Google. When they announced the Motorola acquisition, which was universally just thrown upon. We started pretty close to a 5% position, knowing the business, having that opportunity. But I can count on my hand the number of times we’ve started there. Typically, it’s a 2% to 3% of capital type position. I should mention, we are not market timers. So, we are long only and we’re fully invested. So, we occupy the equity component of our clients. We say we’re the protein– Remember back when you’re a kid, part of this complete breakfast, [Tobias laughs] when they’re selling you a sugar cereal? We try to be the protein.
Tobias: We got the protein and the veggies. I guess that makes me the carbs here.
Jake: Yeah. Toby, you are the– [crosstalk]
Jake: Boxed you out on that. [laughs]
Jake: The dessert.
How to Build a Diversified Portfolio with Factor Investing
Tobias: You say that you’re diversified or potentially better diversification than the S&P 500. But how are you thinking about diversification and concentration, names and sectors, and how do you think about that?
Scott: Yeah. So, in our industry, we’re trained to think about it in terms of sectors, and I find that to be really blunt. So a couple of years ago, S&P breaks out REITs, separate and distinct from financials. They get their own label, but that doesn’t make them more or less interest rate sensitive, for example. The other side of that is you look at a company like Amazon, it’s a consumer discretionary. But realistically, it behaves as if it’s a technology stock. So, we use a proprietary model– I’ll really stressed at the beginning, we’re fundamentally driven bottoms up. But we’ve got phenomenal factor resources internally that are proprietary. They’re driven largely by data that we stem from an outside vendor, but we can ascertain– It’s essentially a big regression on what’s moved stocks at the end of the day.
So, if you can ascertain what’s really driving stocks, you can own less than 30 stocks and have a beta that’s similar or lower than the index, because you’re not stacking factors, because you’re blinding yourself with sector bias. By and large, sectors are a generally good tool. But like I said, they’re blunt. And if you look at the index for comparison, whether you want to use the Russell 3000 or the S&P 500, it turns out, again, because cap weighting, that top end is monolithic. So you’ve got Microsoft, Apple, Amazon, Alphabet with the two classes added together, Meta, Tesla. You get down a pretty good ways before you get to UnitedHealth or Berkshire Hathaway. And so that top end looks a lot alike.
We’ve got a chart in our deck, which I don’t know, if you want to link these things, but we can link it. Fancy names for all of these, by the way. The better the data, the funnier the name, and we call it the bubble chart. But literally, it is just a factor correlation of each of the two stocks, and we cap sort it. You can see when you look at the index, the way we draw it’s a bunch of blue circles. If you look at our portfolio, it’s fewer blue circles, more blue and red, indicating that the names are not highly correlated from a factor sense. And so, we think, if for no other reason, because we start with an engine that’s considering a little bit above 30 overall factors, some of them move together.
To the extent that three factors or four factors behave similarly, you don’t need to diversify across them. You just need to have exposure to one of those. Now those relationships change a bit over time. But to the extent that you’ve got exposure to one of those factors, the other two or three are going to behave similarly, we call them virtually independent. Right now, you can describe the behavior of the index, I guess, if you will, in a mid-single digit number groupings of factors. That’s taking 33 or 32 down to 6 to 8, just because even though Amazon, as I mentioned, is consumer discretionary, it behaves a lot like Microsoft. Whereas our portfolio has somewhere close to double the number of virtual independent instruments, and that’s going to take a huge asterisk and description, I’m sure, for compliance purposes to describe what that is. But the net effect is, if three things behave similarly, you don’t need to own all three.
Tobias: Are you quantita–? Sorry, JT.
Jake: Do you feel like that the more that we see indexing eating the total allocation pie, do more and more factors clump together in that scenario?
Scott: Yeah, especially at the top. On a year to day basis, what is the S&P? Up mid-teens percent, something like that. The NASDAQ somewhere up 40%, something like that. Those names that we described, that top 8 or 10 of the index, what is it, 30% or 40% of the cap weighting the index? So yes is the short answer to your question.
Tobias: Are you quantitative?
Scott: Me, personally? We’re digging right in though, aren’t we?[laughter]
Jake: Yeah. How high can you count?[laughter]
Scott: Jake, I think I told you last night, I was at this reunion this weekend, my friend has two kids in college, one studying calculus, one studying accounting class, and he said, “No, dad, it’s not a counting class. It’s an accounting class.” [Jake laughs] I’m more likely to need the counting class, but we’ve got a team that we work with who are quantitative, I would say. But more importantly, the process and the way we manage capital is not. This is an adjunct. It’s an information source. It’s an objective partnership, if you will. And so, we can understand, for example, if I’m considering including a name in the portfolio or considering excluding a name that we have owned, we start with a fundamental sense, but we need to know from a qualitative standpoint, what does this do to our factor exposure?
So again, to your question about, what is concentration, if we’re going to between 25 names and 30 names on average, I want to make sure that we don’t have massive factor stacking at the top end, i.e., we’re not a closet tech fund. But at the same time, there are certain factor exposures that we might choose to over index or under index. And so, what it does is– This team is an essential component to what we do and is complementary, because personally, I’m not quantitative. The process has a quantitative input that is complementary, but it doesn’t drive the investment decision making, if that makes sense.
Tobias: So, the investments are discretionary bottom-up fundamental analysis. But then, whether it’s added or taken away from the portfolio, there is some consideration of, do we need the fifth energy name or whatever the case might be?
Tobias: Are we too exposed from a risk perspective, perhaps?
The Energy Sector: A Monolithic Monster or a Hidden Opportunity?
Scott: Energy is a great example of that. Because if you look at that sector, look, the price per barrel is really the predominant driver. At the end of the day, especially if you get down, there might be some nuanced differences between one small cap drilling in one basin versus another offshore in an exotic location. And so, you’ve got different risk parameters that you’re bringing in there. But realistically, at the end of the day, even though we try not to invest based on the underlying commodity price, in other words, to the extent there’s upside in the commodity, we want to get that for free. We don’t want to pay forward for that, but your risk is very similar. Energy in particular behaves almost monolithically.
Tobias: Let me give a quick shoutout to all of the folks at home. So Seattle, first in the house. Santo Domingo. Gulf of Mexico. Got a question from Brent. Going to have to come back to this. It’s going to be, “Why do you think the government would raise rates much higher when it would have to pay more debt–?” Petah Tikva, Israel. What’s up? Brandon, Mississippi. Moncton, Canada. Savonlinna, Finland in the house. Mérida. Durham. Gaza, Palestine. Really?
Tobias: Stay safe there. London. Battersea, London. Toronto. Hamburg, Germany. Houston. What’s up? Scott’s from Houston. Albany. Gothenburg, Sweden. Salon from Dubai. How is everybody? Thanks for joining us. I think I’ve got all. Oh, Winter Park, Florida. Sorry. Knoxville, Tennessee. I think I got all you guys now. Cool. Let me ask you– [crosstalk] Yeah, JT. Sorry.
Jake: I was just going to make a joke that Scott’s from Houston, and land of big trucks and oil and everything. But then his initials are SJW.[laughter]
Jake: Couldn’t help but point it out. You don’t strike me as particularly a social justice warrior.
Scott: Well, I might have my soft spots.
The Druckenmiller Algorithm
Tobias: Scott, to what extent does the macro factor into what you guys are doing? If you’re fully exposed, probably not a great deal, but how do you think about it?
Scott: Well, you’ve got to be aware of it. To the extent that you’re a ship going through an ocean, if you see a wave coming, you want to turn into it for stability. So we use, obviously, outside providers. I’m less interested in what an analyst forecast for the S&P 500 at the end of the year is. I’m more concerned with where we’re seeing inputs, obviously. I think the world has become more attuned to this, but liquidity absolutely matters. Not just rates, the liquidity. I want to say it was a Druckenmiller algorithm that fundamentals may move securities, but liquidity moves markets. It’s absolutely true. So we’ve got a host of tools that we’ve built internally to track that. We have one person on our team who comes through [unintelligible [00:12:28] data every Friday afternoon.
Going back to Alphabet, is the Fed activity going to change our investment thesis this week? No. Is it important over time and is it a consideration in the background to the extent you build a mosaic for each and every security? 100%, absolutely.
The Straw That Breaks the Camel’s Back Could Be Credit Distress
Tobias: I get teased because I talk about the 10-3 inversion a lot. But to what extent do you look at rates or those sort of things like the 10-3? Because I’m fully invested, whether the 10-3 inverts or not is largely irrelevant to the portfolio construction. I just point it out because it’s got a record of front running recessions, which equity markets tend to do poorly in recessions to put it mildly. So that’s why I’m alert to that as a risk. Do you look at it? Do you think about it?
Scott: Oh, yeah, absolutely. It is important, and certainly to the extent that you want to look at the risk curve. If you’re looking at a business that is, say, more dependent on external capital and there’s a debt roll, it’s not a financing need that gets you. It’s a rolling the debt need that gets you from a bankruptcy. There’s a business that Jake and I are going to discuss later today, that’s got a substantial amount of debt. Its average coupon has a three handle on it. They’re rolling into a six-handle market, they’re going to be less profitable. Just prima facial.
To the extent that an inversion implies recession, I think one of the comical lessons of 2023 is we entered this year with everyone on the planet waiting for a recession that may or may not have already arrived, depending on whose scorecard you want to use. And yet, at the same time, we’ll have half the analysts on the planet out there trumpeting that the curve inversion is a nearly perfect record for predicting the recession. And at the same time, an almost nearly stalwart record is that however many number of times you’ve had the S&P– I forget the specifics of this. I should have written it down. But if you’re down more than 20% by August, you’ll be up the next year something like 8 out of 10 times, that didn’t fit the narrative. And so nobody trotted that statistic out until we woke up in August and said, “Oh, my gosh, the market rallied. How’d that happen? By the way, where’d that recession go?”
If a business is using external capital, rates absolutely matter. It’s absolutely part of it. I think that one of the fundamental things that we preach is that you have to underwrite the credit before you can understand the equity. More often than not, as equity investors, we take the credit for granted. The big lesson of 2008 was that you can’t do that anymore, but you can have acute credit stress. And to call 2008, a Great Recession, I think it’s probably not the right label. I just think it was a credit distress event.
It’s funny. We talked to our institutional clients, and there’s a decent cohort of institutional clients who are deemphasizing their public equities in favor of private credit at the moment. I think that there may be some merit to that discussion, but it overlooks what I think you’re getting to, which is that rates are higher, spreads are not yet really meaningfully higher. To the extent that we do go into a recession, they will be, and there will be ample sponsored businesses that have trouble rolling their debt.
I spoke with somebody yesterday who works at a healthcare business that’s private equity sponsored. That’s, I think, by his admission, seventh in their market, and they’re rolling their debt. And of course, he’s worried about his job. There’s real credibility to that view. [chuckles] To the extent that you’re first in the market, you’ve got an asset that might have strategic value to somebody else in the space. To the extent that you’re seventh in your market, you’ve got a call list and a product that clearly is lost out to better product in your marketplace. When your debt matures, it’s going to roll to the extent possible at a higher rate, it’s going to cost you more. That could be the straw that breaks the camel’s back there.
The Fed Needs to Stay Disciplined, Even if It Hurts Stocks
Tobias: Do you have a view on where the economy is, whether it’s cooling and it’s heating up?
Scott: No, it sure feels like deceleration, doesn’t it?
Tobias: I think so. Yeah.
Scott: I think that this particular week, and as I look over Kesh & Kerri’s on Bloomberg right now, the Fed is being vocal about needing to maintain discipline. There’s a certain cohort of equity investors who cry foul and say, “The rates are too high, you’re choking off the economy.” And a few people who want to run for president probably say the same thing. The fact of the matter is inflation is really tough on assets. And to your audience, we don’t need to describe why. But as long as that view holds amongst policymakers, and as long as we do not yet have a labor crisis, and I think crisis is the right way to think about it, I think to the extent that we’ve shed jobs, much of them have been technology or finance white collar jobs, which aren’t–
Let’s just say, if you lose your job as a barista somewhere, chances are your marginal propensity to consume is more diminished than if you lose your job at Facebook. And so jobs are not an issue. Inflation is off the boil of June, a year or so ago, and it’s a high single digit number. It’s still above the target. And certainly, to the extent that you look at PCE, which is their purported metric, there’s no basis for saying the Fed needs to act unless you just want your stocks to go up. And of course, I want our stocks to go up, but we also want to play the long game here. So you are not at the extreme either way, but you’re not accelerating either it doesn’t feel like.
So, from a monetary standpoint, we’re restricting the flow a bit. From a fiscal standpoint, whether it’s the CHIPS act, the Inflation Reduction act, there’s a lot of stimulus going in to the capital market space, essentially, and that offsets some of what the Fed’s doing.
Tobias: Yeah, that really muddies the picture. I don’t know how you resolve that one way or the other, honestly, because I don’t know– That inflation Reduction act, the rate at which they’re getting that out the door seems to be pretty—They seem to getting it out pretty quickly. There’s a lot of spending around.
Scott: Yeah, I think the name’s wrong too.[laughter]
Jake: Yeah. You might have that backwards.
Scott: When the bill was passed, we know that inflation was on the front page of every newspaper in the United States. So, it was important to say it. I think for a large portion of our population, if you say, “Hey, look, we did this thing called the Inflation Reduction act.” Somebody at home can say, “Look, they’re reducing inflation.” That may not be exactly what’s going on there. And by the way, there’s external forces, not the least of which the war in Gaza, the war in Ukraine. The Panama Canal doesn’t have enough water to get all the ships through that. I noticed earlier two ships have turned around and passed back.
Well, guess what? If you ship through the Panama Canal to the Gulf Coast of the United States from Asia, and now you’ve got to go all the way around South America, that longer ton miles seems very inflationary to me.
Tobias: It’s hard to know–
Jake: Not great, Bob.
Tobias: We’ve been through such a strange time with COVID, and then the lockdowns, and then all of the– That stopped production domestically made importing more difficult. And so there was a big backlog of ships out here in Los Angeles at the port for a long time. At the time, we were joking about the fact that like they were projecting– It was going to take them 18 months to tidy that up, which to me that just sounded like we don’t know when that’s going to be tidied up. But I guess they must have got there by now. They must have cleared it because it’s not in the news anymore. I don’t see the ships out on the ocean here– [crosstalk]
Jake: Look out the window, Toby. Give us a real time update on it.
Tobias: I only see a handful of them around. They must have sorted that out. That would have seemed to be– [crosstalk]
Scott: [crosstalk] shipping expert. But as I recall, that backup was largely resolved, I think, in the first quarter of 2022. And if you think about the seasonality of cargo shipping into Long Beach, there’s a lot of toys that are shipped in the fall for obvious reasons. When those toys didn’t make it under the tree by Christmas, but they were still on the boat and on the way and they came over and they arrived January, February, maybe into March, your seasonal adjustment on that first quarter GDP was completely wrong. [laughs] The seasonality was wrong because of the post data that, and that’s why we had a good print there, which I think fed into the inflation narrative in a way that a lot of people didn’t fully appreciate.
Jake: That doesn’t make any sense to me. I thought that Santa brought them on Christmas Eve.
Jake: Do they have to come through the port?
Scott: Of course, he does. He just dropships a few for easier distribution.
Scott: [laughs] The reindeer need to stop for green juice.[laughter]
Tobias: So, we talked earlier about the concentration of the Magnificent Seven. The last number I saw was 33%. I’m not entirely sure how old that was. But say 33%, which by any measure going back, that’s about as high as it’s ever been. That does seem like very high concentration, and traditionally, that’s been a warning sign that some sector or something has got a little bit overextended. But it seems to me now that those businesses really are the biggest businesses in the market. They’re rich, but I don’t think that they’re overvalued. In some instances, you could probably make a pretty good argument. Some of them are fit with reasonable value. What do you think?
Jake: How do you navigate that as a large cap manager?
The Magnificent 7: How Digital Ads Have Destroyed Other Forms of Advertising
Scott: Yeah. Your point is correct. The concentration is high. There have been periods of time when it’s been high. Prior to a lot of investors lifetimes now, but NIFTY 50, period, et cetera. If you look at Polaroid and Exxon and the companies that were the darlings of the day, you didn’t have them all really in one industry. And certainly, you’re right, depending on how many numbers of companies you want to use in the top end of the index are 30-ish percent. But it’s also, on a year-to-year basis, over 80% of the performance.
Scott: It matters. Three of them are in the cloud business. Several of them are [unintelligible [00:23:54] There’s decent concentration around a business, which I’d further point out is not as capital intensive as the businesses were NIFTY 50, period. I think Michael Mauboussin and others have done great work on the distinction between an income statement today versus what you would have seen back then. But all that goes to your greater point, which is, yeah, they’re good businesses. We don’t happen to own Meta, for example. You could look at that and see– For example, the product monetization arc coming in Reels, and you could see and get excited about that. But at the same time, you’ve got a management team that was losing Sheryl Sandberg, who many would have said was the grown-up in the room, the adult at the party, so to speak.
You’ve got a management team that’s throwing tens of billions of dollars at reality labs. Here we are today, fully capable of putting goggles on for this conversation, and yet we choose not to do it. I don’t know where that market will be. I just know that it’s an incredibly profitable business that, in my estimation, was flushing dollars down the toilets. But for a stroke of luck, they had a change of heart to reduce some exposure there, and it turns out that the Nvidia chips that they bought have application for their AI effort. Blind luck, which has been helpful to them. But it doesn’t change the fact that the underlying business at Facebook is a good business. The underlying business at Google is a good business. Apple is a good business. Apple’s a tech company that is essentially a high margin staple at this point.
Further to that, I shudder at the fact that I’ll be the first to bring up this whole growth versus value thing, because I think that [Tobias laughs] the end of the day, we’re going to preach value. Our firm, our roots are in value. But at the end of the day, I’ve never met a value investor who would swear off growth or a growth investor who would voluntarily overpay. It’s just a question of where you think that is. But point of fact, a lot of these businesses are in the growth hand to value index. So, you don’t have a disparity on that metric. You don’t have a huge disparity on what they do. You just have this crowding about the top of the index, which, to me, says that, if you want diversity, you want to get away from that, maybe–
First of all, does that undermine the validity of the S&P 500 as a benchmark? Look at it over time. Far be it for me to cast a shadow on their business wall. By the way, that’s probably the greatest business model. You get to use our name and you pay me a bigger and bigger fee every year, and guess what? We’re going to raise the rate more than inflation. I’d love to own that business.
Tobias: It gets cheap every now and again.
Scott: Yeah. I just feel like, as an investor where capital preservation is a preexisting condition for survival, having all your eggs in one basket is risky. Now, we’re paid to be measured against the index, and so we have to be aware of it. But our goal is to compound our client’s capital at a mid-teen rate. We want positive asymmetry. In other words, if we’ve got a 50% upside expectation, we cannot have a 50% downside expectation. It can’t be a flip of the coin. It’s got to be a better than 50-50 bet. But we want to compound in a mid-teens rate because at the end of the day, our clients hire us. Yeah, they choose us instead of, or maybe in complement to an index, because they think that we can do better. Part of doing better is not looking exactly like it. And so to finish first, you must first finish. That’s why having an absolute return goal, I think, is an essential component of anyone’s approach. Otherwise, you’re just playing a game. You’re not investing.
Tobias: Yeah, I couldn’t agree more. I think it’s an interesting construction of those top are. They’re all regarded as being tech, but they are still like– Netflix is quite a different business to Apple. Apple’s quite a different business to Google. Microsoft’s completely different again. Amazon’s doing something completely different. Again, even though there is a lot of overlap with the cloud, and they’re probably buying and selling a lot of services to each other too. That concentration makes me nervous when I see it get up like that. When I see things that are unprecedented in the market, I always get a little bit nervous.
Scott: Well, they’re all ad businesses at the end of the day. If you think about it, they’ve destroyed pretty much every other form of advertising. That’s because the efficacy of a digital ad at various forms is way better than putting something in print, or radio, or even up on the billboards. It’s measurable in a way that those other forms are not, and it’s more interactive. It’s just– [crosstalk]
Scott: Yeah. It created a new space. And essentially, in so doing, depending on how deep you want to go in the ad rabbit hole, you go from being an advertisement to being a commission on a sale at the extreme.
Why Fairfax’s Stock Price Has Tripled in Three Years
Tobias: JT, do you want to take a shot at your veggies?
Jake: I do, and I shall.
Jake: [laughs] I don’t remember why it popped up, but in late October 2020, I did an interview, an appearance on TIP with Preston and Stig. I don’t usually talk about individual names ever, but I made an exception that time, and I talked about Fairfax back then. I thought it might be interesting, now that we’re three years on, to do a little post mortem on that. What I saw at the time, what’s happened since– If you rewind the clock back to three years ago, we were smack dab in the middle of the pandemic. We still didn’t know what we were really doing from a policy standpoint. Not sure if we ever figured that out.
But you also had, like, the market had ripped 30% off of the March lows already by October. I felt a little bit like whistling past the graveyard sometimes. It’s easy to forget, but US Treasury, the 10-year was at zero point 79. Like, 0.79. We were talking about MMT at that time, we were talking about, can rates go negative in the US. I think there was something like $17 trillion worth of sovereign debt that was trading in negative rate territory already. Why wouldn’t the global reserve currency also potentially trade negative? The line from the last 40 years pretty much looked like this direct arrow that was going to go negative.
Tobias: It’s not over yet. It’s not over yet.
Jake: [laughs] You’re right. Don’t call it. Yeah. And of course, in that situation, banks and insurance companies like Fairfax, they’re going to have serious trouble earning on their assets. They have this big pile of cash that they have to do something with. If you’re getting 0.79 a 10-year, boy, your ROE is going to suffer. Fairfax was no exception at that point. They had really inconsistent operating results for the five years before 2020. Net income was roughly flat in 2015 and 2016. 2017 was a little better. I think it was around $1.7 billion. Then 2018, it was flat again. $2 billion in 2019, flat again in 2020. So, you’re just like up and down, can’t really get it in gear. The ROEs, of course, are following that same kind of earnings pattern. They were relatively anemic, especially compared to historical, if you looked back.
Prem[?] and team at that time were being much maligned for this, hedging into the face of a bull market at that point. The narrative was really that a lot of the pessimism basically was justified because they weren’t doing a great job in their investment portfolio. It was up and down. It just felt like, where is this going? But the market sentiment, actually, surprisingly, the price to book over that five-year period was actually like 1.2 times, which was higher, actually. Sorry, that was a high of one and a half times in 2015. And a low of 0.9 in 2019. And the five years before that, from 2010 to 2015, they were actually cheaper. They averaged about one time price to book during that phase.
So you had results, and yet it wasn’t really that cheap all along. I guess maybe people thought they were going to figure it out. I don’t know. Anyway, what’s happened in the three years since that setup? Of course, insurance rates have experienced a hardened market mostly through that time period. They’ve had pretty good results, as you would probably expect. Net income in the last four quarters alone has been almost $5 billion. That’s on today like $20 billion market cap. These rates going up, obviously, is really helping their ROEs quite a bit. And especially for Fairfax, they didn’t take a lot of duration risk. So, their bond portfolio didn’t really get pinched and hammered as much as other people who took more duration risk, more credit risk, and really reached for yield during that time period.
So as bond yields have been going up, they’ve been able to deploy into these higher yields. The average ROE for Fairfax since that podcast came out has been around the 20% range, which is, obviously, quite a bit healthier than zero that it was before. Naturally, then the math, book value has grown from $11 billion to $20 billion. So in late October 2020, the price per share was around $266. And today, it’s around $900. Now, lest you think I did anything too heroic here with that price movement, my cost basis is higher than that, $266, [Tobias laughs] but not a ton. But what’s been really interesting to watch, it’s been fairly easy to hold it this entire time, and that’s not always the case often when you have the price going up of something that you own.
It’s because I felt like Mr. Markets never really pressed my hand by giving me too tough of a decision, by pulling forward gains. So, the average price to book over this time period, the last three years, has been 0.9. So, you’ve still been like below book value this entire run. The high was earlier this year, and it didn’t even get above 1.2. So, it never really felt like, “Hey, man, this is getting expensive. You should probably punch out.” No, it’s just been business results growing, staying relatively cheap, and so you haven’t really been that tempted to sell.
When I contrast that with something like Markel, which I’ve also owned, on average, it’s traded at 1.4 times price to book. So, there’s a little bit of a difference between 1 and 1.4. 40%, by my math. [chuckles] But it briefly got down to 0.9 price to book in March of 2020 for like a week. I was a relatively happy buyer at that point as well. It’s not anything heroic there either. You follow these businesses, and they sell off occasionally, and when they get to that level, if you just hold your nose and buy, I think it tends to work out.
I think one of the interesting things I’ve observed is that sometimes the higher quality business is actually harder to make money on because it doesn’t trade at these extremes that some lower quality businesses do. And as long as you feel like, in general, that the trend is a little bit up and to the right for the business results, the fact that the valuation can move so far up and down away from that actually provides you the opportunity to be a clever buyer and seller along the way and boost your return over and above if you just bought and hold the entire way. So ironically, sometimes I feel like I could make more in a Fairfax situation than even a Berkshire, even though Berkshire objectively is a better business across almost any measurement that you would want to trot out. So, the difference between just purely business analysis, but also taking advantage of Mr. Market, I think you have to marry those both together if you want to get the best result that you can.
Tobias: Yeah. March 2020, what a great time for buying stuff.
Scott: Pretty much.
Jake: Who knew?
Jake: Yeah. Pretty much.
Scott: Unless you put it all on toilet paper that day, you made money.
Tobias: I posted a few things. I was tracking Berkshire’s price to book through that, and Berkshire got about as cheap as it got. Most of the comments underneath were how the book value was impaired at the same time, which was true, but slightly missing the vast forest for the trees.
Scott: Jake, it may not have been your intent, but one of the veggies I took from your discussion of Fairfax, there is the notion of standard deviation of a stock price, which is often conflated with risk from a mathematical sense in our business. It could actually be not necessarily just risk.
Jake: Yeah, absolutely. I think the standard deviation gives you the opportunity set to be able to do things that, when it moves to extremes, you can hopefully make some smart decisions around that, as long as you can get comfortable.
Jake: I think half this job should probably be really keeping just an inventory of businesses that you understand, and trust that the trend is generally up and to the right. It doesn’t have to be perfectly linear. And then just being patient and waiting for when they do go on sale, and then being a little cutthroat when they get overly expensive, and they might come back to you again.
Scott: What would you call that list of ideas?
Jake: Idea inventory? I don’t know.
Scott: It’s funny.
Jake: What would call it?
Scott: It’s exactly what we do. We don’t know what to call it. So, we’ve got our 27 or so names today that we own, and we’ve got a list of probably 100 great businesses. I call them great businesses. We’ve called it the ideal list, which is not really ideas, because these are names that we’ve met with management, met with competition, met with suppliers, understand it. And if given the chance to invest, we could act quickly. That’s where most of our ideas come from. We nurture that. I can’t say it’s the same level of maintenance and diligence for things that we own, but to me, that’s the wellspring.
I’ve been at this firm for over 20 years now. There are businesses that we’ve owned maybe three times through that period. And the good thing is, most of the things that we do in this industry from a knowledge perspective are cumulative. Said differently, very seldom do you look at a business that’s a higher ROIC business with improving margins, and then all of a sudden, it’s not. Occasionally, you’ve got a business that has a lower return division that they sell off and it pops up, or maybe they deploy capital and they haven’t fully absorbed the fixed cost yet, or something like that. But by and large, there’s certain attributes to businesses that tend to be sticky. And so, there’s utility in maintaining those ideas and names on the shelf. I just don’t know what to call it. [laughs]
Jake: Yeah. I feel like watchlist implies more like you’re watching the price. I don’t know, if that’s fair or not. But in my mental model of the world– It’s not really the price that you’re necessarily hyper focused on. I think it’s also maintaining some range of intrinsic values where you’d be interested in, or maybe even ranges of valuations that you would be interested in taking an action.
Tobias: I feel like this earnings season, there’s been a lot of volatility around earnings, particularly that companies have sold off in size 20%, 30% on earnings that haven’t been that bad from my– even the Magnificent Seven have had pretty good earnings and then gotten smacked in the after hours. I think a lot of it’s recovered. I think they’re at all-time highs as we’re speaking, but that’s always true, right, evergreen?
Scott: Yeah. Flipping over to the screen, it’s definitely shades of green. I think you’re right. I don’t have a study on the data yet, but anecdotally, there’s been more noise this quarter than there has been in the past. I think oftentimes when everything– This goes back to the liquidity comment. When liquidity keeps coming in, it’s a function of up and up more when you’re at a slack tide, let’s say, fundamental performance matters. And to the extent, you have a competitor report a good or a bad quarter and your stock price reacts, and then you report something similar or opposite, you might adjust or correct that– I think said differently, for most people, their investment lifetimes have been marked by declining interest rates. We’re through that for a while. It would be very difficult to have another 30 years like the last 30. So, for the next 10 to 30– [crosstalk]
Jake: Where do you go? Negative 10?
Speaker 4: Yeah, exactly. You don’t have that extra wind in your sale, so the alpha component of your returns stream is that much bigger by comparison. So you can’t lean on beta as much, if that makes sense.
Tobias: I’ve got a suggestion for your watch list from the crowd. Padraig Murphy says, “You should call it a BULLPEN.”
Scott: I like it.
Jake: Ooh, BULLPEN. Yeah.
Scott: I think…
These are names that we follow, want to look at, and add and do the work. But you’re right. Bullpen can us that we’ve done the work, we have the ideas contained, so to speak. I like that.
Jake: Yeah. Jon Huber has a construct that he uses baseball related, and it’s like his AAA team, his AA team, majors team stuff that you own.
Scott: So, I love using sports metaphors when we talk about investing. When we talk with clients, I say, “Look, if you’re going to pick a team to win the game, you need one good quarterback, a good line, a running back receiver, defense, kicker, ec cetera.” I get laughed out of the office, particularly by my colleagues, one of my colleagues is a huge NBA fan. I respect it, but it’s not my favorite thing. I don’t follow it. I’d rather follow stocks, but I digress. I made a reference to the worm[?] the other day, which clearly marked my age, and he had no idea who the worm was. And so I’m working this in only because I’ve been sworn off discussing and using sports metaphors in the context of client meetings. But unless and until this is specifically construed as a client meeting, I feel like we’re okay with sports metaphors.
Tobias: You can use them. I might miss a few of the–[crosstalk]
Tobias: Jake is giving you [crosstalk] references.
Scott: If I’m all thumbs in basketball, I’m not going to be no good on cricket. Sorry. [laughs]
Tobias: Yeah. Cricket and rugby. That’s what I’m going to be talking about.
Scott: Soccer, I can meet you there in soccer.
Jake: Kangaroo boxing. What else you got, Toby?[laughter]
Tobias: Yeah. I played soccer when I was a kid and so I understand the offside rule, which makes me Bill Belichick among the dad coaches in AYSO soccer.
Jake: Oh, yeah.
Tobias: Nobody understands the offside rule. It’s hilarious. Even the referees.
Scott: It seems to be arbitrary and enforcement too, at least in the league my son plays in.
Tobias: Yeah. They’re all volunteers. That’s what I always say.
Scott: It’s funny. The first admission, he was in a baseball tournament the other day and I was chatting with one of the Elms in between games, and he said, “Sometimes it strikes us this big, sometimes it’s this big.” It really depends on how the game’s going. I really appreciate [Tobias laughs] your candor. I didn’t think anybody would ever admit that. Unfortunately, we don’t have that luxury in our business. The data is objective. It’s greener, it’s red at the end of the day. That’s all you can handle.
Too many people in our industry go out and try to pick a team full of Tom Brady without considering that they need a line and a running back and that sort of thing. I think you hold everything to the same, super low risk, high return, et cetera. Obviously, it’s got to meet those thresholds and ideals. But at the end of the day, you have to have components that complement each other. To our earlier discussion of diversification, just having two different sectors represented doesn’t do the trick. They need to actually be complementary assets.
Jake: That’s a fun game. Which stock today is Tom Brady?
Tobias: Undervalued– [crosstalk]
Jake: Like, not retired, but [crosstalk] it depends on what–
Tobias: What vintage?
Jake: Yeah. Well, that’s the question too. Like, it’s the vintage as-
Tobias: 199– [crosstalk]
Jake: -best years behind him, but also the greatest of all time. I don’t know.
Microsoft’s Transformation: Phenomenal and Unbelievable
Scott: The first name that jumps in my mind right now– I’m going to say one of them because the other one might not stay in my mind in that context, but Microsoft, I think that Steve Ballmer probably gets short shrift for the accusation that anything decent in Microsoft was subsumed in Windows because that was his baby. It’s probably not without merit, but also not fully true. But the transition that the company’s had since Satya arrived, or at least took over with respect to the cloud transition now on straight into AI, it’s phenomenal. It’s just unbelievable.
If you look at the productivity gain just today, the folks that do the data representation for the factor analysis that I was describing earlier with the fancy bubble charts and whatnot, they tell me that the productivity gains that they have through using ChatGPT, which isn’t specifically Microsoft, of course, but it’s similar, are unbelievable. If you think about how many programmers they have at that business and just overlay any productivity gain estimate for that over the number of people that Microsoft employs, it’s phenomenal. It weaves through everything we’ve discussed so far with respect to Magnificent Seven, even advertising. By the way, you don’t have to have Bing be a competitor with Google as a search engine for it to work. [laughs] I don’t hold out hope for that.
Jake: Well, we’re going to need all these productivity gains to offset all the money printing we’re doing.
Tobias: I think there are two notable events this week that we should discuss. One of them was Sam Bankman-Fried has been found guilty of fraud. I was watching snippets of the cross examination as they came through Twitter. And then late Friday night, somehow, he was– I saw it in like Asian Bloomberg. I think Bloomberg Asia announced the conviction. So, that’s maybe the period at the end of the crypto craziness over the last three years.
The other thing was WeWork has slipped into bankruptcy. I find that a little bit perplexing because I would have thought if there was a business that was built for this time where offices are being cleared out, people are largely working from home. Working from home is pretty lonely. If I had a place that was like quasi coffee shop with some private office space that was like a WeWork, for example, that would be a [Jake laughs] good place to be. I’d probably have a– They can’t make it work. I just find that bizarre. I think somebody’s going to pick up that idea and run with it, and there’ll be a WeWork. In 5 years or 10 years’ time, it’ll be not called WeWork, but something like that. What do you guys think?
Scott: I think capital markets just don’t get Adam Neumann, do they?
Tobias: By the time it went public, he wasn’t there.
Tobias: He did okay. I’m not worried about Adam. He’s clipped out his billy. [laughs]
Scott: This environment that you describe where people gather and do work in the same place, in Texas, we call that an office.
Tobias: It is. I agree. But I think that I can see something where– The offices in Los Angeles are all clustered downtown, and you can’t go downtown. And so you want to be close to– [crosstalk]
Jake: No one goes there. It’s too busy.
Tobias: It’s not that it’s too busy to acquire.
Scott: There’s no doubt that there were regional differences in the COVID response with respect. I remember a couple of years ago when Jake and I were here, went out to dinner, we couldn’t get an Uber for $25. Actually, last night, it took about…. Whereas we had folks in Houston who just kept going to the office. There are health concerns and political concerns that deserve attention but are not germane to this conversation. The fact remains that today, if I’ve got a meeting in Boston or New York, it’s going to be Tuesday through Wednesday. It’s not going to be on a Monday or a Friday. LA is probably the same way. A large portion of that is because there’s really long commutes in those cities, right?
Scott: There are people in Houston and Dallas that have long commutes, but those are by choice and fewer in number with respect to relative population. In Boston, for example, the train service isn’t operating with the frequency that it did pre-COVID. As I understand it, I’m no train expert, subway expert. So there’s a work environment attribute that really has taken over from COVID.
Jake: It is weird to have like Monday in a big city being a ghost town, and then Tuesday, you can’t get-
Tobias: It’s a zoo.
Jake: -a seat to eat lunch. Yeah.
Tobias: Tuesdays and Thursdays are zoos. Mondays and Fridays are ghost towns.
Jake: That kind of hard to run a business with that utilization rate, isn’t it?
Tobias: You can’t run a business that’s servicing that– [crosstalk]
Jake: At these fixed costs, right? You need lower costs somehow. The rent is too damn high.
Tobias: It just seems obvious to me that office is going to get– Office and everything that feeds into office is in a little bit of trouble here. I think there is some recognition of it. There are some crazy buildings are going for sale. It’s just silly numbers as far as I can see. But there’s only a handful. We haven’t seen the flush. We haven’t seen the waive-off yet. But I guess that all the debt falls due over the next year hasn’t happened yet. Haven’t had to come to reality.
Jake: Survive to 2025. That’s the mantra. Rates will be back lower again. You can refinance. Save your bacon. Don’t sell out now.
Tobias: You got to get there though.
Tobias: I guess if it’s leased out–
Jake: It’s not me saying that.
Tobias: No, I agree. I’ve heard that. I realize you just– I don’t know, it’s a funny time. Do you consider those things, Scott, the portfolios? Because the things get cheap often because people know that there’s something wrong there and you got to tease that.
The Problem of Too Much Debt in a High-Rate World
Scott: To your point, funding costs are higher. We can debate about the cultural utility of debt. But in the United States, debt is a component of most large asset purchases to the extent that it’s an investment in a building or your own home. We know somebody who got in a wreck recently and had to buy a new car. They can’t buy the same car because the payment today is higher. They can’t replace what they had even with the insurance proceeds, apparently. The specifics are not important. The point is, if you’re going to have fewer purchases, you have fewer ancillary investments and purchases with them.
Again, you’re not going to buy a new house, you’re less likely to end up painting the rooms in it. You’re less likely to buy a sofa. That has a slowing effect, which, by the way, is the intent. That’s what the Fed’s trying to do because the inflation boogeyman is real. It’s very, very, very scary. And so, the question is, can you have a disinflationary environment and support economic growth and keep people employed, or do you go straight into deflation, which is in most ways even scarier. Let’s not overlook the fact that, not just the United States but essentially the entire developed world has, what, a lot of people would say is too much debt. So you’ve got too much debt. That’s not just the government level that’s across the board. Households, less so than in the past, but certainly corporations and definitely governments. You get too much debt in a high-rate world, and that debt is rolling as well, it’s going to consume a large portion of the federal budget. So, what do we do? Are we going to issue more debt? Are we going to run out of buyers for that debt because rates are higher?
This goes back to the transmission mechanism, which are the capital markets. And so, to the extent that the Fed is successful in architecting or averting inflation, let’s say, or slowing it, because clearly they haven’t averted it. [Jake laughs] But getting control of it is a better way to say it, I guess.
Jake: You might have had that right with architecting at the beginning. [laughs]
Scott: Well, clearly, I need to architect a better way to describe this. The point is, to the extent that you can construct, lead, whatever, a soft landing, it’s way better than the other sides, and it’s also really, really tough to do because there’s a lot of debt out there. It’s fascinating time to be allocating capital, to be sure.
There’s No Place To Hide!
Tobias: I don’t know if they’ve ever actually managed to do it. The equity multiples should come down, and it also affects your business results because you’ve got some clients who can’t make acquisitions, can’t purchase your goods if they’re not financing it. And then your own cost of capital is higher, if you’ve got debt in there and you’ve got to roll the debt. Those three levers should mean that business values come down a lot, I think. I don’t think we’ve really seen that yet. Maybe the Magnificent Seven are immune to it because they’re self-financing. Still should impact the multiple a little bit, but maybe they’re– [crosstalk]
Jake: Wasn’t advertising revenue at one point considered economically sensitive? It was like the first thing that got cut was an ad budget.
Tobias: It Used to be.
Scott: Yeah. It used to be a great leading indicator, right?
Scott: I think you’re right. The extent that multiples are high in certain businesses, it’s obviously a reflection of the market’s expectation of what those businesses can do. If we tap the brakes on economic activity, you would think those would come down. The flip side of that is there are certain businesses that are really good businesses that are forlorn from the multiple perspective. Look at large banks, look at some resource businesses. You’d be hard pressed to find double digit PE types for some of those. And so, you’ve got greater, I’d say, disparity around valuations. It wouldn’t surprise me to see a narrowing of the spread from the top end to the bottom end of multiples in what you’re describing. So, does that mean high multiple stocks go down more? It’s certainly possible.
All I know is, if I’ve got capital allocated to a high multiple stock right now, and we do, to be clear, what we’re looking for is the shift in the second derivative of growth. Said differently, it’s not enough to grow, it’s got to be growing faster. And if it’s not, it’ll be fast.
Tobias: Yeah, that probably describes some of the action that we’ve seen around the earnings, where there’s pretty good numbers. But the second derivative, as you say, is indicating some slowing in the growth and they’ve been cut down a lot as a result.
Tobias: It also describes the variability in the results that you were alluding to earlier.
Tobias: Yeah. It’s hard to hide out. There’s really no hiding places. The banks have got a lot of exposure to– They’re highly economically sensitive. Energy is economically sensitive. I don’t know, where’s a hiding place?
Scott: I don’t know if there’s a hiding place, but that’s why we have jobs. Let’s be honest.
Jake: Yeah. [laughs] If it was easy, we’d all be–
Scott: Yeah. May be pretty straightforward, but it’s definitely not easy. That’s what keeps it so fascinating. That’s why we joke around the office. The last day I leave the office, my toes are up, just because it’s a fun game. It’s a really fun game. When you lose, it sucks. But with respect to overall positionings now, you can look and you can make a great fundamental case for energy, as you were describing. I know it’s not as easy as it may have been when oil futures were negative in the spring of 2020.
But then again, it didn’t seem easy at the time then either. Jake knows this. I may not be your typical person from Houston in that. I’m not a cheerleader for the energy business in particular. I think there are wonderful people doing wonderful things there, but I’m not necessarily a chest pounding Houstonian with respect to we need to drill, baby, drill to the extent that I actually have an electric vehicle, which in some circles makes me a bit of a, at least transportation– [crosstalk]
Jake: Social justice lawyer.[laughter]
Scott: Yeah, there you go. [laughs]
The Credible Case for Investing in Energy Stocks
Jake: In fairness though, Scott, you have taught me a lot about the energy industry.
Scott: Well, that’s you. I’ve worked there a bit. I’ve got a bit of a background, let’s just say that. The fact remains is, however high minded our ideals may be of replacing hydrocarbons in particular, we got to get to the point where we can do it and we’re not there. By the way, the developed world is actually doing a pretty good job. At the margin, we’re doing a pretty good job. Broad strokes. The developing world are probably justified in the view that it’s their turn and they should not be denied the path of economic growth for our ideals to this certain extent. It so happens that the GDP intensity of oil, for example, in a developing country versus the developed world is higher and growing faster. And so if you put on another point or two to GDP in the United States or Europe, your oil goes up, but not near as much as a point or two of GDP with– [crosstalk]
Jake: Yeah. It’s massages, not cars for people.
Scott: By the way, if you take, whether it’s the EIA or the BP and some of these broad reaching energy studies, and you look at the component of energy consumed in the developed world versus developing– For my entire investing history, the developing world has been the tail of the dog. I don’t mean that in a pejorative sense, I just mean a smaller component. That’s no longer the case. This is way, way outside of my area of comfort with respect to knowledge, but my sense is that the developing world is consuming almost, if not as much, oil as the developed world.
Said differently, to the extent there is any growth, you should have positive inflection of demand coming from the greater portion that is the developing world. And guess what? On the supply side, and as far we do know, we can’t meet it. There’s just not enough. At the same time, there are plenty of investors who can’t or choose not to own it. Much like the tobacco industry of a few years ago, there are plenty institutional investors where it is strictly forbidden.
Jake: Other than that, how was the play, Mrs. Lincoln?
Scott: Yeah. Well, no, I think there’s a credible case to be made for cyclical improvement in equities in that space based on unmet supply, and the fact that a lot of people can’t necessarily own it. I look at our clients who can’t own it and I said, “Well, at a certain point, we’re going to have a real conversation about what’s a fair measurement of success.” Because to the extent that our strategy owns one or two oil companies or energy businesses writ large, and that is a disproportionate share of the strategy’s return. But you chose not to own it, which is fair. I respect that you underperform. It’s not necessarily our fault, then. We’re not there yet, [chuckles] but that day may come.
For individual investors who don’t necessarily have an axe to grind, let’s say, or maybe they do on the climate, they’re actually energy companies with scope two plans out there. [laughs] They’re not all of them. And certainly, the industry is telling you in disparate moves. These are not companies that we own, but BP seems to be moving more away from hydrocarbon dependence, whereas we saw what Exxon and Chevron did. By the way, there’s no coincidence to the timing of the Chevron acquisition of Hess right after Exxon announced their acquisition of pioneer. But those are two large acquisitions. That’s a large deployment of capital from two companies that are essentially doubling down on their hydrocarbon exposure there.
Tobias: On that topic, on that point, that’s it, fellas. That’s time. Scott, if folks want to follow along with what you’re doing or get in touch, how do they go about doing that?
Scott: Yeah, I’m going to disappoint you because unlike most of the folks that you chat with, I’m not– [crosstalk]
Tobias: [crosstalk] anything.
Jake: Yeah. [laughs]
Scott: We have a website. You may have heard of this, vaughannelson.com V-A-U-G-H-A-N-N-E-L-S-O-N dotcom. That’s not long enough into the sufficient obstacle. Nothing is. We do actually– [crosstalk] Go ahead.
Tobias: The link that you discussed at the start, they can find that via the website?
Scott: The link that which– [crosstalk]
Jake: There was a report or–
Jake: Your bubbles, I think are on the chart, clear that through compliance.
Scott: A portion of our marketing materials which I believe are online, but I may need to make sure that it’s added now as a consequence. When I do that, I’ll send you a direct link.
Tobias: Okay. Thank you.
Scott: I don’t know that it’s particularly revelatory on its own, but it’s certainly fit into the conversation as we were discussing.
Tobias: Scott J. Webster, thank you very much.
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