In their latest episode of the VALUE: After Hours Podcast Jake Taylor, Tobias Carlisle, and John Huber discuss:
- Coffee Cans vs. Punch Cards: The Balancing Act of Portfolio Management
- Ergodicity in Action: Betting on Skiers with Risk & Reward Trade-offs
- Free Money + Carry Trade: Why Buffett’s Japan Bet is a Masterclass in Value Investing
- Buffett’s Korean Basket Bet: Achieving Diversification and High Returns
- Value Investing with Cash, Not Multiples
- The Power of Low PE Ratios and Index Orphans
- Is the Market Poised for a Value Investing Comeback?
- 30x PEs & Capital Intensity: Can Big Tech Keep Growing?
- From Hardware to Household Brand: How Apple Changed Its Valuation Game
- Capital Light Companies: Hidden Costs & True Capital Intensity
- Data Center Rush? Google, Meta, Amazon Plow Money into Infrastructure
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. This is Value: After Hours. I’m Tobias Carlisle, joined as always, by my cohost, Jake Taylor. Our special guest today is the legendary John Huber. What’s up, John? Good to see you again.
John: Hey, good to see you, guys. I don’t know how legendary it is, but I’m glad to be back. It’s been 10 months since the last–
Tobias: Is that right?
John: Yes, I think so.
John: I wasn’t good enough to get invited back on the regular rotate, but good enough to get invited back.
Jake: Listen, John, if you could have my spot here and I’m sure that the ratings would go through the roof-
Jake: -the whole thing would take off, I’m keeping Toby down at the moment.[laughter]
Tobias: I don’t think that’s true at all. It is good to have you back, John. We’re having a really interesting conversation before we came on. I think we should continue that one. You were saying that it’s an excellent time to be a deep value investor. That’s all I heard. Just keep on going.[laughter]
Jake: Yeah, just feed me that confirmation bias, nice and slow.
The Power of Low PE Ratios and Index Orphans
John: Yeah, right, Well, yeah, my thinking is just in general terms. We were joking, but I was telling this to a friend the other day that everybody talks about how they were a– Oh, I started off as a Ben Graham investor and I migrated to a quality Charlie Munger type investor. I was joking with him like, “I feel like I’m going the opposite direction.” In reality, that’s not the case, but I am finding more value in some of the– I’ll call it like the small cap, mid cap. Even in pockets outside of the US, I think Japan is really interesting. And there’s some different pockets I’m looking at for value.
I think when I started my fund 10 years ago, Visa was at 15 times earnings, Google was at 15 times earnings, Apple was at 10 times earnings. Just incredible companies. The world’s best companies. And if you think about Visa, I was looking at some of my old notes the other day, and if you think about how good of a business Visa is, it can grow without capital. And most people understand that. But it’s worth highlighting the math of what that really means. When Visa is at 15 PE, what that really means is you’re getting a 6% or a 7% free cash flow yield,
And on top of that, because it needs no money to grow, you’re getting whatever growth it can grow at. And so, if Visa can grow at 8%, if nominal GDP around the world is growing at 6% or 7% in nominal terms, not real terms, because Visa is like a perfect inflation hedge because it’s just taking a cut of every transaction, so it’s in nominal terms. So, if Visa grows at 6% or 7%– or if GDP is 6% or 7%, and visa is taking a little bit of market share, which it’s been doing, and it gets 8% growth, and then you get the 6% free cash flow yield, all of a sudden you got a 15% per share compounder with no multiple expansion. And then, of course, if the multiple expands, then you get a real good investment on top of that.
Jake: Or, buybacks to–
John: Yeah. I’m assuming that free cash flow yield, you’re getting that as a buyback. And they’re still doing that now. The math changes a lot if the stock is at 30 PE, because now you’re getting only 3% instead of 6%. So, it’s still a compelling company, but the valuation is incredibly undervalued, I think at 15 PE or even 20 PE, less so at 30 PE, it still might be good. But anyways, all that to say, those are the types of companies that have, I think migrated upward. Apple’s at 30 PE, and the math is different at a business at 30 PE than it was at 10 PE.
There’s a lot of companies that are really good businesses run by smart capital allocators. They’re doing smart things with the capital. They might be in unloved industries, but their stocks are really cheap. And so, they’re not conventionally defined as quality, but if you look at the metrics and you look at what the management teams are doing, I think there’s some actually really good businesses in some of those pockets. So, I’ve been poking around in those areas over the last year or so.
Jake: Do those tend to be index orphans?
John: Yeah, a lot of them are like index orphans. Some of them literally have been kicked out of the index, some of them just are not in the index, some of them are sort of– You could look at the energy space generally, and there’s some pockets inside of energy that are on the blacklist of institutions all over the world. I can’t invest in that because of ESG reasons and so forth. And so, you have this natural sort of a lid on the valuation, because you have forced sellers basically, and you have people that are not willing to buy. And so, what you’re left with is an undervalued security.
Sometimes that’s not really going to do anything for you as a shareholder if they’re not allocating the capital properly. But if you have a management team that’s taking advantage of the share price and buying back shares, then you can have– I talk about these three engines. You could have a little bit of growth, maybe even no growth, but you can have– If your stock is at 5 PE and you’re getting a 20% free cash flow yield, that’s all you need.
So, I think there are certain companies that might be able to take advantage of some of those structural dynamics indexing. They’re out of the index. We’ve had such a rush toward passive indexing that I think there’s some real opportunities there. So, I’m of the mindset, like, I’m actually optimistic for guys like us. Especially Toby, [chuckles] you’re banging the drum every week on value. I’m not sure when it hits, but there’s enough compelling value out there that you don’t even need the multiple or rerate. You pick the ones that are– David Einhorn talked about that. “You buy the ones that are buying back their own shares and you can make the free cash flow yield with no multiple expansion.” So, that’s a nice thing.
Value Investing with Cash, Not Multiples
Jake: It’s more of a self-help story at that point for the businesses.
Tobias: I gave up hoping for multiple expansion in about 2020, so now I buy things that don’t need any multiple expansion. There’s a fair bit around that does it right. And at some point, I guess you get the multiple expansion on top, but I certainly wouldn’t rely on it.
John: Yeah, I would not rely on it. I think it’s nice if you pay a price where if you’re buying something at like a mid-single digit PE multiple and you’re getting most of that in cash, which is not always the case. Most times it’s not the case. But if you can find a business that does not need to retain a lot of capital and doesn’t have a place to put it for growth, normally that might not be looked upon as a good thing. But if you have, again, a 20% free cash flow yield and the management team knows it has nowhere to put that money and it’s using it all to buy back shares, you’re going to get a really nice compounding effect just through the share buybacks.
That’s a secret sauce with a business-like NVR where for years and years it traded at 5 PE, 6 PE, 7 PE, and everybody undervalued it because– I’m going back 15, 20 years when it was a — Now it’s a household name in the value community, but for a decade or so, or even longer, it was lumped in with other home builders. It was a free cash flow generative machine that was just eating its share count year after year after year because the price was always at 6 PE or 7 PE or 8 PE. And so, you’re getting a 12% to 14% free cash flow yield every year, and that’s really the secret behind some of those compounding machines, I think is– [crosstalk]
Jake: O’Reilly’s the–
John: Yeah, exactly. O’Reilly is in it.
Jake: Ross Stores.
John: Yeah. I don’t know Ross as well, but I know that’s been a great stock. And obviously, if you combine a little bit of growth– Jake, you’ve done some great work on AutoZone as a case study, and that’s a really good one, where you combine a modest amount of growth, but healthy growth, like, 6%, 7%, 8% year after year after year, little bit of margin expansion, and then of course, smart capital allocation, and then you get those three engines working, you got lower share count, higher growth, and then perhaps the multiple goes up a little bit, perhaps it doesn’t, but–
Jake: Ideally, you don’t want it to. You want it to stay low, so you can–
John: Exactly. Yeah that’s–
Jake: Take out your co-owners at lower prices.
John: Exactly. Yeah, it’s beneficial for you, if you’re a long-term owner, for those things to just permanently stay at 7 PE or wherever they’re at, because it might feel good if the stock goes up to 12 PE. You think about like AutoZone would not have worked as well as it did if it traded at 30 PE, 20 years ago. We wouldn’t be talking about how great of a stock AutoZone was if that was the case.
Jake: If I remember right, it was under 12 or under 10, like, that entire time.
John: Right. Yeah, that’s the secret sauce is it has to have some– I think with NVR, it was always– Well, this is a cyclical industry. There’s always a reason why it’s cheap. It takes a long time for people to realize, “Wow, this is like a different type of a business model within a business that is conventionally not that great.” And same thing with auto-parts stores, it is sort of– For a while it wasn’t viewed as an overly attractive industry, it’s low growth, there’s not a lot going on there, but–
Jake: It’s not a of AI. That’s for sure.
From Hardware to Household Brand: How Apple Changed Its Valuation Game
John: Yeah, there’s no AI, although all these companies are trying to incorporate AI these days. Those are really interesting ideas. And then one other thing I was going to say on multiple– Your comment on multiple, Toby, one thing I’ve noticed with looking at some of these beaten down stocks in various markets, I think investors tend to extrapolate the recent past and just assume that that is the norm. And so, when I say recent past, I’m talking like the last 10 years, because that feels like a long time. And it is a long time. But if you go back 30 years, you might say, “Wow, this market or this cohort of stocks, this industry group traded at a lot different model.”
You could even look at banks in the US. If you ask, what’s a normal bank model? But probably like 10 PE. But for years and years, it was maybe 15 PE. 10 years ago, Apple was always viewed as a consumer electronics company. It should be at 10 PE. There’s a hardware company.
Jake: Now it’s a utility or–
John: Yeah. Well, now it’s a consumer brand and it should be. It should have been that way, but people would always say, “Well, it’s a consumer electronics brand. It’s very competitive. You got Samsung, you got these Chinese domestic manufacturers, you got all this competition.” They lumped it in with Dell, and it really was like Nike [Tobias laughs] or Starbucks. It was like a consumer brand that should trade at 20 PE or 25 PE or 30 PE. And so, sometimes you get like these C changes in sentiment– And now it looks normal. Now it’s like, “Oh, Apple just trades at 30 PE. That’s normal.” But it’s not always the case.
So, it’s just interesting to keep in mind as a value investor, like, things can last a long time, but sometimes you get this C change where maybe everything in Japan shouldn’t trade at half a book value. Maybe it should trade at book value. [chuckles] You just know when it’s going to happen, but that’s just another thing to keep in mind, I guess.
Is the Market Poised for a Value Investing Comeback?
Tobias: I think what is interesting about that date, 2014, when you’re looking at Visa and it was so– All of the good stocks were compressed, that was when Jake wrote his worst opportunity set for value and I republished it. I thought it was a great idea, just showing how compressed everything was. That was when the spread was very tight. The good stuff was as expensive as the ugly stuff.
John: Is that right? Yeah.
Tobias: That was a compelling opportunity for the better stuff.
John: Yeah. I think coming out of the financial crisis– I started my fund in 2014, but I was investing, obviously, well before that and through the crisis, things were just depressed. I just remember stocks like we’ve talked about, these great companies trading at extraordinarily reasonable valuations. Not like 5 PE, but 12 PE, 14 PE for some of these businesses that could grow like a Starbucks could grow unit, still growing unit counts at double digit rates and same-store sales growth on top of that. You’re talking about a 20% compounder trading at one-point low double digits, even under 10 PE, I think for a brief moment in time, but really cheap stocks. But even subsequent to the crisis itself, like 2011, 2012 it was still– The S&P 500 was 12 times earnings in 2011, 2012. So, just the market itself was very cheap and–
Jake: Magic going back to that today. That’s a lot of pain to get to there. [chuckles]
John: Well, that’s the case. You guys have talked about this. I think you and I have talked about this, Jake, at times. If you do the math on the S&P 500 and say, even if you expect– We had about 4% sales growth over the last decade and 7% earnings growth. And the bottom line is tricky because that included a 20% tax cut. A tax rate that went from $35 to $21, which is a 20% instant bump. And if you amortize that out over 10 years, that’s roughly just under 2% per year.
Jake: Yeah, tailwind.
John: So, you get a 2% tailwind. If you’re looking at a data set, a point in time data set, that 10 years ago, that’s incorporating a 2% per year tailwind that we’re not going to have obviously. [crosstalk]
Jake: Leverage added to do buybacks. So, that’s like another pretty healthy tailwind that you probably can’t pull that lever again.
John: Exactly. Yeah, you got the buyback lever, you got the leverage, I think increasing leverage and low interest cost. So, some of those things have reversed themselves and it will be headwinds now. Just throw all that aside and just say, “Hey, let’s just assume that the S&P 500 can grow at 7%.” You still have the multiple– We got an 80% or 90% bump in the multiple, or almost a double in the multiple.
Jake: I think it was a 6% compound from 2011 to 2021 just from the multiple expansion.
John: Right. So, you take that six points and you say that could be a negative three if we go back to 18 PE or 16 PE. I’m not predicting anything, a disaster or anything like that, I have no idea, but over the long run, you could paint a scenario where the S&P does mid-single digit returns. And then you’re looking at other stocks that are outside of that index trading at 15% free cash flow yields, and you’re thinking that might be pretty interesting over the next decade or so. So, we’ll see. In the short run, the AI momentum is not going to be stopped.
Tobias: It’s real.
John: Yeah, it’s–
Tobias: I feel like the 2014, 2015, or even 2011, 2012 to 2015 was largely driven by– There was a bust in 2000, which was a growth stock bust. As much as everybody remembers it as a dotcom bust, it was big in growth that got busted. And then 15 years later, none of those stocks had gone anywhere because they’d gone through another bust in 2008, 2009, which was the banking stocks, the credit crisis. And so, there were stocks that were Walmart, Microsoft, all those things. They’d done nothing for 15 years, even though the underlying businesses were doing what they always do, growing pretty quickly, it’s just they were working off such a huge overvaluation. I remember Whitney Tilson pitching Microsoft in 2011, and it was just kind of boring, because it was Steve Ballmer had its first year of sales going down.
Jake: Yeah. Revenue finally [crosstalk] other way for the first time ever.
Tobias: He was like, “It’s an 11% free cash flow yield.” They’re buying back stocks. Steve Ballmer runs it, it just like, “Ah. Now, wow.” That was a pretty good position it turned on.
Jake Taylor Yeah.
30x PEs & Capital Intensity: Can Big Tech Keep Growing?
John: Yeah. Microsoft was another one that was in that group of just incredibly great businesses. I think Microsoft’s interesting because you couldn’t have predicted, or I think very few people would have predicted how great of a business it became because of the transition to cloud.
Jake: Yeah. That’s not normal to make these big technological leaps and still stick the landing.
John: Yeah, I think that’s exactly right. The infrastructure as a service movement was very early innings. I couldn’t have told you what the cloud meant 10 years ago really. It was not a-
Jake: I still don’t know.
John: [laughs] It was not something that–
Tobias: It was just somebody else’s computer.
John: You give Microsoft credit for that, because the nice thing about buying a stock at 11% earnings yield is once in a while, you get that call option of the business does something better. It got a better CEO. It got a different business model. They’ve done so many smart things there to open up their ecosystem to Apple and others to become more collaborative, more of a partnership, and they’ve opened up that whole ecosystem. And of course, the cloud is just this monster secular tailwind. So, they benefited from all.
But yeah, Apple, they’ve added different products, they’ve obviously added significant products, but you still have the iPhone. It’s still an iPhone company. There’s not that much of a dramatic difference with Apple and it was still so cheap back then. So, once in a while, you get those types of opportunities in markets. And so, I tend to try to stay open minded to all those ideas, but there’s just less so on that front I think today.
Jake: Yeah, I think that was the real insight in 2015 that I missed was that there was a lot of embedded optionality that was basically free or at least very cheaply priced relative to probably minimal optionality on call it the value basket. And so, when the spreads are compressed, maybe it’s not even so much like business quality that tends to be mean reverting over time, but there’s some options perhaps that are baked in there depending on the price. And now at 30 times, well, you’re paying quite a bit for that optionality. You actually have to have some stuff that turns out better than expected to justify larger valuations.
John: Yeah, I agree. It’s the same thing we talk about with the S&P 500. There’s two things going on. One is the valuation is double what it was 10 years ago for many of these stocks. And two, they’re much bigger businesses. And so, naturally, if you have a $200-billion-dollar company– I read Microsoft’s earnings report and it’s just bonkers. 18% revenue growth, 33% bottom line growth–
Jake: Just all base rates.
John: Yeah, it is, it absolutely is the anomaly. But you still have a business where I do think eventually you start seeing– You’re seeing that with like AWS, the growth rate up until a couple of years ago was growing at 30%, 40%. Now it’s growing at 13%. So, there is a limit to the growth of even these types of unbelievable companies. When that happens, you pencil in like what you think the growth is going to be, what you think the shares outstanding are going to be, and what do you think the multiple is going to be? And those are what’s going to determine your stock price. And so, it is harder to do that at 30 PE, for sure.
The other thing about Microsoft– Apple, not so much, but Microsoft, Amazon, the rest of the big tech primarily is they’ve gotten much more capital intensive. It’s really interesting to go back and look at Amazon 10 years ago. They still do have negative working capital in their retail business, but they basically had no capital invested in 2014, 2015. I forget when they really started ramping up– And of course, COVID, they really ramped up and they spent, I think, over $200 billion on their warehouse network and their infrastructure, but just $200 billion of CAPEX. So, they have a huge amount of PP&E in the balance sheet now, but they had no capital not that long ago.
And so you think, naturally, when you have a business with no capital and now you have a business with $200 billion of capital, it’s harder to move the needle on that. If you’re thinking in terms of return on capital as a business owner, it’s just naturally going to be harder to do that.
Jake: Do you think that that’s actual real CAPEX now an advantage again, like, how it used to be in the 1950s, 1960s? General Motors, of course, was just plowing money into factories. You couldn’t keep up with their CAPEX. And then we moved away from that where everyone wanted to be capital light, and it was always about returns on no incremental capital, basically. I don’t know, I feel like there’s diminishing returns to all of this stuff eventually, and this is probably a pendulum that swings in history back and forth, perhaps.
John: I think so. I think that’s a good point, because the CAPEX, it puts a lid on your future earning power as a business. The returns on capital are going to be lower at– Amazon going forward than they were when they had no capital because–
Jake: Yeah. Denominators just– [crosstalk] denominators.
John: [crosstalk] denominator. But even if in theory, a smaller Amazon had just exponential returns on capital. And now their returns the in next couple of years might be really good because they overloaded in COVID, and now they have excess capacity, and they’re going to fill that up, they’re going to grow into that. So, the incremental returns the next year or two are going to look outstanding. But just generally over the next 10 years, it’s just going to be harder.
Capital Light Companies: Hidden Costs & True Capital Intensity
John: As a counterpoint to that though is what you’re talking about, Jake, is like, how are you going to compete with Amazon? What are you going to do–? There’s only two companies in the world that can compete with them really in cloud. And it’s Google and Microsoft. And primarily, just Microsoft. So, you have this oligopoly developing in the cloud. And then in retail, it’s just an unbelievable machine that they have that is going to be really hard to disrupt. So, the question is like, what are the economics of that? Because you could have like an oil refinery that cannot be replaced, and it’s an incredible barrier to entry, but the economics of that refinery may or may not be very good. Maybe it’s not good. And so, it doesn’t necessarily make it a good business.
GM was not that great of a business, even though it had a huge barrier to entry. It’s got staying power, it’s going to stick around a while. So, the trick is like, how to value what the returns on capital are going to be on that CAPEX, I think? I think there’s some studies out there that show like generally speaking, as businesses grow their capital levels, they’re going to have lower returns. It’s a pretty commonsensical type relationship there. These guys, to your point on Microsoft defying base rates, maybe they can continue to defy those base.
Jake: Yeah, they took a See’s Candy and morphed to a BNSF in some ways.
John: Yeah, for sure. Absolutely. It’s funny, because you mentioned the railroads. The railroads are far less capital intensive, if you just look at the numbers than Amazon and Microsoft. The CAPEX– [crosstalk]
Tobias: In absolute numbers.
John: Yeah. Well, you can compare it to sales and different things. I have a chart of this that I’d have to go back and look at each individual company, because they’re so different. But I think Amazon’s far more—Obviously, in absolute dollars, you’re spending way more. But even–
Jake: Capital Intensity is higher, I think.
John: Yeah, even if you measure it as a percentage of equity or percentage of sales, however you want to look at a percentage of gross profits, I think these companies that have been considered like capital light are much more heavy than they were in previous years. It’s not necessarily a bad thing. You were talking about the returns on incremental capital and the capital light companies and how the whole software world– Everybody’s trying to go in that direction, Jake.
But the other thing is like those guys were still hiring a ton of people. And so, I’m not sure how much better that would because that technically does not show up in the balance sheet, but it does show up in the cost structure. And so, is a business-like Uber capital light? I don’t think so. How much money have they lost over the last decade? That’s real capital. Shareholders had to pony up that capital. So, it’s tough to say– If there’s any ever a study anyone wants to take a look at that, it’d be fun to look at how capital intensive really are these “capital light software companies,” because they’re not necessarily as capital light as you might think.
Jake: The capital is so light, it’s gone.
John: Yeah, exactly.
John: It floated away.
Data Center Rush? Google, Meta, Amazon Plow Money into Infrastructure
Tobias: It’s funny. The last time that I looked at the level of reinvestment, just on an absolute sense outside of what you needed for CAPEX. I was saying maintenance CAPEX, and I was just saying depreciation, amortization is maintenance CAPEX, who’s investing over and above that. And the two standouts were Tesla and Facebook, which I thought was interesting. Maybe that was their Metaverse spending. I don’t know how that went. [crosstalk]
John: What was that relationship, Toby?
Tobias: It was just the amount of capital spending that they were doing. The amount of reinvestment in the business, if you backed out–
Tobias: Appreciation, amortization, just say, that’s maintenance CAPEX. And so, anything above that– And then the two that were standing out were Tesla, which is obviously investing a lot, because they’re building factories, and Facebook, which was building the Metaverse, I think, at the time. I don’t know where that money went, but Facebook– [crosstalk]
John: Yeah, Meta is in there with Microsoft and Amazon and Google. My view is like they’re just plowing money into data centers. These data centers cost a billion dollars or more.
Jake: Does anybody remember the early 2000s, late 1990s, where money was just being plowed into fiberoptics?
Jake: Yeah. It was just a mad rush to build the rails of the future. That’s the same arguments I’m hearing today.
John: I’ve thought about that. If you think about what was the result of that, as consumers, we pulled forward an incredible amount of technological advances. I don’t know what it would have looked like in an alternate universe had we not done that, but obviously, all kinds of shareholders put that capital up in exchange for the value that we all received as consumers. They didn’t get any benefit from it, but we all got– Netflix maybe five years earlier than we would have had they not made that investment. So, stuff like that. Facebook, all of these companies that we may have not had that that capability. We would have eventually, but maybe we pulled that forward.
Jake: Toby, you did a lot, didn’t you, in fiber area in your legal career?
Jake: Lot of assets changing hands. [laughs]
Tobias: That was in Australia. But after the bust, there were lots of stranded assets around, lots of assets that could be built cheaply because there was just no demand for it. But the story that we were told was that the builders, the American builders, of the fiber optic cables had been paid– They’d been incentivized because the eyeballs was the metric. The metric for these guys was just the amount of cable that you had in the ground. So, they were just putting cable in as quickly as they possibly could without thinking about whether there was a customer attached to the end of it who could pay. And so, they overbuilt all of this cable. [crosstalk]
Jake: It wasn’t cable.
Tobias: I guess the infrastructure caught up with it eventually, and so it gets used. It’s got a very long life. It’s interesting. Yeah. JT, top of the hour. Do you want to do your veggies?
Jake: Yeah, I’d love to. So, I know John is a rather sporty fellow with his running.
Tobias: John’s going to run a marathon.
Ergodicity in Action: Betting on Skiers with Risk & Reward Trade-offs
Jake: Well, he’s run lots of marathons. Yeah, he’s going to run Boston. So, I have a little sports segment here that’s on downhill skiing. So, it’s not quite running. So, just a little fun background on downhill skiing. It has ancient origins. Like, they trace back even to prehistoric times in Russia, and Finland, Sweden, Norway, these cold northern latitudes. And it’s been an integral part of transportation in colder countries for thousands of years at this point.
And in the 1760s, skiing was recorded as being used in military training. So, that’s all the way back to revolutionary times, basically. There was a Norwegian legend named Sondre Norheim, who was the first downhill ski champion in 1868. But the first slalom competition, which I think is what we all think of when we’re thinking of this downhill skiing was occurred in Switzerland in 1922. So, we’re well into more than 100 years’ worth of this. And the term slalom is from Norwegian dialects. Meaning, trail on a slope. It’s kind of a portmanteau of that.
A recent study showed that there’s more than 114,000 alpine related injuries per year. And in alpine skiing, for every 1,000 people that are skiing in a day, between two and four will require medical attention. So, there’s a bit of danger in this, which you’ll see what I’m going– [crosstalk]
Tobias: [unintelligible 00:32:01] pickleball.
Jake: Yeah, I think there are more acute injuries in skiing and more repetitive injuries in pickleball. I don’t know. So, who’s the greatest downhill skier of all time? You guys have any guesses?
Tobias: Eddie the Eagle.
John: I can’t name– Well–
Tobias Carlisle Name a skier, John. [laughs] [crosstalk]
John: I can picture some great Winter Olympics and some of the great faces of these American downhill skiers, but I can’t tell you who it is.
Jake: All right. Well, it’s probably Mikaela Shiffrin. She’s a US skier still actively skiing. 17 global medals, 6 consecutive world championships, winning gold. In 270 starts, she’s had 95 World cup wins. She’s got like a 35%-win rate. And just for reference, like, Hall of Famer Lindsey Vonn, who’s like a household name, she won 21% of her races. So, it’s possible that Michael Jordan is the Mikaela Shiffrin of basketball.[laughter]
Jake: So, however, in during the 2022 Olympics in Sochi, she was the odds-on heavy favorite to really clean up. And yet, during the games, she had three failures to reach the bottom of the course, which matched her total number of DNS, did not finishes, over the previous four years of racing. And it was just like a complete disaster. She ended up closing the Olympics without winning anything.
So, right now, we’re going to reintroduce our old friend, Ergodicity, to the discussion. we’ve done some segments on this before. I’m actually borrowing an example here from researcher and author, Luca Dellanna. I don’t know if you guys have ever followed any of his stuff, but he’s got–
Tobias: He wrote the book, right? He’s Ergodicity. He’s made ergodicity into a black swan.
Jake: Kind of. Yeah. I think I would probably say that Ole Peters might be a little bit ahead of him on that front, but fair enough. So, imagine this little scenario. You’ve got two different skiers, and one has a 20% chance of winning any race that she enters and a 10% chance of breaking her leg. And then we have a second skier who takes fewer risks, and she doesn’t push as hard, and so she’s only going to win about 15% chance of winning. But because she’s less aggressive, she only has a 1% chance of breaking her leg in any one race. So, which skier would you want to bet on in this scenario, so basically like a 20% winner and a 15% winner?
Tobias: To bet on at any given rates?
Jake: Yeah, who do you want to bet on given those–? [crosstalk]
Tobias: I’ll take the one with a better win rate.
Jake: It’s 20%? Yeah. John–
John: Give me the numbers again. So, the win rate is 20% and 15% between the two skiers?
John: And the other was accident rate?
Jake: 10% chance of crashing, and 1% chance of crashing for the other one.
John: Ah, I guess I would take the 20% winner. Yeah.
Jake: So, you guys are right. However, it completely depends on how long the championship is, how many races. If it’s a single race, you want to bet on the risk-taking skier. She has an 18% expected chance of winning, which is just 90% chance of finishing times 20% chance of winning when she does finish. That’s 0.18. The other safer skier has a 15% expected win rate. Like, 99% chance of finishing times a 15% chance of winning rounds up to 15%. So, you have 18% versus 15%. However, the more races in the championship, the higher the chances that the riskier skier will break her leg and have to forfeit the remaining races after that.
Jake: This is where it’s a non-ergodic at that point. This is what ergodicity is all about, really. And in this little scenario, anything longer than five races means that the more conservative approach has a higher expected payoff. So, the payoffs completely depend on time horizons. If you’re a professional money manager and your LPs have you on a, let’s say a, three-year shot clock, which I think probably accurately describes most of the industry even if everyone says they’re long-term, you may be forced to take risks that you otherwise wouldn’t really want to, and maybe even a lot of it happens at a subconscious level.
And if you’re part of a portfolio of other managers like in an institutional allocator sense, they may really want you to press your bets in a way and go all out for the win like that 20% chance skier. And if you crash and break your leg, so be it, like, they have other racers in the field. But for you, you’re done from the race now. And so, you personally as a manager are in a terrible spot. So, you really can’t base your decisions on a payoff that is computed on a time horizon that doesn’t match your time horizon. I think so much of, like, you have to know what your time horizon is and be on the same page with everyone who’s involved with your investment style, including if it’s for family members or whatever, if you’re a smaller investor or if you’re professional, like your LPs, you have to all be on. This is why it’s so important. I think probably mismatched time horizons might be the number one biggest flaw in the investment universe to solve for.
And as we see with our two-skier example, different strategies are optimal over different time horizons. It depends on the number of races that you’re aiming for. So, there really is no one size fits all in these non-ergodic systems like this. And Dellanna makes the point that catastrophic losses can absorb future gains. So, when you get taken out, your ability to win the future races after you break your leg disappears, and the math of winning the championship completely changes and skews, and then towards being more conservative at that point.
So, shorter-term optimization is to push hard and win, which I think you see that a lot in the investment world, but the longer-term optimization of not breaking your leg, you have a lower win percentage is more optimal over that. And this always brings me back to that Niki Lauda quote that I love, which is “The secret—” And he was a race car driver, right? “The secret is to win going as slowly as possible.” Over longer-term horizons, I think the math proves that out. Whereas over shorter horizons, you have to theoretically push harder and risk breaking your leg.
John: Yeah, that’s really interesting. Yeah, if you’re picking one race, you want the 20% winner. But if you’re drafting like a downhill skiing fantasy league, you’re going to take the one that gives you the most likelihood of finishing.
Tobias: The other complication though is, as Jake points out, if you’re the allocator and you have 30 downhill races, then you want them all going as hard as they possibly can. It doesn’t matter to you if a handful of them break their legs, even though for them it’s catastrophic. I guess you got to work out which where you are.
Jake: So, that type of system is ergodic for the allocator and non-ergodic for the individual manager. And a lot of times, there’s a mismatch there where people are facing very, very different setups in the consequences of chances of winning versus failure.
John: Yeah, that scenario is not unlike the VC world, where a VC is going to make a bunch of different bets and try to achieve that ergodic type result, where you’re going to have maybe 1 winner out of 100, or 2 or 3 winners out of 100. Many of the startups aren’t going to make it. But yeah, the point on time horizon is, to me, it’s the biggest advantage, I think, in today’s market. We were talking about smaller companies, and there are some unloved and hated companies. But even there, it’s less of an informational thing. It’s more of just, “I can’t own this thing right now, or I don’t want to own this thing right now, or the stock hasn’t done well, so I don’t want to own it for the next couple of years. I’m going to wait for it to do this or that.”
I think you just got to look at the last two years to see even the biggest and the best companies in the world and look at their stock prices, how they have fluctuated violently up and down. It’s remarkable. There’s a lot going on with those companies fundamentally, but the intrinsic value is not fluctuating nearly as much as the stock price. And so, that’s the real time arbitrage opportunity it seems like there.
Buffett’s Korean Basket Bet: Achieving Diversification and High Returns
Tobias: There’s good comment here from Dimitrios. “This is why starter investors tend not to appreciate diversification and are under-diversified.” How do you feel about diversification, John? How do you approach that problem?
John: Yeah, it’s really interesting because that– Ideally, you want to have more diversification is better, because you’re going to achieve that same result that we’re talking about here in mathematical terms, like, if you had 30 stocks that all have the same risk-reward profile, it’s like running an insurance operation. The more lives you can insure, the better. And so, more diversification is better. I think the reality though, you got to play within the confines of reality.
And for me, the reality is there’s just not that many ideas. I’m not saying 30 is right or wrong, just generally speaking, my appetite for diversification is not satiated by the reality of just not that many ideas. And so, I have fewer ideas. But I do think you need to allow yourself room for error. So, whatever level is right for you, I think investors have to figure that out. That’s more of a personal decision, what do you feel comfortable with? What are you good at? You want to be able to stick with positions over the long run. So, I do think you need some level of diversification that is a baseline minimum. And then above that, it’s more a matter of your strategy and your personality and your risk appetite and that type of thing. But generally speaking, diversification is a good thing.
Tobias: What’s a baseline minimum for you?
John: In Ecclesiastes, Solomon said that “You should invest in seven or eight ventures because you don’t know what kind of disaster is going to come across the land.” Solomon, he was one of the richest men ever, seven or eight is what he recommended. That’s probably saying that tongue in cheek. Charlie Munger says, “Hey, three is all you need.” That’s too little for me. [Jake [laughs] That’s not enough. And honestly, if you look at his own portfolio, he had Berkshire, and he talked about Berkshire and Costco and Li Lu’s fund. But those are investments in and of themselves that are very diversified. So, I think that’s different. I think you need to look at what types of companies you own.
If you own six or seven holding companies, then you’re probably going to be very diversified. If you own a company that has 40% of its revenues coming from one customer, that’s not enough. You’re going to need more of those. So, seven or eight would not be enough. Yeah, generally speaking, I think 10 is like a minimum. I’m not suggesting that’s the right number, and I’m not suggesting there is a right number. I’m just saying, for me, 7, 8, 10 is a baseline minimum. And then I’m also okay having a group of investments that cover a basket in certain cases. I’m thinking along those lines with a couple of different investments right now where you might be diversified within the basket.
Buffett talked about concentration. Number one, he does have a lot of stocks. And number two, he would invest in baskets in his personal portfolio. Like, in Korea 20 years ago, he made a basket bet in Korea, and he just bought a bunch of them because you could achieve those numbers. You could get diversification and still get the return profile that you were looking for. And that’s the ideal situation.
Jake: Japan [crosstalk]
John: Yeah, Japan.
Tobias: Conglomerates. Yeah.
Jake: Even before that though, in his PA.
John: Yeah. I think it was Korea, if I’m not mistaken. He invested in a bunch of– He talked about this cement manufacturer that was trading three times earnings and stuff, and he found a bunch of those. Maybe it was Japan as well. That would be ideal. I was rereading his partnership letters recently. I was reading through those because that was a moment in time where he was running money more similar to, I think, all of us pretty much. We’re maybe running money professionally. Or, even if you’re an individual, those letters are much more applicable in terms of portfolio management I think, then you’re going to learn a lot more about business by reading, obviously, the more current letters. But he’s got some interesting nuggets on portfolio management where he buckets these investments into three or four different categories, and he’s got generals and workouts and how those play off against each.
He was fairly concentrated. He had like five or six or seven that represented half of his money. He obviously had big position in American Express, big position in Disney at times, but he also had, at the other end of the portfolio, had a bunch of different small workouts. It’s not like an either or. You could have kind of both depending on the opportunity set.
Free Money + Carry Trade: Why Buffett’s Japan Bet is a Masterclass in Value Investing
Tobias: Japan was a good one. The more recent Japan one was a good one. How many of those big trading companies did he buy?
Jake: Five, I think.
Tobias: Five. Yeah.
John: Yeah. I think he’s got four or five. Yeah, the investment has been extraordinarily good so far. It’s only been three years. But I wrote a post recently or last year sometime, and I did the math on it. I haven’t updated the numbers recently. But in his first three years as a basket, the first investment, they compounded at over 40% annually from 2020.
Jake: It’s okay.
John: It’s not bad. And that was coincidentally right around the time in 2020 where people were questioning that he had been over the hill.
Jake: Can you imagine?
John: Yeah. And even now, people say, “Well, he did the Apple thing, but he hasn’t made many other bets.” But that Japan investment flies under the radar. That has been an extraordinary investment. And it’s become big. It’s a big position now. I think it’s in his top five. It doesn’t show up in 13F, so I think people overlook it. But collectively, that Japan investment is up there with– Apple is far and away the biggest, but it’s up there with OXY and his Coke investment and some of the others.
Jake: How did you calculate the borrowing at 0% interest to the purchase?
John: I just did it on a cash basis. So, the return on equity over that he’s achieved is astronomical.
Jake: Infinity, almost may be?
John: Indefinite. Because he borrowed money to make the investment. He used debt to fund that investment. To me, I think what he’s doing is he wanted to keep his Japanese assets paired with Japanese liabilities. So, he’s borrowing money in yen, so that he doesn’t have to worry about the currency. He wanted to make an investment– I see a lot of people talking about how he’s doing this incredible arbitrage with the cost of debt, and he certainly is taking advantage of Berkshire’s AAA credit. But that in and of itself is not– I don’t think that’s the reason he did the investment. I think he saw these stocks as incredibly undervalued, and he’s like, “How can I fund it? I can fund it with cash, which I have plenty of.”
Jake: Free money.
John: “I can fund it with 1% long term debt.” [Tobias laughs] “Oh, let’s fund it with 1% long-term debt,” and then don’t have to worry about the currency to boot.
Jake: Yeah, especially with the dividend policies that tend to be with those companies. The carry trade that he put on made it like time then can just– It could take as long as it needs to, I’m getting paid pretty adequately for my effort.
John: He’s making a net interest margin of 4%. Probably even much higher than that on a cost basis, because these companies have increased their dividends. So, his cost of funds are 1%, and he’s probably collecting dividends that I would bet in excess of 7% or 8% on his cost basis right now. So, his net interest margin is probably double that of Bank of America, and he’s taking far less credit risks. So, not a bad investment.
Jake: He might be okay at this.
John: [laughs] He’s still got it.
Tobias: You see that Facebook is going to start paying a dividend?
John: I saw that. Yeah.
Tobias: We should mention that. Zuck is going to clip out $700 a year. He’s going to use to feed wagyu cattle macadamia nuts and beer.
Jake: I think that’s what it’s for. He doesn’t want to sell, and he just wants some stick a little–
Tobias: Is he folding money, some walking around money?
Jake: Yeah. Little Vanderbilt type of–
Tobias: He’s got the bug out shelter with the wagyu cattle being fed macadamia nut and beer. Smart.
Jake: Boy, speaking of dividends though, and I know we were a little harsh on Ballmer earlier, but my gosh, his Microsoft investment and never selling any of it sure looks pretty smart right now. He’s clipping like a billion dollars a year in dividends from that.
Tobias: That’s a lot.
John: Who is?
Tobias: Steve Ballmer.
John: Oh, Steve Ballmer. Yeah. What’s amazing about Ballmer is his– I think isn’t his net worth approaching Bill Gates?
Tobias: He have overtaken him.
Jake: I think he might have overtaken him with the foundation like requirement.
John: Wow. So, it’s just because he just didn’t sell it or sold far less of it than Gates did.
John: That’s something. That is pretty remarkable.
Coffee Cans vs. Punch Cards: The Balancing Act of Portfolio Management
Tobias: What’s your longest-term investment, John? Have you held onto anything for the whole ride?
John: I don’t have anything from 10 years ago. The longest investment is seven years. Yeah, ideally, I have a few that I look out 10 years and say, “Hey, I hope I continue to own this in 10 years.” But the reality is, back to those Buffett partnership letters, one of the things he says in there is, I do think there’s a balance between the never sell mentality and the reality that you have a certain amount of equity in each investment, and your goal, as an investor, is to compound that equity at the highest rate you can with a minimum of risk on an after-tax basis.
And so, your goal is not to achieve a 30-year investment that’s in the coffee can and your cost basis is a dollar and the stocks worth $300. That’s always a nice story and stuff. Obviously, that would be ideal if you could do that.
Jake: Yeah, let’s just do that if it’s so easy.[laughter]
John: I have mixed feelings on that, because I have these dissonance in my head between the coffee can mentality where you have a certain amount of investments and you let them go. The ones that work are going to grow into these fabulous winners, and the ones that don’t become more or less irrelevant, and then you couple that with the punch card mentality. And the punch card mentality means focusing on your best ideas. You’re always going to have– We were talking about Apple. Apple at 10 PE is a lot different than Apple at 30 PE. If you bought it at $10 and you still own it at $30, it might turn out to be– that’s the right thing to do, and that’s great. But your equity at $30 might compound at a lower rate than–
Jake: Something else.
John: Something else in your portfolio. So, to me, a tricky thing. That’s what makes investing so fun and so interesting is there’s no way to truly master it, because you never know in real time what those opportunity costs are. Specifically, you have an idea of what they might be, and your job is to try to optimize those. Yeah.
Jake: That assumes that you have to be right about the business also over very long periods of time. That’s no easy. Buffett and Munger have talked about how– They found a handful of those things where they felt super confident that that business was going to be bigger in 20 years, bigger and better. That’s at looking at, I don’t know, what, probably 10,000? It’s an incredibly small number of actual that surfaced as being these obvious inevitables as he called it at one point.
Tobias: Well, the two inevitables were Coke and Gillette, weren’t they?
Jake: Original? Yeah. Those were–
Tobias: Do you think they look as inevitable now as they did then?
Jake: Hard to say. Gillette’s inside a PNP now, right?
John: They certainly have been incredible companies, but things do change. Yeah, you look at Coke and you say, “Ah, I don’t know.” if the sugar consumption in developed worlds is probably growing at a slower rate or even at a stagnant rate, Coke servings might be– You could see a scenario where maybe it doesn’t look as bright in the future. But it’s less about is Coke right or Gillette right or wrong? To me, it’s like things change over time. So, you have to be adaptable somewhat. And again, if you think about the partnership letters, he bought Disney and sold it. And that probably was a mistake. He calls it a mistake. I think it’s actually debatable whether that was a mistake, because if you look at how his equity compounded.
Jake: Yeah, what he put it into?
John: Yeah, what he put it into worked out pretty well. But American Express is another one that held for four years, and it quadrupled. It went up 4x, and it got to a level where presumably– he doesn’t talk about in his letters, but presumably he felt like it was probably fairly valued, and so he sold it to buy something else. I think that’s more along the lines of how, I would say, most of us operate unless you own a holding company where you have excess cash coming in, or perhaps, you’re an individual investor, and you have excess cash from your employment, and you can operate your own little mini-Berkshire Hathaway doing that. Never sell anything, and just keep putting money into your next best idea. That’s actually not a bad strategy as an individual. But I think Buffett would be running money differently if he were running a smaller amount inside of a fund. He would be– [crosstalk]
Jake: At a fixed pool of capital.
John: Yeah. You wouldn’t hold Coke at 50 times earnings. I think even he admitted that might be extreme. So, some of these investments get to extreme levels where I think you may want to reevaluate your cost of equity capital. Meaning, your opportunity costs in your portfolio and reallocate to something that has better. I have a low turnover approach, and I love the idea of owning something forever. But the reality is stock prices adjust and opportunity sets are always changing, and so you have to couple those two different viewpoints, I guess.
Jake: I think maybe Munger’s got it right when it’s like marriage where you want to go into the investment with your eyes wide open, but once you’re there, maybe it pays to have them a little bit shut.
John: Yeah. [laughs] You want to give things time too. The other side of the coin is businesses go through rough patches. And so, as an investor, obviously, you want to be cognizant of that and be ready to add perhaps, and not be too quick to adjust. And then on the other side of the coin, when things work out well, like Microsoft, and all of a sudden, they have this incredible cloud machine, and the stock went from $10 to $15, well, don’t be too quick to sell, because it’s still a great business. It’s still a 6% yield. It’s got all this growth in front of it. Maybe that’s still worth holding. So, you have to hold those two opposing views. When I say opposing views, coffee cans/punch card, you have to hold those two simultaneously, and that’s part of the trick of portfolio management, I think.
Tobias: Buffett did slightly do something with that Coke holding when he merged into Gen Re. He used the overvalued Berkshire traded into undervalued Gen Re, get the dilution that way. So, it’s didn’t really sell it down, but got the tax free dilution of the position at least with a big slug of bonds.
Jake: Right. He turned claim checks on overvalued Coke into bonds, basically, in a tax– [crosstalk]
John: That’s a really interesting way to look at it. Yeah, he issued stock, which he’s loathe to do. He did it because presumably he felt like that arbitrage made sense given the contents of his portfolio and the valuations of the stocks he held. So, that’s a good way to look at it.
Jake: And it was 3 times book on 60 times PE Coke look through. That’s a pretty watered down analogy or something.
John: Yeah. So, you could look at that and say, he did that or maybe it would have made more sense just to sell the position. But Berkshire is in such a great spot where you don’t need to sell anything because you have this cash coming in monthly. And so, you got this huge tax deferred liability and you got all this cash coming in, so it’s a different situation. It’s a pleasant place to be in.
Jake: Sounds like a fun game.
Tobias: Hey, John, we’re coming up on time. If folks want to follow along with what you’re doing or–? [crosstalk] contacts.
Tobias: I like Base Hit. I’ve learned lots of things from you John over the years.
John: I like that.
Tobias: I am a fan.
John: I’ve learned a lot from you too. So, I appreciate the reciprocity there.
Tobias: Well, thanks very much. Folks, next week is the 200th. Billy’s back. Billy’s been in the comments telling some cider jokes. So, we’re going to be partying next week. We’ll see– [crosstalk]
John: It’ll be a real show. It’ll be a real show.
Jake: Wow, 200th episode next week, huh?
John: Congrats, guys.
Jake: My God.
John: I’ve enjoyed watching a bunch of them.
Tobias: Well, thanks very much. That’s very kind.
Jake: Aging and dog ears here.[laughter]
Tobias: Get a run of value, then we’ll young again.
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