VALUE: After Hours (S06 E11): John Rotonti Jr on Best Value Firm Processes and Valuing Buybacks

In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and John Rotonti Jr discuss:

David Einhorn’s Shift in Value Investing Strategy: Prioritizing Cash Flow
The Nygren Effect: 6x PE + Share Repurchases = 20% EPS Growth (Even Without Earnings Growth!)
Murray Stahl’s Blueprint for Investing During Inflation: Why Royalty Companies Are Key
Unveiling the Best Predictor of Stock Market Performance
The High Cost of High Growth: Chasing Returns vs. Avoiding Blowups
Sell First, Ask Questions Later: The Julian Robertson Tiger Cub Approach’
The Cash Flow Conundrum: Why Value Investors Struggle With Bitcoin’
Invasive Ants, Hunting Lions, and the Future of Private Equity
Separating Smart Capital Allocation from Financial Engineering
Understanding Sustainable Growth: Buybacks vs. Organic Growth
Understanding the Tailwinds for Builders FirstSource

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:

Transcript

Tobias: And we are live. This is Value: After Hours. I am Tobias Carlisle, joined as always, by my cohost, Jake Taylor. Our special guest today is John Rotonti Jr. What’s up, John? How are you?

John: Hi, Tobias. Hi, Jake. Thanks for having me on the show again. [crosstalk] doing well.

Jake: Welcome back.

John: Yeah, thank you.

Jake Taylor: I see that I’m no longer esteemed cohost. I’ve been demoted to just regular cohost.

[laugher]

Tobias: Would be esteemed. I felt a bit bad. I thought maybe that was like a-

Jake: That’s too much.

Tobias: -[unintelligible 00:00:31] or something.

Jake: [laughs]

John: You’ve been demoted. Yeah, now you’re just longtime cohost.

Tobias: No veggies. Demoted– [crosstalk]

Jake: The spark is gone, TC. We’re just going through emotions now. [laughs]

Tobias: Sorry about that. My esteemed cohost, Jake Taylor.

John: There you go.

Tobias: John, for folks who aren’t familiar with your work, give us a brief background. Left the Motley Fool, what are you up to now?

John: So, I left the Motley Fool about a year ago, almost exactly. I was there for nine years. I was a Senior Analyst and the Head of Investor Training and Development. And since then, I have been working on my podcast, the JRo Show, where I try to interview portfolio managers for some of the biggest, most respected investment management firms in the country, really, about their philosophy, but really their process as well.

I’ve published eight episodes now, and I haven’t asked for one stock idea. I love stock ideas. It’s just, that’s not what I’m going for on the podcast. It’s just really about like, what is the research process, what is the day-to-day life of analyst or portfolio manager at the firm, what is expected of the analyst down to how many ideas are they expected to pitch year, what is the deliverable expected to look like, is it three pages, is it 30 pages, is there a model attached, is there a PowerPoint attached? Just deep into the weeds of what their day-to-day process looks like.

Jake: Teach Amanda Fish. And the other one too is– Oh, gosh, who was it now? Was it Picasso? He had a club—Like, artists would get together, and it was called the turpentine club, I think. And it was because they didn’t want to get together and talk about art history or whatever. They want to know where could you buy cheap turpentine.

John: Love it. [Tobias laughs] Love it. Yeah. Last thing I’ll say about the show is I hope to start releasing some different content on the podcast. So, I have just recently recorded an interview with the CEO of a company that I own stock in. And so, I’ll start to roll out some of these CEO interviews.

Tobias: Having conducted all these conversations with these guys, do you have any ideas about a good way to run a firm? Or, what sort of works, what’s successful or what’s something to avoid?

Jake: Commonalities.

John: Yeah, it’s interesting because– So, I’ve done maybe two really respected value investing firms in Harris Oakmark. And I’m going to release Diamond Hill next week.

Tobias: Awesome.

John: And then I’ve done two really respected GARPy, growth at a reasonable price firm in Poland capital and Parnassus. And there’s so many similarities. Most analysts are expected to cover about 15 stocks on average. On average, across these four big firms, most analysts are expected to pitch about three to four new ideas every year. All of those firms that I just mentioned, the analysts are expected to do three statement financial modeling. So, a lot of times, when people hear modeling, they just think about like a simple DCF. That’s not what these firms are talking about.

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Sell First, Ask Questions Later: The Julian Robertson Tiger Cub Approach

So, if you’re interviewing at these firms, they want to know that you can build out all three financial statements. Like, a Wall Street equity research report. Connect the financial statements, and they all model out– Parnassus models out earnings per share three years. The others go out five to seven years. So, that’s common expectations. Cover 15 stocks, find me three or four new actionable undervalued ideas a year, and keep an up-to-date model, update it quarterly, model out anywhere from three to five years, what you think per share economic value is going to be, and then put what you believe is an appropriate multiple. Those are some commonalities.

I’ll tell you one that I think is common across them, and then you can ask me any questions you want. A lot of these investors have learned to sell quickly and almost ruthlessly when something comes out of nowhere and surprises them. It’s not that they don’t have the emotional discipline to hold on. It’s that if something comes out of nowhere, surprises them, that was not in their original analysis, was not part of their original thesis. Rather than put investor capital at risk, rather than risk a blow up in that name. Some of these funds are concentrated and if you blow up in one name, that can really mess with the earnings compounding of the entire portfolio. And so, what they do is they will sell.

This doesn’t happen often where you get surprised out of nowhere. But when it does, they will sell out, and then rethink it and then rehash it before deciding to get back in or not. So, that’s a commonality I have found.

Tobias: It’s a Julian Robertson Tiger approach.

John: It is. It is Julian Robertson– Bill Miller adopted that approach. So, I interviewed Bill Miller in print, 2014 or 2015, and I asked him some of the lessons he learned from his tough time during the global financial crisis. And he said, one of the biggest lessons and corrections they made was that selling out quickly when just something unexpected happens. And so, I think some other good investors have adopted that practice as well.

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David Einhorn’s Shift in Value Investing Strategy: Prioritizing Cash Flow

Tobias: Just before we came on, we were talking about Einhorn’s latest letter.

John: Yeah. So, it’s something I’ve been thinking about a lot recently. David Einhorn is investor that I have deep admiration for. In fact, if you were to ask me who I want to have most on my podcast, the JRo Show, it would be David Einhorn. He’s done a few interviews where he’s talked about this, and then he wrote about it in his year end 2023 letter, where he said that his theory, his philosophy is he can no longer wait for the market to properly value stocks. So, traditional value investing was, you buy what you believe to be an undervalued security and you wait for the market–

If you’re right, sometimes you’ll be wrong, but if you’re right, you wait for the market to come around to your correct point of view, and the market will rerate the shares higher, and then you can benefit in two ways. You benefit from the closing of the gap from the stock price to the estimate of intrinsic value, which is higher than stock price, and then you can also benefit from growth of per share value over time. Einhorn believes that the active fund management industry has been decimated. That’s the word that he used in his 2023 letter. And I can read a “If you’d like.”

Tobias: 1 out of 10 have been gone out into the field and killed themselves.

John: Right.

Tobias: Just to frighten the enemy.

John: Yeah. [Jake laughs] And that certain companies have been forgotten or left for dead. They’re just not covered anymore. And so, he doesn’t think he can rely on the market to properly value these securities anymore, at least not in a reasonable time period. So, he doesn’t think he can rely on the market to rerate a company to a higher deserving, justified multiple. And so, he shifted his strategy, at least in his larger positions, of investing in companies that are not only cheap, but that are currently returning gobs of cash to shareholders through either dividends, buybacks, or in some cases, interest on a high yielding debt security. So, he’s getting current cash flow from the securities.

===

It’s something I’ve been thinking a lot about. And then I read the most recent issue of value investor insight with Murray Stahl, the founder of Horizon Kinetics, and he said something very similarly. Here’s just one sentence, but he said, ” Obviously some stocks deserve to be inexpensively priced, but cheapness can also just be a reflection that fewer people care and no one is paying attention.”

And so, I thought it was something very similar to what David Einhorn was saying, that some of these stocks, even good businesses that don’t deserve to be cheap, have just been completely forgotten and left for dead, because there is so nearsightedness or even manic laser focus on some of these tech names right now. But that large swaths of the market, good profitable growing business are just forgotten about.

Tobias: Do you agree that that is the traditional definition of value that it was price action, that was the thing that delivered the returns?

John: Jake, I think he’s probably asking you.

Jake: [laughs]

Tobias: I think I know what JT’s answer is going to be. But JT would say no, and I would agree with it. But go ahead, Jake.

John: Please, please, we can have a larger conversation around this.

Jake: I think it depends on lots of different flavors of value over the years.

John: There have been. Yeah.

Jake: If you’re buying net-net’s, it was probably more of a valuation rerating. When you took existential risk off the table for a few of these companies, it’s a pretty big binary change there when it went from this company is going to zero to, “Wait, this might actually last a little bit longer. There’s a big step up there, kind of nonlinear. “

In the other version of like, “Oh, never really a question about whether it’s a going concern or not, but just more like it’s cyclical or maybe its best days are a little bit behind it, but there’s still a viable business here.” That one might have been a little bit less on just pure rerating. But I would imagine that the neglect is likely more of a benign thing now just from so much indexation. There’s just not enough people looking–

Tobias: It’s not John Huber’s idea, but John Huber talks about it a lot. Even big, well followed companies will vary widely over the course of a year from a low– The difference between the low and the high might be three times or 30% depending on which way– [crosstalk]

Jake: Yeah. Greenblatt would start his class with– He’d pull up the paper and show the 52-week high and the 52 week low for–

John: 50% difference.

Jake: -A Huge differences on these giant blue chip, very stable as far as you looked at any of the business results are relatively stable compared to these 50% swings in the price.

Tobias: I think your return is embedded when you buy. Whatever the stock price does, you’re getting this expected return. And provided that the stock does what you anticipated that it would do, you’re getting that return whether the market recognizes it or not. But having said that, I think that Buffett’s strategy is exactly that. To buy something where the expectation is that he’s going to get a lot of his capital back pretty quickly. I think he’s done that in just about every single big acquisition that he’s done from the railroads to take your pick.

He’s looking for OXY recently. He’s pinning them to the mask by putting that plan to return capital in his own meeting note saying, “Hey, you said this. We’re going to hold to this publicly.” So, I agree that, even though– I think Einhorn’s being a little bit cute with the reasoning. But I think that the outcome is right. Yeah, I agree with the outcome.

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The Nygren Effect: 6x PE + Share Repurchases = 20% EPS Growth (Even Without Earnings Growth!)

John: So, the way you asked the question, Tobias was, do you think value investor returns have largely come from that? No. [crosstalk]

Tobias: I said. Yeah. Is that the traditional expectation?

John: Right. So, I think the philosophy and where the returns actually came for may be different. I think the philosophy was at a large margin of safety, buying a dollar for 50 cents with the expectation that it’s eventually going to be valued at a dollar. Was that an expectation of traditional value investors that the margin of safety would close? And so, you buy it when it’s trading at 50 cents on the dollar. And then if you’re right, you start to sell when it’s trading at 90 cents on the dollar. And then, you’re out by the time it’s a dollar. [crosstalk] dollar.

Tobias: Give the example of Nygren’s six times earnings.

John: Right. And so, in the real world, I did say– [crosstalk]

Tobias: I think we talked about that offline. Talk about the– Do that calculation for everybody.

John: Absolutely. So, in my most recent print interview with Bill Nygren, he says, “If the cash conversion rate is 100%, the company could reduce shares outstanding by 17% annually and grow per share value by 20%.” Just to recap, he’s saying six times PE, business value is flat. Earnings are not growing, they’re just stable. Free cash flow conversion to net income is one times or 100%. In that scenario, the company could reduce shares outstanding by 17% annually and grow per share value by 20%.

So, earnings per share are growing by 20% even though net income is growing 0%. And [crosstalk] Mauboussinput out a white paper like a week ago, maybe two weeks ago, talking about this very thing, how low PEs can drive massive EPS growth when you’re buying at a discount.

Tobias: So, let’s keep this thought experiment going. Let’s say I own stock in a company that’s doing that, and it buys back stock. And eventually, it buys back all of the outstanding stock, and I’m the only person left. Do I care where the bid is in the market, or am I getting the intrinsic flows that are far superior to anything that I’ve ever paid?

John: This wasn’t planned. So, in the same interview–

Jake: Nothing is on this show.

John: Right. No, I love this. [Tobias laughs] In the same interview, Bill Nygren says, “If a company generates a lot of excess cash and buys back stock when the valuation is too low, that eventually forces the valuation higher.” So, there’s a forcing mechanism. So, Tobias and Jake, so think about it.

Tobias: I don’t even need a, “I’m saying I like this thing.”

John: I love this thing. Let’s use easy math. I can go through the math of the 17%, the 20%, if you all want, because I broke it out for a student that I mentor. [Tobias coughs] But let’s do it.

Tobias: Let’s do it. Let’s break it out.

John: So, it’ll just take me a second. I have it right here. So, let’s assume zero debt. So, interest expense is zero. EBIT is $125, tax rate is 20%, assume 100 shares outstanding. Tax rate is 20%. So, 20% of $125 is $25 in taxes. So, net income is $100.

We also know, based on the Nygren quote, that free cash flow is at least $100, because free cash flow conversion is 100%. So, he gave us a PE of six. So, PE of six, we know that net income is $100. So, six times $100, we know the market value is $600. So, we have a market cap of $600, a 100 shares outstanding, so stock price is six.

Now, you repurchase 17% of 100 shares outstanding, which means you buy back 17 shares for $102. 17 shares times the $6 per share stock price, okay? That’s $102. So, you spent all of your free cash flow. Free cash flow was $100. In this example, we’re saying $102.

Net income is still $100, because remember, he said earnings are stable or flat, and buybacks come out of distributable or free cash flow, not from net income. So, net income is still $100, shares outstanding are now 83. We started with 100 shares, we bought back 17, we now have 83 shares outstanding. So, original EPS was $1. Net income of $100 divided by 100 shares outstanding, $1. The new EPS after the buyback is $120. Net income of still $100, now divided by 83 shares outstanding. That’s a $1.20.

So, EPS went from a $1 to a $1.20. You get 20% growth in earnings per share when you buy back 17% of the shares when the PE is six. Net income did not grow one penny. So, that’s the power of buybacks at low PEs or high free cash flow yields.

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Tobias: I saw a good Tweet. This has been on Twitter for the last week, but they said, “If Michael Saylor continues to buy back bitcoin and he ends up owning all of bitcoin, what is the intrinsic value of bitcoin?”

John: Oh, I didn’t see that tweet. Did it give answer?

Tobias: Well, it’s a thought experiment, but you can work it out [laughs] if Michael Saylor owns all of bitcoin.

John: But Tobias, here is not a thought experiment. So, let’s just use easy math. 10 times earnings and you’re buying back 10% of shares a year, 10% of the mark cap a year. If the stock price does not go up, then you end up owning the entire company after 10 years.

Tobias: That sounds great.

John: Well, I know you love that. But that’s the forcing mechanism that Bill Nygren talked about in that interview. When you’re buying back stock at low PEs, but really at large discounts to intrinsic value, it forces the multiple higher. Otherwise, you’re going to end up owning the entire thing while earnings per share are growing 20%, 30%, 40% a year, because you’re buying it back at lower and lower PEs.

Tobias: Let’s do it.

Jake: This is how I win.

John: Yeah, this is how I win. Exactly right.

Jake: It was kind of a private presentation, I don’t know, two or three years ago now. And I went through a lot of this math and used AutoZone as an example of what this looked like in an archetypal sense.

John: Absolutely.

Jake: Very minimal, top line growth, margin stayed reasonably, call it 11%, 12%, lots of buybacks done at very– They had the opportunity to do it. Like, they never got much above a 10 PE for that entire time.

John: It’s a beautiful thing.

Jake Taylor: It’s a very beautiful thing. So, then I broke it down to really, you could turn the world into two types of investors. The ones who, on the day that they buy, they hope to see the price go down. And then there’s the ones who buy and they hope to see the price go up. Which one are you? And this is like, in one world, I would say the last 10 years, or maybe call it the 2008 to 2021, maybe time period, you did better if you were the type who bought something and just wanted to see the price go up that next day.

My hypothesis is that the next 10 years, the 20s– And the title of the talk was the boring 20s, instead of roaring. In that, it wasn’t going to be top line, it wasn’t going to be prices ripping and multiples going up. It was going to be boring stuff like capital allocation, reasonable business results that then were translated into– really a cheap multiple turning into an attractive earnings yield on the purchase, and that was how you were going to win the next 10 years.

John: Jake, I not only love that, but I agree 100% in Sea Change, which Howard Marks wrote, I don’t know, year and a half ago, he said basically the same thing, “What worked during the era of free money is not what is going to work going forward.”

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Murray Stahl’s Blueprint for Investing During Inflation: Why Royalty Companies Are Key

Tobias: Murray Stahl had some other interesting– You had some other interesting insights into Murray Stahl too.

John: Oh. So, I just think that Murray is– He’s an incredible thinker. So, I saw him speak live last year at the Project Punch Card conference in New York.

Jake: I haven’t heard of that one. What’s that about?

John: The lineup is always incredible. So, last year’s lineup was like Lee Cooperman. By the way, Lee is the second guy that I want to get on my show the most. So, he calls in over Zoom. Everyone else is speaking live.

[laughter]

John: He calls in over Zoom.

Jake: From the car. [laughs]

John: And he’s sitting at his desk in Florida. I just read his book, by the way, not to get off track, but he’s put out a book from the Bronx to Wall Street or something. He’s 79 years or 80 years. He’s still working 17 hours days today. 17 hours days. He just loves it. Anyway, and so, someone in the audience asks him what he’s buying, what he owns. He takes out of his desk a piece of paper, a printed piece of paper, and he reads 15– It must have been 15 of the 20 stocks that he owns. He just reads, “Well, I own this, and I own this, and I own this, and I own this. I’ve been buying this. I’ve been buying this.”

He was just so transparent and awesome. But Murray Stahl talked that year. David Marcus runs Michael Price’s family office, the late Michael Price. Just an incredible lineup. So, there Murray Stahl’s lecture was on investing in royalty companies. Because Murray Stahl believes that inflation is going to be higher and more volatile for longer. Not necessarily 6%, 7% inflation, but above the 2% target, and it’s going to be more volatile. And in a high and volatile inflationary world, he loves royalty companies. Royalty companies own land with natural resources and lease out the land to E&Ps, exploration and production companies, mining companies.

Tobias: That’s how TPL do it. You can skip right on the royalty. You can get a cut of the royalty too. That’s different. There are some different variations.

John: Yeah. Texas Pacific Land is a big holding of Murray Stahl. You don’t invest any CapEx or very little. You don’t have any expenses. You’re just leasing out land. And so, Murray’s thesis on these royalty companies like Texas Pacific Land is that the top line is going to grow with inflation, but your expenses don’t grow with inflation. So, you’ve got one of these expenses are flat, top lines growing, and so the margins expand. And so, in virtually any environment, these things are generating 40%, 50% free cash flow margins across the cycle. If you look at Texas Pacific Land’s margins, some of the highest margins you’ve ever seen. The higher– [crosstalk]

Jake: What is this? The software?

John: Yeah, exactly. [Tobias laughs] But higher. And so, that’s what he spoke about then, was how to invest through inflation. But the thing that fascinates me about Murray Stahl is, on the one hand, he’s a traditional value investor in the sense that he wants to buy something at a significant discount to his conservative estimate of intrinsic value. He’s not scared to look at old economy companies.

And in the most recent issue of Value Investor Insight, he was saying that some of these high valued tech names are going to come under pressure for a variety of reasons. One of them being more competition from China, but a variety of reasons. On the other hand, he was one of the earliest investors at scale, at size in bitcoin, and he’s been mining bitcoin for years now.

Jake: Out of his basement? No, I’m just kidding.

John: I think it may have started there, but now he’s got a full operation going. And in this latest issue of Value Investor Insight, he talks about how he plans to hopefully bring his bitcoin mining company public.

Tobias: I’m going to sell the energy to the bitcoin miners.

John: Right. Exactly. Yeah. And so, you have this interesting dichotomy where he’s more traditional value focused. And a lot of traditional value investors that I follow are not yet on board with bitcoin. I don’t know if they ever will be, but they’re not yet at least. Murray is, and he was early and he was in size at large. He’s a billionaire. I think he was a billionaire before a lot of the bitcoin stuff, but he’s definitely a billionaire now.

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The Cash Flow Conundrum: Why Value Investors Struggle With Bitcoin

Tobias: What do you think the reticence is for many value investors with bitcoin?

John: Well, by definition, if you’re an intrinsic value investor, it means you’re trying to value the future cash flows of the business. The value of any cash flowing security, any financial security, any financial asset, is the present value of future free cash flow. You can’t do that with bitcoin.

Tobias: It’s a currency, right? It’s much more suited to the macro guys, who– They use cup and saucer or bearish harami to work out which way bitcoin is going. But then I guess the intrinsic argument might be,-

John: Different method.

Tobias: -you just short the US dollar printing or you short central bank currencies.

John: Yeah, that makes sense. But I think their reticence is that there’s no cash flows to value. It’s not throwing off any cash flows. And because of that, they don’t believe it can be intrinsically valued.

Tobias: Yeah.

John: Yeah.

Jake: well, let me ask this. What’s the right price for bitcoin?

John: [chuckles] I wish I knew.

Tobias: I liked that little frame that I saw it on Twitter. I apologize to whoever– I’ve stolen this from, but the frame was, “If Michael Saylor buys back, buys all of bitcoin, what is the intrinsic value, or what’s the value of bitcoin? What’s bitcoin worth? If Michael Saylor owns the whole lot, it’s not worth anything.”

John: That’s interesting. It’ll be micros strategy that owns it, because– [crosstalk]

Tobias: I think he’s selling micro strategy to buy bitcoin directly.

John: I think he’s selling 5,000 shares a day or something like that of micro strategy stock. And so, it’ll be micro strategy that ends up owning it. But yeah, that’s interesting.

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Tobias: Let me do a quick shoutout and then we’ll do some veggies. VA, is that–? What’s VA? Help me out.

Jake: Virginia?

Tobias: Virginia. Dubai. Kennesaw, Georgia. Valparaiso. Gothenburg, Sweden. LA in the house. Tallahassee. Antigonish. Savonlinna, Finland, what’s up? Tampa. Miami. Old Ocean, Texas. Hamburg, Germany. Jupiter, Florida. Congrats. Porto de Mós, Portugal. Mendocino, California. Quebec City, Canada. Boston, what’s up? Some good ones in here. Nashville, Tennessee. Congrats. That’s a good list. What do you got for us on the veggies, JT? London, UK. Last one. Sorry, everybody.

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Invasive Ants, Hunting Lions, and the Future of Private Equity

Jake: All right. So, this is called ants and lions hunting and private equity. So, we’ll see if we can turn this all into making any sense out of. So, first, a shoutout to my man, George, for sending me this delicious little veggies prompt from a– It’s from a scientific American little piece that’s titled These Invasive Ants Are Changing How Lions Hunt.

So, we’ll start out with the idea that regularly, almost every year at the AGMs, Mr. Buffett will say that, “In economics, you always have to ask yourself, And then what?” And the same is true for another complex adaptive system, which is mother nature. We’re going to follow a series of and then what’s, and we’ll see where it goes. And then we’ll see if we can draw some lessons back to business in investing.

So, researchers were exploring a regional ecosystem in Kenya, Africa. There were these ants that were indigenous to that region. They were fierce defenders of these local acacia trees. So, when an elephant would come to graze on the tree, for instance, or trample it over, the ants would swarm the elephant and crawl up inside of its nine-foot nose and use their mandibles to pinch inside the elephant.

Tobias: Oh, man.

Jake: Yeah, it’s rather unpleasant, I imagine. And as a result of these ants, the elephants would largely leave these trees alone. It’s not worth it, right? And then, it’s really not worth going and getting like ant neti pot every time you [chuckles] try to eat a leaf off of a tree. So, these indigenous ants had long protected, and their own living home in this symbiotic relationship.

Well, recently, researchers found a new invasive species of ant has moved in, and they’re killing off the local indigenous acacia ants. These invasive ants are actually smaller than the acacia ants, but they’ll team up and they’ll hold the acacia ants down by their limbs, and then basically draw and quarter them. They’ll dismember the ant, which mother nature is not messing around.

So, in not too long after, the new ants are displacing the old ants. And shortly thereafter, herbivores have figured out that these acacia trees aren’t being protected by these tiny protectors, and especially the elephants, who do a lot of damage rather quickly. So, the tree population, of course, has started to decline. And with that less tree cover then, we’re going again, these series of and then what’s, with less tree cover, the zebras are more safe because less trees make it harder for a lion to ambush an unsuspecting zebra and make them their lunch.

And then what? What are the lions doing now that they can’t eat zebras as readily? Well, it turns out they’ve shifted to hunting buffalo more, only that’s a lot tougher and more dangerous for the lions because the buffalo is twice as massive as the zebra and they have a much better defense against lions. Like, there’s videos online of these buffaloes, like, chucking a 400-pound lion into the air to fend off attacks. And of course, the lions are at least moderately successful, so the buffalo population is suffering now.

And so, this is like a classic butterfly effect, right? You disturb one little, small seemingly inconsequential thing, in this case, a tiny, invasive species of ant, and you get this cascading effects where they lead to an eventual decrease in a buffalo population, 10 links down the chain. So, the first lesson, I think, is that it’s fiendishly difficult to predict all of these complex interactions.

And so, it is with economics. No matter how much modeling expertise you have, how much modeling you do, it’s impossible to predict, I think, how shifting– Let’s say interest rates, for instance, how they ooze their way into every crevice of the economy and what will manifest because of these changes. So now we’re going to shift to talking about private equity and see if we can draw some parallels to our and then what exercise.

So, Bain & Company came out with a recent report on all things private equity. And this was flagged by a friend of the show, Dan Rasmussen. So, in 2023, the deal value fell by 37% from the year before, and exit value slid by 44%, so almost half as much. And things are not very much like they were in the go-go years of 2021. And today, nearly half of all global buyout companies have been held for at least four years. So, there’s $3.2 trillion of aging, un-exited company value on PE’s balance sheet right now. And just for context, that was like $1 trillion in 2016.

And of course, there’s a lot of discretion around how you mark these assets. Like, good firms are still– they’re clear about their valuation policies to their LPs and are appropriately conservative. But of course, I think that Cliff Asness would agree that volatility laundering is still alive and well in the PE industry.

If you think about it just from an incentive standpoint, like, why if you were a PE firm would you want to show bad results? And also, if you’re one of these big pools of capital, like an endowment, why would you want to hear bad results if it’s possible that they might smooth themselves away over time? Of course, just don’t tell me, if it’s going to end up being better later. So, I’m left wondering to whom will private equity exit these $3.2 trillion worth of businesses to? Themselves, each other, public markets? The IPO window is a bit frosty lately.

And then the FT Alphaville, if you guys follow and read that, but they said that PE is sitting on an astonishing $2.6 trillion of capital it’ll eventually have to deploy. So, public companies tend to borrow in long-term and fixed, and private equity tends to borrow short and floating rate. And they’re often borrowing in private credit markets rather than issuing bonds like a public company would. And so, the median sponsor backed company saw their borrowing rates already move from 4.9% in 2022 to 7.2% in 2023. Whereas the median S&P 500 borrower only moved from 3.2% to 3.7. So, the S&P has hardly even noticed that rates have gone up relative to private equity, which has really seen them gone up, really seen them increase. So, for PE, basically what was once cheap debt isn’t cheap anymore.

And then what about valuations? This is another issue that have been talked about. Private equities closed transactions at 13.8% EV to EBITDA in 2021 and 2022. That number used to be more like five times rather than-

Tobias: Ouch.

Jake: -13 times when David Swensen was putting up awesome returns at Yale by tipping towards privates. So, from reference, from 1990 to 2010, private equity returned 14.4% per year, compared to 8.1% for the S&P 500. And that 6%, roughly outperformance, was net of private equity’s 2 and 20 free structure. So, that means the gross return was really more like 20% a year for that kind of heyday. But there’s a feeling that a lot of this compounding is stalling. And last year, revenues for PE firms were actually slower growing than the S&P 500, 4% versus 5%. PE backed firms generally have lower margins than public companies, so the rise interest costs have meant that the median PE backed firm now is actually generating zero free cash flow. All the margin has basically shrunk and been absorbed by debt servicing.

So, after 40 years of declining rates, in our analogy, like maybe these were sort of the ants that were protecting the acacia trees, perhaps the fed elephant has removed the tree cover, and these lions are going to have a much more difficult time finding juicy zebras to feast upon. So, with this more expensive debt, perhaps a less target rich opportunity set higher valuations, too much money chasing too few assets, I personally find it a little hard to be as bullish on the prospects for most of private equity. And of course, I’m sure there are exceptions of people doing smart things. There always are.

So, perhaps they might be forced to hunt more dangerous beasts like buffalo and are more likely than to suffer resulting injuries. And in general, whether it’s mother nature or finance, you got to be careful of these small, seemingly inconsequential changes, because they can lead to rather consequential consequences that just propagate throughout a system.

Tobias: Good one, JT.

John: That was excellent. Some good connections there.

Tobias: That private equity model is one way of converting that platinum growth fixed PE stock that’s doing all the buybacks. It’s a way of turning that into equity appreciation, because you’re using the cash flows to pay down the debt and your equity, assuming that the enterprise value is staying steady, your equity should be going up as the debt comes down.

Jake: Yeah. How do you become a billionaire in private equity? Borrow a billion dollars and pay it back.

[laughter]

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Unveiling the Best Predictor of Stock Market Performance

John: Yeah, that’s true. That was awesome. My question is, if everything is a complex adaptive system, which I think it is, markets and economies especially, and we can’t predict the future because of that, what do we do as investors? That’s a conundrum which makes investing hard. In the last couple of years, investing doesn’t seem that hard. If you own a tech index, you’re doing great.

Tobias: If you own SPY, you’re doing pretty well.

John: Exactly. If you’re doing SPY, you’re doing very well. Yeah. But it turns out, it is hard because everything is hard to predict. Yet, as investors, we’re trying to make predictions. That’s what we’re trying to do. We’re trying to see which stocks are going to be higher in the future. That’s a prediction.

Jake: My mind goes to an insurance analogy, because that is also about predicting the future. It’s about what risks are you taking?

John: Absolutely.

Jake: Are you being properly compensated to take that risk? I think there’s a couple of different smart ways to do it. I think you could think of it like auto insurance, let’s say, GEICO as a for instance. And I would like actually what Toby does to GEICO, which is, you don’t know exactly which of the policies that you write is going to be profitable or not. But you know that as a base large numbers expected outcome that you– you have a little bit of an edge there just based on what you’re choosing, you’re probably arbitraging some behavioral bias. It’s going to end up working out okay, and you’ll probably do a little bit better than average because of that.

And then I think occasionally, markets throw off just absolute no brainer things that just don’t make any sense to even a reasonably intelligent businessperson who’s looking at the situation. You get paid really well to do that. And recognizing those, you have to hang around and see them enough to find them. But they’re very, very rare. I would liken that then to specialty insurance, like a [unintelligible 00:40:27] is writing where there’s these mispriced things where like, “Okay, we’re getting a ton of premium relative to what we feel like the risk is that we’re underwriting.”

You just have to be very discerning at that point and recognize that it’s reasonably rare that those get thrown up. But they do on occasion present themselves. And so, I think both of those make sense to me as ways to mitigate the uncertainty of the future.

John: That’s how I deal with it, especially the way that Tobias does. There’s overwhelming research. I shared I think a dozen slides on X at one point in time. I can send this to, y’all, showing that high free cash flow yield is far and away or owner earnings yield, whatever you want to call it, is far and away the best predictor of forward rate of return. Far and away. Bank of America looked at 40 metrics. This was about seven or eight years ago, but it looked at 40 metrics. And free cash flow to enterprise value outperformed the market by the most.

Manning & Napier, T Rowe Price, several other firms, like I said, there’s a dozen slides that I sent all showing that high free cash flow yield is far and away the best predictor of market outperformance over a five-year period. Far and away. So, it’s empirical.

Tobias: I think it varies a little bit depending on the date that you do it. But free cash flow, it’s free cash flow or it’s operating income, or it’s operating cash flow, or it’s one of those more broader based earnings measures than just the PE right at the very bottom of their statement. But I think the interesting thing is how predictive it is. So, that’s one thing that I’ve spent a lot of time looking at, how far out can you–?

So, I always thought quality, and there’s lots of different definitions of quality, but we know return on equity is pretty mean reverting, but there are other measures of quality, some of which are less mean reverting. But of all of them, I can’t find anything that really has any predictiveness that is anywhere near just the price ratio. So, price to free cash flow to EV say, that is predictive out to about five years. Beyond five years, nothing’s predictive. And it’s only the price ratios out to about five years. The quality metrics, funnily enough, seem to break down pretty quickly or I can’t find the–

John: No, that’s what the research shows. So, the 40 metrics that Bank of America looked at weren’t just valuation. It was quality ratios, profitability ratios, growth ratios and free cash flow yield. Far and away was the best predictor of five-year performance.

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The High Cost of High Growth: Chasing Returns vs. Avoiding Blowups

Tobias: Given that is the case, what do you think is the utility of building those complex models that go out five to seven years?

Jake: Marketing. Sorry. What?

John: I’ll say, for cyclical industries, I think there’s probably some utility in getting a normalized mid cycle number. Five years is arbitrary. But I think one of the mistakes some investors make when they’re earlier in their career or retail investors with less experience that just go to Yahoo Finance or some other free site and get a PE, they have no idea what’s in that, right?

Tobias: Yeah.

Jake: Yeah.

John: They don’t know if that’s peak earnings, trough earnings, if there’s a– [crosstalk]

Tobias: Asset sale. [chuckles]

John: Exactly. And so, I think modeling out a few years can at least help you get to a more mid cycle number, but also normalized number that takes out some of these non-recurring–

Tobias: Let’s say three years, we agree that you have some predictability out to three years. One of the problems with a three-year modeling number is, if it’s a high growth company, the growth doesn’t really describe the value of the company until it has a few more years to compound. So, you’re always missing those– It’s a little bit of a bias of my method that it’s going to miss those higher growth companies. But I think that the base rates for those higher growth companies has historically been so bad that it doesn’t bother me that they’re not being caught in the method. But I’m just curious, what do you think? Does that model and capture? Does a five- or seven-year smoothing cyclicals make sense, but it also lets you capture some of those higher growth companies?

John: In my opinion, if you miss some of the higher growth companies, if you’re good at doing what you do, you can generate the exact same returns or better than a high growth investor because you’re going to have fewer blow ups. You’re going to have fewer blow ups. A high growth investor who’s going to have more multi baggers, potentially, but more blow ups. And so, in the end— I’ve looked into this. I’ve back tested a lot of performance. I’ve looked into a lot. I think the best investors outside of Buffett and Marks and maybe a handful of others on one hand, I think the best investors are doing 15% annualized over time, over a career. 15%. [crosstalk]

Tobias: I think that’s about right too. I think that’s the right bogey.

John: Yeah. The best of the best are doing 15%. And some of those are the best of the best growth investors, and some of those are the best of the best more value investors. There’s a spectrum, of course, of value investing and a spectrum of growth investing, but the rides will be very different. But if you look 10 to 15 years in the future, I think you end up in the exact same place.

Tobias: Somebody who can do a sustainable 15% is elite. I think that’s absolutely elite.

John: I think it’s elite. It’s exactly right.

Jake: I know a grizzly old manager who says like, “Anyone who’s aiming for more than that is basically almost assuredly going to blow themselves up.”

Tobias: Yeah.

John: People don’t want to hear that right now, because everything’s going up every day by a lot. And so, people don’t want to hear that right now. Tobias, back to what you said about the free cash flow, it’s such an important concept– And back to the idea of you can buy in the whole company, if the stock price doesn’t go up. A lot of people don’t actually think about what free cash flow is. But Warren Buffett’s got this great quote, “Book value or invested capital is what’s been put into the business. Intrinsic value is what you can take out of the business.” That’s free cash flow. It is what is left to investors after investing and maintaining and growing the business.

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Separating Smart Capital Allocation from Financial Engineering

Jake: I was going to push back a little bit and do a red team or devil’s advocate. How do you avoid then–? Not to name names, but let’s say like a Boeing situation, where they borrowed and did a ton of buybacks, I don’t know, let’s say, before 2020, and now operationally have really not been particularly stellar, it seems, did they underinvest in their business?

John: Yeah, I think they did.

Jake: How do you know where’s the right amount of–? Yeah.

John: Intel did the same exact thing under their prior CEO, where Intel for a while was the leader in semiconductor manufacturing. But then they made the decision to invest less in the business, less in R&D, they mortgaged their future, they mortgaged their moat in order to buy back a lot of stock and do this financial engineering.

Jake: Yeah.

John: There’s a time and place when buybacks are absolutely the best use of capital. Buffett has a quote, he says, “When your stock is undervalued, it’s the surest way– the surest way to grow per share value is to buy backs at a discount.” But not if you’re sacrificing your moat. Not if you’re under investing in R&D. And so, Intel went through that. Now they have a new leader, Boeing– [crosstalk]

Tobias: How do you identify that in real time?

John: Who did?

Tobias: How do you identify that in real time?

Jake: How do you tell financial engineering from–?

Tobias: Rather than like after the fact, where Intel stumbles, Boeing stumbles, “Whoops, we should have paid attention when they were doing that five years ago.” How do you know five years ago that they would–?

John: It’s hard. You can probably look at market share loss. Intel was definitely, there was a point where it started to lose market share and those market share losses started to accelerate and they just came up with a bunch of excuses. It’s not easy though. Another thing is ASML, arguably the most important company in the world. Intel had ego or whatever you want to call it, saying, “We’re going to make the most advanced chips in the world without ASML’s machines, without their EUV machines.” And they said, “We’re going to try to replicate this.”

Well, Canon and Nikon tried it over a 20-year period, and they gave up. They said, [unintelligible 00:49:17]. They completely got out of the EUV business completely. It’s very hard to do. And if you do do it, you need hundreds of billions over 20 years. And Intel tried it, and then they fell farther behind. But that’s all hindsight. Like you said, I wasn’t really doing a deep dive into Intel at the time, but maybe market share losses, something like that.

Tobias: it’s hard to know. I think probably that you need to take even one more step back from that and somebody said it in the comments here, “But don’t buy fast changing industries.” All of these businesses, essentially—Like, Microsoft is a business that they’ve pivoted a few times over the years to get to where they are now. But that’s uncommon. That’s unusual for businesses to be able to pivot. Most businesses-

John: Especially that large.

Tobias: -they’re just like Kodak had the first digital camera.

===

Understanding Sustainable Growth: Buybacks vs. Organic Growth

John: Yeah. Two, three weeks ago, I posted, I think, eight quotes from Buffett saying virtually that– He said, “Berkshire Hathaway is just as fascinated by all of these innovations as you are as the rest of the world is.” We’re just as fascinated by it. We just don’t know how to model it. We don’t know how to predict. When there’s lots of disruptive innovation happening, the ground under those businesses are not stable. And so, it’s an industry that’s very hard to build moats, sustainable moats. And it’s an industry that’s very hard to build high barriers to entry.

Jake: At one point, Bill Gates, I think, in the late 90s, said that, because of those exact factors, that tech should probably really trade with a low multiple, lower than most businesses, because that terminal value is harder to underwrite with so much disruption.

Tobias: Well, those ideas come into vogue every mid cycle. So, we’ve just gone through one where we had tickets are high multiple, but we might go through one where tickets are low multiple.

John: Obsolescence is a big risk. It’s a big risk. But just back to that free cash flow, that’s what it is. It’s what the owner could take out– It’s what a sole proprietor could take out of the business every year and pay himself a dividend. It’s after investing and protecting that moat. After investing in all of the growth. Down the income statement and the growth down the cash flow statement, and working capital and CapEx and acquisitions. After all of that, it’s what a proprietor could take out and pay himself or herself a dividend. And so, that’s why it’s so predictive. If a dividend yield is what the company actually pays out as a dividend every year, free cash flow yield is what the company could potentially pay out if it chose to return all of its free cash flow as a dividend.

Earlier in the show, we went through the math talking about how even if the company is not growing, 0% growth, as long as it’s not deteriorating, as long as it’s not shrinking, company can grow 20% a year if it’s buying back stock at a single digit multiple. And that can go on for a long period of time. That’s sustainable growth.

Jake: It’s a shower, not a grower.

John: It’s a shower, not a grower.

===

Tobias: What’s Buffett’s little–? One of his lieutenants, Ted or Todd, has that Sunday lunch with him where they discuss? Do you remember the formula?

John: Todd goes to his house. Yeah, the formula is they look at the S&P 500 and they have three criteria. What stocks are trading at a forward PE, 12-month forward PE of 15 or less.

Tobias: Yeah.

John: Which do you have a 90% confidence level, earnings will be higher five years from now. It doesn’t matter how much higher. Just higher. And then which do you have at least a 50% confidence level. Earnings per share can compound by at least 7% over the next five years.

Tobias: What does 7% compound over five years get you to? Is it 50% bigger or something like that?

John: Yeah, it’s 50% bigger. What I think it does is if you’re buying 15 times or less today, if you’re paying 15 times or less today, and a company can grow high single digits, seven, eight, nine, you can grow into a 10 times free cash flow in five years.

Tobias: Yeah. Right.

John: That’s the kicker. Jake, you said earlier today, grow into a 10% earnings yield. That’s like my rough heuristic. I’d love to pay 10 times or less today for a growing business. If I can’t, I’d really like to see it grow into a 10% free cash flow yield by year five. That’s my rough heuristic that I try to stick to.

I’ll just go one step further. I know we’re running out of time. If it is one of these faster growers that I get seduced by and I pay 20 or 25 times earnings, [chuckles] I’d like to believe that the earnings per share can grow fast enough, so that it drops to a market multiple by year five. So, down to 15 or 16 times by year five. Those are rough heuristics for me.

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Understanding the Tailwinds for Builders FirstSource

Look at a company like Builders FirstSource. This is a company that is– It’s put out three-year guidance for three year forward EPs guidance of $18 of earnings per share. It’s at 200 today. So, Builders is trading at 11 times. 18 is the bottom end of its guidance. It’s trading at 11 times the bottom end of its guidance three years out. And this company serves absolutely a crucial economic need. It saves its customers time, money and waste. And in the last two and a half years, it has bought back 37% of the stock. Hold on, I wrote this down. So, in the last two and a half years, it’s bought back 37% of the stock at an average stock price of $83. It’s trading at $200 today. That’s pretty impressive.

Jake: Are they still doing buybacks at $200 or do they turn it down?

John: Oh, sorry, yes. No. So, over the next three years, they gave medium term guidance, three-year guidance. So, over the next three years, they plan to buy back another 30% to 40% of the shares at 11 times earnings. Three year forward, 11 times earnings, looking at three year out numbers.

Tobias: Do you ever worry that a company like Builders FirstSource is beholden to the building–? I just don’t know whether this is secular or cyclical. But clearly, we underbuilt for a long period of time following the GFC.

John: Over 10 years, I’d say.

Tobias: Over 10 years. Yeah. And you can see that in the data that we haven’t built enough houses through that period of time. And so, now there’s this unusual thing in the market where rates have gone up so quickly, people who have a mortgage, pre 2020 or whatever, can’t get out of there, or it’s probably later than that, pre 2022, pre 2023 are stuck and they can’t move. So, these new houses that have traditionally been at a huge premium to previously owned houses, they now trade at about the same price.

So, the Builders are just shipping houses and going through this unusual boom. I don’t know whether it’s going to peter out this year or whether it’s got a decade to run, I have no idea. But to what extent, do you think about that when you think about something like Builders FirstSource?

John: So, two-thirds of Builders FirstSource revenue comes from new home construction. That’s an important part of their business. It’s the most important part of their business by far. Two things I’d say. The latest– What’s that podcast? The business deep dive podcast. I’m not going to be able to think of the name right now, but they did a deep dive on D. R. Horton, and the guest, who knows the industry very well, estimates it could take 20 years to dig ourselves out of this hole. That’s how under built we’ve been.

I’ve done similar math, suggesting it could take us 7 to 10 years to build us out of this hole, depending on how many new starts we have a year. So, I do think we could have an extended upcycle in new home construction, because the supply-demand imbalance, I feel is acute. It’s real. We have record low supply inventories home for sale, or thereabout record lows at the same time when demand is sky high, because millennials are entering prime home buying years. And so, there’s an acute supply demand imbalance. And so, I think that’s one thing.

The other thing with Builders FirstSource is they’ve transitioned their business model. A couple of years ago, less than 30% of their business came from these value-added services. Value added means they’re doing things the construction crew used to do. So, they will completely prefab off site. Builder will prefab a roof truss or a floor truss or a whole wall panel, and then deliver it and then install it. That saves labor, right time. They install windows, doors, custom mill work, they build it all off site and install it. So, things that the construction crew used to do, Builders is now doing for them. That’s much higher margin. 800 to 1,000 basis points of higher margin than simply distribution of lumber, which is their older business model.

They’ve been a leader in consolidating the industry, so the industry is much more rational when it comes to pricing. I think there’s a lot going for the company and then just buying back a lot of stock, 37% in less than three years.

Tobias: I certainly like the buybacks.

[laughter]

John: I know you do. I do too. It’s weird that we’re getting excited about buybacks, and a lot of other investors are getting cited by the Nvidia conference yesterday, which was very exciting. Don’t get me wrong. There’s lots to think. There’s more than one exciting thing in the market happening right now, is all I’m trying to say.

Tobias: What do you make of that? Is that sustainable?

Jake: AI?

Tobias: There’s a little boom going on. There’s a little bit like Cisco in the early 2000s, or do you think it’s got a longer timeline than that? Actually, we’re coming up on time [unintelligible [00:59:47] [laughter]

John: Speaking of time. Right. That’s for next time. Have me back.

Tobias: Yeah, absolutely. We will. Good point. That’s John Rotonti. How can folks get in contact with you or follow along with what you’re doing?

John: I’m on Twitter, @jrogrow. So, J-R-O-G-R-O-W

Tobias: And what’s your podcast called?

John: The JRo Show.

Tobias: Good name.

John: Thanks.

Tobias: Jake, as always, a pleasure.

John: Great veggies, Jake. I’m getting stronger veggies.

Jake: [laughs]

Tobias: Thanks for coming. Folks, we’ll be back next week. Same bat time, same bat channel. I think we’ve got Eric Cinnamond coming on next week.

Jake: Oh, fine.

Tobias: Jake managed to lure him out of his cave.

Jake: Absolute return, bear cave?

[laughter]

John: Hibernation. Hibernation cave. Yeah.

Tobias Carlisle: Thanks, folks.

You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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