In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Victor Cunningham discuss:
- Best Lines From The 2024 Berkshire Meeting
- Value Investing Insights: The Role of NAV Discounts in Outperforming Stocks
- Exploring Telic and Atelic Activities in Investing
- Waiting for Value: The Art of Holding for Long-Term Returns
- Avoiding Investment Traps: Capital Allocation Efficiency
- Prioritizing Balance Sheet Strength and Value Over P/E Ratios
- How Marty Whitman’s Views on Growth Transformed Modern Value Investing Strategies
- Identifying Opportunities in Backlog Companies for Long-Term Gains
- Business Experience Enhances Investing Skills
- How Ergodicity Shapes Risk Perception in Investing
- Making Sense of the Earnings Gap: Small Caps vs. Large Caps
- Market Trends Analysis: The Road to Fiscal Normalization
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: All right. We are live. This is Value: After Hours. I am Tobias Carlisle, joined, as always, by my co-host, Jake Taylor. Very special guest today, Victor Cunningham, who is Third Avenue’s Small Cap Value PM. Super exciting for us. We’re all old fans of Marty Whitman’s and Third Avenue’s and small cap value, three of my favorite syllables-
Jake: Words that go together.
Tobias: -in the English language.
[laughter]Tobias: As hard as it is. How are you, Vic? Thanks so much for coming on.
Victor: Thank you. Pleasure meeting you too, and thank you for having me. I’m honored.
Tobias: So, this is really exciting. You joined in 2017. I’ve read through the letters and really, hopefully, this is going to be a great chat because we’re definitely–
Jake: We’re all off of post sugar high at Berkshire as well. So, let’s help.
Tobias: Yeah.
Victor: Yes.
Tobias: We are going to do the Berkshire wrap up. Vic’s been a shareholder since 1999, and that’s 25 years of following along that closely. So, we’ll get some.
Jake: And compounding.
Tobias: But let’s just start off a little bit. Tell us a little bit about the Third Avenue Small Cap Fund.
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Prioritizing Balance Sheet Strength and Value Over P/E Ratios
Victor: So, we’re one of the most concentrated funds in the marketplace right now. We have 23 equity holdings in the fund right now. We’re investors, we’re not speculators. So, our turnover rates are about 20%. That’s been consistent over the past seven years. We are extremely in the Marty Whitman spirit of well capitalized businesses. We are trying to figure out how we can lose.
I think if you look at the Third Avenue platforms or our strategies, you can see that we really have very strong balance sheets, but we also have high active share, close to 100% across the strategies. I think the reason for that is that we value companies different than many folks out there. We live in a P/E world, but if you sat in our research meetings, all the investment professionals meet two days a week. You probably wouldn’t hear the word P/E ratio, maybe once a quarter, if that, and maybe just as some type of reference. But it really has very little to do with how we value the businesses.
So, what we’re trying to do is we’re all fundamental analysts and we try to figure out what the component parts are, whether that’s business segments or real estate or looking at the cash or the debt structure of the business and trying to come up with we think is a conservative net asset value and trying to find businesses that we think can compound that net asset value at double digit rates over time.
So, I think because we come at it from a different approach, as I always say, we grade differently and because we grade differently, our portfolios don’t really look like many other products out in the marketplace. I don’t know, if you guys saw, but just recently, we were awarded the Lipper Fund Award for best small fund family, which is a composite of our strategies over the three-year period for best risk adjusted returns. As this cycle is turning, I think our strategy has been out of favor, but fortunately, we’ve stuck to it. I think is now we’re maybe entering a period of a more normal cost of capital, that having balance sheet strength and compounding that capital productively will be more important than maybe it has been in this previous cycle.
Jake: From your lips to God’s ears, Vic.
[laughter]Victor: Yes.
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Jake: I still always remember in Marty’s books– I’ve only read one of them. I don’t know if there were more, but he talked about that some liabilities you could almost view as an asset. It blew my mind. I actually didn’t really understand it the first time I read it, but then I really didn’t understand it until I had a 30-year fixed mortgage on my house that was well below the rate of inflation. I realized, wow, this is what he meant by having liabilities that could actually be an asset, if you think about him.
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Applying Aggressive Conservative Investor Principles to Modern Investing
Victor: That is a terrific point, Jake. It’s so evident now. This gets back to having real cost of capital. But one of Marty’s phrases that we use in a lot of marketing materials is that we want to buy companies that have management teams that are not only good operators. I think the good operators manifest themselves in these EPS, P/E ratio companies. Of course, that’s important. But in addition to that, we want companies that are good financiers who are going to lock in fixed cost debt at a low rate and are always going to have the balance sheet capacity to take advantage of opportunities. And then thirdly, we want to have them allocate that capital productively.
Any company that we look at, we will put them through that funnel to make sure that they’re passing that test. We spend a lot of time reading the proxies. By reading that, you can see if the management’s rewarded for those types of activities, a lot of times, it results in very strong investment outcomes.
The other piece is, one of Marty’s books is called The Aggressive Conservative Investor. That book is, again, something that is a cornerstone of how we think about good investing is that we want to have that conservatism where they have access to capital and they can move quickly, but then they also need to be aggressive. So, when your stock’s trading well below its intrinsic value, you should be buying shares. If there are attractive assets out in the marketplace and other management teams are hiding under their bed or trying to figure out how to deal with their next refinancing, you should be getting involved in buying those assets. So, that sort of mosaic approach is different, but it’s something that all the people here passionately believe in.
Our meetings are really productive, because we respect each other’s opinion. We believe in the written word. So, when we present a new idea, we do the Amazon model where you send out a five-page report. And then it goes over all these aspects of the investment. But then we debate. It’s almost trying to make sure that you have missed anything, and that you’re putting yourself in the best position and not get beat.
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Tobias: Vic, let me just do a quick shoutout to the folks who have tuned in. Pants is first in the house with Petah Tikva, Israel, What’s happening? Nashville, Tennessee. Mendocino, California. Palestine. What’s up? Mac, Valparaiso, how are you? Ballynamullan, Ireland. Milton Keynes. Varanasi, India. Honolulu. Havertown, Pennsylvania. Durham. Badami, India. York, UK. Hamburg, Germany. International Space Station. Glad it’s getting up there. [Jake laughs] Sheboygan, Wisconsin. Scotland, the brave. Jupiter, Florida. You’ve already won. Panama. Perth. Good on you. Santo Domingo. That’s cool. Everybody’s in the house.
So, the question that I really wanted to ask you, as a huge fan of Marty Whitman’s, as one of the true greats of value investing, Modern Security Analysis is a spectacular book. What did you take from theory and then seeing Marty working that in practice?
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How Marty Whitman’s Views on Growth Transformed Modern Value Investing Strategies
Victor: Well, I’ll tell you anecdotal story, which I still find fascinating. So, Marty wrote that book, he was 89 years old. After the book was published, he went to a board meeting, and one of the board members asked him, “What did he learn writing this book versus the other books that he had written?” The first thing out of his mouth was, “You have to have growth,” which you didn’t think a Marty Whitman would have said that. But what he said was that, “If you don’t have growth, most likely your net asset value is going to end up being wrong.”
I think that’s something that, as a firm, we are trying to look for situations where that growth is underappreciated. We’re cheapskates, all of us. So, we don’t want to pay. But certainly, companies go through cycles and things, and so we are trying to do that.
If you looked at that book for some of the other things that he did, he definitely got involved in some of the Asian securities, but these were companies that were trading at deep discounts but he thought were growing at rapid rates and you weren’t paying anything for them. That was very interesting to him. So, it was an evolution, but I think value people have this reputation as everything’s cigar bud. I think there’s a difference between buying things on the cheap and buying things that you think at some point are going to turn things around.
But I think why our strategy works is we’re so focused on the balance sheet that we can sit around and wait for three to five years for the situation to turn around. One of our energy positions in the fund right now, we were underwater for five years. We bought it out of bankruptcy. We were one of the largest holders in security across that firm, but then finally, it took off and it’s generated a lot of return. And now the CAGR is excellent over that seven-year period, but we just had to wait for five years.
The balance sheet was strong time, so we never really worried about any kind of impairment. But it was just frustrating having all that capital tied up in something that wasn’t working. So, I think having that balance sheet ballast gives us the license to be patient and wait for things to turn around. But we’re generally getting involved in situations where the outlook is cloudy and black.
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Value Investing Insights: The Role of NAV Discounts in Outperforming Stocks
Jake: That’s interesting. [Tobias laughs] Toby, I think you did some research around this, didn’t you, on net-nets? Obviously, Vic’s talking a little bit more about, probably more going concern and a little higher quality business than a net-net. Didn’t you look Toby one time on the net-nets and actually like the money losing ones outperformed the ones that were not losing money?
Tobias: Well, there’s an Oppenheimer’s paper that came out in 1983 is that he identified that and he said the money loses outperform the moneymakers. And then among the moneymakers, the dividend payers underperform the dividend non payers. But what drives the returns is the discount to NAV, so the cheaper the better. To the extent that favoring a moneymaker over a discount to NAV, that leads you astray. So, the idea is that you should stick to the cheaper NAV.
And then we did some research. Oh, I think it came out in 2010. I think it was 25– Because he had looked at 25 years to 1983, so we looked at 25 years to whatever that was, 2008 or something like that and found exactly the same thing. There’d been no change over the following 25 years. I assume it’s still the same way.
Victor: Yeah. We’ll get involved with companies who are losing money, but the balance sheet’s got to be working. The balance sheet’s got to be tight. COVID was an excellent stress test where you just had to go through every security and make sure you knew when debt was coming due, because you just didn’t know what the financing markets were going to do. It’s a useful exercise, but we were lucky we went through that period and really our companies weren’t forced to do anything.
We had one company that locked in a bunch of fixed rate, low-cost debt, as you said, and a year or two later went and did an acquisition with it. That’s the kind of behavior that we want to see. But they were operating from position strain. So, we don’t really care about P/E or anything like that. So, again, if the company’s losing money, and especially if you need– We have a recent investment where the company wasn’t making that much money on an EPS basis, but they were generating $3 a share in depreciation over CapEx. [chuckles]
I think that’s one of the last free lunches still out there in the marketplace, because a lot of times, those companies get overlooked. But if you do the work, and especially in universes where we operate, where some of these companies have no coverage and barely– [crosstalk]
Jake: Yeah. Not part of indexes, so they just get sold off.
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Identifying Opportunities in Backlog Companies for Long-Term Gains
Victor: We’re really attracted to situations where there is a lot of insider ownership or even complicated capital structures, because a lot of times, they’re on a do not buy list for a lot of people. They almost are in a too hard pile. But we like hard. So, we’ll just go in and buy things and we’ll spend time trying to figure out where the risks lie. But if we think that at the other end, they’re going to come out much better, we’re comfortable doing those all day long, because we can buy them at the right price.
Munger used to say, “I always want to buy them cheap, but I don’t like to sell them too quickly.” We’re kind of the same mind. I think that was a mistake earlier in my career where I would always buy cheap, but I would probably– Once I started working, I’d make that 30% and I’d move on. That’s really hard to do, because you’re always reinvesting in troubled situations. [laughs] The real money is made by holding on if the company’s doing well. So, that’s something that comes with wisdom and practice.
But I think as a firm here, we do that really well, because we want to buy and hold. As I said, our turnover rates are very low relative to many of our peers, because we have that mindset.
Jake: Its interesting. I think, Vic, on the different points in the cycle, different portions of the financial statements become more or less important. On the income statement, you probably say working from the bottom upward, profits matter at some points. And then you work your way up to where revenue and growth is the only thing that matters. And then from there, when things are really start getting hairy, it goes over to the balance sheet and you work your way up there. Like, no one gives a shit about balance sheets when everything’s going to the moon, right? Like, what’s a balance sheet? That doesn’t matter. But then you keep working your way up the balance sheet and then it’s like, “Well, do they have enough cash to even survive at the very top of the balance sheet?”
Victor: Yeah, absolutely. Now, we as a firm, we start with the balance sheet, we’ll compile over. [crosstalk]
Jake: But that’s what you’re doing wrong for those– [crosstalk] [laughs]
Victor: Yeah. That’s why we banging our heads up against the wall for periods of time. But yeah, I think that’s what we really hate to lose. So, if you start with the balance sheet and you look at the debt maturities and you do those kinds of things– I don’t even like buying companies more than a turn of leverage. We have handful of our securities that are cash or near net cash. So, we don’t want to have to think about that. We want to think about the business, and what they can do and how they can use that cash.
The thing is is that what we’re not doing is we’re not buying the quality value, the 40% gross margin, 30%, we’re not doing that. We’ve made a lot of money buying companies with 5% operating margins. But they’re run by really good people. Incentives are aligned. They’ve just been quietly using their strong balance sheet to be value investors and buy businesses at the right prices. Those are situations where you can wake up 5 or 10 years later with multiple baggers.
Jake: Yeah. When the margin goes from 5 to 10 compared to 40 to 45, it’s a dramatically different.
Victor: And gives you the opportunity. Margin goes from 5 to 4, that’s a 25% increase in hitting the margin. So, then those companies can get attractively priced very quickly. But if you know the assets and you know the management team, you can step in and buy them at super attractive prices, and then just let them do their thing, and put their cash flows to work and create a business.
I also think some of these companies are backlog companies. That’s another area where it’s not getting picked up by the quants as much, but it can tell you a lot about the future direction of the business. And so, if you’re getting behind those numbers and doing that work, you can maybe find pockets of opportunity that maybe other people aren’t looking at. And especially, in small cap world, is as I said earlier, it’s just a less picked over space.
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Avoiding Investment Traps: Capital Allocation Efficiency
Tobias: Vic, your 2017 letter just after you joined has a great roadmap for what you were planning to do. I just wanted to take you through. You said the things that you’re looking for, strong financial position, honest and capable management with full financial transparency. And then this is the thing that– Hey, it’s a Marty Whitman of place. [Jake chuckles] Discount to readily ascertainable net asset value.
And then you gave the example of Seaboard. You showed Seaboard had these quite choppy earnings over the period of time either before you picked it up or while you were holding it. But the balance sheet net asset value had been steadily marching upward consistently for years and years and years. Can you just talk us through the philosophy and how that applies in Seaboard?
Victor: Yeah. So, just a point of clarification, I started with Third Avenue in 2012, but I was originally hired to work on the value fund when Marty retired for public money. And then I worked on that fund until 2017, and then I was put in charge of the small cap value fund then. So, I’ve been here for 12 years.
Yeah, I think that’s a good example of just focusing on the balance sheet. So, that company has been compounding book value at high single digits, low double-digit rates for a long period of time. It’s a capital-intensive business. It’s a conglomerate, so it’s hard to get your hands around. But they’re just continuing to take the capital and reinvest it in the business. They’ve done it with a strong balance sheet, the entire time.
Coming back to well financed capital allocation, it’s dirt-cheap right now. It’s trading at 30% discount to tangible book today. It is a security that has high insider ownership, so they don’t really do much interaction with street. But that’s a perfect example where we might have gotten scared out of that position. That’s a company that at times will lose money. As a matter of fact, they lost money last year. But that’s okay, because the book value is continuing to compound and the returns on those assets is quite strong. So, we just focus on that.
I started my career as someone who’s very focused on cash flows and readily attainable net asset value is something that– I admit that I read Marty’s books, but I didn’t fully understand it until I got here. But I think what Marty’s philosophy has taught me is that if you spend time studying the equity account closely and looking at how it’s moved and how their capital allocations worked out, it will go a long way towards avoiding value traps, because it will highlight companies that have had a sloppy track record of buying companies.
Some of my most frustrating investments earlier in my career were companies that were generating the cash flow, but they were just deploying it poorly. By moving away from that and looking at the equity account– And especially in small caps, because you don’t have the same degree of stock buybacks as you see in larger cap companies, which sometimes can distort the analysis in the equity account. But if you study the equity account, you can glean a lot of wisdom about who’s in charge, how they think about capital allocation. Everyone says the same thing when you talk to management, but when you look at their scorecard, the equity account tells you how well they’re doing it.
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Business Experience Enhances Investing Skills
Tobias: When you joined in 2012, you had been running your own firm called Lucid. I just wanted to know Buffett often talks about being a businessman makes him a better investor, being an investor makes him a better businessman. Having run your own firm, does that ring true to you?
Victor: Absolutely. I had worked for a competing firm for five years, and I was a research director there. I spent all my time just looking at securities and managing the team. But when you run your own company, you really realize that you need to start thinking about how are you distributing this product, what types of customers do you want to have as part of your business, how are you going to manage people, how are you going to retain people, what type of culture are you trying to build?
Most importantly, marketing and sales, when you’re a small company, you’re trying to find ways to stand out. I think when you go through that process, you have so many aha mo–Even on the legal side, how do you protect the business from getting in trouble with the SEC? All of those types of things that you take for granted when someone else is taking care of it. But now, when you’re running your own company, you need to process all of those and you need to make sure that you have the right people in charge and that you are dedicating the proper resources to those activities, so the business can grow.
I learned more about myself. I learned more about business going through that process. It didn’t work out. I ended up not growing it. $50 million was peak, and that just wasn’t enough to take care of college bills and things like that. [laughs] But the wisdom I gleaned, I still carry with me today.
Jake: Quick funny story.
Victor: It is a great question and I appreciate it.
Jake: Funny story on that I heard recently. There was a manager who was basically just didn’t– I think maybe he didn’t need all that much money and didn’t want all the complication, but he’s running a relatively sophisticated strategy. But he was just charging 50 bips, just flat fee to run the money on the AUM. He was talking to some endowments. They passed on him. The real reason that they passed was, well, this guy could get 2 and 20 instead of 50 bps. Like, he must be an idiot. Like, I don’t want to back somebody who [Tobias laughs] can’t take every dollar off the table. Like, how good a businessperson could they be? So, it’s funny.
Victor: It’s so funny you say that, because it’s just so funny how they– First of all, the reason why I got backed is because one of the backers was an institution, but they actually did it because they wanted to get built, they wanted to get capacity. [laughs] If you think about that today, it’s got you raising money. But it’s funny you say that. I don’t want to name him, but a guest on your show recently called me when– I priced it at one and a half flat. I didn’t do a hedge fund structure. But he told me I was crazy, and I shouldn’t do that. When you think about that conversation today, it’s almost laughable. 150 basis points is considered crazy. So, yeah, things change. You’re right.
I’m surprised that the industry hasn’t pivoted, because some folks have tried to come out with incentive-based structures or maybe you charge 40, 50 basis points with an incent, and they really haven’t taken off at all for the exact point you just raised, Jake. I think people are accustomed and it’s almost you’re looking weak by providing a fee structure that might be advantageous to the client. Strange.
Jake: Yeah, its wild.
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Tobias: Let’s talk a little bit about Berkshire. You’ve been going for 25 years, since 1999. What were your impressions? What did you think about this year’s meeting?
Victor: It was my favorite. I laughed afterwards, because the way they did it– Between Buffett setting the stage with his letter and then the video to kick the meeting off for all these years– [crosstalk]
Jake: Yeah, that was great, wasn’t it?
Victor: It was outstanding. But the thing that was great was that they did that one picture of Batman and Robin, and it was all along Munger has been Robin. Whereas I thought with Buffett labeling him the architect and the way he was revered during the meeting, it was almost Munger’s Batman.
[laughter]It was a little bit different. Credits to Buffett in that. Not only did he do that, but he did a really nice job of deferring, and he really showed that there was a passing of the torch going on. I thought Greg and Ajit were really nice– Even picking them up at some of the answers that they had. I feel really good about– Culture so much matters. I know the history of conglomerates like this is not positive, but if I had to bet on something working, at least for another generation, I bet on them versus many of the other people out there because of the culture they built.
Greg made that comment that I love where he just said, “Listen, if you’re a manager that wants autonomy and just wants to focus on growing the business and be left alone, this is a place for you to work.” Not many companies can say that. The companies want to intervene, and so it’s going to bring that sort of entrepreneurial, whether they’re companies or whether they’re managers that hopefully will be able to let the culture endure.
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Best Lines From The 2024 Berkshire Meeting
Tobias: One of the great lines from Charlie when they– I wish I knew the interview that it had come from, but he was sitting in a chair and he said, “You know, to the effect, we’re irreverent people. We joke around and we have fun most of the time. But we find some things that are worth revering and we’re reverent when it comes to those things.” I thought that’s such a great sentiment. That’s exactly the way I try to live my life.
We laugh all the time on the show. We’re very irreverent. But there are some things that I think are worth revering. And the philosophy that those guys espouse is one of them, I think.
Jake: Yeah.
Victor: Absolutely. Yeah.
Jake: I agree. It was rather humbling just to see what a life’s work could really turn into and have all those people there who appreciate it. He said that what really got him out of the bed in the morning and excited to come to work was that he really liked when people trusted him. That was a good feeling for him. And that Charlie was the same way. That fiduciary gene that Buffett really exemplifies, I find to be very inspiring. Shit, he just did it. Lived the life that or has live the life that you would wish on your kids or anybody who you wanted them to do well.
There was one really touching moment. The room got a little dusty for me at that point, but where he did his normal– He was answering a question and then he said, “Charlie?” and then realized right away what had happened, and the crowd cheered for it and made him feel really good about it, I think. And then, Greg did a good job by saying that he had nothing to add. So, that was a pretty special moment. Actually, I feel very privileged to have been there in person to experience it and feel it, like not just see it recorded, but actually be in the moment with it. I think that’s going to mean a lot to me for a long time.
Victor: I 100% agree. I’m glad you flagged that line, because that was all of us as being stewards of other people’s capital. When he said, “I want to look out for the people who trusted me,” that was just so powerful and it’s something that we should all get up every day and think that way, say, “Hey, people trust me. I need to do right by them.” It’s great.
A thing I also found interesting was that, usually, it really thins out in the second half, whereas people just– The impact-
Jake: It didn’t. Oh, yeah.
Victor: –people just couldn’t get enough of it. Every moment was just building on the other. At the end, everyone gave them the standing ovation. It was just impactful and something that I’m never going to forget.
Tobias: Let’s do favorite lines. I’m going to get this one out first, because this is everybody else’s favorite line too. “Some people will bend over backwards for you. Some people bend over forwards” is crack.
[laughter]Victor: The one line that he probably wanted to take back.
Tobias: Oh, no.
Jake: He’s earned it at this point, right?
Victor: Yeah. That was quite funny. But yeah, it was wonderful. The tribute at the end of the first half to Ruth and Carol Loomis was just so Buffett-esque really.
Jake: Yeah. Another nice part of the weekend was actually just getting a chance to hang out with Toby in person and spend some quality time together. And then also, lots of listeners who came up and were so nice and chatting with us and making us feel special. So, it was a great weekend.
Tobias: Yeah. We love hearing from everybody. It was awesome chatting. It is really touching. We very much appreciate it. We’re just a couple of randos in-
[laughter]-operating out of our bedrooms, really. So, it’s cool to chat to everybody.
Victor: Yeah.
Tobias: The other one that really stood out to me that I love, and this is sort of a– I’ve got a book that’s going to be coming out at some point in the future. But this is the theme of the book. I just love that Charlie said– He said this a few times, but it’s one of the things that I think you embraced this, Vic, and I think it’s an important one. But he said, “In terms of trying to complete a project, that what you want to be doing is avoiding stupidity rather than achieving brilliance.” He said something like, “While I think that they’re probably the same thing, the better frame is to think of it as stupidity avoidance.”
I just think that’s such a powerful idea that’s unappreciated among particularly younger investors. I certainly didn’t appreciate this when I was a younger investor. And now, it’s become the very first thing that I consider. But I think that that’s true for you too. Do you want to talk about that a little bit?
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Victor: Yeah, absolutely. Kind of getting back to being a steward. You want to avoid situations where you’re going to take the impairment, and you just need to think about how can I get beat? Having that mindset– There’s plenty of stupid things going on out there and you need to have the discipline. Even during the COVID period, and the SPACs and all that stuff, there was so much reward for such poor decision making. When you’re underperforming and all those things and you got to just take it and that you just deal with it.
But that to me is something that I think reading those two and certainly just listening to them over all these years, is that if you can avoid getting yourself in trouble, you can do pretty well in this business, but you got to be sure that you’re not taking undue risk. That’s just something that I think a lot of people– We were talking about this before the call started, just about, there are a lot of companies out there that are getting rewarded for living on the edge. That’s not the promise that we’ve made to our shareholders. And so, we were trying to get up every day and figure out how not to.
Tobias: Part of the problem with that too, is that it forces everybody else in the industry to do the same thing just to keep up. Either you blow up or you die the death of a thousand cuts. It’s sort of you’ve pushed as fast as the most aggressive player in the industry. I don’t really know exactly how anybody deals with that other than just knowing that eventually that behavior blows up.
Victor: Yeah. If you’re playing a short game, you can win battles, but you’re going to lose the war. You just got to be comfortable losing those battles. Some people just aren’t comfortable losing those battles. We are. But it’s not– I don’t know–
Tobias: It’s uncommon.
Victor: I don’t know how big that constituency is.
Tobias: Yeah, it’s small.
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How Ergodicity Shapes Risk Perception in Investing
Jake: Yeah. It does speak to the non-ergodicity, actually. We’ve talked about this before on the show, like the example of racing. By the way, shout out to Luca Delaney, who we met on Sunday. This is his framing of ergodicity. But that idea that like, let’s say you have a ski racer who wins a disproportionate amount of the time, but he also crashes a lot. When he crashes, he breaks his leg and he’s out for the rest of the season. And so, current losses that you take can wipe out future gains, because you can’t race in those next races. And so, your expected probabilities actually dramatically decrease when you look at it as a geometric series, as opposed to just each individual race arithmetically. I think that’s really underappreciated in the finance industry.
Victor: Well, one internal control that we have is that we want to concentrate a portfolio. So, I say our minimum cost for entry into the fund is 2%. If we can’t do a 2% position, it’s not worth our time. So, our feeling is if we can take initial position somewhere between 2% and 5%, we better be right. Because if you crash and burn on the ski hill, you’re going to cost your investors a lot of money.
So, a lot of these folks are comfortable taking say 25, 50 basis points. And if it blows up, who cares and all that. For us, we want to focus our time on things that we think can grow and compound. But if we’re wrong, the penalty is going to be severe. So, we need to be hypersensitive to those types of crash and burn situations, because if something does happen, it’s going to be painful.
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Exploring Telic and Atelic Activities in Investing
Tobias: We’ve come up to the top of the hour. JT, you’ve done a lot of travel. Do you have a veggies?
Victor: Here you go. [laughs]
Tobias: Give the people what they want.
Jake: And apologies to everybody from last week, because I had them ready to go. I had to catch a flight like right in the middle of the podcast. So, it was very unfortunate. I felt like a bad host. I just left Toby on his own to [chuckles] defend.
Victor: He did fine. [laughs]
Jake: I had the utmost confidence that he would be fine. All right. Actually, I learned a few new words while I was reading this book called Four Thousand Weeks by Oliver Burkeman. Actually, I really enjoyed it. I thought it was pretty poignant. But if you’re like me and you find yourself thinking about the future a lot, and its at the expense of the present and being present, that book could be a valuable read for you.
So, these new words that I learned are telic and atelic activities. So, we’ll start with telic. That word is derived from Greek word, telos, meaning and or purpose. In Austrian economics, you might have come across this term, teleological, which means starting from the end and then reasoning back and explaining things based on their end purpose. It ends up connecting then with subjective value theory and von Mises and praxeology, which is really just a study of human actions toward some purposeful behavior.
And so, telic activities are goal oriented and they’re performed with the end in view. And in investing, we might call it like systematic planning and focusing on outcomes. For instance, buying stocks with the expectation of a certain percentage return. These activities are really driven by satisfaction that comes from achieving a goal. Once that goal is reached, the activity’s purpose is fulfilled. You made your money, you time to sell and move on. There’s something very defined and explicit about it, and maybe even transactional feeling.
Now, let’s contrast that with atelic activities. Of course, a prefix of A means opposite. So, here it’s an activity where the value isn’t derived from the ultimate aim. It’s not done with some terminal goal in mind. It’s for the sake of the activity itself. Sometimes these are belittled as hobbies even. But there’s a few examples in nature of atelic activity. Many birds engage in, what appears to be, just spontaneous singing. This form of birdsong occurs outside of the context serve some other purpose. They just do it for the active itself. Maybe it’s just a pleasurable for the bird.
Dolphins are famous for this. They engage in play, they surf, they play with seaweed, they blow bubble rings. There’s a lot of screwing around when you’re a dolphin. There’s no obvious survival function here. It just seems to be performed for the sheer enjoyment of it.
So, this brings up then like Robert Hagstrom, actually, I think, who’s coming on the show in a few months or a month or so.
Victor: Oh, great.
Jake: He wrote a terrific book called Investing: The Last Liberal Art. And in it, Hagstrom weaves together unrelated disciplines into a lattice work. The point is really that investing can offer an element of atelic activity. Like, you’re learning to just do things for the fun and the joy of it and the learning of it. It doesn’t have to be necessarily about achieving some specific endpoint. Like, you can just enjoy the learning journey. Perhaps, maybe the ultimate atelic activity is just like simply walking. You usually end up right back where you started. You often don’t know what the exact path that you’re going to take. And that’s okay.
Rarely do you get a walk done– Like, normally, [chuckles] you don’t reach a point in life ever where like, “Well, we’ve accomplished all the walking we’re aiming to do.” Like, “We’re done now.” Imagine like, “I’ve really checked off that lifetime walking box. What’s next?” [Victor laughs] So, I think that when you look at investors and study them, I think you find that the best are energized by the atelic nature of their craft. It’s not a necessarily atelic exercise. And if anything, that the success of the telic activity is really more residue of just being naturally interested in it.
Buffett boils this down and has said this many times. But when he’s considering buying a business from an entrepreneur, he’s looking to answer the following question, “Do they love the business or do they love the money?” I think the best investors, they love the game, they love everything about it, much more so than necessarily even the results. They like the money too. But it’s really more about just the passion for the game. And Marty maybe was one of the best examples of that.
Victor: Oh, absolutely. Most of Marty’s clothes were free stuff that the firm gave him during [Jake laughs] Christmas parties and stuff like that. He took the subway to work as long as his wife would let him. The material parts of his life were not there.
I heard a story that when he was at book signing and one of his neighbors wasn’t there. You might know Marty’s, the business school is named after him at Syracuse University. This person has been living next to him for probably 30 years and he said, “I had no idea. I had no idea.”
[laughter]Victor: “I don’t know anything about this guy.”
Jake: Also, why don’t you mow your lawn?
Tobias: [laughs]
Victor: He had a very generous heart and he gave liberally. But he was 100% atelic. It was all about the process and doing the work, and he would just say, “Give me the papers.” And then he would [Jake laughs] sit in his office and read the papers. That was what he did.
For folks like us, and I mentioned this in the pre, even though he retired from running public money in 2012, he never lost interest in the game. He managed his foundation and had management meetings in the office the day he passed. So, he loved doing the work. He had as nimble of a mind as you’ll ever see. I think he was a revolutionary in terms of helping create the bankruptcy industry. He saw around corners and other people did. But his focus on one thing–
He was a devout family man. I can’t say one thing, because that’s unfair. But he just loved practicing what he did. He did not care about the money at all. He accumulated it, because he made a lot of people rich in a process, and he deserved to get rich for that, but he didn’t care about any of that.
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Tobias: JT, great veggies as always. I don’t know how you do it. Hats off to you. [Jake chuckles] Vic, you wrote a white paper about the small cap versus large cap. Opportunity and just looking at the equity risk premium of large caps versus small caps, do you want to walk us through that?
Victor: Sure. So, what I was doing was just taking the yields of the large caps versus small caps. Right now, small caps, depending on which index you use, let’s just say 15 times earnings, so you’re getting a mid-single digit 6.5 yield. Whereas the large caps are trading around 23, I think. You’re getting sub 5% on that.
So, right now, cost of capital has changed. That dynamic has helped the large caps. A lot of large cap growth has come from valuation expansion. So, I think that spread is to levels that we haven’t seen since the tech bubble in 1999. When you look at that spread, when it’s widened out to the extent that it is now, you’ve generally seen significant outperformance by small cap.
So, a perfect corollary is the tech bubble, because most investors look at that period from 2000 to 2010 as the lost decade for stocks, because stocks were flat for that period of time. But large caps were up over 50%. They outperformed by over 4% annualized over that time period.
Jake: Vic, you mean small caps?
Victor: Small caps. Sorry. Thank you. So, these things go in cycles. We’re in a period now where the large caps have trounced small caps. It just seems that that goes against years and years of history.
Jake: Vic, what do you think about the Michael Green thesis of the indexation that leads to buying pressure of market cap weighted, which means the biggest, and then that–?
Tobias: Float-adjusted micro-cap weighted too. Market cap weighted. Sorry.
Jake: Yeah. And then selling off of the actively managed, what’s tended to be some of the smaller stuff that’s not as indexed, more active share that you’re going for. You just have this flows that are relentless and just keep moving prices further and further away from each other.
Victor: Yeah, Michael stretches the mind quite well. He’s a brilliant person. Yeah, I’ve listened to and I’ve read a few things from him that stretch my mind and it gives me pause. But I guess we’re not going to know until we get redemption.
[laughter]Jake: Yeah.
Victor: I have always wondered if you had a big shift in capital allocation, what type of dislocations it could cause, but it needs to be tested. Listen, I think you can make money going to undiscovered places. If the companies are doing well, you’ll eventually get paid. You might not get paid as much. So, maybe they’re not going to be as overvalued and maybe there are companies that are generating subpar operating performance that are just getting multiple expansion. But if your companies are growing, they’re doing well, you’ll eventually get paid.
Michael’s thesis makes a lot of sense. But I think if he is right, that it could be the change in leadership and the change of, maybe a more positive view towards active management. So, we’ll have to see. But we need outflows to test it.
Jake: I think the implication that I take away from that– This also comes a little bit from what David Einhorn has talked about recently. The requirement of patience is as important as ever in this. So, if flows keep moving against you, but yet– It’s going to make you feel dumb, because the businesses are going to continue to create value and really inflate the balloon, and yet, the flows are pushing the balloon further and further underwater. But eventually, theoretically, that’s– What did I say? Like, if– [clears through] I can’t remember what it was. But something like, if it can’t go on forever, it won’t.
[laughter]Tobias: That’s Buffett, isn’t it?
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Waiting for Value: The Art of Holding for Long-Term Returns
Jake: No. I think it was like somebody’s last name was Stein. I can’t remember. But anyway, the point being that you can’t just go buy something at 10 times earnings and expect within three or six months to get it rerated to 15 times earnings, and then you just keep doing that over and over again. It’s just going to take more patience probably to realize your eventual successful outcome. What it may end up looking like instead is, perhaps a good quintessential example of that might be something like the Dillard’s and what that looked like.
Victor: No. Yeah.
Jake: I know, Toby, you posted something today on that. But where it’s like, it’s just going sideways forever, it seems like, “What the hell is going on here? The price does not seem to reflect reality of what’s happening underneath the hood.” And then, the well inflated balloon underwater just gets released and it’s whatever 5, 10 bagger in six months or a year or something.
Victor: Yeah. Seaboard, which Tobias asked about, [laughs] I’ve been following that company for 12 years. You just would buy it under book and just then it would go to one and a half times book and you just keep making money. And now it’s trading at 30% discount to tangible, [laughs] and no one cares. But it’s well capitalized and the book value is growing. So, whether they go private or they do something along those lines, the IRR will probably be pretty good at some point, because it has a complicated capital structure and all that. No one really cares. It’s got no coverage. And so, it just sits there. But it does seem unsustainable.
Look, the people on the other side, the management team, they own a lot of stock themselves. They’re humans, and so either they start selling some assets or doing something to get some marks in the portfolio. We’re very comfortable wading through those situations. But you’re right. If you don’t have that tailwind of these flows, they’re constantly coming. If you look at the shareholder list, the Kahn Brothers brothers remain with us. It’s these old school value people, [laughs] but I like that. But some people don’t. We’ll sit in there and wait and have that happen. It’s funny.
We have another example. It’s our second largest position right now. But that was a company that, as you said, it flatlined for many years. And the revenues were growing at double digit rates every year. And then all of a sudden, they were doing business in renewables and things like that. And then all of a sudden, people started looking at the operating metrics and it’s exploded. But you don’t know when people are going to wake up to the situation. But if you’re willing to just wait it out for three, five years, and the company’s operating at a high level, you’ll get paid at some point. As you said, you need the patience to wait for it to happen.
Tobias: This is my favorite holdings where you hold them for three to five years and they’ve done all right over that period of time, but they’re still at a big discount at the end. So, there’s no pressure to do anything. You can just sit there and let it keep on going. If management’s any good, they’ll capitalize on that under valuation at the same time. So, you don’t need to sell. You just let them do a big buyback or something else to recognize some value there.
Victor: I 100% agree with that.
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Making Sense of the Earnings Gap: Small Caps vs. Large Caps
Tobias: I just wanted to play devil’s advocate a little bit, because I’ve noticed that the big spread between large and small as well. I’ve talked about this a little bit. If you look at the Yardeni charts, they do a really good job of breaking this out. That’s the yardeni.com, and you can go– [crosstalk]
Victor: I saw the tweet. You put out a tweet on– [crosstalk]
Tobias: Yeah.
Victor: I saw it. That was very good.
Tobias: If you break out the S&P 1500, the largest 1500– The S&P 500, everybody knows. S&P 400 is the mid cap and S&P 600 is the small cap. If you look at the earnings of the 500 since 2020, 2021, 2022, when they topped out, they fell through 2022. There was a little earnings recession through there. But they’ve shot ahead now and they’re at all-time highs. Whereas if you look at the mid and the small, they haven’t recovered above their 2022 peak and they’re down and sideways.
And as a result, the small and micro and the mid cap, they’re trading around 15 times, 14 times earnings. Whereas the 500 is trading, I think it’s north of 22. It could be 23. I don’t know exactly where it is. But to what extent do you feel like that it’s deserved that they trade at that discount, because the earnings are where they are and sideways?
Victor: It’s a good question. We spend a lot of time thinking about that. Now, we’re trying to find the ones that aren’t doing that, but it’s not perfect. I think there’s a few things. We have had some research put in front of us which was speculating or trying to put some context behind the fiscal changes that we’ve seen in the post-COVID period, and that a disproportionate amount of those monies are going to larger cap companies, which has helped boosting their earnings in their top line, that the small and mid-cap companies haven’t benefited from that to the same extent. So, that’s hurling back.
I think the other thing—So, small caps, Russell 2000 is 15% financials. And Russell Value, which is our index is over 20. Those earnings have been miserable. So, this post-Silicon Valley period has been quite challenging for the bank and real estate.
I was looking at the sector performance over the past five years. And those two sectors have been pretty sizable underperformers. I think because of what’s happened from the interest rate environment, they’ve been held back. Now, that’s where we’re putting money to work today. We’ve made a lot of money industrials over the past couple of years, and they’ve been excellent performers and I think benefiting from some of this fiscal largesse that we’re talking about. But I think the more we go down the line with this more normalized interest rate environment, these financial companies are able to reprice their assets. Some of that earnings pressure that they’ve been feeling are going to start going the other way as they reinvest and get higher yields on the assets.
Most of the banks we look at, most of them are trading at single digit multiples and earnings are down considerably from where they were in 2021, 2022. So, I’m speculating a little bit, but I think those two factors are certainly not helping. But yeah, it’s something to watch.
I think the other issue with small caps is just that because the number of equity securities that are out there right now has compressed so much that you’re having to scrape a little bit more to fill these indices up. So, maybe there is a lower quality component there that maybe wasn’t there in other cycles.
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Jake: Do you think private equities buying power and has perhaps cherry picked out some of the better companies out of those indexes?
Victor: Yeah, I think there’s something to that. What would be really a boon to small caps is, if high yields went up and there was some restructuring going on, I think you could get, as Marty would say, good company bad balance sheet turned into a good company with a good balance sheet. We saw it with that post bankruptcy situation in the energy space that we did. But that had a Scarlet Letter attached to it for many years, “Oh, we went bankrupt and no one wants touch it.”
If that cycle happened and we can get a bunch of good companies coming out of bankruptcy that are starting, I don’t know, real small caps, you could probably find some really things to do. I thought that was going to happen in 2022. It just didn’t happen. I think whether it’s private equity or private credit, there’s just been a lot of other factors that have stepped in and disintermediated some of the more normal capital providers. We’ll have to see how those investments have played out. It’s too early.
But that I think would be something that maybe could get just a fresh charge of new high-quality type companies getting into the indices. There’s something to what you’re saying, and it bothers me and I try to get my hands around it. But what do you think? Do you have an opinion on it or you, guys, what do you think?
Jake: Toby, I’ll let you take this easy one.
Tobias: Yeah. I think that ultimately, valuation and what the managers do at the company level drives the performance of the stock price. And so, I’m not too worried about the shorter-term behavior knowing that longer term–
The story of how we got here, I almost don’t really care. I just think that I’m relying on the fundamentals and the management teams to go forward. That leads me into a little bit to my next question, which was, we’ve looked at– It’s been an odd period in the markets as often when we have these cycles where there’s a lot of cheap money going around and you have these silly little manias run through. And so, the thing that characterized the market up to the 2021, that mania that we had, the meme stock mania or whatever, and you picked this up in your Q4, 2023 letter, where you said “The nonearners are outperforming, the low ROE are outperforming and the companies with no sales are outperforming.”
That’s the one that you wrote in 2023. You could easily have said the same thing in 2021. But we’re still looking at this world where we’ve got the low valuations in small caps and stretch valuations in the larger companies. What does the next decade look like to you, Vic? What do you think?
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Market Trends Analysis: The Road to Fiscal Normalization
Victor: Decade is a long time.
[laughter]Tobias: I’m trying to give you enough time, so it’s not short term.
Victor: Yeah. I do think that what the repricing that we’re going through right now is healthy. I’d be surprised if some of these trends that have been going on in this post-COVID period sustain. I think the fiscal situation needs to normalize, because that is putting a little bit of helium under some situations. And so, I hope that that normalizes and maybe between higher cost of capital and less fiscal intervention, that we do have another cleansing period and that we can get back to where it was in the early parts of the 2000s, where I think it was a more normal environment where people had to pay real multiples for good businesses and they couldn’t buy companies that were living on the edge from a capital structure perspective. I’m hopeful. If I had to bet, I’d bet that’s the case. But I’ve been surprised before.
2023 was shocking that some of these– I thought the cleanse was 2022, but some of these situations are happening. As I mentioned earlier, I think even this month, you’re seeing some crazy things happen since Paul’s conference. So, I don’t know when it ends, but I’m confident it will, because it doesn’t make sense.
Jake: One of the comments this weekend from a friend was about just shocked that crypto has reflated. He’s like “Usually, when the souffle collapses, it doesn’t ever reinflate itself.” So, it’s been fun to watch.
Victor: So, I got to think that the fiscal has something to do with this, but that’s just because it’s something that I haven’t seen before and it’s illogical.
Jake: Running what? 7%, 8% deficits in unemployment rate. That’s where it is just–
Tobias: Conditions are loose.
Jake: That’s right frankly shocking.
Victor: Yeah.
Tobias: Rates are up, but conditions are very, very loose. And so, where’s the liquidity coming from? It could only be fiscal, right?
Victor: We have one company that sells to municipalities. What they were saying was that, “Yeah, these monies have been dispersed, but they haven’t been distributed.” They’re benefiting. The company’s doing exceptionally well. But the thing is is that this money, it takes a while to push all that money through the system. And so, it’s creating maybe some of these distortions. It’s confusing, but you just got to just get up and manage through it.
Jake: So, buy toilet paper in bulk now. Is that what [chuckles] for it double the cost?
Tobias: It does seem to have flushed through individuals balance sheets, because if you look at the excess savings that all popped up from all the bailouts and all of the things that happened through 2020, as of last month or this month, that is now back to the long run average. It’s now all gone, all those excess savings. It’s interesting.
Victor: Yeah,
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Tobias: Vic, we’ve come up on time. It was incredible. It was really fun chatting to you. If folks want to get in touch with you or follow along with what you’re doing, what’s the best way to go about doing that?
Victor: The best way to find us is at our website, www.thirdave.com. That’s T-H-I-R-D-A-V-E dotcom.
Folks here just did a really nice job refurbishing it and upgrading it. So, there’s tons of content out there about not only the small cap value fund, but also the other fund strategies at the firm. You can learn a little about history, but that’s the best source.
There’s also a place on there where you can send us your email address, and we can put you on our distribution list and send us some of our material. So, love to hear from you.
Tobias: I recommend checking out Vic’s letter.
Jake: I was wondering who Thirdave was.
[laughter]Tobias: Yeah. I recommend checking out Vic’s letter from 2017 just as a great statement of principle. I definitely learned a few things reading through that. So, I really enjoyed that.
Victor: Thank you for that, Tobias. I appreciate that very much.
Tobias: JT, pleasure as always. Good seeing you in person.
Jake: Yeah, thanks mate.
Tobias: Folks–
Victor: If I don’t see you before then, I’ll see you at Berkshire next year.
Tobias: Yeah, let’s do that.
Victor: Okay.
Tobias: Folks, we’ll be back next week.
Victor: Pleasure meeting you.
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