In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Brian Bares discuss:
- Gaining an Edge in Investing: Information, Analysis, and Behavioral Insight
- Maslow’s Eupsychia: Imagining the Potential of a Self-Actualized Society
- The Art of Identifying Leadership Qualities in Potential Investments
- Investing as a Form of Addiction: The Thrill of the Chase
- From Google’s Dominance to AI Disruption: Analyzing the Shifts in Tec
- Reflecting on Market Opportunities and Misses in 2015
- Finding Undervalued Stocks in Overhyped Markets
- Identifying and Holding Option-Rich, Growth-Oriented Companies
- The Art of Holding: Why Long-Term Compounders are Worth the Wait
- How to Identify Competitive Advantages for Superior Stock Performance
- Biotech Investment Strategies: Selecting Researchable Companies Without PhDs
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: This meeting is being livestreamed. I am Tobias Carlisle, joined, as always, by Jake Taylor. This is Value: After Hours. And our special guest today is Brian Bares of Bares Capital Management. Brian’s one of the biggest and best growthy small cap investors around. We’re going to learn all of his secrets over the next hour. How are you, Brian?
Brian: Doing well. Thanks for having me.
Jake: Good to have you, Brian.
Tobias: Have I accurately described you? You wrote a book called The Small-Cap Advantage. But I know that you’re not small cap alone, but you still have some interest in small caps, I assume.
Brian: Yeah, I think the characterization is roughly accurate. We started the firm almost 24 years ago. We’ll sell our 24th anniversary here in a couple of weeks.
Tobias: Congrats.
Brian: Yeah. Thanks.
Jake: Yeah, that’s no small feat.
Brian: Yeah. It’s still feels like the gritty startup, but here we are [Jake chuckles] 2.5 decades later. So, the characterization is roughly accurate. We started in micro-cap and then moved up the cap spectrum. We have two strategies, small micro and mid large. Mid large is really a mid-cap strategy, where we’re trying to have an uncapped ability for the businesses to grow if we find the next great compounder and let it grow into small cap.
So, while we pay attention to the Mag 7, for obvious reasons, competitive reasons, the companies we own, that sort of thing. We’re not doing really anything in that ultra large cap space. So, you can think of us as a small cap manager that spans from micro to mid.
Tobias: What’s your definition of micro and small and mid? How do you break this up?
Brian: The easiest and simplest thing to say, which is accurate, is we just take the Russell 2000, Russell 1000 split as of the latest reconstitution. Anything below that is on limits for small micro, anything above that is on limits for mid large. It’s interesting that, when I started Bares Capital, our original strategy was a 10-stock microcap strategy. I looked at CRSP, the Center for Research and Securities Prices data set, and the 9th and 10th deciles representing the smallest 20% of the market-by-market cap. The top of the 9th decile was about $176 million. And today, that’s more like $600 million.
Tobias: Oh, wow.
Brian: And so, these definitions change– [crosstalk]
Jake: What does that come from, the expense of being public, or is it more global scale now is more achievable for businesses, or is it just there’s less businesses total that are publicly traded?
Brian: Yeah, it’s a lot of those things. So, what I’ve witnessed over my time at Bares Capital is that the cost of being public has gone up. And so, Dodd-Frank and the associated regulatory– [crosstalk]
Tobias: Sarbanes–Oxley?
Brian: Yeah, Sarbanes. It’s basically made it less and less appealing for the ultra-small companies to stay public. And then obviously, you have this dynamic where it used to be advantageous to actually go out of the public capital markets and raise money earlier as a venture backed firm. And now obviously with a swath of institutional money flowing into venture, they’re allowing these businesses to raise money in various series that allow them to grow in terms of value and then finally go public.
Probably 30, 40 years ago, Uber would have been public in the micro small cap space. And then now with the advent of VC, they’ve just delayed and delayed and delayed until they’re larger companies.
It’s interesting, the Wilshire 5000, which is the broadest definition of market cap, where it was, when I started the firm, I think it had like 7600 companies or something like that, 25 years ago.
Jake: 3,400 now or something? [laughs]
Brian: Yeah, 4,000 or something like that. So, I think people look at that. By the way, obviously, it getting smaller is coming from the bottom up. And so, people look at that and say, “Well, microcap is less numerous and therefore less opportunity rich than it once was.” But the practical implications of this are that, when I started the firm, I tried to hand select those businesses in the top of the Russell 2000 market capital or below that were truly investible for us. There were a lot of $2 million, $3 million, $4 million, $5 million companies at that time that were just off limits even for me with a small amount of capital.
And so, the real universe was around 1,800 to 2,000 companies that really made sense to us. And that number is actually not that different today. So, like legitimate companies that look investable to us is that opportunity set really hasn’t changed all that much. In fact, I actually just ran these numbers a couple of months ago over the holiday break while everyone else is celebrating, I’m sitting here going through microcap biotech’s.
Jake: [crosstalk] [laughter]
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Biotech Investment Strategies: Selecting Researchable Companies Without PhDs
Brian: Yeah. Roughly 1,800 companies that are on limits for us, about one in seven is a microcap banker thrift, and that’s about the same number. I think it was one in six when I started. The biotech space, and one of the reasons I was focused on that is, it’s actually grown significantly as a percentage of smaller companies. And so now, I expect 300 and change biotech companies where that used to be probably 100 to 150 when I started 25 years ago. And then there’s a bunch of commodity driven businesses.
And so, if you aggregate those up the investable universe, we pitch out another, call it, 400 to 500 companies that just don’t meet our basic criteria for our process. That is, we can’t go into a regional bank or thrift and gain some kind of variant perception. The returns on capital in that space are pretty average, and we’re looking for something that could compound at a more exceptional rate.
We don’t have views, despite our site us in Austin, Texas on oil and gas or commodity-based businesses. So, we typically throw those out. And then biotech, one of the reasons I was going through this is there’s a lot of pick and shovel businesses in biotech that are very researchable for us, and I wanted to isolate those versus the ones that are-
Jake: Pipelines.
Brian: -binary outcome business, where there’s an FDA trial and it’s either thumbs up or thumbs down. We don’t have PhDs in Biochemistry on staff to analyze those companies. There are specialist managers that do a great job in that area. So, I was sifting through to see what we could feed into our research pipeline.
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Jake: It’s really interesting. You hear people lamenting about the quality of the Russell, like, degrading, but that composition shift explains a little bit of, like, the financial statements from some of these biotech companies. They’re going to look rough. It’s all losses until something big happens. It’s this very binary outcome. So, it makes sense why, if you aggregate all these numbers, that look shittier than it did, whatever, 10, 20 years ago.
Brian: Yeah. Biotech had an awful 2023, as everybody knows. When I was doing this work a couple of months ago, what’s really interesting is I found seven net-nets, like true Ben Graham net-nets, where the market cap adjusted. Debt and cash was less than the net cash on the balance sheet. I found seven of those that also had growing revenue.
Jake: Hold on, I’m going to get a pen. Can you tell us what those names were? [laughs]
Brian: You get those tickers? Yeah.
Jake: Yeah.
Brian: Yeah. I just buy 100 shares and cross your fingers. It reminded me very much of the story that I’d heard of what about a decade ago, when Buffett did this similar exercise in Korea, I think somebody sent him a Citigroup compendium of Korean businesses and he just sifted through there, turning the pages of value line and found some net-nets and bought a basket of them. It very much sparked some pattern recognition in my mind in that time.
Tobias: Brian, you’re probably best known for the work that you’ve done on moats and finding an edge. Can you talk a little bit about that? And also, smaller cap companies are always going to be a little bit earlier in their development. They’re smaller a little bit earlier in their development. Can you just talk about the differences between them? Your approach when you’re looking at the small and micro versus your approach when you’re looking at the mid and large, which should be a little bit more established a little bit further down the road.
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Gaining an Edge in Investing: Information, Analysis, and Behavioral Insight
Brian: Sure. So, I should start by saying that, as an investor, you can have an edge in your information, the actual data that you’re getting. You can have an edge in analyzing that data differently than other people, and then you can have some sort of behavioral edge that tries to take advantage of market or human psychology expressed in the market.
What I think people tend to get wrong when they think about smaller companies is that that the universe is ripe for information mispricing. I think that even when I started 25 years ago, that is a generally incorrect statement. That is, the market has been getting more efficient for a long time. We can talk a lot about this if you want to which I think is one of the reasons why things like a rudimentary price to book value ratio has probably stopped working in the Fama-French three-factor model for the last two and a half decades.
It’s just a recognition that the parimutuel aspect of the market is incorporating investor expectations more and more efficiently over time, and therefore, a business that’s trading at a low multiple in relation to its book value is more likely indicative of a business that’s under earning on its capital base and an economic decline than it is a Ben Graham indication of contrarian investment value, which I think was always just a marker for a behavioral, potential, psychology contrarianism indicator in the market.
And so, we don’t think that– It’s very rare, let’s say, that we come up with a true informational asymmetry, where our work is uncovering something in the footnotes that’s nobody else has noticed. We did have a situation about 20 years ago where we went to a company in Fort Worth and they were like, “Yeah, I think we’re doing some exploration on company headquarters here, and we may have hit the jackpot where there might be some natural gas underneath the land or something.”
[laughter]This might be the classic, we never invested, but that was one of those informational things where I was like, “Okay, maybe there is some shoe leather informational advantage still available to people.”
Jake: You think that that might be coming back though, a little bit, Brian, with so much indexation and a lot of investors lamenting that no one’s really doing the work anymore? Do you think it’s possible that that particular that information asymmetry might be pendulum swinging back a little bit? You think about going to some of the meetings and like– There’s nobody there, hardly, right? Nobody’s calling in on the meeting. Nobody’s paying attention.
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Brian: Yeah. It’s funny. I just this morning got a text from one of our analysts at a microcap company annual meeting in Dallas. We are doing research on it. He was one of two analysts there, and they turned them both away because we don’t own shares. And so, the lawyer was like, “You can’t come in.” It’s stuff like that that makes me think, “Well, maybe there’s some information asymmetry still available to people that have a resource effort and are doing the hard work.”
So, I think the answer to your question is probably– But I think the broader answer is that there are so many people looking in this space compared to 25 years ago, and the information dissemination is so much quicker with the advent of all of these technology platforms that allow us all to collaborate on and share research and information, so the market adjusts and reacts much more quickly.
Jake: And Reg FD.
Brian: Yeah, absolutely, Reg FD. What I would say is that, a true information asymmetry is usually illegal. We wouldn’t want to trade on it anyway. And so, we don’t, obviously, try and figure out what our next quarter’s earnings are. Anything we’re buying and hold and we’re trying to get a qualitative assessment of a business that would allow us to have a differentiated view about the future prospects of a business and then to allow intrinsic value per share compounding to out in stock price over time. So, we’re really trying to figure out is what the competitive position is of the business, what the people are running at and what the potential is for the growth of the business.
And so, those things, we can get competitive information. That would fall into that second bucket, that analysis that we’re taking existing information we’re trying to process it a little bit differently. We’re trying to get an edge in qualitative information that isn’t related to next quarter or year out or whatever. And then finally trying to get a variant view on the potential growth prospects of the business. Is there a potential step function change through initiatives that the business is taking in its total addressable market? Are they maybe acquisitive, which a lot of people will correctly say that, “We don’t buy acquisitive companies,” because the 80% of acquisitions fail to meet their intended synergy targets. That’s something that we just leave aside. We believe in that too.
However, Berkshire Hathaway is obviously example A of businesses that can do it well. There’s the Danaher’s of the world. We owned HEICO for a long time, which was a real great example of that. And so, those businesses can have acquisition events that themselves are unpredictable, both in size and timing. And therefore, a traditional DCF analysis of those companies fails to capture what will likely be the main story of the business going forward. And so, if we can discern that the range of outcomes for those businesses is not normally distributed but heavily skewed to the upside, then that can be a source of continual variant perception for us in analyzing a business like that, and then trying to calculate what the growth prospects could be. So, we play in that second bucket, that analytical bucket.
And then the behavioral bucket is interesting, because it was a real hot topic when I started in the business, this behavioral economics, and there were firms that were starting– That had their entire strategies built around the psychology of misjudgment and things like that. I love all of that work and I think it’s really interesting. To the extent that it is there and available to us, we will obviously take advantage of it. But I don’t think it’s a continual source of edge for us over time. And so, we always come back to that kind of second bucket.
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How to Identify Competitive Advantages for Superior Stock Performance
The type of information we’re trying to glean is qualitative in nature. So, the two pillars of our firm are that we’re very qualitative in our analysis and underwriting and in our portfolio construction. We’re very concentrated conviction weighting our bets. And that qualitative really comes from first principles. It’s like, what are stock prices? Well, neutralizing for dividends and distributions, and multiple expansions and contractions. Stock prices simply mimic internal compounding of business value per share.
Okay, well, if you want above average stock price performance, you got to be looking for above average business compounding per share. How do you get that? Well, you can’t get that in a purely competitive environment. You have to have some competitive advantage for the business, you have to have exceptional people running the business and then you have to have good growth prospects. And so, those are the three buckets of qualitative exceptionalism that we’re looking for. And so, we have 10 analysts here, and they’re running around the country in rental cars and airplanes trying to sort exceptional from average in these three areas. That’s the bulk of our work.
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Tobias: Given that that’s your process, and the outcome seems to me to be– You tend to buy things that are a little bit higher growth, perhaps a little bit earlier in there. They’re not the free cash flow machines that they perhaps will be at some point. You buying them earlier in their lifecycle. How do you characterize the portfolio and the kind of companies that you tend to buy?
Brian: Because we have that moat management growth framework, growth is clearly a piece of that. It tends to be an area where there’s more potential for variant perception. That is the M&A unpredictable size and timing concept that I talked about, but also just the runway for growth. What you’re seeing in the market today, it’s very interesting, actually, in the last 18 to 24 months. A lot more activity has tended towards what you would call the short end of the alpha curve, because multi manager firms have been really garnering lots of institutional allocations.
And so, for those of you that may know this, it’s probably redundant. But if you don’t, a pod shop is basically a group of portfolio managers. They’re given a sandbox to play in. They’re pretty much equally long and short and net neutral in that sandbox. They’re trying to glean three, four, five points of alpha per annum, and then that’s leveraged to get the mid-teens return to the investor that they’re looking for.
What that means is, as more capital goes that direction, the risk management parameters around that portfolio managed activity cause all sorts of grossing and de-grossing issues with short-term stock prices, especially more liquid companies. And so, a lot of the names that we have, if they were beat on earnings by a penny or by a nickel, we’d see an up 2%, 3%, 4% day 20 years ago. Today, it’s up 15%, 20% or down 15%, 20%.
Jake: Just wild swing.
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The Art of Holding: Why Long-Term Compounders are Worth the Wait
Brian: Yeah. The punishment for being wrong in the short-term is just extreme, and the reward for being right in the short-term is also extreme.
For us, a concentrated portfolio can of be an optical nightmare sometimes for our clients, [Jake chuckles] but it obviously provides opportunity for the long-term investor. If you’re patient, you get a much rockier path. But hopefully, the results is even better, because there are times when you can buy your favorite names on discount. Knowing that these pod shop compensation cycles are usually about a year, that’s like this annual rank and yank process of the PM’s there, they got to be right in the short term. They’re looking for very different things than we are, and so that qualitative focus can be an enabler.
It does make that smooth line up and to the right more difficult if you’re looking at businesses that have more intrinsic value out in the long duration part of the growth equation. And so, it’s been a little bit more difficult for us recently. 2022, it was an awful year for us. 2023 was a great year. We’re doing well this year. But you have these cycles where if duration is getting punished, it’s really bad.
We think there’s variant perception in the growth elements of our process. And so, all things being equal, want growing companies. We want big tams and we want to take these bets. If we’re right about something and we have been right about them, they can grow very, very nicely. We’ve discovered a lot of long-term compounders. I think one of our mistakes has been that we haven’t held onto them as long as we should have. We can talk about that, that’s I think the hardest thing in professional investing. Maybe be own CoStar and HEICO and Align Technologies and all these. We’ve identified all these when they were smaller companies. And so, those have been winners.
And then we have some that their stair stepping of intrinsic value is happening, but the stock price is just super, super volatile along the way. I’ve been joking internally that if we were a private equity firm, we’d just have this nice smooth– [crosstalk] [laughter]
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Brian: Because the underwriting of the businesses has been largely correct, and we’re seeing the expected economic growth that we want. It’s just that we’ve lived, especially through COVID, this just super volatile multiple expansion contraction story. We largely have the same portfolio that we did four or five years ago. And so, it’s just been this interesting ride. My career has been marked by being at the top of the heap and then the village idiot, and then the top of the heap and the village idiot. [Tobias laughs] We just cycle through that every couple of years. I remember– [crosstalk]
Jake: What do you do in 2021 where it has to feel like, “Gosh, everyone is very optimistic about what all these businesses are going to be able to do, and they’re paying up”? The business results that are implied by the price make you scratch your head a little bit.
Brian: Yeah.
Jake: Especially, if you’re underwriting further out, and that’s where probably some of the most egregious assumptions lived, what do you do in that scenario?
Brian: Our mid large strategy was up over 60% in 2020. That’s a Hall of Fame year for any money manager. But this just to give you an understanding that this business is a recipe for unhappiness. When you have that sort of year, especially during COVID where the small business around you is closing their doors and things like that, you’re almost like, you hide about these things, because you’re almost embarrassed about them for just societal reasons. Even having a good year, you’re just like, “Oh, great.” More and more of the future value is being pulled quickly into– [crosstalk]
Jake: We’re going to give that back. [laughs]
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Identifying and Holding Option-Rich, Growth-Oriented Companies
Brian: Appraisal, right? You’re buying and hold and you’ve articulated that to your investors, and we have a lot of taxable investors and so, all of a sudden, we’re just going to create this nightmare tax situation for our clients. And so, we did some trimming, obviously not enough in that time period, and then we got whipsawed in 2022, and then you rebounded in 2023 and it’s just this year-to-year painful, rocky experience that’s certainly exacerbated from the ride that we’ve had earlier.
We had similar things going into the financial crisis and coming out of the financial crisis. And so, it’s not our first rodeo, as they say, but it also doesn’t make it any easier. I think for us, the secret really has been, first of all, we sell people philosophy process like, “This is what we do. This is our philosophy. If you like our philosophy and our process, please make an investment with us. Just know that we’re not 100% of anybody’s portfolio. We’re some small percentage of that portfolio. We play some role in a broader asset allocation. And then here’s what we own.” We talk about what we own. “And here’s the economic progression of what we own.”
If this were a private business or a conglomerate, we would all be sleeping very, very well at night. The fact that Mr. Market is assigning these elevated multiples and discounted multiples occasionally is, it can be opportunity, but these are the businesses that we own and we want to keep owning them and we think they’re option rich. We think they have great growth prospects. We think they’re competitively advantaged and we think the people running them are doing really rational things with the capital. And so, long as we just keep pounding the table on that mantra through the good times and the bad times that we’ll get to where we all want to go.
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Tobias: Let me just give a quick shoutout and then let’s talk about what has changed over the last 24 years since you launched. Old ocean, Texas. Warren Buffett’s called in from Winter Park, Florida. How are you, Warren? Good to have you on again. Petah Tikva, Israel. Bendigo, Australia. You must be early there. Mac’s in Valparaiso. How are you, Mac? Gothenburg, Sweden. Dubai. London. Miami, Florida. Varanasi, India? Niles. Abu Dhabi.
Santo Domingo, Dominican Republic. Ottawa. Havertown. Tallahassee. Kennesaw. Costa Rica. Edmonton. Tomball. Jupiter. Hong Kong. Jupiter, again. Congrats, you’ve won. One-way-boomerang, Australia. Helsinki, Finland. Reykjavík, Iceland. You might have come the first. Perth. Winner.
So, the question was, you launched almost 20, 24 years ago, which is an amazing achievement. This is a tough business to survive. I think that the main marker of success as an investor is longevity or durability. So, congrats on that. Hopefully, there’s another at least 24 to come. Have to check the–
Brian: My desk is wood and I’m knocking on it right now.
[laughter]Tobias: I have to check the actuarial tables to see if you’ve got it. Yeah.
[laughter]What has changed? You say it’s become much more efficient than it was 24 years ago, but you felt like there was a lot of efficiency. Then we’ve gone through some weird times. If you started in 2000, you must have seen the tail end of the dotcom where you saw the bust. You’ve seen the GFC. Now you’ve seen the COVID. What’s changed? What’s stayed the same?
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Brian: Well, I think the thing that pops into my brain first is, while the market is a blended consensus and has gotten more efficient in terms of information dissemination, that does stand a little bit in contrast to the money that is flowing to the short end of the alpha curve and the intraday volatility. I read this on– I don’t know the citation nor have I fact checked it, but I suspect it’s correct that Citadel is now 25% of daily volume. A third of daily volume is now traded in the final hour of the trading day.
Tobias: [laughs]
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Adapting Investment Strategies in a High Frequency Trading Era
Brian: So, all of that is to say, that’s much different than– I started my career in 1996 at a small cap value shop. I called a $2 broker on the floor of the New York Stock Exchange to execute a trade, who was talking to a specialist who was tasked with maintaining an orderly market and the security. That’s all out the window now. The simplicity of yesteryear is gone, and now it’s obviously high frequency traders and pod shops that are making, I think, the incremental trades in the market that are creating price discovery, and that fundamental investors like us have to just be really patient, because eventually value will out as Buffett says, “There are reasons why private equity activity will take out your company if it trades at a discount too long.”
We’ve had instances where management teams would just come right out and say, “This stock is cheap. We’re going to do a tender offer.” There are ways of forcing the value mechanism to get the market price to get closer to appraisal. So, we have to be patient. But in the interim, there are different forces that are creating, I think, incremental trades that are affecting pricing in ways that weren’t around 24 years ago.
The institutional business is a little bit different. In the 1980s, it was like 60/40 stocks, bonds, and then the endowment model came out in late 1990s popularized by David Swensen, who recently passed away, the Yale endowment. He wrote a book, Pioneering Portfolio Management, which was very instrumental in prompting me to start my business, because I saw an ability to create a concentrated equity strategy as all of these 200, 300-stock managers were getting fired.
The brand name Wall-Street firms charging 1% for 300 stocks, and being a 2% position in an allocator’s portfolio. To me, it was like, “This is all bonkers. Everyone’s getting passive results and paying active fees.” And so, concentration just made sense from a first principles investment standpoint. But it also seemed to be fitting very, very well in an institutional portfolio. And so, I made the life bet at 27 to create Bares Capital around that concept. That was a great moment in time, and I think I was correct about hitting the business side of Bares Capital at the right time and grew on this bow wave of concentrated manager adoption.
That’s a little bit different today. People talk to me and say, “Hey, I’m starting my hedge fund or I’m starting my single manager shop. What’s your advice? I want to do what you did.” I say, “Well, I think that endowment model story, while still very relevant, has been broadly adopted through the institutional space. And now you’re competing for replacement capital.” But the tectonic shifts investment management continue to happen. My story, starting today, probably is not going to be as successful. The Brian Bares of 2000, and that strategy may not garner the institutional attention that it did 24 years ago.
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Interestingly, and something I saw that Toby, you, I think, put out there on Twitter is that the disparity between small and large cap seems to be very similar today than it was 24 years ago when I started. And so, I did have a little bit of a tailwind, I think in small cap when I launched, which is very helpful. And so, we launched a ’40 Act Fund at the beginning of last year based on our small micro strategy. So, up to this point, we haven’t had a retail focused distribution channel that people could invest with us.
So, we started that last year thinking the same lines, that this environment actually looks pretty similar as it did 24 years ago and is set up pretty well. I think in the middle of last year, I was telling the guys in the office, I was like, “Wow, I haven’t seen low teens PE with debt free good returns on capital in a really long time.” What we’re seeing it in the middle of last year, and so that’s usually a pretty good sign that we’re in for good for returns.
Tobias: What do you think drove that? Is it return to normalization of interest rates, something like that?
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Finding Undervalued Stocks in Overhyped Markets
Brian: Tough to say. In 2000, clearly, it was the dot bomb, the backside of the dotcom era that drove that. I remember in the middle of the mania in 2000, I was looking at the highest yielding names in the investment universe. There were REITs yielding like 13%, 14% that had cash from operations that were well covering all of their obligations that were conservatively capitalized. I was just thinking, everyone was interested in the globe.net and the-outpost.com and all these different businesses, and you had money lying in the street. In our initial portfolio, we owned Utah Medical Products and Landauer and Aeon. These were companies that were trading at eight, nine times free cash flow, debt free with 40% returns on capital. I’m like, “I probably will never see this ever again in my career.”
Jake: [laughs]
Brian: We didn’t get to that point last year in small cap, but it was the first time where there were echoes of that. And then contrast that with to just show you how difficult this business is, in 2014, I wrote a letter to my partners here at Bares Capital saying, “I feel like the market is a little bit elevated. It’s probably overvalued by traditional metrics.” It did nothing but go up for the next seven years and so.
Jake: [laughs] Ah, welcome to the club.
Brian: Wouldn’t you be a fool if you were just waiting around patiently on cash for seven years while the world’s passing you by? So, the good news about us is we have a fully invested mandate and we’re paid to invest. We have a qualitative approach, which means that qualitative plays into the portfolio management construction a little bit too, because we recognize that a DCF or intrinsic value calculation can’t capture everything about a business. ABC at 80 cents on the dollar is not the same as XYZ at 80 cents on the dollar. Different management, different prospects, different competitive aspects, etc.
So, we make conviction weighted bets where we will sometimes pay what looks like an optically high price to other more traditional value investors. That actually saved us candidly, in that latter part of the last decade, where the entire market was, I think, in retrospect, probably a little ahead of itself. But we were able to participate in relatively good performance during that time period by owning some very high-quality names that stayed elevated.
I think we’re seeing a little bit of that today. Many of these sort of consensus compounders where you’ve got 40, 50 times earnings and names that I’m sure we all know.
Jake: Costcos of the world?
Brian: Yeah, I was thinking that exact name. I don’t know how much of the forward value is being pulled into the current price in some of these names, but it’s a lot. And so, the hardest portfolio management question in our business is, at what point do you capitulate? You move on to something with a better risk adjusted returns.
So, Buffett spoke to my class at University of Nebraska, 1994, I think it was. Somebody asked him, “When’s the right time to sell a stock?” And he said, “If you have the right business, the answer is never.” You just let great things happen. Yet somebody, I think, just posted that his average holding period is like two years.
Tobias: Is that right?
Brian: And the Berkshire portfolio.
Jake: I see [crosstalk] there’s someone sharing that at the bottom.
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Brian: Again, I haven’t fact checked if that’s true, but there’s a lot of turnover in the non-Coca-Cola, American Express areas of the portfolio. And so, we are in the public markets. We lived a very acute version of this, where we had the massive run up in 2020, 2021 and then the whip showing in 2022. And so, it’s just hard to know when–
If we were believers that you should sell a business at 100 cents on the dollar, buy 60 cents, wash, rinse, repeat, we would have suffered a horrible stretch of underperformance for the better part of the last decade. It would have been absolutely awful. And so, thank God, we were hanging on to these companies. Some, you would argue that we didn’t hang on long enough, the high that was at the world we owned Aeon, the heating and air conditioning business in Tulsa, which has been a long-term compounder, but we only caught part of it. Middleby was another one.
And so, we’ve had these stories where, it’s like, “Hey, this is getting ahead of itself.” We sell, and we think we’re inning eight or nine, but were actually inning two or three, right?
Jake: Yeah.
Brian: That’s a horrible feeling of remorse, because we did the work, we nailed it, we got it right. In many cases, got it before it became a consensus long for everybody else. We didn’t get the full benefit of the compounding. Okay, so then take that mental model and port it onto 2020, 2021, 2022, and we do hang on to those names and then ultimately come up– [crosstalk]
Jake: Make it and take it out the woodshed.
[laughter]Brian: Yeah. So, this is the sausage being made. This is very, very difficult. There’s no quantitative approach that I know of that addresses these problems correctly. And so, if you’re a long-term investor, where you view stocks as business ownerships, I think, as Munger said, “Sometimes you just got to stomach this awful volatility in order to get where you all want to go.”
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Reflecting on Market Opportunities and Misses in 2015
Tobias: Jake wrote an article in 2015 that I reposted. So, I think we would have all agreed in 2015 that certainly, our part of the market was definitely getting ahead of itself. And Jake’s article in 2015 said the spread between the most overvalued and the most undervalued in the market is as tight as it’s been in 25 years. So, it’s the worst opportunity set in 25 years. What neither of us did was then think what next.
Jake: We weren’t smart as Brian at that point.
Tobias: Yeah. Go into the better companies.
Jake: Keep optionality in that other nice half of the– [crosstalk]
Tobias: Yeah, we missed that.
Jake: -dummy. [laughs]
Tobias: So, well done there.
Brian: Well, so what we do is we qualify businesses based upon these qualitative factors. And so, we’re qualifying on moat management growth. If we find something that’s truly exceptional– We of our analysts brings it back, we do some more vetting, we do site visits, we’re training on software, we’re going to the industry trade shows. We’re doing a lot of qualitative fieldwork that our competitors are not. If it truly is one of, say, the 50 best companies in, say, small micro, we’ll present it internally. We’ll have a debate where the youngest analyst in the room starts to prevent bureaucratic bias and then give their opinion on up to myself and our company president, Jay Creel.
If it’s a thumbs up around the room, and this is truly one of the 50th best businesses, then we’ll appraise it and put it on our focus list. And so, appraisal is done at the end of the process, because we don’t want to get suckered into a value trap by knowing that it’s a low PE business going into it. We just want to pre-qualify best businesses, best people with the best prospects for growth. But the reason I’m bringing this up is that our focus list that’s appraised, we have the cheapest and the most expensive. And through that period, you’re talking about that 2014 to 2021 period, the most expensive on our focus list radically outperformed the cheapest.
[laughter]Brian: Radically outperformed. And so, even having a minor value discipline that we did, candidly, there was some serious performance leakage there that had we just invested in the whole thing, but it was just really hard to pay 10 times sales for a Tyler Technologies or whatever that we know is obviously a great business that we love and we would love to. We identified as a micro-cap and we never owned because it was just consistently too expensive.
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Those are the conundrums that we face every day. It’s the true parimutuel system. You know that horse is superfast and is probably going to win, but it only pays eight to seven or whatever the ratio is.
Tobias: So, it definitely grew into that 10 times sales valuation, it grew in.
Brian: Well, look at Salesforce. When Salesforce came public, I think it was about 10 times sales and it was been a great long-term compounder and has just permanently traded at 10 times sales. And so, we’re not averse to owning those types of companies, if the growth is there, but you’re penalized very heavily if that growth doesn’t materialize obviously.
Now, in the perfect world is we want to buy a business that can be rated at 10 times sales at some point in the future, but is not today. So, that’s the qualitative work that we do.
Tobias: We usually do some veggies from Jake at the top of hour. We’re running a little bit late. You got some veggies for us today, JT?
Jake: I do.
Tobias: [unintelligible 00:40:33]
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Maslow’s Eupsychia: Imagining the Potential of a Self-Actualized Society
Jake: [chuckles] I’d be curious to hear your take on some of this stuff, Brian, because especially when we start talking about culture and what maybe what you’re looking for sometimes culturally in these really high-quality businesses. This is Abraham Maslow and the Blackfoot Indians. So, most of you have probably already heard of Abraham Maslow’s hierarchy of needs, this famous pyramid. But there’s actually an interesting backstory, which led to an incredible foresight by Maslow.
Just a little background on him. He was a prominent American psychologist. He had this hierarchy of human motivation in the form of this pyramid. It suggests that there’s five levels of needs. The first is at the very bottom is the physiological needs, which are air, water, food, shelter, reproduction. The next one up is safety needs, so personal security, employment, health, property. The next one, above that is love and belonging, so friendship, intimacy, family. Above that is esteem, so respect, status, recognition. And at the very top of his pyramid was self-actualization, and that’s like becoming the most that you can be.
Now, according to Maslow, each individual must then satisfy the lower-level needs before they can get to the higher level. Like, you can’t be starving and then also self-actualized, perhaps– [chuckles]
Tobias: [unintelligible 00:41:57]
Jake: Yeah, I was going to say– Wasn’t that that what the Buddha did? Anyway, so what’s less commonly known about Maslow is the influence of the Blackfoot people on Maslow’s work. The Blackfoot Indians are this group of native American indigenous tribes that were traditionally residing in the northwestern plains of North America. Maslow spent six weeks in 1938 on a reserve with them, basically conducting anthropological research. During this time, he observed and interacted with their community. It really impacted his understanding of human behavior and motivation.
The Blackfoot have their own model of human needs and societal structure. It actually contrasted quite a bit with Maslow’s hierarchy. So, their model emphasized a communal approach to wellbeing and fulfillment. Like, their central philosophy was actualization, but a different context. It wasn’t individual centric. So, their actualization was like community-oriented process, and it was deeply connected to the collective wellbeing and really spirituality of the community. So, they believed that one person’s development and fulfillment were intertwined with the health and the wellbeing of community. This holistic view of self-actualization was in contrast to Maslow’s, which was a very individual version, like a very western version.
So, the Blackfoot’s top tier represented cultural perpetuity, actually. So, focusing on the preservation and continuation of cultural knowledge, tribal knowledge and practices for future generations, which is interesting to stretch out Maslow’s hierarchy, not only upward from you as the individual but also temporarily through generations.
So, his experience then influenced his later thoughts. So, after he’d already published his work, that was very seminal, in his later work, he introduced this concept of self-transcendence, which goes beyond self-actualization, includes a more holistic, interconnected view of humanity.
So, he took this integrative view, and then he started exploring the corporate world. I read this book. It was called Maslow on Management. It’s really just like a series of notes and journals that he’d taken to himself about what he was seeing and what else he wanted to research in the corporate setting. He wrote this in the early 1960s, and he was way ahead of his time. At that point, American corporate culture was very, very still industrial age. Like, “Here, I’m the boss. You go turn this wrench.” That was how it was run. It wasn’t like, “Oh, I want to make sure my guy on the forward line was self-actualized while he’s turning the wrench.”
So, anyway, in this, he delves much deeper than into the force for good that business can represent and can harness. He’s talking about enlightened employees, delighted customers, rewarding shareholders, happy communities that the businesses are operating in. He thought that the business world was actually the best laboratory for conducting experiments and observing human psychology. These thoughts, really, he anticipated so many management fads that became in vogue in the next 50 years.
He actually coined this term called, and I might be mispronouncing this, but it’s Eupsychia, E-U-P-S-Y-C-H-I-A. What that is is a thought experiment, basically like, imagine 1,000 self-actualized people on a sheltered island with no outside interference, what would be the upper limit of what human culture was capable of them working together in a self-actualized way? It’s like a utopia. That upper limit would be called Eupsychia.
So, one last little piece that I got from the book that was interesting, he identified that dignity and self-esteem really stems a lot from one’s work. He said that one really has to deserve the applause and the prestige and the recognition. Otherwise, it actually creates these harmful side effects of, like, when you know it’s not deserved, it causes guilt and self-doubt. And all of which, while I was reading this, he said that all sorts of psychopathogenic processes may start from undeserved applause, which made me wondering like, “Gosh, all these participation trophies that we’ve been handing out for the last 20 years [chuckles] in society are like, ‘Are there longer term ramifications to that?’” But anyway– [crosstalk]
Tobias: We’re finding out now.
Jake: Are we?
Tobias: We’re seeing it now.
Jake: Is that what’s happening in college campuses right now? I don’t know. We better not go there.
Tobias: My college campus was just as bad as that, I think. I don’t think that’s changed. But that’s a good segue, Brian. Culture is a very qualitative assessment. How do you go about assessing the people, assessing the culture? How do you bring some sort of replicable scientific rigor to it? Is that possible?
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The Art of Identifying Leadership Qualities in Potential Investments
Brian: Yeah, very difficult, obviously. So, we do the table stakes work that everybody does in terms of analyzing alignment of incentives through– We prefer as outside passive minority shareholders for a founder, owner, operator dynamic, or a great alignment of incentives in the proxy with the right types of return on capital-based incentives. Look at the history of the actions of the people. Do they map to the incentives? Do they map to what we expect? We don’t always get this part right.
A lot of people will say, and I read a bunch of research from Paul Meehl from the University of Minnesota that basically says that, “A computer can read a radiological scan better than anyone radiologist.” And so, you’re better off just not even trying, because all of your biases and misjudgments as a human, when you’re trying to assess these soft things are just going to lead you astray.
I actually don’t believe that at all. I think if you meet one manager, you might be super impressed by the meeting, you walk away. Then you meet 10, and then you might go back and say, “Well, that first one wasn’t quite as exceptional as I thought they were.” And then you meet 100, you can start to tease out little patterns. Life, and especially our business is very much about pattern recognition. It’s about discovering these deep patterns.
You start to see things in people’s backgrounds, the way they behave, the way they talk, the way they interact with employees that start to give you an idea for what a person is all about and whether they can be trusted with the capital that they have within the business.
Jake: You get intuition now for that, Brian? Like, so much pattern matching now where maybe it’s almost a subconscious thing?
Brian: I think so. I think pattern recognition develops into intuition. So, I think that that is correct. I love it when one of our research analysts comes back to the office and is like, “Brian, you have to meet this guy, or you have to meet this woman. They’re amazing.” That’s happened a number of times. Typically, it’s a pretty–
Jake: What’s the hit rate after that?
Brian: Yeah, it’s a pretty good sign. And so, some people just jump off the page. I tell people that you don’t get to the top of a business without having a silver tongue and being very persuasive. A lot of the people come up through sales, and so you end up being snowed by the people’s personality and the elements of their character that made them successful.
Jake: The rizz now is what the kids would say.
Brian: The rizz. Yeah, absolutely. A great example of this is there’s a guy named Selim Bassoul, who’s one of our favorite CEOs of all time that ran a company called Middleby, which is a metal bending, the maker of the hot side of equipment for restaurants. And so, they own brands like TurboChef and Viking and things like that.
I saw his very first investor presentation when the company was like $250, $300 million in market cap. I don’t know, today I’ve lost track, but it’s $8 billion, $9 billion or $10 billion, something like that. So, he gave his presentation and I was just completely wowed. I was like, “I just saw a combination of Thomas Edison and Steve Jobs give a speech.” I was like, “I got to just step away from this situation because I’m completely under this guy’s spell.”
Jake: Yeah.
[laughter]Brian: So, I just sat there sucking my thumb until it went to $800 million in market cap. We finally wisened up and bought it, I think it was a three or four bagger for us. He was just unbelievable talent.
If he were in the room with us, you would all walk away with a brand-new pizza oven and have spent 8 grand on it or something.
[laughter]He’s just an amazing CEO. One of our favorites that would be in our Outsider’s book, which we could write on the small cap space, he’d be chapter one. And so, the degree to which he would stand out is really, really amazing and indicative of our ability to spot exceptionalism from average.
Now, Madoff stood out and a lot of these other people stood out. And so, you have to be very, very careful and you have to check all these, the enthusiasm with the data and you have to make sure what they’re doing is rational and stuff. We have a portfolio of positions. If you get, say, 10 to 12 Selim’s, I don’t care what business they’re in, if they’re running hot dog stands, you’re probably going to have a great result. So, yeah, it’s tough to underwrite these soft elements of culture and things like that.
Yeah, I found your Maslow discussion really interesting. To port that on Bares Capital, I been working long beyond where it makes rational sense for me to keep working. I worry about in our business, the younger generations are saying, “Well, I just want to hit the lottery, not pay taxes, buy some crypto, move to Costa Rica, just get out of my community, because America is awful,” blah, blah.” And it’s like, “No, no, what creates meaning in your life is actually engagement. It is the building of community.” It is, for me, especially the duty that I have to our investors, the duty I have to my fellow employees, to my wife, to my kids, to the community at large.
By voluntary acceptance of increasing amounts of responsibility, actually provides you much more meaning than the feckless pursuit of freedom which I fell into that trap. It was like, “Why was I an entrepreneur starting Bares Capital?” It’s like, I wanted to get to the financial finish line quickly so no one could ever tell me what to do again. I could do whatever I wanted with my days. But that thinking will land you on therapist couch. It just will. It’s not the end all be all.
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Investing as a Form of Addiction: The Thrill of the Chase
Jake: I think Viktor Frankl had this great quote about, “When a man can’t find, or woman, I guess, can’t find meaning in their life, they’ll seek to fill that hole with pleasure.”
Brian: Yeah. People end up finding meeting in a bottle or in a shooting something in their arm or going to Vegas and doing the wrong things or whatever. And so, I just think that the oldest answers are probably the right ones, which are to voluntarily accept more and more responsibility in your life. Like, Jordan Peterson says, “Pick up a load, move it from here to there and see if that doesn’t solve most of your problems.” [Jake laughs] It’s like, just start working hard on something.
I just happened to find a business that I really enjoy. I’ve been talking about this recently, which I think is, I haven’t heard it elsewhere, but I think investing is like fishing, in that its variable intermittent rewards. The dopamine snacks that you get from finding the next potential compounder are very similar to getting a strike on the line when you’re fishing for muskie in Minnesota or whatever.
And so, I think there’s this variable intermittent reward aspect of our business that keeps me coming back that I really enjoy. That is a psychological, call it, addiction. I’m sort of guy that probably wouldn’t let other people manage my money. And so, I’m going to do this for the rest of my life anyway. I might as well do it with a team of people that I really like and respect and with a group of clients that is, I’m privileged to have entrusted me with money.
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From Google’s Dominance to AI Disruption: Analyzing the Shifts in Tech
Tobias: I’ve got some questions here from the audience. Brian, if you’re prepared to take them– Do you want to talk about–? I’ve got a question about individual name that you hold. Someone’s [unintelligible 00:54:38].
Brian: No. We don’t talk about those.
Tobias: Don’t talk about that?
Brian: [crosstalk] -something, they might be buying it.
Tobias: Fair enough. Here’s one that it’s unlikely that you hold. Here’s the– “Sam Altman SPAC: Moonshot or Financial Blackhole?” Let’s just broaden it out to AI. Is that of interest to you? Is it in your companies? How are you thinking about it, dealing with it?
Brian: Yeah. Who would have thought that the Google 10 blue links would be as vulnerable as they are today. The world’s greatest monopoly now potentially disrupted by this. And so, I think it’s a broader comment about the topple rate, which is, the rate at which companies leave the index is just increasing. It’s because technological disruption is an increasing threat on all fronts for all businesses. And so, we absolutely pay attention to this stuff.
There’s a couple of business we hold that we think could beneficiaries of that, because the proprietary nature of the data that they have could be a unique training set that could accelerate the growth prospects of the businesses. We don’t have any direct investments in AI, but we have hopefully businesses that can benefit from that. But we’re paranoid about everything and that’s just one more thing we’re paranoid about.
Tobias: I always wondered if the way that those companies were ultimately toppled was some– The way that Microsoft lost its desktop monopoly was by transitioning to the phone. It’s a completely different frame of reference for approaching the problem and they’ve got a lock one but not the next one. Is that– [crosstalk]
Jake: [crosstalk] -the garage, isn’t it some accident in a garage that–?
Brian: Yeah. It’s very rarely like a head on assault that you see coming, right?
Tobias: Yeah.
Jake: It’s always oblique.
Brian: Yeah.
Tobias: Little’s got that great line where he says that, “The line of victory or defeat comes along the line of least expectation.” [crosstalk]
Brian: Yeah. I like the line from Bruce Greenwald in competition demystified where he said, “In the end, everything’s a toaster.”
Jake: Yeah. It’s very powerful.
Brian: Everything just becomes commoditized in the end. It’s just about that competitive advantage period, and can you harvest economic profits and then channel them back to outside passive minority shareholders during that time.
Tobias: The innovation becomes table stakes. It’s amazing how many times that’s happened in– In the 1990s, like having a website was regarded– That was enough to make you a dotcom. And now, everybody’s got a website. It’s just trivial.
Brian: Yup.
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Pivoting for Success: Adapting Competitive Advantage in a Shifting Market
Jake: Do you feel like that you underwrite shorter competitively vantage periods now than you did 24 years ago?
Brian: Yeah, that’s a great question. I think we are more paranoid today than we ever have been about the threats for technological substitution. I’d like to think we’re quicker about just making it a position to exit when we feel like that threat is potentially materializing. But a lot of these things, they seem obvious in retrospect. But in the fog of war, it’s really, really difficult [chuckles] where the bullets are coming from.
Jake: Sure. Even then there still could be long periods of cash flow that can happen on some of– Even a business is declining. If it’s not, how do you think of–? I know there’s money printed in telephone books for a really long time after you would have said like, “Well, that’s dead and gone,” right?
Brian: Yeah. Well, what’s really amazing is companies that can successfully pivot into the new paradigm. I think Microsoft with Azure is probably the prototypical example of a company that has been really, really successful in and adopting into a new paradigm that looked to be a competitive threat.
Tobias: Microsoft’s pivoted–
Jake: [crosstalk] -rate on that has to be so low though, right? Most of the time, you don’t catch the next train leaving town.
Tobias: When the Windows– [crosstalk]
Brian: Yeah. [crosstalk] innovators dilemma. There’s a whole book written about that and is very accurate.
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Tobias: Hey, Brian, we’re coming up on time. If folks want to follow along with what you’re doing or get in contact, what’s the best way of doing that?
Brian: Yeah, just go to our website, barescapital.com. Institutional investors and individual investors now get the same strategy, same access.
Jake: That’s B-A-R-E-S, by the way, not– –
Brian: Yeah.
Tobias: B-E-A-R-S.
Jake: I don’t know what you get if you go to B-E-A-R-S. [laughs]
Brian: Nice curse of- [crosstalk]
Tobias: Macro.
Brian: -team going into our business where I’m a long [Tobias laughs] investment manager. [Jake laughs] Yeah, the fund company we recently launched is BCM Focus Funds. So, bcmfocusfunds.com. All the appropriate disclaimers, you can go, visit there. We stood up our own series trust and so. Will Thorndike, who wrote The Outsiders is on our board. Sandy Leeds, who’s a professor at the University of Texas, and I are the three board members. And so, that’s a new effort and growing, so individuals can look there, institutions can reach out. I won’t give out my email for a fear of-
Tobias: No, that’s fine.
Brian: -getting deluged, but with things that gum up my time. We have a Twitter presence. You can find @barescapital on Twitter. I’m on Twitter, but I don’t really post anything. I’m just kind of lurker.
Tobias: Well, that’s fascinating, the podcast. Brian, once again, thanks so much for joining us.
Brian: Thanks for having me. It was fun.
Tobias: Fascinating stuff. Brian Bares, Bares Capital Management, thank you very much. And JT, as always, great work.
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