In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Pieter Slegers discuss:
- How to Use Reverse DCF and EPS Growth Models in Quality Investing
- Adapting Your Investment Strategy: Evolving with Market Changes
- Cybernetics as a Mental Model: Understanding Systems and Control Mechanisms
- The Power of ‘I Don’t Know’: A Logical Riddle to Test Your Reasoning Skills
- Building a Winning Quant Strategy: Combining Value, Quality, and Momentum
- Narrowing Down 60,000 Stocks to Quality Picks
- The Art of Quality Investing: Balancing Moats, Owner Operators, and Valuations
- Understanding Multiple Expansion and Contraction in Quality Investing
- Why S&P 500 Margins Don’t Matter in a Bottom-Up Stock Picking Strategy
- Beyond the Numbers: The Value of Qualitative Criteria in Quality Investing
- Why Intrinsic Value Growth Trumps Multiple Expansion in Investing
- The Appeal of Niche Market Leaders: Case Study of Games Workshop
- Exploring Kinsale Capital’s Superior Underwriting and Market Growth Potential
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. That means it is Value: After Hours. I am Tobias Carlisle, joined as always by, my co-host, the inimitable, Jake Taylor.
Jake: Ooh [crosstalk]
Tobias: [laughs] Good one. New one.
Jake: Upgraded. [chuckles]
Tobias: Just something to throw you a little curveball limit. And our special guest today is Pieter Slegers. He’s from Belgium. He’s @qcompounding on Twitter. He’s written a new book called The Art of Quality Investing. Welcome, Pieter. How are you?
Pieter: Welcome. Doing well. It’s an honor to be here. As I already mentioned before we went live, well, I’ve been following you and I’ve been, yeah, a fan of you for a very long, Toby. So, it’s an honor to be here, and hopefully we’ll have some fun during the next hour.
Tobias: Oh, that’s very kind. Tell us a little bit about QCompounding and a little bit about the book.
Investing in Quality Stocks: The Compounding Quality Philosophy
Pieter: Yeah, sure, sure. So, what I’m doing right now full time is running Compounding Quality. Compounding Quality, well, I think the name already tells it compounding, compound interest and then quality, so we are quality stocks. So, with Compounding Quality, the main objective is to find or to invest in the best companies in the world, basically, just like Buffett made the move from cigarettes butts to more quality investing approach.
Before running Compounding Quality, I used to work in the industry, but, yeah, obviously, just like you, Tobias, just like you, Jake, loved investing. It’s your hobby, it’s your passion, it means a lot to you. But as Buffett said, “Well, people in the Rolls Royce take advice from people who take at the subway.” I felt like that was true, a lot of commercial incentives and so on and so on. That’s how Compounding Quality basically starts just to be able to anonymously tell what you thought about the market, and share some investment insights and so on. Then the account kept growing, and growing and growing, and then all of a sudden, you were able to do this full time. So, really grateful about that, because as a kid, I always wanted to become a teacher.
When I went to university, I also wasn’t that, “Well, should I follow my passion for investing or should you pick something in the teaching part?” I think with the newsletter, with social media accounts and so on, I think you are doing a bit of both. So, obviously, following the markets 24/7, and also the teaching part, trying to help other people along their investment journey.
Trying to help other people, teaching other people, that’s actually also a very good way to learn more yourself, because when you are able to explain something to someone else in a simple manner, and when even your nine-year-old niece can understand your investment rationale, well, that’s probably an indication that you’re on the right path.
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The Art of Quality Investing: Balancing Moats, Owner Operators, and Valuations
Tobias: Talk to us a little bit about quality. How do you define quality, what are you looking for?
Pieter: It’s subjective. When you ask 10 people, what do you think about quality? You probably get 10 different answers. Yeah, in the end, probably, all intelligent investing is value investing, in the sense that you try to buy companies for less than what they are worth. On the stock market, probably multiple roads that lead to avenue, you can do value investing, maybe more your cup of tea, you have the growth investing route. And then for me personally, it’s quality investing.
So, yeah, how would you define it? It’s a bit also based on Terry Smith, but I would say, well, you really try to invest in the best companies in the world, or you can use a three-step framework in that case, it’s one. Well, you want to buy wonderful companies. So, companies with a moat, obviously, great capital allocation skills, low capital intensity and so on.
Second part is, for me, the skill in the game part is really important. So, in general, mainly looking for owner operator stocks, so companies that you identify as quality or [unintelligible 00:04:45] quality and where in an ideal world still the founder is still running the business. When that’s not the case, the family is still owning at least 10%. So, you have the wonderful business part, you have the owner operator part or the skill in the game part.
Obviously, third part is the valuation part. The market often recognizes that the business is a great business and yeah, then those companies are usually trading at higher valuation multiples and then it’s probably the art to try and pick them up at fair valuation levels and hopefully at low valuation levels. But those kind of companies, they seldomly trade at a very huge discount compared to the S&P, for example.
Jake: I thought Terry Smith step three was to do nothing.
Pieter: Yeah, exactly. I try to at least tweak it a bit to my own beliefs and so on, but doing nothing obviously is also the most important part. I’m not telling anything new for you, guys, here, but probably was it JP Morgan who did the study that the people with the highest return within their investment accounts where people who were dead, and then the second kind of persons were the ones who forget about their accounts. So, doing nothing is probably great advice as well.
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How to Use Reverse DCF and EPS Growth Models in Quality Investing
Jake: Let’s talk about the valuation component, because this is I think where it might get difficult for some with trying to imagine– [clears throat] I feel like that there’s been a reasonable shift in the industry, I think, towards quality and recognizing it and people generally paying up for quality. And is there some price where eventually you say, “Gosh, I just don’t know how I can win from here, even if this is the best company in the world.”
Pieter: Yeah, sure. So, as I mentioned briefly in the beginning, I used to work in the industry for three years actually. And then, obviously, you are working as analyst, you are building those Excel models with 500 rows, 1,000 assumptions and so on and so on. I really believe in the idea to keep it simple. So, I think rule of thumb should be really good.
For me, personally, I always use three models or three ways to look at valuation. First is very naive in some way and very simplistic. It’s just comparing the forward PE of the company with the historical average from the past 10 years. Obviously, that doesn’t say a lot because it also depends on the outlook of the company, what’s happening, the balance sheet and so on and so on. But it gives a first indication.
Second and third model are more interesting. Probably, it’s an earnings growth model and then a reverse DCF. Well, earnings growth model, in theory, it’s really easy which return you will get as an investor in the sense that it’s always your EPS growth of the future, plus the dividend yields, plus or minus the change in the valuation. So, obviously, the EPS growth is an assumption, the change in the valuation is an assumption.
But you try to, for example, use an exit PE, exit price earnings ratio, which you think is fair in the very long-term and rather low to use a margin of safety, then you try to make an educated guess about EPS growth, you can do that via management guidance, expectations of analysts, but obviously those are most of the time way too optimistic. So, also there you can use a margin of safety.
But for me, personally, when I do research for a quality stock, I want the outputs in earnings growth model to be at least 10%, so that your expected return per year is at least 10%. You can even put it a bit higher, for example, 15%, meaning that the stock will double in five years or more or less, and then you have an extra margin of safety.
And then the third model is the reverse DCF, like Munger said, “Invert, always invert. Turn the problem upside down.” So, with the reverse DCF, you are not making many assumptions yourself, but you just try to or you look at which expectations are implied in the current stock price. And yeah, obviously, you want those expectations implied in the stock price to be more or less correct.
When you take a company like LVMH, for example, which obviously maybe a disclaimer. Nothing I mentioned here is investment advice. But for example, for LVMH, well, the implied free cash flow growth for the next 10 years in reverse DCF is something like 10% or 11%. Is it realistic? Well, I think it might be the case. Well, everyone should do its own due diligence, probably, but 10% or 11% is more or less how LVMH has grown in the past.
Well, another extreme. Take Nvidia, for example, a company everyone is talking about, writing something about it on Thursday. That’s why I know the numbers by-heart. When you do a reverse DCF on Nvidia, it states that their free cash flow should grow by 27% over the next 10 years. But when you do that, it also means that in 10 years from now, Nvidia should generate more cash than all big tech stocks combined today, so Facebook, Amazon, Apple, Netflix, Microsoft, Alphabet, and so on. Is it realistic? I don’t think so. Could it happen? Yes, but there is probably no margin of safety at all. So, that’s how I try to think about valuation.
I think also that you hit a very good point in the sense that quality investing is becoming more and more popular. And over the past years, even over the past decades, quality investing has done really well. Declining interest rates have definitely helped quality investing in the past. So, the comparison or will it outperform as much over the next two decades as it did over the past two decades? Well, probably not is the honest answer, but still believing there in the strategy.
Because for a value investor, for example, the margin of safety is in the low valuation level. For a quality investor, the margin of safety is more in the moat of the company. And the longer your investment horizon, the longer you keep a company, the less important valuation becomes and the more the growth of the intrinsic value becomes. Obviously, this doesn’t mean that you don’t need to take into account valuation at all, because then some horrible things can happen. But it’s more like trying to buy those companies at a fair valuation multiple and not trying to buy them dirt cheap, for example.
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Tobias: Let me just give a shoutout to folks who are calling in from home. We get Old Ocean, Texas. Chapel Hill. Mac in Valparaiso. How are you? Savonlinna, Finland. Gothenburg, Sweden. Bangalore, India. Colorado Springs. Tallahassee. London. Jupiter, Florida. Mendocino, California. Farmsen, Hamburg. London, UK. Brandon, Mississippi. Stockholm, Sweden. Portsmouth. Wolcottville. Seattle. [laughs] And Pieter’s in Belgium. Tell us a little bit about Belgium, Pieter.
Pieter: Sure. What do you want to know about Belgium? I was born and raised– [crosstalk]
Tobias: Big industries.
Jake: It’s in Europe, Toby.
[laughter]Pieter: It’s in Europe next to Germany. No, I was born and raised in Belgium. I think obviously we are a very small company. People in Belgium, when we talk about finances and so on, they are really conservative in the sense that when you talk about stocks, it’s more like, “Oh, that’s dangerous.” My grandfather lost money during the dotcom bubble, and then my parents lost money during the Financial Crisis. So, please stay away from that. So that’s obviously something that gets you a little bit sad, because in the long-term, it’s the best way to create wealth. We passively managed ETF, for example. Well, it’s not that difficult at all to invest periodically in an index fund.
Yeah, right now, there are around 110 stocks in Belgium. Most of them are not that good at all. So, what we see in Belgium is that many companies are delisting. There are a lot of companies that, for example, for quality investor, the return on invested capital is really important. So, you want to return on invested capital larger than the weighted average cost of capital. Why? Because when it’s not the case, growth actually destroys value.
For me, personally, I want to return on invested capital large than 15%. Well, when you just screen on that metrics on the Belgian stock market, there are probably only five companies that remain. So, that already tells you something, and maybe also something interesting. Well, I don’t know how many Europeans are watching, how many US people are watching, but obviously, over the past decade, for example, US stock market has done way better than European stock markets. This is out of my head. But for example, over the past five years, the Belgian index, the BEL 20 index, it almost remained flat over the past five years.
Well, one of the reasons I think there is obviously when you compare the US companies with European companies, for example, US companies are in general just way healthier businesses. Their profitability is higher, their capital allocation metrics looks better. It’s more an ownership culture, so that obviously helps. So, in some way also a bit jealous about you guys and how you guys are doing in the US. But on the other end of the story, I’m a proud Belgium, and I’m probably sticking here for some extra few years and let’s see what the future brings.
Tobias: When you look at the investment, you’re looking probably mostly Europe and the US and other developed markets, if you’re looking for quality, is Terry Smith, is that his approach? Is he global in his approach?
Pieter: Yeah, it’s a bit the same. So, I don’t know if you were there, but, for example, the AGM of Berkshire this year.
Tobias: Yeah. We both were there.
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Narrowing Down 60,000 Stocks to Quality Picks
Pieter: Yeah, exactly. So, having dinner at [unintelligible 00:15:41] there. So, the favorite steakhouse of Buffett with Team Fundsmith this year, which was really insightful. I think the approach that Fundsmith is using and what I’m probably using are very, very similar. So, global, mainly US, a bit of Europe and then some Australia, Japan, if you find opportunities there, knowing them, just because for me, personally, I consider it out of my circle of competence, and then you just try to find the best businesses in the world. Worldwide, there are something like 60,000 listed stocks, and obviously, you are just not able to analyze everything there. So, to me, investing is about saying no as fast as possible.
So, the criteria you use are very strict. When you use them, well, out of the 60,000 companies that there are, maybe only 150 remain, just based on the quantitative criteria. And then, obviously, you go one step further and you dig into those companies and dive behind the numbers, into the moat and so on. Obviously, and it’s also some people ask that a lot, for example, Warren Buffett is the best investor in the world. You see it in my background, the poster of Charlie and Warren. Why just not Invest in Berkshire Hathaway? Why not just invest in Fundsmith, for example? I think it’s a very fair point.
For example, compared to Buffett, well, I think or I hope you have two main advantages. Don’t get me wrong, because Buffett is probably a way, way better invested than you are, but I hope I have still a longer investment horizon than Warren. [chuckles] And then the second point, obviously, is same for Berkshire and in some sense also for Fundsmith, it’s just the law of large numbers. So, we have the privilege or the opportunity to also invest a bit in small and mid-caps.
One of the key takeaways for me working in the industry is I was involved in a rather small equity fund, 300 million in assets under management, but even we didn’t even look at the company under $10 billion in market cap. So, everyone on Wall Street is just looking at big tech. The market is way more efficient there. There’s way more information.
When you are able to do your homework in the small and mid-cap space and you can find a quality stock with plenty of reinvestment opportunities there, I think that’s really where the big money could be made. Obviously, then you really need to do your own homework, because there is no investment research about those companies. Maybe they only publish half year results, which is a two-page document, and then you don’t hear anything from them for another six months. But it’s an interesting world to be active in.
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Tobias: When you look at Terry, Fundsmith–
Jake: That’s not his name.
Tobias: [laughs] I just think it’s funny.
Jake: It is funny.
Tobias: When you look at the free cash flow yield of that portfolio, one of the things that really stood out to me, is that the free cash flow yield has come down very substantially over the last decade, which is completely understandable, because that’s what’s happened everywhere in the market. That’s an indication of the return that they’ve received too, which being multiple compression or multiple expansion rather, which leads to that sort of compression.
Looking forward, how do you feel like that plays out again? I just think it’s hard to see that keep on getting squashed down at some point, that mean reverts a little bit and then you got a little bit of a headwind there, either abruptly or over an extended period of time.
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Understanding Multiple Expansion and Contraction in Quality Investing
Pieter: I think it’s a good point. I think in general for quality investor, well, reversion to the mean takes place and the market has been proven. I think it’s something you are using to your advantage and what you are doing. But when the company has a moat and a high sustainable return on invested capital and so on, well, usually, reversion to the mean doesn’t take place.
Take Visa, Mastercard, for example. What you basically in hindsight obviously could have done 20 years ago is you could have made a DCF or reverse DCF for Mastercard, where they would be growing above average for 20, 30 years. And then whatever assumptions you made, well, the stock would be undervalued. So, that’s what’s happening there. Obviously, please don’t do something like that, because it’s very dangerous things to do assuming that the company can grow above average for 30 years.
To come back to the Fundsmith example, I think there are two very interesting things. Well, the Fundsmith in 2010, when it launched is a different Fundsmith than today. Why? For example, 10 years ago, 14 years ago, they were more invested in companies like Procter & Gamble, the huge Unilever. They weren’t investing in Coca Cola, but those kind of companies, and they moved more to technology companies and so on. So, that’s one thing that is a reason for the declining free cash flow yield or the higher valuation level.
Another thing, and this is really interesting and I’m pulling those numbers out of my head, and those numbers, I made a calculation three, four years ago. Well, since 2010, I think Fundsmith compounded by 15% per year. What I tried to do a few years ago is I tried to look how large would the return be without the multiple expansion. So, just from the growth in the intrinsic value and you don’t take the multiple expansion into account, I think it was something like 11% or 11.5%, so without a multiple expansion. Obviously, that’s an extra return of 3.5% per year is very huge when you compounded a trade for several years.
So, when you look at quality, when you look at Fundsmith over the next years, over the next decades, well, extra multiple expansion definitely won’t be healthy for the market. So, that’s an unlikely scenario. It might be a scenario that remains more or less stable or you indeed get a slight multiple contraction.
So, for example, yeah, you can do the math also the other way around for Fundsmith. So, if you say, okay, over the past 14 years, the intrinsic value compounded by 11.5% per year, let’s say that now there is more than multiple expansion of 3.5% per year, but a multiple contraction of 3.5% per year, well, then you have an expected return of 8.5% per year. For something like Fundsmith, I think it’s definitely something to think about, something to keep in the back of your mind. But it’s not something that I’m worried about.
For me, my portfolio, I think it’s more the Fundsmith approach, but more the smaller companies with hopefully higher growth. Most of my models, for example, in my reverse DCF in my earnings growth model, I use the assumption that valuation will come down, so the exit PE will be lower than the forward PE today, for example. But as long as the intrinsic value can keep growing at very attractive rates, it’s not a very big issue, because in the long-term, it’s mainly the intrinsic value that will determine the stock price if you keep it long enough.
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Tobias: I’ve got a really good question– [crosstalk]
Jake: [crosstalk] any–
Tobias: Sorry, JT.
Jake: I was just going to ask any thoughts on, Margins for the S&P have been quite high for a while, historic anomaly high. But back below, I think we peaked at 13.3 a couple of years ago, back down around 10-ish now. I don’t know which way it goes from here, but any thoughts on the whether that can sustain or if that– Because that could also turn into another headwind that you might face just everyone is– Corporate America is just generally less profitable than they were when you had tax rate changes that really helped, a lot of favorable, low interest expense also helped. Every lever was pulled in the direction of Corporate America there for a while.
Tobias: Lot a stimulus too
Jake: A lot of stimuli too. Yeah.
Tobias: It cannot just show up. It does show up. It’s an accounting identity, as John Hussman points out.
Jake: Right. So, if you have to give any of that back, what– [crosstalk]
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Why S&P 500 Margins Don’t Matter in a Bottom-Up Stock Picking Strategy
Pieter: Yeah, exactly. I think to put it bluntly, talking about how the margin of the S&P will evolve over the years, the answer would be don’t know, don’t care, I guess. Just because it’s mainly focused really the bottom-up stock picking strategy. And for example, in the quality field, you try to exclude all cyclical companies. Obviously, when you talk about, for example, the profit margin or free cash flow margin of the S&P, those cyclicals affect the average free cash flow margin there.
So, I just care about, yeah, how the margins of the companies within your portfolio did in the past and then your expectations for the future. I think that’s also one of the essentials for quality investors. Well, what are you looking for? High and sustainable return on invested capital large than 15%, and a high and sustainable gross margin of larger than 40%. When that’s the case, then it’s already a serious indication that the company has a moat or a competitive advantage. So, that’s exactly what you want. You probably also have read the studies from Chris Mayer, and they have a lot of great multi-bagger studies.
It’s also, how do you create a multi-bagger? It’s usually a small company that can grow at very attractive rates, that can grow or even double its margins and then the force be or whatever the valuation doubles. It’s a multiplying or an exponential effect you have right now.
Yeah, regarding the S&P, obviously, right now, I think over the past 30 years, it has never been the case that the top 10 largest companies accounted for such large weights within the S&P. And then you have all those big tech companies. Obviously, those companies are very capital light, their profitability is very high, which will probably also have resulted in a higher or somewhat higher average profit margin and so on for the S&P. Yeah, let’s see how things evolve there.
But the general approach, I guess, is to make as little assumptions as possible and then go from there. So, we will see. It was JP Morgan who said, “What will the stock market do tomorrow? It will fluctuate.” Well, same will happen with S&P and the margins. So, yeah, happy to follow everything. It’s very interesting, but mainly interested in the margins of your own companies.
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Tobias: I’ve got a good question here from Tyler Pharris, who’s unpaid producer. He’s got a good question.
Jake: To be fair, we’re all unpaid here. So, it’s fine.
[laughter]Tobias: The outperformance of quality suggests that it is persistently discounted in the market in the sense that folks aren’t paying up enough for it. It’s a funny phenomenon, because the names of the companies that are generally regarded as quality companies, for the most part they’re pretty well known because a lot of them are consumer facing. So, what’s the reason for that persistent quality discount? Do you think that continues into the future as quality becomes more well known?
Jake: Why is it not ARB’d away?
Tobias: Yeah.
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Adapting Your Investment Strategy: Evolving with Market Changes
Pieter: Yeah, sure. So, I think, for example, once again compare value with quality investing, well, for value investors, the margin of safety is at a low valuation. So, what you do is you try to buy a company. You think is cheaply valued; you buy it. If your investment is correct, well, the under valuation goes away, and stock goes up and you sell the company because it’s fairly valued and you do it again and again and you need to find a new undervalued company.
With quality investing, well, your margin of safety is in the moat. When your assumption is correct, when your homework is correct, and indeed the company has a sustainable competitive advantage and they had a competitive advantage 20 years ago, they have one today. When it still has one in 20 years from now, that usually means that they are very strong in their business and that they indeed are able to grow at above average rates for very long periods of time, then you come back to the DCF example for UF, we talked about Visa, Mastercard, same for S&P Global and so on.
S&P Global was the market leader 20 years ago. They are the market leader today. They got a lot of bad stuff going on during the financial crisis, but even that didn’t manage to take away their dominant position, basically. So, also, likely that in 10 years from now, in 15 years from now, it’s still the case.
For whatever company that’s in the stock market today, when you with run a DCF, that’s where the company can go at the above average rates for 15 or 20 years, almost every company looks undervalued. Obviously, that’s a very dangerous thing to do, because when a company loses its moat, the valuation comes down and the growth comes down. So, it’s a double-edged sword in a negative sense. But I think that’s what’s really happening.
There is an example, when you would have bought the S&P in the 30s at five times earnings, so that’s the best possible moment you could have ever bought the S&P, and you would have sold it just before the dotcom crisis at 30 times earnings. So, you have multiple expansions that went six times as high. Your return would be around 12% per year from 1930 until 2000 or 1999. Only 1.5% to 2% of that is for multiple expansion. All the rest is from the growth of the intrinsic value.
So, when you have an investment horizon of 10 years of more, the intrinsic value is truly what matters. When you have a period of one year, it’s the multiple expansion or the changes in the valuation, that’s what matters the most for pure old school value investors, in the Benjamin Graham sense of the word. Then in the medium term, it’s more than the earnings growth and so on. And then on the very long-term, it’s more the culture of the company, the value that is created. So, I think that’s what’s happening.
Many people still see Warren Buffett as a classical value investor. But what he even said in his letter, in the Shareholder Letters of 1979 is that, “Well, I’m looking for companies with a return on equity that has averaged more than 20% over the past 10 years. And second condition, while the return on equity could never be lower than 10% per year.” Well, those are basically things quality investors are looking for. So, Buffett has already been doing that since he bought See’s Candies in 1972, and it has been huge for him.
But I also think, for example, look at the situation 50 years from now, value investing works really well. Value investing in the classical sense of the word, the Benjamin Graham style. Right now, over the past few decades, quality investing worked really well. I think it’s also really important to keep evolving, and keep slightly tweaking and working on your investment strategy, because it’s quite sure. For example, I hope that in 20, 30, 40, 50 years from now, I’m still using quality investing, but probably the strategy will look slightly different compared today, because obviously you keep learning, or hopefully you keep learning.
Second thing, that the market also keeps changing. Even the best company in the world, even the best quality stock in the world can be a horrible investment if you hugely overpay for it, obviously. So, there definitely is a point for companies that it’s just not worth buying them anymore, because the valuation is so ridiculous and there are plenty of examples like Hermès, like Copart, like [unintelligible 00:33:06], and so on that’s high core that I would love to buy, definitely or at least in my opinion, are quality stocks, but just the valuation is too high, in my opinion.
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Cybernetics as a Mental Model: Understanding Systems and Control Mechanisms
Tobias: We’re at the top of the hour, JT. You want to give us some vegetables?
Jake: Yes, if you’re hungry for some vegetables. So, we’re going to be talking about cybernetics today. I’ve been learning about it, recently, starting at a complete zero literal knowledge. In fact, embarrassingly, I wrongly associated it with Scientology, which apparently Hubbard called that Dianetics. I had those two confused in my head for whatever reason. But really, I read this interesting book called The Unaccountability Machine by Dan Davies. It introduces cybernetics, and it ties it into modern decision-making systems, like governments and corporations and committees. So, I feel rather foolish that I’m so late and have been ignoring this really interesting mental model, which is really it’s just the study of decision-making systems.
So, let’s do a little history lesson on cybernetics first to set the table. Norbert Wiener is the father of cybernetics. He was a child prodigy. He got a bachelor’s degree from Tufts at age 14. Did graduate work in zoology at Harvard and philosophy at Cornell, all before he was 17. Then he traveled to Europe, and learned from Bertrand Russell at Cambridge. And then he had a brief stint as a soldier in World War I. And then he eventually ended up teaching math at MIT.
He had this book called Cybernetics: Or Control and Communication in the Animal and the Machine. It was a pop science hit in 1948. It was really an outgrowth of Wiener’s World War II research, where he worked on automation and feedback for anti-aircraft guns. So, he invented this automated gun site that could predict the movement of an enemy airplane and aimed sufficiently ahead to compensate for the flight of the bullet. So, his book was one of the first to put forth the ideas of thinking machines. And so, I think that’s probably where that Terminator cybernetic organism comes from. It’s like this thinking machines.
But it turns out that cybernetics and Wiener were inspired, actually, Claude Shannon’s information theory in a lot of ways. He also discussed the modeling of neurons with John von Neumann. He’s pretty legit, dude. As you know, Shannon laid the groundwork for understanding how information can be quantitatively measured, and efficiently communicated and bringing in concepts like entropy, like the loss of information.
Wiener integrated a lot of things from information theory as well to explain how systems use feedback and control to process information and maintain stability in a way fighting entropy. And so, it’s actually a very Mungarian adjacent concept. It’s interdisciplinary study of systems and control and communication in animals, machines, organizations and focusing on how they regulate and adapt to achieve goals. So, it’s like a legit mental model to have in your lattice work.
This has all been probably a little too theoretical. So, let’s give a practical example of what cybernetics looks like. It’s your home thermostat. So, the system’s goal is to maintain a desired temperature in your home. It uses sensors, like this thermostat, to measure the current temperature. And then there’s usually a feedback loop. So, if the temperature deviates from a set point, thermostat sends a signal. And from these feedback loops stems regulation and control, so the heating or cooling system comes on and adjusts the output to bring the temperature back to the desired level, shuts off when it reaches a set point.
This allows then adaptation from the system to continuously monitor and adjust to maintain this temperature, not regardless of what’s happening with the external environment. So, this process of sensing, feedback and control are the core principles of cybernetics, and it’s a decision-making system in that way.
So, let’s dive a little bit deeper into the cybernetics pool here. We have this guy. It’s called Ashby’s Law of Requisite Variety. All right, a lot of big words there. What does it really mean? It’s the first law of cybernetics. It states that only variety can absorb variety. In this context, variety refers to the number of possible states or the range of behaviors that a system can exhibit. So, higher variety means there’s more options or responses available to the system.
Said more simply, really, there has to be a matching of complexity between the system, the decision-making system, and its external environment. So, any organization or machine or biological entity, it has to have a range of responses that are at least as diverse as the range of challenges that it encounters from its environment. Otherwise, it’s unable to cope with all these possible disturbances and it leads to eventual failure.
All right. Let’s explore some actual real-world examples. Imagine traffic. A city’s traffic lights, they don’t have sensors. It’s not smart. There’s no real time, like tweaks that it can do. The variety of traffic patterns that can happen then due to rush hour accidents, road work are greater than the fixed responses of the traffic lights. The consequence then you get traffic congestion, increased travel times, gridlock.
All right. Next, let’s say education. Let’s say an educational system employs a one size fits all method without accommodating different learning styles of students or the changing demands of occupational skills from the real world. The variety of the students learning abilities and preferences then can exceed this uniform teaching approach. So, the system isn’t keeping up with reality, and the consequences that students struggle to learn, there’s disengagement, dropouts and probably a bunch of debt that’s incurred for skills that aren’t in demand in the real world, like sound, kind of familiar.
Now, let’s shift back to finance and talk about debt. Debt actually comes up in the cybernetic research as a control system for the corporate organism. It’s kind of interesting. So, it could be a forcing function on management to trim largess corporate perks in order to create the cash flow necessary to service the debt. In the 1980s, this was the argument commonly by private equity especially, was that–
They were probably a force for good at that point, acting against all this corporate lazy balance sheets and entrenched management, private jets, expensive art hanging in their offices. These corporate raiders came in and they used debt as a control mechanism really to rein in these coddled management teams. But of course, a good idea can be taken too far and too much debt, and you end up starving the company of needed resources to invest for the creation of tomorrow’s cash flows because you’re only servicing the interest expense of today.
So, beyond a certain point then debt really becomes a pure instrument of control. If a creditor isn’t paid, the bank or whoever it is, can take over, break up the company, fire management. It has a very drastic effect on the viability of the system, which is really what cybernetics is all about. And so, I hope you enjoyed this new little mental model possibly added to your arsenal that I didn’t have until recently.
When you think about it, you start to look around and you see all of the control systems around you, they’re trying to manage a system. And even just the idea that if the control mechanism is not sufficiently complex as the environment that it’s operating against, that’s what leads to failure. Once you have that concept in your head, you start to see it all around you.
Tobias: That’s a good one, JT. What was the gentleman’s name?
Jake: Norbert Wiener was the father, but Ashby was the guy who came up with that first law of cybernetics.
Tobias: That was an impressive CV that he had– the impressive academic record.
Jake: Yeah. No, he was legit. Yeah.
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The Power of ‘I Don’t Know’: A Logical Riddle to Test Your Reasoning Skills
Tobias: That was good stuff. This is a little bit of a nonsequitur, but I saw a little riddle the other day that I thought was interesting about the power of “I don’t know.” So, there’s two logicians, and I won’t ask you two guys to give answer to this, because I had to write this down to figure this out. But I did ask my nine-year-old son, and he answered off the top of his head and got it right. So, it is possible.
This is the riddle. There are two logicians, which means that they’re able to reason perfectly, they’re not going to make any reasoning mistakes, who sit down facing each other and they have each chosen a number between 1 and 30, and they don’t know the other’s number. So, the first says, “Is your number double mine?” And the second says, “I don’t know.” Second says, “Is your number double mine?” And the first says, “I don’t know.” The first says, “Is your number half mine?” And the second says, “I don’t know.” The second says, “Is your number half mine?” And the first says, “I don’t know, but I know your number and I know my number.” So, you have to be able to figure out what the two numbers are. Put your answer in the comments, and we’ll take a look. Next week, we’ll give the answer.
Jake: Wow.
Tobias: So, my nine-year-old got that off the top of his head, but I had to sit down with a pen and paper and cross out all the numbers. But it is achievable on that information.
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Building a Winning Quant Strategy: Combining Value, Quality, and Momentum
Tobias: Let me ask you, Pieter, while everybody’s figuring that out, do you look at the factors for quality? Do you have any views on the factors.
Jake: Like, [unintelligible 00:42:36] type of work?
Tobias: Quality factors.
Jake: Is that what you’re referring to?
Tobias: Yeah, like a factor ETF or the academic factor for quality, which I think AQR has done a lot of work on.
Pieter: It’s quite funny that you ask, because quite some time ago, I actually did my thesis about quant investing and also built my own quant model as well. So, obviously, big fan of what works on Wall Street, and the factors and so on. It’s also definitely something I truly believe in. Also, just the quant strategy, what I learned, or at least one of my conclusions during my thesis was, you can build a quant strategy based on the combination of value and quality, for example. But when you add momentum to a quant strategy, well, at least in all the back test side that used to work very well.
I think when you look at your own strategy, well, in some sense, you are using also a factor or quant approach, because first thing you do is using a screener where you screen for a high return investment capital, high profit margin, a healthy balance sheet, attractive outlook and so on.
For me, also, on the website right now, there is, for example, an ETF portfolio. I think that for many investors, it’s a great idea to just buy an index fund, sit tight or relax and let it do its magic. But I also believe in the fact that it’s also what I do with my ETF portfolio is that you can make small tweaks or use small factors that are able to do better than the S&P 500, for example, in the long-term, just think about, there are examples of ETF’s who invest in US small cap stocks with a quality tilt or exclude all companies that have a negative free cash flow.
Well, from a rational point of view, from logical thinking, it makes complete sense that those kind of ETFs can do quite well. And then you have indeed the efficient market hypothesis, and so on that says, “Okay, smaller size is a risk factor, quality is a risk factor and so on.” Yeah, volatility isn’t risk. The only risk is a permanent loss of capital. I don’t see those kind of factors you are using as serious risk factors. So, I truly believe in that. You have small cap, you have a quality tilt, you can do the mid cap quality funds, you can invest in ETFs that only invest in companies with a moat, for example. Those are small tweaks that used to do quite well in the past on the stock market.
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Beyond the Numbers: The Value of Qualitative Criteria in Quality Investing
Jake: Let me ask you this. I have some friends who are super thoughtful and tend towards quality investing. One of them uses the analogy of branches and roots. And so, branches of the tree are things that you can see, like high returns on invested capital or smart capital allocation decisions. Everybody knows those things. Like, they’re quantifiable, they appeal to our logical brains. But the roots of the tree in this analogy are– There’s some essence to a company, something deeper, that’s a quality to it that is hard to define and maybe even non-verbal actually. There’s some deep pattern matching, that there aren’t words for it maybe. Do you think that there’s room for intuition in evaluating quality, or do you need to see numbers only? If the market can read numbers, isn’t it more likely to be arbitraged away if it’s just purely looking at return on invested capital versus I know the essence of this company?
Pieter: Yeah, it’s interesting. Together with Luc Kroeze, I worked on The Art of Quality Investing, and all credits to him. He did 99.99% of the work. So, credits to him and kudos to him. When we just look at the book structure, it’s usually just first part, qualitative criteria. Second part, quantitative criteria. And then the third part is valuation, how to build a portfolio, and so on. I think you are completely right. In today’s world, the quantitative criteria really easy and everyone can screen for them or filter for them in a few minutes.
And then you have the qualitative part, which is hard to write, and then you really need to do your own homework, like, okay, for example, sometimes in the numbers, you can already see that the company has a moat, like their return invested capital, the gross margin. But what’s underlyingly the reason that they have a moat and how sustainable is it, what’s the risk of disruption? For example, Netflix evolved from handing out or mailing out DVDs to the largest subscription company in the world. Amazon went from a loss-making online bookstore to the largest e-commerce company in the world. Other side of the story, you have Kodak or Nokia, which were completely disrupted and went out of the market.
So, the qualitative criteria are definitely very important. They are the most difficult. That’s I think why you really need to do your old school homework, in a sense, that reading the 10-Ks, reading all the earnings call transcripts, talking with other investors, talking with experts and do industry calls and stuff like that, so that’s probably where the real difference is made as well. And that’s something that AI won’t be able to do, I think, also not in 10 years from now.
As an investor, you can have three kinds of advantages. You can have analytical advantage that you are able to better analyze a company. Could be that it is the case for you, but it’s hard, for example, in big tech companies. You can have an informational advantage, but I think that’s also very hard to have in today’s world, or at least if you’re not using insider info or something like that.
Well, third advantage you can have is just a behavioral advantage. So, like we discussed, well do nothing, don’t trade too much. Try to be rational, stick to your investment strategy also, when things start to get tough. That’s probably where the real difference is made for investors. But the qualitative part is definitely something that is very important as well.
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Why Intrinsic Value Growth Trumps Multiple Expansion in Investing
Tobias: What do you think is– Sorry, JT. You go.
Jake: Well, I was just going to follow up with, I think one of the things I’m interested to see over the next decade to watch from professional investors is that if you do have, let’s say, more general difficult economic than we had the last decade, if we have valuations come down, so you have that headwind that you’re fighting against, and if you have a decade of really that in a lot of ways could look like a lost decade, just coming off of the 1999 to 2009 was a lost decade, it’s one thing if it’s your own portfolio, and you’re sitting there and you know the company so well, because you’ve done all this work that you have this qualitative intuitive feeling for it. But if you are managing other people’s money and you’re trying to bring them along for this decade of headwinds, do they have the same type of perseverance? Because by definition, they haven’t probably done the work that you have on that company.
And so, if you can’t point them to the branches, if it is the roots that they haven’t dug in to see and the branches are what they are, but the returns are not there because you’re fighting all these headwinds. I’m going to be very curious to see over the next decade what the appetite looks like for quality investing, just based on some of these psychological things.
Pieter: It’s an interesting point. For me, personally, as long as the owner’s earnings or as long as the intrinsic value keeps growing, even then when you have some headwinds from multiple contraction, it isn’t a big issue for me. For example, that’s also something I say on the websites, to readers, to partners. Well, when you, for example, would back test the strategy, I’m using right now and the criteria you use and so on, well over the past, since 2000 more or less, the strategy compounded by 18% per year.
Is this something to expect for the future? Absolutely not. But you also don’t need to compound at 18% per year, if you have some multiple headwinds. And it’s 12%, well, I would sign for that. That’s an excellent return when you can have that for 10 years or for even longer. So, yeah, multiple expansion. No, probably not. But as long as the intrinsic value keeps going, I think it’s a very valid strategy and it will remain a strategy that keeps working over the next few years and over the next few decades.
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The Appeal of Niche Market Leaders: Case Study of Games Workshop
Jake: Any concerns about technological disruption and the pace of that increasing that then shortens the competitively advantaged period that you’re underwriting?
Pieter: Yeah, every company is a tech company, most people say. That’s also something why, for example, I’m very cautious or very ready to own companies in cybersecurity and even AI. But it’s even one step further, because it’s very hard to try and determine how the industry there will evolve. Well, what happens as a result of that is when you are looking for those quality companies and you want to be able to make an educated guess about how the company will look like in 10 years from now, and you are managing or using smaller amounts of money so you can look into small and mid-cap space, in that case, you usually arrive at companies that are market leaders in a small niche market and they completely dominate that market.
So, that’s a lot of companies within the watchlist, for example, are companies like that. You have an example like Games Workshop, who actually published its results today. Well, what does Games Workshop do? It’s UK company, and they are basically producing miniatures for board games.
Jake: Yeah, Warhammer.
Pieter: Basically, it’s also a fun story. When I went to a party of my girlfriend’s family for the first time a year or a few years ago, someone was interested in the stock market. Well, we started talking. And then all of a sudden, I started talking about Games Workshop. Not sure how we arrived there, but then all of a sudden, he was yelling all over the table, “You are a crook. You know that you are a jerk.” This is my first time–
Jake: Or, for charging me.
Pieter: This is the first time at the family I want to make a good impression. And then indeed, all of a sudden, he started laughing. “Well, you are selling to people that are as addicted as cigarette consumers [Tobias laughs] in the sense that those are usually people that are completely into these board games. They want to buy the miniatures, no matter what.”
Every single year, Games Workshop increases its prices by 5% or 6%. They still keep growing a bit, and just very loyal customers. They have a lot of pricing power. They still can grow. They buy back shares and so on. Those are also examples of some kind of companies you used to arrive. As a quality investor, and for one second, leaving the ethical aspect aside, when someone says to you, “Well, the customers are as loyal as cigarette users,” that’s something [chuckles] that’s good to hear.
Jake: Put your buy order in right there.
Pieter: [chuckles]
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Jake: It’s not entirely clear to me that modern capitalism works without dopamine hacking, really.
Pieter: Yeah, exactly. So, that’s also the interesting thing. You always keep learning. You keep expanding your knowledge. Without that, you will make plenty of investment mistakes in the years ahead. Everyone will do that. But at least or if you can be right 6 times out of 10, then you’re probably a very good investor. That’s why you try to achieve. It’s also for me, the company quality portfolio started one year ago, and then performance has been good.
You also see that the majority of the returns has been driven by just two companies. So, that’s also the case there. You have a few big winners who basically make up all of your return. And yeah, if you can be right 55% or 60% of the time, I think then you probably are a very, very good investor already.
Jake: [crosstalk] done some work on this, haven’t you, with especially when never sell was super popular, you did some portfolios?
Tobias: I think that anything over 50% is elite. Even low 50s, 52, 53 is a very high hit rate. Last question that I had, where we’ve got about four minutes, Pieter. But “As a representative of qualities, is there a better representative than LVMH?”
Pieter: Is there a better representative? Yes. Disclaimer. I own LVMH, and I think it’s an excellent business. Yeah, I can give some names of quality companies, but I think indeed–
Tobias: Yeah.
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Exploring Kinsale Capital’s Superior Underwriting and Market Growth Potentia
Pieter: Yeah. [chuckles] Bernard Arnault is richer than Warren Buffett. The conglomerate, they will keep growing. Right now, they are suffering a bit from– During COVID, margins expand heavily and they are struggling a bit there that there might be some margin contraction. Well, maybe another example I can give is, it’s one that published its results last Friday. It’s one that ticks all the boxes in my case. So, quality business, owner-operator and then valuation it went up. Last Friday, it published results, it went up 17%. It’s Kinsale Capital. I’m not sure if many people know them. So, it’s an E&S insurance company in the US. So, they basically specialize in ensuring special risks.
So, for example, when you have a car driver who has had some accidents and he’s refused by basically all car insurance, well, they come to Kinsale, they pay a very expensive premium and they go there. Right now, the CEO and founder, Michael Kehoe, he found the company, still owns a significant share. He wants to double its market share over the next 15 years, or at least within 15 years. They have the lowest combined ratio in the industry. So, a very attractive business, if you ask me. It reminds me a bit of the progressive story of Buffett in the sense that it’s the same there. Their underwriting is superior. They are consistently taking market share. E&S insurance market is growing at faster rates than the general insurance market. So, it could be a very interesting one.
To give another indication, for example, the website, a few months ago, we did a one on one with the CEO. Obviously, it’s an insurance company. So, they also invest money. Two things, right now, they are more and more investing in equities or increasing their exposure towards equities. So, then you get a bit of the Berkshire [unintelligible 00:58:36] or whatever. The second part is, right now, their equity investments that are outsourcing everything to Blackrock. When some partner asked, “Well, when are you going to insource or inhouse the investments?” Well, right now we are managing around $5 billion when it’s about $15 billion, we will do that. So, that will be probably something within the next five, six, seven years. So, it gives an indication about the growth path that is still there.
Yeah, third point, obviously, the valuation right now is definitely not cheap, especially not after the 17% increase last week. But it’s definitely a stock that if the market gives opportunities and it will give it one day without doubt that it’s a company I’m very interested to keep adding to that position.
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Tobias: A great answer. Pieter, if folks want to follow along with what you’re doing or get in touch, how do they go about doing that?
Pieter: Probably best way is just via the website, compoundequality.net or obviously, on Twitter, @compoundquality. I’m always happy to help and answer certain questions when I can. It’s always very lovely to meet other investors, and share ideas, and so on, so we all keep learning.
Tobias: And the book is The Art of Quality Investing.
Pieter: Exactly. I’m not sure whether we can show it with the background.
Jake: [chuckles] [crosstalk]
Pieter: [chuckles] No, it’s available on Amazon. So, The Art of Quality Investing.
Tobias: Great job. All right, folks, we’ll see everybody here next week. Thanks, JT. Thanks–
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