In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Ben Beneche discuss:
- Use Owner Earnings and Opportunity Cost to Drive Valuation Decisions
- Invest in Durable Brands
- How Language Reveals Management’s True Commitment to Shareholders
- Knot Theory Meets Private Equity: The Takahashi-Alexander Model Explained
- Lessons from the Magnificent 7: Spotting Future Giants in the Market
- Japan’s Hidden Gems in Retail: Cosmos Pharmaceutical and Genky DrugStores
- Undervalued and Overlooked: The Case for UK Mid-Cap Investments
- Howdens Joinery: The UK’s B2B Answer to Home Depot
- Masayoshi Son’s Vision for SoftBank: Growth or Bankruptcy?
- How Admiral Group Built the UK’s Most Profitable Auto Insurance Model
- Japan’s Corporate Structure Prioritizes Collective Good Over High ROE
- How Tourbillon Filters 70,000 Companies to Find Quality Investments
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: It looks like we’re live-
Jake: We’re live.
Tobias: -which means this is Value: After Hours. I completely forgot what it was that we were doing here. Value: After Hours. I’m Tobias Carlisle, joined as always by my cohost, Jake Taylor. Our special guest today is Ben Beneche, and his firm is Tourbillon Partners. How did I go with that pronunciation, Ben?
Ben: Awesome, Tobias. You nailed it.
Tobias: Do you want to give us the authentic French version of–
Ben: Yeah. We’ll go with Tourbillon.
Tobias: There we go. Tourbillon. That sounded much better when you said it. I should have had you you introduce it.
Jake: Yeah.
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How Tourbillon Filters 70,000 Companies to Find Quality Investments
Tobias: Ben, welcome to the show. Would you please give us a brief introduction to Tourbillon and yourself, and we’ll go from there.
Ben: Yeah, sure. So, Tourbillon is an offshore fund. We invest globally in pretty small number, 15 to 25, what we view as durable businesses. We skew smaller and mid-size than most of the companies we look at. Now, that’s not necessarily by design. We try and step away from standard definitions of small and mid-cap or growth and value. But the simple reality is 70,000 companies listed globally, there’s more small ones than big ones. So, that’s where we’ve tended to find opportunity.
We’re also invested pretty heavily outside of the US. So, only about 20% of the strategy today is invested in US listed companies. About 45% in Europe, and I’m including the UK in that number [Jake laughs] and around 20% in Japan. And then, there’s a few characteristics that we look for in order to find durability.
We don’t start with quantitative backward-looking measures. We have a couple of, what we think are, pretty core fundamental truths, one’s built around the idea of scale. We call those symbiotic loops, but typically found in businesses in certain retailers, certain low-cost financials, where they have a real scale advantage and share that with the customer. And then, the other idea is around scarcity. We call that fulcrum assets. But basically, companies which have a product or service that has no close substitutes in the eyes of customers. So, that can be tangible.
[unintelligible [00:02:32] is obviously the usual example. But it can be metaphorical, it can be a certain brand. So, that narrows down the 70,000 companies to a more manageable list, a couple of hundred, which we feel we understand that a good representation of those ideas.===
Use Owner Earnings and Opportunity Cost to Drive Valuation Decisions
Tobias: When you construct a portfolio, what is the sizing at initiation? How big would you let something get? What’s the criteria for buying, and selling and so on?
Ben: Yes, I mentioned 15 to 25 investments total. That’s pretty top end skewed, so 80% of the assets are in the top 10 investments. Then, we think there’s some value to having a tale of smaller investments where reduce the mental friction associated to being able to increase or decrease the size somewhat quickly as a behavioral element as opposed to a purely rational type of thing.
But the sizing beyond that is driven by, A, our approach to valuation. We like to see cash flows upfront as opposed to somewhere in the ether. So, we just think about basically normalized free cash flow yield this year or next at the very latest. We call that owner earnings, but it’s pretty much synonymous.
We’re looking to buy things that are owner earnings yield somewhat better than effectively what our opportunity cost is. For us today, that’s around 6.5% things that we understand and pass our criteria, but it definitely has to better than long-term cost of money. So, call it 4% today in the US, 5% very, very long-term. So, we’re trying to buy a lot better than that and sell when you’re getting down to the 3% type of range. So, sizing is a function of that valuation.
And then, we also implement a checklist. So, borrowing from Daniel Kahneman System 1, System 2 type of thinking, we’re trying to bring some of these things account, but can’t be counted into the realm of something, and make sense of and actually quantify or at least form a discussion around. That checklist is married with evaluation to bring us an idea of where we should be sizing or at least what we should be thinking about when it comes to sizing decisions.
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Jake: Ben, in your letters, you have this cool chart that shows entry and exit based on earnings yields. Could you explain that, and what the thinking is behind it?
Ben: Yeah. So, we tend to buy things on average at around a 7.5% or an 8% owner earnings yield. We’ve been selling things when they get to around the 3% type of level. So, although our primary filters, the way we get from 70,000 companies down to a more manageable number, is more qualitative, it’s about business endurance more than anything else.
Beyond that, valuation is an important component. That’s where we’re really thinking about that owner earnings yield, plus the long-term growth of the business to drive our return. We’re not counting on a certain cap rate at some point in the future or a multiple. We want the business to do the heavy lifting for us. Really, that’s the thinking around it.
Tobias: Ben, we’re getting a note that you’re a little bit quieter than us. Is there some way you can-
Ben: Yeah, I can hold–
Tobias: -boost your mic a little bit?
Ben: Totally. Let’s try that. If not, I’ll just speak up.
Jake: Project.
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Invest in Durable Brands
Tobias: Durability is something that I’m particularly interested in. But how do you think through durability? What are the indicia of durability?
Ben: So, look, it’s those two ideas I mentioned are the two that really count to us. So, it’s really putting yourself in the shoes of the customer. The only way we feel you can create durable value in the world today is pretty much through having real value for the customer and then, it comes back to these ideas of scarcity or scale is something better. So, you’re willing to pay more for it over time. That’s in the eye of the beholder, but a buck in bag, I don’t know, my wife would probably suggest it’s worth quite a bit of money. [chuckles]
Tobias: Exactly what you have to pay for it.
Ben: I don’t agree on the value that she ascribes to it, but again, there’s a market for it. They carefully nurture that brand. Hermès famously, a few years ago, had a very successful line that was made out of cloth and sold for a few hundred bucks. It was incredibly successful. Instead of pushing the foot on the accelerator and selling more of them, they cut the line, because it was diluting the brand. So, you want management teams who really understand what they’re sitting on and nurture that advantage they have over the long-term instead of profit extracting today.
The same goes for the scale advantage, whereas the idea of scarcity is something better, scale is something cheaper. Everyone knows the example of Costco. I’m not going to talk about valuation there, but the reality is the company runs at, what was it, 12% or 13% gross profit margin. That’s probably close to eight points better than even Walmart, but much better than most other people. They’re not profit maximizing. They’re reinvesting over the long-term and preserving that value proposition.
So, when we’re thinking of durability, we’re thinking of companies who have that advantage and then have a stewardship team, a management team, who are nurturing that advantage. That looks a little bit different in different sectors. I think the hallmarks of seeing that, I don’t think there’s a screen that can really give it to you. It takes a degree of experience in individual industries to get that insight. But that’s really what we’re looking for.
Now, a history of having done it for a long time is great. Everyone’s familiar with the Lindy effect. If something has lasted for a while, it’s likely to last going on into the future, that’s also great. But we focus more on those first principles more than anything else.
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How Language Reveals Management’s True Commitment to Shareholders
Jake: What do you look for with management?
Ben: Look, skin in the game is great, but really, we want management who have an intangible insofar as they’re obviously thinking for the long-term. They’re willing to make those trade-offs which are maybe hard today, but which are in the long-term benefit of the business.
So, the obvious thing is management teams, who don’t employ too much leverage. In the US, almost every company we look at is optimized to within an inch of its life. In many cases, it’s great while it lasts, but you have a small hiccup and it’s one thing that you learn, I think when you’ve done this business for even a short period of time. You realize that black swan events, 25 standard deviation away from the norm stuff happens all the time, and you don’t want management teams who are going to stumble at the first hurdle. So, it’s a conservative balance sheet. It’s skin in the game. It’s a history of strong capital allocation.
On the intangible side, it’s management teams, what I’m kind of a sucker for is management teams who talk themselves down. I remember Mark Leonard for years would say how expensive his stock is. It might be now. [Jake laughs] It probably wasn’t 10 or 15 years ago with the benefit of hindsight, looking at how cash flows did evolve over time. Management teams who talk down their prospects, talk about their failures as much as they talk about their successes. These are intangibles that are actually quite rare. I can count on the two fingers of two hands and maybe my toes, the number of management teams who actually do that.
Jake: I’ve discovered one little hack, little secret tip, in how management talks about the company or the assets. The worst is when they say, “My company, my assets, my employees,” whatever, next best is our company, “Our assets. That’s a little bit better.” And that’s what average looks like. But the best, and you’ll hear Buffett when he’s talking at the shareholders meeting, is he say “Your assets, your company, your employees.” I think there’s a little bit of tell there in how the management even discusses what they’re in charge of that stewardship.
Ben: Yeah, that’s totally true. If you’re actually thinking about investing in public equities as a permanent owner, that’s how we like to think. You’re expecting to get your return from the business, you need to trust the people in charge. If you pay, let’s say, a 6% earnings yield or free cash flow yield and it’s growing 6% a year, if you assume no exit value for that business, it’s taking you well over a decade to earn a return and probably a couple of decades to earn a 10% IRR. You’re just relying on the cash flows. If you don’t trust the people in charge to make that accrue to you in some way or another, some point in that journey, what’s the point? You are in the greater full game. I don’t really want to play that game. [chuckles]
Tobias: It’s been working pretty well for the last 15 years– [crosstalk] [laughter]
Jake: Somehow there’s always another fool right behind this.
Ben: I know.
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Tobias: Many more than any of us could have possibly imagined. [Ben chuckles] Before you started Tourbillon, what was your background? How did you get to that point?
Ben: Yeah. So, I’ll start briefly right at the beginning. So, I was born and raised in France, French father, English mother. My father was an entrepreneur. He was a businessman. He was, I guess what you’d call, a value-added reseller today in IT. But at the dinner table, we always talked about business and investment. That was the common language we had and I always found that particularly interesting.
I wasn’t always the best student. I was a decent student, but I was always pretty handy when it came to business, economics and history. Parlayed that into university. And then, in 2008, joined the place called Pictet Asset Management, where I started as a young equity analyst, a generalist, ended up specializing in oil and gas. This was when the oil price was running high, 120s level. And then, in 2012–
Tobias: You’ve seen it 120 to 0.
Jake: Yeah, negative 35.
Ben: Yeah. Well, exactly. I had brilliant timing with that one, [Tobias laughs] because in 2012, I was asked if I’d like to become a portfolio manager on a pretty large few billion-dollar international equity fund with specific focus on the Japanese part of the fund. I was way too young for it, but no one else wanted to do Japan in 2012 before Abenomics, this was post Fukushima lost a couple of decades.
So, I jumped at the chance. And then, for the next 10 or so years of my career was pretty much focused on Japan. Eventually, branched out and became co-head of the international equities team. But a large part of my formative years was doing Japan during the 2010s and through to 2020. And then, in 2022, decided I wanted to try and build a different type of investment operation alongside my partner, Ramesh, and we set out and built Tourbillon.
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Jake: How was your Japan experience over that decade? I know it wasn’t the most tailwinds. Like, value strategies over this entire 30 lost years have actually– They did just fine.
Ben: Mm-hmm. Yeah, I think for a long time in Japan it was actually– I’d never call it easy, but I think if you looked at the broad landscape of Japan, it’s around 4,000 or so listed companies and outside of the top 100 or 200 very well-known large companies, companies like Toyota, the trading companies, the banks and then in the more, let’s say, quality type businesses like Keyence or FANUC or something like that. Outside of that, there was a whole heap of really well managed businesses domestically which were trading at valuations that made absolutely no sense in relation to the intrinsic qualities of the business. Mostly– [crosstalk]
Tobias: Too low?
Ben: Too low. Too low. You were able to buy some of the Japanese drugstores, for example. And in Japan, some of the drugstores really are more like the hard discounters in the rest of the world. They do a lot of food and sundries. But great businesses which for 50 years had probably never had a down year in terms of earnings per share, but traded on high single digit PE multiples. And for no other reason than the fact that they always had, and that’s just the way it was.
And so, if you’re willing to do a little bit of Scuttlebutt research and look at those businesses from a first principles perspective, you could do really well, not just in a Japanese context, but relative to the S&P or any other benchmark you may choose.
So, that was the context in which I started doing Japan. It’s still very much the case today. I think over the past couple of years the small-cap Japan index, the Mothers’ Index, has probably underperformed the Nikkei by– I’m going to throw a number out there, but it’s directionally correct, 50%. Everyone’s become very enamored with weekend beneficiaries, companies which are restructuring, going from terrible to slightly worse. It’s left behind again a lot of these smaller domestic businesses which are, in some cases not all of them, don’t get me wrong, but in some cases, very well-run, great businesses.
Tobias: Ben, I know that you’re a native French speaker, because only a native French speaker could say Hermès and not Hermès, which all the rest of us who don’t speak French are compelled to say. [Ben chuckles] In Japan– JT, what was the name of the– What do you call the very durable, very long lived?
Jake: Shinise
Tobias: The Shinise. Japan seems to have many more of that shinise style business than any of us. I don’t know why maybe it’s because it’s an island. I don’t know why– Cultural maybe.
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Japan’s Corporate Structure Prioritizes Collective Good Over High ROE
Ben: Yeah. The history of Japan is really interesting. That kind of island Galápagos type syndrome where they became self-sufficient and built their own ecosystem. It started in the 1650s– from 1650 to about 1850 when an American came along, he’s called Matthew Perry and basically said, “You have– [crosstalk]
Jake: Friends? No, it’s a different one. Yeah.
Ben: Different Matthew Perry. But he came along and he basically said, “You’ve got to trade with the West.” He came with a few ships, and then he came with a whole armada of ships and then that led to the whole Meiji Restoration of Japan. But for 200 years, Japan was totally isolated from the world. They did their own thing. It’s obviously very homogenous from an ethnicity and cultural perspective as well. So, they’ve always emphasized their way, and they’ve always emphasized durability and they’ve always–
There’s this collectivism in Japan I think that’s not always particularly well understood. The common good is really emphasized. It’s an interesting anecdote I have there. Every year, they have a meeting, it’s called the Keidanren. It’s basically the government gets together, the CEOs and management teams of let’s say the top 1,200 or 1,300 companies, and they say, “This is what you’re going to do with minimum wages this year. Wages are going to go up by x percent.”
Everyone follows suit and does as they’re asked. But it’s this idea of collective good and watching out for your suppliers, your creditors, obviously your customers and employees, which is really prevalent and creates that durability which is bankruptcies and that sort of thing just don’t tend to happen.
Tobias: And yet, the stock market has underperformed for an extended period of time.
Ben: Mm-hmm. Well, the ROE suck.
[laughter]Up until recently. I think the changes that are happening now, a lot of them could end up being more one time in nature. You have a dramatically over capitalized balance sheet, you make it slightly less bad. Does that change every incremental capital allocation decision the management ever going to make? No, it doesn’t. That’s a deep cultural thing. But the reality is, yeah, if you pick the starting point of 1990, there’s been a significant amount of underperformance. A lot of it is warranted by, what has been, pretty terrible returns on equity.
Tobias: Plus, overvaluation at that starting point, right?
Ben: Yeah, exactly. That was a pretty tough time to start. I think since 2012, the market’s done probably quite well. So, yeah, pick your starting point. The valuations are still overall much better than what we can find. We’re not particularly comfortable investing in a lot of emerging markets. There’s a lot of places where we just don’t understand what’s going on. But from our perspective, Japan, and actually the UK are probably the two markets where the valuations are most appealing and where we understand the rule of law etc.
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Tobias: Just before we leave Japan, we were talking before we came on, the three breweries in Japan. Have they seen the same– There’s a trend away from macro to microbreweries, and just a general secular decline in the consumption of alcohol generationally, I think. Have they seen the same problems that the rest of the world has faced? Are there microbreweries in Japan?
Ben: None that I know of. I know in the US, you have– Is it Sam Adams? People like that who are listed.
Tobias: Yeah.
Ben: I’m sure there are microbreweries which exist, but there none that I know of which are listed. Sapporo is the more premium one. So, there’s Asahi, Kirin and Sapporo are the big three. Sapporo is more premium. I think they’ve done better from a volume perspective. But Asahi and Kirin have seen persistent volume declines.
In the case of Asahi, they’ve tried to offset that with acquisitions. They bought something in Australia, Carlton & United Breweries, overpaid for the asset almost certainly. But they’ve been trying to diversify away from the core market and at least buy growth elsewhere. The mixed results on average.
Jake: Isn’t that interesting though, like 1980s Japan acquisition was incredibly– Like, that was taking over the world. They were buying all these US assets. Everyone was worried about Japan taking over the world. And then, obviously, things got a little ahead of themselves, valuation wise, leverage ratio wise. And then, you pay the comeuppance of that for 30 years. But I don’t feel like you’ve really seen that kind of return of Japan Inc doing a lot of global acquisitions as much.
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Masayoshi Son’s Vision for SoftBank: Growth or Bankruptcy?
Ben: Outbound deals. The trading companies have consistently done it, mostly in the commodity space. They’ve done it quite effectively. They’ve done it and then, there’s a certain, Mr. Masayoshi Son.
Jake: Well, that’s a good point.
[laughter]Jake: Yeah, I forgot about that.
Tobias: Masayoshi Son.
Ben: He can’t be stopped. He’s a bit of anomaly. He views himself, I think, as an outsider in Japan. He’s ethnically Korean. He’s got a bit of a chip on his shoulder in a lot of ways. But you’re right, it’s not as pervasive as it was in the 1980s.
Tobias: Can that souffle rise a third time? What do you think?
Ben: I think SoftBank will either be the biggest company in the world or bankrupt.
Tobias: Yeah.
Jake: No in between.
Tobias: That’s bold, Ben.
[laughter]Ben: That’s the one prediction I’ll make. I’ve been fortunate enough to meet him a couple of times in the past, as well as some of the people who are running the Vision Fund, the CFO, Goto Son and Marcelo Claure, who was in charge of Sprint. It’s now merged with T-Mobile, obviously. But they’re smart people.
You have to think about where Marcelo came from. It’s been a bumpy ride, but he started off– I think he was at Berkeley, and he invented a pocket translator, which he sold to Sharp, I think. I think that’s right. And then, he parlayed that into a reseller of software in Japan. Then, he bought the defunct Vodafone assets in Japan and turned that into a viable, really strong competitor in the mobile space there.
He got away with Sprint. He managed to somehow make it work. And then, there’s obviously Alibaba and now, Arm are relatively good. So, he will almost certainly get close to bankruptcy again in the future. He just likes leverage too much, and that’s I think it’s his major flaw, along with trusting people who he thinks are similar to him. So, aggressive, visionary types. So, Adam Newman– [crosstalk]
Jake: The shining eyes.
Ben: He’s not the best judge of character in my opinion, [chuckles] but he does make moves. They’ve not all been terrible. So, yeah, my call is huge or bankrupt. [laughs]
Jake: It’s an inherent like Martingale strategy. It’s double or nothing [crosstalk] keep going.
Tobias: We’re going to get him for– Cents on the dollar when he’s close to the bottom for the option, like ride back to the roof. Nobody is doing well.
Ben: Well, I think he’s got these 100-year visions in terms of how he thinks the business will evolve and how the world might evolve around it. And then, he’s got four months of liquidity in hand–
[laughter]Jake: To get there.
Tobias: To [unintelligible [00:26:44] that up.
Ben: A duration, maturity mismatch going on there.
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Tobias: Let me give a quick shoutout to the folks who are playing at home, and then JT to– You want to do some veggies-
Jake: Yes, sir.
Tobias: -the top of the hour. Danny Beltran. First in the house in Santo Domingo, Dominican Republic. How are you? Mac’s in Valparaiso. Boise. Porto de Mós, Portugal. Dubai. Birmingham, Alabama. What’s up? Boulogne, France. Breckenridge, Colorado. Toronto. Savonlinna, Finland. Tallahassee.
Greensboro. Cleveland. Phoenix. Portsmouth. Brandon. Mendocino. Jupiter, Florida. You’ve already won. San Diego. Kennesaw, Georgia. Dublin, Ireland. Petah Tikva, Israel. Madeira Island, Portugal. Cincinnati. Les Whynin in Boing Boing, Australia. That might be a real place. I have no idea. Boneroo, Alaska. Kingston, Jamaica. Nothing really dirty this time around. Good boys and girls.
Jake: They tricked you into saying Boing Boing?
Tobias: Well, Les Whynin’s probably not a real one.
[laughter]Tobias: But if there are good ones, I’ll read them out. I read anything that’s on the teleprompter. All right, JT.
Jake: I’m Ron Burgund.
Tobias: Burgundy? Yeah, I am.
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Knot Theory Meets Private Equity: The Takahashi-Alexander Model Explained
Jake: All right. So, for today’s veggie segment, in mathematics, there’s this Knot theory which, like K-N-O- T, like, actually studying knots and the mathematics behind knots. It’s really these loops that are in three-dimensional space that they don’t intersect with themselves. So, think of it as taking a piece of string, and tying into a loop and then joining the ends, so it can’t be undone. There’s actually mathematical theories behind all this.
The main goal is really to classify and understand different types of knots, and studying their properties and how they relate to each other. There’s these things about knots that don’t change even when they’re stretched and twisted. These are then called knot invariants, like not changing, basically. And so, for example, the number of crossings within a knot is an invariant and counts how many times it crosses itself.
Another important invariant is this Alexander polynomial, which, it’s like this mathematical tool that helps you distinguish between different knots. Keep that name in the back of your mind for a minute longer. Another thing is this thing called Takahashi manifolds, which are a special concept in knot theory, named after Michio Takahashi. These are three dimensional spaces created from knots where they have this thing called Dehn, D-E-H-N, surgery. This is a process where you cut a knot, and then reglue it back together in a new way to form different 3D spaces and unique properties.
I don’t understand any of this stuff. I’m just [Tobias laughs] reading off the teleprompter, [laughs] I’m just kidding. But there’s actually some practical applications from all this, surprisingly. So, in theoretical physics, this knot theory helps understand these complex phenomena like quantum entanglement, and how particles become interconnected in strange ways. And then, also studying knots has actually led to improvements in how we allocate resources in complex systems, like distribution networks. There’s really abstract concepts, but they actually can help in logistical planning.
And so, here’s where things get a little bit weird and coincidental, okay? Remember those names, the Takahashi manifolds and the Alexander polynomials? Okay. Well, in the world of like large capital allocation like endowments, there’s a model that’s used to help forecast cash flows for private equity and venture capital. The name of that is the Takahashi-Alexander model. It was developed in 2001 by Dean Takahashi and Seth Alexander at Yale University.
No relation to these mathematical knot people. So, what are the odds of that? I found that to be quite striking. Yale, of course, was famous for David Swensen’s trailblazing asset allocation models that he did. Takahashi and Alexander were both Swenson acolytes. Alexander now runs MIT’s endowment.
So, what’s this Takahashi Alexander model in the endowment world? It’s a framework for estimating future cash flows and valuations in private equity and venture capital portfolios. It can be really difficult for an allocator to plan, because the money is typically called in chunks over the life, let’s say, the first five years of a 10-year fund. And then, the next five years after that, the money’s then distributed after these businesses are liquidated.
So, in the simplest terms, the model helps you figure out how much money you’ll need to invest upfront and rolling as the investment period runs and then when can you expect to get it back? The analogy might be like if you’re planning a road trip and you need to know how much gas you’ll need to buy along the route, these are the capital calls. And then, how many snacks you can afford to buy along the way, and these are your distributions. You don’t want to end up stranded in Barstow with no gas money. So, the Takahashi-Alexander model helps you plan out this liquidity scheduling.
So, as George Box famously said, “All models are wrong, but some are still useful.” The TA model, it relies heavily on assumptions about the future contributions and distribution. So, if you’re wrong about those, then the model’s going to give you pretty crap in, crap out, as the saying goes. And of course, it can lead to overconfidence in your predictions, because it gives you a single point estimate outcome and not really a range of probabilities.
So, of course, people have taken that now and run like Monte Carlo simulations, lots of historical data inputted that helps you create a range of possible outcomes instead of just one single prediction. That makes it a little bit more of a probabilistic approach, which is probably an improvement. Now, let’s see if we can wed knot theory and cash flow planning into some unholy matrimony.
Tobias: Land it, JT.
Jake: I’m going to try. So, a lot of the key lessons remain consistent between these twos, like simplicity, like thinking about a simple knot or a simple cash flow planning can lead to incredible complexity. Interconnectedness matters. Models, you have to consider uncertainty in them. Simple loops can form very complex shapes, just like a straightforward asset allocation model can actually create very intricate patterns of cash flow modeling, and then, just like these knot invariants that we talked about help maintain stability, like they’re a common thing that don’t change.
These models should have principles in them that can stay effective even when the market conditions are changing. So, probably, give that 6 out of 10 on the sticking the landing, but [Tobias laughs] I just couldn’t believe that there’s this Takahashi-Alexander, like they’re both things in both knot math, which is like, who the hell’s even never looked at knot math before? And then, also an obscure endowment model system. How’d that happen?
Tobias: I think the Takahashi manifold in my Toyota has broken down. I’m taking it in for-
Jake: Take it in for repairs?
Tobias: -check up tomorrow. The Takahashi manifold again. It’s always the Takahashi manifold.
Jake: [laughs]
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Ben: It’s interesting though. So, does that mean that if there’s a larger pool of committed but undrawn capital at private equity firms, the TA model effectively means that it becomes less risky, because there’s more predictability in the nature of the distributions?
Jake: I don’t know. You know what the numbers are going to be on the capital calls. You just don’t know how quickly or slowly it’s going to be. So, there are these things in there that are called like bow factors that account for the speed of calling. And then, of course, that can change a lot depending upon the strategy and the environment.
So, let’s say, that it was a buyout fund, and there wasn’t that much to be working on and maybe they’d be slower, they’re more conservative and to deploy, then you would know that probably the calls are going to be further pushed out back, further out in time. So, it’s all just about modeling these calls and distributions. I don’t know, if you’re really changing the risk as much though. And then, of course, the distribution part is under the assumption that you actually are able to sell the business, realize the capital, and then send it back to the LPs, which is, that’s not necessarily always a given either.
Ben: Yeah. Well, continuation prompts and stuff can happen.
Jake: [chuckles] If you can find some other someone else to sell it to, that is always an option, including yourself. That does happen, for sure.
Tobias: There’s been this ongoing investigational query about whether that size premium ever existed. Or, if it didn’t in fact exist, if it’s gone away. If that the fact that it’s gone away, if it’s cyclical or secular. And then, there’s been some suggestion that private equity might have absorbed some of that size premium, because they tend to pick off towards the very small end of the listed company space. Have private equity returns picked up enough to cover over that disappearance of the returns in the small and large?
Jake: So, you’re saying public markets, small might not actually be a positive factor historically now as we’ve extended– [crosstalk]
Tobias: I think that it’s possible that the underperformance has been so bad for such a long period of time that the premium has– [crosstalk]
Jake: They back all those previous premium?
Tobias: I think the premium has gone away. And so, the question then is, did it ever exist? If it did exist, has it gone away? If it has gone away, is it cyclical or secular? And if you can answer that question correctly, you’re going to make a lot of money.
Jake: Yeah. [laughs]
Ben: I wouldn’t suggest that it’s private equity who have absorbed it. Most of the studies I’ve seen suggest that private equities returns relative to the S&P, for example, have basically been market return, plus leverage minus fees, more or less. But it is market return as opposed to better than market return.
Jake: Yeah.
Tobias: I guess it’s a little bit of the definition too, because when we say private equity, I always think of buyout. But it’s inconceivable that’s sitting in VC. Has VC done better than it has previously? We asking at the wrong part of the cycle.
Jake: Yeah, VC has had a really good run for the last decade, especially. Now, it remains to be seen whether that’s going to continue. Bill Gurley had a post yesterday on Twitter that linked to an article that was talking about, basically, the GPs—So, the VC firms themselves and the businesses that they’re buying and funding and some of the mismatch that can happen there when 2 and 20 is the model, and VC industry was relatively small and so it was more really about the 20.
Tobias: Yeah.
Jake: Like, the management fees were– those were good for keeping the business going, but you wanted to get rich from like growing the pie, which is where the 20% carry kicked in. Everyone was aligned when that was what you were optimizing for was the carry. The GPs are getting rich, because the funds returning well. The LPs are doing well. And the businesses themselves are doing well, because everyone’s looking for a big outcome.
Well, as these funds have gotten bigger and bigger in the VC world, that 2% of a big ass number turns into a pretty meaningful, nice way to get rich. It’s risk free relative to the 20% carry. So, when funds start optimizing for 2% instead of the 20% and then they’re just shoveling money out the door, because they really only get paid on money that’s in the ground, then the GP and the business actually can start to get mismatched as far as outcomes go.
Maybe they’re not going to pay as much attention to you, because they don’t care about the 20% carry. It’s just about getting the money out the door, so that you can raise the next fund and get the asset base even bigger. So, there’s some questions on whether you’re going to be able to have anything returns looking like what they look like for the 10 years before when it was more about the 20 than the 2.
Tobias: Ben, let me just read out a few– Bonnaroo, Alaska. Kingston, Jamaica. Leuven, Belgium. Helensburgh, Australia. Kansas City. Just in case I missed those ones last time. From one smaller island nation with a pretty big industrial base to another one, Japan to England, what are the things that you like about England right now? Or, is it just that you’re finding individual names rather than more broader macro?
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Undervalued and Overlooked: The Case for UK Mid-Cap Investments
Ben: Well, it’s not a macro call, per se. We are comfortable with the rule of law here and how business is generally done. It’s the valuations which are most striking. I think the PE on the FTSE 250 which is smaller and mid-sized businesses is around 12 times today. So, within a developed market context, that paints a broad picture that there might be some opportunity. Although there are some companies which are more, let’s say, old economy metal mining, banks, etc., that’s what the FTSE 100 is very much known for.
There’s a lot of innovation and globally relevant companies in the smaller side of things. Companies people may know like Games Workshop, for example, are generally good at what they do. They operate in a niche, but they’re irrelevant company. So, it’s more on the micro side, in general. But the broad macro in the valuations are definitely appealing.
I don’t think I’m the only person who feels that way. You’re seeing a huge amount of inbound M&A attempts in the UK. You saw Anglo-American, there was Currys, Rightmove. REA had tried to have a go and a lot of these bits have been batted off. But it’s quite clear to me that from a business owner perspective, there’s opportunity in the UK. The people who are selling– well, there’s a few people, but a lot of it has been the domestic pension funds who–
There is no home bias in UK [Tobias and Jake chuckles] domestic pension funds. I think their allocation to the UK equity market is 3% or 4%. It’s in line with global averages. So, they have been the sellers and the smart people, or at least trade buyers. And corporate execs have been the ones buying. Yeah, I think it’s clear what side of that trade I’d want to be on.
Tobias: What does it take for some catalyst, or what does it take to turn it around? Is it enough that it just gets too cheap or is there–
Ben: Yeah. It could just be corporate activity. It could be a combination of MBOs and M&A. That certainly seems to be the case right now. But UK companies, in general, are also relatively generous when it comes to dividends. So, again, I think the average dividend yield for the FTSE 100 is 4.5% or so. So, you’re getting to a lot of the more traditional companies like the banks, NatWest, Barclays, etc. They’re buying back shares at an incredible rate.
NatWest over the past five years has probably bought back and retired around half of its equity capital base. So, there’s a few external factors, and then there’s management teams who generally speaking get it in a broad sense and do the right thing. So, they’re their own catalyst in a way. Other than that, no, I can’t think of a specific thing that will change the tide other than those two things.
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How Admiral Group Built the UK’s Most Profitable Auto Insurance Model
Tobias: Are you able to discuss any individual names? Do you discuss names or you prefer to keep them to yourself?
Ben: There’s a few which we’ve already discussed in public, so happy to talk about them in broad terms again. But in the UK, for example, we have a position in two companies which we’ve talked about, one is Admiral Group. Admiral is–
Jake: GEICO of UK? That’s what everyone says. [chuckles]
Ben: That’s a generous interpretation. There are some nuances. The business was actually founded by an American in 1994 called Henry Engelhardt. He started with one brand 50 odd employees. And in the past 30 years or so has basically built Admiral into the largest P&C auto focused insurer in the UK with 14% or 15% market share. It’s measured by net written premium.
So, it’s a wonderful business. They’re quite unique when it comes to insurance insofar as they reinsure 80% of their policies. And so, they’re actually able to generate something like 50% returns on equity 50, because they don’t have the same capital requirements as most insurers. They use that capital efficiency to pay out, basically, most of earnings. 95% plus is paid out as dividends.
Henry was famous for saying he basically wanted– He thought basically management needed to have a gun to their head, they needed to feel some pain, they needed to realize that capital was constrained and that would make the business run more efficiently and better. And it’s worked.
Jake: So, almost like a REIT at that point practically, huh?
Ben: Pretty much. It’s not stopped them growing. Vehicles insured in the UK by 7%, 8% a year consistently. They’re based out in Wales, which is a lot cheaper than here around London. I think 10,000 or 11,000 of the 12,000 total employees have some shares. So, that dividend actually means something to them. They’re vested in the success of the business. Those small things combined has meant– Their combined ratio has averaged, say, 83% over the past decade.
Jake: That’s good.
Ben: That’s pretty darn impressive.
Tobias: Yeah.
Jake: Is it true that there are more losses in the UK, because you guys drive on the wrong side of the road?
[laughter]Ben: Same as Japan, mate. [laughs] Must be something about it. Yeah. No. I’ll tell you, make it serious. There has been claims inflation, but you’ve had the same elsewhere. Bodily injury claims, bent metal claims have been going up pretty consistently for everyone. Where we lag or where Admiral lags versus the US– Not so much GEICO, but progressive is that they don’t really have a good telemetry offering. So, there’s definitely some work they can do there.
Jake: That sounds just like GEICO.
Ben: Yeah, it’s a bit like GEICO.
Tobias: How do they go on the asset side of it? If you’re investing locally, it’s been a tougher run than some of the American insurers, which you’ve had sloppy– [crosstalk]
Jake: Yeah. What’s the float situation?
Tobias: Yeah.
Ben: Yeah. Well, because they reinsure a lot of the business. They do commute the contracts back onto their own balance sheet, typically, after three years or so. But because they reinsure a lot of it, they don’t actually hold that much of the asset.
Tobias: I see.
Ben: So, the investment side of the operation, it’s not like it doesn’t matter at all. It’s probably about £100 million a year of profit on—So, It’s pretty small. It’s mostly about the underwriting.
Jake: It’s almost more of a broker-
Ben: Yeah.
Jake: -in that sense.
Ben: Yeah, exactly. They make a lot of money on the underwriting. They make quite a lot of money on the ancillaries, so financing for premiums, that kind of thing. It’s a little bit of a unique quirk of the British market, in general. All of the peers, Direct Line, Aviva, they’ve all got that quite high skew towards more fee type income. It’s the only way the market can be viable.
It’s probably more competitive than the US, because there’s a culture of going through price comparison websites in the UK. There’s a lot of direct business. The pricing is fierce. You don’t have the agent intermediaries who can smooth that out a little bit with relationships and that kind of thing.
Tobias: How do they keep that to 83%? How do they keep that so low?
Ben: Well, there’s not paying– There is still a large part of the market that does use agents. It’s not all direct in the UK. Agents are taking 10% to 15% commission on premium. So, cutting them out is a good thing. And then, otherwise, their call center is all in house. It’s based either in Cardiff or in Bangalore. It’s just the cost focus there. But the biggest, most obvious one, is you’re cutting out any intermediaries, which it’s an advantage versus still half of the market.
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Howdens Joinery: The UK’s B2B Answer to Home Depot
Tobias: That’s an interesting play. That’s Admiral. What’s your other two other positions?
Ben: Howdens Joinery. So, that is going to use Americanisms. Let’s call it the Home Depot [chuckles] of the UK. It’s a bit nuanced insofar as they just do B2B. So, they sell kitchens. not particularly glamorous, but they have 30% overall market share of the kitchen market in the UK. They have 70% of the trade channel. So, they’re pretty dominant in what they do.
I think they’ve got about 814 depots today. They say that the vast majority of tradespeople are within five miles of a Howdens. That’s very important. If you’re a tradesperson, price is a factor, but availability is probably an even more significant factor. But because of the way that they do business, they don’t have expensive showrooms where they’re showing kitchens on an open floor plan for retail. It’s really a warehouse. Very, very bare bows. That’s what trades people care about.
But it means their OpEx is much lower than people like B&Q in the UK who have a retail operation as well. They have a private label business. So, if you look at the supply chain for kitchens and joinery, anywhere in the world. There’s a company in Canada called Richelieu Hardware which just does the wholesale. That is a very high margin business. The cost of failure is high. It’s logistically complex. So, they do about 35% of what they do in house. They’re vertically integrated. They build their own cabinets. They have their own wood sourcing and that kind of thing.
So, a combination of a better efficiency, floor footprint and vertical integration means they’re able to run 60%-ish type gross profit margins, mid-teens, EBIT margins and still be offering a product which is materially cheaper than the next best out there. It’s relatively cheaply valued today. It’s on 18 times next 12 months. Earnings has been a bit cheaper in the past. We were able to buy it a little cheaper fortunately. But the exciting thing there is they’re really only scratching the surface of going outside of kitchens.
So, kitchens is where they’re dominant today. Still the vast majority of what they sell, but they’re starting to experiment with bedrooms, bathrooms, flooring, all of that kind of stuff. Given the nature of the relationship they have with tradespeople, given their logistics and the back hall that they have, there’s a good chance that they’re successful there, in my opinion.
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Japan’s Hidden Gems in Retail: Cosmos Pharmaceutical and Genky DrugStores
Tobias: That’s another interesting one. Have you discussed any other Japanese holdings or any other international?
Ben: Yeah. I will be careful with this one. [Jake chuckles] We’ve talked about some of the drugstores in Japan. So, in Japan, unlike the US where Walgreens, CVS or in the UK, Boots, or in Hong Kong, Watsons, are entirely dominant. In Japan, the drugstore market is still very fragmented. Half of the market is made up by large players. The rest of his independents.
Not only that, drugstores in many cases are more like the hard discounters. They sell a lot of food and sundries at low prices. So, the two drugstores which we own, Cosmos Pharmaceutical and Genky DrugStores. They both generate about 70%, 75% of their sales from food. So, their drugstore is a bit of a misnomer in terms of what they do.
When it comes to retail, there’s a pretty clear playbook as to what makes a good, hard discounter. It typically looks like low gross profit margins, i.e., good value for money for the customer, coupled with very low operating costs as a proportion of sales in order to be able to sustain those low prices. You get growth, you get good same store sales. That’s positive working capital dynamics, and so on and so forth. You end up being more durable and more resilient as a result of it.
Those two I mentioned are both running around 20% gross profit margins, Cosmos around 3.5% EBIT, Genky around 5%. That’s fully 10 points better on gross profit margin and 7 points better on SG&A as a percentage of sales than the vast majority of their competition in Japan, the big retailers like Aeon Group. So, that is a model I like and we think has led to some pretty fantastic outcomes over time.
In the case of Cosmos, especially, they’re investing in new parts of Japan. So, they’ve gone from the western island Kyushu, then moving more into Kantō, which is Tokyo. That has been detrimental to margins. Over the near term, margins have gone from 4.5% to 3.5% level I mentioned. It takes a while for these stores to ramp up. They don’t do marketing, a relatively big box format. We’ve seen that playbook again.
But the market has just extrapolated the trend and led to the stock trading on the case of Cosmos 0.5 times EV/sales, 0.5 times at a normal margin, that would be around 8% owner earnings yield and then the business is growing low teens and probably can do for the foreseeable future. They’ve got 1,500 stores. If you extrapolate their store penetration in the western parts of Japan to the other regions that they’re starting to expand and at least scope of 5,000, and still be tiny in the grand scheme of things.
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Lessons from the Magnificent 7: Spotting Future Giants in the Market
Tobias: Does Japan and England just see– they’ve got lower multiples than the US See’s and those multiples have been going against them for an extended period of time, where– I guess to some extent, that’s been the experience in the small and micro and probably even mid cap in the US.
Ben: Mm-hmm.
Jake: It’s all flows, baby.
Tobias: Yeah. If it’s not Magnificent 7, then it’s just not getting much love anywhere.
Ben: Yeah. There’s definitely some truth to it. But I don’t know, call me a hopeless romantic.
[laughter]Ben: If you find these businesses which can truly compound over time at decent rates, at some point, someone becomes forced to agree or you just make your money from the business. It’s interesting. I was reading a study– I think it was Joel Tillinghast at Fidelity did the presentation on it. He ran the low-price fund. But he did this thing showing Warren Buffett’s “compounder investments.” So, I think it was GEICO, Coke. Maybe, Wells was actually in there. I’m not sure. But it was instructive to me. Amex was in there.
He showed multiple Warren pays, multiple of prior peak earnings which was very relevant to GEICO and Amex at the time. And then, multiple of earnings three years forward. So, Coke was the most expensive at maybe 15 times. But three years forward, it was on five times. GEICO was two times prior peak earnings and one times three years forward. So, the point is I think you can buy really good smaller businesses, maybe going on the temporary troubles. If you’re buying with that margin of safety, let’s say you’re right.
Jake: That’s the key. You have to be right about all of–
Ben: You’ve got to be right about it. You’ve got to be looking– Einhorn talks about how markets are broken and you can’t rely on the multiple to help you anymore. And then, those Warren investments. But still compound are great businesses. You didn’t need the market to agree with you. You’re going to make a return. That might be a very high bar [chuckles] trying to find great businesses on long time earnings. That’s pretty tough. It’s not easy to find. But if that’s your starting point and you work back from there, you can probably afford to let the multiple go against you for a while.
Jake: It’s hard to get to that low multiple three years out when you start at 30 plus today. Like, it’s not easy.
Ben: Yeah. I’m going to self-flagellate a little bit. You think of Meta or Facebook at time that IPO-ed in what, 2012?
Tobias: Yeah.
Ben: I remember that IPO was pretty like vivid to me, because I remember it IPO-ed at 30 bucks a share, and then it had a bad couple of days and then it cracked and everyone was talking about how Goldman’s tried to prop up the share price. Probably troughed at 20. I know where we’re at today. 500 or so? I don’t know-
Tobias: Yeah.
Ben: -what the number is. But people were talking about a bubble back then in 2012 with Facebook’s IPO. I think Meta is probably going to earn 20 bucks a share this year. This is not three years forward, but 10 years forward type of thing. So, now, you had to have perfect foresight. You had to have that insight to be able to say Meta could earn anything close to that earnings power. That wasn’t me. Maybe another guy could have made that judgment with some confidence.
Tobias: I think it’s a good point, well made. It’s something that all those Magnificent 7 have had periods of weakness over that last 10 years or so too, when they were all eminently viable. Google, certainly, Meta, I think even Amazon have all had times when they were cheap, and they could have been bought. I didn’t, but maybe Meta—
[laughter]Jake: Somebody’s smart out there and figured it out.
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Tobias: On that Ben, that’s time. It’s been really great chatting to you. If folks want to follow along with what you’re doing or send you a message, how do they go about doing that?
Ben: Check out our website. That’s the best way. It’s got all the contact detail, and socials and everything. So, it’s tourbillonpartners.co.uk.
Tobias: I’ll link that up, because it’s spelled a little differently to the way that it sounds.
Jake: [laughs]
Ben: Thanks, Tobias.
Jake: JT, any last words?
Jake: No. Thanks, Ben, for coming on. It was a pleasure.
Tobias: Ben Beneche, Tourbillon Partners, thank you very much. Folks, we’ll be back this time, next week.
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