In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Rich Pzena discuss:
- Warren Buffett – Balance Sheets Before Income Statements
- Avoiding Value Traps
- How To Value A Company
- Surviving 10 Straight Quarters of Massive Underperformance
- Betting on GE
- Revisiting Graham & Dodd
- AI: Finding Value in the Overlooked
- From Oilfields to Wall Street
- The Gulf of Mexico Bidding Fiasco
- Starting at Sanford Bernstein
- Stepping Down and Letting Others Lead
- From $2 Billion Dreams to $70 Billion Reality
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’s Value: After Hours. I’m Tobias Carlisle. Joined as always by my host, Jake Taylor. Our very special guest today is investment legend, Rich Pzena. How are you, Rich? Good to see you.
Rich: Great. Great to be here. Thanks for having me.
Jake: Welcome, Rich.
Tobias: We’re very happy to have you along. You graduated from Wharton in 1979, and then you cowrote a paper with Joel Greenblatt that was published in the Journal of Investment Management called How the Small Investor Can Beat the Market. What was the reason for doing that research and what did you find? Do you remember?
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Revisiting Graham & Dodd
Rich: Yeah. We went to Wharton at the height of the efficient market hypothesis where the professors were trying to teach you that you can’t win in the market, because everybody has the same information that you do. We’d also read the Graham and Dodd original Security Analysis book, which said that if you do basic stuff, you can win. So, we just decided to replicate the work of Graham and Dodd. They used the term net-net working capital. So, that was working capital, net of all liabilities. If you could buy a company for less than that and it was not losing money, it’s a smart thing to do.
So, we decided to test that hypothesis in 1979. You got to go back to 1979 when there was no fact set, there was no Compustat database. We had stock guides, Standard & Poor’s printed stock guides. So, we looked and we were doing it by hand with a ruler on the stock guide.
Jake: Yeah. [Rich laughs] Charting it all out.
Rich: Our sample was companies that began with the letter A or B, because to go through it for all the companies was just going to take our whole lives. We basically found that everything that was in that original book worked still beautifully and published that– Joel was the real enterprising guy who wanted to– I was the one with the ruler on the stock guides-
[laughter]Rich: -and he was the one with the brains, and the energy to go and get it published.
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From Oilfields to Wall Street
Tobias: And how did you get your start in the industry after you graduated?
Rich: It’s funny, because when I took a course at Wharton called Security Analysis, it was the worst course that I had in my college career. [Jake laughs] It made me totally uninterested in being a professional investment person. That on top of all the efficient market hypothesis. I remember really vividly one of my colleagues, friends in school getting a job at this company called Fidelity, which nobody had ever heard of at the time, and he was going to be analyst. And I said, “Why would you want to do that?” And of course, he ran one of the big funds and retired at age 35.
I went to work in the oil industry. I really thought that investing was going to be a hobby for me and not a career. You have to go back to that period, because the oil industry was just as hot then as the tech industry is today. I think it was over 30% of the S&P 500 was oil stocks. The job opportunities were really interesting. I was very young, so I didn’t know what I was doing. So, I chose my first job based on how the job sounded it would be. And it actually turned out to be just that.
I got this exposure originally in the corporate treasurer’s office. I worked for Amoco. It was Standard Oil of Indiana at the time. They had a small group that they tried to bring in their top business school recruits. We worked on everything from financing projects in the Middle East, from structuring intercompany transactions.
One of my first jobs was reviewing the executive compensation plans of Amoco for the treasurer for an upcoming board meeting. I learned a lot, because I wound up becoming a very big skeptic. My first report that I wrote there which my boss ripped up, said, [Jake chuckles] “We should scrap all the- [crosstalk]
Jake: These guys are all overpaid.
Rich: -because all being gamed and they’re not acting in the best interest of the company long-term.”
Jake: So, then that you got shoved out of the oil industry after that.
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The Gulf of Mexico Bidding Fiasco
Rich: Well, because it was booming, they sent me down to the Gulf of Mexico to New Orleans, and then I got to witness another set of corporate excesses which was the bidding for lease sales in the Gulf of Mexico. So, you go back to the early 1980s, and the US government opened up the Gulf of Mexico for area wide leasing they called it. So, you could nominate a block of acreage that you were interested in exploring and then they would put it into a sealed bid.
I was the finance guy. I was 22 years old working on the offshore division exploration committee with an engineer, a geologist, a geophysicist, a land guy and me. I was doing the numbers. We had this one thing that they wanted to bid on. We had a million-dollar spending authority on that committee and we wanted to bid $1.1 million. So, we had to go to our regional management who had a $5 million spending cap, but they got really excited about it and wanted to bid $6 million. So, it had to go up to the corporate headquarters.
Jake: [laughs]
Rich: Then it went to the board, and we bid $93 million on this, okay? [Jake laughs] And then, we went to the Superdome to watch them open the bids, we won. The next highest bid was $800,000.
Tobias: Oh.
[laughter]Rich: These were great, great lessons that you couldn’t learn out in the world. I got into Wall Street. Originally, got a head honor call saying, “Do you want to be an oil analyst?” And I said, “No. [laughs] No interest.” And the head honor said to me, “Well, you can make a lot of money doing that.” I said, “Why would people pay a lot of money to those kinds?” And she said, “Why don’t you just meet this guy. He’ll buy you a drink in Chicago.” I wound up meeting the guy who became my boss at Sanford Bernstein, and I took on the job as a sell side oil analyst and that was my first professional exposure to Wall Street.
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Starting at Sanford Bernstein
Tobias: What are you doing in that sort of role?
Rich: Well, I was publishing research, making recommendations to other investors. I quickly grew old. I wanted to be one of those other investors, not the guy publishing research. So, I pushed at Sanford Bernstein, and fortunately they gave me the shot. Bernstein, when I joined, they had something like four billion in assets under management and now with hundreds of billions of dollars. But they were just expanding into other strategies and they gave me the chance to start a small-cap fund. So, I went from big oil to small-cap, hired a team and set about trying to build a business within Sanford Bernstein and I was hooked at that point.
Tobias: How did the small-caps look in those days? They’re talked about today as if they’re not very good businesses, because they’ve been–
Jake: Picked over by private equity.
Tobias: Exactly. All graduated out.
Rich: Yeah. Look, I came to appreciate over the years that the cap size didn’t really matter very much when you’re looking for opportunities. I used to think actually that there were better values in large-cap companies, because when something went wrong in a big company and you had 25 analysts covering it and 25 people writing negative research reports that you could get a better value than having one person writing a negative research report.
But in the end, I thought there wasn’t very much difference. I still think that. And the companies that are small-cap or companies that used to be big cap and they’re still big businesses and their caps got small, so that’s often a good thing to buy. So, I think that there’s still the kinds of opportunities across the cap spectrum today.
Tobias: So, you don’t feel like the small-caps are worse quality necessarily than they were when you started out? Do you think that it’s comparable, it hasn’t changed much of these?
Rich: I think it’s comparable, because very often you can buy leading companies in a smaller market. They’re focused one thing. We went through a period in our history where our business was a public company.
Tobias: I owned some.
[laughter]Rich: When we went public at first, people were paying big multiples for asset managers and then they stopped. I think we were all 20 times earnings, 20 times after tax, PE multiples. And in 2007, and 10-years later, there was no double-digit multiples at all except unless you were an alternative or a wealth manager. So, did our business get worse? Not really. The business is the same. There was clearly more expectations of growth got much lower because of the massive wave of indexing, and that made us traditional active management have a negative growth rate, organic growth rate, long-term.
But if you knew what you were doing, it didn’t have a negative organic growth rate. We experienced positive growth throughout our history as a public company and we continue to do that today. But nobody distinguished in valuation between someone who was shrinking 5% a year and someone was growing 5% a year got the same multiple. So, it seems to me that those opportunities continue to exist.
Tobias: There’s a big bifurcation now between FANG or FAAMG or whatever they’re calling that very biggest end of the market and the rest of the markets. One of the ways that it’s expressed is you see that small-caps are very cheap relative to large-caps.
Rich: Yeah.
Tobias: You’re saying they’re still the same quality. So, do you feel like is that a good opportunity, is that a good place, small-caps over large-caps?
Rich: I really believe that the opportunities are very similar in small and large. If you’re going to use large-cap indices to compare them against, yes, you’re right, they’re much, much cheaper than these cap-weighted indices which are always skewed by what’s going on the select few companies. But if you’re going to just say, how cheap are the cheapest large-cap stock companies and how cheap are the cheapest small-cap companies, they’re not that different.
Jake: And Rich, a lot of people have drawn correlations to the late 1990s and that bifurcation idea of Mag 7 versus everything else. You live through that and manage money through it. Do you agree with that observation, or what are the contrasts-
Rich: I do.
Jake: -from late 1990s today?
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Surviving 10 Straight Quarters of Massive Underperformance
Rich: So, I’ll tell you my story from 1999. We had started our business in 1996, and we had a good first couple years, and got to a break even and we were feeling good. And then, we went through this 10 straight quarters of massive underperformance compared to the broad market. I had a client who came in, sat in our conference room, and she walks in the door and says to me, “My grandmother’s a better investor than you.
[laughter]Rich: And all you have to do is buy Cisco. Everybody in the world has figured this out except for you, and you’re just stubborn.” So, I tried to go through arithmetic with her [Jake chuckles] and I said, “You realize that Cisco is now at a half a trillion-dollar valuation. First company to ever achieve that mark. And you’re used to double digit returns. You would be unsatisfied with anything less than 15% a year. So, if you bought that whole company for $500 billion, they would have to earn $75 billion a year for you to get your 15% return, and they earn one. Don’t you think there’s something wrong with that?” She just looked at me and said, “You don’t get it, do you?” to which I agreed.
Jake: Yeah. “You’re right. I don’t get it.” [laughs]
Rich: And that was going to be the backbone of the internet. It was all just as exciting as it is today with artificial intelligence.
Jake: Was that a very painful time for you, or was it like you-
Rich: It was.
Jake: -just recognized that, you know what, this is just craziness and I know that the world will get back to reality at some point?
Rich: No. When you’re a struggling business that just achieved profitability and now your clients are telling you’re an idiot and they start closing their accounts, we weren’t sure we were going to make it. And in fact, Joel Greenblatt, who you mentioned earlier, that was my partner at Wharton in our little research project, he was my backer in getting going in this business.
We went in the red and we got an offer from another firm to buy us. It would have gotten all of us a job. Here was the deal, Joel could have get his money back and we would all have a job. [Jake chuckles] And I said, “Joel, it sounds like a really good deal. You should take it.” And Joel said, “No way. Whatever you need to make it through this period, you have a blank check.”
Jake: Wow.
Rich: That’s pretty much what he said.
Jake: Incredible.
Rich: He didn’t ask for any incremental equity in exchange for that. Now, he must have been really prescient, because that was in February of 2000 when that happened, and March 9th, it turned around and he never had to put another penny in. We were 6,000 basis points behind the S&P 500 cumulatively from the inception of the firm, hopeless, right? It’s hopeless.
Jake: [laughs] Is that tough to sell when you’re–
[laughter]Rich: And by the end of 2000, in nine months, we were ahead of the S&P.
Jake: Oh, my God. Incredible.
Rich: Yes, that was what we lived. And believe me, that 10-quarters was not fun. We didn’t lose hope. We looked at these other things that everybody’s buying and saying, “I don’t get this. I’m not putting any of this into our portfolio.” By the way, it was fortune that that happened. It didn’t feel like fortune at the time, but so many of our traditional value peers caved. They closed down, they started putting things into their portfolio that you would quasi value, like they put IBM in. IBM was ridiculously priced too, but not anywhere near any of these other things. It’s a real company with real business, but it didn’t do too well after the bubble burst.
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Jake: And you were telling us that before we started that at that time, your portfolio was full of five times PE companies where the CEOs were telling you that our business is humming along just fine, right?
Rich: The businesses were great. The environment that you were in– Because it’s not only the Internet bubble, you have to understand what was going on the other side. We had just had all the Asian currencies collapsed. Everybody was talking about manufacturing in Asia. And then, you add the internet onto that as a way to go to market for these foreign companies, and the stock prices just imploded. So, while Cisco was going through the roof–
I’ll just use one that was our big one– Nobody will even know these companies, but a little company called Kennametal, which made cutting tools that were used in a manufacturing process. They would sit there and say, “You know why people use our products? They use it, because if their cutting tool breaks and they have to get a new one, if it’s not up and running in the same day, the amount of production loss is gigantic compared to what you might save on importing one from another country. And we’re not going to lose any business.”
These CEOs were adamant. “We’re not going to lose any business.” And the market was valuing these companies as if they were going to go out of business. And so, we bought them. They were profitable. They were profitable for years. They were high margin. They were dominant market share positions, everything that you could dream of, and they’re five times earnings. And so, it was half of our portfolio.
And then, when the internet crumbled, people just put money in this because they said five times is too cheap. They went from 5 times to 10 times in a year. They were still cheap, because they were still high margin growth businesses. They doubled again over the next few years. So, they were doubles and triples and quadruples while the S&P was negative for a few years. So, we hit a billion dollars in assets under management in our third year in business thinking this was beyond the wildest dreams.
Jake: Yeah.
Rich: Then we went to half a billion dollars and in the red. And five years later, we were at $30 billion-
Jake: Wow.
Rich: -and five years in a row of being one of the top performing managers.
Jake: And that when in the– I’m not going to call it victory lap times, but clearly, things are working. Is it hard to avoid hot money at that point?
Rich: Well, it’s impossible. They don’t listen to you. They think you’re being honest.
Jake: Yeah. [laughs] You tell them, it’s not going to be amazing like that last few years.
Rich: Yes. My partner and I, who built the business, my partner, William Lipsey, who is the marketing genius in our firm, he and I went on the road and we would just go from meeting to meeting in the room and they would hire you. We would tell them that, “This is a bad time. Do you realize that we have none of the opportunities we had in the last five years?”
They all hired us and then fired us two years later. But it tells you why it’s important to make sure your clients understand what they’re getting themselves into, because it’s not good your own business to have hot money. Hot money is not good. So, you have to–
Jake: Do you think there’s anything you could have done differently to try to avoid some of that? It’s just inherent in the system.
Rich: I’ll tell you, we had people who telling us their system for evaluating managers, that “We have managers. If you underperform the market by two quarters, you get put on a watch list and then the third quarter we haul you in and the fourth quarter we fire you.” And I would say to them, “I guarantee you’re going to fire us.” I would say that in the committee meetings, and they still hired us at the time.
Tobias: Rich, let me just do a quick– I’m going to do around the horn of the folks who’ve dropped their locations in the chat, just so we give you an idea where everybody’s coming in from. Boise. Santo Domingo, Dominican Republic. Valparaiso. What’s up, Mac? Brandon, Mississippi. Prince George, BC. Tampa, Florida. Tomball, Texas. Dead Cat Gully, New South Wales. Is that real?
Dubai. Savonlinna, Finland. Los Altos, back from Stockholm. Östermalm, Sweden. Moncton, Canada. Toronto. Antalya, Turkey. Gerard’s Cross. Jackson Hole. Pittsburgh. Perth. What’s up? Cincinnati, Ohio. Mallorca. Always just jumps on me a little bit at that point. Dubai. Wodonga. Turku, Finland. Gulf of America. Jupiter, Florida. You’ve won. Vero Beach, Florida. Island Park. Houston, Bulgaria. Iceland. Tallahassee. Saskatoon, Saskatchewan. Nashville. Fredericia, Denmark. Stavanger, Norge.
Jake: That’s a good spread.
Tobias: I messed up the name.
Jake: Rich, I was worried we’re going to have to get Toby a cold shower after hearing that story for maybe the setup might be similar for value-oriented folks for [laughs] today.
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How To Value A Company
Tobias: Yeah. I’ve run a firm, got it to break even and then run into the buzzer of the last few years. But Rich, your strategies, how do you think about valuation?
Rich: For us, it’s very simple. We use one metric, price compared to normalized earnings. And normalized earnings, it’s a concept, but it’s not a complex concept. It’s what should the business earn over a full economic cycle. Not the peak, not the trough, but on average, what’s the earnings power of this business. It’s informed by the history of the business. It’s informed by the competitive positioning.
If you talk about stories of things that you’ve invested in– We were talking about the internet bubble. Well, COVID was another opportunity to buy things at crazy prices. We can save this for a little bit later, but I don’t think we have the same opportunities today. But COVID we did. And our biggest holding became in probably by the end of the second quarter of 2020, GE. You can’t imagine a worse business than building jet engines during COVID. It’s not only that travel was down–
The number of takeoffs and landings were down 60%. But the volume of GE’s business was down more than that, because first of all, nobody was buying new airplanes. But most of their revenues came from the repair and remodel, the repair side of the business, the spare parts business, because that’s the high margin business. And so, if you were parking airplanes, you would operate the ones you weren’t parked until they had an overhaul date, and then you would park it and pull another one out and you would spend no money on maintenance. So, their revenues were down 70%, something like that. And imagine a giant manufacturing operation with an R&D operation with a 70% revenue decline, it had 20% margins before that or 22% margins.
Jake: That’s real operating leverage you start to see there, right? [chuckles]
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The COVID Opportunity: Betting on GE
Rich: Yes. So, their free cash flow rate, if I’m remembering my numbers correctly and I think I’m pretty accurate, was at negative $7 billion a year and the stock went down to $5 a share. This was a stock that used to be the biggest company in the S&P 500 20 years earlier at $70 a share. So, you’re buying it down 90% from its high.
Now, granted, a lot of stuff happened in the interim. But when you visited the company, they didn’t know what was going to happen. All they knew was that they had to be focused on costs and survival and liquidity. And if you have $7 billion negative run rate, you better do something about it. What made us comfortable is they had 50 billion of liquidity of cash and credit availability. That meant they had seven years to fix the problem.
Their new CEO was telling us that they were going to let go 14,000 people and they were going to get the costs down, so that they could at least be break even without a revenue increase. As we calculated it, without inside data, just trying to get a sense of what this company would earn if permanently air travel never recovered. And that was our downside case.
Our arithmetic and you can find flaw with it, but it was around 75 cents a share of earnings from a negative $7 billion run rate to a positive, whatever that was, that created 75 cents a share and the stock was $5. So, I said, if the world doesn’t recover, I can lock in a 15% annual return.
If you listen to Culp, who’s the new guy who had this history of running industrial companies with 30 plus percent margins, he said this should be one of those. That’s what he was telling us. This should be one of those. It shouldn’t have been a 20% margin business. We’re going to run it at 30% when we get back to normal. And 30% margin, you would have had something like $2 of earnings on a $5 stock. So, you sort of say, “Wow, the downside cases, I make 15% a year. And the upside cases, I make 40% a year. What am I missing?” Now, that was one of the extreme ones admittedly, but that was the kind of opportunity that was available.
Tobias: In a similar vein, when you graduated, you came out with oil and gas as if it’s a tech industry, very hot and sexy. And then, through COVID, oil traded famously negative. A barrel of oil negative on the day. Did you look at any of the oil and gas companies around that time?
Rich: We had. One of our largest holdings was Halliburton. So, Halliburton bottomed at $4 a share. They earned $4 a share at the prior peak. Now, that was peak. But average earnings power was $2 a share for a $4 stock.
What’s amazing about the oil and service business is it’s hard to go cash flow negative. The costs are almost all variable. And certainly, the cash flow is variable, because they were a big fracker. So, fracking is capital intensive in trucks, but you just stop spending the money on the capital.
The whole oil industry, it’s like the original gig economy. I don’t think those [Jake laughs] people who worked in it thought of it as the gig economy. But you mobilize a well, you hire the crew and do whatever you need to do. And then, if there’s no job next, the payroll stops as well as the capital spending. So, you didn’t have bankruptcy risk, viability risk. So, yes, you have to take advantage of those opportunities when they come up.
Jake: And Rich, when you’re doing this normalization process and work, over your career of doing this, does it feel like it’s gotten harder to underwrite further out, just because I know changes may be happening faster. And maybe this is a little bit biased by Toby and I went to China like three weeks ago or so. We saw the pace of creative destruction there and the competition and how quickly it can just come right up as soon as a concept is working. The idea of underwriting full cycle seems harder than it might have been. Maybe it always seems hard, but what are your thoughts on that?
Rich: Well, if you’re in an area where that’s subject to displacement through technology, it’s always been hard, okay? It’s not like technological innovation is a new thing. The question you always have to ask yourself is, who’s going to be the beneficiary of the technology? Is it the firm that invented the technology, or the firm that’s going to use the technology? Everybody’s biased to say it’s the firm that invented the technology. But if you’re a good franchise, if you have a solid business franchise that’s based on a long history of client service, we have this issue today.
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AI: Finding Value in the Overlooked
Nobody will like this example. We bought it though. Call center companies. What’s more displaceable than somebody answering your phone when you have AI that’s going to do it. We went and visited the companies that do this. They use the term customer experience businesses, because they’re trying to make it sound better. [Jake chuckles] But the reality is, if you look at technological innovation over the last couple of decades in answering the phone, first, it went from Americans answering the phone, then it went to Indians answering the phone at much lower cost. And so, you started this wave of outsourcing to other countries, but arranged by the service provider.
If you’re AT&T and you want to have your call center outsourced, you’re not going to India and hiring a bunch of people. You’re hiring a company that knows how to do that. And then, you had voice recognition technology come in. Guess what? Outsourcing increased, didn’t decrease. Nobody said, I think I’m going to go do that by myself, because I can buy the machine.
Their case now is AI is going to increase their business even more. It’s going to lower their price and widen the gap of whether you’re a user of AI or not. But the question that you say is, are these companies going out of business? They were selling for five times current earnings. Those went down to five times current earnings. The Goldman Sachs, early in the AI boom, had a list of all the industries that were obsolete. This was at the top of the list.
Jake: [chuckles] It’s a good hunting list.
[laughter]Rich: So, I know from our own business, when you’re in the investment business and, people ask you, “How are you going to use AI?” I know they’re asking the question to say, “Am I going to replace all my analysts?” But I answered the question, “No, I’m going to be able to answer RFPs without humans, because it’s a hard job and it’s a thankless job.”
If you’re in the institutional asset management business and you’re thinking of being somebody wants to hire you to manage a big chunk of their pension plan or whatever, they send you like a hundred-page questionnaire to fill out and you have to answer their questions and you had humans doing this. Now have we done it? No. We said, “I’m not doing that. I’m waiting till somebody comes out and sells us that software package and then I’ll be the first one to buy it.”
Jake Hopefully, a venture capitalist is going to subsidize you in the first years of using it.
Rich: Right.
Tobias: Rich, Warren Buffett stepped down from the CEO role at Berkshire over the weekend. Do you have any thoughts on that?
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Stepping Down and Letting Others Lead
Rich: Well, it’s funny. I stepped down as the CEO of my firm about two years ago and I have a lot of thoughts about that, probably more than you want to hear.
Tobias: No. Go ahead, please.
Rich: I’m going to say– Let’s see. Nine years ago. So, I was 57 years old and our biggest client was Vanguard. We were the subadvisor for the Vanguard Windsor Fund. We were down at Vanguard for a board meeting. The day that their CEO announced he was stepping down– And he was the same age as me. And so, I had a chance to talk to him after words and I said, “I don’t get it. You’re too young to retire.” So, he said, “I’m not retiring.” I said, “So, why are you stepping down? Look at what you’ve built in this organization. It’s a $5 trillion amazing business. Why are you doing this?”
And his answer was, “Because my successor is ready.” So, I spent the whole ride home from Pennsylvania thinking about, I think we have ready successors in our organization too. And if you don’t give them the opportunity– Plus when you’re an investment person and you start an investment firm and you find out that there’s things you have to do other than investing– I didn’t even know this from the beginning.
A silly story, but one of my partners at Bernstein, when I told them I was leaving, said, “I have this great back-office person who doesn’t like her job and she’s been doing it for 20 years. Why don’t you talk to her?” I said, “Sure.” So, I talked to her and she interviewed me. She said, “Well, how are you going to do this, how are you going to do this and how are you going to do that?” I said, “I didn’t even know you had to do those things.
[laughter]Rich: You want a job.” [chuckles] You wind up getting pulled away from investing. Now, I think Warren Buffett managed not to have to do that. So, I don’t want to say that he waited too long to step down.
Jake: That’s how you get those last 30 years.
[laughter]Rich: But I didn’t want to do what you have to do in our business. You need youthful energy and new ideas. And investing is something that you can do for a long-long time, as Warren Buffett has proven. It’s very, very interesting for a long-long time. It doesn’t get old, because the things that we’re dealing with today are not exactly the same things we dealt with before. There’s patterns. But what better way is there to keep on top of what’s going on in the world than have a team of analysts who are digging into things and being in the center of that? And so, he really did that for a long-long time. I don’t think I’m going to make it till 94, but I’m going to do as long as I possibly can.
Tobias: So, you’ve just stepped down from day-to-day running of the firm and you’re in the research investment-
Rich: Correct.
Tobias: -side now doing all the stuff that you really want to do and none of the stuff you don’t want to do.
Rich: Correct.
Tobias: Congrats. [laughs]
Jake: Well, I could give a little bit of some dispatches from Omaha since I was there last weekend.
Tobias: This is your veggie segment for– [crosstalk]
Jake: Yeah, yeah, let’s do that. Yeah, hit the timestamp, everybody.
[laughter]Jake: Of course, I felt very privileged to have been in the audience when Warren announced that he was going to step back. The five-minute standing ovation was incredible to experience. It did get a little dusty in the stadium there for a bit for me. It actually wasn’t a huge surprise, because I had heard rumors all weekend before that there might be that kind of announcement or something. I personally thought that it was a bit of a bounce back year for him. I felt like he was quicker, more tight responses and a little less rambling, maybe perhaps from a year or two before. I thought it was like, “Oh man, Warren’s back. I could picture two or three more of these here. This is great. Super excited for it.”
Yeah. And then, the rest of the weekend of course, it’s nonstop meetings and talking to people. Thanks to everybody that came up and said, hi and all of our 10 listeners somehow were there. [chuckles] It was great. And then, a couple questions. Like one question I had that I was hoping would get addressed, but there weren’t any questions taken after was, what are that 350 billion cash pile and the rest of the equity portfolio, is that Greg’s responsibility or is that some of that now more going to be for Todd and Ted to handle? Are they taking over the equity portfolio to do make decisions on? That wasn’t brought up at all. I’d be curious to see how that goes.
Tobias: Do you think the fact that he’s remaining as chairman and he’s there for any special projects might mean that he’s there for any chances to deploy that-
Jake: Special allocating.
Tobias: -big chunk of money? Which would be the fun part. You don’t want to run all those little businesses and answer to all the CEOs. You just want to hunt for elephants.
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Warren Buffett – Balance Sheets Before Income Statements
Jake: I don’t know though, because he gets monthly basically financial statements from, I think it was 49 companies he said that are internally and that he loves going through it. Another thing he said that I thought, and Rich, you probably appreciate this is he said that he likes to sit down– I’ve never heard him say this before. He likes to sit down eight- or nine-years’ worth of balance sheets and just go through the balance sheets of whatever company he’s looking at.
Tobias: Before he looks at the income statement.
Jake: Yeah. The income statement’s secondary and of course, you could imagine he’s building his own income statement as he’s looking the change in balance sheet year over year. But I thought that was interesting. I’ve never heard him say that before.
Tobias: What do you think, Rich?
Rich: I was going to say, I think there are people who, it’s a gift, I’ll say, to be able to look at a page of numbers and create a picture of what’s going on in the business. And for me, that’s always been second nature. But it’s not for everybody. So, I can understand about getting excited doing that.
Jake: Mm-hmm.
Tobias: You started with a net-net paper at least. Does that mean that you’re a balance sheet guy, first and foremost?
Rich: I’m much more of a balance sheet guy as the downside protection case than I am as– You don’t find the opportunity very often to buy hard assets below penny on the dollar. A dollar on the dollar. Usually there’s something associated with it like this giant cash drain going on or there’s evidence of historical unwise capital allocation or something. So, the idea that there are profitable businesses less than their net-net working capital just doesn’t exist.
Tobias: Not without some serious heir.
Jake: Yeah.
Rich: Correct.
Jake: I think the last part, and we always have to have something macro in this podcast just for fun. [chuckles] Actually, several other well-known investors who I won’t name brought this up as well that I talked to. There’s a lot of concern about the dollar specifically. If the US treasury market were to run into problems and not be able to get the same issuance out the door at reasonable interest rates, there’s a lot of question marks about that.
It was a rare amount of, I felt like American tailwind question, pessimism there that Warren has not– He’s pointed out problems, but he’s historically been still pretty down the line of the America is an exceptionalism, said in other ways. But this American tailwind and that the luckiest kid is the one born today in America. I felt like it was a little bit more pessimistic than he’s been in years past in the things that he was calling out. I don’t know, Rich, I’m sure you’re smarter enough to not try to get bogged down in all that macro stuff, but any thoughts on that?
Rich: Well, first of all, I’m definitely smart enough not to get involved in the monetary side of macro stuff, because I never understood it to begin with.
Jake: Kudos. [laughs]
Rich: I had to take a banking class in college, and I never got it.
Tobias: That means you did understand it.
Jake: Yeah. Yeah.
Rich: I still don’t get it. So, that’s why when somebody talks about crypto, I just bow out of the conversation, because I don’t have anything intelligent to say. But I would say the same thing about gold. I don’t get it. I don’t get gold. I don’t know how you pick one currency over another. What I get is if a business does something that people need, there’ll be a way for them to figure out how to do it profitably. And that’s a fundamental belief.
But I see that under, what you would say, a democratic society as well as under an autocratic society. The economy is important to an autocrat as much as it is to the leader of a democratic society. And so, when everybody said like a year ago or two years ago that China was un-investable–
Jake: Yeah. That make your ears perk up?
Rich: How could you say that they– They have great franchises, some of which have nothing to do with anything that’s going on in the world, and you can own a piece of them and share in their profits. So, I don’t spend a lot of time thinking about currencies, or interest rates or things that are too esoteric like that.
Tobias: You’ve got global strategies though. You don’t hedge, you just figure it all comes out in the wash.
Rich: It’s so hard to hedge, because you don’t even know what to hedge in, because you really don’t know exactly what the currency exposures are.
Tobias: Because they trade internationally?
Rich: Well, you know what they trade in, you know what currency they trade in. And there is some relationship. But the businesses that are conducted globally are done in all kinds of currencies and the cost exposures and all kinds very complex unless you have the inside data. So, you would still have to allocate and decide what’s cheap and what’s not. The local country has some impact on that. But I don’t think of it in terms of currency hedging as much as I think of it in terms of how low does the multiple have to before I will buy Russia, let’s say.
Jake: Yeah. It is quite difficult when there’s a part that has been traversed all over the planet, and then maybe a lot of it in China and then they put the last little weld on in Vietnam to get Vietnamese–
Rich: They can’t even figure out how much tariffs they’re going to have to pay.
Jake: Yeah. [chuckles] How are you supposed to know what the cost structure should be for currency exposure?
Tobias: When you look at the market in the US for the stocks that you’d like to buy for the portfolio, how do you feel about the portfolios today versus say 2020, 2009, 2000?
Rich: Well, I’ll quantify that. Our range of buying stocks has been between around 5 times their normal earnings at the most extreme and 10-times at the highest, and we’re right in the middle. So, it feels like a very normal environment. The kinds of companies we’re buying, the things that are there– They’re different businesses that are cheap today than were cheap during COVID, and they’re more expensive than they were during COVID, but they’re right in the middle of their long-term average.
Tobias: After 2020, there was a pretty big bounce. Did it get expensive around– Just before the year 2022 was a soft year? Probably, I think we got cheaper at the bottom in 2022 than we have in this most recent– [crosstalk]
Rich: Well, we’ve never got to the high end. The only time that we’ve really been at that 10 times was in 2005 and 2006 in the last 30 years. So, we’ve gotten higher than midpoint, but never to the point where you say, I can’t find anything to do. It’s been almost 20 years since I would have said that. 20 years ago, I would have said, “It’s hard to find things to do.”
Tobias: Can you carry cash in the event that you can’t find [unintelligible [00:49:16]
Rich: No. I like that discipline personally, because deciding on cash is to me it’s much more of a short-term trading decision than it is a long-term, because cash yields you 4%, whatever it yields you.
Tobias: Negative 2% real.
Rich: Yeah.
Jake: [laughs]
Rich: I can find things that are better than cash over the long run.
Tobias: I know you’ve got global funds and you’ve got domestic US funds. Do you have any preference in terms of future performance for the domestic funds versus the global ones or vice versa?
Jake: Tell us your favorite child.
Rich: I just instinctively think that global is the best place to be, because you just expose yourself to more opportunities. As long as you understand that global means buying the cheapest stocks, not having some preconceived idea that I have to be in every country.
Jake: Mimicking ACWI somehow.
Rich: Yeah. There’s a lot of investors that particularly on the institutional side that care about how close you are to what the underlying universe is. We’re less concerned about that than we are about– We want a diversified set of opportunities with diversified geographies, but I’m not going to say I have to be India. I can’t find anything to buy India that’s cheap.
Jake: Yeah. Could you give us that alpha but without any of the tracking error, please?
[laughter]Rich: I haven’t figured that out. I did figure out though that the two metrics that people use for risk tracking error and volatility neither make any sense whatsoever.
Jake: What would you use Instead if you were in their shoes?
Rich: Well, there is no quantitative metric. That’s the problem. I would use the risk of permanent impairment of your capital rather than temporary impairment. I mean, volatility is this. It doesn’t mean bad. It just means vol. Really what a value investor does is to some extent exploit other people’s fear of volatility to buy things when they get particularly cheap.
So, if I was going to say my risk metric is I want to avoid volatility, it would be very hard. You want to avoid bankruptcy, you want to avoid something where you can’t have any chance of beating inflation and you want to avoid overpaying. That’s the most important thing to avoid, because if you pay 20 times for something that’s worth 10 times, you don’t ever get that money back.
So, if you stay on the cheap end and you don’t eliminate it, because you still make mistakes, but you minimize that risk. And then, the failure risk, it’s a combination of research and understanding when you don’t know what you’re talking about and say, when you see a stock that’s massively volatile and you don’t really get it, you probably shouldn’t put too much money into it.
It’s hard to put zero, especially if you see something that looks really, really compelling. But if you have something really compelling with a very levered balance sheet that is– When you’ve suffered bankruptcy, here’s a Warren Buffett-ism, we owned Fruit of the Loom before it went bankrupt, and Warren Buffett owned it after it went bankrupt.
Jake: Yeah. [laughs]
Rich: And it’s the same business. Same business. It’s just that the lenders got nervous and so said, “I’m out of here.” They made the wrong call, the lenders. But if you were an equity owner, you got zero and Warren Buffett got it all. So, as a pure equity investor, you have to be sensitive to that risk.
Tobias: Combination of leverage and cyclicality of the business.
Rich: I know, but that was underwear. I mean, that was underwear.
[laughter]Tobias: It shouldn’t be cyclical.
Jake: Yeah. Rich, there’s a lot of people make, I think, reasonably persuasive arguments that we could be in for maybe a choppy period that looks more like the 2000 to 2009 maybe. So, buy and hold may not have the best experience just based on starting conditions. But perhaps if it’s a high vol era, there’s a lot of ups and downs, does that make you excited that maybe active investment will have a little time in the sun relative, because we know that passive has been eating the lunch for a while?
Rich: It does. The buy and hold where you’re buying with the idea of never selling isn’t a concept that fits with what we do. Particularly, when you’re buying the most deeply undervalued companies, they’re there because something’s wrong with the business, and they’re either going to fix it or not fix it. If they fix it and then it’s fairly valued, why do you want to keep holding it when you can find another one that is half price.
So, I’ve never operated under the buy and hold philosophy. I’ve operated under a longer-term hold than a trader might, because the reality is if you want to get something really cheap, the odds that it’s going to turn around in 6 months or 12 months are pretty low. And the odds that I know it and nobody else knows it are pretty much impossible.
Jake: It always takes longer than you ever could imagine, right?
Rich: Yes.
Tobias: Rich, you must have had your fair share of value traps. Do you have any thoughts on identifying them before the fact? What do you think about value traps?
===
Avoiding Value Traps
Rich: Well, I think that trying to avoid value traps pretty much ensures that you’re going to avoid value. [Jake laughs] I think the answer is you don’t know which are going to be the value traps. If you think you should know, you’re going to have a tough time as a value investor.
Now what would I say? I would say, if the balance sheet is questionable of the– Because as you said, Jake, that it takes longer than you think. If you’re on the edge, time is not on your side. So, yes, you want to avoid the risk of dilution and you won’t be perfect at that, but you can have smaller exposures to companies where the balance sheets are a little scary.
And then, the businesses that are like everybody knows are in perpetual decline, those are the tough ones also to invest in, because most managements, particularly of public companies can’t accept that they shouldn’t do anything. They want to do something. And doing something means let’s try a different business, because our business is no good.
Jake: Yeah. That’s waste a bunch of money trying to do something else.
Rich: Right. But absent that, being uncertain is part of the game. So, you either live with uncertainty and be a value manager and say, “I’m playing the odds–” I would say, if we are superb at what we do, we’ll be 60/40. We won’t be 80/20. But what I want to be able to say, is that if I’m 50/50 on my judgments of whether this is a value trap or not, I want to have a good record being 50/50, because the ones that go up are going to go up by more than the ones that go down go down. And that’s the key to it all. And then, you try to be 60/40 with a very intensive research effort and that’s– So, you spend all this effort to go from 50/50 to 60/40, that’s how I think of it.
Jake: Mm-hmm. I’ve wondered before too if it’s a bit like– You hear like you would say the fifth best copper producer on price is where all the juice really is in a commodity business and swing. Maybe you’re a coin flip on that one working out. But maybe if you moved up to the best low-cost producer, you’re up to a 80% chance. But it’s a much tighter– Like you’re not going to get the same explosive pay. And so, just going between those is really difficult.
Rich: I would tell you that this is what I think. If you were going to draw like a curve of all use quality metrics, like the low cost producer, but if you’re going to use return on capital employed as a proxy for that, if you study that over time, it’s interesting that if you invest in the companies with the lowest return on capital, that’s generally not the best place to be. And if you invest in the companies with the highest return on capital, it’s also generally not the best place to be. And it peaks in between and it looks like that. It looks like this kind of a curve.
Jake: Like a U-shape.
Rich: Yeah.
Jake: yeah.
Rich: And so, I think that I’d rather own an industrial company that generates a 15% after tax return on capital than one that generates a 50% after tax return on capital.
Tobias: We’ve had the same discussion.
Jake: Yeah. Reversion to the mean is coming for you.
Rich: [laughs] Correct. Correct.
===
From $2 Billion Dreams to $70 Billion Reality
Tobias: Rich, we’re coming up on time. Pzena Investment Management is nearing on $70 billion and 30 years in business. Did you think you’d see those sort of numbers when you’re getting started?
Jake: Wow. Incredible.
Rich: Now, we made a forecast at the beginning to attract my partners to join me. And two billion was the ultimate upside case.
Jake: That would be preposterous if you got to two billion. [laughs]
Rich: Yes. Yes.
Tobias: Well, congratulations on a wonderful career.
Rich: Thank you.
Tobias: Congratulations on the next leg and on your daughter getting married and so on. You’ve got lots to look forward to. Thank you so much for joining us today. We really appreciate it.
Rich: Great. Enjoyed it. Enjoyed it. And lots of luck to you, guys.
Tobias: Thank you very much. JT, any final words?
Jake: No, just a real pleasure to have Rich on. I think I teased him a little bit before that– They always caution you not to meet your heroes, but in this case, it ended up working out okay.
Rich: I appreciate that.
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