In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and John Huber discuss:
- China’s Wild Capitalism and the Mag 7
- The AI Disruption: Google, OpenAI, and the New Web
- The Reinvestment Engine: High Free Cash Flow + Smart Management
- Understanding Competitive Edge: Informational, Analytical, Behavioral
- Drawdowns, Survivors, and the Evolution of Stocks
- Is Google Still a Buy? Capital Allocation and Waste
- Small Banks, Annual Meetings, and Scuttlebutt Edge
- What Separates the Comebacks from the Death Traps?
- Growth, Mean Reversion, and Market Expectations
- Costco, Walmart, and the Illusion of Safety
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: I think we’re live. This is Value: After Hours. I’m Tobias Carlisle. Joined as always by Jake Taylor. Our special guest today, he’s returning, one of our fave, John Huber. How are you?
John: I’m doing great, Toby. Just trying to give you, guys, some quality minutes off the bench whenever you need me. So, glad.
Jake: [chuckles] Well, unfortunately, I think the interview you did with Bill was so good that I think I’m not sure how we’re going to be able to keep the bar that high, but we’ll do our best.
John: Well, you just got to have Bill back. So, swap me out, and put Bill in and you’ll get the same quality.
Jake: [laughs]
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China’s Wild Capitalism and the Mag 7
Tobias: We were just talking China before we came on. Jake and I did a visit. John visited in 2018. We were talking about how China has been the wild west of startups and we’ve seen these giant companies come out of nowhere. And then, some of them have been surpassed by other giant companies out of China. We’re just wondering whether the West is immune to that violent capitalism that the Chinese are engaged in. What do you think of the Mag 7? Which is the most at risk from China or competition? Does Tesla fall in the Mag 7?
John: Yeah, I think Tesla’s in the Mag-7 still, right?
Jake: Yeah. You only get into the acronym if your price is going up. Eventually, if your price stops going up, you’re out of the acronym, we’ll make a new one.
Tobias: They snuck out. Netflix for a little while snuck in Nvidia.
Jake: Yeah. Netflix– [crosstalk]
Tobias: Netflix is back, baby.
Jake: [laughs]
John: Yeah, that’s a good question. I don’t know which one would be most vulnerable, but we were talking before you push the button. But it’s very competitive. I think that you guys have been there and I was there seven years ago now, which is like seems so long ago, because so much has changed since I was there. I was there right at the end of the Xi Jinping’s first term and then in the fall– I think it was the fall that year that he said like, “Things are going to be a little different around here and I’m going to be sticking around longer,” and things I think changed significantly after that.
But the one thing that probably hasn’t changed much is China is just so fast moving and fast paced and competitive. And with AI, it just seems like things are moving so fast and the competitive advantages might be totally different in the next decade or two than they were in the last decade where you had these walled gardens and network effects that are still extraordinarily valuable, but they might be–
You can see these companies shifting with their capital spending and their strategies. Everybody’s shifting to AI, but it’s uncertain to me who’s going to emerge as the winner there. But obviously, the existing incumbents have a lot of advantages. But yeah, it’s competitive, for sure.
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The AI Disruption: Google, OpenAI, and the New Web
Tobias: A couple of interesting data points that I saw. I was watching a GaryVee video, because I watch some GaryVee every now and again. He said that, “The click through rate for social had gone from Google would–“ In the original,” I don’t know how long this is now, 10 years ago, “Google would go to your web page twice to deliver you one click. If you’re earning your money through advertising, then that’s a pretty good rate.” And now, it’s six times for one click.
OpenAI does 1,500 visits for every single click. So, the monetization of web pages is going to be much, much lower than it was in the past according to him. The solution is rather than building a big social following, because it’s not social anymore. It’s purely virality. You have to go viral, you have to say something outrageous and become it on Twitter for a day, which that doesn’t appeal to me at all.
Jake: Oh, boy.
John: Yeah, there’s some ramifications there that might not be– There’s pros and cons. [chuckles]
Tobias: I can see the cons. Tell me what the pros are.
John: Yeah. Yeah, I don’t know how good that would be.
Jake: Was that the step that wasn’t explained in the movie, Idiocracy, where it was like, [chuckles] you had to have selection for stupidly outrageous viral content.
John: Yeah. I don’t know. There was an article I think in the Journal that I glanced at this morning that talked about that, Toby, where I think news organizations, I think they cited the Atlantic as, “All hands-on deck, we need to change the game plan here, because we’re not getting the pass-through volume from Google.” And so, it’s–
Jake: Yeah. Organic search, right? It’s been–
John: Yeah, organic search is going to look totally different. Somebody said, “Google’s essentially now answer engine. It’s not a search engine anymore, it’s answer engine.” And so, that’s going to be interesting both from how that affects everybody else and then also how Google tries to monetize that and how other AI platforms try to monetize what they’re doing, how does ChatGPT make money and all that’s very interesting–
Jake: Banner ads. Chat– [laughs]
Tobias: Yeah.
John: I think Ben Thompson was– He said like– Yeah, I think he was joking, but it’s like “We’re coming full circle back to banner ads, back to internet 1999.”
Jake: Oh, gosh.
Tobias: That was Google’s promise originally. It was just a more if a better search and a clean web page. And now, if you go to ChatGPT, it’s a pretty clean web page and a better search. Google’s great risk, is that it gets– The ChatGPT, whatever page you engage in your search with, it’s not Google. Dinosaurs like me, I still type the question into the search bar and then I take [crosstalk] AI answer.
John: Yeah. I still use Google a lot. I would be interested to look at my usage of it to see how it has changed, because I’m using it differently. But I’m on Google every day. Obviously, Google has all kinds of different products that I use every day. I’m using maps and all kinds of things. Obviously, Gmail. But the way I’m engaging with it for me is totally different. I’m using it really as and– If I need a quick answer to something, if I want to check, “Give me the NBA game.” Like, “I want the score of that game” or just something quick, I type it into the search bar and it just answers my question right away.
And then, for ChatGPT, I’m using that– And of course, you could use Gemini or some other AI solution, but I use ChatGPT. That has definitely replaced a lot of my Google– I guess the use case of going down rabbit holes and reading articles and clicking on all kinds of links, ChatGPT has replaced a lot of that for me. I use it all the time for research. It obviously serves up links too that you can click through. I do that, but I find it more of an effective tool for research. So, from an investing standpoint, that has definitely replaced a lot of the Google.
But in terms of Google’s core monetization, you’re still probably using it to search for car insurance quotes, for travel, certain things like that. They’re in a great position to potentially, eventually win the game. It’s uncertain to me that ChatGPT is going to be the winner even in the very narrow use case that I’m describing.
Jake: What if they’re Netscape, basically?
John: Yeah, who knows, right? I don’t really know the economics of that company. They’re getting subsidized by Microsoft. So, how long can they afford to do that? If Microsoft makes them pay a fair market rate for their compute, then maybe they’re at a disadvantage to Google, what they probably would be. So, it’s going to be very interesting to see how it plays out.
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Is Google Still a Buy? Capital Allocation and Waste
Tobias: Google might be cheap then?
John: Google looks cheap relative to its historical valuation. It generates a ton of free cash. The problem I have with Google is it’s harder– There’s a lot of waste I feel like in the– If you look at the expense line and you compare it to Apple or Microsoft or any– Apples and oranges in one way, but you can look and get a feel for how much they’re spending on a– [crosstalk]
Jake: I see what you did there.
John: Yeah. And so, I don’t know. I think there’s two things. The excess spending on stock-based comp and then also I think the leadership and the capital allocation. Apple is so disciplined with their M&A. I think that’s one reason why Buffett, I think, likes Apple and never bought Google and Amazon and Facebook and these others, is he couldn’t predict these acquisitions.
Google spent $32 billion on a company that I’ve never even heard of. It doesn’t mean it’s a bad acquisition, but it’s harder to predict how that’s going to play out. It might be very good. I’m not suggesting it’s a bad deal. But it’s harder to predict that, whereas with Apple you know what you’re getting. They’re just much more disciplined. Same with Microsoft, they’re much more disciplined cost structure.
Jake: They did a big acquisition. Apple did, but it was of themselves.
John: Yeah, exactly. Yeah. Yeah. They probably spent more than 490 of the 500, in terms of market cap [crosstalk] on their own stock. So, it’s just a more predictable use of cash. Now, at this level, it’s not as nearly as good. It’s not as valuable. When your stock trades at 10 times free cash flow and you’re growing at 6%, which is what they’re doing, you’re going to get mid-teen returns as a shareholder. Even with no multiple expansion. The multiple could stay at 10x and you’re going to make mid-teens returns through 10% buyback yield and 5% or 6% growth.
Now, with the stock at 30 times, it’s obviously not nearly the same equation. So, it’s not necessarily a good stock. They’ve done a very good job, I think, staying focused. Some people would say, “Well, maybe they’re behind the eight ball now.” Who knows? I don’t own Apple. I used to own Apple for many years, but I don’t own it now. It’s not the same valuation and there’s probably some uncertainty there too in that business model.
Tobias: What do you think about the Beats acquisition by Apple years ago? Was that a good thing or was that just–
Jake: Kind of rounds to zero, doesn’t it, at this point?
Tobias: Yeah.
John: Yeah. I think they spent $3.2 billion on that. I don’t know if maybe they got some IP out of it or they never really– The AirPods came around soon after, I feel like. For a while, Beats was the thing, I feel like. And then, AirPods revolutionized everything in terms of– So, yeah, I don’t think anything really economic amounted from that deal. But that’s an example of one of the few things that they did do. It was obviously a rounding error in terms of the size for Apple. They do a few of those deals, but not much and say 90% of their money goes to buybacks.
Jake: It was accretive for Dr. Dre, I think. So, that’s good.
Tobias: It’s good for Jimmy.
Jake: It’s good for Jimmy. [laughs] Those guys did all right.
John: Yeah, they did. Yeah.
Tobias: There are a couple of posts in your blog that they’re old now, but I like to go back and I just like to remember them. One is big companies go between the peak and the trough. It’s like, 1/3rd to 3x over the course of a year. And the other one is your sources of edge. Informational, analytical or behavioral. Do you want to just talk a little bit about that third one? Sorry, the second example.
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Understanding Competitive Edge: Informational, Analytical, Behavioral
John: Yeah, the behavioral edge?
Tobias: Yeah. Just the different types of edges.
John: Yeah. Well, I think you can gain an edge in the stock market through knowing a piece of information that nobody else knows. That’s not inside information, obviously. We’re talking about just information on a small company that you uncover through your own research that no one else knows about. You know, Buffett used to live on that type of edge in the 1950s and 1960s, like a lot of other investors, not just him. But Walter Schloss and all these other guys, they could flip the pages of the Moody’s manual and uncover all these great deals.
I think a lot of that has gone away. But I have lately been trafficking in some of these smaller companies, and I actually have changed my mind that there are still a fair amount of informational edges. They’re not gaping holes. They’re not massive edges. But every once in a while, you just get to know a business better than most of the market participants. I’ve just noticed it through, just you can connect with people at the company. You can talk to employees. It’s just easier to really do, I guess, scuttlebutt type research that does give you an edge. So, I do believe that is still available.
Jake: Sometimes, have you been to annual meeting where they’re saying things that are pretty important and you know that there’s nobody really there listening for these smaller companies.
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Small Banks, Annual Meetings, and Scuttlebutt Edge
John: Yes, absolutely. I have a basket of small bank stocks. And this is not a recommendation or suggestion or anything like that. There’s a lot of banks that trade at 50 cents or 60 cents on the dollar in terms of tangible book value. A lot of these banks are subscale, so maybe they only have $500 million of assets and they really need to be sold to consolidate those assets and deposits with a larger bank.
If you look at where banks sell– Almost every week, one of them sells, there’s still 5,000 or 6,000 banks in the country. QAnd that consolidation trend is a long, long runway, which is one of the attractive aspects of that investment. But the private market value is so much different than where some of these stocks traded. They’re not all that cheap, but you can find decent banks that are well run.
By going to the annual meeting, sometimes you go and there’s two or three people there. Sometimes I’m the only one there. It’s hard to buy some of these stocks. You can’t get a lot of them, but over time, you can. Yeah, just by going and talking with them, you get an understanding of– It’s not even a piece of specific information. It’s more just their mindset on capital allocation, how they think about buybacks. You get a real conviction around their strategy that you can’t really get from just reading the filing. So, that bill is available, I think.
I think the analysis side of it is just how you think about something. We were talking about Apple. In 2016, Apple was trading cheap, because people were worried about two things, basically. One was, Samsung as a competitor here in the US and around the world. And then, two, is the Chinese domestic manufacturers in China competing, and taking Apple’s market share in China. So, those two things combined with a worry at that time. This was like late 2015, maybe early 2016 about the next iPhone cycle was rumored to be poor.
iPhone saturation, people were worried about that. Growth had slowed down. For the first time ever, iPhone sales had ticked slightly lower. And so, everybody was– Those, I guess three things, now that I think about it, combined to create a stock that was like Apple was $500 billion, it had $50 billion of free cash flow, $100 billion of net cash on the balance sheet with no debt. And so, you have a stock that traded at eight times enterprise value to free cash flow. And so, I think there’s no information advantage. Everybody knows everything about Apple.
In one of those posts that you’re referencing, Toby, that was what got me thinking about Apple, because a lot of my investors had come to me and said, “Hey, why do you own Apple? What do you know about Apple?” The basic gist was like, “I’m not paying you to own Apple.”
Tobias:
Yeah.
Jake: Yeah.
John: Bill Belichick used to say like, “I’m trying to do his best for the team. I’m just trying to make the best decision if it’s a small-cap. Or, if it’s Apple, it shouldn’t really matter.” And so, that’s what drove me to start thinking about like, “What did cause this price to get mispriced?” It’s not an informational advantage. I think it was just a matter of thinking about it in a different way and thinking about that ecosystem.
In 2016, the ecosystem that everyone cites now was not really valued by the market at all. People were aware of it, but it was still relatively early days in terms of iPhone adoption. It wasn’t a given that Apple’s ecosystem was going to dominate, although I thought it was fairly predictable that it had a strong moat. You could just look at the lines outside.
When I was thinking About Apple initially 10 years ago, every time they would announce– Just like today, it’s no different today, but you’d watch these announcements and go on social media and there’d be lines out the door. It was just evidence that there’s real brand power there. This wasn’t rocket science. It wasn’t like that unique of an insight, but it was thinking about that and the long-term value of that. So, thinking about it differently, so that’s the analytical. You think about something that’s going to be valuable 5, 10 years down the road versus like, “Hey, what is this quarter going to look like?”
And then, in terms of the competition with China and the competition with Samsung, I wasn’t sure about the Chinese manufacturers that I did not have strong conviction on, but I was pretty confident that Apple was a better product than Samsung, because I tried them both. So, I felt like, even if they did lose share in China at eight times free cash flow, things will still work out okay if that moat stays intact.
Jake: I’ve been surprised that they were able to keep that 30% take rate this whole time.
John: Yeah.
Jake: You would have thought that at some point, people would be like, “You’re not doing 30 worth of value here.” Like, “Get off of it.”
John: Yeah. Well– [crosstalk]
Tobias: The government’s saying that?
Jake: Yeah. That’s what I meant. I’m surprised this lasted this long.
John: Yeah. It’s taken a long time. Epic Games, which is right here in my backyard here in North Carolina, that’s– It’s funny, because I love Apple as a business, but Epic is a hometown team. I have friends that work there. It’s a great organization. The leader, Tim Sweeney?
Tobias: Mm-hmm.
John: Tim Sweeney. Locally, he’s well respected. I think he’s got a good point on that. But that’s the thing with monopolies is they end up– Peter Thiel used to say, “The monopolies will never say they’re monopolies. They’re always very competitive. They’re in very competitive industries, and non-monopolies are always saying they have such a moat.”
Tobias: Yeah, that’s funny.
Jake: And then, how about the behavioral part– [crosstalk]
John: Well, the behavioral thing is just– that is more where I think most of the edge lies today in any of us that are picking stocks, is you’re just able to think about a business using a long-term time horizon. That’s obvious. Everybody talks about it. But sort of like hard work. Everybody says, they’re a hard worker, but nevertheless hard work is still valuable. Why? Because only a minority are willing to get out there and work–
Charlie Munger used to say that, “The top 10% are always going to be in the top decile.” That thinking long-term is very difficult if you’re a professional investor. It’s just there’s so many institutional imperatives. [coughs] Excuse me. I have lots of conversations like you guys do with other professional investors. Everybody says, they’re long-term, just like everybody says they work hard. But it’s difficult.
It’s hard when your livelihood maybe depends on making a decision or making a certain amount of profit this quarter or this year. It leads you to make decisions that aren’t optimal for the portfolio long-term. And so, I think that behavioral edge is always going to be an advantage in stocks. I think it’s actually only gotten more of it’s– That advantage is grown over time as time horizons have condensed.
Jake: How about the common refrain we hear is about like, “Well, the flows are going against you so much and it can be for so long that you feel like, ‘Gosh, how do I survive to get to the time where things make sense again? Because everything’s just– that the tide is going against me this whole time’”?
John: Yeah. Another question I get often is like, “Well, okay, these stocks are undervalued, but what about value traps?”
Jake: This came from a viewer who wrote in who goes by the initials T.C. I don’t know who it was. [laughs]
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The Reinvestment Engine: High Free Cash Flow + Smart Management
John: All right. T.C. Toby’s one of my favorite TCs. See, there’s three things– If you can find these three ingredients in a stock– I think it’s very rare, but if you can find a high free cash flow yield and you can find a durable business where you can look out, say 10 years– I call it 10 -year tests. You look out 10 years and you say, “Okay, I can visualize what this company is going to be doing. I can get a certain level of conviction around their competitive position a decade out.” So, it doesn’t mean a long growth runway or a fast-growing runway, but just a durable stream of cash that you can predict. So, that’s the second.
And then, the third, and this is the part that makes it rare, is a management team that understands that the value of that high free cash flow yield. The common conflict is management is worried about entrenching themselves or making acquisitions, growing their empire instead of buying back shares. If you can find a stock that trades at a 15% or a 20% free cash flow yield, which is relatively rare, obviously, but if you can find that and you can couple that with, again, a durable business with a management team that uses the free cash for buybacks, what you effectively create is a reinvestment engine, right?
So, you can buy stock in a growth stock that– Let’s say, a classic Peter Lynch growth stock that’s a retail chain that’s growing its store footprint and investing into– Taking all of its earnings– Walmart or a Starbucks back in the day where they would take all of their earnings, they’d put up a new box, they’d earn 30% cash on cash returns, and it was just this fabulous growth story. But that requires an enormous amount of execution. It requires a big moat and it’s possible to find those.
But I think a lot of people undervalued these, I’ll call them like these high free cash flow yields, because they see the growth as like mediocre or– Maybe it’s consistent but it’s not growing. Or, there’s always the worry that it’s a value trap, what about these flows? Is the market ever going to go from 5x to 10x? Well, you don’t need to worry about it. If it’s trading at 5x and the management– If the multiple never moves, it’s actually an advantage for you, because you can create that reinvestment engine where on a per share basis, you’re getting a 20% compound annual growth rate on a per share basis. And so, that is actually more attractive to me than the classic reinvestment engine where you’re going out and expanding your business.
Because the reason is it’s more attractive is because they don’t need to do anything different. The management team from an operational perspective just has to keep doing what they’re doing now. They don’t need to execute on this huge growth plan. They can just buy back shares. So, it’s just really interesting to think about– I think at least right now, that’s where more opportunities are.
Not to say there’s not great growth stocks. There always will be great growth stocks. But 10 years ago, we’ve talked about this before. I think the three of us have chatted about this last time, but it is true that multiples have gone up a significant amount and part of that is due to the index flows and part of it’s due to I think the trade deficit, which is a capital account surplus on the other side of the coin, which means more and more money from foreigners are coming into the country and they need a place to put their money, and it goes into treasuries and it goes into the S&P. Foreign ownership of the S&P has doubled in the last decade, I think largely because stocks are going up and the S&P is a very liquid place for large foreign investors that have dollars– It’s an easy place for them to put their money.
So, those stocks, they’re just not going to offer the same yield that they did 10 years ago. And so, I think the opportunities are seeking out these stocks that are outside of the index perhaps. Some of them might be in the index, but for whatever reason, they’re undervalued. I think people should stop worrying too much about, like whether it’s a value trap and just focus more on trying to find the management teams that are allocating capital in a way that you would if you were running the business. Those are hard to find, but they are out there. So, that’s where I’ve been spending more of my time.
Tobias: Let me give a quick shout out to everybody at home. Toronto. San Rafael. Petah Tikva, Israel. What’s up? Temecula. Portsmouth, New Hampshire. Rochester. Bellevue. Bremerton. Dubai.
JT, we come right to the top of the hour. Do you want to do your-
Jake: Yes, sir.
Tobias: -veggies for John?
Jake: Veggies for John. All right.
John: Yeah. Yeah. Serve them up, Jake.
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Drawdowns, Survivors, and the Evolution of Stocks
Jake: All right. So, you are staring at your screen and your heart sinks. It’s another day of red. How many days in a row can this damn stock just keep going down? You look at it all the time, and you look back to that all time high, and then where you are now and you realize, “Oh my God, this thing’s down 90%. Just been killing me.”
Tobias: 10 bag at back to break even?
Jake: Right. And you start to wonder, “Am I the world’s dumbest investor or is this just the price of greatness?” It’s a haunting question. As it turns out, it’s not hypothetical, because this isn’t some flim-flam micro-cap biotech that never had a chance. You were holding Amazon, you were holding Nvidia, two of the greatest wealth creators in the last 25 years. And both cratered over 90% at one point. We’ve all been there or we will be there at some point. Why do some stocks die and then proceed to come back stronger while others just die? To unravel this, we’re going to leave Wall Street for a minute and head somewhere much older and much wilder. We’re going to need to bring a biologist along with us. We’re rewinding back to 1972.
Harvard Professor Stephen Jay Gould and his colleague, Niles Eldredge, drop this bombshell in evolutionary biology. Their paper challenges Darwin’s sacred cow of gradualism, which is that the species slowly evolves over time through tiny incremental changes via DNA mutation. You know, the tooth gets a little bit longer or the fur gets a little bit thicker.
Darwin’s phyletic gradualism was a great theory. The only problem was Gould found that it didn’t fit the fossil record. So, what they observed was that the species typically remains stable for very long periods of times, millions of years, and then bam, a shock to the system. Maybe it’s environmental, geological– And then, in this blink of an eye, geologically speaking, you see these massive changes. They named their theory punctuated equilibrium. In essence, that’s a fancy term for stasis is normal. You get the same stegosaurus for generations, but then change comes suddenly and abruptly and episodically. This disruption drives evolution.
Gould understood that the world really doesn’t run on these tidy curves. It runs more on chaos and surprise and luck. A little background on Gould. He wasn’t just some dry academic. He wrote very vivid prose, philosophical, poetic, even. He blended Darwin and jazz or baseball stats with the nature of time. He was a huge Yankees fan, which we’ll try not to hold against him. When he was five years old, his father took him to the hall of Dinosaurs in the American Museum of Natural History, and he encountered his first T. Rex skeleton. He knew in that moment that he wanted to be a paleontologist.
He’s now generally known by the public mainly for his– He had over 300 popular essays in Natural History magazine, and numerous books that were for both specialists and nonspecialists. And sadly, Gould passed away in 2002 at the age of 60 from lung cancer that was likely caused by asbestos exposure. So, let’s take ideas Gould of punctuated equilibrium back to investing, because markets often behave in very similar ways. And in fact, there’s a new white paper out from Michael Mauboussin called Drawdowns and Recoveries. It sketches out this financial fossil record and gives us a treasure trove of very useful base rates in this phenomena.
So, Michael and his team looked at 6,500 US stocks from 1985 to 2024. So, call it 40 years. And the headline stat that will probably grab your attention. The median drawdown for a stock was minus 85%. This is not the worst performers. That’s the middle of the bell curve. And it took about two and a half years to fall and another two and a half years to recover after that, if it recovered at all.
Another sobering fact. Only 40% of the stocks ever made it back up to their prior highs. So, if you have a big wipeout, the base rate is basically a coin flip that you’re ever coming back. The good news is the average recovery was nearly 340% of par. And that seems quite promising, right? Buy that dip, baby. But the average is considerably higher than the median recovery, because there’s some extreme skewness in the data that really pulls that average up. So, this tells you that some of the stocks produce very, very high returns off the bottom when they do survive.
It’s going to get a little bit worse. If a stock falls from 95% to 100%, so basically a complete collapse, the odds of recovery are only 16%. And it takes 6.7 years for the average duration of that drawdown and then another 8 years to get back to par if it ever happens. So, out of every 100 companies that fall into this abyss, only 16 ever claw their way back. And peak to trough back to peak, it’s almost a 15-year grind. So, yes, [chuckles] it’s a little daunting, that’s the dark math here.
It’s just like evolution. Like most species, like most stocks, don’t make it. The ones we remember are the survivors like Amazon and Nvidia, but they warp our expectations a little bit. What makes those 16 out of the 100 different? Michael gives us some clues here. The survivors had cyclical headwinds instead of secular decline, which is quite difficult to untangle, I think. Maybe John, we can follow up with how you try to think about that.
They typically had good unit economics. There’s a lack of lumpiness in required investments. So, think about opening a 1,000 square foot Starbucks kiosk versus building a $20 billion chip fab, for instance. Strong capital discipline and relatively clean balance sheets. Obviously, the more debt, the more precarious the situation. Access to liquidity during a crisis, and clear eyed and adaptive leadership.
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What Separates the Comebacks from the Death Traps?
Jake: So, this list might be your biological equivalence of thick fur, or sharper claws or the ability to hibernate during an ice age. So, what should we take away from all of this? Expect big drawdowns at some point. The average stock will get rocked eventually. That’s the rule. Not the exception. If you’re only investing for the straight lines’ up and to the right, you’re likely in for some unpleasant surprises. Evolution of markets have these discontinuous jumps.
These drawdowns really aren’t a bug in the system. They’re the sorting mechanism. They’re a filter, just like evolution. Most of the fossil record is made up of biology that didn’t make it. And so, it is in the stock market. And so, focus on adaptability and survival first as best you can, but expect to be tested and understand that the base rates of these drawdowns and recoveries are quite daunting.
Tobias: So, once it’s down 85%, 40% of those recover back to their all-time highs in two and a half years. So, that means that you’ve got a two in five chance of having a six or seven bagger in two to five years, and the other six don’t do anything. You’ve got to write that off. But I think you’re ahead if you do that, don’t you?
John: It sounds that [crosstalk] screen. Just screen for stocks down 85%.
Tobias: And buy those?
John: [chuckles] If 40% of them go up, what would be the math there? 6x.
Tobias: Yeah, it’s a 6x.
Jake: Well, that 85% is the median stock. How far it’s down?
Tobias: Okay. And then, there’s this other group that if they go down, if they go 95%–[crosstalk]
Jake: 95% to 100%, then you’re a 16% chance of ever getting backup– [crosstalk]
Tobias: In that 5%, so they’re down less than 5% of their peak. They’re not moving from 5% to 100% down. If they’re 100% down, that’s overrun.
Jake: Right. Right. Yeah, right. And that represents something like I think it was like a quarter of the entire sample that they looked at fell into that bucket. It’s the biggest bucket.
Tobias: Down 85%, but not 95%.
Jake: [chuckles] [crosstalk] maybe.
John: Carvana wasn’t it down 99%? I think it’s back to its all-time high.
Tobias: Just for Jim Chanos to come out.
John: Yeah.
Tobias: Spike it at the top.
John: On 99%, so that requires 100 bagger to get back to its previous high. But yeah, those are the exceptions, I think. I think it’s so interesting to read about those or follow those exceptional companies, because it could have gone a different way. Carvana was very close to bankruptcy. There’s a lot of different ways the universe could have played out in 2022, where they wouldn’t have made it or they would had to restructure or something.
Jake: Or, massive dilution or something?
John: Yeah.
Tobias: I think that deluded.
John: There’s some really smart investors that have been– I would say correct in their assessment of the company’s position and they were right about a lot of aspects of it, but it’s really hard to predict that. Same with Amazon. Amazon, I don’t think a guarantee in 2001 that that business would have made it. The thing with Amazon that they had is they had negative working capital, whereas Carvana was very capital intensive. Amazon really had very little capital invested on their balance sheet until 2017. It’s really remarkable if you go back and look as you–
You think of Amazon is like a pretty capital-intensive business, unlike the other big tech companies that have always been– We’ve always viewed them as capital light. Now they’re all capital heavy. But Amazon was very capital light. No, those are super interesting stats. It’s a sobering thing because the other– I forget which study it was, but you guys have all seen the study of all of the stocks going back to 1926 and the percentage of stocks that end up.
Jake: Best and Binder study that the 4%.
John: Yeah. That’s what it is. Yeah. Yeah. Like a majority of the stocks go to zero or don’t make it.
Jake: They don’t perform better than T-bills, I think. It was–
John: Or, maybe a majority of them underperform T-bills. All right, underperform cash. I forget how many actually go bankrupt– A fair amount actually I think do go to zero, but yeah, majority of stocks underperform cash.
Jake: All of them on a long enough time horizon.
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Growth, Mean Reversion, and Market Expectations
John: Yeah. Yeah. Yeah. So, it’s interesting. The other thing that dovetails with this in terms of the topic of what makes this game difficult and I guess also very interesting– The base rates around growth rates. I think Mauboussin has talked about this too, but they’re– I think actually on Bill’s podcast, I was talking about a study where it highlighted how difficult it is to sustain a growth rate. If you find a company that’s growing at 10%, I think 1 out of 12 chance that it grows at 10% for the following decade. So, it’s very unlikely that it’s going to continue to grow at that same rate.
Tobias: So, you wouldn’t think that 10% is a high growth rate either. I mean, it is a pretty high growth rate– [crosstalk]
John: That’s the other thing is 10% is an extraordinary growth rate over a long period of time. Very few companies can grow that fast, if you think about it. It doesn’t take too long to compound those numbers. If you’re a very small company– There are companies that can grow at 10% for a long time, but it’s a lot more difficult than people realize. If you’re looking at companies that just did that in the last decade, it’s very unlikely that they’ll do it again. You’re better off looking for a company that hasn’t grown at that rate and has some change, some something happening fundamentally that’s changing. But yeah, it’s–
Jake: That’s especially true on the, as you work down the income statement. Revenue actually has some reasonable persistence in maintaining a growth rate. Like you said, I mean if it gets too big, it’s really hard to keep it up. But persistence generally in revenue, but as you work down to, down the line, net income or returns on capital, all those things, there’s serious mean reversion there.
John: Yeah. Yeah. Those are highly valued by all of us. We all want a business that can grow predictably for a long period of time, and that’s what makes a lot of these companies, I think, so highly valued now that they used to be reasonably valued 10 or 15 years ago and now, a lot of them, not all of them, but a lot of them are priced if not to perfection, then at least fairly valued, where you’re forward returns are probably just going to be average equity like returns which is okay, but not necessarily what–
Jake: That’s if things go well though, there’s also that–
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Costco, Walmart, and the Illusion of Safety
John: That if that’s the things go well. Yeah. There are extreme examples. Costco is one that just perplexes me. It’s such a great business and it does have a super strong moat, but it’s trading at 60 times earnings. It’s not a business that has these call option type. Nvidia is very hard to predict. Nvidia could be very cheap. There’s a lot of things that could happen there that would be surprising on the upside. Whereas Costco, you understand what the business is. It’s growing at 10%. If the multiple gets cut in half, even over a decade, that’s a 7% headwind per year.
If Costco trades at 30 PE, which is its average historical multiple, which is not that cheap, but just average, you’re going to be in it for a lost decade. There’s a lot of stocks that are priced that way. So, yeah, you got to be careful with growth. Yeah, the drawdown thing is just the reality, I guess, of capitalism, right?
Jake: But John, have you read Zen and the Art of Motorcycle Maintenance? Of course, you got to buy Costco. [laughs] I’m teasing quality friends. Don’t send me hate mail.
John: I love quality stocks. We all love quality stocks, but we are trying to produce a good return on our investment. Costco is not–
Jake: It’s not just a game of analysis either. It’s a meta-analysis. If the price implies certain expectations, can you meet or beat those?
John: Yeah. I think Costco has this bit of a halo effect from in part, I think, because of Charlie’s love of Costco. And understandably so, it is just this outstanding business. But the other thing Charlie said that is worth keeping in mind is, which is, what you just are implying, Jake, it’s like the horse odds. The goal isn’t to pick the fastest horse. It is to pick the horse with the best odds. And Costco is not the horse with the best odds. It might still continue to do well. I don’t think it’s the horse with the best odds.
Tobias: I think it’s a little bit like the early 2000s when there were lots of really good businesses around that continued to be really good businesses, Walmart, Microsoft, GE to a lesser extent, but lots of those businesses. They just went sideways for 15 years. It wasn’t that they were doing anything wrong. It was just that expectations were so high going into 2000 that the businesses had to catch up to the valuations, which they did eventually and they’ve grown beyond that many of them, so you can– [crosstalk]
Jake: Set that calendar reminder for 2040 to buy leaps on Costco. [laughs]
Tobias: Well, the nice thing, is that at some point, they’ll be pretty good value.
Jake: Yeah.
Tobias: And people will say, “Well, it doesn’t matter if it’s a really good business. It just doesn’t go anywhere. It’s too big.”
Jake: They just think, this is [crosstalk]. It doesn’t go anywhere.
Tobias: That’s what happened to Walmart. Walmart just went sideways for so long.
John: Walmart’s another example of a stock that– Yeah, it traded at– That’s actually a great point, Toby, because Walmart in the late 1990s was probably 40 times earnings, and then it went down to 10 times earnings and now it’s back to 40 times earnings. So, these things are a little bit cyclical. There’s always a reason to ascribe. Whenever I talk about this or write about it, I always get comments about the reasons that– People ascribe reasons that justify the multiples like, “Well–
Tobias: Yeah, of course.
John: There’s all these flows. We talk about index flows. Well, they’re great businesses. They have these high returns. Those are reasons perhaps that contributed to the valuation, but it’s not a justification for the valuation. The valuation might still be unjustified. That could be why people have bid those stocks up to high levels, but it’s not a reason to feel safe with your investment there, because those stocks can be very risky. They could be very great businesses, but very risky investments at certain levels.
Same thing with Microsoft in the late 1990s. Microsoft’s a little different because the business changed so much, but Microsoft went down to 10 PE, and now it’s back to wherever it is. But yeah, it’s–
Tobias: And it made total sense at the time too, because they had the first year of revenue, not like– I think they shrunk one year, like 2010, 2011. They had Ballmer as the CEO and people didn’t like Ballmer as the CEO. Hadn’t done anything for a long time at that point since 2000. And Whitney Tilson was pitching it at value investing Congresses. I remember hearing him pitch it and just thinking, yeah, good luck. That’s not going to work.
John: Whitney had that one. [Jake laughs] He was right about that one.
Tobias: 100%, he was right about that.
John: [laughs] Who knows if he had the cloud. The thing about Microsoft is the cloud business didn’t exist and nobody really knew about it.
Tobias: And they changed to the subscription pricing model.
John: Yeah. But Microsoft’s a good example of a company that like to Jake’s point, on this drawdown stuff, like you need to have an adaptability. You have to be a company that’s dynamic and adaptable. it took a leader that– once Satya came in, I think he changed the culture in a way where they were going to start focusing on little things, focusing on opening up their– As a user, one of the things I always hated was you couldn’t get Excel on your Mac.
Tobias: Yeah.
John: It’s ridiculous. And he’s like, “Yeah, we’re going to do–” Like, “we want to be where all of our users are on any platform.” And so, it was a pretty big change in philosophy, I would say. And then, other stocks like Walmart, they’ve had some changes too. Obviously, e-commerce has been a big change, but I think a lot of it is just people like buying stocks when they’re going up and they’ve done well. The stocks have done well, and so you have this false sense of security that the stock is safe, because it’s done so well, it’s a compounder.
Tobias: I think the narrative follows the price.
John: Yeah, the narrative problems with price.
Tobias: If the price has been going up, you’re fine.
John: Yeah.
Tobias: They know what they’re doing. If the price is going down, they’re idiots, they don’t know what they’re doing.
John: That’s right. Yeah. So, the next phase, who knows? It’s hard to be precise with this stuff, but I do feel like we’re at a spot where some of those stocks are going to start to underperform and the businesses are going to keep doing fine. But if you’re paying 40 times earnings for a lot of these companies, you know great companies Moody’s and others, Walmart, Costco, these really high-quality stocks that are in the S&P, I think it’s going to be hard for those stocks to perform well.
And other stocks that are, I would say, probably viewed as relatively boring or maybe the business– You could poke holes in the business or something, but there’s a lot of stocks that have an underappreciated stream of cash flow that’s more durable than I think the market might expect. The business isn’t really growing, so it’s not exciting. But those stocks might outperform the Mag 7. I really think like some of those stocks are going to do much better than the stocks that are conventionally viewed as great stocks today.
Tobias: [crosstalk] Sorry, JT.
Jake: I was going to ask, any tips on how you untangle cyclical versus secular.
John: That’s one of the trickiest things with investing. We talked about Apple. It was always like, is this a cyclical? Is this just a bad quarter, or is this something more systemic where they’re losing market share? It’s always difficult for me to predict that stuff. I’ve had more success finding stocks that are either, for one reason or another, they’re undervalued– Apple would be an exception to this. But most of my successful investments have come from a change in capital allocation, where the underlying business is solid but there’s a change in how the business is going to allocate cash.
I’ve written about a company called Natural Resource Partners which is a mineral rights company. This is just an example of a company that in the past, it got over levered. It’s actually a great business. 90% margins. It’s like a royalty. It is a royalty company. So, there’s no CapEx, but they made acquisitions under a previous management team, previous capital allocation regime and they took in a lot of debt. And in 2015, they said “Hey, new game plan, we’re going to get out of debt, we’re going to simplify the business, we’re going to sell off these non-core assets that probably we shouldn’t have bought.” And eight or nine years later, they have essentially achieved that and they’re just about debt free. They’re a year away from being debt free and then they’re going to return all the cash as dividends. So, that’s a change in capital.
It’s the same underlying core business. They own 13 million acres of land. There’s not a really any change in the core business, but a huge change in capital allocation. With the businesses that are undergoing a like bad quarter, it’s really hard to know. I’ve made more mistakes there than– I’ve gotten more of them wrong than I’ve gotten them right.
Netflix did have a inflection in free cash flow, where they started to buy back shares. But Netflix was facing a lot of competition. It was really hard to know is it– All these different streaming platforms that were willing to lose billions of dollars competing with Netflix, it was hard to know if what their appetite would be to sustain those losses. And of course, in hindsight, the appetite wasn’t very big, because 2022, the downturn came along and it wiped out a lot of those playbooks. And so, companies had to rationalize, they had to cut costs, they started focusing on free cash flow and Netflix emerged as the winner.
And so, I think a lot of people had that right. You could look at it in hindsight, say, “Yeah, it’s obvious.” But in real time, it’s always hard to know, like you might have a hunch, but it’s hard to get conviction on those. So, I don’t really have a good answer. I’m open to what you, guys, think about that.
Tobias: I agree with you. I think it’s impossible to tell in the moment which ones are cyclical and which ones are secular. But I think Jake’s Mauboussin veggies were answered that question a little bit. It’s probably your own experience might be two out of five you got right, but it didn’t matter, because the two out of five went up six times. So, it paid for itself.
John: Yeah. That’s the great thing about this game, is you can get a lot of them wrong and you make a lot of mistakes and the winners more than compensate for the losers. And so, that’s the one advantage you have as an active stock picker. There’re other advantages too. I think long-term time horizon. I think index investing has become so popular, but you can still run a diversified portfolio.
This is what you do effectively, Toby. You can run a diversified portfolio and have– I think that’s what attracts a lot of people to the index, but you can structure your portfolio in a way that is much safer than current index levels. You can still take advantage of those tail events on the upside that inevitably come along every once in a while.
Jake: Yeah. If you took some of the concentration levels that are in the index right now as an active manager, you might be looked at–
Tobias: A rogue.
Jake: Yeah, you’d be looked at as perhaps a little like risk taking or a little crazy even maybe.
Tobias: I do agree that you should grow to that level rather than initiate at that level. I think you could forgive the index for getting there, just because it just doesn’t sell. Whereas people size up those positions from the outset, doesn’t always work out. One of the questions that we have here is why did Walmart have a run up to such a high PE? But I distinctly remember when Walmart was one of the hottest stocks around. People used to produce these little think pieces where they’d say, “What PE do you think you could have paid for Walmart in the IPO and still earned the market return since then?” It was crazy. It was like 80 times or something. Maybe it was a 1,000 times wildly high.
John: Yeah. I guess he’s referring to this. In the late 1990s, it was priced similar to where it is now. What’s interesting about Walmart, is they have the annual reports on the website and so it is fun. The annual reports are like 13 pages. That’s another thing, just a side thing that is interesting when you compare it to the 10Ks today which are 200 pages of– You know 190 pages-.
Tobias: Well applied.
Jake: Yeah.
John: -written by an attorney and 10 pages are actually useful. So, they just had the useful pages. So, you can read through those. It’s really interesting to look at that business. One of the things that I always thought was interesting, is they never generated a dime of free cash flow until 1998. I think it IPO’ d in 1972 maybe, or maybe I’m wrong on that.
Tobias: Something in the 1970s.
John: Yeah. Maybe early 1970s, I want to say. Let’s say, three decades of their existence, they did not generate free cash. And it was just a growth story. They were obviously hyper successful on growing, and that’s part of what made the stock so highly valued then. What makes it highly valued now? I could speculate that it’s just some of the reasons that we’ve already talked about which is, number one, the stock’s done well recently. And two, it’s viewed as a safe stock. That’s my pushback on a lot of–
There’s an undertone of safety to a lot of these stocks that I think is dangerous. I think it’s viewed as a safe asset. It’s done well. It’s defensible. It’s recession resistant. It’s a great business and people have bid up those types of companies.
Tobias: There’s a good point in the comments here. Mohnish said, and I’ve read this as well, that “You could have beaten the market if you held the Nifty 50 and Walmart was in the Nifty 50.”
John: Yeah. [crosstalk] So, this is another thing that I don’t like, because cash was like double digits. So, eventually, you got back to the high 25 years later. But for 18 years, you could have earned double digit returns in T-bills, risk free. And so, your opportunity cost was huge by holding the Nifty 50. It doesn’t make any sense to me that the argument that, “Well, if you would have just held those stocks,” your opportunity cost was astronomical, because you had to endure the huge drawdown and then it took you 20 years to get back to even or whatever.
But in the midst of all that, you could have held cash or other investments. I think Walter Schloss was compounding at 30% a year in the 1970s and 1980s owning value stocks. So, it’s true that that happened, but it’s not– Again, I wouldn’t use that as a reason to pay up 40 times for today’s Nifty 50s. That’s not a good– You don’t want to sit through 20 years of flat performance with a big drawdown when you had all these other opportunities to compound.
Tobias: Hey, Johnny, just clip that bit of John saying that up and we’ll replay that. I’m talking to Johnny Hopkins, clip that up of John saying that value worked really well in the 1970s, 1980s, we’ll just play– [crosstalk] [laughter]
Jake: Just play that over and over. If I recall correctly, Chris Bloomstrand told me that he found some error in– I think it was Jeremy Siegel is the one who did that Nifty 50 analysis. Chris found some error that made that not true. I can’t remember the details of it.
John: Well, I’m not sure what error Chris is referring to. But if you just chart the Nifty 50 next to cash– We think of cash as like we’re used to cash earning zero or low…
But cash back then was earning double digits. Not to mention lots of other opportunities. So, there’s a huge opportunity cost when you pay that price. It is true that if you pick the right business, maybe you’ll get back to even. But it’s a very risky– As Jake would say, the base rates aren’t favorable there.
Tobias: Hey, and on that note, that’s time. Thanks, John. Incredible as always. If folks want to get in contact with you, follow along with what you’re doing, what’s the best way to do that?
John: I wrote a blog called Base Investing. My firm is called Saber Capital. Yeah, you can find me online. Occasionally, I’m on Twitter. Yeah, we’d love to engage as always. But yeah, thanks for having me on. It was always a lot of fun chatting with you, guys, for an hour.
Tobias: Pleasure. Thanks for coming. JT, any final comments?
Jake: No. Have a good summer, everybody, and we’ll see you next week.
Tobias: Thanks, folks. We’ll see you next week. Same bat time, same bat channel.
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