During his recent interview with Tobias, Ben Claremon, a Principal and Portfolio Manager at Cove Street Capital provided some great insights into why successful investors need a devil’s advocate to try to kill potential investment ideas. Here’s an excerpt from the interview:
Ben Claremon: And the proxy statement is a gold mine to tell you how people are compensated and how they’re going to act, and so we spend a lot of time evaluating that stuff. So let’s say after the first view, I’ve determined, or one of my colleagues has determined that this looks like a pretty good business, the people seem good to okay, and looks reasonably valued, right?
Then we move into stage three, which is our team tackle, and so this is something that’s a little unique about Cove Street, and it’s an outcropping of the fact that we’re going to limit our asset size because we’re a small-cap focused firm. We’re going to limit the number of strategies that we have, and we have a limited number of securities because we run concentrated portfolios. So, what that means is that we can team tackle ideas, and so what a team tackle is, is that every idea has two longs on is and one short.
Ben Claremon: And the two longs are kind of focused on creating the Bull case, and when we move to stage three, we put this into our workflow. So it’s not like we drop everything, but we’ll have to recruit, so if I have an idea I like, I’ll recruit one of my colleagues, and he’ll be my co-long, and we’ll say, “Who wants to be the short?” And so what’s the point of the short? A short is the devil’s advocate, a short is the person who is coming up with reasons why we shouldn’t own it. The idea like, “How do you kill the idea?” And so what that does is it creates this back and forth dialogue about the risks and the benefits of this company. And so basically you have the whole team working on it, and what that does is, we benefit from the fact that we have different backgrounds and different thoughts processes.
Ben Claremon: So, I think Jeff [Jeffrey Bronchick] created Cove Street in a way that he didn’t want all of us to be, and there’s nothing wrong with being this, but he didn’t want us all to be like ex-investment bankers who spent three years in banking, worked one year in private equity, and now are working on the buy side in equity research. Eugene Robin, my colleague worked ViaSat as a satellite programmer, I come from the real estate industry, my colleague Dean basically worked for a government agency, was like an outsource CIA kind of investigator. So really what it is, is taking all these peoples backgrounds, and all these different perspectives both on value and a focus on value investing, and meshing them together and coming up with a really, I think, good back and forth about this company, and so that’s stage three.
Ben Claremon: And so-
Tobias Carlisle: Just before you go into stage four, how often does a short prevail over the two longs and what are the sort of reasons why a short might prevail?
Ben Claremon: That’s a great question, and so I mean, by definition, the short prevails far more often than the opposite because we pass on so many things. And it doesn’t necessarily mean that the short had some kind of like, silver bullet moment where “We can’t own this because of this.” Like you found a fraudulent thing, it’s not that. It’s more like, you can convince your colleagues who are excited about it, that there are more risks than rewards, and that the symmetry isn’t there or maybe the value isn’t there. Or that, and this is something that, or that the people are not people that you can trust. And so, I think what this does more than anything else is creates a culture where we’re both willing and able to accept criticism, where we’re willing and able to accept other peoples ideas, and we listen to each other. And I think that’s really hard to build, and I give Jeff a lot of credit for being able to kind of inoculate that culture.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
In this episode of The Acquirer’s Podcast Tobias chats with Ben Claremon, a Principal and Portfolio Manager at Cove Street Capital. Ben’s focus is on the SMID-Cap Universe, where he believes the best opportunities exist for investors. Ben provides some great insights into:
– How To Identify Buffett Style and Graham Style Stocks
– The SMID-Cap Universe Provides Greater Opportunities Over Large And Small Caps – Here’s Why
– The Proxy Statement Is A Gold-Mine To Tell You How People Are Compensated And How They’re Going To Act
– Successful Investors Need A Devil’s Advocate To Try To Kill Potential Investment Ideas
– When You Run Concentrated Portfolios, You Only Need A Couple Of New Ideas
– Before Buying A Stock Ask Yourself – “Would You Rather Own Tootsie Roll?”
– Investors Should Spend More Time Focusing On The Culture Of The Business Behind The Stock
– PEST Analysis Provides Investors With A Great Risk Assessment Measure
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias Carlisle: Let’s do it. Hi, I’m Tobias Carlisle, this is the Acquirers Podcast. My special guest today is value investor Ben Claremon of Cove Street Capital, he’s a principle and a portfolio manager there, we’re going to talk to them right after this.
Speaker 3: Tobias Carlisle is the founder and principle of Acquirers Funds, fore regulatory reasons he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds of affiliates. For more information, visit acquirersfunds.com.
Tobias Carlisle: Hi Ben, how are you?
Ben Claremon: Doing well, Toby. How are you?
Tobias Carlisle: I’m very well, you’ve got a disclaimer that you have to read, so let’s do it right now at the front.
Ben Claremon: Yeah, I know, I promised my compliance person that I would read the following, the views expressed herein are those of myself and do not necessarily reflect the views of Cove Street Capital, or any of its employees. The information on this podcast should not be considered as a recommendation to buy or sell any particular security, and should not be considered as investment advice of any kind. You should not assume that any security discussed is or will be profitable.
Tobias Carlisle: So, basically what they’ve done there-
Ben Claremon: We can start.
Tobias Carlisle: They’re trying to make sure that you’re personally liable for any stock recommendations that you give in this podcast.
Ben Claremon: Yeah, well, you know, this is the world we live in and I do what I’m told to make sure that I don’t get in trouble.
Tobias Carlisle: So you and I have known each other for quite a while. I met you possibly even before you have started your MBA at UCLA, is that possible?
Ben Claremon: So it was probably during the MBA.
Tobias Carlisle: During the MBA.
Ben Claremon: Because I moved here in 2009 for the MBA, but yeah, that’s probably when we met so, it’s almost ten years now.
Tobias Carlisle: But I feel like I’ve known you because you wrote the Inoculated Investor blog, the fantastic Inoculated investor blog. When did that start, 2009, 10, something like that?
Ben Claremon: Yeah, so let’s start with the fact that I never really wanted to be a blogger, I always wanted to be a portfolio manager and an analyst and I wanted to work on the buy side. But, I started my career in 2007 and if any of you recall what had happened over the next two years was the financial crisis. And that was not an easy time to get a job and so I kind of bounced around on the buy side in New York City, and you know, I’m always looking for something to distinguish myself. And so I started the blog basically with a launch with the notes from the 2009 Berkshire meeting. I went to the meeting, and I had the crazy idea that I was going to take down every word that Buffett and Munger said. I will tell you, going back to 2009. I wrote this out, I didn’t even use a laptop, so, it was-
Tobias Carlisle: It was handwritten?
Ben Claremon: Handwritten, I think the first two were handwritten and then I got smart, I said, “This is ridiculous.” And so, that was it, its unique content, back then there weren’t that many people, that wasn’t transcribed over any internet platform. So really, all you had was people taking notes and posting their notes, and so that was kind of the genesis of the blog, I thought that would be differentiated content, I was just trying to stay in the game. Because I was transitioning to business school, wanted to stay as on the ground as possible in value investing and so that was a great platform for that and I met a lot of really interesting people like yourself. And it’s funny, people recognize me, they’re like, “Oh my god you’re Ben Claremon, the Inoculated Investor.” I’ll be at a conference or something like that, it’s funny and gratifying in a certain way. But these days I spend very little of my time writing and most of my time researching companies.
Tobias Carlisle: So I just want to tell everybody, the Inoculated Investor comes from that great Buffett quote where he says, “Value investing is like an inoculation, right? It takes or it doesn’t take.” So clearly, unfortunate both you and I have been infected and have suffered as a result over the last decade. But you’ve gone into Cove Street Capital, which you’re a principal there and a portfolio manager, and you guys run about a billion dollars based in Los Angeles. Tell us a little bit about the value strategy, because I always say, value’s a very broad church and it encompasses very deep value guys through to the franchise compounder guys like Buffett. So how do you characterize your style and how does that manifest?
Ben Claremon: Yeah that’s a great question, and I’ll even add another nuance there, it’s been different, value means different things to different people at this firm. We’re not even one uniform beast when it comes to how we look at value, but let me give you Cove Streets general philosophy and the way we approach value, and I’ll come in and put my own spin on it. Because as I’ve learned, and I’ve suffered in certain investments, I think my preferences have changed a bit. So, Cove Street, we look at value two ways, so what we call a Buffett stock and a Graham stock, and a Buffett stock is your traditional compounder, higher returns on invested capital, with a moat, and it’s a business that’s probably not training at a 20 cent dollar, 30 cent dollar. You’re probably playing an 80 cent, 90 cent dollar and you invest in it because the business is getting more valuable every day because the people who run the business understand capital allocation. And you benefit from the math of compounding and so you’re not getting it dirt cheap, but over time the value increases and that’s how you make a return.
Ben Claremon: So those are our Buffett stocks, and on the other hand, there are our Graham stocks, which are kind of an homage to Ben Graham who was a net investor. Not many of those these days, but when we’re talking about a Graham stock, we’re talking about a business that is, for some reason just not great. Whether it’s got cyclicality to it, or whether it’s got just a small total addressable market, or it’s got customer concentration, or end market concentration, that leads to cash flows that might not be particularly predictable or returns on invested capital that are just somewhat mediocre. And so, those businesses you want to buy cheap, you want to buy 50 cent dollars, you want to buy 60 cent dollars, and the difference in terms of our sell discipline, which we talk a lot about and think a lot about is before we buy a security, we pre-identify, is this a Buffett or a Graham? And if it’s a Buffett, and it gets to fair value, we’re more likely to hold it because we can benefit from the math of compounding and the business getting more value on the every day.
Ben Claremon: On the other hand, you have the Graham stocks, and what a Graham stock gets to fair value, we’re much more likely to sell it. We don’t want to fall in love with a business, we understand what it is, we understand what the risks are, and so once that margin of safety has been reduced, we’re much more likely to sell it. And so, our portfolio or our core small-cap portfolio is an eclectic mix of Buffetts and Grahams, and I would say we would prefer to own all Buffett businesses, in a perfect world we would own great business that are trading at 60 cents on the dollar and then we would go to the beach. But unfortunately, it’s a little harder than that, right? And so, Jeff Bronchick, our founder, he has a very eclectic view of value.
Ben Claremon: He will take an 80 cent Buffett or he’ll take a 60 cent Graham, we’re just very careful about position sizing and our sell discipline to make sure that we’re not assuming too much risk. On my evolution as an investor has really been colored by the number of times that I’ve seen businesses that either had mediocre people or just were mediocre in terms of their returns or their addressable markets. I feel like, if you just looked back at our history, the mistakes that we’ve made have been in lower quality businesses. And when you’ve been scarred enough times by investing in cigar butts and businesses that aren’t getting more valuable every day, for me personally it changed my philosophy.
Ben Claremon: So not to compare myself to Buffett at all, but in a sense, he made that progression, he studied with Ben Graham, and then he started to think about, “Hey, maybe I should invest in better businesses.” And so that’s kind of where I am, and so the portfolio that I co-manage Jeff, our founder, is a more Buffett oriented strategy. And I think these days I spend all of my time start with a good business, figure out who’s running it and whether these people are friend or foe and then focus on the value. And one other thing is create the Buffett list, which is the list of companies you’d like to own at a certain price and do the work, create model, have a price target and you know what the great thing about markets is that they’re … Well, they used to volatile. In theory, they’re volatile and vicissitudes of the market can create opportunities for us.
Ben Claremon: So do the work, be ready and have a list of companies that you’d like to own, and so that’s kind of the framework we’re operating under, and kind of bifurcated between Buffett’s and Grahams.
Tobias Carlisle: And your universe is quite clearly defined, I don’t think I’ve seen anybody as explicit about the universe that they look in. You guys are small to smid-cap, is that fair? Or small to mid-cap?
Ben Claremon: Yeah, smid. So, our small-cap strategy encompasses three billion and under, any securities three billion and under, and our smid-cap strategy, the one that I co-manage with our founder is a billion to 12 billion. So, I think basically we consider ourselves a small-cap firm, and so why would we do that is the question, right? I’ll put it out there, we’re not asset gatherers, we’re not looking to raise 20 billion dollars in large-cap value, because that’s a strategy that’s scalable, and you can raise a ton of money in it if you’re successful. It’s not in our heart, and we feel like it’s much harder to be differentiated in large-cap when you’re looking at Apple and Microsoft and Google, there are hundreds of analysts in the buy side and sell side looking at these things. And for us, we don’t feel like we can gain any kind of edge by the work we do, and so our general strategy and our process is to do a lot of work, and what does that mean?
Ben Claremon: I mean, I think everybody says that on their website, and I’m not disparaging everybody, but I think it varies depending on your process. And so our process, since we, and I’m going to get to the, “Why small-cap?” In a second. But since we do a lot of work, and our process is based around trying to determine, trying to figure out if we can get information to have an edge, and so, what are we doing? We’re going to trade shows, we’re calling customers, and competitors, and suppliers, we’re going to meet management. We’re going to poke around their office to see if they have fancy paintings and chandeliers or whether they’re kind of the true value and true Buffett like value investors. And they drive the same car that they’ve driven since the 70s, we’re really trying to understand the people and do a bunch of due diligence on the business.
Ben Claremon: And our sense is if you do that, and you’re successful at it, and you have a repeatable process, what you can do is, obviously we’re not talking about inside information. But you can have an understanding of the business and the people that a lot of people don’t have, and these are businesses that are often covered by one or two analysts, not 20 or 30. They may or may not have conference calls, I mean, we like things that are kind of off the beaten path. People who are not focused on short term wall street stuff, and not focused on quarterly earnings, and they’re really thinking three to five years out. Maybe even a family owned, a family-controlled company, someone who has what Tom Russo calls, “The willingness to suffer.” Right?
Ben Claremon: Someone who will invest for a long run at the expense of the short run, and so why small-cap is, in general, we think we can do that better in small-cap, and we can get some kind of informational edge and the academic research, I’ll let you … The guy who does the research thing about this, but I think for the part what we have is small-cap is an anomaly right? The thing that has for a long period of time outperformed.
Tobias Carlisle: I think you’re getting trolled there.
Tobias Carlisle: That’s fantastic. You’ve got a really detailed interesting process in the document that you sent through. You’ve got this four, you describe it as a four-step process, can you take us through those steps and talk a little bit about that?
Ben Claremon: Yeah, happy to do that, again I think we pride ourselves on more than anything else, is on the process because you can’t control the outcome, but you can control the process. So we want to put ourselves in a position of having a good process and even if we have bad outcomes, at least we’ve covered our bases, and we want to understand the difference between good process, good outcome, and bad process, good outcomes. Because a bad process, good outcome is just luck, and we’re trying to as little as possible depend on luck. So we have a four stage process, which starts kind of in a screening, so everyone has some form of screening. We have Capital IQ populated screens that run every Saturday.
Ben Claremon: We run through them, and on Monday morning we come and talk about them, and so what are we screening for? We’re screening for good businesses trading at reasonable prices and we’re trading optically cheap businesses and so again, the Buffet and Graham paradigm. And so with traditional valuation metrics like enterprise value to Notepad and enterprise value to EBITDA plus it’s more like a Greenblatt screen, which is stolen from Joel Greenblatt, trying to figure out good businesses that are trading at reasonable multiples. And then we also just screen for behavioral changes. So a CEO change, someone mentions strategic alternatives on a conference call, some kind of evidence that there’s a movement at the company.
Ben Claremon: Because we think that a lot of money can be made or lost, depending on investing in inflection points, and so if you can determine an inflection point in the business, you have an opportunity to make a fair amount of money. So, there’s that, so that’s one element of our screening, the other thing is, we may not be the largest firm in Southern California, but we’re strategically located right by the airport, and what that means is that we get a lot of management meetings. The south side brokers bring a lot of people through here, we don’t spend a lot of time even thinking about what the sell side things, but we have relationships with these brokers and I think Cove Street’s a pretty good spot for management meetings because we ask thoughtful questions.
Ben Claremon: We’re not bothering them about quarterly earnings, we’re thinking three to five years out, so kind of with that long term focus often it’s refreshing to executives in a sad way. So the other thing we do is, we, at least we have, a fair amount of institutional knowledge. So everything we do and read and see gets captured in either OneNote or in a Word doc. And so what that builds, it’s like a fair amount of institutional capital of businesses that we’ve looked at in the past, and then Jeff, our founder, has been in the business for basically forever since the early 90s and so he’s got a fair amount of institutional knowledge. I’ve been in the game for almost ten years now, so we’re talking about a fair amount of institutions knowledge there.
Ben Claremon: So, really what it is, is that’s our screen process, and so people always ask us, “Where do ideas come from?” And you know what, we’ve looked back and we actually record this in our stage four of the process, and there’s no consistency, and I don’t know that’s a bad thing per se, right? Sometimes, someone comes into the office and it’s really interesting, sometimes it’s the company we followed three years but have never really done the work on but we found something was interesting. And sometimes we’re reading the Wall Street Journal and maybe not the main company that was mentioned in the article, but a sub-company. And then another thing is, we often like to, and you see this dynamic in small-cap versus our small-cap plus strategy, is that in small-cap we’ll own kind of the little brother of a larger cap company.
Ben Claremon: So we’ll own them both, but one’s a small-cap and one belongs in our smid strategy. So people always try to pin us down in terms of how we find ideas, let me just say it’s eclectic and we’re opportunistic. And since we run a concentrated portfolio of kind of 20 to 29 in smid, and 30 to 39 names in small-cap, we don’t need that many new ideas. And so our strategies are designed to be lower turn over, and so honestly if we can find two or three new ideas a year, I think that would be plenty. So, our process, and so I’m framing our process a little bit, our process is deep with the intention that we’re going to discard 9 out of 10 things that we look at, 19 out of 20 things we look at. So, that flows into stage two of our process, which is kind of our data download, what we’re trying to figure out is, what kind of business is this?
Ben Claremon: And this is what we call the verify stage, and so we’re trying to figure out, is this a Buffett or is this a Graham? Because what we’re trying to do is pre-determine our sell discipline. If it gets to fair value and it’s a Graham, we’re going to sell it, if it gets to fair value and it’s a Buffett, we’re more likely to hold it. And so this is where we have a Cap IQ populated spreadsheet that basically is just the template for a model, and so you plug in the ticker and all the historical information pops out. And what that does, is it allows us to try to determine what kind of business this is, and so that’s readings ks and qs, we spend a lot of time thinking about the proxy statement. More so than just about any other investors I ever talked to, we’re always scrutinizing that document to figure out what incentivizes people because the truth of the matter is, tell me how you’re compensated and I’ll tell you how you’re going to act.
Ben Claremon: And the proxy statement is a gold mine to tell you how people are compensated and how they’re going to act, and so we spend a lot of time evaluating that stuff. So let’s say after the first view, I’ve determined, or one of my colleagues has determined that this looks like a pretty good business, the people seem good to okay, and looks reasonably valued, right? Then we move into stage three, which is our team tackle, and so this is something that’s a little unique about Cove Street, and it’s an outcropping of the fact that we’re going to limit our asset size because we’re a small-cap focused firm. We’re going to limit the number of strategies that we have, and we have a limited number of securities because we run concentrated portfolios. So, what that means is that we can team tackle ideas, and so what a team tackle is, is that every idea has two longs on is and one short.
Ben Claremon: And the two longs are kind of focused on creating the Bull case, and when we move to stage three, we put this into our workflow. So it’s not like we drop everything, but we’ll have to recruit, so if I have an idea I like, I’ll recruit one of my colleagues, and he’ll be my co-long, and we’ll say, “Who wants to be the short?” And so what’s the point of the short? A short is the devil’s advocate, a short is the person who is coming up with reasons why we shouldn’t own it. The idea like, “How do you kill the idea?” And so what that does is it creates this back and forth dialogue about the risks and the benefits of this company. And so basically you have the whole team working on it, and what that does is, we benefit from the fact that we have different backgrounds and different thoughts processes.
Ben Claremon: So, I think Jeff created Cove Street in a way that he didn’t want all of us to be, and there’s nothing wrong with being this, but he didn’t want us all to be like ex-investment bankers who spent three years in banking, worked one year in private equity, and now are working on the buy side in equity research. Eugene Robin, my colleague worked ViaSat as a satellite programmer, I come from the real estate industry, my colleague Dean basically worked for a government agency, was like an outsource CIA kind of investigator. So really what it is, is taking all these peoples backgrounds, and all these different perspectives both on value and a focus on value investing, and meshing them together and coming up with a really, I think, good back and forth about this company, and so that’s stage three.
Ben Claremon: And so-
Tobias Carlisle: Just before you go into stage four, how often does a short prevail over the two longs and what are the sort of reasons why a short might prevail?
Ben Claremon: That’s a great question, and so I mean, by definition, the short prevails far more often than the opposite because we pass on so many things. And it doesn’t necessarily mean that the short had some kind of like, silver bullet moment where “We can’t own this because of this.” Like you found a fraudulent thing, it’s not that. It’s more like, you can convince your colleagues who are excited about it, that there are more risks than rewards, and that the symmetry isn’t there or maybe the value isn’t there. Or that, and this is something that [inaudible 00:21:52], or that the people are not people that you can trust. And so, I think what this does more than anything else is creates a culture where we’re both willing and able to accept criticism, where we’re willing and able to accept other peoples ideas, and we listen to each other. And I think that’s really hard to build, and I give Jeff a lot of credit for being able to kind of inoculate that culture.
Ben Claremon: But I would say, since we pass on 9 out of 10 things, 19 out of 20 things we look at, the shorts are often either very persuasive, or I think the most often is the case, is that we all get into our analyst room, and we kind of banter back and forth the lead analyst realizes that this is for whatever reason, whether it’s the value, whether it’s the business, whether it’s the people, it’s just not the right kind of investment for us. But the good thing that we do is that we make sure that we, and this goes into our stage four, we capture that decision, and we make sure that if it’s just about price, if we’re not willing to pay what the current price is, what price would we buy it at? So that all that work that we’ve done isn’t lost, and it’s recorded, and we put it on a watch list with a price target.
Ben Claremon: And if it hits that price target, then all of a sudden we can re-engage, and so all that information, all that back and forth is captured and not lost. And so I’ll move into our stage four, which is our decision process spreadsheet. So we don’t write 20 to 30-page investment memos, I know with some firms do that, we have a very flat organization. We all sit out together, we’re not locked in offices, if I want to talk to Jeff, or I want to talk to Eugene, or I want to talk to Dean, I can just stand up and talk to them. The information flow isn’t kind of gated by either having offices or having to speak on emails or being in different cities. We can iterate, and do more work and come back to each other very quickly, and so this is our final process.
Ben Claremon: So let’s say I’m the lead analyst on an idea, I like the idea, I want to bring it to a decision. So, we all get into the room, and we record our decision. So, we fill out our decision process spreadsheet, which is really just a checklist of many of the mistakes that Jeff made over his career encapsulated in a spreadsheet. And so we have a tab on the four key variables, so why four? There’s nothing magic about the number four, it’s just that Jeff and the way he created his firm, and I think it makes a lot of sense is that, he recognized that there are a million different variables that you could consider for a company. But really it’s going to come down to three to five really, really important things that are going to determine whether you make money.
Ben Claremon: We also have the short points, so the short writes down his kind of reputation of the long premise. We have soft thoughts, so they have to ask like, “What are we thinking the markets not thinking?” Because if all we can do is regurgitate what the markets thinking, we probably don’t have a differentiated perspective. What’s our downside if we’re wrong? So trying to capture, if we’re wrong, how bad could it possibly be? And where is this company in seven years is another question we ask. Not a quarter out, not three months out, not three years out, but seven years. Trying to take yourself out of all of the noise that surrounds companies in the short run mainly because of the quarterly earning cycle.
Ben Claremon: And then we have a question like, “Would you rather own Tootsie Roll?” And I don’t know if you know anything about Tootsie Rolls-
Tobias Carlisle: Of course.
Ben Claremon: The interesting thing about Tootsie Rolls is, it’s the easiest company in the world to understand, they sell candy, right? And they sold candy for a really long time, and the stock trade did an unbelievable multiple and it’s like, I don’t know, but it was a husband and wife team, it was just an incredible little business. But it’s really a question about simplicity, is this business really difficult to understand, are there a million moving parts, 20 different things that have to go right for you to make money, like wouldn’t you rather just own tootsie roll my you know what it is? And so, these are the things that we put on our spreadsheet, and the lead analyst fills it out, and then we all get in the room and then we discuss it.
Ben Claremon: And so, Jeff, in his infinite wisdom, wanted to make sure that he didn’t bias the process, and that we could create a process that mitigates the behavioral biases. So this is what you learn from being in the industry as long as I have, and managing other peoples money, is that you’re constantly bombarded with behavioral biases that creep in. I know for a fact that anchoring, which is kind of that you become anchored into a number, so if I thought we should be buying a stock at 30 and we didn’t and the stocks 35, I’m going to anchor to the 30 dollar number and it’s going to be very hard for me to move off of that.
Ben Claremon: And so I recognize some of my biases, and all of us have different biases. But our process is designed to try to mitigate some of that, and so that flows into our final decision process. So everybody who worked on the idea weighs in and records their preference, so why do we do that? One, because we don’t want the kind of he said, she said two years later, “I said we should have bought that stock.”. “No, you didn’t want to buy it.” Right? We write it down, we record it. And the other thing is, in terms of compensation, Jeff can figure out, as he’s thinking about compensating us, like who’s doing well, who’s giving good ideas. And then, if he’s not accepting our good ideas, then maybe he needs to rethink about his process.
Ben Claremon: And so, Jeff as the portfolio manager on our small-caps strategy always goes last, because he doesn’t want to bias us, because if your boss says, “Hey, we should buy this.” Well then, maybe you change your opinion. He wants to hear our unbiased opinions, and we go around the room, you know, “Ben, what do you think it’s worth, what are you thinking we should do? What position size, and if we aren’t going to do something now, is there a price that you’d buy it at?” And then we all go, and then Jeff weighs in on the final decision. The only difference between a small-cap and the strategy that Jeff and I run is that Jeff and I are the final decision makers in our smid strategy.
Ben Claremon: But, I’ve given you the 30 thousand foot overview of our process, I think it’s very comprehensive, it’s designed to unearth interesting information about companies and it’s also designed to make sure that we are not falling subject to any number of behavioral biases.
Tobias Carlisle: It sounds like a great process, and it sounds like you guys have created a great culture there, and I noticed when I was going through your slide deck that one of the things you look at in the firms that you’re examining, in the stocks that you’re examining, you spend a lot of time on the culture. And I thought that was an usual slide, and particular detailed, can you just expand a little bit more on what you’re looking for in terms of culture in the stocks that you’re looking at?
Ben Claremon: Yeah, so I don’t want to get on a soapbox, but I’m going to spend a second on it, to some extent the idea of shareholder value, is that shareholders be more valuable than all the other stakeholders has captured corporate America, right? And I think that leaves a lot to be desired in the sense that, there are plenty of other stakeholders in a business, whether it’s your employees, or suppliers, the environment, the board of directors, there are plenty of other stakeholders involved here. And if you’re only focusing on shareholder value, I think you miss out, and you potentially cut off your own legs in terms of the ability to perform over the long run.
Ben Claremon: So, we’re really focused on finding people who are thinking long term, who are acting long term, there are red flags that come up that we try to stay away from. So if someone who’s constantly restructuring, which means that you’re always firing people, you’re probably impacting the culture negatively if people don’t know whether they have a job anymore and they’re always worried about being fired. These are things that are problematic, and so we have a list that we go through when we’re assessing management. So when I think of culture, our whole assessment of management embodies within that idea of culture. And so maybe to make it more concrete, I’ll give you some things that we are looking for and things that we are not looking for.
Ben Claremon: And so let’s start with what we are not looking for, so, we are not looking for companies that when you go through their financial statements they have a laundry list of environmental liabilities or legal liabilities. These are things that might be indicative of a culture that might be a little bit too aggressive in certain ways, we’re certainly not looking for people who are focused on the short run in any way, shape, or form. So whether that’s focused on making quarterly numbers, whether that’s going to the proxy statement and seeing that they’re focused solely on kind of short term results, or primarily on short term results.
Ben Claremon: We also want people who are focused on things that we care about, which is free cash flows and returns on invested capitals, and not quarterly earnings per share. Because again, incentives are a huge determinant in terms of how people act. And so, if I have to encapsulate it, long term focus people who are creating cultures that can last, and a lot of that can be reflected, and this is something else we do, we look at Glassdoor and Indeed.com to see how people are rated, right? And we track that over time just to make sure, or if it’s improving that’s good, but just to make sure in the companies we own that it’s not getting worse. I actually did a presentation at UCLA on assessing management in the proxy statement.
Ben Claremon: And one of my messages to the students, to the undergrads, was that it’s just really hard, it’s not quantitative, I mean, there are quantitative metrics, but it’s really qualitative, it’s a little bit squishy, but it’s doesn’t mean you could ignore it, right? Just because it’s hard to quantify doesn’t mean you can ignore it, and so what we try to do is we try to create a list of things we’re not looking for, try to create a list of things we are looking for, and have a checklist of those things. So, people who are focused on long term are willing to sacrifice short term results for long term gains. People who have a culture where when someone fails, they don’t get fired, it’s a learning moment, an organization that supports its employees, is willing to pay a living wage. I just think there’s a balance between short term profitability and kind of longevity that is, in a lot of cases, skewed way too much towards short term profitability.
Ben Claremon: And we’re looking for businesses who are thinking the long term, “How do we make this business sustainable? How do we make sure that we’re still around in 20 years?” And I just think businesses like that will be able to adapt much faster than someone who is focused on what they’re going to earn next quarter.
Tobias Carlisle: That’s fascinating, one of the things I noticed as I was going through your deck was this a PEST analysis, a P-E-S-T analyze, I’ve never encountered that before, I’m embarrassed to say but I did look it up before we talked. So can you tell us, what is a PEST analysis and how do you apply it?
Ben Claremon: Yeah, so we’re not macro investors, we don’t pretend to be macro investors, but we recognize that if you completely ignore the macro, you have a risk of being just totally kind of blindsided by some events that you weren’t considering. So, PEST is something that we fill out on our decision process spreadsheet, there’s a tab called PEST, and it stands for Political Economic Technological, and Social and so what are those? Those are political, economic, technological and social trends that can either benefit or hurt the company. So I’ll just give you some examples, so we were looking at an animal health company recently, and on the political side, there’s been a fair amount of regulatory things going on with feeding antibiotics to animals.
Ben Claremon: So, making sure that you are identifying that there’s a risk of further regulatory reform, more regulatory scrutiny, that would fall into political. Economic is kind of your normal, how economically sensitive is this business, does it follow the business cycles, does it have some kind of anti-fragile elements to it, does it have some kind of cyclicality to it, that’s the economic side. Social is, continuing the animal health idea, is like okay so if people are eating less meat because they’re eating impossible burgers, well that’s a social trend that maybe could impact this company or people have moved away from specifically poultry, moved away from having antibiotics in poultry and that’s been a social thing, it’s been less government mandate, it’s been more of a social thing.
Ben Claremon: So that has been an interesting dynamic for certain companies, and so which way are the social winds blowing is something that I think you can’t ignore, especially if it’s a consumer product of some kind. And then technological is like, what is the opportunity for technological disruption? If you are selling furniture online, I think there’s a fair amount of risk of technological disruption in that and new entrance, but if you’re selling aggregates for example, like you have a quarry, very hard to disintermediate that, there’s no app that can help you build a road, right? You need the aggregates, and so we’re trying to determined, how much risk is this company to technological change?
Ben Claremon: And so, the PEST analysis is just another risk assessment measure, and so we’re trying to figure out in everything we do, we’re really trying to figure out why not to own this company, and I know that might sound a little strange, but we’re looking for reasons not to own it. And if the overwhelming evidence is that the PEST analysis is a big threat, there’s two ways to look at it. One, you just shouldn’t own it, or one you should require an enormous margin of safety in order to feel comfortable with all of these risks. And so, we know that we’re not going to predict the direction of interest rates, or oil prices, but at least we can acknowledge the risk associated with the companies that we invest in.
Tobias Carlisle: How do you think about sizing positions, so you describe yourselves as concentrated, you said you’re running between 20 and 29 positions, how do you think about sizing them at inception, do you trim as they go up? Do you add as they get down, how do you handle that process?
Ben Claremon: Yeah, the ultimate question, and so it’s very difficult, these are the things that as you run money, you realize how difficult these things are in practice versus watching other people do them. But, in small-cap plus we have three position sizes, 2.5, 5, and 7.5. And in small-cap we have 2.5 and 5, and those are at entry, I think you want to have discretion as an investor but you also want to pin yourself in at sometimes so that you don’t have just what a consultant would call a dispersion. Where you don’t have like 1% positions here and 2.5% here, we try to keep it tight, and it helps frame the investment as well.
Ben Claremon: It’s not just a way to make sure that we don’t have accounts that are all over the place, it’s more about, “Is this the best idea or is this a half position which would be a good idea but maybe our best ideas?” And so, those are our position sizes to start, and as you can recognize, those are pretty concentrated position sizes, and I think the trimming and adding thing, there’s no universal answer to that. It’s, “Tell me about the security, what kind of business is it?” So, we want to buy businesses that we’re excited when they go down because we can buy more, and so in a Graham, if stock goes down 20%, I think you’re less likely to add to it, if it’s a Buffett, I think you’re more likely to add to it.
Ben Claremon: So I think we are opportunistic in terms of adding and trimming, and it goes the other way like is a Graham starts depreciating towards fair value, we may sell it all or sell a piece of it, or sell it back down to a 2.5% position. But if it’s a Buffett, you may be less inclined to sell it. So again it gets back to like everything we do kind of stems from this identification of what this business is, what this security is, is it a Buffett or is a Graham, and that will kind of tell us what to do when it’s up, what to do when it’s down, what to do when it gets to fair value.
Tobias Carlisle: Do you have a limit to the number, say you size something to 7.5%, so that’s very high conviction, and then it goes against you materially and if you still like the position, you like it more now because it’s cheaper, it’s at a bigger discount, would you be prepared to buy more in that instance?
Ben Claremon: Yeah, I mean I think you have to, and I’ve talked to a lot of my friends who run portfolios about this, and some people have rules about, “I’m only going to average down once or twice.” Or, “I don’t average down and we just let it ride.” I think everyone has different philosophies, I don’t think there’s any one right philosophy, it’s just about being right, right? It’s just about picking the right security, and not buying the one that goes down more and buying the one that turns around. But I think we’re always re-underwriting our ideas, and so if nothing is changed except for the fact that the market has determined that it’s worth 20% less than it was three weeks ago, I think we’re inclined to add to it.
Ben Claremon: And then at certain times, circumstance change right? Businesses change much more slowly than do stock prices, but it is true that businesses change over time. And so things that we had a fair amount of conviction in the past, we may not have as much conviction in the future, so those you’d be less likely to average down. And the truth of the matter is, if I was being intellectually honest if I’m not willing to buy it here, maybe we shouldn’t own it at all, right? And so maybe it triggers a reassessment or re-underwriting or a decision process node where we all weigh in on whether we should own this thing at all. I mean, I guess everything is about the Buffett rules right?
Ben Claremon: First rules is don’t lose money, second rule is don’t forget the first, right? And so once something becomes a security in which we see a risk of permanent capital impairment, that can trigger … I guess that’s kind of the answer to the question, is the security being down evidence of a risk of permanent capital impairment, or just the volatility of the market? It’s the latter that we want to take advantage of.
Tobias Carlisle: You are I were at a conference recently and we were chatting about small and mid-cap, and out of that you sent me a paper by Jeffreys talking about the opportunities in smid-cap. There are a couple of interesting facts in that, that really stuck in my mind, one is that of the Russell Indices since 1979, that smid-cap index is the best performed over that entire period. And one of the arguments that they make is that mid-cap gives you the returns of small with bat 15% less risk, presumably they’re defining that as volatility in that instance. But what’s the attraction for you in particular of that small to mid-cap range?
Ben Claremon: So, you’re preaching to the choir, I mean, I sent you that because I thought it validated our strategy. But the data’s interesting, and so let me give you the philosophy and then I can give you some anecdotes that I think will kind of crystallize why not necessarily our smid strategy, but any smid strategy can be interesting. Well maybe I’ll start with some anecdotes about Cove Street and they’ll kind of guide us to why we even started these strategies. One, so small-cap, the problem, I love small-cap and it’s evergreen because there’s just so many companies out there and there’s always a great opportunity in a few names, right? But the issue with small-cap is that your Buffett’s eventually leave small-cap.
Ben Claremon: And so we found ourselves at Cove Street, having to sell our Buffett stocks out of small-cap because at certain point if your entry point is three billion and under, and it’s an eight billion dollar company, it’s doesn’t make any sense to be in small-cap anymore, right? And so that was one thing that we saw, and the other thing that I saw is that, and I’m not trying to disparage anybody, this is just a personal anecdote is that, there are just the quality of everything surrounding the company, the management, the business, the end markets, you just find much better, more robust businesses in the four billion plus range. And so, it kind of gets to the idea that the Jeffrey’s piece discussed, which is you get a similar return, maybe a little bit less, but in this case, smid’s done better, but you may be a little bit less return, but there’s just less risk.
Ben Claremon: Because you have large total addressable markets, you don’t have as much customer concentration, you don’t have as much end market risk because you have diversification. And then maybe you have an international operation, so just having spent time in the sub-500 million market cap range, what you find is that these are just … You know, I joke, and I don’t actually mean this, but sometimes small-cap is like adverse selection. If it’s a small-cap, there’s a reason it’s a small-cap, maybe that’s because the total addressable market’s not that big, or management never had the bandwidth to go international. Or just the return structure, it can compound at a fast rate to be able to kind of get escape velocity and kind of create a business that can kind of get into the smid-market cap range.
Ben Claremon: And so, this is the way I put it to people, is that so if on one hand, on one end of the spectrum you have a manager who runs sub-Saharan African private equity, and on the other hand you have large-cap US value, I think that basically captures total inefficiency on one hand to relative efficiency on the other hand. I personally think that smid, even as you get about four or five billion in market cap, I think you’re much closer to the inefficient side. And so while you give up a little bit of that inefficiency that’s available in small-cap, I think you get it back in spades with quality of business quality of processes, quality of management, and these are just more robust business.
Ben Claremon: And then I’ll get to one more point here, is that what we’ve seen in areas where I said, I said we’ve made mistakes in business that just were kind of smaller and had maybe more impactful variables that could be materially negative, is that smaller businesses just cannot take punch, right? If they’re punched it can create a spiral, and whatever it is they become levered and they have to borrow from aggressive lenders and then they don’t generate cash anymore because interests rates, the spiral can really, really occur. On the flip side, if a four or five billion dollar business has one end market or one segment that’s underperforming, there’s a ballast, there’s a robustness that allows it to survive.
Ben Claremon: And so I think the data suggests what we saw anecdotally, and as I spend more and more time in this space I’ve felt the same thing, I feel like there are businesses that we can invest in that have all of the attributes of a Buffett stock, that aren’t household names, that are covered by 80 analysts, that have the ability to compound but they’re somewhat underappreciated. And so we’re always looking for stocks that are underloved, underappreciated, and underfollowed. And it’s been surprising to me the number of those you could find in the smid-cap range.
Tobias Carlisle: Yeah I couldn’t agree more, it’s my favorite universe, or it’s the universe that I use, on the low side I think I look at about, I think the smallest is 2.5 billion, but the average is around 4 or 5. I don’t have an upper limit, but just by virtue of the fact that I’m looking for very cheap companies, they tend to be down at that end, closer to the low end of the range. and this sounds slightly contradictory because I do agree with you that they tend to be underfollowed because all of the analysts in the bigger firms want big, liquid companies, so that pushes them into the large-cap stocks. But I think it’s where you find the professional private equity and professional activists, they sort of hunt in that 5 to 10 to 15 billion dollar range. Which is great if you’re buying a little bit cheaper than that, hopefully, they’re paying the take over premium to take you out, or they’re creating the activist campaign to sort of generate some returns for you.
Tobias Carlisle: So you see that in your stocks, do you find any activists or private equity targeting them you after you’ve bought them?
Ben Claremon: I think the simple answer is there are a lot of micro-cap and small-cap activists who unfortunately have like one remedy, buy back stock, right? Or sell yourself, there’s just two things, I think you’re right that as you get bigger you get into a much more sophisticated governance and shareholder-friendly advice from people. But I think even more interesting is about this space, and we haven’t actually seen this as much as I would have thought in our smid-cap strategy. But these are digestible deals, so it’s not that no one’s going to buy Cisco, it’s just not possible. But, a four or five billion dollar company is a digestible deal for either private equity as you said or from a strategics perspective. So, it’s like they’re not so small that they’re under the radar for the big PEIs and the big strategics.
Ben Claremon: But they’re also not so large that they can’t be bought, so I look at smid a little bit like a Goldilocks space, and when you have good businesses within that, that are getting more valuable every day, I think it always makes sense for either a financial buyer or a strategic buyer to be looking at these businesses, and I think I just want to be clear about our process, we certainly do not start an investment with the idea that “This is going to be bought.” What we’re starting our investment is, “This is a good business that’s getting more value every day, it’s run by people who understand capital allocation, it’s trading at a reasonable discount to our conservative assessment of intrinsic value, and someone else may recognize that and accelerate our return.” And in some cases, you’re sad about that because they take a compounder from you.
Ben Claremon: So, as a firm that’s built for the long run, and focuses on the long run, sometimes immediate gratification is not what you’re looking for. But our sense is if you combine the business value and people characteristics that I’m talking about, other individuals will recognize it as well and hopefully at least push you towards success.
Tobias Carlisle: When you step back a little bit and think about value as, it’s not an asset class, but value as a strategy, it’s been a difficult time for value, I’m not necessarily talking about your returns, I don’t know what they are, but it’s been a difficult run for value starting a year or so after the recovery in 2009. To date, do you feel positive about the future for value, do you think that we’ve got some time to go until we sort of shake everybody out?
Ben Claremon: So, I mean, this is the impossible question to answer, is value had been identified as an anomaly in academic research forever, right? And it worked for a really long time and the last ten years have been miserable for value investors. Especially on a relative basis, and so I think we fundamentally still believe in mean reversion, nothing has changed about that, right? Nothing grows to the sky and nothing continues to the fall to the center of the earth, and so in some ways, we will eventually see some mean reversion. But if you just think about what people are excited about in the world today, for the most part, it’s not the businesses we own.
Ben Claremon: And I think I wasn’t investing in the 2002 period, but I actually looked at the numbers recently and I thought this was interesting, is that I think it was, whether it was in 2000 or 2001, the market overall was down, the growth was down, but value was up. And so it was like there was this weird bifurcation in the market where it was really the high fliers, all those businesses that we joke about now that are not around anymore. Those were the ones driving the growth side and people, and when that turned around it turned around very quickly in terms of those stocks. But the value stocks outperformed and they outperformed by a large margin.
Ben Claremon: And you know, there are plenty of whatever those articles about Buffett being dead and value being dead and all those things. So we can’t spend that much time worrying about that, I mean, I will say from a firm perspective, yeah it’s been really difficult to convince a bunch of institutional investors that value’s the place to be. Because the truth of the matter is, even if they are long term looking, if values underperformed for 10 years, very few people have that long a time horizon. So, we can’t focus that much on it, and what I love about our strategies is that it almost doesn’t matter, I don’t want to be flippant about it, but it doesn’t matter to a huge degree whether the market is expensive or not.
Ben Claremon: Because I think overall, we fell like the market’s relatively expensive, it’s hard to find really interesting values, but when you run concentrated portfolios, you only need a couple new ideas. And market inefficiency is as such that you’re going to find opportunities over time. If you do the work and be pre-prepared for ideas to fall into your lap, and so that’s what we do. And it would be very nice if at some point there’s some mean reversion in terms of the value versus growth paradigm. But, we’re not counting on it, we don’t bank on it, we spend every day looking at securities from a bottom-up perspective. And that’s all you can do, aside from lament with people like you about the lack of opportunities or the poor relative performance of value.
Ben Claremon: It’s kind of like, you take it for what it’s worth and you try to find the interesting ideas, irrespective.
Tobias Carlisle: I couldn’t agree with you more, but it’s a funny point in the market where we both know that we can look at the historical returns to well-known value investors. You can look at the historical returns to the value anomaly, and it has typically outperformed. But, over the last 30 years, it’s really only had a brief period of outperformance in the mid-2000s and late 1990s was very, very tough as Buffett lost magazine territory. And then the early 200s to about 2007 really did massively outperform, and that’s that idiosyncratic return path of value where the market was getting crushed, but just being a long-only value investor generated returns. And then we’ve gone into a new regime again over the last 10 years where value really just can’t get out of its own way and the flows and the performance seem to have gone into the growth stocks.
Tobias Carlisle: But really, we’re at this funny point now, still where the value stocks, the value decile, that value anomaly, they’re still not that cheap, they’re at a slight premium to their long-run average. But the growth stocks are in nose bleed territory which is like a late 1990s, early 2000s type. So I have no idea what happens, but I do think that that gap has to close at some stage, and I do think that that’s beneficial for value. But I don’t know, and I’m sort of more hoping than believing.
Ben Claremon: Yeah, you have to be able to keep your clients long enough to realize whenever that mean reversion comes, right? What else can you do? I mean, these are things that, again we focus on process and not outcome, and if you have a good process and if you’re identifying good securities, we believe that the market will eventually recognize what we see in these businesses and then that’s the only way we can really outperform over time.
Tobias Carlisle: It’s been wonderful chatting to you, Ben. If somebody wants to get in contact with you, what’s the best way to go about doing that?
Ben Claremon: Yeah, so covestreetcapital.com, you can see our profiles, and I think my email address is on there, but bclaremont@covestreetcapital.com, happy to chat more about Cove Street, our process, our philosophy, talk about our culture because we didn’t talk that much about culture in terms of like what we’ve created here. But we’re a quirky group, I think in a good way, so I’m happy to chat about that as well, and happy to follow up on any of the things we talked about.
Tobias Carlisle: Very much appreciate you sharing the process and the philosophy that you guys use, Ben Claremon, thank you very much.
Part of the weekly research here at The Acquirer’s Multiple features some of the top picks from our Stock Screeners and some top investors who are holding these same picks in their portfolios. Investors such as Warren Buffett, Joel Greenblatt, Carl Icahn, Jim Simons, Prem Watsa, Jeremy Grantham, Seth Klarman, Ray Dalio, and Howard Marks.
The top investor data is provided from their latest 13F’s (dated 2019-3-31). This week we’ll take a look at:
Cemex SAB de CV ADR (NYSE: CX)
Cemex is the largest ready-mix concrete company and one of the largest aggregates companies in the world. In 2018, the company sold roughly 69 million tons of cement, 53 million cubic meters of ready-mix, and 150 million tons of aggregates. As of Dec. 31, 2018, the company had annual cement production capacity of 92.6 million tons. The company generates roughly 26% of sales in Europe, 23% in Mexico, 26% in the United States, 12% in South America and the Caribbean, and 10% in Asia, Middle East, and Africa.
A quick look at the price chart below for Cemex shows us that the stock is down 24% in the past twelve months. We currently have the stock trading on an Acquirer’s Multiple of 4.69 which means that it remains undervalued.
(Source: Google Finance)
Superinvestors who currently hold positions in Cemex include:
Here’s a recent keynote presentation by Tobias Carlisle at the Planet MicroCap Showcase 2019 in Las Vegas, NV. The topic for his speech: “Deep Value and the Acquirers Multiple”.
I’ll be in Manhattan in early June. If you’d like to grab a casual cocktail with me and some of FinTwit’s best and brightest, come to The Churchill Tavern on June 5th at 6pm.
Here’s a great excerpt from an interview that Howard Marks recently did with themarket.ch. During the interview Marks talks about the psychological aspects that make successful investors great saying, “Most of the great investors I know are unemotional people”. Here’s an excerpt from the interview:
What about psychological aspects? The higher asset prices go, the more difficult it gets to stay on the sideline. The economic historian Charles Kindleberger said: “There’s nothing worse for your mental wellbeing than to watch a friend get rich.” It’s a great saying because it’s one of the strongest forces in the world. People do not buy a stock at $ 5 and they do not buy it at $ 10, $ 15, $ 30 or $ 40. But when it gets to $ 50 they say: “Shoot, I can not stand the pressure, I have to go in.” The point is, everybody wants to get rich. And everybody wants to find a way to get rich which does not entail risk. So people are optimistic for the simple reason that they want to get rich.
Oftentimes that’s when things end up in tears. How can you stay prudent and avoid short-term temptations in order to earn superior returns in the long-run?
Investing is a funny thing because a long-run is a series of short-runs. Yet, the long-run is a thing in itself: If you aim at pursue long-run performance then it does not work to try to accomplish superior short-run performance every year. The things you might do to try to be in the top decile in a given year increase your risk of being in the bottom decile. But if you just do it well, with no trips to the bottom or even to the bottom of the distribution, it will make you superior in the long-run. So trying to be superior in the long-run by presumption maximization in the short-run is the most reliable course.
In other words: Just striving to do better than average every year is the key to coming out on top in the long-run?
It’s a philosophical thing. Trying too hard in the short-run exposes you to the risk of doing badly. Trying to find big winners on every trade exposes you to the risk of having losers. You accomplish more by having these are modest but more reasonable. Put differently, trying to make a big home run hitter induces the possibility of strike-outs – and strike-outs have a very bad effect on your long-term performance. That’s why the investment business is full of people.
Then again, keeping a clear head when things get really exciting is easier said than done. The major volatility of the market is the result of change in psychology: Good news makes people excited and buy. Bad news makes them depressed and sell. But if you get excited when things go well and depressed when things go badly you’ll buy high and sell low, and you are unlikely to have superior results. By definition, your reaction has to be different from that of others.
How do you do that?
There are only two ways: You can be an unemotional person who’s in charge of his or her psyche, or you can be an emotional person who can keep it under control. Most of the great investors I know are unemotional people. They are intellectual and analytical, solid and not volatile. In the great crash of 1907 for instance, JP Morgan walked out on the floor of the New York Stock Exchange and said, “I buy.” Another example is Warren Buffett’s $ 5 billion investment in Goldman Sachs during the financial crisis.
Oaktree, too, made some big and successful bets at the depths of the financial crisis. How do you remember these turbulent days?
As I recount in my recent book , in the fourth quarter of 2008, we spent more than half a billion dollars a week on average for fifteen weeks in a row. I could not say we were absolutely sure or we had no fear. We were uncertain and we did it with trepidation. But we did it anyway. So the essential question is: Do you feel control you? Or do you control them?
One of the best resources for investors are the publicly available 13F-HR documents that each fund is required to submit to the SEC. These documents allow investors to track their favorite superinvestors, their fund’s current holdings, plus their new buys and sold out positions. We spend a lot of time here at The Acquirer’s Multiple digging through these 13F-HR documents to find out which superinvestors hold positions in the stocks listed in our Stock Screeners.
As a new weekly feature, we’re now providing the top 10 holdings from some of our favorite superinvestors based on their latest 13F-HR documents.
This week we’ll take a look at David Abrams (2019‑3‑31). The current market value of his portfolio is $3,560,707,000.
Top 10 Positions
Stock
Shares Held
Market Value
CELG / Celgene Corp.
6,752,869
$637,066,000
PCG / PG&E Corp.
25,014,000
$535,299,600
BEN / Franklin Resources, Inc.
9,772,486
$323,860,000
ORLY / O’Reilly Automotive, Inc.
748,124
$290,497,000
TEVA / Teva Pharmaceutical Industries Ltd.
18,046,356
$282,967,000
LAD / Lithia Motors, Inc.
2,300,000
$213,325,000
UHAL / AMERCO
561,258
$208,513,000
WLTW / Willis Towers Watson Public Limited Company
In his recent interview with Tobias, Dan Rasmussen, who is the Founder and Portfolio Manager of Verdad Advisors provides some great insights into how investors can use ‘good’ leverage to magnify returns. Here’s an excerpt from the interview:
Tobias Carlisle: Well, I think I’m agnostic to the leverage in the company, provided that the operating income is there to support it. It’s not excessively leveraged, but I have found, and you perhaps know better than I, whether there’s a tipping point where debt is good up to a point and then beyond that point it’s sort of deleterious to your return. So, do you want to talk a little bit about the sensitives of debt, how you sort of assess whether something is sort of a safe investment, and where you think that the limit might be?
Dan Rasmussen: Yeah, and I would say that the world of safe investments is not the world I play in. You know? I am on one end of the risk and volatility spectrum, and happily so. So, if you want safety, go buy bonds. Where our goal is to outperform and my view is that to outperform, you have to take risks. So, setting that aside, leverage. Leverage, more debt is bad. More debt is bad. If you measure debt as debt to assets, debt to EBITDA, debt to interest, any absolute value of metric, you’re gonna find that the more levered a company is, the higher the probability of bankruptcy. And bankruptcy is like getting a zero on your math test in eights grade, right?
Dan Rasmussen: One zero will sink your entire semester grades, so you don’t want zeroes. And debt is what creates the possibility of a zero. And so, what you find is that increasing leverage increases the risk of bankruptcy. Now, what you also find is that just like buying a home or any other asset, if you buy something well and let’s say you buy it for $100 and you borrow 90 of those dollars and you sell it for a $110, wow you made 100% profit on a 10% rise in values. So, leverage amplifies the returns. And so, what you find, I think, of leverage, is sort of a trade off; there’s good leverage which is leverage as a percentage of your purchase price right?
Dan Rasmussen: So, if you think you’re making a good investment, you’d ideally want it as levered as possible to magnify gains when it works. But, on the other hand, if you’re wrong, you want less leverage on an absolute basis. And so, that’s why the intersection of leverage and value is so important. If you buy cheap things with debt, you tend to have the advantages of the magnification and you don’t have too much bankruptcy risk. But, on the other hand if you buy expensive things with debt, you know, God love ya, it ain’t gonna turn out too well.
Tobias Carlisle: You have a nice strategy in that the debt is by virtue of the fact that it’s raise by the company, the target that yo put into the portfolio, it’s non-recourse to you, so it’s not like your carrying debt at a portfolio level. It’s carried up the holding level. So, in that instance, if you’re going to do it, that’s sort of the way to do it so that any individual stock that might fail doesn’t sort of risk the entire portfolio.
Dan Rasmussen: That’s right, and think you know, this is Robert Schiller won the Nobel Prize for the finding that market prices are 20 times more volatile than fundamentals. So, if you think about where you want leverage, you don’t want leverage on the really volatile price movement of a stock. You want leverage on the balance sheet of a company where it’s dependent on that company’s earnings. And what you find is that when you have leverage there, it’s asymmetric. So, if you say, have a margin loan, you have symmetric exposure. If the markets go up 10 then you’re levered 100%, you go up 20. And if it goes down 10, you go down 20.
Dan Rasmussen: If you buy a portfolio of levered companies, that are equivalently levered, you tend to not quite go up, if say 50% levered, or 50% debt, 50% equity, you don’t go up quite 100% when the market… you don’t up 2x when the market goes up, you go up a little less than that. But when the market goes down you don’t go 2x down, you go only little bit worse, because unless a bankruptcy risk of the company is meaningfully changed, the equity won’t reprice to reflect the fact that the company’s leverage is 50%. And that’s sort of the key insights to making this work.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Hosts Tim Travis and Tobias Carlisle will speak briefly and answer questions on the stock market and value investing in a relaxed event with complimentary cocktails and appetizers.
Tim is a veteran deep value investor and money manager with a long history of success in traditional investments, such as stocks and bonds, and deep value investing. He has developed an innovative methodology of combining options and distressed investing with value investing to generate income, reduce risk, and add an element of timing. Tim Travis is CEO and Chief Investment Officer of Coto de Caza-based T&T Capital Management, and currently ranks in the top 1% on https://www.tipranks.com/bloggers/tim-travis
In his recent interview with Tobias, Dan Rasmussen, who is the Founder and Portfolio Manager of Verdad Advisors provides some great insights into why investment decisions should be based on empirical data and not stories and emotions. Here’s an excerpt from the interview:
Dan Rasmussen: I talk to respective investors a lot, it’s part of my job. And the one question I dread the most, is when they say, “Tell us about some of the companies in your portfolio.” And I’m just like, “Oh no. And I’m like, the more you know about the companies, the less you’re gonna like the strategy. Just hold your nose, blindfold yourself, and buy. Because, do you really wanna know that the largest holding is a Russian steel company, or would you rather not have known that?”
Tobias Carlisle: There’s two reasons to hate it. It’s Russia and steel. That’s why it’s cheap.
Dan Rasmussen: Yeah that’s why it’s the cheapest darn thing in the world. But, it’s funny. I think that’s exactly why, and I think people make decisions so much more on stories and emotions than they make it based on data. And that’s what I think quantitative investors are fighting, right? Because someone’s gonna make a decision to invest in a stock or invest in a fund, based on an emotional or person connection. Not necessarily based on reason or that sort of, what Kahneman calls The Type two, or type logic. And I think that’s often a challenge we face, with being quant investors.
Dan Rasmussen: And that’s why I think work like what you’re doing, is so important, because we need to tell the story of why statistics work. We need to talk about things like the acquirers multiple, and say, “You know, if you actually walk through he intellectual journey, you’ll start to come to an emotional connection with this way of thinking. And if you come to an emotional connection with this way of thinking, then maybe you’ll act based on reason.” But you have to do so much work to overcome people’s bias, because it would be so much easier to walk in and say, “What I buy is great companies, the best companies in the world.” And you know, “Gee, it’s not just important to buy the best companies, you gotta know them better than anyone else.
So, we put more work and more money into understanding these great companies and why they’re great, than anyone else. And blah, blah, blah.” And that’s what so many people pitch, and by and large that’s where the money flows to those types of people, and to me it’s just crazy because it’s just not likely to work.
Tobias Carlisle: You have to find the good story to sort of explain the data you’re using, which is what I’ve tried to do in the books. Here’s the story that you can remember, but the real message is the underlying data that tells you how it works. But I’ve seen many examples, and I’m sure you have too, where there’s no limit to the amount of research that a firm can do. Big firms that have multiple analysts and can send them out.
And I know that, for example, I won’t mention the name of the firm, but a local firm in Los Angeles had a very big position in Sino-Forest, a $100 million position, established weeks before the fraud was uncovered. And they had done as much as send an analyst to China to go and have look at the forest and they’d been taken out and shown, here is the forest that forms part of the portfolio. The only problem was that that particular forest wasn’t actually in the portfolio.
Dan Rasmussen: It was just a forest. It was a nice forest. I think back to my days in private equity, and we’d go on these factory tours and you’d see all these machines, and you’d be in your suit and go, “Oh that’s a nice machine over there.” You know? “Great factory, really great.” And what do I know? I can’t tell the difference between a good factory and bad factory if my life depended on it, but yet somehow that was part of the diligence process. It’s just so silly.
But, you know, the other thing people miss is that the bigger you are, and thus the more you can spend on research, the fewer opportunities you have to invest because there are so many fewer big companies than there are small companies. And the bigger amount of capital you have to deploy, the more constrained your opportunity set is.
Dan Rasmussen: That’s why an individual investor actually has an advantage over a point 72 or a Bridgewater, when it comes to choosing stocks. Now, maybe there are other areas that they are really advantaged in, but if you’re trying to pick stocks, the smaller you are, the more options you have to choose from. So, even if you have slightly worse analysis than some brilliant hedge fund, you are so advantage by being able to invest in small stocks, relative to being only able to choose from the stocks of 10 million dollars of daily volume. I think it’s an interesting sort of truth about markets that research budgets can’t overcome deficits in size.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
In his recent interview with Tobias, Dan Rasmussen, who is the Founder and Portfolio Manager of Verdad Advisors provides some great insights into how investors can implement a successful private equity strategy in the public markets. Here’s an excerpt from the interview:
Tobias Carlisle: So, just so we can understand the strategy that you’re approaching right now, can you give a little background to how you came up with the strategy and how you’re implementing it now?
Dan Rasmussen: Yeah, absolutely. The strategy really borrows from private equities. So, if you look at the broad history of private equity, from 1980 to 2006, private equity was the best performing asset class by a wide margin. And I think 80% of private equity funds that were raised during that period, outperformed the public market equivalent. So a tremendous track record of success. According to Cambridge Associates from late 1980’s until 2006, it was 6% net of fee outperformance the public market for the private equity index. So what were the private equity firms doing during that period?
Dan Rasmussen: I had a really unique chance to figure this out when I was at Bain Capital, because we were trying to answer this exact question. What had driven our historical success? What do we need to do to continue it? And when we started to look into it. We found that there were some fascinating elements of what had made private equity work, and it’s gonna resonate very closely with your Acquirers Multiple as you indicated in the opening. But, what we found is there are really three characteristics that predicted success in private equity. Well, there were two that defined it and one that predicted it.
Dan Rasmussen: So, private equity relative to public markets; private equity firms are buying companies that are small, generally 200 million of market cap versus 30 billion for the S&P 500, that are levered, typically about 65% net debt to enterprise value verse 10% for the Russell 2000. And 3rd, if you divide private equity by purchase multiple; the cheapest 25% of deals turns in at less than seven times EBITDA, accounted for 60% of the industry’s profits. And the most expensive 50% of deals done over 10 times of EBITDA, accounted for only about 10% of the industry’s profits. So, in aggregate the story of private equity was buying small, cheap stocks with debt.
Dan Rasmussen: And, if you think about why that worked; it’s small value on steroids. It’s small value times leverage and, gee if you buy something cheap and it’s small, so you’ve got a lot of upside, and you lever it right, no surprise it works. And, it looks like private equity was earning about 6% outperformance of the broader market and they were taking about 6% a year out in fees, so the true outperformance of the growth strategy was about 12% per year. And, so, what I set out to do was say, “Gee, I wonder if we could replicate what private equity had done in the 80’s and 90’s by buying these companies that had the same quantitative characteristics in public markets.” They were small, they were cheap, and they were levered. And probably the leverage is the biggest departure point between me and most other value investors, but I’m sure we’ll talk more about that.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
In this episode of The Acquirer’s Podcast Tobias chats with Dan Rasmussen, who is the Founder and Portfolio Manager of Verdad Advisors. During the interview Dan talks about his replication of private equity investing in the public markets using levered small cap stocks. He also provides some great insights into:
– How Can Investors Implement A Successful Private Equity Strategy Into The Public Markets
– How Smart Investors Use ‘Good’ Leverage To Magnify Returns
– What Are The Real Drivers Of Private Equity Returns
– More Knowledge Doesn’t Make You A Better Forecaster
– There Is No Relationship Between Who The CEO Is, Or How The CEO Gets Paid, And What Happens To The Stock Price
– You Either Take Risk And Get Return, Or You Buy Things That Everyone Likes And You Get Mediocre Returns
– Investing Decisions Should Be Based On Empirical Data – Not Stories And Emotions
Tobias Carlisle: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Dan Rasmussen of Verdad Advisors. Dan has a PE replication strategy that is quite similar to my own approach to deep value, so I’m very interested to talk to him. No less a personage than Jim Grant of Grant’s Interest Rate observer, describe Dan as a human Ferrari. So, we’re gonna talk to him right after this.
Tobias Carlisle: (intro music)
pod intro voice: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the inquirer’s funds on this podcast. All opinion expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds or affiliates. For more information visit acquirersfunds.com.
Tobias Carlisle: Hi Dan, how are you?
Dan Rasmussen: Great, thanks for having on Toby.
Tobias Carlisle: My absolute pleasure. So, just so we can understand the strategy that you’re approaching right now, can you give a little background to how you came up with the strategy and how you’re implementing it now?
Dan Rasmussen: Yeah, absolutely. The strategy really borrows from private equities. So, if you look at the broad history of private equity, from 1980 to 2006, private equity was the best performing asset class by a wide margin. And I think 80% of private equity funds that were raised during that period, outperformed the public market equivalent. So a tremendous track record of success. According to Cambridge Associates from late 1980’s until 2006, it was 6% net a fee out performance the public market for the private equity index. So what were the private equity firms doing during that period?
Dan Rasmussen: I had a really unique chance to figure this out when I was at Bank Capital, because we were trying to answer this exact question. What had driven our historical success? What do we need to do to continue it? And when we started to look into it. We found that there were some fascinating elements of what had made private equity work, and it’s gonna resonate very closely with your Acquirers multiple as you indicated in the opening. But, what we found is there are really three characteristics that predicted success in private equity. Well, there were two that defined it and one that predicted it.
Dan Rasmussen: So, private equity relative to public markets; private equity firms are buying companies that are small, generally 200 million of market cap versus 30 billion for the S&P 500, that are levered, typically about 65% net debt to enterprise value verse 10% for the Russell 2000. And 3rd, if you divide private equity by purchase multiple; the cheapest 25% of deals turns in at less than seven times EBITA, accounted for 60% of the industry’s profits. And the most expensive 50% of deals done over 10 times of EBITA, accounted for only about 10% of the industry’s profits. So, in aggregate the story of private equity was buying small, cheap stocks with debt.
Dan Rasmussen: And, if you think about why that worked; it’s small value on steroids. It’s small value times leverage and, gee if you buy something cheap and it’s small, so you’ve got a lot of upside, and you lever it right, no surprise it works. And, it looks like private equity was earning about 6% outperformance of the broader market and they were taking about 6% a year out in fees, so the true outperformance of the growth strategy was about 12% per year. And, so, what I set out to do was say, “Gee, I wonder if we could replicate what private equity had done in the 80’s and 90’s by buying these companies that had the same quantitative characteristics in public markets.” They were small, they were cheap, and they were levered. And probably the leverage is the biggest departure point between me and most other value investors, but I’m sure we’ll talk more about that.
Tobias Carlisle: Well, I think I’m agnostic to the leverage in the company, provided that the operating income is there to support it. It’s not excessively leverage, but I have found, and you perhaps know better than I, whether there’s a tipping point where debt is good up to a point and then beyond that point it’s sort of deleterious to your return. So, do you want to talk a little bit about the sensitives of debt, how you sort of assess whether something is sort of a safe investment, and where you think that the limit might be?
Dan Rasmussen: Yeah, and I would say that the world of safe investments is not the world I play in. You know? I am on one end of the risk and volatility spectrum, and happily so. So, if you want safety, go buy bonds. Where our goal is to outperform and my view is that to outperform, you have to take risks. So, setting that aside, leverage. Leverage, more debt is bad. More debt is bad. If you measure debt as debt to assets, debt to EBITA, debt to interest, any absolute value of metric, you’re gonna find that the more levered a company is, the higher the probability of bankruptcy. And bankruptcy is like getting a zero on your math test in eights grade, right?
Dan Rasmussen: One zero will sink your entire semester grades, so you don’t want zeroes. And debt is what creates the possibility of a zero. And so, what you find is that increasing leverage increases the risk of bankruptcy. Now, what you also find is that just like buying a home or any other asset, if you buy something well and let’s say you buy it for $100 and you borrow 90 of those dollars and you sell it for a $110, wow you made 100% profit on a 10% rise in values. So, leverage amplifies the returns. And so, what you find, I think, of leverage, is sort of a trade off; there’s good leverage which is leverage as a percentage of your purchase price right?
Dan Rasmussen: So, if you think you’re making a good investment, you’d ideally want it as levered as possible to magnify gains when it works. But, on the other hand, if you’re wrong, you want less leverage on an absolute basis. And so, that’s why the intersection of leverage and value is so important. If you buy cheap things with debt, you tend to have the advantages of the magnification and yo don’t have too much bankruptcy risk. But, on the other hand if you buy expensive things with debt, you know, God love ya, it ain’t gonna turn out too well.
Tobias Carlisle: You have a nice strategy in that the debt is by virtue of the fact that it’s raise by the company, the target that yo put into the portfolio, it’s non-recourse to you, so it’s not like your carrying debt at a portfolio level. It’s carried up the holding level. So, in that instance, if you’re going to do it, that’s sort of the way to do it so that any individual stock that might fail doesn’t sort of risk the entire portfolio.
Dan Rasmussen: That’s right, and think you know, this is Robert Schiller won the Nobel Prize for the finding that market prices are 20 times more volatile than fundamentals. So, if you think about where you want leverage, you don’t want leverage on the really volatile price movement of a stock. You want leverage on the balance sheet of a company where it’s dependent on that company’s earnings. And what you find is that when you have leverage there, it’s asymmetric. So, if you say, have a margin loan, you have symmetric exposure. If the markets go up 10 then you’re levered 100%, you go up 20. And if it goes down 10, you go down 20.
Dan Rasmussen: If you buy a portfolio of levered companies, that are equivalently levered, you tend to not quite go up, if say 50% levered, or 50% debt, 50% equity, you don’t go up quite 100% when the market… you don’t up 2x when the market goes up, you go up a little less than that. But when the market goes down you don’t go 2x down, you go only little bit worse, because unless a bankruptcy risk of the company is meaningfully changed, the equity won’t reprice to reflect the fact that the company’s leverage is 50%. And that’s sort of the key insights to making this work.
Tobias Carlisle: It’s a fascinating strategy, and it’s one that you were, I don’t want to say a junior, but an associate, or an analyst at Bain Capital; when you were tasked with this what others drivers of outperformance and I think that he levers might have been operational improvement leverage and possibly the purchase price. So, can you just talk a little bit to that study.
Dan Rasmussen: Sure. Yeah, so we looked at a whole variety of things. The first thing we looked at was every private equity deal we could look at. So, I think we built a data set of 25 hundred deals, 350 billion of invested capital and private equity, and we looked to a predicted success. And there were a lot of people that thought industry was going to predict success, but industry was sort of an irrelevant variable as it turned out; it was all about purchase price. And, even those other things; size and leverage, every private equity is small and every private equity deal is levered. So, if you’re within private equity they don’t really predict anything, because 200 million of market cap is the average PE deal, right? That is an extreme micro cap in public equities.
Dan Rasmussen: I think there have been only a dozen private equity deals that are larger than the large end of the small cap index. So, you know, buy in large what we’re talking, is tiny little things. So, whether its 400 million of market cap, 200 million, 100 million; it’s all small, doesn’t really matter. Leverage levels, again, 65, 70, 55, doesn’t really matter much at all. Because, everything is levered, so controlling for everything else doesn’t make much of a difference. What really mattered is the valuation. And that was so powerfully predictive. And especially I think in a levered environment, for those reasons we were talking about.
Dan Rasmussen: And we looked at the other drivers, which I think you brought up. I think that private equity firms would tell you that there are really maybe two or three core strengths that they have. One is that they do better diligence; so they spend a huge amount of work, they really know the companies. By the way they have access to private information, so they have knowledge advantage over say, public investors. And the depth of… they own 15 companies rather than 50, so of course they know them better. And then second, that they’re able to improve them, that’s why they have control, they own 100% of the company so that they can sit on the board and make them better. And then, third, and sort of related to that; they have the ability to higher or fire the CEO, and so they can replace them with a better person from their staple of operators. And those sort of key drivers allow private equity in their minds, to outperform.
Dan Rasmussen: And what’s I’ve found is, and this goes back to Phillip Tetlock, a student of Daniel Kahneman, right; more knowledge doesn’t make you a better forecaster. So, great you have access to a data room, great you spent a million dollars on McKenzie, you’re no more likely to predict EBITDA growth than anyone else. And anybody who has every looked at EBITDA forecasts from any buy side firm, will tell you the error bars are so huge as to make even the whole endeavor of forecasting EBITDA growth, worthless. And we broadly found that to be true.
Dan Rasmussen: In terms of operational improvements, is every private equity guy trained at an investment bank magically a better CEO than every public company’s CEO, are they magically better board members than every public company board? Are the McKenzie people that KKR hires that much better than McKenzie people that the public company hires? Right? It’s just not plausible. And if private equity guys were really such better managers, shouldn’t Harvard business school and Stanford be teaching the private equity approach to management? But, they don’t, well why is that? Why is that this is so flaunted, yet they don’t teach it? Well, because the private equity approach to management is lever the company up, that’s it. And then, sit on the board and if things go wrong, bring in McKenzie again and again, or maybe switch to BCG because they have industry expertise. And that’s about as far as it goes and it doesn’t really help. And then third; choosing a CEO. Who the CEO is in my mind, doesn’t really matter. And we can talk more about that.
Tobias Carlisle: Lets dive into that. You’ve more recently released a paper describing looking at the characteristics of CEO’s and whether that is in fact, predictive of performance. So, would you like to talk to that a little bit?
Dan Rasmussen: Sure, I think it goes back to the 80’s and a guy Michael Jensen at Harvard Business school. And Jensen had this idea that he noticed that Harvard Business School students, gasp, were not going into corporate management, the horror. So, why weren’t they going into corporate management? And he asked them, they said, “Well, we don’t get paid enough.” And so he said, “Well, it’s such a disappointment because my students are so brilliant, and if they ran public companies, then cash America would be a better place, because they could pass my wisdom on at their companies, et cetera, et cetera. And so what we need to do is pay CEO’s more in order to attract the best and brightest to corporate management. I mean what could go wrong?”
Dan Rasmussen: And so, his solution, and this is such a common hackneyed phrase now, but he wanted to align incentives, right? And now everybody is so into alignment incentives that you find the VP at the private equity firm is trying to give his nanny a bonus for higher performance or something. It’s like, “Oh dear, right? They’ve really drunk the Koolaid on aligned incentives.” And aligned incentives in the equity world, and then it goes back to another idea; the Milton Freedman idea that all that matters is shareholder stock price performance. And so, why not incentive CEO’s to make the stock price go up? That was Jensen’s logic, it makes sense, right? Tie performance to price, tie salary to performance, and they did that with options, and they did that with essentially massive stock grants to CEO’s.
Dan Rasmussen: And what my research looked at is saying a few things. One, is there any relationships between the best and the brightest, Jensen’s students, being CEO’s and share price performance? And what we found is no. MBA’s are not better CEO’s than non MBA’s. Harvard MBA’s are not better CEO’s than non Harvard MBA’s. In fact, if you look at any sort of pedigree related thing, whether they were a banker or consultant, even whether they founded the company; there’s no statistical relationship to the stock price performance. In fact, there’s no statistical relationship between incentive pay and performance either. Right? I mean, and in fact, even if you look at historical performance; so just say, “Okay, well there’s gotta be some great CEO’s, so let’s look at CEO’s whether their three years predicts the next three years. If you’re a great CEO, your greatness should be persistent.” And we found no relationship there.
Dan Rasmussen: And then we said, “Well what about the CEO’s that do a great job at one company, or a really bad job at one company, and get hired to be CEO at another company?” No relationship there either. There is essentially no relationship between who the CEO is, anything about the CEO, or how the CEO gets paid, and what happens to the stock price? And so, now we’re sort of arguing for a null hypothesis, that none of this matters. You can’t prove a null, you can only defend the null, but there’s shockingly no convincing evidence to suggest anything about who the CEO is, from how they’re paid, who they are; that’s any relationship to equity markets. And so, Jensen’s logic, while it sounded good, was entirely wrong.
Tobias Carlisle: Jensen wrote a series of papers where he was suggesting that the importance for buyouts and takeover in the 80’s, was the free clash flow that these companies were generating, which seems like a pretty trite observation to most investors, but naturally groundbreaking in an academic sense. And then resisted fiercely, even though the company throws a free cash flow, so therefore it can support debt. Pretty clear observation. It reminds me of Buffett’s comment that, “Where the CEO with a reputation for brilliance tackles the company with a reputation for poor performance, it’s generally the reputation of the company that persists.”
Dan Rasmussen: Yes, yes.
Tobias Carlisle: So, you were a Harvard undergrad, then Bain. Stanford MBA, and while you’re at Stanford did you start formulating the idea for Verdad and is that… I know that you were at Bridgewater somewhere in there, I’m not entirely sure where Bridgewater fits in.
Dan Rasmussen: I interned there in college, yeah. And a very short period of time, but very influential in my thinking. But, yeah I came up with this idea while I was at Bain Capital and I said, “Look, you know, I wanna go do what Bain Capital, and KKR, and Blackstone did 20 years ago. Not what they’re doing now, I don’t like what they’re doing now. I want to do what they used to do, and just copy it, because it worked.” And I think most people that create good things are just copying better ideas from other smart people. There are no new ideas, only implementing good ones from the past.
Dan Rasmussen: And, so I decided to go to Stanford because there was this guy Charles Lee who was a professor there, who was just absolutely brilliant. He’s a hardcore quant, teaches a class called Alphanomics, just all about quantitative investing. And I said, “Well gee, I have this very simple insight, which is buy cheap, small, and leverage.” And though I’m not a quant, I’m not like a super algorithm guy, those are all quantitative things. Right? Size is quantitative, value is quantitative, and leverage is quantitative, and so what I want to do is figure out how those interact, how those work, and try to find the principles of what works. And then also take all the other knowledge from quantitative investing and then apply it onto those variable and see how we can improve. So that was really my idea in going to Stanford and it was a great decision because Charles Lee is an amazing guy and an amazing mentor.
Tobias Carlisle: Its funny, I came to it in a possibly in a similar way, to you did. I was a junior attorney working on a lot of private equity deals, sort of happened in the early 2000’s. And it’s an enormous amount of effort to take something private, there’s a diligence process, and there’s a lot of paper that’s debt and equity and lots of things to be considered. The company’s taken private, then you’ve got this enormously liquid asset that you can’t shift easily, and you pay a premium when you take it private. And at the same time, I could look at companies that were listed on the stock market that you can buy for virtually no effort, open your brokerage account and up and buy them, and then don’t pay that premium and get at least equivalent returns, and likely better returns for less efforts.
Tobias Carlisle: So, I think that the strategy is, I’m sort of talking my own book a little bit, but I think the strategy’s a really good one and it’s likely to perform very well, but it’s still a value strategy. And so, it’s been a very tough time for value. How do you feel about it relative to something like the value factor or EVE which is probably a reasonably good proxy? Are you gonna track that closely, or do you think that you’re gonna be able to out perform? Or how do you think about it in those terms?
Dan Rasmussen: Yeah. I think there are two dimensions to it. I think one, is we have leverage right? So, in theory if we both own something for the same price, but I’m 50% levered, I should do the whole… I’d say, broadly levered small value performs like small value on steroids. So, so there should be a magnification effect to investing in the levered portion. So, I think that that broadly, theoretically makes sense, now, it’s gonna be painful when things go down, but it’s gonna be really nice on the upside. So, that’s sort of the trade off.
Dan Rasmussen: And I think the other thing that’s worth thinking about, with all value strategies is, and all quant investing is in some sense a ranking, right? YOu’re saying, “Well I like cheap things, and so well the 10 cheapest things should be better than the next 10 cheapest things, should be better than the next 10.” And what’s sort of interesting is, sort of, if you look at the distribution of the markets, most of the really cheap things are also really small, for sort of related and obvious reasons. But, what this means is that if you want to be a very disciplined, extreme value investor… If you say, “Gee, I really love EBIT to EV.” And I do, right, it’s a great signal. … And you wanna own the 50 cheapest EBIT to EV companies, probably the average market cap on those, is like 200 million.
Dan Rasmussen: And so, the other sort of question you have as a sort of factor investor or quantitative investor is, “Am I willing to run a fund that can invest in those things? Am I willing to know, and tie my hand behind my back and know that I can’t ever get bigger than say, 200 million of capacity because then I couldn’t buy the very things that define the value universe.” So, I would say, when I think about what I do and how it compares to the broader universe of small value, I’d say there are really two differentiators; one is the focus on leverage, which hopefully should amplify things. And then the next is sort of, a very conscious commitment to staying very small and focusing on the extremes of the value factor, which I think is also really important to generating Alpha.
Tobias Carlisle: I think you touched on it a little there, but you also have a very recent paper, which is a fascinating read, about looking at the very cheapest and then seeing if you can determine which, cherry pick out from that group, or determine which of those are likely to out perform the others; which is sort of the Holy Grail, if you can really figure that out, then you’ve got something special. So, can you describe the paper and what were your findings?
Dan Rasmussen: Yeah, so that would be the Holy Grail, if it were possible Toby. So, we’ve gotten really into machine learning. And I like machine learning because it’s sort of Bayesian, it’s probabilistic. And, it’s sort of in my mind, after linear factor models, I think machine learning is sort of the next stage for quants. And so, we thought, well what’s the first way? If you’re looking at quantitative research, you know that the linear factors are the most important, right? They show up in regressions, of course they matter most.
Dan Rasmussen: So, what you want to do is start with those linear regressions and then layer on machine learning on top. So, what we naturally said is, “Okay, well let’s start with the linear model,” and we know what small value is, so does everybody else, “let’s look at the extremes of small value, which are really what drives the Alpha, and then lets look within in that to try to pick out the things that don’t work.” So, what we did is we took the one third of worst outcomes. So, where the linear model said it’s gonna expect a return of 30% and it actually had a return of negative 50. And we tagged those third of worst outcomes going back 25 years, in the U.S. and Europe.
Dan Rasmussen: And then we said to the machine learning algorithm, we gave it everything we could think of, everything; and we said, “Go and tell us why the model’s wrong.” Why does small value produce such high error rates and such high dispersion? Why does some small value stocks do really well, why are others value traps, and why do others go bankrupt? And our hope was that we could more finely tune our factor model, right? And so, we came back and we were delighted. The machine learning said, “Hey we can achieve something close to 50% accuracy at telling you what are the 30% worst outcomes.” I said, “well great, look at how wonderful…We’re so brilliant, this model’s great.”
Dan Rasmussen: And so he said, “Well tell us what the biggest predictors, of your essentially, probability of being wrong, what are the biggest predictors?” The number one was the linear regressions expected return variable, so basically the model was telling us; the higher the risk, the higher the return. And in fact, the higher the realized return. So, if you purely said, “I wanna only buy the things that are most likely to be wrong.” You had the highest returns relative to the stuff the lowest likely at being wrong. So, there was almost like a beautiful proof of market efficiency.
Dan Rasmussen: Now, we did find that in some extremes, probably the 5% of most extreme probability of being wrong, the machine learning model was actually really good at identifying really bad things. And it was also good at sort of identifying things which might be a little bit less risky than their price implied. So, it does improve a factor model, using machine learning does definitely improve the factor model, but for the most part, it’s a very incremental improvement. Okay, it’s machine learning isn’t magic, nothing in investing is magic, but the linear regressions are pretty darn good. And markets are pretty darn efficient, but machine learning can help you fine tune those things. But, by and large, even with the most advanced tools, you’re gonna find that things like price matter most.
Tobias Carlisle: We took a similar approach in quantitative value. We looked at that cheapest decile of EV, EBIT, and then tried to divide it into two halves, because it’s already a fairly small universe of stocks. And so, to get a sufficiently large portfolio, you can’t really divide it much more than in half. We looked at a variety of things; margin strength, and so on. And that’s one of the departures between Wes and I, is that I just prefer cheaper, and Wes prefers cheap and good. I think that, just changing gears slightly, I first read your work without realizing who you were at the time, was when you wrote a critique of Porter’s Five Forces. It’s a wonderful paper. Can you just… What is your critique of Porter’s Five Forces?
Dan Rasmussen: Well, to put it very simply, my critique is that there’s no evidence that it’s right. I think you and I are in this very controversial school of investing that you call evidence based investing, which is the revolutionary idea that maybe your ideas should be supported by evidence. And, unfortunately, Michael Porter’s ideas just aren’t. They sound nice, they sound good, they’re just wrong. And what’s sort of fascinating, what’s sort of most interesting in some sense about Porter’s ideas, so you have to kind of go into the DNA of his ideas. So, Porter studied in the field of industrial organization, and the field of industrial organization in the 60’s and 70’s was very focused on anti-trust and monopolies.
Dan Rasmussen: So, they had this idea that monopolies were evil and bad, because they could screw everyone over, and thus earn really, really high profits. And in the industrial organization field, there was this theory called Structure Conduct Performance; so they said the industry structure determines the firms conduct, which determines performance. And let’s make it even simpler than that. Basically, they said, “The closer you are to a monopoly, the higher your margins will be.” So the higher your market share, the higher your margins will be. So, if you want to study business, what you should be studying is industry structure and figuring out which companies have monopolies. And there’s something very intuitive about that right? You sort of think, “Wow, gee, if I owned all the railroads, I could charge a big price for my trains.” That hasn’t worked well for Amtrak, but again we’ll get back into the evidence a little later.
Dan Rasmussen: So, Porter was sort of a disciple of this school and he came to Harvard Business School in the 80’s and Harvard, business school has a checkered reputation as an intellectual field. When Harvard Business School first opened, people were saying, “What are you gonna do, you gonna bring in cobblers and butchers and chefs, an teach them…” I mean it just seems like not something Harvard should be doing, you know teach them Latin. But, at the time, in the early 80’s, Harvard Business School’s approach to teaching corporate strategy was to teach people SWOT analysis; strengths, weaknesses, opportunities, threats. And I think to anybody with half a brain, that sounds like a dumb idea, or at least in the realm of, “Really, I go to Harvard Business School and you’re teaching me SWOT analysis?”
Dan Rasmussen: There was something lacking, and Porter came in. He said, “Let’s overhaul the strategy curriculum and teach Structure Conduct Performance. And we’ll teach them how to take Structure Conduct Performance and apply that to corporate strategy.” And that was the origin of the five forces. So he said, “The more market power a company has, the higher the market share, the closer it is to a monopoly, the more power, the more force it should be able to apply, relative to its competitor, suppliers, et cetera.” Right? And that was the idea, and it should be no surprise that the idea of an advantaged, powerful establishment dominating everyone else, so appealed to generations of Harvard Business School graduates.
Dan Rasmussen: And this became the dogma of business, and sadly… and I felt Warren Buffett a little bit here, because he adopted this wide moat concept, became a dogma among value investors; who started to say, “Ah, well we don’t just want cheap companies, we want cheap companies that are competitively advantaged, that have these five forces.” So, it caught on like wildfire, and yet at the same time, it’s really interesting, this whole idea of Structure Conduct Performance, was also being applied in the legal system and in academia. Right?
Dan Rasmussen: So in the legal system, this was being used to break up monopolies and break up companies with high market share. And the Supreme Court, in a series of landmark decision in the early 80’s, they basically looked at a bunch of sophisticated econometric analysis, and found that there was no evidence that higher market share led to higher margins, no evidence whatsoever. There never had been. And so, they said, “You know what, you can’t use market share as an indicator of anything anymore. It’s not ipso facto, anti-competitive to have high market share. There’s just no evidence of that.” I mean, you actually have to prove consumer harm, and that was what the Supreme Court said, so basically, in the early 80’s, Supreme Court said, “Structure Conduct Performance, as far as the courts are concerned, is dead. We don’t believe it, we don’t buy it, we’re not gonna apply it. So, keep it out of the legal system.”
Dan Rasmussen: And at the same time, the field of industrial organization was starting to do all these market share margin studies, industry margin studies; and what they ended up finding was that industry had no relationship to conduct or performance. And market share had no relationship to conduct or performance, just the legal scholars are finding. And by the late 90’s the field of industrial organization had basically admitted that industry analysis was dead, traditional industry analysis didn’t matter, there was no evidence for it.
Dan Rasmussen: And this is at the… Porter’s star is rising and rising and rising. I think the economists or Forbes named him global guru. Which, you pretty much know anyone who’s a global guru is wrong. But, it had really, his star had peaked. And what I wrote, a piece is just saying, why are value investors still so devoted to this cant? Which is what it is, it’s cant: it doesn’t work, isn’t true, and isn’t even basically supported by logic. Which, to what you were saying, is it buy cheap and good? Well, no, it’s just buy cheap things, and you try to buy good things, you just move away from buying cheap things, and then it works less well.
Tobias Carlisle: It’s a little reminiscent of another guru, Tom Peters, who had that book, In Search of Excellence. And, he said these are the criteria for excellence, and it included various things like; a high return on invested capital, high sales growth, and so on. And an analyst, Michelle Clayman along and said, “Well, let’s go in search of the un-excelled.” And she found, that the companies that had the characteristics on the other end of the spectrum, which were; very low returns and invested capital, little to no growth in earnings, they outperformed quite substantially, the excellent companies, so called. And that study was updated by a gentleman who worked for her, his name escapes me now, but I put it into deep value.
Tobias Carlisle: Basically, over the full data set, it’s a stunning outperformance for the unexcellent companies, and the reason is very simple; the excellent companies, you pay two times book for them on average in this data set. And the unexcellent companies you get them for .6 times book. In both cases there’s this sort of diminution in that the businesses get worse after you buy them, in the 12 months after you buy them. But, so the driver of the performance is purely that reversion in the price to book, or price to underlying intrinsic value. It’s one of those fascinating things, I’ve been saying it for a long time, but I can’t find many value investors who are prepared to, or who believe it at all, so I’m always very happy to find a fellow traveler.
Dan Rasmussen: No, it’s exactly right. And I always say investing is a game of meta-analysis, not analysis. So, it doesn’t matter if you think a company is good, if you everyone else thinks it’s good. It’s what you think of, relative to what the market thinks. And so, ultimately, a company’s price today depends on everyone else’s projection about what’s going to happen in the future. The sort of, if you wanna be a meta analyst investor, step one: find things that everyone agrees are bad, and then among those figure out which ones you wanna own. And understanding that consensus pessimism, if the future is completely unpredictable, then both extremes of optimism and pessimism are gonna be wrong. So, what you wanna own is the things people are pessimistic about; the unexcellent things.
Dan Rasmussen: And I think that’s just logical, but I think part of it is, you try pitching this to sophisticated institutional investors and they don’t wanna hear… You’re like, oh what do, “I buy really bad companies that everybody else hates, that might get a little better. I don’t have any reason to think they’re gonna get better, I just sort of think, who the hell knows what’s gonna happen in 2020. Maybe newspapers won’t be as bad as everyone thinks they’re gonna be.” And people are like, “Well, over here, this guy who’s really done a deep dive on sales force, and boy is there a bright future for sales force. And they own 20% of their funds sale, they have super high conviction.”
Dan Rasmussen: And I was joking with one of these large institutional investors, I said, “You can either have higher returns or you can buy things that you have really high conviction on. But, the universe of things that are high conviction, high return is a null set. You either take risk and get return, or you buy things that everyone likes and you get mediocre returns.” There’s just no more, sort of, obvious truth in investing in that.
Tobias Carlisle: The Venn diagram doesn’t really overlap very much in that.
Dan Rasmussen: Exactly. We wish it did, but it doesn’t.
Tobias Carlisle: Buffett has sort of been a proposed…as you pointed out, the reason for this is that Buffett, who is the highest profile, most successful value investor, possibly we wouldn’t even know the term if Buffett hadn’t been so high profile, and been so generous with his writing. The problem though, is that if you try to do it yourself, you find it extremely difficult to do that. And I think Michael Mauboussin has this great study where he took buckets…he could rank say the Russell 1000, he could rank them from highest return on invested capital, to the lowest return on invested capital. And then I think he puts them into qintar, so one fifth each. And he tracks them over 10 years to see what they do. And, as you’d expect, they sort of have this mean reverting function where the ones that are the worst, tend to get much better, and the ones that are very best tend to get worse. Reason’s very simple of course, it’s because everybody wants those very high returns and they compete for them, and nobody wants to be in the industry that has very low return and they leave and that sets them up to do better.
Tobias Carlisle: Maubousssin’s looked at the drivers of those returns, and he’s never been able to say prospectively which of the companies, what the drivers of it are. He can come up with conclusions at the very end where he says, “Buyer technology, Pharma did very well, you don’t want to be in retial, you don’t want to be in anything that’s got these very high…. you want higher margins rather than lower margins. But, nothing is sort of particularly predictive.” I find is fascinating that this research is out there, and for whatever reason… sadly I have these arguments on twitter all the time. There’s a recent, recent paper on unpopularity. Did you see the–
Dan Rasmussen: Yes, I loved that. I thought that was so good.
Tobias Carlisle: Capturing that again, where Morning Star has those three categories, where they say there’s a wide moat type of company.
Dan Rasmussen: Same story as the Porter stuff.
Tobias Carlisle: Wide moat, narrow moat, no moat, and I love the Morning Star definitions of these things. I think it’s an excellent description of what you would look for in a moat. I don’t think there’s anything wrong with their method, I think it’s a very good method. It’s just that when you look at the returns to those three categories; no moat outperforms narrow moat, narrow moat outperforms wide moat. And the reasoning is always, “Well it’s because narrow moat is riskier, sorry, no moat is riskier, narrow moat is less risky, wide moat is the least risky.” But then, I always think, if we did a Monte Carlo simulation of it, shouldn’t we get equivalent returns across all three, because we’re getting failures in no moat, and wide moat sort of persists.
Tobias Carlisle: It doesn’t seem to be the case. It’s sort of accepted so well in the literature, and then it manifests in these discounted cash flow models that everybody builds. Because, they say this particular company that I’m looking at has this very high return in invested capital. So, therefore should be able to grow and compound, and it’s gonna grow over this 10 years or so, and then the terminal value is gonna be enormous, because it’s gonna grow in perpetuity; sort of at a slightly higher rate than GDP. Are you a proponent of DCF’s, do you use them in your firm?
Dan Rasmussen: Well, yeah, there’s the old joke that an economist and an engineer are on a desert island and they’re starving, and there’s no food, and a can washes up. And the engineer says to the economist, “Well what are we gonna do?” And the economist says, “Well I have an answer.” And the engineer says, “Well what is it?” And he says, “Well assume a can opener.”
Tobias Carlisle: I love it.
Dan Rasmussen: You know, in theory, discounted cash flow is right. Predict the entire future, discount it back based on it’s riskiness, and then that’s the value of any security. But, what alludes me is why investors think they can predict the future in the first place. If you say, “Well predict how much money is gonna be in your bank account in ten years.” Well you’re the worlds leading expert on you, surely you should be able to develop a very sophisticated excel model, that should give you a pretty precise answer to that. But nobody does it, because we all know it’s impossible. You know, Coca Cola is a much more complex system than you. Why do you think Coca Cola’s balance sheet should be predictable? I mean, it’s just nonsensical, but it starts from the premise that, if you can predict the future yeah it’s right, but you can’t predict the future so it’s wrong. So, it’s like the first premise is flawed.
Dan Rasmussen: And yet again I think business schools are to blame for this. The DCF models, again, it’s a Harvard Business School idea from the 1930’s. For some reason, people wanna plan, and they wanna say, “Well, what should this be worth?” And I think the answer is, no one has any idea. We don’t know what the future is gonna hold, so you might as well buy it cheap.
Tobias Carlisle: I don’t mind the Beau Williams model as a statement of what you are looking for, that is true that something is worth now, the cash flow is discounted from here until kingdom come, that’s absolutely true. The difficulty is in implementing that theory in any practical way, in any individual company. It’s virtually impossible to do that. The other thing, and I’m sure that you have built these incredible complex Excel spreadsheets with multiple tabs, all sort of linking through, projecting out margins and growth and so on, and then discounting that back at whatever is the correct discount rate, I have no idea. But, they all sort of boil down to this; you only really have a handful of inputs.
Tobias Carlisle: It’s the future, it’s the dividend or the cash flow that you expect over the next few years, the discount rate, and the growth. That’s three very simple inputs that are then expanded out, exponentially. This is another thing, I get trolled about all the time; I’m anti-DCF, but only because there are only a handful of inputs. And they say, “it’s silly to use a multiple, it’s silly to use a ration when you can look at these other…” Well, really the only thing that the ratio is missing is the growth rate, and I don’t know.
Dan Rasmussen: Right, well I think there is a two by two. Right? There’s importance and know ability. And I think what investors miss is the know ability portion. So growth rate, really important, unknowable.
Tobias Carlisle: Right.
Dan Rasmussen: If we knew the growth rate, we’d know the value of the company. Well we don’t know the value of the company, it’s unknowable. So you multiple that in the equation and it comes out to zero right? Cuz know ability is zero, and so even though importance might be a hundred, if know ability is zero, the value of that variable is zero. Multiple on the other hand, is both very important and very knowable, so you multiply those together and you get the answer right. I mean, that’s the logic why people miss the know ability portion of it. And that’s the fundamental mistake people make. They think that the future is predictable when it isn’t. And I think there’s no more fatal intellectual flaw, than to believe that you are a fortune teller, or a prophet, or a sooth-sayer; when in reality, you’re just a guy with a spreadsheet.
Tobias Carlisle: So, I’ve seen you describe your approach before, as the Chicago School of Business approach. What do you mean by that and what does that mean in a practical sense?
Dan Rasmussen: Yeah, you know the sort of joke around here, we call ourselves part of the Chicago’s. Well I think the Chicago School, to me, means sort of the disciples of Eugene Fama. And generally, people that think it in terms of evidence. I mean, the Chicago School of Economics was famous for saying, “No, we need to prove this works in the real world. We need some empirical evidence.” And for example, on growth rates, there’s a great, I think it’s a 2004 paper, I think it’s by [foreign 00:42:20] and it’s–
Tobias Carlisle: That’s the contrary in investing.
Dan Rasmussen: No, it’s a different one.
Tobias Carlisle: Not contrary in investing?
Dan Rasmussen: Maybe I got the authors. It’s the Persistence and Predictability of Growth. And, I might have the authors wrong, but it’s The Persistence and Predictability of Growth, and they find that growth is neither persistent, nor predictable. So, if you actually look, and you actually try to predict it, you can’t. And nobody can, and they haven’t been able to. Right? And I think for me, when I say Chicago’s School that’s for me, it’s saying, “Oh, okay. You’re gonna build a DCF model, well before you build it, why don’t you prove that you can forecast the growth rate. Prove that you can forecast the growth rate, then let’s do the DCF model. Don’t just build the DCF model assuming you can break the growth rate.” And I think that, for me, is what the Chicago School is.
Dan Rasmussen: And I think it’s funny right, because people will say, “Why don’t you do more analysis? Why don’t you meet with management? Why don’t you forecast the growth rate?” And I say, “I’d do it if it it worked. You show me evidence that it works and then I’ll do it.” But I’m an evidence based investor, so I don’t do things that I don’t have any evidence or logic to think that they work. And I think the most common conceit, is that some people believe that the more you know about something, the better you can predict the future, about that thing. And I don’t think that’s true, in any meaningful way. I don’t think that just knowing more about something make you better at forecasting it. There are a lot of people that really know a lot about baseball, but it doesn’t mean that they can predict who the winner of the World Series is, anymore than anyone else can, because it’s unpredictable.
Tobias Carlisle: James Montier has a great collection of these studies that show all of the various different ways of predicting the future. He has a great one on horse handicapping, where he gives people, you get a small amount of information about which horse is likely to win. Then the professional handicappers rank the horses, then they give them increasingly, more and more data about these horses; they sort of randomize it so no individual is getting the same data at the same time. And it demonstrates two things; one is that we tend to anchor on the first bit of information that we see more than any other, and the other is that we get increasingly confident with each little bit of data that we receive about the horse that went right. But our accuracy doesn’t improve at all beyond the sort of one, two, or three pieces of information that we receive at the start. It’s kind of a… And then that is replicated over and over again through the literature.
Tobias Carlisle: I think Paul Mele said something like, “When you see this phenomenon replicated that many times, it sort of becomes this golden rule.” And the golden rule is that simple statistical models do better than experts, which you and I sort of seem to embrace. But, I’ve yet to see it really penetrate the investment world, other than the quants, who sort of seem to construct very large portfolios. When you go about constructing a portfolio, how many positions, how diversified, how concentrated, what are you looking to achieve?
Dan Rasmussen: Yeah. So, I tend to like the 40 to 50’s stock range. So, I think that, in theory you have to embrace the idea that your models are good, but the world’s unpredictable. So, the R squared of even the best model is not that big. And again, as we talk about the extremes of cheapness, you have really high dispersions. So, you wanna hit enough, you wanna see enough pitches that your statistical insight works out. However, on the other hand, you’re balancing that with of course, you have a ranking system. So, is the stuff that you can buy at three times[inaudible 00:45:47], then three and a half, then four, then five, then six, the more things you own, the less of a hit you’re getting from buying cheapness.
Dan Rasmussen: For example, whatever it is you’re ranking on. And so, my view is that you have this trade off where you want enough names that you have at least some diversification, but not enough that your alpha starts to deteriorate, because you’re looking too much like the index or diluting your factors exposure. So, I think it’s a compromise between the two things. I think there’s no perfect answer, but I think obviously factor investing, in the big realm of things; should a 50’s stock factor investor be better than a 500 stock factor investor be better than a 15 hundred stock factor investor? Of course. Right? Of course, if the factor is right, the guy with 50 is gonna beat 500, beat 15 hundred. Is 70 or 30 the right answer? I don’t know that I know, or anyone really knows.
Tobias Carlisle: It sort of becomes this slightly, it’s almost a nihilistic approach to investment, just to say that the only things I’m gonna use are the the things that I can. You know, I prefer historical earnings to afford projections, so on. So, I want things that have been printed in black and white, that have been recorded presumably because they actually happened. But it’s sort of, the approach becomes this Tetlock. If you embrace Tetlock, if you embrace the behavioral arguments about why everybody else is so bad at investing and then potentially… and you’re clearly a very intelligent guy; you’ve got Harvard undergrad, Stanford MBA–
Dan Rasmussen: Or maybe I’m just a really good actor, and I’ve learned to read my script very well Toby, and tricked you.
Tobias Carlisle: Who really knows you could be picking the stocks, but what do you take from the… Tetlock has the fantastic book, it’s Tetlock Super Forecast? I’m forgetting now.
Dan Rasmussen: Yes, yeah that’s right. Yeah.
Tobias Carlisle: Tetlock is su–
Dan Rasmussen: That’s right.
Tobias Carlisle: …So, what’s the Tetlock story?
Dan Rasmussen: Yeah. So look, I think at it’s heart, forecasting, that is what we do. Right? That is what investors do, that is what investment models do, they forecast prices. They say, “These are the things where the price today is the lowest relative to the forecast price.” Very, very simple. We are all forecasters right? And so, it seems logical to me, that if you’re a professional forecaster, which is what we all are, you should probably study forecasting. Well, there’s only really one scholar, I mean their Mele, and there’s Tetlock basically right? There’s Kahneman’s school of thinking, but there’s basically they all agree on a few sort of, simple findings about forecasting.
Dan Rasmussen: One, is that when you forecast, you want to forecast like an insurance actuary. If you have two alternatives, how long is Toby gonna live, well I’m gonna send in McKenzie, they’re gonna spend three months with him, they’re gonna do a projection of how much he works out, what he eats, we’re gonna forecast into the future. We’re gonna 50 slide power point deck, we’re gonna interview everyone he’s ever known, and we’re gonna come up with the answer to how long he’s gonna live. And the insurance guy just says, “Okay, he’s a male, he’s this age, does he smoke or not? How much doe he drink? What’s his family history of chronic illness?” Plug it in to a model and say “Here’s the answer.” And Tetlock basically says that’s the better way to do it. Because you want to use probabilities, base rates, historical statistics.
Dan Rasmussen: So, you want to orient yourself around what the historic incidence of something has been. That’s the best way to make decisions. You say, “I’m gonna renovate my house. How long is it gonna take to renovate my house?” You know, one way to do it is ask an architect, think about what it is, how long is gonna take. Otherwise just say, “How long have similar renovations in this area or similar size, taken?” That’s the base rate approach, and it tends to work much better because you’re actually basing it on data. And this is why the statistical models work better than the experts, because the statistical models are just saying, “Take all the historical probabilities and assume that.”
Dan Rasmussen: Now, I think there’s a role for, not expertise, but analysis, because someone has to say, “Okay, well what is the base rate?” What variables are important? How do we define that actuarial table? There’s an element of nuance to that, and I think there’s also some element of saying, “Does this fit within the base rate, or is there an acception?” I think Tetlock would even say, “At the end of all that statistical work, you might wanna adjust based on some specific details.” So, if you’re actuarial table says, you’re gonna live til you’re 80, but we know you’re going to do base jumping next week, we might adjust the model just a little bit. Right? And that would be sensible and logical.
Dan Rasmussen: And I think that’s what I take away from Tetlock, which is; you have to use base rates, if you’re not doing base rates, if you’re not using statistical models, you’re not paying attention to what we know about forecasting and good forecasting, and if you’re not paying attention to what we know about good forecasting, why are advertising yourself as a professional forecaster in the first place? It beats me.
Tobias Carlisle: That’s an interesting idea that you bring up there, because there’s a phenomenon that’s sort of, I’d describe it as broken leg theory; where you have some information about whether John goes to… and I think this is from a Paul Mele paper, I think he gives this example where he says, “You have an estimate about whether John goes to the theater on a Friday night. And you might include such things as, it’s an action movie and he likes action movies. It’s raining and he doesn’t like to go out in the rain.” And then you can find the statistical guess as to whether he goes out.
Tobias Carlisle: Let’s say on this particular occasion, he’s got a broken leg. Should you be allowed to update the model, or override the model rather, to reflect the fact that he’s got this broken leg? And the answer tend to be no, for the reason that we find many more broken legs than there actually are. And it’s particularly apt in a deep value world, because every single company I look at has a broken leg, which is why it’s cheap. That’s why you get there in the first place. So, if I was to override the model, I wouldn’t have anything in the portfolio, you know? Because I think the businesses are as junky and as cyclical and everything, as everybody else. I just have to rely on that base rate bailing me out.
Dan Rasmussen: I talk to respective investors a lot, it’s part of my job. And the one question I dread the most, is when they say, “Tell us about some of the companies in your portfolio.” And I’m just like, “Oh no. And I’m like, the more you know about the companies, the less you’re gonna like the strategy. Just hold your nose, blindfold yourself, and buy. Because, do you really wanna know that the largest holding is a Russian steel company, or would you rather not have known that?”
Tobias Carlisle: There’s two reasons to hate it. It’s Russia and steel. That’s why it’s cheap.
Dan Rasmussen: Yeah that’s why it’s the cheapest darn thing in the world. But, it’s funny. I think that’s exactly why, and I think people make decisions so much more on stories and emotions than they make it based on data. And that’s what I think quantitative investors are fighting, right? Because someone’s gonna make a decision to invest in a stock or invest in a fund, based on an emotional or person connection. Not necessarily based on reason or that sort of, what Kahneman calls The Type two, or type logic. And I think that’s often a challenge we face, with being quant investors.
Dan Rasmussen: And that’s why I think work like what you’re doing, is so important, because we need to tell the story of why statistics work. We need to talk about things like the acquirers multiple, and say, “You know, if you actually walk through he intellectual journey, you’ll start to come to an emotional connection with this way of thinking. And if you come to an emotional connection with this way of thinking, then maybe you’ll act based on reason.” But you have to do so much work to overcome people’s bias, because it would be so much easier to walk in and say, “What I buy is great companies, the best companies in the world.” And you know, “Gee, it’s not just important to buy the best companies, you gotta know them better than anyone else. So, we put more work and more money into understanding these great companies and why they’re great, than anyone else. And blah, blah, blah.” And that’s what so many people pitch, and by and large that’s where the money flows to those types of people, and to me it’s just crazy because it’s just not likely to work.
Tobias Carlisle: You have to find the good story to sort of explain the data you’re using, which is what I’ve tried to do in the books. Here’s the story that you can remember, but the real message is the underlying data that tells you how it works. But I’ve seen many examples, and I’m sure you have too, where there’s no limit to the amount of research that a firm can do. Big firms that have multiple analysts and can send them out. And I know that, for example, I won’t mention the name of the firm, but a local firm in Los Angeles had a very big position in Sino-Forest, a $100 million position, established weeks before the fraud was uncovered. And they had done as much as send an analyst to China to go and have look at the forest and they’d been taken out and shown, here is the forest that forms part of the portfolio. The only problem was that that particular forest wasn’t actually in the portfolio.
Dan Rasmussen: It was just a forest. It was a nice forest. I think back to my days in private equity, and we’d go on these factory tours and you’d see all these machines, and you’d be in your suit and go, “Oh that’s a nice machine over there.” You know? “Great factory, really great.” And what do I know? I can’t tell the difference between a good factory and bad factory if my life depended on it, but yet somehow that was part of the diligence process. It’s just so silly. But, you know, the other thing people miss is that the bigger you are, and thus the more you can spend on research, the fewer opportunities you have to invest because there are so many fewer big companies than there are small companies. And the bigger amount of capital you have to deploy, the more constrained your opportunity set is.
Dan Rasmussen: That’s why an individual investor actually has an advantage over a point 72 or a Bridgewater, when it comes to choosing stocks. Now, maybe there are other areas that they are really advantaged in, but if you’re trying to pick stocks, the smaller you are, the more options you have to choose from. So, even if you have slightly worse analysis than some brilliant hedge fund, you are so advantage by being able to invest in small stocks, relative to being only able to choose from the stocks of 10 million dollars of daily volume. I think it’s an interesting sort of truth about markets that research budgets can’t overcome deficits in size.
Tobias Carlisle: Dan, absolutely fascinating discussion. Really enjoyed it. If folks want to get in touch with you, how would they find you?
Dan Rasmussen: So, I’m on Twitter. @VerdadCap is my Twitter handle. I have a website, www.verdadcap.com. We have a weekly research newsletter, which I promise is controversial, occasionally polemical, but hopefully always empirical.
Tobias Carlisle: I’m a subscriber. I think it’s absolutely wonderful. Dan Rassmussen Verdad, thank you very much.
Part of the weekly research here at The Acquirer’s Multiple features some of the top picks from our Stock Screeners and some top investors who are holding these same picks in their portfolios. Investors such as Warren Buffett, Joel Greenblatt, Carl Icahn, Jim Simons, Prem Watsa, Jeremy Grantham, Seth Klarman, Ray Dalio, and Howard Marks. The top investor data is provided from their latest 13F’s. This week we’ll take a look at:
Vishay Intertechnology (NYSE: VSH)
Vishay Intertechnology provides discrete semiconductors and passive components to original equipment manufacturers and distributors. These products are found in industrial, computing, automotive, consumer, telecommunications, power supplies, military, aerospace, and medical markets. The firm’s portfolio of products includes transistors, diodes, optoelectronic components, capacitors, inductors, and resistive products. Less than half of the firm’s revenue is generated in Asia, with the rest coming from Europe and the Americas.
A quick look at the price chart below for Vishay Intertechnology shows us that the stock is down 18% in the past twelve months. We currently have the stock trading on an Acquirer’s Multiple of 4.59 which means that it remains undervalued.
(Source: Google Finance)
Superinvestors who currently hold positions in Vishay Intertechnology include:
We’ve launched a new investment firm called Acquirers Funds® to help you put the acquirer’s multiple into action.
Acquirers Funds®
Our investment process begins with The Acquirer’s Multiple®, the measure used by activists and buyout firms to identify potential targets. We believe deeply undervalued, and out-of-favor stocks offer asymmetric returns, with the potential for limited downside and a greater upside.
The returns to deep value are potentially realized in two ways:
First, through mean reversion in the underlying business, and
Second, through a narrowing of the discount to valuation, either through the passage of time or the intervention of activists and buy-out firms.
We take a holistic approach to valuation, examining assets, earnings, and cash flows, to understand the economic reality of each company. An important part of this process is a forensic-accounting diligence of the financial statements, particularly the notes and management’s discussion and analysis, to find information that may impact investment decisions.
We implement the strategy in a highly liquid, tax-efficient, capital-efficient structure.
We identify the 30 best deep-value opportunities right now in all US and Canadian stocks and ADRs (excluding financials and utilities) using The Acquirer’s Multiple®. Choose from four universes: Large Cap 1000 (free), All Investable, Small and Micro Cap and Canada All TSX.
Our The Acquirers Podcast we talk to value investors about how they find undervalued stocks, deep value investing, hedge funds, shareholder activism, buyouts, and special situations.
We uncover the tactics and strategies for finding good investments, managing risk, dealing with bad luck, and maximizing success.
We’ve just been reading through the latest Graham & Doddsville Spring 2019 Newsletter which features interviews with:
Yen Liow, Founder and Managing Partner of Aravt Capital
The first interview is with Yen Liow, founder and managing partner of Aravt Capital. Yen discussed the value of having worked under a couple of investment legends, the importance he places on systems design, and why he only focuses on a specific set of investment opportunities to compound growth over a period of years. Yen shared a couple of his “horses” (i.e. durable compounders) in Black Knight (BKI), GoDaddy (GDDY), TransDigm (TDG), and Constellation Software (TSE: CSU).
Bill Stewart, Founder of both Stewart Asset Management and W.P. Stewart and Company
The second interview is with Bill Stewart, founder of both Stewart Asset Management and W.P. Stewart and Company, the latter of which was sold to AllianceBernstein in 2013. Mr. Stewart shared why he focuses on predictable earnings, how he comes up with an earnings multiple, and what he thinks of the retail industry. He also discussed his views on ADP and Disney.
John Hempton of Bronte Capital
The third interview is with John Hempton of Bronte Capital. John is well-known for his public (and accurate) calls on both Herbalife and Valeant. John discusses his approach to finding fraudulent companies, why switching costs matter, and the benefits of global scale. He specifically discussed Mattel and provided additional color on his variant perception on Valeant.
One of the best resources for investors are the publicly available 13F-HR documents that each fund is required to submit to the SEC. These documents allow investors to track their favorite superinvestors, their fund’s current holdings, plus their new buys and sold out positions. We spend a lot of time here at The Acquirer’s Multiple digging through these 13F-HR documents to find out which superinvestors hold positions in the stocks listed in our Stock Screeners.
As a new weekly feature, we’re now providing the top 10 holdings from some of our favorite superinvestors based on their latest 13F-HR documents.
This week we’ll take a look at Howard Marks (3-31-2019):
The current market value of his portfolio is $5,265,263,000.
During his recent interview with Tobias, Justin Carbonneau, a Partner at Validea Capital discusses how value investing will turn around but no-one can say when. Here’s an excerpt from the interview:
Tobias Carlisle: We’ve seen this really difficult time for value. I get the feeling that you’re not necessarily a believer that value can turn around. You don’t think it can do it again?
Justin Carbonneau: You don’t think that? No. I strongly believe, to your point earlier, I think value investing, there’s the underpinnings of what makes value stocks work. I believe very strongly in that. I just don’t believe anyone can time the turn in value or the turn in any of these factors. But, mean reversion is a very powerful thing in the market.
Looking out over the next ten years, I do think value stands a very good chance of certainly improving its relative performance. But, you also have to always question your beliefs to some extent and just try to be … That’s one thing I’ve tried to do more of and my partner, Jack, he does a really good job at it. I don’t. I tend to, on Twitter and the articles I read and stuff, I read the things I agree with. When I hear fundamental investing is dead or somebody that’s bashing Buffett for his performance over the last 15 years, I don’t agree with that stuff. But, I also want to be open-minded to that in the markets, things change and things can go on a lot longer than we think, and they have been for a couple of years now.
Tobias Carlisle: I think value investors have been doing a lot of introspection. The last decade’s been rough, but the last five years in particular. I thought five years into the underperformance was enough.
Justin Carbonneau: Yeah. I think we were writing about it five years ago. Turn in value.
Tobias Carlisle: Here it comes.
Justin Carbonneau: I think we might have been one of the earlier ones, and we were wrong. It kind of humbled us, I think, in that sense.
Tobias Carlisle: I’ve been saying, “It’s five years,” for so long that it’s longer than five years now. I’ve been saying it for six or seven years. I’m actually going to say it’s seven years. It’s so long.
Justin Carbonneau: Exactly.
Tobias Carlisle: I always think of that article that Malcolm Gladwell wrote about Nassim Taleb. Nassim Taleb used to say to his trader, “Have you introspected today? Introspect. Introspect.”
Justin Carbonneau: Yeah. Right.
Tobias Carlisle: Every value investor out there, there’s so much introspection going on. Why aren’t these strategies working? If you were a value investor who’s kept up with the market over the last decade, you’re a genius. You’re just undiscovered. Having lived through it, I remember all the… There’s a suggestion that the problem with the value strategy at the moment is it’s so focused in bad sectors. It’s focused in energy, it’s focused in financials. Having lived through it, I can point at each stage along the way. All of these disasters like Chinese reverse takeovers, they all came on. They looked pretty cheap. They all floated down into the value stuff if you bought them, you got carted out. Then there was the for-profit colleges.
Justin Carbonneau: What was the Corinthian college and-
Tobias Carlisle: I remember it well.
Justin Carbonneau: Yeah. These things were trading at PE of four or something, you know?
Tobias Carlisle: If you backed out the cash, though, free.
Justin Carbonneau: Right.
Tobias Carlisle: Then energy more recently. At every stage along the line, you’ve just walked into a value trap industry.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Here’s a great recent interview with Charles Munger and Andy Serwer at Yahoo Finance – Influencers. There’s one passage in particular in which Munger admits to being ashamed that he missed out on Google, and has the following to say about loss-making Unicorn IPO’s:
“Well, there are a whole lot of things I don’t think about. And one of them is companies that are losing $2 or $3 billion a year and going public. It’s not my scene.”
Here’s an excerpt from the interview:
ANDY SERWER: I want to ask you a little bit about some Silicon Valley stuff. I mean, you said yesterday you were ashamed of missing on Google.
CHARLIE MUNGER: Yeah, I am. We could see, if we had looked carefully at our own companies, that their advertising was working way better than other advertising. Just we weren’t paying enough attention.
ANDY SERWER: So was it too late?
CHARLIE MUNGER: I don’t know. I don’t know everything, you know?
ANDY SERWER: Well, we’ll leave that aside. But, you know, you look at these tech investments, so they’re Apple, now Amazon. Did you know about the Amazon purchase? Were you involved in that decision?
CHARLIE MUNGER: No, of course not. I have never owned a share of Amazon. I am a huge admirer of Bezos. I think he’s been sort of like Lee Kuan Yew. He’s a leader that’s all by himself. He’s been just a perfectly amazing human leader. But it’s always been too complicated and uncertain for my particular temperament.
ANDY SERWER: It’s interesting because–
CHARLIE MUNGER: And I find other things to do that’ll work fine.
ANDY SERWER: Someone was telling me the other day that they thought that you could actually sort of think of Apple and Amazon not as technology companies so much, but as big-branded growth businesses, which would be something that would be appealing to you.
CHARLIE MUNGER: Oh, I think they’re both brands and technologies. And it’s hard to separate the effect of one from the other.
ANDY SERWER: OK. And as far as what’s going on in Silicon Valley right now with IPOs, unicorns going public and not having any profitability or any prospect of profitability in the near term, what do you think of that situation?
CHARLIE MUNGER: Well, there are a whole lot of things I don’t think about. And one of them is companies that are losing $2 or $3 billion a year and going public. It’s not my scene.
ANDY SERWER: Have you looked– so, you’re not interested in Uber or companies like that necessarily?
CHARLIE MUNGER: Well, I have to be interested when they’re that important and sweep the world and change practice. But I don’t have to invest in everything I’m interested in. I’m looking for things where I think I can predict what’s going to happen with a high degree of accuracy. And I have no feeling that I have the ability to do that with Uber.
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