Talk Your Book: Compounding with Concentrated Portfolios

0:00Today's Animal Spirits is brought to you by Acri Capital. To learn more about investing in the Ackrey Focus Fund, go to AckreyCapital.com. That's A-K-R-E Capital.com. All right, Ben, we had a very interesting conversation with John Neff about the three legs of their stool, how they think about long-term investing, concentrated investing. This is no closet index fund. They are really going for it. And one of their big things is long-term moats, sustainable growth, all that sort of stuff. And I'm looking at a chart from Alex Morris at the Science of Hitting. And the chart that I'm looking at is the Costco annual membership fees, which just eyeballing this, it was about$500 million in 1998.

0:54And that line, Ben, has gone one direction up to the right with very few hiccups. Are you a member? What's that? Are you a member? I'm not. I'm not. We are. So now that is, so$500 million in 1998,$4.3 billion in 2022. I don't know what the Kager on that is, but it's impressive. Anyway, point is, companies like this exist. They're out there. And it's very difficult to do two things. Of course, if you knew this in 1998, you would have mortgaged the house to buy Costco. But compounding is the point that I'm getting at. It's so hard to really, really, really, really, really think. No, 20 years is too far.

1:45But even like five years, 10 years. it's hard to think about what happens when something grows at even high single digits, right, over time. Well, so we talked to John Neff from Acre about this, and his whole point was it's much easier to buy and sell stocks than it is to hold stocks. And holding is the hardest part because there are going to be times where the fundamentals of the business could be improving, but the stock price isn't, or vice versa. If you overlaid the price over this chart, look crazy, right? The analogy about the economy and the man walking the dog is the stock market. Yeah.

2:22I thought the most impressive thing about their fund is that they hold like 17 or 18 stocks and not one of them is in the top 10 of the S &P 500, right? Or they're not those big seven like tech stocks. There's no NVIDIA or Apple or Amazon or Google. I'm sure they're not the only mutual fund that doesn't own one of the Magnificent Seven. But considering that they're not buying small cap stocks, that's got to be a short list. Don't you think? Yeah, it's impressive. So this was a fun conversation. So here is our talk with John Neff from Ocrie Capital Management. Welcome to Animal Spirits, a show about markets, life, and investing.

3:06Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

3:32Welcome to Animal Spirits with Michael and Ben. We're joined by John Neff, partner and portfolio manager at Ocree. Is it Ocree? It's Ocree. Yes. Ocree Capital. I would have got that wrong. I would have got that wrong. You would have said acre, Ben. I know. I could tell. Don't make fun of someone from mispronouncing a word because it means they learned out how to do it reading, right? Give the proper credit to where that quote is due. I don't know. Yes, you do. That's from Morgan Housel. You know it's Morgan. I know it's Morgan. Everyone knows it's Morgan. All right, John, welcome. So we – on Animal Spirits last week, Ben and I were talking about the fact that it's highly unlikely that a new investor today would start out educating themselves with a book like The Intelligent Investor or Securities Analysis.

4:19If I know you like I think I do and I've only just met you four minutes ago, was that one of the first books in investing that you read? Was that your intro into investing or was it something else? No, Buffett and Buffett's antecedents were my introduction to investing. So yes, 100%. So Ben Graham, but Buffett himself. I mean, Intelligent Investor is a great book because it's so focused on behavior as opposed to Ben Graham's security analysis book, which is sort of unreadable and also really quite quantitative in a way that became kind of sort of market efficiency, sort of the market sort of moved beyond his ability to sort of, you know, encapsulate value with these sort of simplistic equations.

5:10And the intelligent investor is the one that's really kind of continues to resonate because it's about behavior. And so much of investing is behavior driven. Actually, maybe this is a good segue. So some of the stuff in securities analysis, in my estimation is data, not just because of the techniques nobody uses anymore, because obviously it's all in the computer or whatever, but in terms of the way that companies are analyzed and the way that companies should be analyzed, is that timeless? Do you all still take lessons from those early days, or has the game evolved way past how you would analyze a business in the 40s or 50s?

5:46Well, what Ben Graham was doing was trying to buy, for example, at a time when screening and computers weren't used. He was trying to essentially pay less for the market cap of a company than its networking capital. Imagine. It sounds pretty easy. No offense. Well, it's a good way to uncover value, to be sure. The problem is today that obviously you can screen and opportunities like that are probably few and far between. One of the things, though, that's really a hallmark of how we've always approached the investing process. My own view is that quantitative analysis, while very important, and financial analysis, while very important, is unlikely by itself to uncover a great business that you are capable of holding for years upon years.

6:39The understanding that required to do that and to do what we do isn't quantitative. It's qualitative. And when I say qualitative, what it really boils down to is a qualitative understanding of what makes a business competitively advantaged. In other words, how deep and wide is the moat and how sustainable is that advantage over time? And the only way to sort of screen for that, you can't screen for that, is the bottom line. That requires a qualitative understanding of what makes a business great. And that greatness may or may not show up in the numbers. Has that qualitative piece changed too? Because I don't want to name any names here, but there's a lot of value investors who had concentrated positions who are still living off of like pre-2008 return numbers.

7:30You're talking about Duncan? Oh, number one. And since then, I don't know if they've fallen for value traps or just not gotten to some of the growth, your names are changed, but the returns haven't kept up. And you're concentrated booktooks it has. And one of the things we look at here is that everything, one of the things people are talking about all the time this year with regards to the market is, the market is so constantly concentrated in these top seven or eight names, and they're all these big tech companies, right? And you have a very concentrated portfolio as well, but you own none of those companies, it looks like.

8:02So did you have to change your qualitative framework at all to account for a new market that is more tech heavy and maybe intangible base and all these other things? We don't think so. But you're right. I think we've had, in my opinion, we've had a good year this year and we've had it owning none of the names that have really driven the broader indices. AI is essentially the topic du jour. And I joke sometimes that we literally in the first quarter of this year, we went from fretting about an incipient banking crisis. Three months later, it's all about fear of missing out. AI is leaving the station, get on board now or miss it forever.

8:48And we don't, if AI, I guess my view is if AI is as remotely impactful and meaningful as people seem to think it will be, then the ability to sit here today and forecast who's going to be the biggest beneficiary for how long, to what extent, is a challenging thing. There's certainly some companies out there that are clear beneficiaries today, but we think we own plenty of companies that are going to be beneficiaries to the extent one can be from AI. We own companies like MasterCard and Visa, which have been using AI and machine learning for years and years and years. We own companies like Moody's that has created a partnership with Microsoft to essentially infuse AI and machine learning techniques into basically every product that they offer.

9:45So we own Adobe, which is a clear beneficiary seemingly in these early days. But we haven't had to chase a potential bubble in certain AI names in order to, A, participate, and B, to do well. John, maybe we should take a step back, as they say in podcast parlance, for the audience and just introduce Ocury. You guys have been around for a long time, have a storied history, just a little bit about the firm for people that are unfamiliar. Sure. So, Ocree Capital was founded by Chuck Ocree in 1989. And we started the mutual fund that we're probably best known for, the Ocree Focus Fund, in 2009. And I joined that year to the firm.

10:35And essentially, Chuck started this firm with a philosophy that he sort of encapsulates with the term three-legged stool. So what we're looking for as investors are businesses that are exceptional. And by exceptional, it goes back to that aforementioned competitive advantage. What makes this business likely to win today and going forward? How sustainable is that? Can we understand what makes that business exceptional? The second leg of the stool is the people running the business, requiring equal parts skill and integrity is what we're looking for in terms of our managers. And the third leg of the stool is reinvestment.

11:22And that's where the rubber really meets the road in a way that I don't think a lot of investors understand or appreciate. So when we talk about reinvestment, we're talking about what does the business do with this great free cash flow that it's generating? And how does it reinvest it? Does it invest it organically back into the business at high internal rates of return? Or does it decide to pay it out as a dividend? And one of the things that we look at is how a company, because the reinvestment menu is the same for every single business. There's five things a company can do. They can reinvest organically.

12:00They can make acquisitions. They can pay a dividend. They can buy back their shares or they can pay down debt. That's the reinvestment menu for every single business. But how a company rank orders that menu and then has opportunities against those different menu items is going to have an enormous impact on our ability to compound. So one of the things, if you look at probably the greatest example of reinvestment, which is Warren Buffett's Berkshire Hathaway, look at what he's done over the decades. He's never paid a dividend. Yet the common wisdom for investors is own companies that pay dividends.

12:40The common wisdom is, well, acquisitions are often value destructive, and they are. But if there's a company out there that can allocate capital against acquisitions, make them more valuable to them as a buyer than it was to the seller, that's a way of absorbing more reinvestment capital and putting it to work at a higher rate of return than simply paying it out as a dividend. Do you have a good example there of a company that's done that with acquisitions that has done so in a value accretive way? John, let me step in. I believe you're talking about a company like MicroStrategy. In terms of not doing it well?

13:15Yes. Or putting your cash balance into crypto. Absolutely. Some of those good investment decisions. But Berkshire Hathaway is a perfect example. They've never paid a dividend. What's he done instead? He took a money-losing textile company, which is the namesake of the entire business, and reinvested it into better businesses. He never paid a dividend. He's made acquisitions and organic reinvestment, and that's been the key to Berkshire's compounding over the decades. And that's what we're looking for. So we own companies that pay dividends. But what's more important to us is that that dividend payout, which we look at more as a return of capital rather than a return on capital, that that dividend payout is appropriately ranked low on that reinvestment menu from a management prioritization.

14:04So I'm looking at your top holdings as of June 30th. And concentrated portfolios have more or less gone the way of the dodo, as far as I can see. And there's a lot of reasons why. A lot of mutual funds just tend to look very similar to the index. So you've got, again, this is as of 630, at the risk of doing quick math. I think it's 75 in the top 10, right? 75 % of the top 10. Yeah, that's about right. More than 50 in the top five. So you guys are going for it in a way that is both refreshing and risks being very, very different from how you are judged, which for better and for worse, it's the S &P 500.

14:45And so there has to be a great deal of communication between you and your end investors as to, and maybe I'm sure they've been trained over the years because you're not a new company. So how do you all communicate your value and performance? Because that's how you are judged, unfortunately. Again, probably over short of timeframes than you would like to be judged. How do you communicate that to your clients? So it's easy. I talk about the three-legged stool, and it's a really clear and simple and fast concept to describe business, people, reinvestment. It's really easy to describe. What's really hard to convey is how discriminating that philosophy actually is in practice.

15:30It's really hard to find businesses that we think are exceptional, are durably exceptional, have great people running them, and terrific reinvestment opportunity and acumen. And then even if we can find a business that meets all those criteria, the ability to buy it at an advantageous valuation is another thing that results in these being really hard to find. So it's why we run a concentrated portfolio. Because if you're dealing with criteria that are this discriminating, by definition, you're going to run a concentrated portfolio. It would be a complete contradiction in terms if we were talking about how discriminating our process was, and we had 150 names and 60 % turnover.

16:21It doesn't work that way. I agree with you on the grand piece that the intelligent investor is all like the behavior. How did you personally get around to that, the idea of concentrated portfolio? Because I think the behavioral piece has been the harder parts of it because by having concentrated portfolio, your range of potential outcomes is wider than the market, right? You could either knock the cover off the ball or potentially strike out if one of your concentrated positions goes awry. So was that something that you immediately took to personally, or did you have to come around to the idea of having more concentrated position?

16:52Because me personally, the risk factor there is tough not being more diverse. So how do you get used to that as an investor being so concentrated and putting all your eggs in one basket? I think it ultimately boils down to the level of work that you get to do on an individual name. because if you look at the industrial logic of a mutual fund, just say an average mutual, just say, take a mutual fund that has 100 positions and call it 60 % turnover or so, which is about the industry average, by the way, of the last 30 or 40 years, call it 60%. And then think about what that math requires from the standpoint of identifying, selecting, and then purchasing a new idea.

17:45At 60 % turnover, roughly, you're going to have 60 new names a year in that 100 stock portfolio. That's what the math potentially dictates. Exactly. That's exactly right, Michael. So what does that mean from the standpoint of the research that's being brought to bear on going through all the companies that one can look at and I purchasing, doing enough work to purchase a new one every week. There you go. So the way we get comfortable, Ben, in terms of concentration is really exercising the maximum discriminatory power of our framework. What really is an exceptional business? What really is an exceptional management team?

18:33Where are they demonstrating this great reinvestment opportunity and acumen? And then can we buy it right, such that our starting valuations are conducive to the kind of returns we want to generate over time? Because what we're not is collectors of great businesses. We're investors in them. So we have to buy them right. We can't just identify that this is an exceptional business. So as I'm looking at your top 10 holdings, I guess if I had to say anything that stood out to me, it would be, I would guess the average age of these companies is far greater than the average name in the S &P 500. And I would also guess that while this might be a value tilted portfolio, these are not, you're not going to find Visa ever trading at a deep valuation.

19:21It's not a cigar butt. It's just that's not what these great businesses don't – they could be attractively valued, but they're not going to screen on like a deep – they're not going to trade at two times earnings. So I guess the question that I have is when you're looking at these – so let's flip this a little bit. What causes you – because I don't know what would cause Visa's moat to deteriorate or their brand or their people or whatever. When you're unwinding something, what are some of the common reasons? And I don't know what your turnover is. I'm sure it's quite low. But when you do exit a position, what are some of the reasons, the most common reasons for exiting?

20:02So what we typically will not do is we won't typically exit a position for valuation purposes. In other words, boy, company XYZ looks expensive relative to this year's or next year's earnings. Let's sell it and move on. we typically won't do that. And the reason being that, again, based on everything I've just described, once we found a business that we think belongs in our stable for things we own or want to own, the last thing in the world is we don't take a commoditized view of that company. That's a business that we own. It's not a flickering stock ticker somewhere. There's nothing gamified about it.

20:45We own a business and that business we've deemed exceptional. We expect an exceptional business to periodically look expensively valued. That's not a reason to sell it in our book. What is a reason to sell it is when there's a negative reassessment of either the quality of the business. In other words, it's competitive advantage. The people are behaving in a way we don't appreciate or the reinvestment opportunity and acumen get called into question. So in other words, it's a deterioration of one or more of those three legs of the stool. I would guess that there's usually not a single catalyst where you hear one thing on an earnest call.

21:26Maybe there are examples of that in the past, but is this something that you tend to see deteriorate? Again, you're not making snap decisions. No, we try not to, but oddly enough, for a fund with the turnover as low as ours is, And it's typically in the low to mid single digits, or maybe mid to high single digits. When we think there's been a real severe deterioration in either the business, people, or reinvestment, we're actually fairly quick to sell, regardless of valuation. And the fact that our turnover is as low as it is, is not by design. It's an outcome from having more or less done a good job at the inception of identifying businesses that continue to demonstrate being worth holding on to year after year after year.

22:25It's not something that we're trying to minimize. We spend most of our time reassessing the names that we already own. And we're very critical. And so the fact that the turnover is as low as it is, is actually much more a statement about how good the companies are than about something we're bringing to the table. You also wrote a piece about your thoughts on holding cash and how it can offer some optionality. I remember I used to work in the endowment fund space, and there was always a clash there a lot of times with the people in the endowment fund and the portfolio managers. And they would say, you know, we're not paying you to hold cash.

23:03We do the asset allocation decisions. You pick the stocks. we don't want you to. So I'm curious how you decide, like, when is the right time to hold a raised cash and whether it's opportunistic based on like the market overall or just your portfolio of companies and that opportunity set. And like, what is the most cash that you have all ever held as a percentage of the portfolio? Well, in recent years, I'll take the last one, Ben, we came in, we came in to COVID. So March of 2020, we were about 20 % cash. and that was a function of inflows. We'd had strong inflows, but it was also a function of letting those inflows build up as cash.

23:45So in other words, we weren't taking the sort of, in my mind, artificial approach of saying, well, we can only have X percent cash. That X has to be a low number and we're going to take anything above that and pro rata sprinkle that up and down the portfolio. That's not what we do. Cash is always earmarked for the highest, best use. We don't sprinkle up and down pro rata regardless of valuation in order to minimize cash in an artificial way. So the way we look at cash, as we wrote in that piece, the way we think about cash, the return on cash is not the return on cash. The return on cash is better behavior on the part of us as investors.

24:30So if we will put that cash to work at valuations when it makes sense to do so, and if it doesn't make sense to do so, then we're very content to let that cash build. And so it's essentially a barometer of the opportunity set as far as we can see it. So I'm doing a lot of assuming here, but just given what I know about the company and the portfolio, please correct me if I'm wrong. But here's an assumption that you are aware of the macro because you're investors, but it's not dictating how you make decisions. And when I say macro, you're not doing macro forecasts. I get that. Nevertheless, you are investors.

25:09And so something as macro as interest rates, for example, they play a huge role in just the cost of capital. I'm going to assume that you have models that are discounting cash flows. And when a variable as important as interest rates change, the math looks a lot different. So could you talk to us about that particular variable in your process? We have very detailed models. We actually don't run DCFs or do valuations on the basis of DCF, at least not explicitly. But what we are doing is essentially, sometimes I'd look at it this way. If you could get one piece of information about a stock in terms of what it would be, I might say, for me, tell me what the stock price is going to be five years from now.

25:56Okay, well, I can't get that. Nobody has got that crystal ball. Yeah, what's next best? The next best, exactly. The next best is to say, OK, well, if I can't get the stock price, give me an earnings estimate and a reasonable multiple, which is essentially how you might deconstruct the stock price one step removed. So we're already forecasting out what we think the owner's economics are five and six years out. In other words, call it earnings per share for our purposes here. So now the question becomes, OK, well, we've got that half of it. So what kind of multiple do we feel comfortable underwriting for this business looking out five or six years?

26:40What multiple are we paying today? So that's how we sort of back into an IRR in terms of our valuation approach. Everything we're doing is from an IRR perspective, essentially. And we're trying to underwrite to situations where on a low case scenario basis, we're getting, call it, mid-single-digit IRRs. And on a base case, we're getting mid to high teens. So you're more likely to say that a company, I'm making this up, Moody's, for example, is trading at whatever, 13 times our estimated 2027 earnings. You're more likely to do that exercise than, say, a terminal value like they teach you in the CFA.

27:20Right. Yeah. No, those assumptions, I've just found those assumptions way too sensitive to sort of work with. We're doing essentially sort of the same, a similar exercise, but it's less input sensitive. We're really trying to forecast the business, the balance sheet, the demands on the cash flow, their ability to buy back stock, make acquisitions, et cetera. Basically trying to come up with our estimate of owner's economics, which we typically think of as free cash per share. and then thinking about the rate at which that's growing and what we'd be willing to pay for it. How many opportunities did you find in the 2022 bear market?

28:00Were you making big changes? I know you don't have a lot of turnover, but were there good opportunities that were thrown up by the bear market last year for you? There were periodically some good things. The thing is we came into 2022, and we did not have a great year in 2022. Our fund was down, I think, 22 % in 2020 to do. And I always say that was an unpleasant experience, but there was nothing about the experience that was insidious. We came into the year with high starting valuations for businesses we owned, although we didn't own any of the bubble type stocks that were leading to some incredible things happening in some pockets of the market in 2020 and 2021.

28:44But we did come in with high starting valuations and interest rates moved higher and we had multiple compression. And there was nothing insidious about that. So sometimes we get asked, well, what did you learn from 2022? Nothing much. It made sense, right? Michael and I have said that this is one of the bear markets that really made a lot of sense, that rates go up, stock prices should go down. It seemed to make sense. Yeah, there was nothing sort of new era anything in my mind. Interest rates were higher. We can live with that. We never were underwriting, back to that question of how we think about valuations, but we were never underwriting a situation where interest rates were going to continue to be 0 % to 1 % forever.