Adam Karr – Extreme Alignment at Orbis (EP.338)

28:40Now, that doesn't drive it to be in the portfolio, But we're using as an idea generation mechanism to say, looking at what we've done historically and identifying ideas, what would the models be saying we would be doing right now? What's an example of how that works? Some of the cyclical retail sectors in the US right now are being flagged. They're under a lot of pressure right now. And they're being flagged in the system. Now, where the real work happens, it's identifying that space, but then within that, selecting those that have durability and can really be the ones that will survive and be the alpha generators.

29:16That's the phase one, phase two, phase three process. So idea generation is phase one, and that's about a day of work. And it's really just what would be the thesis here? What are the key questions? And a lot of the work is automated with historical financials and some charts that are proprietary to us. And the big question there is, should we spend more time on it? So there's a conversation with the senior investor. If we advance it, it goes to phase two. Phase two is what I call real work. It's desktop work. We try really hard not to be going out externally at the phase two level. You're trying to develop that view internally without being influenced outside.

29:55You're building out a model. What are the three or four key thesis points? And that's generally a couple weeks of work. That's written up. Again, have a conversation with the senior investor. Should we progress this or not? And then we go to phase three. Phase three, we really, really go deep. And typically, we're going external. We're going to meet with the company. We're going to talk to experts. Maybe we'll talk to some people on the short side. You've developed something that you believe and now you're trying to kill it? Are there good reasons this is off? And it depends, but that can be many weeks, sometimes months in that stage, depending on what's necessary to get to that view.

30:34And then after you've completed that phase three, that's when something that would be recommended to the portfolios. And we have what we call policy group meeting, investment committee meeting. And one of the things that we do is everybody votes in advance before that meeting. So you don't know the views of others going in. We have the discussion, the interrogation, and then at the end, you're given the chance to change your vote. And then it's on the individual analyst to buy that in their paper portfolio and on the portfolio manager to buy it in the strategy. Now, to your original question, last year, 2022, we had, I think there was 425 names that came through at the phase one level.

31:1711 of them made it into the portfolio. So that gives you a sense of the winnowing process going through that. What does the typical portfolio structure look like? We're not didactic around particular hard risk rules or parameters. We think about sizing across four dimensions. So the first is discount to intrinsic. Second is what are the range of outcomes here? Does it have right tail, left tail skew? Third is size and liquidity. And then fourth, is correlation. And a target for us would be 2 .5 % of capital in the global strategy. So when we're at ideal, we'd have a 40 -stock portfolio. You're never at ideal because you're always moving in and out of positions.

32:04And so if you step back, we've got 35 analysts across the globe. Each of them is running, call it a 10 -stock paper portfolio. So that's 350 names. And in the strategy, we're seeking to narrow that down to call it 60, 70 high conviction positions in the global strategy. How does the decision -making work on the portfolio? So in our global strategy, there are three portfolio managers. I'm one of the three, and I have overall accountability for the strategy and risk. Each of us manages a sleeve roughly of equal size. And it's an independent decision for each of those of the most compelling ideas that they're seeing around the globe.

32:51Now, we're in the same investment committee meetings. Every week, we're meeting with each of our five teams and interrogating what they're seeing, sharing what we're seeing, driving research direction. We're in the same risk meetings. But we all show up with somewhat different perspectives of the world. And on top of that, I have overall accountability for the strategy. So if there's something that I view as off from a risk perspective or a sizing correlation, then I have responsibility to change that. How do you think about the duration of your investments? We model and we frame in our discussions over a four -year investment horizon.

33:30And I think one of the things that we try to do across everything is to play the long game. And so I'm a big believer in game selection from, are you scraping to the millisecond to completely on the other end of the continuum, the person that has an infinite holding period. And we're very much in that long -term, multi -year holding horizon. We've owned some of our stocks in Japan for 20 years. I've owned some companies in the US for a decade plus. Ideally, you want to own them forever if they can continue to compound at an above average rate. But that's the perspective that we try to apply to every investment and how we construct the portfolio.

34:19You mentioned a couple of times having a lot of data. So you have data of each of these individual shadow portfolios. You have data on the main portfolio. How have you thought about using all this data to integrate into your process and prove what you're doing? I'll take that in two dimensions. I think the core is the paper portfolio system. And we've been using that for 30 years. And that's really the flight simulator. We use that to identify the talent within the team to really zero in on the superpowers of the individual. And so we have a dedicated performance attribution team. All of our analysts get scorecards every six months.

35:02These are 25, 30 -page documents. It's going to look at success ratio. It's going to look at win or lose or skew. It's going to look at slugging percentage. It's going to look at that voting track record from the investment committee meetings. it's going to show you a visual graph of every recommendation and how you've managed that position sizing wise based on how the stock is traded. And everything in those paper portfolio trades based on actual volume and VWAP from when you execute the orders, it's subject to the same compliance provisions that we have. So it's real. And we use that. And it's interesting because you You see some people are very good at things that they work themselves.

35:46Some people demonstrate a lot more skill at ideas and they're more objective on the ideas of others. Some people can be very good at idea generation, but not necessarily pulling the trigger. And so there's so many nuances to that, but it gives you really clear, objective data to work with as you're making those decisions. And it's the same thing for the analyst to get that feedback and to use it. Now, we've been doing that for ages, since inception. It's gotten more sophisticated over time as we have better tools. One of the things, and this is a newer area, which we call decision analytics. And so what decision analytics is doing is it's taking all that data and it's looking at particular behavioral biases.

36:29We actually contracted with a third -party software firm, and we just got this amazing set of data and running that through. And all of our senior decision makers, we've now run through this. And it comes back, and it gives you this pattern recognition of your own biases. I've demonstrated certain biases. And you have this construct in your head. I'll give you an example. So my view is that the riskiest position is your newest position. You've got the least insight. And so I have tended to scale into a position when I'm undertaking a new position. Turns out, data says that's not right for me in particular.

37:08If it's sufficiently good enough to meet that buy hurdle, I should buy it with full aggression. The scaling thing is detracting value and it quantifies it, right? And so one, it's fantastic to have that objective mirror back to you. But then we take the second step, which is we've now programmed in what we call nudges. And so if I'm initiating a position, it can send me a nudge and say, that hasn't worked for you. And it's nice to have that there as a prompt to you because you get so into it in the moment that getting those objective reads I found to be really valuable. This is a newer area for us, this area of decision analytics, but it's an area that we've been investing in leading in quite a bit recently.

37:53I'm really curious about signal versus noise in a lot of this. So why don't we start with, in your assessment of shadow portfolios, how do you determine that the outcome, say the performance that you're seeing is the signal and not something that's happening in the input that you're missing because there's noise in markets? Ted, there's tons of noise in that data, to be clear, right? And I think to really come to a quality view of a track record, you probably need a decade, decade plus, to be fair. So we're looking at this data over these rolling three and five -year periods. And we have to be clear that there is noise in there and not to over -extrapolate that.

38:36But it's also a tool. It's a valuable tool to help make those decisions as an individual and as one that's making decisions on people. And so we try to use it with that humility. As you look at managing the organization and assessing the different skills that analysts have, how have you evolved the roles of the people on your team based on what you've learned from the shadow portfolio analytics? I've been at Orbis for 20 plus years and took over January last year as president of the firm, head of our investment efforts. One of the things that I believe in a lot and that I've been really trying to lean into is making sure that we're really playing to our strengths.

39:19And I think people evolve to certain roles that may or may not really suit them or their superpowers. And to really believe in that and lean into that, whether it's some people are fantastic at idea generation. Others are really great at really going deep and getting into that last 5 % where the magic is at and finding that true insight, but there are shambles when it comes to putting it all together. Some people are fantastic at managing people. And so let's be objective with humility at looking at that data and having real conversations with each individual and making sure that we're aligning that as much as possible.

40:03And the tighter and the better that we do that, I think the better the outcomes. I'm a big believer of just grinding for those small improvements at each dimension. and over time that compounds to be something quite meaningful. I'd love to know how you experiment with that. Let's say that someone the data shows is a good idea generator. You could put them in a role of idea generation, but you could also find that they're really good at idea generation when they're spending their time looking at all these different ideas because that's when they realize what the good ones are. So just with that as a little example, how do you take the idea generator and try to tilt it so that that strength benefits the firm as much as possible?

40:47The short answer is test and verify. And so I think one of the areas that you see quite a bit is somebody who's in a particular domain, they know industrials better than anyone else. And they're very, very good at that. And it could be to a particular geography, but when they start to go adjacent either geographically or adjacent sectors expanding out, the signal that's coming through is diminished and it's natural. Doing that thing really well is magic let's recognize that game selection let's really play to that. At the same time you don't want to discourage somebody that wants to go adjacent and wants to play with that.

41:26As a leader I want to have the space for people to do that but recognizing the very important trade -offs And then if you come back to the decision analytics, when you have a relatively low turnover or longer holding periods, how do you get enough data in those entry -exit decisions so that you're comfortable saying in your case, wow, I probably shouldn't scale. I should just take this position on full right up front. It's tied to your earlier question, but you have to be really mindful of that. Myself, you've got 20 plus years of data. You can have greater conviction. And our data scientists as well will come back and express that as well in terms of whether or not they feel like there's enough information in that to actually be putting forward recommendations.

42:13And so the strength of those recommendations can vary. But in my engagements directly with analysts as I'm mentoring them up and developing over time is you just have to be mindful of that because in your earlier years, you are working off a much, much smaller data set. You just have to be honest about that. I'm big at looking at the trajectory. And so by that meaning, we all make mistakes. We make a lot of mistakes, but how do we improve our own algorithm based on that? How do we adapt based on that? And so at the younger levels, you're really looking at seeing how that's tracking and how they're adapting to that or not.

42:52I find there can be signaling that. What are some of the ways over time that your portfolios maybe looked, as you say, different because you went about things differently? I wasn't at Orbis at the time. You go all the way back to Inception, 1990. Japan was 45 % of the world index and we had zero. That was right from the start. You go back to 2008, we had quite a big position in the managed care companies. And so the Aetnas and UnitedHealthcare and Humanas of the world. And the reason was that Obama was going to get elected and the fear was we were going to go to universal healthcare. When you get the calls from clients like, don't you follow the news?

43:36You see that they're going to go to universal healthcare. And we had, I think, more than 10 % of the global strategy in that sector at the time on a view fundamentally that they played a really critical role and that wasn't going to change dramatically. And in fact, there was a chance that that could flip and it would become a better business because of some of the legislation that was in play. You can go back years when we were buying some of the memory companies, when the memory industry was consolidating and literally companies were going bankrupt. And our view was that that consolidation actually was going to lead to a healthier DRAM business.

44:15But it was tough in the moment, which I think ties back to the core of you have to have the ability to take those independent views. You have to have an aligned client base that allows you to do it because your time horizon is only going to be as long as their time horizon. And then you have a culture internally and a set of incentives that reinforce being able to take those decisions. And as you look today or the last couple of years and looking forward, we've had this big growth versus value style discrepancy and curious how that's played through in the structure of some portfolios. It's been a massive headwind.

44:51I mean, if you look past last decade, I mean, the most prevailing trend in the market, I think, has been the cost of capital and just the massive government intervention. I wrote last year that it looked like a sea change was upon us. Last year was quite rewarding because it was the first time that you were seeing real price discretion coming off the NF teams and meme craze. But then interestingly this year, we revisited it. Now, I do think regardless of what's happened this year, the cost of money has changed. I think that creates a much more conducive environment for fundamental stock pickers.

45:29And I think you can look at the data going back historically to regimes with different interest rates and what the opportunity set is for alpha. Our data tells us that the spreads, meaning you take the top part of the market versus the bottom part of the market, and you just look at the relative valuation differences, and it's on different metrics, are not as wide as they've been at the most extreme, but it's pretty extreme. And so we want to lean into that. You see that in how we're positioned. We've been in Japan for a long time, but last year, we started to really see some change. It's been cheap for a long time, but fundamentally starting to see some real change with regard to delivering for shareholders.

46:14Tokyo's Exchange came out and told companies that were trading at less than book value that they needed to work on that. And they started doing it. How long have people been talking about that? I've never seen our Japanese team as excited as they are right now. is a combination of years and years of apathy and underperformance, really cheap valuations, but for the first time, actually seeing constructive change. I'd love to hear if there's an example, maybe it's a stock level example that brings all of this together. So everything from the alignment up top in duration to the shadow portfolios, how you're thinking about intrinsic value.

46:55In the US, our largest position is a company called Fleet Corps. Fleet Corps is a payments company. About half of the business is fuel -related payments. So if you're a small business owner and you've got drivers out in the field, they use this car to gas up. And then the other half is software -driven accounts payable. So for small businesses to facilitate that. The business, if you look historically and you take a long -term view has had phenomenal returns on capital and equity. Historically, it's traded at call it 20%, 30 % premium to the market. Today, it trades at 11 or 12 times. Why? It's clearly out of favor.

47:40That's been changing more recently, clearly out of favor. That's a situation that we'd be drawn to. Looking at the long -term history, something that's deeply out of favor, a very clear, well -articulated bear case. And by the way, my favorite types of situations are where the bear case is actually the bull case. When you understand the business well enough that you can flip that on its head. So we spend a lot of time really going deep and understanding the business, understanding the whole business that they have in Brazil, to their fuel card business in the US, to their emerging EV business in the UK and Europe.

48:15So just the premise of deep, fundamental, bottoms -up work, first principles. The CEO of the company is what I call a moneymaker. He's been running the business for 20 years. He owns a billion dollars of stock. So alignment, what are his incentives? His incentives are to allocate capital well, which he's done historically. I think he'll do that in the future. The bear case is what happens as we transition to EVs. Well, there's two. One is just a cyclical one, and that's just having a longer term time horizon to say, this is a cyclical factor where small, medium -sized businesses are under incremental pressure.

48:55It's a cyclical factor that will normalize in time. That's pretty straightforward. The deeper factor is really understanding the business deep enough and well enough to understand that there's actually quite a meaningful opportunity here, which is they have an existing relationship with all of these fleet owners. It's very unusual and it's rare that as you transition, that you on one swoop transition your entire fleet from ICE to EV. You transition over time. So who has that relationship? Who's in the best position to manage it? By the way, who's out in the market and has developed or developing the software to actually track the charging?

49:36If you've got your car at home and you're charging up at home, you need to be reimbursed for that. You need software to track that and to facilitate that happening. They have that. We can look at their business in Europe and we can see clearly that the economics on that are actually on par, in fact, better than their core combustible business. And in fact, as the market comes to that view over the long term, that's not going to happen like that, but over the long term, what was viewed as the bear case, we think will turn to actually be the bull case because they are uniquely well positioned. That's just in that core fuel business.

50:14They also have the software business. Most of the businesses in this space trade at 25, 30 times. We own it at 11 times. And so I think ultimately the CEO will say, if it's not being recognized, he'll figure out how to take an action to unlock that. And we know that we're aligned and he'll do that in time. I don't think a lot of people would debate that it's a reasonably good quality business, but a lot of people don't want to step into it because of the time horizon factor. So on the way from 20 or 25 times down to 10, 11, 12 times where it is today, usually you get to 17, 16, 15, 14, 13, 12.

50:53I'm curious, when did this find its way into your portfolio? It's a good question, Ted. It wasn't at 11. I want to say it was more around 15 times. We can see that in the data. We tend to be early, right? There's so many investors that talk about alignment of interest and talk about the value of duration of capital. When you put together these sort of business principles with your investment model, why do you think more people don't do it? It's hard. It's really hard. In concept, everybody talks about alignment, but to actually do it requires some pain. When we launched the refundable fee, it was with consternation.

51:31We had to reserve on our balance sheet for many years. We had to forego profitability for a number of years, not just to build on our balance sheet, but to build up in the client reserve. I think if you were at most partnerships and you proposed it, I'm not sure that it would go over that well. You really do have to think longer term. And so I think that's a big part of the reason, right? It's difficult to do. It comes at cost to yourself. You have to bet on yourself in a huge way. We don't generate operating cash flows unless we generate alpha. And so it's a big bet on yourself and your ability to do that.

52:12And that's incredibly focusing too. I've seen that in the paper portfolios, by the way, too. When I'm recruiting and I talk to analysts, I describe it. And some analysts, they literally lean in and they get really excited. Really? You do that? That's fantastic. And some, you can tell they're getting nervous. They lean back. And I go, well, when exactly does that start? And the great thing about that is we're not for everybody, but we're in a phenomenal place for a certain type of person and a certain type of client. And that alignment's awesome. But it promotes that self -selection because it's giving you a signal right up front, either this is something I really gravitate to or don't.

52:52What are the things that you would like to be doing, whether it's analytically or with your team that you think you'll get to in the next five years that aren't present today? I love seeing people succeed. My two passions are investing and people, developing people. And so looking forward five years is cultivating people who are doing it better than you. Gives me great satisfaction. I won't stop doing it because it's just what I love doing, but helping cultivate them to see them go full cycle and thrive playing to their superpowers is something that I want to see and gives me a lot of satisfaction.

53:32Great. Well, Adam, I want to turn to a couple of closing questions. What is your favorite hobby or activity outside of work and family? So something that I've been leaning in quite a bit, and this is coming out of COVID, is just live entertainment, right? So whether it's a sporting event or a concert, I've been taking my son, my son's in middle school, took him to an Olivia Rodrigo concert. We went to see Lil Nas X in San Francisco. That was quite the event. My wife and I went to see Dave Chappelle, who's the goat. So yeah, I've been leaning into live entertainment. What's your biggest pet peeve?

54:08So in life, it's really simple. It's just the lack of courtesy, simple please and thank yous, and a lack of gratitude. We just have so much to be grateful before. What investment mistake have you made that you'd never make again? Man, there's many. Probably the one that stings the most goes back to the GFC. I'll never forget, it was right in the middle of the GFC. I was in the office on a Sunday night and I got a call from our broker at Goldman. And she said, we've got the whole trading desk set up. We're trading contracts contingent on whether or not Lehman files by midnight tonight or not. And we're here to serve.

54:45And I remember hanging up the phone thinking, wow. And the next morning, we had an investment committee meeting to make a decision as to whether or not we were going to add or sell our position in AIG. And we decided to add to it. The mistake, which I'll never forget, is the difference between liquidity and solvency. We spent so much time, Ted, on the fundamental bottoms up of the credit. They had insured these AAA portfolios and we were convinced they were money good. The problem is they have to post collateral based on marks. That got them in a lot of trouble. We know the rest of that story.

55:23Just the difference between liquidity and solvency. We pride ourselves on being contrarian, but it's not just about being contrarian. It's also being right. You don't get paid just to be different. Which two people have had the biggest impact on your professional life? I have to say the founders of Orbis, Will and Alan Gray. I've known them since I was 22 years old and they've had a big influence on me. I'll talk specifically about Alan. I mean, Alan is really one of our generation's greatest investors that, at least in US circles, nobody knows. And the opportunity to work alongside and learn from him, I think it's been amazing.

56:00And more than an investor, just as an entrepreneur, as a philanthropist, as a father, as a husband, he hit full cycle. And I'm very grateful for that. He was very tough. And he set a really high standard, but that brought out the best in people. And then the second person I have to mention is Sabin Streeter. So Sabin Streeter was a partner at the Sprout Group, which was DLJ's venture capital group. He was an adjunct professor at Columbia Business School. And he was also a big supporter of SEO, Sponsors for Educational opportunity. And I met him when I was in college, when I was 19 years old, he came to Chicago and I was terrified.

56:46And he immediately took a shine to me. And not only did he accept me in the program, which was game -changing for me, but he said, you have to come to my firm, to DLJ. And I didn't know it at the time, but that was an amazing fit. And the biggest thing is he believed in me before I had that belief. And belief in a young person is just a priceless gift. What teaching from your parents has most stayed with you? So that's my grandfather, who's my hero. I mean, he dropped out of school when he was in seventh grade and he's the hardest working person I've ever seen. So it's really just testament to hard work and generosity.

57:27There was a lot of dysfunction in my family and he was the one person that was always there for everybody, giving of himself always. And it's something that's just deeply imbued in me. Adam, last one. What life lesson have you learned that you wish you knew a lot earlier in life? Culture, culture, culture. I started my career doing distress turnaround investing. So all I cared about was hard assets, contracts. And then I came to the public side. And I think what I've really learned is great companies, not just companies that you invest in, But as I think about Orbis, it's all about the people and the culture.

58:04And that's where the magic is. And I wish that I would have leaned into that much earlier because that's where it's at. Adam, thanks so much for sharing this really interesting structure and alignment and everything you've done at Orbis. Thank you, Ted. It was great. Very grateful. Thanks for listening to this Sponsored Insight. Sponsored episodes are paid opportunities for another 12 managers a year to appear on the podcast. If you're interested in telling your story in front of the largest audience of investors in the industry, please email us at teamatcapitalallocators .com to apply for one of the slots.