Rob Small and Anil Seetharam - Public Equity Adjacent to Private Equity at Stockbridge (EP.397)

27:19We followed the acid test that Rob articulated, which is, is it a long-term winner? Can we understand it? And is it cheap enough? And we're cycling through those very, very quickly. And so one of the things that the scarcest in our business is time. And so we've been doing this for 17 years. I think that's a muscle we've refined fairly well over time. And the reason for putting something down falls into one of those buckets. We look at hundreds of things at various levels of depth, and we only allocate that full diligence exercise to a very small handful. We track this fairly closely. We invest in two to three things a year.

28:01We probably look deeply at 10 to 20 things a year with a pretty big team. And so the several hundred that we look at, we're putting them down very quickly for one of those reasons. It's one of the hardest things about investing. We've been trained our whole lives to try to get to answers. And so when you start looking at a problem, you want to get to a yes or no. We try very hard to only invest in things that we have high conviction. Our no is not that this isn't going to be a great investment. It's that we're not going to get to high conviction that this is going to be a great investment. And that makes it a little easier.

28:40We have passed on many things that have turned out to be great. But the goal is to only let things in that will be great. How do you ultimately decide what goes into the portfolio? As a firm, we're very consensus oriented. That's been our history on the Berkshire Partners private equity side, and we carried that through to Stockbridge. So as an entire group, we discuss every idea that's making its way into the portfolio. From a very early stage, which we call our tear sheet stage, where we're just introducing the whole team to the business, to a final investment memo, everybody from the newest analyst to the most senior partners is weighing in on that decision at that investment meeting.

29:20And the group will vote on whether it should be admitted to the portfolio or not. It served us really well as a firm to have that process. We think many engaged minds thinking about a company deeply over a long period of time leads to a better investment decision. And for some of our more junior team members, it's more of an apprenticeship. So they see that process happening. And obviously, the older and more experienced you are, the louder your voice is in that room. But insight comes from a lot of different places. We want to make sure that if someone has a deep insight, they have the ability to share it.

29:56That's a process we've carried over from Berkshire Private Equity. What's very, very different is just how do you decide how big something is in a portfolio? In private equity, The size is somewhat predetermined. The company needs X hundred million dollars of capital. But in public equity, that tends not to be the case. And so we can choose for a company to be 5 % of our portfolio or 25 % of our portfolio. And we have a different portfolio management process, which we had to build early on to separate the investment decision making from the portfolio management process. Portfolio management is probably the part of the process that has evolved the most over time and continues to evolve.

30:36On the diligence side, we push incremental improvement and we try to get better. And I think we do get better each year, but the increments are smaller. On portfolio management, way back when, we probably had this view that we would be like private equity, buy a chunk of stock, look up five years later, check the price and sell it. Public market doesn't work that way. And frankly, it gives you more opportunities than that. So we've developed over time. We were religious about keeping our five-year internal rate of return models up to date and trading off that. The higher the IRR, the bigger the position.

31:09We learned that wasn't the best way. We changed over time at that point to adding a conviction element. And we did that in an interesting way. We had noticed that we did all this diligence on all these companies, but we had no way to take that diligence and put it into action. You'd get a drip of either good or bad news about a company and what drove you to make the position bigger or to get out of a position. And we were, frankly, at the beginning, more concerned about getting out of positions. So we added a conviction poll quarterly or three or four times a year, typically trying not to be around the emotion of earnings, of polling the group, of rating absolute and relative conviction among the different names, with and without price, really trying to get questions to surface about which companies do people have doubts in or which should we do more work on.

32:02And what we found out of that, not only did I identify the bottom end of the portfolio, there was a huge amount of consistency at the top end of the portfolio. And so we realized there were just companies or businesses that we had higher conviction in. And the logical conclusion to us was maybe we should make those larger positions. So we started taking conviction into account when we were doing position sizing. We continue to evolve. And currently, we have a minimum position size. Even though we have seen over our history that conviction can build over time, if you have a low bar at the beginning, things sneak into the portfolio and your time gets diverted and you let in some things that you probably wouldn't let in.

32:47Then we make the decisions about whether to supersize them because of the opportunity in front of it or the conviction level. And occasionally we will shrink on its way out in some ways due to valuation. And so that ultimately leads to a portfolio of typically around 15 names. We've had a position become up to a quarter of the portfolio. That's more the exception. Typically, the largest position will be in the 15 % and then a bunch of things around 6%. Robin, your early studying of behavioral finance as you were getting ready to invest in the public markets, what did you learn that allowed you to drive consensus decision-making when often that ends up being a lowest common denominator?

33:33We're going to take a quick break in the action to tell you about SRS Aquium. Want to make sure your M &A processes aren't stuck in the past? partner with a company that's been defining the future of dealmaking for nearly two decades instead. When it comes to M &A innovation, SRS Aquium has reshaped the way that deals get done, streamlining processes for maximum efficiency and minimum headaches. Professional shareholder representation, online M &A payments, digital stockholder solicitation, SRS Aquium pioneered each and continues to set the bar for game-changing innovation. So leave the days of disjointed deal management behind and define your future with SRS Aquium, the smartest way to run a deal.

34:24Learn more at srsaquium.com. That's S-R-S-A-C-Q-U-I-O-M.com. And now, back to the show. Yes, that's definitely a fear that we've always had in our system is a lot of investors very much look for, is there one person making the call? I had grown up in private equity side where that was completely not the way it worked. And I thought we made really good decisions. We've designed our product to be consistent with that in many ways. I think if we were a fast twitch hedge fund making multiple decisions every day on trading, it wouldn't work. You'd need single points of decision, whether there's a number of them or one of them.

35:12But we don't make a lot of decisions. We've actually designed our process and we keep pushing our process to make fewer decisions, but have them be more well considered. We have consensus on the basic type of sub-businesses we're looking for. And so there isn't that level of argument. It's does this fit and why? and we have respect for each other, both enough respect to challenge each other, but also have some respect to listen to each other. And I think that's ultimately worked for us. I know it doesn't work for everyone, but it works really well for us. Once you own a name, how have you thought about the cost benefit of going on a public company board?

35:51What we've learned over time is we're not trying to go on a board to change what a company is doing. Across the firm, we're very, very collaborative and we partner with management teams. So we think even at the Stockbridge side, we're best on boards when our role is to help the management team achieve with the company what they're setting out to achieve. We think it's hard, lonely, and not very fun to be in a conflict situation with the management team where you're trying to change something that they or the board are trying to do. So the key is, if we have a problem with the company, it's better for us to sell than it is for us to go on the board and try and change it.

36:28And we've been pretty fortunate with the boards that we've been on that what they've done is they've increased our conviction in the underlying goodness of the company, the management team, and the thesis. And what we're looking for when we go on boards is, do we think this is a situation where we can add value to this management team because of the unique skills that we bring, given our board experience and our connection to Berkshire Private equity? And do we think being on this board is going to help us maximize our profit opportunity because it'll help us build conviction. It'll keep us around for longer.

37:01It'll help us own things that may seem more expensive, but open our eyes to the opportunity that exists at this company. Those are typically the tests. Boards are a big investment of time for us. And so it's not something we'll undertake willy nilly. I'd love to talk about some examples of some of these companies that you've held for a while. I know there are a few that have gone back and forth between ownership in the public markets and the private markets of Berkshire. Maybe dive into one or two of those. I sit on the board of a company called Advanced Drainage Systems, a wonderful company based in Columbus, Ohio.

37:37Berkshire Partners invested in the company in the late 80s when it was a small agricultural plastic pipe producer and held the business continuously until 2010 through multiple funds and then sold it to another PE firm who took it public in 2014. And the investment thesis has been the same for 35 years, which is that plastic pipe is taking share from traditional concrete solutions because they're cheaper and faster and better to deploy than the incumbent solutions. And because of things like climate change and increasing regulation, the need to deal with stormwater is going up. So the need to just manage water runoff rather than let it just flow into the environment is increasing.

38:25So you have this double tailwind, increasing demand for the product and increasing substitution of traditional solutions with plastic pipe. And that was the investment thesis from the 80s to 2010. It was the investment thesis when we Stockbridge reinvested in 2015 when it went public. We held it for nine years. Along the way, the business unfortunately got into an accounting restatement, had a management team change. And those two opportunities created a really interesting opening, both from a valuation standpoint and from our ability to help the company standpoint for both Berkshire Private Equity and Stockbridge to significantly increase our stake.

39:06In 2017, we bought about 20 % of the company after they were through their accounting restatement and then subsequently joined the board. And with the underlying thesis that we love the business model, we love the tailwinds, and that the new management team could really drive significant ongoing growth and improvement in that business. And it worked pretty well. But that's an example of a business where you wake up decade after decade after decade, and it's the same thesis, because it's just a long, slow-moving trend you can bet on, which gives the firm across public and private multiple chapters to invest in that company.

39:46I do think it's interesting that on our board positions, which there have not been a lot of over history, each time it was not a part of our investment thesis. We had made the investment. We had interacted with management. We had shared our work. We had had a dialogue with them. Then ultimately we went on to the board. And when we're on the board, we certainly, and I think fortunately for the company, do not try to manage the company. We are not managers. We are advisors and cheerleaders and help bring resources if they need it. But the management team's managed. We're just an aide. But as Anil said, it does give you a front row seat.

40:26And a front row seat and your best companies can be really good to building conviction. An example of that is Transdime. Transdime first became known to the firm ages ago when it was founded. And one of my partners was section mates with the founders in business school and had an opportunity and passed on the deal to look at it back in 1993. In 2003, after two periods of private equity ownership, our private equity side, which I led a team when I was working there on looking at Transdime, and we ultimately lost the auction to Warbird Pincus, who bought the company and took it public in 2006. I had remembered it as probably my most disheartening loss in private equity and one of the best companies I had ever seen.

41:16On all three of the criteria I talked about, the secular tailwind of aerospace, the position of having parts that were crucial to an airplane on long-lived airplanes, and finally, in the management team that executed incredibly well. And so when we started Stockbridge, that was the first company we looked at and we invested. It has become and been our largest position through most of our history. And at a few times during our history, there's been significant disruptions in the stock. And our private equity side has been able to take advantage of some of those by investing alongside us in the public stock.

41:55We invested in 2007. I joined the board three years later as Warburg was selling down. So inevitably, when you have these long-term holds, and maybe even when you're on the board, things don't always go smoothly, even slow-moving successful businesses. Curious how you've tackled some of those challenges, knowing that you want to be a long-term holder. Maybe the long-term thesis is still intact, but somewhere along the way, there's a significant bump in the road. Every company we invest in has a bump. There are very few businesses, or at least I've yet to see businesses that are a straight line forever up and to the right.

42:34We expect the bumps and we've tried to set ourselves up to take advantage of the bumps. So the obvious thing that we do is when a bump hits, we do a very quick look. Hopefully we've done enough work to be able to put it in context and understand it, but we'll do a lot more work. An example of that was in 2016, I believe, Transdime had a short attack. A number of shorts came out with allegations against the company and the stock reacted strongly. And we quickly talked to the company, but we also did all our outside-in work as well. We didn't want to rely on the company. We thought we would do a ton of work.

43:18We interviewed priors. We did all sorts of things to try and see if there was any sniff that we had gotten it wrong, because you have to be prepared to be wrong. And we found that wasn't the case, so we were able to buy more stock at that time. So it turned a problem into an opportunity because it wasn't a real problem. Same thing happened with COVID for TransTime. The biggest risk to The TransDime who serves the aerospace market is that people stop flying. We weren't creative enough to figure out that COVID was coming. But when COVID came, we did the work. We spent a lot of time trying to understand what their liquidity profile was, whether the leverage was handleable, and came to the conclusion again that because the business is more diversified than meets the eye, although it's all in the public disclosures with defense and freight and business aircraft that it was going to get through the period and that people would want to fly again.

44:12And so again, it created an opportunity. The other side of it is you have to have room to create the opportunities. You have to be disciplined enough that when your position size hopefully grows because of price appreciation and becomes larger than the return and conviction level justify that you trim it. And when you're on the board, sometimes people ask, are you willing to sell your stock when you're on the board? And we have trimmed all the companies and ultimately sold advanced drainage systems, have trimmed Transdime numerous times, both just to get its position size back in line or trying to figure out when it's either more highly valued compared at other times or to create room for the next opportunity.

44:56We've learned a lot from the management teams that we've partnered with to see how they're reacting to the business. And it's remarkable. The world doesn't operate in market hedge fund time. Management teams who run businesses have different constraints. They think about the business differently. They have different solutions to the problem. And so I think it's made us better investors to see that contrast between how a management team will react and just see all the pieces they need to move and what's in their control and how they manage the people and how they think really long term about the choices they're making in the business and not just reacting to the stock price.

45:34The volatility of stock price is way larger than the volatility of the operating performance of the business. It always amazes me when you look at some of the companies that are now multi-trillion dollar companies, when they move two or three percent, that's more than the value of most of our other companies in total. When we see these stock price moves, it's usually an overreaction one way or another. Going back to private equity, I've always been surprised. Private equity is usually a really well-informed seller selling to someone who can become a pretty darn informed buyer. And so you don't see too many crazy prices.

46:14In the public markets, first of all, it's incremental stock sale. No one's buying and selling the whole company. And it's usually people are often selling for reasons that have nothing to do with their view on the company. They either may have some redemptions they're buying because they have some new money to put to work or different things. And so we've seen crazier prices on both sides by far in the public markets than I think you tend to see in the private markets. If you think about the last 10 years in public market investing, the types of businesses you typically describe with this private equity mindset in the public markets often haven't included the MAG-7 that have driven the public markets.

46:52I'm curious how you've thought about that set of opportunities. When we first started, we probably had a presumption, and I think some of our investors had a presumption, that our diligent skills would lead us to small cap stocks and unearthing these little gems that were misunderstood. We hoped to do that, but we also found that our quality focus and our long-term focus led us to little bigger companies that had risen above the fray in some ways and differentiated themselves. I remember when we first bought Visa back in 2010, a number of people said, that's too big a company. How can you explain why you own that?

47:34And the response we have given and we still give today is, look, we told you our rules. Can we understand it? Is it a long-term winner? Does it give a good return? When we start adding, what will people think? We've made the game way too hard. And so we've just avoided that. We stick to those three rules. And if we can answer those questions with conviction, we'll invest. We own a couple of the Mag7. Amazon and Microsoft are the ones we've been comfortable enough to get conviction and invest in. Amazon's a super interesting one. We actually didn't begin by trying to invest in Amazon. It was a research project.

48:09We, as a firm, have invested in brick and mortar retail businesses over our entire history. We have a huge investment practice in digital infrastructure. So things like data centers, fiber, wireless towers. And so we were running into Amazon regularly in 2015, 2016 timeframe, either as a major threat to some of our investments or as a major opportunity. And so it was really important for us to learn to understand Amazon. And as a result of our broad network, it turned out that we had really deep insights into Amazon. Because we're competitors, because we're suppliers, because people in our network have been competitors and suppliers, we felt like we could understand it extremely deeply.

48:56And so that's how we started our investment in Amazon. It turned from how can we learn about Amazon in order to go back to doing what we were doing before to actually let's just invest in Amazon because this is a great expression of our core investment beliefs. A number of the Mag7, we just find it hard to get conviction in those businesses because they're just outside our circle of competence. They're not in areas that we think we can understand deeply or where our conviction won't be shaken in the event that there's significant volatility. And so while, let's say, a company like NVIDIA is an extraordinary business by all accounts and one we've looked at, we just don't think we would be a great owner of that business at this point in time.

49:43Because while I can tell you all the great things about NVIDIA, I don't know how deeply I believe them because we don't understand it as well as we need to. What causes you to sell it in the portfolio? Well, there's three reasons that you sell. One is you lose conviction in the thesis and you think you should move on. Two is it gets so expensive that you think the returns looking forward aren't acceptable or at least certainly compared to what else. Or three, you need to make room for something. And that's an important one. We love having a continual flow of new ideas to put pressure on names in the portfolio.

50:24So when we get a new idea that people are excited about, because we want to have a minimum position size, that often forces a name out. So we'll sell for any one of those three reasons. There's an element to which, as you describe this process, like an elegance to the long-term hold and allowing compounding to work. Where have you found that you've made mistakes and could improve? The systematic mistake that we're always trying to work on is understanding how some businesses can outperform and making sure that a Excel-based valuation methodology doesn't really capture the full distribution of outcomes.

51:05A good business with great tailwinds and a great management team can create their own luck. And it's hard to model that. Rob mentioned this earlier. We started off with a very IRR-based framework. So 18 was by definition better than a 14 % IRR, or a 25 was by definition better than a 22. That's not the way it works in the real world. The real world doesn't live in a spreadsheet. Companies make amazing acquisitions, or they do really dumb things, or there's disruption that happens in the world. And so just understanding there's human element, a luck element, a change element to investing and appreciating that that needs to factor into your investment process is probably the source of our biggest set of mistakes is, hey, the IRR says X, we should sell.

51:54So selling winners too early has been a constant source of frustration, one that you can just open up your Bloomberg and see it hit you in the face every single day. How about behavioral mistakes? I remember one trade in 2016. Fortunately, we were quite small as a firm then, and we seem to be getting whacked daily with bad news. And for a whole variety of reasons, we made one small trade that I think was emotion-based. Within hours, you realized that in some ways, I'm happy we made that trade because you learn your lessons from mistakes. And we haven't really done that since, I don't think. It also showed the value that day of having really great partners and long-term committed partners.

52:45We received a phone call from our largest investor who follows our portfolio and so had an idea of where our portfolio stood at that point and asked if they could put in more money, which was a huge boost a show of confidence in us that I think was at a very needed time. So both of those examples are examples of effectively being right long-term, but selling too early or getting emotional and selling. How do you balance being stubborn and wanting to buy more versus a situation where you're just wrong? We certainly have been wrong in our history, or we have decided we were wrong. The fascinating thing about investing in the public markets is in some ways you never know if the judgment you made was good or bad.

53:33Investing is ultimately predicting the future. And future is obviously very uncertain. My analogy has always been if you have a coin that flips and nine times out of ten it's going to flip heads and one time out of ten it's going to flip tails. if you choose heads, which is obviously the wise decision, one out of 10 times you're going to appear to be wrong. At the same time, you have to recognize that sometimes you might choose tails and that was the wrong decision and it could either come out heads or tails. And so that's why if we start to lose conviction, we have to be quick to decide that we got it wrong and if we have something better to invest in.

54:12And so you move on and moving on is often important and sticking to your guns unless you have really high conviction. Then if you have really high conviction, you stick to your guns until you don't, until it gets shaken. So that's how we try to handle the situation. It's important to have evidence in a long-term investment that things are working, that may or may not show up in the stock price, but there's a set of markers along the way that give you confidence that your long-term thesis is right. I think Rob also mentioned a really important point, which is we don't have to be right in every choice.

54:50We do a lot of work up front, but we do multiples of that work after we own a company. And just ensuring that we're not holding onto something simply because we did a lot of work and we have endowment effect and it's in our portfolio. And the ways to do that are, number one, to do a lot of follow-up work and be honest about the thesis and how things are tracking. And The other one is we're always out looking for other companies. So we don't need to make money with things that are in our portfolio today. We love putting pressure on our portfolio to go out and look for something that's better and comparing it to what's in our portfolio today.

55:25We think that process has worked reasonably well. We try very, very hard not to be emotionally attached to any one company. I'd love to circle back in the current environment to a place when you started Stockbridge, you noticed that public market valuations had gotten cheaper than private markets. We've now gone through this period of time, certainly the last couple of years, just until recently, where there's been insatiable demand in the private markets and valuations are going up. How do you look at that contrasting of the two going forward? I think public markets and private markets in some ways are starting to blur a little more.

56:07Private markets have grown so dramatically over the last decade that they have become a really significant part of the world's economy and assets continue to flow into private markets. And there are a number of companies that want to stay private for very good reasons. They don't have need for a lot of capital. There's a lot of headaches that come with being a public company. So I think there's going to be great opportunities on both sides. And the key is we're excited that at Berkshire, we have both the private equity group and Stockbridge to take advantage of the opportunities that arise. I don't think we will make market-based bets of now's the moment to invest in public and now's the moment to invest in private.

56:51I think that each group just sees that there's plenty of opportunities ahead. As you look back at this last nearly two decades of investing in the public markets, what are the biggest lessons you've learned along the way? One of the biggest lessons that I've learned is that investing is about predicting the future. So there's no set of analysis that will give you an answer. You have to take all the analyses as inputs, but then you're ultimately making a judgment about what's going to happen down the road. Another really important one is that you need to invest with conviction. It's really hard to do what we do and be waffling.

57:30That's why we demand unanimity among the senior people to invest in something because you're going to get hit with a bump. And so when you get hit with a bump, you have to have enough information, enough belief to evaluate the new information, but be able to stick to your beliefs if they have not changed. And then one of the harder things, shockingly, I think, is we've learned that you need to trust the work. You did the work to make the judgment. Keep trusting that and live by it. You got to keep adding to that work, but ultimately keep trusting the work that you did. We did a 15-year look back.

58:05We had written down a list of the lessons and Rob captured them. One thing I would add is that we're at our best when we make a small number of very consequential choices and really making sure that our process and our decision making is aligned to doing that. It's very easy in this to think about making a shorter term trade or adding a smaller position to the portfolio, but that's not really what we're set up to do. And when we do that, we're more likely to make a mistake. And so what we've really honed in on is just really trying to make a very, very small number of good decisions because ultimately those are going to drive the bulk of your returns.

58:44I'd love to turn to a couple of closing questions. Maybe Rob, we'll start with you and go back and forth. What's your favorite hobby or activity outside of work and family? As the father of relatively young children, there's not a lot of time outside of work and family, but I try to keep active. I spend a lot of time skiing, working out, golfing, things that get your mind on something completely different to focus on than what's going on day to day. I know. We love traveling. As a family, I've grown up traveling from literally the day I was born. We hopped on a flight to Baghdad when I was three weeks old.

59:19And my dad has, I think, been to every country in Asia except for East Timor. And so we've tried to carry on that tradition. And what's one fact that most people don't know about you? One fact that people don't know about Stockbridge is actually that one of my partners, Saad Hassan, and I went to elementary school together at the British International School of Cairo in Egypt. and we didn't actually know that when he joined in 2011 that we were having drinks at a bar next to the office and I just asked him where are you from and he said well I lived in Egypt for a while and I said I did too what school did you go to turn out we went to the same school we were a year apart and I went to my parents held on to our yearbooks and so I grabbed our old yearbook from the British International School of Cairo in 1986 and pulled it out and there's a photo of Saad and I as kids back in Egypt in the mid-80s.

1:00:14Rob? I would say probably the thing that people who know me today would be most surprised at is that I still believe my hardest job that I've ever had was when I was a 19-year-old having finished my freshman year of college. My dad had fast food, fried chicken restaurants. A manager quit on my first day of summer that year, and so I became I'm the manager of his busiest store with two people twice my age as my assistant managers. And it's still by far the hardest job I've ever had. And it taught me that no one should ever have me in an operations role. Rob, what's your biggest pet peeve? I'd say in investing, when someone says, we proved it, we have the answer.

1:01:01You don't prove anything about the future. And so I think when someone comes with that, I'm not as very easily convinced. I know. Yeah, probably this came out of the fact that our time is extremely scarce. I don't love people who are inefficient with their time. Just lack of efficiency is probably a big one for me. One more. Which two people have had the biggest impact on your professional life? So one is sitting across from me, Rob. Rob hired me to join Stockbridge. And so Rob and the other partners at Berkshire and Stockbridge, from an investing standpoint, I've learned an incredible amount from Rob and my other partners.

1:01:38The other group is we're pretty close to our managers here. And I've spent almost my entire career in a consulting or an investing role on the outside looking in. And just watching Scott Barber at ADS, Nick Howley at Transdime, John Kelly, who used to run CCI, they just think about the world and problems in different ways. And we're blessed with being able to spend a lot of time with them. And so it's been really an amazing learning experience to learn about the world, not just as blinking lights on a screen. Rob? It's hard to limit it to two. I was very privileged to be at Berkshire early in its history.

1:02:16and we had five founders who came together, made a firm where none of them was in charge, a partnership, didn't put anyone's name on the door. And they were incredible examples of both investing, but also how to lead a life. The balance, the integrity, it was how they lived that led to the values that we ended up putting down as a firm, which is that relationships matter, the power of teams and winning the right way. And their example led to those values that I think we've tried to live by as a firm for a long time. So they were incredibly influential. Rob, thanks so much for sharing all this incredible experience and wisdom on this path from private to public markets.

1:03:02Thanks so much for having us. Thanks. Thanks for listening to the show. To learn more, hop on our website at capitalallocators.com, where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more. Have a good one, and see you next time.