E303: What Blackjack Taught Me About Investing w/Ari Levy

0:00David Weisburd:You said that probability theory was your first love.

0:04Ari Levy:What made you love probabilities from an early age? Sports statistics, I would say, number one. I like to simulate baseball seasons when I was really little on the Apple IIe computer on a very early video game that was pretty much mostly statistics and not actually interacting in the game as a batter or pitcher, but just hitting SB if you're trying to steal a base. but I would simulate baseball seasons between, you know, you could have the 1927 Yankees play the 1955 Giants and have Willie Mays play against Babe Ruth. And so I was like, just love that concept and trying to think about advanced statistics at a young age and just games of strategy, played a lot of cards, try to figure out how to win things, good risk-adjusted, asymmetric calculated bets effectively.

0:56David Weisburd:And you ran a blackjack team when you were at Stanford. What did you learn about that? And how does that relate to how you do public investing today?

1:03Ari Levy:I took a course my freshman year at Stanford. This would have been 1997 called Math and Sports. That was my favorite class I ever took. Professor Tom Kober at Stanford taught this freshman seminar. A small group of 15 like-minded folks just thinking about this same kind of game theory, probability theory in both sports, which was the name of the class, but also a deck of cards. And Professor Cover had his own blackjack team in the 70s and just great stories. fascinating statistics professor and a couple of us from the class i've read brad griffith who founded game time which is a ticketing the online ticketing platform and i just took a real liking to it we were we are already friends live in the same freshman dorm and constantly we're quizzing each other on the blackjack statistics and so we just got excited about how we could optimize that that game and in um in cards it's a there's a known quantity known set of you know there's four suits and 13 cards in each suit and all the rules that we all know.

2:09Ari Levy:And so it's much more of a fixed probability. In the stock market, they call it, you know, stock is more of a random walk. So it's a whole different distribution. There's no, history doesn't repeat itself exactly, but like the Mark Twain quote, history doesn't repeat itself, but it rhymes. There's, you know, a lot of historical analysis to help figure out what the future might hold to make educated, risk adjusted. There's some principles from the things I learned in card counting, specifically something called the Kelly criterion, which is a, it's like a theoretical proof of, for a known set of odds, again, with cards having a known set of odds, it tells you how much to risk on any given wager, such that you're maximizing your profit while also not putting your balance sheet at a big, it's called risk of ruin.

3:00David Weisburd:Most famously, long-term capital management had what they believe this risk-free arbitrage, and they hadn't thought about all the second order effects of it. And ultimately, the fund blew up because of Russia and the divergence in pricing. How do you go about looking at your risk and assessing where your trade might go wrong?

3:22Ari Levy:That is a really good point and a really, you know, something that we all think about. If you're a smart investor, you can't believe that it's going to, like what I said, with certainty, there are still, you know, events, idiosyncratic things that could happen. One that I can think of, for example, and this is more of a micro level versus like long-term capitals models, multiple second order events happened. I believe that, you know, with plus some leverage, leverage is always an important factor. but for example in the volatility space vxx is the largest etf it owns a combination of front and second month futures on volatility almost in it's the entirety of its history you could create and redeem it which as i was saying before keeps keeps the etfs in line so vxx if you just look on a bloomberg machine at any given time typically isn't below 10 basis point discount or above a 10 basis point premium and you know they charge a fee to create redeem it so it's not it's not there's another cost, but that's what keeps it in line.

4:20Ari Levy:So if you could buy that at a 50 basis point discount and redeem it that day, you'd make 50 basis points in that day. And that would be obviously credible if you spread it to something that was trading at NAP. Now, in this example, I'm talking about a sort of idiosyncratic risk where the underwriters of VXX, this happened a few years ago, had not properly registered new share issuances with the SEC. No one could effectively know that, I guess, unless you're a super smart lawyer and could figure out that they hadn't registered something correctly. And so what happened was they could not issue new shares.

4:53Ari Levy:You couldn't create Redeem. And there was effectively like a short squeeze on it where it traded at a 20 % premium for an extended period of time until they resolved their SEC issues. And so that mechanism went away. So if you have this rule that you can create Redeem and that's going to keep it at NAV, well, what else could go wrong? That was an example of something that was kind of out of left field. There's however many thousands of ETFs out there that do it right with the SEC and the XX underwriters eventually got it back in line and now it trades in line. But could that happen again in something like that in the case of long-term capital?

5:28Ari Levy:Yeah. Could there be sovereign risk or whatever you're trading that things come out of left field? You think you're trading something that is the same as some other thing, but the underwriter of one of those things had fraud and they were buying something else. We've seen that in different cases throughout history. There's the MF Global, which was a perfect arb there, but you thought you were buying something that was something else and someone was going rogue with the investment that you made. And you got to be really careful about that.

5:59David Weisburd:And the catch-all solution for that risk management is position sizing. So even if it blows up, and even if you have 10%, maybe you lose 2-3%. So you don't have to know how it'll blow up to size it correctly and to keep your entire

6:18Ari Levy:portfolio from getting ruined.

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7:44Ari Levy:Yes. So you have to cap the size of the exposure you have to any one individual thing.

7:51David Weisburd:The only risk to the overall portfolio is if you're making the same trade over and over that has the same underlying catalyst that drags it down yes if they all or multiple of your spreads

8:02Ari Levy:or trades or investments whatever you want to call it have some similar idiosyncratic risk that hits them all at the same time or multiple of them then you know if you lose two percent on multiple different ten percent trades obviously it adds up to more than two percent last time we chatted you

8:18David Weisburd:You said that 5 ,000 to 10 ,000 small cap companies are inefficiently priced. Tell me about that and what are the opportunities there?

8:29Ari Levy:So I don't know how many small cap stocks exactly there are. I know there's thousands and it depends if you look globally or in the US. They tend to be less efficiently priced than large cap stocks because there's informational inefficiency there. In the large cap stock world, you see a lot more analyst coverage. So many more people have read Apple's filings, however many multiples versus some little niche company in an industry you didn't even know existed or weren't thinking about. That's a$100 or$500 million market cap versus a trillion dollar market cap. And over time, we've seen that kind of spread diverge.

9:05Ari Levy:We've had a decade, for example, where large cap, decade and a half, where large cap has just crushed small cap. There are different reasons for that. There's been much more of a regulatory burden on small cap companies where a public company typically needs to spend five plus million dollars to be public. It's obviously more for the larger companies, but as a percentage of their size and their profit and cash flow for the small companies, it hurts a lot more. And so the Sarbanes-Oxley and other costs make it just difficult. There are companies that we own that do 20 million of free cash flow a year.

9:38Ari Levy:Well, if they were private, they would do 25 million because they didn't have to spend that five million dollars to do that. I can tell you from being on the board of a public company, which was Del Taco, small cap stock, we probably spent a third of our board meetings just talking about things that had nothing to do with other than regulatory Sarbanes-Oxley and compliance costs that just add up to much more meaningful amount for a small company as a percentage than a large company. And with index funds just going larger and larger, there's been a huge increase in assets going from active to passive.

10:08Ari Levy:Honestly, throughout my been in the public markets for 25 years, of course, there was the S &P 500 the whole time and the Russell 2000 that I've been in business. But the increase in just number of passive funds, it's now, I believe, over half of the market. And with that, most of it is in the major... We look today, for example, the S &P 500 versus the S &P 600, which is their small cap index, has what is known to be 17 times the amount of dollar assets in the S &P 500. It's actually way more than that. If you factor in all the private funds and indexing, or even like quasi-index funds, they might say they're somewhat active.

10:48Ari Levy:But they're index huggers, we call it. Instead of having a 7 % position in NVIDIA, they've got a 6 % position or something that still makes them look a lot like the S &P 500 or the NASDAQ 100 or whatever. and and the small cap companies uh just get much less efficiently priced so um you know you can roll up your sleeves and you and you uh look at some niche industry some niche business that you think is asymmetric well you're gonna get much better access to management you'll be able to talk to the ceo and cfo of the company versus trying to do that with apple good luck you got to be a you know 300 billion dollar uh mutual fund company or something to get that you know And how do you marry those strategies of meeting management and trying to get a better read on management versus kind of these arbitrage opportunities that are basically in the spreadsheets or in the trade versus kind of this EQ level insight?

11:46Ari Levy:my first love, my favorite are the more arbitrage trades. If you could give me only trades that make five basis points a day instead of, again, the one basis point that the government's offering you, it's hard to make that adds up to, let's say, 18 % of your return. It's hard to get an 18 % of your return compounded in picking stocks. There's more risk. And so I would take that all day long. But finding those things that pay you five bips a day with low risk is few and far between a lot of what we manage is just our own capital to take positions where we take an activist approach and where we will buy 5 % to 15 % of a company.

12:28It depends on their bylaws.

12:30Ari Levy:If they have a poison pill, you want to look at the shareholder profile. But based on all sorts of different inputs and analysis, if the company is really under the radar, you believe it's trading at a big discount to its private market value. And that's not just your instinct, but because you've talked to a bunch of different industry players and investment bankers. There's a bunch of private equity firms, for example, that would love to buy a bunch of these small cap companies. And if all these companies were for sale, I think talk to enough of them that they would drop everything and just focus on those opportunities rather than trading assets to each other in the private market, doing their typical game of cutting costs and then trying to sell at the whatever they adjust to the EBITDA looks like the highest.

13:10Ari Levy:But there's a lot of these niche little companies that these private equity firms would like to own. They are not willing typically to take positions in public companies, certainly not willing to be activist. We're always, we call ourselves friendly activists. But if you have boards and management teams that are not acting in shareholders' best interests because for whatever reason, there's a bunch of the board members or retirees that like saying they're on a public board, they like the compensation from it, but they don't own any stock. They are not aligned with you, the shareholder that owns 9 % of the company.

13:41Ari Levy:And so, you know, we will try to get board seats. We've gotten board seats on a number of different companies. And ultimately, if they're too small to be public, too niche, too hard to understand, they're going to have to grow many multiples to become relevant and get on someone's radar. They shouldn't be public.

13:55David Weisburd:Is that what you're typically doing? You're taking these public companies and you're selling them private markets?

14:00Ari Levy:That is the goal in a lot of our activism. But a lot of the management teams and boards don't like that. So we're open to all sorts of different alternatives. A lot of them will want to divest something at a premium to the multiple that they're trading for a division. Or often we see a lot of them trying to make acquisitions to grow into a bigger thing. That comes with his own risk. You leverage up to do that. And it's a lot of what my partner and I like to call like empire builders, where the board is like, hey, let's do a roll up in the public markets.

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15:48Ari Levy:get started today well if you're a niche little hundred million dollar public company for example i can say this because we're on file we've filed a 13d on a company called quipped home medical that does uh they're about a about a hundred million dollar market cap they they trade for times EBITDA, they're a provider of home health services specifically in the niche that is the respiratory space. So think CPAP machines for things like sleep apnea, oxygen, most of it is respiratory related in-home sales and rental and servicing around that. Well, they've made some acquisitions, but the stock price is ultimately the scorecard is the stock price.

16:27Ari Levy:And so in the short term, it could be a voting machine. In the long term, it could be a weighing machine. But if it's been, if you're five or 10 year, 15 year IRR as a public company is really subpar, you have more vulnerability. There's an annual meeting and an election and those companies, ultimately, shareholders have certain rights. You got to look at the bylaws of the companies. We've typically settled with companies and gotten board members that way. And when you have board members, you have more influence. When I was on the board at Del Taco, because we were trading a a big discount to private market value, we got a number of different inbound bids, typically from private equity, some from large known quantities and some from funds that we never heard of that you kind of get to see how well funded are they?

17:09Ari Levy:Are they for real? Well, first, there's that arb of just if you take away public company costs and also you're not focused on the next quarter, which public companies are too focused on versus the next five years or whatever. I saw it firsthand. We were, their LBO math suggested that they were going to be able to pay a big premium them to public market value, take it private, and still make a good IRR. Now, that's them levering up typically and taking a lot of risk. In the case of Del Taco, we sold it to Jack in the Box. The best buyer typically is a strategic because there's synergies versus private equity.

17:39Ari Levy:We sold to Jack in the Box. Jack in the Box is its own public company. We sold to them in 2022. They just, I believe the enterprise value on the deal was$600 or$700 billion. They just sold it for the low$100s. There's been a whole bunch of things negatively affecting the restaurant industry, fast food, GLP ones and things I could go on and on about. But that was the risk that they took.

17:59David Weisburd:How long does it take you to build a case to go activist? How many conversations? Talk to me about that process.

18:06Ari Levy:It depends on the company. You know, we've just having been in the small cap markets for my whole career, the more, actually the more arbitrage-like things have been more for the last 15 years. But the full 25 years I've been in the public markets has been, I've always been picking stocks. So if you have some historical knowledge of the companies, we're finding companies through screens, but a lot of it's just from having knowledge of finding it, however we found it before, you can talk to other fund managers or whatever. You're trying to do as comprehensive of analysis as you can. Now there's limitations in that there's quarterly public filings.