#50 - Top 10 Insights from 2024 (Part 1)

0:05Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry investment and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, a leading investment advisory firm. Learn more about our show at insightfulinvestor.org.

0:38As we conclude 2024, I'm so excited to highlight the top 10 insights from this year's episodes, ranked from 10 to 1. I'll present these insights in two parts. This episode will count down insights 10 through 6, while the final episode that'll come out next week, the final episode of 2024, will reveal the top five insights. These will be our final episodes for the year as we take a break for the holidays during the last two weeks of December. This pause not only gives us time to recharge and hopefully gives you time to recharge, but also provides you, our listeners, with an opportunity to catch up on some of the highlighted episodes that you might have missed.

1:18Each insight has been chosen based on its value, as noted both by myself and many listeners who have been kind enough to share feedback throughout the year. So whether you're revisiting these episodes or discovering them for the first time. I hope you'll find them as insightful as we have. Before we begin, I really want to express my gratitude to all the listeners and the guests. We launched this podcast on January 2nd of this year, and it has far exceeded all of our expectations. Initially, I was uncertain about starting a weekly podcast, questioning whether I could secure enough high-quality guests with valuable insights.

1:57And before going live, I actually compiled a list of potential guests I thought would be suitable and willing to join a brand new podcast. I set a target of at least 50 to cover the first year. What's interesting is after releasing about 50 episodes, only a quarter of the guests were from my initial list. About a quarter are individuals I know but hadn't originally considered. And the remaining 50%, Half of all the guests are people I had never met who were introduced to me through this podcast. That has certainly been the most rewarding aspect of this experience, the opportunity to meet so many insightful individuals.

2:38Our approach to each episode is comprehensive. I thoroughly research each guest, reviewing their previous interviews or writings. I spend a lot of time crafting a set of questions, which I send to each guest in advance. That gives them enough time to think through their responses. And through this process, combined with conducting the interviews, that process has been incredibly educational for me, and I hope for you, our listeners, as well. The numbers so far suggest this has indeed been the case. We currently average about 10 ,000 downloads or views per month across approximately 120 countries, and the momentum seems to be growing.

3:18Our most downloaded episodes to date have been Jeremy Grantham, Rajiv Jain, George Milling Stanley, he talked about gold. David Dredge, that was a popular one. Karen Carnial Tambor, Matt Smith, Rob Arnott, Mike Green, and Martin Escobari so far have had the most downloads. Most of our podcasts include video content, in case you're not aware, and it's available on Spotify and YouTube, and also on the insightfulinvestor.org website. As always, we welcome your continued feedback and any suggestions you have for future guests who you think may offer valuable insights as we look forward to continuing to share insights in the years to come.

4:02Okay, now let's dive into the top 10 insights of 2024. And I'm going to start with the 10th best insight for the year. Number 10, the power of compounding. The focus of long-term investing is to take advantage of one of the most powerful forces in finance, compound returns. The first clip, which I'm going to share with you, is from Roy Leckie, who is co-chair of the Investment Management Committee at Walter Scott, which is a Scotland-based firm that is a long-term investor in stocks. Compound growth is the best force or tool or ally, whatever you want to call it, that any investor has going for him or her.

4:43But what's the key ingredient to getting that to work. Time, right? Compound multiplied by time equals happiness. Wealth. That's right. World Scott is a long-term buy and hold, high conviction, compound growth stock picker. Benchmark unaware. We just look longer ahead than most people. If you look at the average holding period that most investors own stocks for, it was short when I started my career, and it's got a huge amount shorter. So are we better at valuing a business for the next month, the next six months, the next year? Don't know. Do we have a skill set in identifying companies that have the ability to compound for many years into the future and figure out what a reasonable prices.

5:35I think we do. So it's not so much a comparative advantage on valuation, rather the skill set of thinking about investing as a long-term undertaking, which is increasingly rare, much to my surprise. I mean, one of the many things I've got wrong in my career, when I got to grips with what it is that we're trying to do, I said, well, surely, surely the rest of the market is going to start thinking more long-term. And the exact opposite has happened. And you see that. You see it not just in investor behavior. You see it in corporate behavior as well. I mean, I find it quite bizarre. Many companies seem to manage their business on a quarter-by-quarter basis.

6:16They talk about earnings over the next quarter as if this is the defining criteria on success, which, of course, is not. So it's our ability to frame the investment challenge as a multi-year undertaking rather than a quarter by quarter or even shorter in some instances. In this next snippet, David Dredge, who is the founder and CIO of Convex Strategies, which is based in Singapore, explains compounding in slightly more technical terms and then later talks about just staying in the game by hedging against really bad things happening that could wipe you out. In other words, stay in as long as you can so you can compound.

6:56Again, this goes back to this sort of single slice of time versus a path through time. So if we lived in a single slice of time, we could look at arithmetic returns. And you could say, well, this year I made 50 % and then next year I lost 40%. And you add those together, take the average and you say, well, I'm up 5%. But in a compounding path, that's not true. If I made 50 % this year, if I invested$100, I made 50%, I have 150, and next year I lose 40%, I go to 90. And every step through that process on a plus 50 minus 40, which has an expected return of five, I'm down from 100 to 90 in two turns, assuming it's a 50-50 game that's fair, 90 to 81 in four turns, 81 to 72 in six turns.

7:51And basically the median of that investment path is to zero. And so the simple example Nassim uses all the time when he talks, he's like, if there was a hundred of us in a room and we gave everybody a hundred bucks and say, go to the casino and play one hand of the same game that we know the odds of, and then come back and we'll add up the average and we'll get out of the hundred people with one slice of time, the average. But I gave one person all the money and told him to go play the game a hundred times. He'll go bankrupt every time because the compounding path, the non-ergotic path, I think I said it last time, but everybody should go and Google the word ergodicity and understand the difference between what's ergodic and what's non-ergotic, simply put or mathematically put.

8:42Ergotic means that the ensemble average and the time average is the same. Non-ergotic means that the ensemble average and the time average are different. So my plus 50 minus 40 coin toss through time is non-ergotic because the ensemble average, 5%, and the time average minus one over n every time is different. and so investment paths are non-ergotic and they should be managed accordingly and this is where the geometric compounding comes in and this is how you grow wealth because geometric means that you're going to multiply the returns arithmetic means you're going to treat the returns as additive and once things start to multiply you have the opportunity the potential of exponential growth and this is where true wealth gets built and true wealth comes from and yet as we mentioned earlier The incentive structure, because it's looking at this single slice of time, tends to operate under an objective, a metric of arithmetic returns and ignores the important factor, the single important factor, which is the geometric compounding through time.

9:53Number nine, the inefficiency in private markets. One of the key lessons from these podcasts with all these brilliant investors is that gaining an edge in investing can be very challenging. And this is particularly true in public markets like traditional stocks and bonds. These markets are relatively efficient due to readily available information and a lot of well-informed buyers and sellers. Private markets, however, may offer more opportunities to outperform because they tend to be less efficient, more fragmented, more complex, and more difficult to access. Two segments within private markets where I've noticed material inefficiency include, number one, areas where an expert can add significant value by operating the asset much better than the competition.

10:42And the second is investing in private markets by acquiring assets at a material discount through secondary transactions. These areas of inefficiency can potentially provide investors with unique opportunities to generate superior returns. When discussing the notion of adding operational alpha or adding value through better operations, two firms stood out. The first is an LA-based real estate firm called JRK. The founder, Jim Lipman, talks about why he has focused his career on investing in multifamily real estate because of how inefficiently many properties are managed. And then the CEO, Bobby Lee, details insights into specific ways to add operational value.

11:27Listen to them speak right here. It was actually how I fell in love with this business. So when I moved out to California, the first assets that I took over were two assets. I won't say the names, but in Atlanta, Georgia, and they were struggling assets. And I looked at this and this was, we had taken them over and our own company had done nothing different than the prior company. And I looked at these assets and was able to see the significant mismanagement and opportunities to reposition these assets during, as you probably recall, in the early 90s, a very weak market. And so by implementing those and seeing the amazing difference in generation that they did to the NOI of those properties and the revenues and expenses, I said, wow, this is the right business.

12:15I'd like to touch on one thing going back to an earlier part where you said investing in multifamily, Alex, I view it as part, it's the real estate and part is the business. And I think where most folks gravitate to is they spend 95 % of the time is analyzing the real estate, doing forecasting trends on population growth in markets and sub-markets and where they think demographics are going to shift. Look, it's not that we don't place bearing on that. We very much believe that you got to invest in the right markets. But we've also realized over three and a half decades, 30 % of the time you're going to get those demographic predictions wrong.

12:47So where we spend is we may spend 20 % of the time on the real estate and obviously doing the best we can to forecast the future. We're spending 80 % of our time analyzing the businesses of each of the deals. So it's a numbers game. We're looking at 3 ,200 to 3 ,500 investments a year. We're going to focus on the 15 to 20 very best investments where we like the real estate, we like the locations, we like the physical assets, but that we're going to stack the deck in our hand where the businesses are so under managed or that they're so physically under capitalized that we know that we can deliver alpha over the first three to four years instantly to take a lot of the risk out of the deal and to generate outsized returns.

13:24That's where we spend our energy. I think it comes down to something Jim said in an earlier question, which is this business is difficult. Operating multifamily period is difficult. Operating it as efficiently as you can and optimizing the cash flows year in and year out and compounding success and success becomes even more difficult. So, you know, it takes looking at every single part of our supply and vendor chain, whether we can bring things in-house versus outsource them, what is the efficiency of the maintenance team and the efficacy of the maintenance team and the leasing team, et cetera.

13:57Also on the revenue side, just as much active management, which is looking at where can you optimize the rents and the occupancy on a weekly basis, looking at different demand streams, et cetera, and other sources of revenue. And then looking at things that are maybe taken for granted, to things like fixed expenses, utilities, for example, property taxes, insurance, that we spend a lot of time. They're actually called fixed expenses in our industry because folks don't look at them. It's just a given. We spend a lot of time to make sure that those are made as efficient as possible, as well as things below the line, whether it's interior capital or other operational capital that folks tend to just underwrite at$250 a unit on a blanket and never analyze what it's actually costing them and what kind of return on investment.

14:40So for us, we've set up all of our analytics so that we can look at things on a daily, weekly, and monthly basis. Like I said, our business, I look at the series of low risk decisions that we are making, but you have to constantly make sure that you correct each week and each month if you miss. And if you do that disciplined over time, you find a lot of efficiency in this business. The second one is Mike Odrich. He is the founder of A &M Capital Partners. In this clip, Mike emphasizes adding value to private companies through operational improvements rather than relying solely on financial engineering like many private equity firms do.

15:16His approach focuses on enhancing efficiency and productivity in portfolio companies, which is particularly crucial when economic tailwinds like strong growth and low interest rates are absent. Once I got to understand what A &M was, I had no idea that they had built out this breadth of operational talent across not only the C-level, but the functional expertise. I realized that if we built a private equity platform that could have real-time access to those ops executives, bring them into our investment process to help front to back on the investing side from sourcing proprietary opportunities to diligence and screening of those opportunities.

16:02And then really important, which we never had at Lehman, was the ability to transform these companies operationally, to focus on post-acquisition performance improvement, leveraging interim management capabilities from A &M executives to bring them into the companies, to help professionalize, scale, grow, making sure that all the systems are right. That's something we have a checklist every time we do a deal. We're doing a full analytic on that business and what needs to be improved, what needs to change, and mapping out the roadmap to get to making those changes to get to the end game. It's like building a house, building a foundation in a house.

16:46The second private market segment that may offer interesting opportunities is secondaries, where investors can potentially acquire stakes in private funds at significant discounts, relative to their actual value. Two guests provided valuable insights into this area. Mike Bigot is the founder of Klein Hill Partners. In this clip, he addressed skepticism about the secondaries market seeming too good to be true. And he also explained the dynamics of the secondaries market and its potential benefits. So look, I think there's three points I'd have to make on this. One is to look at the returns that secondary funds actually get.

17:26Second is to look at the performance on the assets that are being sold, you may have already made a lot of money. And the third is on the opportunity cost that you have for the capital. So if you look at returns in the secondary industry, they've been very strong over a long period of time. So if you look at Cambridge Associates data going back to 1993, almost every vintage of secondary funds has delivered double digit net returns, except for a handful, most of which are high single digits. So it does perform very well. But most of those returns are 10 to 15 % IRR to secondary fund investors. And a lot of those returns, especially at the big funds, have a large component of leverage to get that return.

18:10So as a seller, you can think of maybe you're giving up 8 to 12 % in terms of the return that you're walking away from by executing a trade. That's really not that huge of a discount that you're giving up and the liquid asset where the buyer may have to wait three to 10 years for all the cash to come out. The second thing is if you look at the portfolio that you're selling, you very likely have already made a large amount of capital from your investments. So you may have 50%, 100%. So when you're actually going to sell and you apply the discount to how well you've done so far, it may not be so much to walk away from.

18:48And the third is if you look at opportunity cost, when you're allocating into private equity and you're rotating from one portfolio to another, if you're selling and you're losing 8 % to 12%, I can bet you that most allocators are targeting returns much higher than that. For some of the amazing managers that they're going into, they're probably targeting 15%, 20 % or more. And so you can actually see that as being a pretty good trade as a seller. In terms of barriers to entry, I see there's two different angles to look at that question. One is for firms to enter the industry and for firms to compete.

19:23And the second is for the overall secondary industry to innovate and to change to be more efficient in the future. And so in terms of firms entering the industry, first of all, raising capital is not always a straight line. It can take a great deal of time. You have to build up a platform, a team. It's not easy to get the capital. The second is it's very hard to build up the platform. And so if you think of what it takes to invest while in secondaries, you need a massive investment team that's highly experienced. There's a great amount of valuation work, understanding different industries, different managers, different companies, and knowing how to get information that's not public and very hard to find.

20:10So building the teams is very difficult. I'd also say that from like a deal sourcing perspective, you see newcomers sort of show up on the stage and expect to just start doing lots of deals. They're not seeing the deal flow. So just even finding these liquid secondary deals is very hard. then picking the right ones to work on is difficult. And groups that don't have a track record of getting lots of deals done often find themselves stuck and have a lack of conviction on which deals to even do or pay up for. And so what you've seen, Alex, is that there's some massive, very well-regarded firms in the industry that have wanted to launch into secondaries, and they've tried to do it themselves with confidence on their own investing capabilities and their platform.

20:58And typically they have very often tended to either completely fail or take many years longer than they thought. And along the way of firms trying to enter the industry, they maybe have not been the best fiduciary of the capital that they're managing trying to get there. So it's not so easy just to like launch and dive into secondaries and launch a new strategy or a new firm. It's actually quite difficult. And the second thing is if you think about the whole industry and how the industry, which may change over years or what it will take for that to happen. I think it's actually very difficult.

21:33And you've seen firms like NASDAQ that has come in and tried to make an exchange to have very efficient trading of interest on the secondary industry. It's been more challenging than I think they thought it would be in the beginning. And so why is that? I think there's four main reasons. One, first of all, when you're going through to execute these secondary transactions, you really need to know what the right price is. Unlike the public stock market, there aren't these clearing prices. The valuations that need to be made to determine the price are based on highly confidential information that people don't want all over the internet.

22:11It's not easy to access. And actually, we spend a very large amount of resources to dig very deep beyond what's easily available from the managers. So the information is very difficult. Second is the overall volume is just very low. So if you look at a lot of managers or companies, there might only be a transaction for them a couple of times a year. There isn't the volume to support the industry to instantly be hyper efficient. And so it has to be something that will take quite a while to build up. And then third is when you think of trades that happen in the secondary industry, it's not like with public stocks where you realize you want to buy IBM stock and you can research IBM, decide what price you'll pay to buy it or sell it.

22:56In the secondary industry, first of all, as we mentioned before, you're not typically buying for LP trades one company at a time, nor are you buying one fund at a time that may have five companies. but a seller is coming with a package of funds that they want to sell. They're going to have picked out, say, 20 different funds. And so in one go for one transaction, you're going to have to understand 20 managers and all of those companies in that whole portfolio. And so that's a huge barrier, not just for a firm to enter, like we were just talking about, but also just for the industry to provide simple liquidity when you have very complicated buckets of assets.

23:37And then the fourth thing, which today is complicated, is maybe more easily fixable, is that the transfer process is complicated because each of these funds that you're looking to transfer is operating under different contracts and different agreements. And so you actually have to hire lawyers and spend thousands of dollars for each fund that you want to transfer. And typically, those transfers are limited to the end of each quarter. Next, Tony Cusano, who is the co-founder of Banner Ridge, discussed reasons why sellers might be willing to sell at substantial discounts. And he also highlighted information asymmetries that secondary buyers can potentially leverage.

24:18Listen to him here. There's different reasons. Sometimes it's because you're selling a billion and a half dollars of assets. and all you care about is that the pooled assets you're selling gets you some price. Let's say that price is 95 cents in the dollar. Well, you're not going through every line item and trying to figure out, is the venture fund that I'm selling getting me the same price as the buyout fund that I'm selling or the Sequoia Venture Fund that's one of the hottest funds on the secondary market today? I think you're just saying you either got 95 for the whole thing or you didn't.

24:52And so within that, there can be multiple buyers pulled together And almost certainly, some of those buyers are buying for a massive discount to that 95 price. But the question is, are they really buying real value for that discount? And we can talk about discounts in general at some point. But basically, buying a discount in and of itself does not mean you're getting a good deal. Because there are lots of situations where GPs overmark their portfolios. So they're telling you it's worth a dollar. But if you went out and tried to sell that today, it might be worth 70 cents. That's really the secondary buyer's job to determine what the real value is and then make sure they can buy it at a discount.

25:33Now, there are other reasons that people sell at bigger discounts. There's liquidity needs, which happen from time to time. There's a denominator effect issue, which has been plaguing US public pensions for a while, where they're significantly ahead of their private allocation. They might have an allocation to privates of 20%, all privates, buyout, venture, infrastructure, everything. And they're at 35%. Well, that puts them in a position where they, over time, need to either sell or stop making new commitments or hope that the other 70 % of their portfolio that's liquid rips higher and then reduces the impact of the privates and moves it closer to 20 % again.

26:18So in those situations, I wouldn't say they're for sellers because they're really not, but they're motivated. And so as long as you can justify the price that you're buying as being in the ballpark with fair, they'll take it. So there's a lot of reasons, but those are some of them. The best opportunities that I've seen and I've taken advantage of in my career were situations where my team and I had better information about the assets we were buying than the seller did. And this is a unique situation where there are a lot of investors and privates that are very unsophisticated. Because if you think about where so much of the institutional money is coming from, these aren't typically the same types of investors that you would find at hedge funds or at direct private equity funds.

27:02So there's an information asymmetry which exists and creates opportunity. The more skewed the information asymmetry, the better the deal on average. So Banner Ridge cast a pretty wide net, look at everything at a high level, and then try to determine where the information differential is the largest focus there. But I think a lot of people talk about forced sellers because it sounds sexy and it's exciting. It's a story point. But in my career, I could probably count the number of forced seller situations we've been a part of where we bought something on one hand. And actually only one of those deals would make it into the top 10 of the best deals that I think we've done.

27:41So there are lots of exciting kind of inefficiencies that all boil down to the information of symmetry in private markets, specifically in secondaries. And we're trying to really take advantage of as many of those as we can in each one of our funds. Insight number eight, the historical analog to today. Matt Smith, who is a senior fund manager at Ruffer, a UK-based absolute return manager, is a student of financial markets history. In this segment that was recorded back in May, he shared his perspective about the closest historical analog to today's environment. That's a very easy one for me. And that's the late 1960s, which probably tells you a lot about where I think we're headed.