Mailbag: incl. What's the low-down on bonds? October 15, 2023

30:00Mate, we have to do - Turn to Martin's - Sorry, go on. We've got to get to the, what do I invest in this ETF? But we also have to do the inverted yield curve. Yes. Do you want to have a crack at that? That's a big one. So, well, first thing I want to say, so Martin's asked, why are they suddenly emerging attractive investment opportunity with the discounted prices and the anticipation of rate cuts in the US? The bottom line would be, they're not more attractive because the price are being dropped. they are as attractive as the new newly minted bonds so i just would i think we made that point just to address that directly anticipation of rate cuts kind of comes down to locking in a benefit right because andrew's already said that as interest rates go uh up existing bond prices fall the reverse will be true of rates if and when rates get cut at some point the existing bonds will become more more valuable the face value will be more valuable because you want a the fair value is lower, the yield is lower, and therefore it goes the other way.

30:57So that's why we're seeing movements. The price of a bond is effectively inversely proportional to the return, the yield or the interest rate, right? So that's what's going on there. If you're an investor who wants to lock in a higher rate and you think rates are going to fall, then you would scramble for locking in as much money as you can. Again, think about mortgages in this case. Why do people lock in a fixed rate at 2 % three years ago? Because they expected the prices that insurance would rise. You would try and get out of a fixed rate if you could at the current rate, 6.5%, if you knew that prices were going to fall or thought rates were going to fall.

31:35So it's kind of the same way with bonds. It's like term deposits, right? If you thought, hang on, I can get a term deposit now for 4.5%, 5%, whatever they're going for. If I could lock that in before rates fall, then I would do that. And so it's kind of the same thing going on. Now, inverted yield curve, mate, all yours. Gosh. So all you do is you plot out, you have a chart on the X-axis along the horizontal, you have the different maturity. So you might start at three months, six months, one year, three year, five year, 10 year, 30 year. These are bonds that will mature in 30 years and various timeframes.

32:13And on the y-axis, you plot the yield that they're going for on the open market. Now, in a quote-unquote normal world, that chart slopes up and to the right, which makes sense. Why is that? Well, if I'm going to lend you$10 and you say, I'll pay you back later on this afternoon, I don't need much compensation, right? I don't have my$10 for a little while. If you say, give me$10, I'm going to pay you back in the year 2053. Well, can I have some? I need some compensation there, right? In a normal world, the longer I am lending someone money, the more compensation I want. Because A, I don't have the money and there's an opportunity cost.

32:52And B, there's more time for things to go wrong. It's a riskier bet to lend someone. The longer my money is locked up for the – yeah, exactly. The more I want to be compensated for the risk I'm taking. Makes sense. An inverted yield curve, which we have at the moment. Just before you do that, actually. I want to very quickly. What we're not saying, though, is each of those numbers is plotted on a per annum curve, not total amount. Obviously, you get more interest over 30 years over one day. So we're not saying you get more money over that period of time. We're saying the per annum interest rate, so a one-day loan has a per annum interest rate.

33:23It just happens to be, even if it's 10%, the actual rate over one day is probably 0.3 of a percent. So it's the annual interest rate is up and to the right over that time period. Even if they're less than a year, these things are still expressed in per annum interest rates or per annum yields. And so the percentage per annum still goes up over that time for the reasons we've just said. I just want to be clear about that, mate, so people aren't thinking about the amount of money received. Very good point. It's the per image straight. Go on. Yeah. And look, I'd actually, frankly, encourage a bit of Googling here.

33:50I mean, you'll go down a rabbit hole. Or not. Yeah, exactly. I think you've got a spare couple of hours to do that. Because it is a spare couple of years. Like, honestly, I'll let you know when I hit the bottom, right? Like, it hasn't happened yet. So, but an inverted yield curve is when I'm actually, I'm getting compensated less for the longer term. And what it does is it reflects the market, quote unquote, the market's view on the future. They feel as though a recession is coming. Interest rates are going to be lowered in the future. Right. And if interest rates are going to be lower in the future.

34:24And let's remember here, Australians, we love it. Oh, wouldn't it be great if interest rates are low? I was like, well, interest rates are only lowered when the economy needs stimulating and things are in bad shape. Right. So we've got to be careful what we wish for. You know, anyway, so it's reflecting that view. Now, how accurate is that? There's no such thing as any perfectly reliable forecast. It turns out that on average over time, it's been more right than it's been wrong. Generally, it will never tell you the degree of the recession and it won't tell you the timing of the recession. And it can flash red.

35:01I mean, the yield curve has been inverted in the US for, gosh, I want to say two years or something now, like a long time. It's like, still not in recession. So, and maybe he won't, you know. But that's what it's signaling. And that is usually a reason to be bearish. And a lot of people have jumped on that as a reason to be bearish. I mean, you can go deeper. Yep. No, that's a great job. You did a great job. I don't think, and again, you know, it's markets. People who live in markets are mathematically minded, generally speaking. I've said before, investing is at least as much art and science rather than, you know, the economics broadly over the last 50 years has become a econometric, to use the phrase, exercise, endeavor.

35:53It's actually improving, going back to more behavioral, psychological approaches because it's the way humans behave. we use money as the marker but it's the study of how humans behave and we've once we got computers people think well if I could put the model in the computer I can make it work and then what happens is stuff that can't be put in a model then gets discarded because it's easier to just leave it out so you say economists had physics envy is what they did yeah totally and I get it right you would want to be able to say if we could come up with a formula wouldn't that be great yes it would it would absolutely be great can you?

36:23no didn't stop them they just went well let's assume economics do it all else being equal Ceteris Paribas, as I know from my high school. And that's what they did. They literally said, all things are equal, this would happen. And they're absolutely 100 % right, except that all things never equal, so it's relatively useless. Nice way to conceptualize an economy. Well, the benefit, the breakthrough was, here's some ways of thinking about the economy. Here's some models. So that can help inform your thinking when you start to think about some of the inputs and outputs and some of the impacts and phenomena.

36:57Really useful. Can I say that? The quote there is, you might remember who said it, all models are wrong, some models are useful. Yeah, that's right. And I love it. I love it. And I think that's a little bit too cynical. I think almost all models are useful in some way, but they require understanding them, then putting them aside when you try and look at the real world and say, okay, now what do I think? And that's where the behavioral finance, the Kahneman Tversky's work is just phenomenally great. Richard Thaler, who won a Nobel, is great. So, you know, take the models as a bit like, We've talked before about investing, mate.

37:30We all start with calculating ratios, right? It's exactly that. And you kind of go, okay, now I know that. You can't do it without it. You kind of need to know the concept of a DCF, right? Because it helps you think about pricing. And then you put it aside and go, okay, I can use that subconsciously. And now look at the stuff that actually matters. And that's the key. Anyway, the reason I say that is because the inverted yield curve thing, it's only decades old, I think, from memory. In terms of our ability to use that to so-called - It's not a big data set in the grand scheme of things. like maybe it goes back 80 years or something yeah i don't know yeah yeah and so there's probably been what eight nine recessions over that i mean it's it's i'm not saying it's not relevant i'm just saying take it with a massive grain of salt because there's no there's no reason why it needs to be the case that being said this reverse is also true why would rates go down from a high point well probably because either the the uh central banks have done their job and slowed the economy so they were pretty let off the let off the brakes or they've let off the brakes because the economy's in trouble.

38:26So it absolutely makes sense. And again, why would a future yield be lower? Ram's right. We want to be compensated more highly for the money we're giving up. So that's absolutely true. But on top of that, if the prevailing rate's going to be lower from the central bank in five years rather than three years, well, okay, knowing that, you don't need as high a return because the risk rate is now lower. So that's why that yield could give us a verdict. It's a market betting on what the central banks will do in the future. That's what they're trying to do. And the assumption goes, if there is a recession, then the central bank will cut.

38:58Therefore, I can price my bonds or have a lower yield, lower interest rate on those bonds at that future point. So that's why they do it. I am entirely disinterested in what the bond markets think are going to happen because no one predicted COVID, no one predicted X, Y. They're not particularly predictive. They are, to some degree, again, on a trend basis, as I've just explained, not surprising, but it's almost one of those, yeah, no, whatever, Sherlock, right? You know, if rates hit a peak and then go down, hitting the peak will slow the economy, which is what they're designed to do. Surprise, surprise.

39:33We mentioned on Friday, the IMF saying the economy is going to grow in Australia at 1.2 % per year. Okay. Well, next year, sorry. Okay, great. We know that. Is there a chance of recession? Yeah. Even if there's not a recession, will rates be lower if that happens? If inflation is brought under control and economic growth is weak, any central bank would say we don't need to have rates as uh as restrictive as they are now so if they lower rates even without a recession you should have an inverted yield curve for exactly the same reasons so it's you know it's it may well be predictive it may well be correlative can i say that not really correlated um correlated yeah but there's yeah i don't i i personally have put no store in it um it makes a degree of sense that that's what would happen in those circumstances Will every additional vote there?

40:19No one knows. Yeah, I think I put it in the category of massively important but very difficult to apply in any practical sense. So I wouldn't say it's not important. I mean, gosh, it's super important. And if you could know it and if you didn't know it, it's all that stuff. Yeah, and so this is a very long answer. I told you, I warned you, and this is the very short version, by the way. But when it comes to some of these ETFs, you know, should you, shouldn't you? If you have a very confident view on which way bond markets are going to go, then you should. And, you know, I don't. And people who, a lot of people who pretend to know don't seem to have a great track.

41:02It's just difficult. It's really, really, really difficult. We don't really have much of a fixed interest market for the quote unquote retail investor in Australia. But there's nothing, I mean, Where I would find it interesting individually would be if I could use it and apply it in the same way I could a term deposit. Got some cash. I think I'm going to need it in a couple of years. I don't want to expose it to the equity market for that time because I want to put a deposit on a house or I want to go on a holiday or there's some unknown expense. And it's just, you know, as much as we are proponents of equity markets, I don't think any of us would lock money away for such a short period of time given what happens with volatility.

41:43I'd be tempted to buy a government bond and hold it to maturity for one or two years. I could see sense in doing that. Would I lend the US government money for 30 years at 0 %? No, I wouldn't. And I ranted on this, I think it was last week as well. It is amazing on this, literally, I think it's a$200 trillion global market that pension funds, institutions, and the biggest, best, quote unquote, smartest guys in the room. where we're actually making that trade. And it just boggles the mind. So again, it's a good reminder that there aren't any adults in control here. But yeah, I wouldn't want to give advice one way or the other because it's just a bit too tricky for me.

42:27No, fair enough. Bonds, by the way, traditionally have underperformed shares, but not in all time periods. In shorter time periods, they act differently. They actually tend to be – well, this is what's also interesting. So the old, old, old sort of rule of thumb was the 60-40 portfolio, 60 % equities, 40 % bonds. And because when bonds fall, equities go up and vice versa, at least again, historically. What's fascinating in recent history is that correlation is completely broken down. So it goes to show you that these rules of thumbs, these heuristics aren't always terribly reliable. and I actually think that anyone who's got any reasonable amount of time frame ahead of them putting your money in term deposits or fixed interest securities like bonds is just less volatile safer yes but actually I would say riskier over the long term because they're not as protected against inflation and you just you suffer a huge opportunity cost correct so yeah again the reality of someone could time the market they could choose when to be in which and all that kind of stuff but again that requires timing of the market which as you said many many times before is remarkably remarkable can i say the one and again we'll repeat ourselves here the where it so i mean interest rates are important and bonds really i would argue that central banks don't actually have as much influence as we like to pretend they do i'd say the bond markets is the is the real one you ever seen that batman movie where bane puts his hand on the other guy and says do you feel like he goes i'm in control here and bane puts his hand on each other goes do you feel in control?

44:03I think the global bond market is putting its hands on the Federal Reserve saying, are you sure? Because at the end of the day, you can't force a free and open market to buy your securities if you're the treasurer. You can't. I don't want to do it. And so the Fed can jawbone. They can jump up and down and say, no, no, no, you have to, and this and that, and we're setting interest rate. Well, you're sitting overnight lending rates to banks and everything within that sort of system. The only other way you can do it, which is what they do end up relying on, and I feel increasingly likely they're going to have to because of what's happening in the bond market, is they'll go, well, we'll buy the bonds.

44:39So you have the Federal Reserve buying the bonds off the Treasury, and the Federal Reserve is buying the bonds off the Treasury with money that it just created. It just added some zeros to an electronic register. And yeah, you can do that. You can do that for a period. But then counterintuitively, that undermines confidence in the bond market as well. So you can't control – there are certain things that are outside of your control because at the end of the day, these are just all monkeys making promises to each other. And the second that those promises feel as though that they are not good, people won't buy them.

45:16And your left hand can buy from the right hand and you can make it look as though the emperor's got a beautiful robe on. But bond market is massively important in that kind of regard. So what I said, and I said at the beginning, it makes a huge difference to equity markets. How do I treat it? Well, I just, you know, Ben Graham, margin of safety. I don't know where interest rates are going, but I want to try and invest in companies which aren't going to blow up if we go up a quarter of a percent for whatever reason. I don't want a company that's so highly leveraged that the slightest unexpected change in global bond market and interest rate dynamics throws me against the wall.

45:51I want, you mentioned the word before with Friday or today, the anti-fragile business like the Berkshire Hathaway that is so ridiculously resilient and anti-fragile that no matter what happens, it's like, here's the thing. Interest rates go up, Buffett wins. Why? Because he's got a pile of cash there bigger than Texas. $120 billion at last count. Everything goes on sale that he can now deploy. He wins. Interest rates go down. He wins because now his equity holdings all go up, right? Interest rates don't do anything. He wins because he's holding great businesses. Now, that is a smart guy. That is, and I want to be like Buffett.

46:28Be like Buffett is what I'm trying to say. And the trouble, quote unquote, with Buffett's approach is there will be periods, short-term periods that feel like longer-term periods where it's sort of like, oh, you made the wrong move. Oh, look at that. Oh, what a mistake to hold all that cash. You know, what an idiot. You know, it's like, it is if you look at his approach through the lens of trying to time markets and short term gyrations and these kinds of things. But in terms of someone who's trying to custody and shepherd capital over generations, it is super smart. And yeah, be like Buffett.

47:07As you're talking about that, mate, what came to my head is the smart Alec looking at Buffett saying, ha ha, I beat you at this game. and Warren Buffett just casually looking over his glass saying, dude, you're playing the wrong game. It's like, you know, I'm not playing that game. I would have played that game. Dude, you're playing checkers. I'm playing 4D chess here, right? Yeah. There's a great Barron's, I think it was Barron's headline, Barron's a US business publication, 1999. Yeah. Famously, what's wrong, Warren? Yes. Remaining the fact that Warren Buffett had missed out on the tech boom.

47:40And it's kind of one of those, you kind of go, okay, fine. When people start criticizing Warren Buffett, But, you know, he's about to be proven exactly right. It's the way this thing tends to work out. The other great marriage headline was Amazon with Jeff Bezos on the cover in 2000. It was Amazon.bomb. It was like a very clever play on words. Which is another great reminder. These are very well-regarded publications. It's just like you've got to constantly pinch yourself. They're stupid people. They are, you know, and it just, it is continually wrong. Long-term capital management was backed. Look up Google that, by the way, LTCM.

48:17You know, they're multiple, multiple PhDs. Well, I think. Port Noble laureates, mate. Port Noble laureates inside that business. They blew it up. One of them had the combined IQ of 10 of me, right? And they blew up. And they blew up. And it's worth keeping that in mind when you're looking at things going, why is everyone making money and I'm not? When I feel as though I'm doing something sensible and reasonable, it's just like Enron looked really great until it didn't. Bernie Mallerhoff's investors felt really smart until they didn't. And for decades too, by the way. Babcock and Brown was a brilliant investment until it wasn't.

48:56A Forge group here in Australia. There are so many. Remember Forge? There's so many great examples of it. You've got to be careful. That's not to say that sometimes maybe it is you. who's, you know, if you don't know who the patsy at the table is, maybe it is you. So don't assume that you're always right and, you know, if things aren't working out, it's because the market is dumb. But don't make the assumption that the market is this all-knowing, all-seeing thing that is always right because it just patently isn't. By the way, mate, most of those examples you've given and most of the investors who lose money in this sort of stuff are the ones who are reaching too far for returns.

49:31Yep. You know, Buffett has had spectacular returns. And frankly, they've come down over time because his capital is growing. and that's just it's a first-class problem to have but just you know the the old the old story of the the funds that just have to stay alive to do really really well the the average fund if you can get to 10 years old yeah as a fund you're almost certainly beating the market and and so i was your bias by definition but my point is they weren't the top fund every one of those 10 years no they end up there because they did the simple things right for long enough if you compound reasonably at reasonable rates for a long period of time that's why it's why my largest share is Berkshire Hathaway.

50:06I know Berkshire can't do previous returns, right? I don't need, I don't need, I'd love them. I don't need not 20 % returns that Buffett used to generate. If I can get the market plus a couple of points in Berkshire for a couple of decades, I'm going to be very, very, very, very far. On adjusted for risk. Like if I can get, if you can get 12 % per annum over the next 20 years and I got 12 % per annum over the next 20, you did it by investing in Berkshire. I did it by investing in some crypto nonsense, NFT rubbish. so we've both got the same return but who got the safer return there yeah that's right and that's what you can't look at the outcome and say therefore my investing was smart if you take stupid risks and still went up with a positive return good luck to you you got lucky well done versus like Berkshire and again Berkshire's not the only stock you should buy but you know well you could but you know what else do you need ETFs frankly the same sort of return I'll give you the market return but anyway that was a great question by the way it was a really good question thank you for that sorry for going on it for so long well done Martin Motley Fool Money For more, subscribe to the free newsletter at fool.com.au forward slash listener.

51:12Ben hits us up with five points. We're going to try and do reasonably quickly so we can get through them. But they're all individually good points, particularly because he gives us a rap. Dear Ram and Scott, he says, A few comments followed by a question for the podcast. It's not a machine, he says, but a piece of software. Ben, I take exception to your characterization. organization it is clearly a machine your fellow listeners have confirmed to me and to you that it is a podcast machine i don't know what this heresy is about mate you can try and pretend the world is around if you want the rest of us know it's flat okay he says okay so it's a short essay now i look at it oh dear number one great job on the pod thank you as someone who works in the financial services industry your topics of conversation and the suggestions you provide are right on the money the effort you both go to to educate and inform is second to none and a balanced point of view or at least stated position is a rarity these days and rarely leaves me shouting at the podcast ram you're not ranting well enough dude pick the lift you go muck never shy away from going no he's giving you even more rapsy never shy away from going down a rabbit hole taking a tangent or going over time the dog really appreciates the extra walk and as a gen x-er i get all of your jokes and references thank you ben you are now the only listener that gets it but we appreciate it thank you mate number two can i just say can i just say you clearly have to sort of bend the knee and kiss the ring if you want to get your question answered here so we must have ridiculous amounts of praise before we will we'll answer any question you can draw that inference and number two i'm just pattern matching here that's all i'm doing i know i can we're trying to answer I reckon we probably get throughout 75 % of the questions we get.

52:54Yeah. And we try to only exclude the ones. I only leave out the ones that we've either answered a lot before or recently or that are pretty esoteric and kind of don't quite, don't lend themselves to a general audience or a podcast format. Just for listeners, if you are listening to ask a question, we always will appreciate positive feedback and compliments. But yes, if it's relevant, if it's audio friendly, and if it's kind of general enough that most people will kind of benefit from it, that's what will get you on the pod. Number two says, Ben, I was finding the Kogan drinking game a bit slow, which I thought was a criticism.

53:28And then he says, so I have added a new one in which the Berkshire, Buffett, Munger and a double for Ben Graham, given he started the whole thing, drinking game. You're already on the floor at this stage of the podcast. That's what he says. Crap, if you've read this far, there's five drinks already. You didn't know that we've already covered most of those, Ben, but yes, you're right. Number three, in a recent mailbag. A listener asked about investing in private equity. You both pretty much came to the conclusion this was a little better than investing in an S &P 500 ETF. Fair enough. You had 10 years of returns to back it up.

53:59However, given Ram's recent investment in Bailador, is this not the pot or the Ram, my words aren't his, calling the kettle black? Isn't Bailador basically a listed private equity fund? Given most of its investments are unlisted companies and the one that is listed, Sightminder, is something they held prior to listing. A 23 % internal rate of return ain't bad, he says, beats the index. Will we talk about both sides of our mouth around? Yeah, I think so. I think that's a fair call. Yeah, full disclosure, I hold it. I like it. I think I really rate the management, and I think it's fair to characterize them as listed private equity.

54:37They're a relatively small percentage of my holding, so I know that changes really the point. But yeah, I cop that. And I guess if I could square that circle a little bit more, it was more if we did a proper job arguing against the idea of investing in private equity because you should invest in private equity. I think that's wrong in the same way that you should invest in – you should always have a miner there because you should have a miner in a company or you should always have a retailer. Like there are some people in our industry that feel as though you just need certain industry exposure for the sake of having industry exposure.

55:15And that's where I'm against private equity, especially for the quote unquote, you know, common person. You're just like, oh, I heard that I should have exposure to this. And I'm like, should you? In Bailador's case, I guess I make the exception was that I'm not investing in it because it's private equity. I'm investing in it because I really rate the management team and their capital allocation skills and the investments that they've made. And that's the reason I'm doing it. Not so much because of how you might classify their structure. Does that work? It does. I think that's right, man. I think the other thing is, yeah, I think it's, the exceptions always prove the rule.

55:56I would say that I don't invest in listed investment companies, but I own Berkshire shares. I would say, you know, be careful of fund managers because of the fees they charge I had to lose to the market, and yet I'm invested in Solpats and Berkshire, which, again, I kind of enlist investment companies slash funds of sorts in very different ways and different things. But, you know, they are the exceptions that proves they're all conglomerates suck, except for Solpats and West Farmers and Berkshire and probably a handful of others. I don't know about it at all. I have recommended it in the past, I think, in one service.

56:28We've talked to the guys, David Kirk and who's the other guy? Paul, someone? Help me out. Wilson. No. gosh I've gone blank now might be Paul Wilson actually maybe it is I think it's Paul Wilson sorry Paul anyway so yes but so you know it is yes Wilson what I was saying if I had to blindly invest in if I had to throw a private equity you have to throw them six figures probably to get in these days if I throw a private say here's 100 grand invest for me hope you give me some good results in 10 years that's the sort of that's a generic private equity investment if I could invest in you know with bailed off for example and i like their strategy and i like their investments and i like the people and i like what they're trying to do then it's a different thing it's frankly i have to invest in macquarie group as an investment in my mind because it's a jockey play right just is um what's the macquarie model i can tell you what it is now but it would not have been no resemblance to what it was 10 years ago and in 10 years time i think it'd probably be very different again and you can absolutely choose not to do it and say you know macquarie was tired for me i i recommended it um two years ago now probably after after for years having said you know what i I can't forecast its earnings.

57:36I don't know what it's going to be doing as a business. That's still my view, by the way. I ended up deciding that I believed that the incentives in place, the structure meant I was more likely than not to make money. But you can't see the future, right? It's really hard. So, yes, it is talking about both sides of our mouths to some degree. I don't own Frontier. I'll get to that in a second. I don't own Bellator. but if you did you would buy it because you liked what the business is doing right now by the way very different story because even though they as you say they held site minor prior to listing we didn't say we bought it at the ipo either so you're getting it at a price uh with businesses you know about so you kind of you're buying the portfolio businesses and and the management team um point four you have previously spoken about the advantage of the of that the individual investor dare i say retail investor says uh says ben has over the big end of town there was a great youtube clip by the swedish investor there's a story about this called why you can't beat the investment professionals uh why you can't sorry a wall street story end quote the listeners may find interesting and goes to the heart of what you two are helping individual investors do so there's a plug i haven't watched it but i'm sure ben's right nice last last point five after years of listening to you two prattle on, I think she means that positively, I finally bought shares in a couple of companies within my super.

58:59It is a wrap. No need for an SMSF to do this. Anyway, persistence pays. It's all been ETFs, LICs and some managed funds until now. As well as the interest in investigating various companies, I must say, actually listening to the investor presentations has been more insightful than the actual balance sheets and cash flows. It has allowed me to leave the rest of my portfolio alone as I now have somewhere else to direct my energies. Us boys always need something to play with, he says. Which brings me to my question. We got there, Ben. In the search for my next investment, I came across Frontier Digital Ventures, which I mentioned before.

59:31It cropped up on some small cap manager lists, and I also saw the full comment on it, and there was some chat on straw man. While the company is now finally generating some positive cash flow, although not on an EBITDA basis, what would Munger say about that? This is damn it, drink, in brackets. I find it really hard to work out what the future cash flows may look like. There have been so many acquisitions that have powered revenue growth, the normal process of looking back at previous cash flows and projecting forward doesn't seem to apply. How do you assess and potentially value these early stage growth companies?

1:00:03There is the prospect for more revenue via increased transactions and expenses seem to have stabilized. But there's no revenue guidance. And given Frontier has previously kept acquiring other companies, the current Frontier isn't really the same as the earlier one. and let's not mention the share placements he says that would have been dilutive for existing shareholders with no chance to participate there appears to be an experienced management team there is strong founder alignment with shareholders which gives me some confidence it could be an turning point in saying to generate positive cash flows and the share price is down enormously is there any way to readily assess a company like this or is it just a case of sucking your thumb and guessing which way the wind is blowing.

1:00:44Straw on, he says. So tell us what Frontier is, mate, and then let's talk about the company. Frontier, yeah, I do. We actually spoke to Sean DiGregorio, the CEO and the founder in December of last year. So it's an interesting business. They own a portfolio of online marketplaces, but these are all in emerging markets. You know, so think of the businesses that have done really well here, like the car sales and the real estate dot coms and that kind of stuff. Well, they're trying to sort of own that space, but in developing markets.

1:01:22So, OK, gosh, it's a big run up here. The business models are phenomenally attractive at scale. And we've seen that when you when you look at the really big, successful tech companies, they tend to be huge and big and successful because they have these things called network effects. I mean, if I'm going to look at a house in Australia, and that's literally every Australian, I'm going to go to either domain or realestate.com. Like, name me a third one. Like, name me the third one. And if you can, name me the fourth one, right? Like a natural monopolies, duopolies there. Because if I'm a seller, I'm going to go to where all the buyers are.

1:02:01If I'm a buyer, I'm going to go to where all the sellers are. They're extraordinarily dominant moats and very powerful moats and lead to very powerful feedback loops. The difficulty is that they are very hard to establish. And so in establishing them, you need to often spend big upfront. You need to acquire. We don't need to, but it helps to acquire. Not so much because the company you're acquiring might have better tech or even necessarily better branding, but they've got clients and you're trying to get to that stage where you have that network effect. And the tricky thing about not just these kinds of companies, but any early stage tech company or any, forget tech, just early stage companies is, you know, I could just have a company that makes, maybe I'm a brewer making ginger beer, right?

1:02:58It's like, well, I've got to buy the vat up front. I've got to buy the ingredients up front. Money is spent today with the expectation that that capital, capital being a special class of good that is used to make other goods, I need that for tomorrow. And so these guys have an ambitious plan. A lot of the bigger companies aren't interested in these other markets because they're too small. and they've got a good thing going on where they are. Well, they sort of look at Brazil and Vietnam and other places like that, that, you know, people have the internet there. People aren't any different from where we are here.

1:03:39They want the convenience of opening up an app and doing it. And in fact, they've got, I'm going to go blank because I haven't looked at it closely for a while, but I think they do have the leading or close to leading sort of services in all of these areas. So what can be really difficult here is that you've got to, you can't often rely on historical financials. I bet you, I bet you, I'm trying to give a good example here. I bet you Cochlear in its first three years, five years, maybe even 10 years of operation had really bad financials. CSL, right? If it wasn't spun out of a government agency.

1:04:19Well, as a government agency at the time, I'm sure the only reason it got up was because it had all this free government money and capital sort of to deploy it. So that's just how it is. And this is where I love early stage growth companies because I think too often people go, ah, no earnings. It's bad. Ah, look at all the debt that they've spent. Ah, the cash flow is negative. It's bad. And it's like, well, that is really, really big red flags for established companies that are going in the other direction. But it's unavoidable and necessary and just how it is for any other kind of company. Anyone who started a business knows that's the case.

1:04:51Now, that doesn't mean that just don't worry about financials. It doesn't matter. But I think if you're in early stage companies, that's just par for the course. What you need to do, I think, is you need to have a look at – you need to be able to tease apart some of these numbers and look at maybe more the unit economics than the overall economics. So what you would hope with a business like Frontier Digital Ventures, they've got all this staff there that are working, they've got an accounts department, they've got a sales team, all of this kind of stuff that hopefully can service a much, much, much larger number of users.

1:05:25But I'm more interested in what is the client acquisition cost versus the long lifetime value. This is a well-known metric in tech, LTV divided by CAC is what it's called. And if that's a positive metric, it means that I'm going to scale really nicely. Like you look at zero in the early days, right? And I was at the full with you at the time. And I remember how much grief wasn't our services, but the boys who, you know, Matt and Joe who recommended it got at the time. Because the financials looked terrible. But they had the astute observation that actually the unit economics are incredibly attractive.

1:06:04and as long as new people keep coming on and it's attractive to people for people like on each each individual user added is accretive then you can draw a line and it's going to pass a point where it becomes really really attractive so there's a long answer but what i'm saying here is is not to say invest or don't invest in frontier digital ventures but it's to look at it from that lens and think can it scale and i would say if they are the dominant player in those spaces and if those unit economics are attractive. And if you feel that these play, and these are risky parts of the world often to operate in, but if you feel as though they are going to sort of further develop over time, I think you can probably make a case for it.

1:06:48I haven't looked at the share prices, you know, obviously price is what you pay, value is what you get. So maybe it's great value, maybe it's terrible value, even if the business has a bright future. But that's the lens that I would look at it through. And I think what you're seeing with not just, and I can speak very much from experience here, is that it's not just Frontier Digital Ventures that's had a pretty ordinary year, but all kinds of growth companies. Because you've seen the access to capital change, and that's very important for an early stage company. And you've seen the market sentiment change.

1:07:21The market has no, we don't see it with the big indices, because a lot of the big resource companies and banks that are sort of like masking what's going on underneath the hood. Take the US market and take away the top five performing companies. And it's a really ordinary performance, right? But in small cap land, the sentiment has just turned. And it's actually why I think it's a really exciting point. I think there's so many attractive opportunities in small cap growth at the moment, because you've had this change in sentiment and you've had all of these terrible things fall that should have fallen and never deserved to trade on the multiples that they did.

1:07:58But all these babies have been thrown out with the bathwater. Maybe FDV is one, sorry, Frontier Digital Ventures is one of them. Don't think because the price is down that the business is doing poorly. I'll have a quick squeeze while you have some thoughts in, mate. Sorry, that was a long answer. No, it was a good answer. I had a really good answer. I think what i front here is another business that i've recommended in the past and it's a really interesting business because it's not a current recommendation of any of my services by the way it's it's a business where you will see uh the two parallel and not off not always intersecting but hopefully in this case intersecting are issues of the business model and the execution.

1:08:48Frontier is, on one hand, taking some really short parts because it's taking, as Andrew has already said, the models that's seen work anywhere else in the world and saying, we know how this plays out or has played out or can play out. We know that increased adoption of the internet, we know that these incredible marketplace businesses have extraordinary value and extraordinary worth. I mean, I mean, worth for the consumers, right? Imagine trying to find a house that he says, I'm old enough, Ram, some of our listeners will remember, some won't. Remember getting the City Morning Herald, and it was actually in two separate sections because they couldn't fold the entire paper in half.

1:09:23So there was literally, and sometimes they were, I've got to say, I'm just doing with the fingers now, well more than an inch thick. If you put those two sections on top of each other, it was more than an inch, and you couldn't have one section because you literally couldn't fold the paper. And so there was these, and that was the classifieds, right? Largely, I mean, lifestyle and other things, but it was pages of pages of houses and pages of pages of jobs and it was just extraordinary extraordinary business anyway the internet's destroyed a lot or take you know take reinvented it maybe taking it online uh and so we know how incredibly powerful that can be in the developed world and frontier is simple saying hey if we get there first if we can so you gotta do a few things you gotta get there first or first ish uh there's two big housing classifieds businesses but largely only one of every other category because housing is so expensive as a thing you can afford to have a couple different players and you as a seller you want to list in all the places that it's that you know people might look if it's a job if it's a a car uh you're gonna you're gonna go to probably just one the one winner and so front is saying okay we've seen seek and realestate.com and domain and car sales and if we can do that then we'll do really well if we get there first if the market it grows the way we hope it might grow.

1:10:38And if it can do that in a timeframe that gives us a return on that capital investment interest as we already talked about. Because if it takes 10 years, it'll never happen. So there have been businesses before. iCarAsia was one. iProperty was another. Oh, yeah. These companies never really got there. One was, well, they both taken over. I think they were. We'll take private camera anyway. These businesses were trying to do exactly the same thing. Now, under their own steam, neither prospered. They may well now, as parts of other businesses or whatever, or maybe they're private and are prospering.

1:11:09As publicly as they never prospered, because they, I've said it before many times, if Steve Jobs was born in 19, anything up to about 19, I don't know how old he was, but if the iPhone idea would come along any point, less than five years before it did, Jobs is a nobody and the iPhone never happens or happens by someone else at some other later point. He happened to be exactly at the right time when Wi-Fi and 3G and Gorilla Glass and other things were available to make the iphone without that doesn't happen apple's an ipod company right which would be fine um the so so frontier's challenge is are they in the right places are they in the lead can they continue to be in the lead and can they be there to use a surfing analogy on the board when the wave comes through because you can paddle out on a board and sit there all day in a bay and nothing's going to happen and in that case have you got the right board have you got the right cozies have you got the rights have you watched all their online tutorials we've been taught by someone who can yep absolutely can you catch a wave not there's no waves to catch or let's let's torture the analogy if you're on another break where there's so many people you simply can't get on the wave you can't get on the right point of the wave because people are already there so you've got to be first you're gonna have the right business model which i think they have you've got to be first and you've got to be you've got to hope the wave comes before you run out of money and so that's the frontier story now they diversify beautifully across different geographies and different verticals so different types of classifieds i do think they've got a pretty good chance of being successful the share price has fallen meaningfully because we've talked about this before the price of money's gone up we talked about you know in this episode but but before we're talking about you know tech companies are worth less because you've got to wait years for profits and every year you wait when the risk rate is five percent on u.s government bonds rather than two percent the cost of waiting is ever more expensive so that's where frontier is now i haven't looked at it in a long time around particularly closely i can't i can't advance an investment view i'm just having a quick look now yeah i go go ahead oh the last thing i'll just say my my specific question would simply be can they get there quickly enough to justify the current price and i don't know the answer they might also run out of money and have to raise more capital in which case you get diluted even further as has been asked or mentioned so i don't know i uh i don't have a view but if i was going to look at it, I'd say the right model, right expertise.

1:13:30They seem to be in leading positions in those markets. Maybe the market doesn't grow quickly enough or adopt their sites quickly enough to make money. That's the question I'd be trying to answer for myself. Frankly, Ben, I wouldn't look at any of the historical numbers at all. I'd be looking at business unit by business unit and say, are these units in a position to do well from here in a timeframe that offers me a return on my money yeah i mean so the most recent results they made 31 million dollars in revenue in the first half uh that compares to 29 in the previous year 21 and then eight and then seven and then five so and then and then if you look at the full year obviously we don't have the full year yet for fy23 they've got a different reporting cycle but you know there's this there's this in 2017 the whole company made nine million in revenue and last year last full year it made 59 million it's growing at the top line right it's okay tick that's interesting um but what what hasn't what has also been evident is scrolling further down is that the the loss is expanding as well so and just to make things really complicated and get into the weeds there's the operating profit which includes the way that their associates their their subsidiaries are accounted for That's a whole other thing.

1:14:50But on that metric there, their EBITDA went from a loss last year to a$1.5 million gain this year. So potentially they're passing that inflection point. The thing that I guess would worry, I mean, you've got to do much more. This is research on the fly, right? So you take this with a huge grain of salt. But opening up the September quarter cash flow statement, they brought in$16.5 million in cash receipts, but after all of their expenses, they're still bleeding$1.5 million. Yeah. and they've got$28 million left in the bank. So there's a bit of a runway left, but that is the question I would say.

1:15:26The sales is there. The traction is there. The revenue is coming in. The amount of revenue that is coming in is growing. This is all good. I'd also need to look at the share count because maybe the revenue is coming because it's all acquired. That's part of the problem. These are the things you've got to look at. But I mean, high level view here, and you've already nailed it. It's just like, well, business seems to be getting bigger overall. It's just whether they can do that effectively on a per share basis and then make that magic pivot to cashflow positivity, become self-funded, and then unlock that beautiful, beautiful thing called operating leverage, which whereas the fixed costs don't grow anywhere near as fast as the revenue growth.

1:16:07And then you get this ongoing steady and attractive revenue growth, but much, much, much better profit growth. and all of a sudden the market will sit up and go, ah, you did it. Now, maybe they won't and most companies don't. But if they can, that'll be something pretty special. And that's what I would be trying to spend my time trying to figure out. I like it. But I reckon that's a wonderful way to finish this podcast. We just got a little bit long. We did have permission from Ben not to cut it short. So we've taken that. Taken the liberty, yep. Correct, forever actually after this. Now all Ben's fault.

1:16:39If your podcast is going too long, you can blame Ben, dear listener. Mate, that was a fun podcast. Got some great questions. Got some really, really interesting content. I hope you've enjoyed it. Again, as I said on Friday, please do send us your questions, comments and feedback. We love hearing from our listeners. Just so it makes it feel like we're not just talking to each other and into these strange microphones. We'd like kind of knowing it's getting out into the rest of the world. Thank you for listening. By the way, I don't do this very often. Please tell your friends. Tell people that you hope might get something out of it.

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