#310: Modern Value Investing w/ Jose Mayora

0:00In fact, for most hyperscalers is a good example of thinking about return on invested capital. Because like Google before, the reason why also they were able to compound is because they needed relatively little capital to produce the earnings and cash flows of what they were doing into new projects or even just enhancing their search business. Right. Now the tides have shifted. Right. And what they want to do now is super capital intensive. and you know i don't want to deliver the point and repeat myself too much but it's just it makes it at least questionable right

0:43Jose Najarro:hi folks and welcome to another episode of stock club this week we have a very special guest with us jose mayora jose is the author of wall street's blind spots a unique perspective on value investing valuation and capital allocation he's also the founder and senior portfolio manager of the Vita Capital, a value-focused equities fund. Jose, welcome to the show. It's a pleasure to have you on Stock Club here today. It's a pleasure to be here. Thank you for having me. So let's jump right into it. So tell me a bit about your background and how you got into finance. Sure. So I've pretty much been in finance and economics all throughout my life, ever since I graduated from high school.

1:20I went to UVA in the States and studied. I did a double major in finance and economics. Then I went into investment banking for almost five years. While I was in investment banking, I got my CFA. And after that, I went to do a master's in economics. And then finally, after a very small detour that I don't think it's worth going into, I eventually moved back to my finance and value investing kind of world, which is what I'm really passionate about. And over the last four years, I've been managing a fund called Divita Value Growth Fund, which is managed by Divita Capital, the investment manager.

2:05And it's through a value investing approach. And we can talk more about that. And maybe the only thing I'd add from my background that I think is helpful for the audience to understand is that I was studying kind of all my career and all my specialty studies, I was doing it kind of in parallel. On the one hand, it was what I was being taught in college or the CFA or my master's. But on the other hand, I was doing my own kind of self-study because what I was being taught or kind of mainstream explanations for finance and economic phenomena or whatever, I wasn't really kind of swallowing the pill, as I like to call it.

2:48So in the case of, for example, finance, well, value investing is not precisely mainstream. And unless you go to Columbia University or some other few places, you're not necessarily going to be taught value investing. So I was reading value investing philosophy and books as I was studying the more mainstream in college, for example, and in CFA. And so that kind of really gave me a perspective and helped me really think independently because I could see how different approaches could lead to different answers. And I had to always question myself, OK, what's good about this approach? What's bad about that approach, et cetera.

3:23And in terms of economics, not to siderell the conversation too much, but in terms of economics, it was similar. So mainstream economics, it's mostly going to Keynesian economics. I you know there's different schools of thought but Kenshin economics is the more mainstream or variation of it and I wasn't a big fan of the explanations of Kenshin economics of how it described the real world I don't think it's accurate in many respects and so I was doing kind of my parallel studies in other schools of thought of economics Chicago school and most importantly the Austrian school of economics which is where I eventually landed and that's I went to do my master's in economics in Spain because it's one of the few programs that really teaches Austrian economics in that.

4:09So anyway, that's a little bit of my background, but pretty much all throughout it's been finance and econ.

4:15Jose Najarro:Yeah, and very much with the focus on value investing, which can be rare too, especially in this current market stage, I suppose. So tell me Alina, what is your definition of value investing? Because there's a lot of interpretations. The classic, the cigar bush metaphor is quite common out there, but I don't think it can capture what value investing truly is. Yeah, and I'm glad you asked that question because value investing is either often misunderstood or at the very least reduced to a much smaller and narrower field than what it really is. and value investing to me is just really the idea of trying to buy an asset typically a stock or a business at a price that is below what it's actually worth right so it's you're trying to get value the same way when you go to the supermarket and you're trying to look for discounts you're trying to find value maybe you go and buy a brand that is not as well known but it's half the price and the value proposition there is better than the standard kind of mono known around, for example.

5:23So value investing is kind of similar where you're not necessarily going towards investing for what's popular at the moment, maybe so, but oftentimes that's not the case. But what you're trying to do is find a relationship between the quality of the business and price that is much better than what is out there in the market in general, so to speak. And the reason it's important to understand value investing from that lens is because right now, the conventional wisdom or the way people explain it, it's kind of been reduced to investments that are focused almost exclusively in mature companies and investments that have like low financial ratios, like price to book ratio, or most notably price to earnings ratios, and any type of ratios or financial metrics that are relatively low.

6:15And that's not necessarily true because you can buy a higher price-to-end ratio company that's undervalued and you can buy a low price-to-end ratio company that's overvalued. At the end of the day, what I like to say and what I express on my book is that every valuation has a set of kind of like implicit assumptions or expectations that are built into that valuation. So in terms of what growth the company is going to achieve, what reinvestment returns they're going to achieve with what they do with their cash flows, whether that's new projects, dividends, or whatever. And so what you have to think about is, are those assumptions realistic or not?

6:52If the assumptions that are embedded in the valuation are too optimistic, then it's likely overvalued because what's going to end up happening for you to get returns that you want, it's going to be less than what the assumptions commanded initially. So that's kind of how I look at it. And the important thing of looking at it that way is that you're not restricting yourself to any sort of type of stage of a business, whether it's mature or not. You're just focusing on finding value. And in fact, in our fund, our highest position is for a company that conventionally would be called a non-value play and a potentially potentially or end a high growth stock.

7:38But we consider it value just because relative to the expectations that we have, we think it's under value.

7:46Jose Najarro:That's great. From reading all the research and work you've done, it's very much a modern take on value investing, which can be rare because I think the stereotypical value investor is seen as some old man who's like kicking the tires of old utility companies and looking at, you know, free cash flow per share or whatever else. But it's so true about there can be great value in some of the fastest growing companies in the world out there too. And I think we'll talk about the book now. So Wall Street's Blind Spots is very much that bringing a modern approach to value investing. I just, I'd love to know what motivated you to write the book and especially a book that is almost calling out the wider finance industry in a small sense.

8:29Jose Najarro:So I'd love to know what spurred that. No, absolutely. And I love that question because there's really a lot of motivations towards the book. Some of them are like professional and career-wise. Like obviously having the book out there and being able to express my views to existing and potential investors, it's helpful because it instills more trust in them. right but then there's also kind of like the more personal side of what i was trying to achieve with the book and i essentially wanted to call out how typically wall street with very few exceptions misses the most important thing about what creates value in a company and therefore how to value them right and that's why i call it wall street's blind spots and it's all centered around one major theme that has kind of sub themes, but the major theme and the major blind spot that I try to call out and that I think most people ignore is that you can't simply analyze a business in terms of what cash flows you think they're going to produce.

9:33You have to analyze a business of, okay, what they're going to produce, but then what they're going to do with those cash flows. What are their capital allocation capabilities and philosophy? Because if you have a business that is great and it's producing good cash flows, but then they use that to repurchase stock at a high valuation, then your reinvestment returns of those cash flows are going to be low. And so then you're not necessarily going to be compounding. Similarly, if the company goes and does a huge acquisition with those cash flows, potentially even leveraging up for those acquisitions and paying a huge premium for that acquisition, then your return on reinvested capital is going to be potentially very low.

10:19And then the way I kind of like to think about it is good companies that can reinvest their returns at high returns on invested capital. Those are the companies that you should be willing to pay a premium versus traditional kind of valuation metrics like price-term use ratios or things of that nature. Because if you have a company that is reinvesting at north of 20 % returns their cash flows, that's what you want because that's really hard to obtain anywhere else. So if you think about the example I like to use, which is really simple to understand is think about Apple 20 years ago. Right. So they were launching at that stage, roughly the iPod.

11:02Right. And so they got a lot of earnings from that iPod. it was a success. But then they didn't say, okay, I'm going to go and grab those earnings and pay them back as dividends. What I'm going to do is I'm going to reinvest them into R &D and different things to create the iPhone. Perfect. That was a huge success. The return of reinvested capitals of those reinvested cash flows was really high, more than 20%, significantly more. So then they grabbed the profits of the iPhone and then they say, okay, I'm going to reinvest those and I'm going to reinvest them in headphones. That was a highly profitable endeavor with huge returns of reinvested capital.

11:40And then all of those earnings that you're receiving from all these business segments are being reinvested into new projects and new endeavors that have high returns. As individuals, that's very difficult to do. So essentially, when you're looking at a business and valuing it, you can't ignore the capital allocation piece. What they want to do with their cash flows, what they can realistically do with their cash flows. And at the end of the day, that's what determines whether you're going to be compounding returns in the future or not. So to go back to your question, the motivation was very personal in trying to kind of break that paradigm and shed more light on this understated and underappreciated reality that many value investors know.

12:21But even though they know it, they don't necessarily express it in the right way or all the time. and so i just kind of wanted to put my little grain of salt salt uh a sand out there and that's kind of a huge uh motivation for me yeah and then the beauty of apple as well is that they were

12:41Jose Najarro:making so much cash they could buy back shares a lot too exactly and then eventually they started to return a cash flow through buybacks which so far has been a good decision we'll see how it goes in the future. But that's important, right? Because if instead of doing the buybacks and the reinvesting in internal projects, they would have gone and done a huge acquisition and buy, I'm inventing here, but they would have bought Dell, for example, or at some point, Elon Musk wanted them to buy Tesla, for example. But they're doing it and acquisitions typically happen at a huge premium relative to the capital that's needed to create that underlying business.

13:22business, then your returns on invested capital are going to be low. And so that's a temptation that many businesses have and that fall through. And then thankfully, Apple didn't. And that's why they are where they are in part.

13:34Jose Najarro:100%. And when you're analyzing a business, you're looking for the reinvestment opportunities because eventually they're going to need to do something with their cash that isn't just redistributing it or you won't find growth unless it's an incredible business where it's just an expansive mode that has no threats whatsoever and it can just kind of iterate on that model there always needs to be a reinvestment opportunity it's what it's what builds amazon to what it is because it was so quick to reinvest and amazon's a great example for this conversation as well where that stock was never possible to value because it was never profitable up until i don't know 10 years ago maybe it was always reinvesting in itself but those reinvestment opportunities where the value was so it is an interesting uh it's an interesting take because these businesses are so hard to value absolutely and it's a great example amazon i'm glad you talked about it because if you had looked at amazon 15 years ago through the traditional kind of lens of okay cash flows of a business discounting them to the present or even just trying to do a price to earnings ratio that seems reasonable uh you would have missed the huge opportunity because you didn't have the focus on okay what's the returns that they can get on all of the kind of projects that they're working on.

14:50One of them, which was cloud, for example, in which they had a clear advantage at the time. It wasn't as visible as it is today, but one could have argued it was a clear advantage. And then everything that they're doing with logistics and improving their logistics infrastructure and all of those things, if you thought, which I'm not saying is easy to know in hindsight, everything's easy to know, But if you thought 15 years ago that those reinvestments were going to be giving a return invested capital that were really, really high, then you could have potentially said, I'm willing to pay a premium for Amazon and maybe a 35 times price terms ratio.

15:27It's still undervalued because the rate of compounding of the reinvestment is super high. But then you could argue conversely. And that's why I love the Amazon example, because now things may be shifting. I'm not saying that they are. it's arguable, but they may be shifting in that before the investing that they were doing within their business, I would argue had a more clear path to compounding and reinvestment success than it has now, because now they're investing huge amounts of capex, which is not bad in itself, if it has high returns on invested capital, right, which is what we're talking about.

16:04But right now, that capex is capex that can go obsolete in basically chips for data centers, and AI, right, that can go obsolete in the next three to five years. And so they're constantly going to have to be replacing that infrastructure. It's not like, you know, warehousing where you invest in warehouses and you have some maintenance capex, but they're going to last you 40, 50, 60 years, right, the underlying infrastructure. Here it's data center infrastructure whose underlying technology changes really quickly. And so the need to kind of replace it very often is very high. And so I would say that Amazon right now, even though it's a great business, the returns on invested capital might be much lower than they were in the past.

16:49And if you were to agree with me and you don't have to, but if people out there were to agree with me, then you would have to reach the conclusion that it's likely overvalued. Because with low reinvestment returns and potentially negative reinvestment returns, it doesn't matter what happens in the long term, you're going to be toast.

17:06Jose Najarro:Well, and this is a completely different conversation, but it raises the interesting point of just the sheer mathematics of large numbers. Or Google reported last week, and I covered the earnings, they upped their CapEx spend for just shy of$200 billion for this year, and it's going to significantly increase for next year. And if you're looking at this, the basic economics of if they want a 10 % or 20 % ROIC on that money, those ai investments are going to have to return 220 billion dollars 240 billion 250 260 billion whatever it is in the years coming and it really right of profits not of revenue because some people think about the revenue opportunity but the revenue is also associated with some costs in the pro a lot of costs in the process right to service the data centers but also the electricity that goes in for in servicing those data centers so it's turning to a billion of cash flows which means for just what they're doing this year which means that i need revenue of additional revenue of 300 billion or 350 billion or whatever it is right but sorry to interrupt you but i 100 agree with you no but it exposes the conversation as a whole and i think all these companies have just basically agreed that they're not going to get left behind and whatever they spend is going to be worth it which is an interesting take too and then you look at apple which is doing the opposite which is maybe either the riskiest thing anyone can do or the smartest thing anyone can do because they're kind of making the decision of okay we'll just decide who's best and choose them and we still have that physical space yeah and we won't invest in it so we're not subject to that potentially low or negative reinvestment risk right uh but it it google again it's also a great example.

18:51And in fact, for most hyperscalers, it's a good example of thinking about return on invested capital. Because like Google before, the reason why also they were able to compound is because they needed relatively little capital to produce the earnings and cash flows of what they were doing into new projects, or even just enhancing their search business, right? For the search business was extremely high margins, extremely low capital intensiveness. But now the tides have shifted, right? And what they want to do now is super capital intensive. And I don't want to deliver the point and repeat myself too much, but it makes it at least questionable.

19:40And so something that I'd like to say to people is you got to be cautious, right? Because it's not a question about whether ai is going to change the world i think we all know that in a way it already has right you know we work so differently than we used to do three years ago um but the internet also changed the world and the internet also got a lot of overhyped and it gave us a dot-com bubble which had then burst and produced a lot of negative returns for a significant amount of time right and so and i would argue that here the risk is even higher because the infrastructure for the internet wasn't necessarily as expensive.

20:17It was expensive more than people think. The underlying infrastructure wasn't free, but the AI infrastructure is significantly higher, I would argue.

20:27Jose Najarro:And you mentioned a good point there about obsolescence. So if you're comparing, say, the infrastructure that was built out from the dot-com bubble, an awful lot of it was like fiber optics, broadband and stuff, that's really useful even 20, 25 years on. whereas if you're talking about you know just stacking a bunch of high-end chips on top of each other and those being not not sufficient in five years time maybe that's that's that's the difference there in comparing the two absolutely absolutely but even in the internet if you think of like a Verizon and an AT &T right they had a lot of the infrastructure for the internet you know Cisco too and some others but the underlying infrastructure of the internet much of it was built by Verizon, AT &T and similar players, telecoms.

21:16And if you look at their performance over time since the era of the internet, it hasn't necessarily been great. And I would argue because of a similar reason. And that's despite the fact that you're right, that the underlying infrastructure is much more long-lasting than I think chips are and data centers are in terms of the need to replace them. but despite that reality they still have to kind of replace that underlying infrastructure over time and so they were kind of stuck in this circle where okay in order to retain my customers i need to invest in this underlying infrastructure so it's not necessarily a bad move from a business but once i retain those customers i need to keep them and the way to keep them is by updating my technology of telecommunications from 1g to 2g from 2g to 3g and well you can still use some of the infrastructure from 1G and the fiber optic technology from before, you still got to update it over time or otherwise you run the risk of being obsolete.

22:21And so it was still very capital intensive. And again, if you look at the performance of those businesses, it hasn't been terrible, but it hasn't been great either. And so I'm not saying that that's where Google and Amazon are headed towards. But that's a real risk, right? And that's a real risk that I'm personally not willing to pay a premium for.

22:45Jose Najarro:Yeah. Okay. Changing tax slightly, but staying on the same core themes here. You finished your CFA. Is it 2014? Is that correct? No, I think I finished it 15. 15? Yeah. 15. No, actually 16, I think. Okay. 16. Yeah. I started on 14 and finished on 16. So for a value investor that has invested for the last 10 years, how does it feel? Because you could pretty much pick at any point at that time that this was an overvalued market and you have been more or less correct. And yet still the S &P has returned like 14 % annualized returns over the last 10 years, over the last, I think, maybe 17, 18 years since the great financial crisis.

23:35Jose Najarro:How does that compute in your head? Because I think the risk for some value investors is the risk of sitting out. It's a great question and it's definitely a risk. And here the answer has several kind of points to it. The first one goes back to the original question. How do you define value investing? Because if you define value investing in that more narrow conventional way of thinking about it, like mature companies, low price earnings ratio, then yes, you probably would have missed out in a lot of the rally. And outperforming the S &P was probably impossible over the last 15 years, right? Or any other index.

24:15But when you look at value investing more as in being able to play also in new industries, newer ventures, high growth type companies, as long as they're undervalued. like I personally didn't invest in Alphabet 15 years ago, but one could have argued in 2010, I think very convincingly so, that at a 20 times roughly price to earnings ratio, Alphabet was under-rallied at that time. Again, in hindsight, things are easier. But if you look at value investing in that way, you won't necessarily miss out. So that's the first thing I would say. The second thing is part of the difficulty of a value investor is that patience is required and patience is really hard, especially if you're going against the type.

25:06Like, for example, right now, even though we do have high growth companies, we're pretty much almost entirely, there's a few exceptions, but almost entirely out of anything that's AI. And that's regardless of the layer we're talking about, whether that's the infrastructure layer, whether that's the application layer, we're almost entirely out of AI. I mean, all of our companies are using AI in one way, shape, or form, right? But I mean, people who are trying to develop an AI themselves or provide the infrastructure for that development. We're almost entirely out of that. And for now, that has been like a bad decision, if you want to call it.

25:44I mean, if you look at what the index of the chip index, SOXX or something like that has done in the past year or so, it's incredible performance, right? But when you study history and you look at how things eventually, even though they take time, can revert and when they revert, they can do so very strongly and for a long period of time. That's what you kind of need to go back to as a value investor and not fall into the FOMO trap. right uh and if we could have had like this same conversation now for example we could have had in 1999 or even early 2000 where we're saying look the s p 500 and the indexes and the dot com stocks have done incredibly well over the past five to eight years and it's been a bull market since early 1990s to 2000 that's a decade long right but if you had bought at the peak at 2000, you wouldn't have made in the S &P 500, you wouldn't have made a cent until 2010.

26:50That's including dividends. And if you exclude dividends until like 2012, 2013, right? And so as a value investor, we're more focused on protecting the downside and being like, we don't want to be subject to that possible scenario. We're willing to maybe forego some upside. And In case we're wrong, we're willing to forego that, but we're not willing to risk the downside because the downside is where you, over the long term, is where you can recover well. And the reason for that, and I always like to say this, is because gains and losses are not symmetric, right? And so say you invest$100 ,000 in any investment, in a particular stock or in the S &P 500, whatever you want to call it.

27:32If you lose 50%, that brings you$100 ,000 to$50 ,000. And if that's a permanent loss and not just part of volatility of the market and your stock, to get back to the$100 ,000, you need now 100 % return. And so it's much more difficult to recover from a big permanent loss than it is just to be having kind of more steady returns but not subjecting yourself to a big loss. right so part of it is that temperament that you need to have and not try to follow uh the narrative and then again going back to my first part of the response part of it is knowing what value really is and you can't just stick back and stay in the insurance companies and the banking bank companies i mean you can't play there and we're suddenly there to some extent but you can't just avoid anything that's growthy just because the market seems frothy or overvalued at large yeah and it's