MI280: Deep Value Investing in 2023 w/ Tobias Carlisle

25:17The value portfolios, on the other hand, have the opposite effect. The growth tends to go from negative to slightly positive, and the multiples tend to expand, and then all of the metrics start looking better. their returns on invested capital start improving, everything starts improving, and that is mean reversion. And when people see that through successive reports, that tends to be why the multiple expands, the business starts growing. And that's where I try to be. Historically, the research shows that that tends to be the better place to make you bet. It's much more forgiving at that point.

25:49You can be wrong on a few things and still, as a portfolio, do pretty well. So I think that the last few years have been anomalous for value. Historically, it's done very well despite what Charlie says. I see all of the signs of mean reversion still being there. It's just that multiples have been running against us. And at some point, they'll go the other way. And when that happens, everybody will be a deep value investor again. In Meta's case, the mean reversion happened quite quick, you could argue. And it was in your screener and then it was out. So how long do typical mean reversion trades last?

26:22The research seems to show that undervaluation leads to excess returns going out to about five years. But the returns are asymptotic, which means that the bulk of the returns in the first year, then there's a smaller amount in the second year, less in the third year, less again in the fourth year, less again in the fifth year. And by the sixth year, you should expect to get about a market return. The challenge for hold forever investors is that they have to find something that is predictive beyond five years. And as far as I'm aware, there's nothing. High returns on invested capital, what we all want to hold, it's not necessarily what you want to buy because when you buy them, they tend to mean revert down.

27:06So, you're trying to buy things where they'll be mean reverting up, which is what you find in value. So, five years, but the bulk of it is in the first year. The way that I do it, I'm not, so Buffett characterizes himself as wonderful companies at fair prices, and he seems to have been very, very good at selecting those things that do continue to grow and compound beyond the short term. And I think really what he's achieved is he buys these great businesses when they're at deep value prices. And then he gets that mean reversion in the first few years. So you think about his Apple position where it was one of the cheapest 10 % of the market when he bought it again.

27:40So I've written about Apple a few times because it's a funny sort of stock that was quite cyclical for a while. It doesn't seem to be so cyclical anymore. The price more than the actual underlying, but they had this iPhone replacement cycle that sort of happened every two or three years. So, I read about it in 2013. It was one of the cheapest stocks in the market. It was also a very, very good stock at that time. And then, you know, it did quite well over that next three years, but then it went back into another one of its sort of three-year annual sort of reversion to value territory. And it was, again, cheapest 10 % of stocks.

28:11And that was when Einhorn and Icahn took a position. Einhorn said they should turn their cash in to create this security called an iPref, which would have paid out some money. It's just a financial engineering way of getting some credit for the additional earning and the money that you have in the business. Icahn was sort of much more direct. He said, just go and buy back a whole stock, which they ultimately did. They undertook the biggest buyback that the market had ever seen at that point. They did it as quickly as they possibly could. They were earning so much cash when they completed it, they had a huge cash pile again.

28:42It got cheap again in about 2019 for whatever reason. Cheap is 10 % of stocks again. Buffett bought a giant position. He paid$40 billion,$36 billion, I think. And it had sort of gone up three times about 18 months later. It's now like a five bagger or something crazy for him on a gigantic investment like that. What he does though is he buys these things that have that deep value mean reversion in them. So he's going to get that two or three X over a short period of time over the next three to five years. But then beyond that, it's still a very good business. It has a very good ecosystem. It's earning higher returns on invested capital and growing and throwing off cash, returning cash all the time.

29:23They've just announced another$90 billion buyback, which I think is a nice illustration of the difference between Buffett's approach and Icahn's approach. Icahn sort of buys a big position from the outside and screams at them until they do a buyback. Buffett buys a big position and then from the inside clearly has the same conversation but doesn't sort of attract as much ill feeling perhaps. And they have another$90 billion buyback. So I think it's a good illustration of getting a little bit of both, getting the mean version of the deep value companies and also getting the subsequent growth. I think that it's much, much more difficult to do it than it looks from the outside.

30:01It's not just a matter of every quality investor finds a moat in every single business that they look at that's earning high returns and invested capital. But if you look at it as a cohort, there are many more high returns and invested capital than there are moats because most things have a business cycle or a business life cycle even where. So the business cycle is when times are good, they earn a lot. When times are bad, they don't earn much. The business life cycle is they go through this period of very high growth and then they go through a period of very high profitability and lower growth.

30:32And it's that point where it transitions over that they get slightly lower multiples. And that tends to be, I think, where Buffett buys them, where they turn into cash cows and they're returning a lot of capital to him. So, famously, he's bought Oxy recently, which is an energy company. And the reason he seems to have been attracted to it, and he's explicit about this because he took a slide from Oxy's presentation and he put it in his own Berkshire presentation. And the slide showed how much capital they were returning to investors because he doesn't want them reinvesting in. There'll be an energy cycle here probably.

31:03We've underinvested in energy for a long time. It's becoming increasingly difficult to extract energy anywhere to extract oil. We're doing deep offshore drilling for oil now. It's heroic, sort of what we're doing now to get all this, the shale, which is very short term. So companies that have access to these deposits are likely to over-earn probably for a period of time here. The risk though is that you have a management team and this will undoubtedly happen across the whole industry. They'll take all of those earnings and they'll reinvest it in the chase for more earnings down the road. When they reinvest it, they'll overpay.

31:38That's just what happens through a cycle. So he's taken that slide that says this is how much they're going to return and then he's made that public and he's told everybody what good friends he is with the CEO and they've had this conversation. So he's really putting a huge amount of pressure on them not to do that, not to reinvest. He's asking them just to return that capital to him so he can redeploy it and other things. So the challenge for quality investors is finding those things that really do continue to earn beyond that. I think it's very, very hard to do, much, much harder than most people appreciate.

32:09The way that I sort of get around that is I'm trying to buy, I think from the deep value pool, there will be companies that turn into compounds. It's kind of hard to believe, but I've been doing this for long enough now that I've seen it happen over and over again that they're cheap because people don't think they're very good businesses. But at some point, they transition. Either they figure it out or the industry matures or whatever happens or the business gets access to some asset that they haven't had previously and they start over-earning. I think that we're likely to see some of those businesses through a normal business cycle over-earn.

32:39I hope that I own some of them, but I tend to be a buy and sell. when I get that initial year or so return. And I think Meta is another very good example of that where we were buying it about this time last year. We bought it a lot as it went down. We've trimmed since it's gone back up. And as you point out, it's now left the screen. And so, it's probably likely that it leaves the portfolios in due course here.

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36:20That's theinvestorspodcast.com slash tip-finance. All right, back to the show. When it comes to deep value and your screener and the acquirers multiple, what are other things you look for in terms of quality for companies you're going to buy that fit your valuation criteria that I just mentioned? Yeah, I like to see businesses that have this long period of operation where they have, it's a real business. They've been earning money historically. They've gone through a rough patch. Energy is a great example. Energy businesses, when they get going, they will look like software as a service. They'll have massive returns on invested capital.

37:00They'll grow really quickly. They'll generate a whole lot of free cash flow. People avoid them because the last 10 years look terrible because they overinvested for the 10 years before that. And a lot of that went into the shale. It reduced returns. There's also an ESG push. So, they've been starved of investment. At some point, that will turn around. I don't know when. I can't. The problem with value is that it's a terrible timing tool. It's not good at all at predicting when any of these things will happen. All you can say is that something is undervalued and that if it continues to work, then if the underlying business continues to work, then it'll be fine.

37:38So, if you think about the things that you would, I think like a business owner. I've run a small business. I think like a business owner. The things that I know that the business needs are, for one thing, you need cash flow. Accounting earnings are great, but businesses live or die on cash flow. So I always like to see lots of cash coming in the front door. Then I like to see what management does with that cash flow. Are they redeploying it into good projects? Are they using it to buy back undervalued stock? Are they using it for overpriced acquisitions? Are they using it to pay themselves too much?

38:07All of those things tell you management's attitude towards shareholders, and that's important because they get first look at the cash flows. And to the extent that they waste them, it's not going to translate into value for shareholders. But to the extent that they use that undervaluation to buy back stocks, it can really turbocharge returns for investors. And you can find many examples of companies in the market where the underlying business is shrinking. The underlying business is going backwards like O 'Reilly or AutoZone or many those businesses are in that sort of HPQ, which is the Hewlett Packard, the printer business, not enterprise, not the sexy part of the business, not the services, but the printer business where I've got a printer.

38:50I think I paid 300 bucks for it about three years ago. The only stuff I print out is stuff for the kids to color in. It's hardly used for business at all. Everything's done in PDF. Now, I know that it's a dying business, but they've been so good at buying back stock. The stock has done very well, and it's a stock that I have owned, but I don't currently own. And there are lots of companies like that. So, I like big fat buybacks of undervalued stock where they're generating lots of cash flow because over long periods of time, that will lead to very good performance. And it tells you what sort of management team you're dealing with.

39:18You've got a management team that is thinking like an owner and that's really the key. That's why Zuckerberg, for all of my joking criticism of Zuckerberg, he is a good businessman and he does run that thing for the shareholders for the most part. So, they've been very good at buying back stock when it was cheap. He's figured out at some point here that the metaverse probably isn't the direction that everybody's going. It sounds like AI now. If he'd said AI 18 months ago, they probably would have been fine. But instead, he said the metaverse. Now, AI is very, very popular. They'll probably say AI a lot now coming up.

39:49But the point is that whatever happens, they're doing the right thing because they're buying back stock. They're running their business pretty well. They're generating lots of free cash flow. They're doing the right things with it. So, that's the way that I think about it. Just what would I do? What would a business person do if they're in there looking after the shareholders and to the extent that they're doing those things, then I think that that makes them much better bets than otherwise. How important is the portion of returns in the deep value strategy of buyback yields, companies buying back shares, whether they buy it at a high price, a low price, and also from the dividend yield?

40:23How important is that or how much of a piece of deep value investing is that? I think in aggregate, share buybacks are terrible for investors because share buybacks tend to be done at there are many more examples of companies that are overvalued and they see some weakness in their share price and they're just used to these share prices going up over time. And they think that to sort of prop up the share price, what they will do is conduct a buyback at a very high level. And you can see there are all these calls for if you follow Tesla at all, you know, Tesla's now free cashflow positive. I think Tesla's been something that's defied my expectations.

41:00So I should be very careful when I'm commenting on Tesla because I know a little bit but not a lot. But if everybody will just excuse me while I give my two cents out of it. Tesla somehow made the leap from it wasn't making very much money to sort of generating free cash flow. So it seems, it's hard to tell as financial statements are very difficult to pass for me, but it seems that it's generating free cash flow. Just because the stock prices come back a little bit, there are all these calls for them to use that free cash flow to buy back stock, which I think would be an absolute disaster for them.

41:28They're much better off reinvesting in the business to the extent they have any real free cash flow. It's still too expensive to do buybacks. But this is what every other management team does. They do these buybacks at too high a level and they tear up value when they do that. You'd much rather have the cash than have them buying back stock. If the stock is very undervalued though, it has a different effect. The cash buys more value. A dollar of cash is worth more than a dollar of value in a buyback because you can buy these things back undervalued and it concentrates the value of the business.

41:58The business doesn't shrink. The cash, which wasn't being used anyway, is used to shrink down the size of the company that owns the business. And so the shareholders who remain get to own a bigger portion of the business. And if they do that over a period of time in series, then you can find there are lots of companies that are very good at buying back shares and they've shrunk their share counts by enormous amounts. Assured Guarantee is a great one. AGO is the ticker. you can look at the shares outstanding coming in all the time on that business. And they publish in their reports what they think their adjusted book value is because it's an insurer.

42:29They publish adjusted book value, which is a pretty good proxy for what the actual thing is worth. And they're trading a big discount and buying back stock. That's something that should work out over a long period of time. I don't hold AGO, by the way. I just use an example. It's something that I have owned in the past and watch. Buybacks are not so much. You're right in the sense that they're short-term in the sense that it doesn't really do anything for the ongoing business to do that. Some of the cash goes out the door. But for shareholders, it tells you something about the management team and it actually does improve the value of the shares that you currently hold.

43:01So for those two reasons, I'm a big fan of buybacks done at undervaluation. And because we're using our screen, screens are imperfect. My screen is particularly simple because it's only one metric, it's EVE, and then I screen out some of the things that I think are frauds or earnings manipulators and so on. But what remains is a very broad swathe of the market. And so it might help to do some additional work in there looking for cash flow and other things like that. But we've got this thesis for the companies that are in that screen that they are undervalued. And I love to see it confirmed by a management team who says, yeah, we think this is undervalued too.

43:38We're announcing a material buyback. We're going to use genuine free cash flow or cash that we have sitting around that's not being used in the business to buy back stock and shrink it down. It tells me the management agrees that it's undervalued, tells me that they have the free cash flow to do something about that, or they have the cash sitting there. And it tells me that they're thinking about the other shareholders. And those are three very good things. If you only screen on share buybacks or total shareholder yield, which is the same sort of idea, and you just buy the best, the ones that have the highest yield, so the biggest buybacks relative to the size of the business, that strategy will outperform the market.

44:11So I like it in addition to my own sort of undervaluation. The two together are very powerful. So I like it a lot as a strategy. It's supported empirically and I think it's supported intuitively. I believe I heard in a previous interview you've done, it might have even been with us, that you exclude heavily shorted companies. Is that correct? I do. Shorts are smart. Shorts are very good at ferreting out things that might not be obvious to long-only investors like me. Sometimes there are things in the business that aren't obvious from the financial statements. And I think short interest is a really great way of finding those things out.

44:54So it's supported empirically. There's lots of research on this, and I have conducted my own research. Heavily shorted stocks just don't do very well. They tend to underperform the market. That doesn't mean you want to be short those stocks because heavily shorted stocks have a lot of competition for shorts. The borrow is very expensive. You can be short squeezed. You don't want a lot of people in there agreeing with you. When I used to short, I used to screen out from my short screen, also the most heavily shorted stocks for that exact reason because I don't want to be... One of the things I think as an investor, the way that you get good returns is you buy things that people aren't paying attention to.

45:30It's too boring. It hasn't done anything for a long period of time. It's too scary. It's in a business that nobody wants to be associated with. You look silly if you buy it. Those are all things that are great. It also works on the short side. They get crowded. You don't want to be in a crowded short. But you don't want to be long something that's a crowded short either because the shorts are probably right. So I just use it as a sort of, it's my market gauge of, are there things out there that silly longs that for whatever reason, they pass the valuation filter and the buyback filter. But there are some smart shorts out there who figured something out about this business that I can't see from the outside.

46:07And so, I just use their skill that they're actually putting, it's not just an opinion, they're putting their money down to short these things like they have some skin in the game. So, I think it's a very good metric and I use it to avoid landmines that should have been obvious. Having said that, it's very rare that short interest excludes something from the kind of companies that I'm buying because the kind of companies that I'm buying tend to have cash on the balance sheet, very free cash flow, generative and conducting a buyback rather. That's not a company that you want to be short for the most part and they're not.

46:38They just tend to be different universes. But I do these things because and I include in that, I do... So, I use these statistical measures of earnings manipulation, statistical measures of financial distress, statistical measures of fraud. And you find that they all tend to be coalesced together. You don't need to go and do any earnings manipulation if you're not in financial distress. If you're doing really well, there's no need to manipulate the earnings. There's no need to commit fraud. It's the financial distress that drives them to do desperate things. And so when all of those things are together, and I include the short interest in there just in case for whatever reason it just misses all those other screens, but there's something in there that you should know about that somebody else has figured out and they've put money down and bet on it.

47:18That's a good thing just to avoid it until the short interest drains away. Maybe it's a short-term issue. It'll come back into the screen eventually. Maybe it's fatal and then you'll have just avoided a donut. But yeah, I think it's a good metric. So, what's an alarming percentage where you might be worried or it would cause red flags if you see this amount of short interest? What percentage is that for you? I actually don't know the answer to that because the way I do it is I just exclude the most heavily shorted stocks in the market. So I think I only exclude the 1 % that are most heavily shorted, which in my bigger universe, which is the 1 ,000, 1 % is 100 stocks.

47:59And in my 2 ,000 stock universe, 1 % is 200 stocks. So it's whatever all the shorts have basically decided is most shortable. And I ran the Zig when it first came out, it was long short. And so I had a short screen in there. And the names that were most heavily shorted that didn't make it into my short screen. I don't really know what they were either, but shorts are always present in every single stock that you own. It'll be 5, 10, 15, and that's meaningless. It's when it gets up to, but I don't know. It varies a little bit because the conditions for shorting are a little bit cyclical too sometimes.

48:34We're probably going to go into a period now where it's going to become very difficult to short. There's some political unease with the shorts in the banks because banking is a confidence game, really. And I mean that in both senses of the word. Regional banks have got some problems because office is so beaten up post-COVID. Office occupancy rates are still at like 50 % where they were post-COVID. It's going to take a long time for that to work its way out. But there are many buildings that can't pay their interest, and all of that debt is held by regional banks. The big increase in rates has meant that a lot of those books are underwater.

49:11I have a list of those banks and it started with Signature, Silicon Valley, First Republic. There's others in there like PacWest, Ally, all of these things. And I've just watched them go down that list and each one of them, it started with the most egregious examples. And as each one topples and the next one sort of comes into the crosshairs, and so the regulators say, well, that's because the shorts are kind of causing this. It's not the shorts at all, but as soon as there's some political will to stop the shorts, then the short interest metric is going to not be as useful as it was before. So we saw this in 2008, 2009, they banned shorting.

49:48They'll do it again. When this market gets crazy, the day that they ban shorting will be one of... Who knows what could happen in the market that they could be up or down 10 % easily because that might be a signal that we're in some real trouble and it might also be a signal that people are going to be forced to cover. It's coming. We're not there yet, but that's why short interest as an absolute metric, I don't really know and I don't really look at it. I just try to exclude the ones that are most heavily shorted, knowing that there will be periods of time like we're about to go into where the metric might not be as useful as it has in the past.

50:20How do you think about, with your investments, either potential ones or ones you currently own, how do you think about insider selling? Are you not too concerned with it because maybe it's just a personal thing? Maybe they need some money to buy a house or pay for their college fund for their kids or whatever the situation is. So it's not too big of a deal or is it sometimes alarming? What are those situations where it might be alarming? Most executives are sellers most of the time. So it's hard to tease out what is selling because something bad is going to happen and what is selling because they've had a little bit of a windfall because they've had restricted stock units or options or something else and they're just taking the cash.

50:58Or when they get options, the options have a strike and you still have to pay the strike. And so not everybody has those large amounts of cash lying around to pay the strike. So they tend to be sellers just so they can pay the strike on the options. Selling is a very tough one to draw any information from for the reasons that you point out that they sell for lots of reasons. You want to buy a house, you want to buy a car, you want to pay the strike. Better information is when they're buying because they only buy for one reason and that's because they think it's undervalued and really it's and you have to be careful too with those because it's hard to separate out which ones are just options being converted and which ones are actually these guys putting their hands in their pocket to buy some stock.

51:38I don't use it as a metric. I like that, you know, if I was thinking about an individual stock that I really wanted to size up big outside of my screens and I don't hold anything outside of my funds but if I was thinking about buying one single thing, so if I I wanted to buy like a Berkshire as like a big holding of mine or something like that. I would then go and look at what insiders are doing. And I think that you're looking for, say, you know, Moderna. You can go and have a look at the selling in Moderna. Those guys knew that what they had was a short-term chance to sell every single share that they had.

52:11You know, Moderna was one of the producers of vaccines. It's clearly that was only going to be a short-term thing. Any of those businesses that were beneficiaries of COVID, they were just flooding that all of the stock that they held. it was going out the door, it was a fire sale for all of those things. So, you could go and look at the selling of those. That would give me pause if I saw every single executive selling every single share that they possibly had. But I think for the most part, executives are not great at understanding the value of their own businesses, funnily enough. I know that which is why they buy back stock at too high a price, which is why they sell stock all the time.

52:43It's a rare executive really who understands the value of the business. And they tend to already be the owner operator, the main person there, the entrepreneur, the founder, or they're a very good investor in their own right. So Buffett would be that example. And other guys like that, there are other owner, operator, investor type guys out there. And so I watch what they do. Most of the others, I think it's largely noise. As we wrap up the show today, before I let you go, tell the audience where you want them to go online to find you, get your books, your information, your content, where should they go?

53:16I have a website, acquirersmultiple.com and that has links to the books. It has the screener and I think it has a link to my Twitter account, but my Twitter account is greenbacked. It's G-R-E-E-N-B-A-C-K-D, which is a funny spelling. I have some books. If you search my name in Amazon, you can also find the books in Amazon. And I manage a firm called Acquirers Funds and it has an acquirers fund, which the ticker is Z-I-G, that's mid-cap, large-cap, deep value in the States. and I have another one, deep, which is small and micro deep value in the States. I think that the opportunity in both of those is unusually good right now because we've seen a few years of weakness and the valuations are incredibly compressed in that portion of the market.

54:05I think probably there's going to be some more volatility before that gets resolved, but I think that the next three to five years are unusually good for US deep value. Awesome. I'll be sure to put a link to all your resources in the show notes below for anybody that's interested. Just swipe up in your favorite podcast player. You can click the links in the show notes below, or you can go to theinvestorspodcast.com. Find all the links there as well. Tobias, thanks so much. My pleasure. Thank you very much for having me. It's always a pleasure. All right, guys. That's all I had for this week's episode of Millennial Investing.

54:38I'll see you again next week.

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