MI311: Quantitative Wisdom: Lessons for Qualitative Investors w/ Tobias Carlisle

23:11That's why they built an investing platform for those who take it seriously. On Public, you can put together a multi-asset portfolio for the long haul. Stocks, bonds, options, crypto, it's all there. Plus, industry-leading yields on your cash with no fees or minimums. Switch to the platform built for those who take investing seriously. Go to public.com slash T-I-V-P and earn an uncapped 1 % bonus when you transfer your portfolio. That's public.com slash T-I-V-P. Paid for by Public Investing. Full disclosures in podcast description. Just like everybody else, there was a time when I was a beginner investor, and I have to say, investing is particularly filled with jargon that can just make it so difficult for new investors to understand what is going on.

23:56But it's never too late to get smarter about stock investing from the ground up. At The Investor's Podcast Network, we've made a habit of studying the world's best investors, and now I'm distilling those learnings into a simple course for you, or for anyone in your life who you might want to share the gift of knowledge with. With my How to Get Started with Stocks course, you can master the principles of excellent lifelong investing with valuable insights for both beginners and pros. The course covers 10 different sections, beginning with the basics of what a stock actually is and how the stock markets work, to strategies to optimize your retirement savings, how to pick great companies for the long term, what to look for in ETFs, and how to monitor your investments, plus so much more.

24:35To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks. And for a limited time, you can use code STOCKS15 for a 15 % discount at checkout. All right, back to the show. So there's an interesting Credit Suisse research article that was released in 2013. In it, they had some interesting findings on high quality businesses. So they determined that there was little evidence of mean reversion for a company's operating performance. Companies in the top quartile remain there over extended periods of time.

25:13Great businesses remain great. Only 9 % of the top quartile moved to the bottom quartile, and 79 % of the top quartile remained in that top half. Poor businesses continue to report poor performance. 6 % of these had a chance of moving from the bottom to the top quartile. I'd love to get your thoughts on this research piece, given all the work you've done on regression to the mean. If it's credit suisse, it's probably Michael Mavison. Was it a Mavison? Mobison has done some research where he says, he looks at 10-year rolling periods and he ranks all these companies on return on invested capital.

25:48So this is one of the little, when we're talking about quality, there are lots of different ways to measure quality. And return on invested capital is sometimes used as a quality sort of metric. And I think it is a quality metric. It's just that it could also be a profitability metric. And profitability can be a little bit mean reverting. Quality could be quality of the balance sheet, quality of the earnings, recurability, predictability of the earnings, all of those sort of things. So I do think it's certainly the case that there is some momentum in earnings and some of these businesses that do tend to do very well or continue to do well.

26:26If you've got a good niche where you're making money, you've got money flowing in and you've got a sensible management team that's not over-levering the company or doing anything silly like doing silly acquisitions or something like that. They're just focused on what the business is and they keep on doing that. That's what Buffett is hunting for. Ideally, they're kind of returning capital rather than going into slower return investments, which sometimes that tends to happen because they get a bigger empire if they do that. That is the case that there are a lot of these things that are excellent businesses that just keep on doing that.

26:58The problem is that on a risk-adjusted basis, on a valuation-adjusted basis, you can still overpay for a company like that. Now, it may be the case that a really good quality company, you can overpay a lot and the quality of the company will bail you out eventually that it'll catch up. But I have seen it happen enough times that some of the late 1990s, everybody remembers the late 1990s as a dot-com bubble. And it certainly was an element of it being a dot-com bubble. But really what it was, was a large cap growth bubble. And the companies that were, we all agree that they were high quality companies.

27:30So we'd be talking about Microsoft, Walmart. I can't remember the rest of them off the top of my head, but they're all big recurring revenue companies that are very stable. And from 2000 at the peak of the bubble to 2015, when it took them that long to work off their overvaluation, they were still growing most of the time through their extraordinarily high rates, still being high quality companies. It's just that the stock did nothing for that period of time. You're not trying to find the best quality company. You're trying to find the best handicap odds. So, you're trying to find the thing that you go to the racetrack, you're not trying to find the winner.

28:08You want to find the show or the place at good value. And that's how, I don't know, I don't want to say that's how professional and racetrack bettors do it, but that's what I would do if I was a professional racetrack bettor. You're trying to find the best return for the unit of risk that you're taking on or the best return. I think that's right. The best return for the unit of risk that you're taking on. I do think that it's certainly the case that the underlying business can do very well. But as an investor, that's only half of the equation. The other half is trying to find good value and good risk-adjusted returns.

28:37And so, the ideal scenario is like that's really what Buffett is doing is he's got that list of very high-quality companies that compound and grow with great management teams. It's just that they don't ever get cheap enough for him to buy. So, he sits there not buying them. And then he waits until that scenario happens where either it's a system-wide collapse, the market collapses and all of this stuff gets cheap, or there's something that happens specific to that stock that doesn't impact the business. It's just that the stock gets knocked. So American Express with the salad oil scandal in the 60s is a good example of that where he famously went and sat beside cash registers at restaurants and saw them.

29:16The The consumers were still presenting the cards. The restaurant was still accepting the cards. It hadn't impacted the most important part of the business from his perspective, the salad oil scandal. I don't know if your listeners know that story, but I'll tell it very quickly. It was basically, there was this guy, Anthony Tiny DeAngelis, who was a speculator in salad oil, in soybean. I think it was soybean oil, something like that. And he was trying to corner the market, which is where you buy up a whole lot of oil and you squeeze anybody who's short and then when they come to buy, they can only buy from you at a very high price.

29:51He kept on buying oil and the price went against him. And so, he ended up coming up with the tanks had to be stored somewhere. So, he had these warehouses that store the tanks and he used seawater to make the tanks look like they were more full than they were. And he had these little devices where when the inspectors came and put a little dipstick in to check that there was oil in there, it just went into a little tube and the rest was seawater. And then he also had some pipes that he moved the oil around. I was very clever. The amount of effort that went into the fraud, if only you'd found some way to do it non-fraudently, he probably would have been very successful.

30:22But eventually, the soybean oil market collapsed because they figured out that this guy, somebody pointed out he had more oil in his tanks than there was in the entire world, which meant that that was not possible. And so, he got liquidated. It wiped out some of the banks. And then American Express had this business where they would give these warehouse receipts, which is how you turn a commodity into something that you can trade to borrow against. And so, it was American Express who had said, yes, he does have this oil in his tanks. And it turned out that was not the case. And so, they went and sued everybody they could think of, the brokers and everybody, including American Express.

30:54And American Express had the deep pockets. And so, American Express could have been on the hook for, it was like 60 million bucks or something like that. Buffett looked at it and figured out it was unlikely to be as, the payout was ultimately unlikely to be as big as that. But even if it was, it'd be like a one-time dividend that they wouldn't collect. And it would keep on going, provided that the business franchise wasn't impacted. And that was why it was so important that he went and sat and looked at people were still handing over the card, people were still accepting the card that likely was going to work.

31:20So, he put 40 % of the business in. He was at that stage a much more deep value investor. And so, he was really just playing on the crisis, expecting that he would buy it and it would bounce. And then he would basically get out. And so, he did that and he made some good money doing that. But then he revisited it when he was running Berkshire. So, this was when he was running the partnership and he revisited it when he was running Berkshire Hathaway. And it had grown enormously over the period of time that he had been out of the stock, whatever it had been, 10 or 20 years. And he used it as an example or he learned from it himself that you buy these things when they have that little moment of weakness and then you just never sell.

31:55You just let the underlying business chug ahead and that's how you get your great returns. Ultimately, that's where we're all trying to get to that kind of investment style, but it's a very long process, I guess, to get there. You talked a little bit about uncertainty and there was a really good quote in your book by Seth Klarman, which was, quote, high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. How do you relate this quote to courage in investing? That's something I've been thinking about a lot. So courage is not something that you want in an investor, I think.

32:31Particularly through the whole 2020 stock market bubble, and even now when we're back, everybody's pretty bullish at the moment, maybe less so over the last few days, but pretty bullish. I look at things that say when Nvidia ramps, I would say, if you just look at this on a fundamental basis, this is probably likely very, very, this is too expensive. It's crazy. There's so much growth implied in this valuation. And I'll get all of these people come in who are much more brave than I am. I absolutely love that quote from Klarman. And I just think it's such a true... There are these times in the market where the market goes down a lot and it comes through Twitter and it comes through the news and I can talk to people.

33:14And I get a little contact high from looking at Twitter. I can feel the adrenaline of people. I can feel how nervous everybody is. and you can tar it when the portfolio is whipping around then. That's often the best time to be investing. And so rather than rely on courage to kind of charge in and spray money around in that, I like to just... I think the simpler thing is just to remember what you're trying to do and to focus on the valuation rather than the price. And you get these... You can say, yeah, it's possible that I'm buying too early and I'm going to get a better price if I just wait. But it's also possible that the price just bounces from here and I completely miss it.

33:53So you just look at the opportunity set that you have. Klarman has another quote where he says, the best investor is a contrarian attached to a calculator. And that's kind of the way you need to think. Not so much. I know in my Twitter profile picture, I have something like contrarian, but I mean it in the sense that I use that word specifically because there are two very famous papers in investing. One of them is the paper by Fanner and French, where they talk about the efficient market hypothesis. And they also talk about the factors. And one of the factors is value, which they define on a price-to-book value basis.

34:28One of them is size. Then there's the market. And then I think that was the initial paper. There are only two or three. What am I missing there? Size, value, maybe momentum. I forget what's in that first paper, but pretty hot on its heels. Another paper comes out by Lekonisik, Schliefer, and Vishny called Contrarian Investment. And their idea in that paper was the market is not perfectly efficient. The market is filled with people who make behavioral errors because they extrapolate. So he contrasts these two investors. There's the extrapolation investor who looks at earnings going up or stock prices going up and just sees that keeps on going up forever and ever.

35:04And then he contrasts and he calls those or they call them naive extrapolation investors. And then on the other side is the contrarian investor who expects min reversion. and so expects the very high rate of growth to slow down or the earnings going down or the value being compressed to turn around at some point. Clearly, it's better to be the contrarian investor. The contrarian investor gets better returns. I mean, it's objectively, empirically better to be the contrarian investor. So that's the way that I use that expression. But the point is that you're not so much, it's not a brave step to go in and buy those things.

35:37It's just an application of the same thing that if the market collapses tomorrow, it'll make no difference to the way that I invest. I always do the same thing. I'm always, because I have the funds that I run are both long only. There's long only fully invested all the time. And I've looked at lots and lots of different ways. Intuitively, I don't like being fully invested all the time. I would much rather carry cash. It's just that my inherent bearishness makes me want to pull back all the time. And I think you're better off. And this is where, when I've looked at it, and I've looked at lots of different ways of trying to time with a little bit of cash and just none of them work properly.

36:11The only thing that you can do is give yourself a... Buffett says you can have... I think he says you can have a smooth 12 % or a lumpy 15%. And that's basically what I found. You can quantitatively demonstrate that you can have the smooth 12 % or a lumpy 15%. And the difference is really when you're remaining fully invested or holding a whole lot of cash. And so, of course, you want the lumpy 15%. And if you've got a long time horizon and you don't want to use that money. So I remain fully invested all the time. I don't try to time the market. If it collapses tomorrow and we're down 50%, I'll still go through my regular rebalance.

36:48I'll buy whatever's cheap and I'll keep on going. It won't make any difference at all. So there's no bravery in it for me. It's just implementing the same program all the time, whether it's high or low. So one common feature of the investors that you looked at in concentrated investing was that many of them had permanent sources of capital. This allowed them to utilize behavior, which could endure volatility, like you just discussed, without worrying about capital exiting. Why do you think most other investors with permanent sources of capital don't take advantage of this? There's not a lot of...

37:19Buffett describes it as an inoculation. I remember reading the Buffett book by Roger Lowenstein, The Making of an American Capitalist, and just thinking... And I didn't really know anything about the markets. Mom and dad weren't like stock market people. I didn't really come from a market background. And I read that book, and I was like, oh, this is interesting. There's a method to this. And also, I like the fact that he talked about honesty and character. And I had always thought businesses about being ruthless and being aggressive. And that didn't really appeal to me much at all. But I like that you can try and do the right thing and that'll be a good way to invest.

37:55So, when you read through, it's not just value. The way that Buffett and Munger are doing it, there's something else going on in there as well. And it's once you sort of start down that road, but if it's so far ahead down that road, it's funny, the number of times that I go back and read his 1979 letter or whatever it is, or his 65 like partnership letters. And I find something in there that I think that I've come up with this idea myself originally. And I go back and I find that he's looked at it, decided that it doesn't work and dismissed it. I've done that more than once many times. And I've read those letters lots and lots of times.

38:29I read all of those letters many, many times. And so, it's in there and I've read that same sentence 10 times and just not understood actually what he meant when he was saying it. And then I think I found something, go back and find that, realize he's already considered it. So, he's always working through this same idea. And I think that it's basically what we've just discussed. Be conservative in your estimates of what the business is going to do. Try and invest at a pretty big discount to that. Try and survive. Don't get too over, leave it, all those things. And so, you get after a while, you sort of soak this stuff in and it governs the way that you do everything.

39:01You think about the way you think about investing. But the number of times... So, when I started reading this, I think I read that book when I was 17, something like that, 17 or 18. And then I went and practiced law and I practiced law as a corporate advisory, which is like you do mergers and acquisitions, anything from mergers and acquisitions to reviewing annual reports to whatever it might be, whatever the company needs, whatever the corporate it needs you to do, you go in and you sort of help them do that. And then I moved out of that into an activist firm where we'd approach these small cap mostly that were just being run very badly.

39:35And often we'd say to them, why don't you do a buyback? Because you've sold this business, you've got all this cash, you're very undervalued, why don't you buy back some stock and this will be the effect. And they just never considered it before. They'd never had anybody say because they came from an engineering background, they've invented this product. They've been very successful. They've listed this company. They've done very well. They've sold off some sideline or something like that. They've got some cash. They just don't think in those terms of... They don't understand fully the mechanics of the business.

40:05And I just found it strange. I found it amazing. They'd be paying a dividend and raising capital at the same time. So, there are just all these silly things going on that just didn't make any sense. And I'd come from this reading buff when I was 17. And I just think this is just obvious, Why would you be doing all these silly things? If you understood really what was going on, if you thought about what was going on, nobody would do any of this stuff. One of the positions that I like now that I talk about a little bit, they've got exactly the same thing. I've seen the manager, I've seen the CEO interviewed and he says, why would I go and buy back stock when my competitor just bought back stock and their stock price has gone down?

40:40It's gone down further. What's the point? You've misunderstood what's actually going on here and you're thinking far too short term. It's not their fault. They come from their background isn't inventing something. They've invented this product and it's working pretty well. There's a little bit of weakness in the market and they could go and buy back some stock and do very well. They just have to think in a longer term. And then to the extent that people are taught about these things, the way that they're taught is the efficient market hypothesis and they're taught all of that stuff. I did law.

41:05I did a business degree first. My undergrad is business management and that included a lot of finance in addition to some other softer stuff, but there's a lot of finance in there. And they teach what they did when I went through. They were still teaching efficient market hypothesis. They're teaching beta. Nobody is really teaching this stuff. I don't know why because Buffett and Munger have been around for so long. They're so well-known. They're very, very successful guys. They're clearly very well-known. I think the best MBA that you could get really is just reading Buffett's letters. Beyond that, I don't really know.

41:37Read Buffett's letters. Go through the Buffett archive. That's an incredible resource. I think CNBC's website's got it. You can see all the questions that they get asked at general meetings in the afternoons. And the responses in there, they've started businesses. So they've been entrepreneurs as well. They're not just investors. They've started businesses and those businesses have worked for the most part. So that's interesting. And lots of businesses fail. And then they've got other businesses like Seize Candy and they talk about, why don't you expand Seize Candy? And they say, we've tried everything that we can think of for decades to expand it.

42:11It's just that it doesn't travel. That sort of explains why Buffett liked Coke so much because he said, holy cow, here's this product. It's just like the Seize Candy. People like the brand. They'll pay a little premium. And guess what? Everybody in the world knows about it. This is kind of a sure thing. I don't really know why. I guess I do know why. There's a few things. One of it is just lots of people don't know. And the other one is that it's sort of slightly against everybody's way too short term, particularly CEOs of businesses. They're looking forward one quarter, most of them looking forward one quarter, looking forward to the stock price tomorrow or as soon as they possibly can get it back up.

42:45And if it doesn't work, it doesn't work. And it's so funny to say all that stuff because that's what Buffett and Munger said when I read this stuff when I was 17. I'm 44 now. I've been doing this for a long time. Nothing's changed. I don't think anything's ever going to change. I think it'll be exactly the same, which is a good thing because it means if you can stay in the markets and learn over time, nobody else, like the market itself doesn't learn. That's the most amazing thing. I remember the 1999, I was a student. I wasn't investing. I didn't have any money, but I remember the stock market running up and I had read the Buffett stuff and I was looking at all this stuff thinking, this is funny.

43:18This is really crazy that this is going on. Not expecting that it would collapse, not really understanding anything and then seeing it collapse. And since then, I've seen the run up to 2007 and then that collapse and I've seen the run up to 2020 and that collapse and whatever we're going through now, the cycles just keep on coming. And the market doesn't learn anything. But if you can hang around for a little bit with a good theoretical framework, which I think Buffett and Munger give, and you can learn, and you really can, the market gets easier and easier to invest in because people just keep on making the same mistakes and you personally can learn.

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47:14That's theinvestorspodcast.com slash tip-finance. All right, back to the show. So for investors who are interested in concentrating their portfolio, you gave some great advice to maintain a margin of safety with a few positions. Investors can find a strong margin of safety by searching for protection from either, quote, assets or buy a strong franchise and an unlevered balance sheet. I want to focus on the balance sheet part of this equation. Since a concentrated portfolio will be very sensitive to a position going to zero, having a healthy balance sheet becomes very, very important. What areas of balance sheets should investors focus on the most if they intend on running a concentrated portfolio?

47:55The guiding rules should be, it's not, your biggest position shouldn't be the one that you think you're going to make the most money on. It's the one that you are most certain you're going to make money on. The safest position in the portfolio should be the biggest position. And so then if you're just thinking in terms of safety, you would want a liquid balance sheet, you want cash, and you want lots of assets that God forbid you actually have to sell them on some sort of fire sale. That means your analysis is probably wrong in that instance. I don't know how much downside protection assets really provide.

48:27I think that what you want is liquidity, I mean, not a lot of debt. The number of times that I've seen debt damage really, otherwise good business. The number of times that businesses get taken over and they get to leave it up or they get taken private and they get to leave it up or the company just pays a special dividend and leaves it up to do it. It's amazing that it still goes on, but of course it still goes on. Look at most companies, there's too much debt because most big companies that any of the consumer staples that have very stable earnings have had for the most part. And it may be an anomaly that they have looked like that because the world was once, there was one television set that everybody watched and there were a handful of channels and then you went into the supermarket and there was a finite amount of supermarket space.

49:12And so, it was very, very valuable to have Colgate advertising, Colgate sitting there in the supermarket. You could buy it. Now, it's not like that at all. You buy, you scroll Instagram and you find something that you like and you buy it off Instagram. And so, the entry, the barriers to entry are much, much lower for those consumer staples. But you go and look at those consumer staples balance sheets and they're all trash. They've been financially engineered to tweak the last little bit of growth out because it helps the manager. You're a manager, you go in there, you've got a big option slug.

49:43You're going to be there for three or five years as CEO, you're going to lever it up, jack up that share price and sell off into the sunset with a big payoff and that big pile of debt is the next guy's problem. And then there's so many examples of that. It's hard to find companies that don't have that. So that would be the first thing that I would say. You don't want a whole lot of debt. You want a whole lot of cash. And then you want a management team. I think it's really simple. Basically, you want a management team that is like Buffett and Munger. And you're not going to get that. So you just discount as you go down.

50:14There are lots of good guys out there. It's not that you're not going to get that. It's just that Like that's an extreme example of super smart guys doing the right thing for a very long period of time who really understand how to run a business. But then everybody else is a sort of slight discount to that. And so you discount for that reason. They're just not quite as good. I would have said John Malone for a long time with that Liberty Complex. But gee, that Liberty Complex got complicated. And to leave it and cross-holding, it's too complex to figure out. So complexity is an issue. So I tend to avoid complexity.

50:44just because the number of frauds that I have seen that were basically using complexity to cover up the fraud makes me suspicious now of complexity because I think why be this complex? And I don't think my lines are fraud. I think that they're using it for tax purposes. They're trying not to pay tax, which is fine, but the complexity is an issue. And it's always a little red flag. So more cash than debt, simple balance sheets are great, good businesses that throw off lots of cash. And then you want a management team that's reinvesting sensibly, mostly in the same business, but making bolt on acquisitions when it makes sense, buying back stock when it makes sense.

51:22All of those things. I think it's very common sense. I really don't think that the business analysis and company analysis is sort of almost a commodity. You can go and find any number of websites that will do it for you quantitatively. You can go to Seeking Alpha, you can go to Guru Roofocus, you can go to any of these sites. Finding something that's undervalued with a good balance sheet, all of those things is pretty trivial. And I think quantitatively, that's what I try to do. I'm just trying to buy all of those things because I know that if you hold a basket of those, you'll do very well over time.

51:51Every now and again, you'll find one though that's the part that is hard, the judgment at the very top to size something versus something else. That's really hard to learn over a long period of time. And I don't know that necessarily that I have that even now for as long as I've been doing it. I'm very wary of that. I think you can fool yourself that something is better. But the longer you do it, the more obvious things become. One example I think was Meta. When Meta sort of got cheap last year, Meta possessed all the things that I like in a business. Even though it's newer, it's hard to see. There's some behavioral changes all the time and people keep on using the blue website.

52:28Everybody accessing it through Instagram, the people transition over to TikTok. The numbers seem to be pretty good. But at its root, that was a high cash flow generating machine where Zuck's the owner, operator, founder. He knows what he's doing and he wants to win. He's competitive. But the stock price was going down because TikTok's a competitor and all these other things are going on. You remember all that stuff that went on. But I thought this is a pretty good example. If this is about as good as it gets, I think that I would size a position up like that. And that one, that did work out, has worked out so far as a good position.

53:07But I think that the thing that was holding it back mostly was the amount of money that they were spending in the metaverse. And at some point, Zuck's competitive juices got turned away from investing in the metaverse to buying back the stock. And at that point, that was basically a no-brainer, I think. So my favorite case study from concentrated investing was John Maynard Keynes, which he discussed a little bit. I really enjoyed learning about his evolution from an arrogant trader who relied on his quote, superior knowledge of economic cycles, all the way to a long-term buy and hold investor who placed a heavy emphasis on business and didn't bother attempting to time the market, regardless of his economic conditions.

53:46So what were your takeaways from his evolution and how do you try to limit the roadblock of ego in life and investing? There are lots of interesting things from that because he invested through the Great Depression. He was running endowments through the Great Depression where he was responsible for their investments. And it was King's College and things that he cared about. So, he was really trying to get them through. And he had these, I think one was an insurance company and one was the endowment. And everything was way down. Everything had been smashed to smithereens. Just an unbelievable devastation of those portfolios.

54:18They were down 80 % or 90%, which was basically the market was down that much. and one board was so shell-shocked, they just wanted to liquidate and get out. And the other one was feeling the same way and he said to them, look, we're at this point where if everything goes to zero, it's not going to matter whether we're fully invested or not. But if everything recovers, then of course, we want to be fully invested here. So, he managed to talk one into remaining fully invested and he didn't talk the other one. And of course, everything did rebound over time and it worked out ultimately. So, the number of times that I I have come across couples who are in their early 60s.

54:53This was after 2009, in sort of 2015, 16, 17, 18, the number of times that I ran into couples who were in their early 60s who had made a whole lot of money but who had pulled out of the market in 2009 and were waiting for that moment to get back in. It was just so every week I'd go and meet somebody who was like that. And so that just sort of seared into my mind that you've got to be prepared to pull the trigger when the market goes down because otherwise you just never get another chance to get back in. So you have to do that. You have to find a way to be fully invested at the bottom. And sometimes that means you've got to be fully invested at the top.

55:25Unfortunately for me, that's what that means for many other people. You just have to know that it's time to get fully invested. The ego thing is tough. I think that if you spend enough time in the market, you will see enough bulletproof companies go to zero, that you just know that everything has within it the seeds of its own destruction and you kind of have to, as do we all, you have to kind of watch these things and know that any one of them could blow up. And so, it's a reverse. I call it, it's like a via negativa is the approach. You go through and you look at these things and you just, all of the obvious problems, management's not good enough, balance sheets to leave it, cyclical business, all of those things.

56:03You just have to take those out. You can't invest in those things that have those qualities, that have those properties. And you're left with at the end, this handful of things that you haven't been able to eliminate for any other reason, for any other reason. And that's the one that ultimately ends up in the portfolio. and it's sort of a reverse process of not trying to find things, but trying to eliminate everything you possibly can. And sometimes everything just gets through the filters. So, for me, that's the ego thing is also it's a very common behavioral error that people attribute their own success, the success to their own skill and failure to outside.

56:39And so, that's one of the reasons that I stay quantitative mostly and I rely on the model because I know that it's all outside of me. If I have a good idea, so someone will say, whatever, accruals is a great way of finding. Accruals are blowing out. That means potentially it's a great short because it means that they're reporting more income basically than they're earning in cash flow. And so, that has to show up as an asset on the balance sheet somewhere and it shows up as an accrual. It's a very common way of finding lots and lots of frauds. That's a great idea. So, I'll go and test that. Then I'll put that into the model.

57:13And then the model, the next time it's run, we'll be looking for that kind of thing. That's an example. I've always had accruals in there, but I'm just as an example of something. So, it's never me making the decision, good or bad. I don't have really much into any construction or any portfolio. So, if it's good performance, it's not me. If it's bad performance, it's also not me. Oh, it's probably, obviously, it's my fault. But I think that's one way of doing it. You just have to actively combat all of the behavioral errors that people commonly make. I've tried to do that. You get too concentrated, you blow up.

57:45You buy stuff that's too hot, you blow up. If everybody's piling into something, it tends to fall apart. All of those things that are just obvious, I try to put in. So, I think that ego is a problem. The number of times that I have seen too, guys who when they go very well, it definitely flushes you with something. You feel good, you feel like you're powering ahead. And that's often when people make their biggest mistakes when they've had a good run. And the tragedy of it is that if you're a guy who sizes up, you want to be Kelly betting into something, your portfolio is up a lot. The portfolio is really big.

58:20You're going to put 40 % of an enlarged portfolio into a position and that position is the one that blows up. That's how you wax more money than you've made at any point in the entire cycle. Not to pick on Cathy Wood, but Cathy has sized up some of those positions right into the face of the big drawdown. But that's not unique to her. That's basically the way everybody goes. They size up into these things. So, I just equal weight my positions. I don't know which ones are going to be the biggest ones and which ones are going to be the... There's so much noise. There's so much randomness. You could tick all of the boxes, have dodged all of the bullets.

58:56It's just something you haven't thought of. The government changes some regulation, completely changes the nature of that business. So, there are lots of periods of time where Chinese reverse takeovers were very popular for a period of time and then they collapsed. But then shortly after that, there was this for-profit colleges where they looked great on every metric other than the fact that the Obama administration had basically decided to eliminate them. But they were all very, very cheap and they were good businesses. They made a lot of money. It's intellectual property. They get people in there.

59:27It's recurring revenue. And they got very cheap, but they're all gone. Basically, they're almost all gone. There's a handful floating around, but not very many. And so, it would be easy to fill up on those things. So, another way to do it is just to make sure you're not too heavily exposed to any sector or industry or theme or however you define it. You just assume that everything that you're doing has something wrong with it. There's a crack in everything that you're doing. Any single part of it could fall apart and your objective is not so much to maximize your return in the short term. Jake Taylor, who's my co-host on another podcast, Value After Hours, he says this, if you look at the future value equation, it's 1 plus R, which is 1 plus the rate of return, raised to N, which is the number of periods of time that you compound 1 plus R.

1:00:20And everybody focuses on maximizing the R. They want the rate of return to be as high as possible. And he says the real secret is maximize the N. Because if you can sit down and do that calculation, if you can get 30 % a year compounded for 11 years, that'll give you a great return. If you can get 15 % a year compounded for 50 years, it's a vastly bigger return. The N is the secret, not the R. And so to the extent that you're reducing your R to maximize your N, that's always a good thing. So that's what I think about. We've got to survive. I want to be in this business for a really long period of time.

1:00:58I love doing it. I want to go out feet first, toes up. I want to be sitting at the desk. That's the nice thing. It's not a physical business. You can sit in a seat and do it. You can do it evidently. Munger's almost 100, so you can do it to almost 100 at least. Buffett's in his 90s. That's a long time. I want to keep on doing it for that long. I hope that this interview comes back in 50 years' time. It's me saying I want to be doing this in 50 years' time. I hope I live that long. So I'd like to discuss some lessons that qualitative investors can take from the quantitative side of things that you specialize in.

1:01:28If you were talking to a qualitative investor, what accessible data sources are they ignoring that you think would give them additional valuable information? I think there's essentially two ways of approaching investment. And I think the two that you presented at the start are a pretty good view of that range. You're right, either starting with the valuation and then making sure that it's a sufficiently healthy balance sheet and all those other things. Or you come up with your list of names that you want to hold because these are the 100 best businesses in America or the 300 best businesses globally.

1:01:59And they're all phenomenal businesses. The problem is they're all too expensive. So you go through with your 300 and you have a valuation for each one of those, which you will buy at and probably you go and put your market orders in to buy at that price. Or not market orders, sorry. You put your limit order in at that price or however you want to do it. But you kind of say that you will buy or you make a pact with yourself to buy these things at the right price. I don't know that it's so much data because I really do think that the valuation of these companies is largely a commodity. Everybody knows when something gets cheap.

1:02:34Everybody knew about Meta when it got cheap. It wasn't a secret. Everybody knew about Apple when it got cheap. Even after Buffett bought it, you had plenty of time to buy it. All of these companies, it's not like they're not known. It's that when they become known, the problem, the reason why they're now undervalued, also becomes known at the same time. And that's the thing that scares people off. I see people do it on Twitter all the time. They say, if this stock gets to this price, I will back up the truck. And the stock gets to that price and they say, well, wait a second. Now I know the reason why it's got to that price.

1:03:03It's the patent's going to expire or whatever it is. And I think you've done all this research and you've done all of this work. And here you're not prepared to buy at this point in time. What was the point of doing all of that work and all of that research? You should have imagined this possibility that there would be a problem or you should know what the problem is likely to be when it comes to this and you should be able to make the decision. And sometimes the advantage that I have as a deep value guys, I'm always looking at stuff that's busted. I'm always looking at stuff that's got hair on it.

1:03:29There's always a problem with the things that I'm buying. and I'm relying on mean reversion for many of them. I look at the same thing that everybody else looks like. It's just that the valuation is so compelling at some of these prices that we've got to handicap. This thing's not going to win the race, but it is going to show a place and the price that we're getting to show a place is so good here that it's worth putting on this position. Having said that, I know that about half of them are going to be errors, so it doesn't bother me so much that I don't know which ones are going to be errors.

1:03:56Otherwise, I wouldn't put them into the portfolio. But I know that most of the half the time, the market's right half the time. the stock itself, the market is wrong and the payoff in the market is wrong is so big that it's worth putting these bets on. So it's not so much finding additional data. It's just being aware of the valuation. You need to be aware roughly of what... There's an implied return. There's an expected return at every given price for every given company. And so that expected return is basically what is it going to pay you as a dividend and what is it going to be able to reinvest in its own business.

1:04:31And then those are both perpetuities. You assume they're both perpetuities and that gives you roughly what you're going to earn from this business. Some of them, the numbers are just so noisy that you can't really do that. And so that's a cyclical where you're expecting, you're relying on some mean reversion. But for the better companies, that's exactly what you're doing. You're looking at how much cash flow it's throwing off. What are you paying for that cash flow? What is the company then doing with that cash flow? Is it paying it back to you as a dividend or a buyback or however else it gets it to?

1:04:58or is it reinvesting at a rate of return? How likely is it to continue earning that rate of return in the future if you can put those things together? That's the evaluation. It doesn't need to be more complicated than that. It's something you can do realistically on the back of a napkin, having read through a few 10Ks, probably 10Qs as well, understanding that you've got finite information. You don't have all the information that you need. That's the beauty of that Klamen quote that he says. It's the uncertainty that is the thing that scares people. And this is the crazy thing too. You see this in the markets all the time.

1:05:29So I had when the Obama administration was bringing in the Affordable Care Act, and that was going to impact these insurance companies, and they had blocked a few of the insurance companies from merging. So United was the biggest, and then Humana and the other four underneath were combining together. And so combined, they wouldn't be as big as United, which was the biggest at the time. And so I was At that point in time, something had happened to the risk arbitrage industry. So all the spread, someone had blown up in risk arbitrage. Something strange had happened. The spreads were all very wide.

1:06:04And so for a period of time, I was a risk arbitrage through there where I was long some of these names. Not pure risk arbitrage because I didn't put the short leg on, but I had some options and some other things in there. And I watched that spread trade wide. And what they were waiting on was a decision from the administration about whether they are allowed to proceed with the merger or not. And the worst case outcome was that they're not allowed to proceed with the merger. During this period of time, United, which isn't in a merger, the stock price just keeps on going up. But all these other ones with all the uncertainty, their businesses are still fine.

1:06:37It's just whether they combine together or not. They were all trading sideways and down. The day that the administration announces that it's going to be blocked, which is the worst case outcome that everybody was worried about, all of these stocks leapt. It just doesn't make any sense. But what it really showed me was that the uncertainty was worse than the worst case outcome. It doesn't make any sense until you sort of understand that people really, really hate uncertainty. And so, if you can find a way to operate through uncertainty, knowing that sometimes half the time you're making an error doesn't matter because the payoff is so good when you don't make an error or when you turn out to be right.

1:07:14So, that's the way I think about it, it's really finding a way to operate under uncertainty. That is one of the keys to sort of outperforming, I think. So, in a recent discussion with the TIP Mastermind community, you mentioned that value is an early cycle indicator when looking at economic cycles. I'd love to get a better understanding of how performance of value does in regard to economic cycles. This is an observation of mine. I don't know how empirical or how true this is really, but I have heard it talked about in another context. So at the moment, this is a current example, all of these small and value strategies are selling off while the rest of the market still seems to be okay.

1:07:52The FAANG or whatever we're calling it now, the Magnificent Seven is running ahead and it's doing fine. It's probably up today where everything else is down. But it's been my observation that going into a crash, value tends to sell off first. And I don't know why. There's already some uncertainty with these names. So people don't want to be anywhere near anything that's got any uncertainty in it. and then when the crash comes, the rest of the market sort of catches down to value, which is already having its crash. And then for whatever reason, value seems to recover first. So value bounces out of the bottom of the recession, maybe because they're cyclical companies and there's some risk that they go into financial distress or go into bankruptcy.

1:08:29And when it turns out that's not going to happen, you've taken that risk off the table. And so they bounce very quickly back to where they were beforehand or even a little bit higher. And then early stage of the recovery tends to be value. And then as the recovery goes on and it transitions into a normal market and then into sort of a more bullish where people have forgotten about the risk again, then all of the stuff that is growthier and more sort of glamorous tends to run at that point. Value doesn't participate. And then value sells off again at the end. So that seems to be the cycle that typically it's the better the market feels, the less they're sort of looking at the downside risk, the more value seems to not participate because value is just not very glamorous.

1:09:11And then at the very blow-off top end, value sort of sells off a little bit because people are pulling money out of the value stocks that haven't worked to stick into the stuff that is working. And then there's the collapse and it starts all over again, value bounces out of the bottom. That's my observation. I don't know. I think it's John Hussman, he describes it as, he's got a name for it. I just can't remember what the name for it is, but it's basically that idea that weakness in small and value is sort of an indicator that there's some problem with the underlying market. And on the other hand, strengthen them.

1:09:42It's more of a classic bottom of the market when value starts bouncing first. I think that that's sort of what I think is true. I've never sort of seen any study demonstrating that it's the case, but that's what I feel is true. Tobias, thank you so much for joining me today. Before we say goodbye, Where can the audience connect with you and learn more about you, your books, and the Acquirer's Fund? Thanks so much for having me, Kyle. It was really great chatting to you. My funds are ZIG, which is deep value, mid-cap, large-cap in the US, and DEEP, which is small and micro value in the US. You can go to theacquirerisfunds.com, has a link through the websites, or you can go to acquirersmultiple.com, which has a screen, has a free screen of large-cap companies that to meet these criteria of being cheap on an acquirers multiple basis.

1:10:32And there's links to the books. If you go to Amazon and you search my name, some books will come up. And I do have a new book coming out sometime in the next few months. I'm just finishing it up right now. So I'm hoping to get that out. Really, it's way, way overdue. So it's coming. Okay, folks, that's it for today's episode. I hope you enjoyed the show and I'll see you back here very soon. Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by the Investors Podcast Network. Every Wednesday, we teach you about Bitcoin. And every Saturday, we study billionaires and the financial markets.

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