MI337: The Power of Alignment: Strategies From A Fund Manager w/ Jeremy Kokemor

29:30and it helps them to kind of turn their inventory of lots faster. They come through on their commitments to the land developers. So I've talked to land developers who are like, look, I've worked with all the big guys, including NVR. And NVR always does an amazing job of kind of doing what they say they're going to do. And so I don't mind having a bigger portion of my business with them because I know they're going to get it done on time. It helps me plan my business. And I bring all this up to say that a lot of times when I see sell-side analysts talk about the home building industry, they'll often make a relative value comparison and say, well, gosh, the other home builders trade at one times book value, or they trade at six to eight times earnings.

30:23And then you look at NBR and the multiples that it trades at are much, much higher. Okay. So that's one point. The second point would be, well, we could look at NBR stock price performance over pretty much any period of time over the last 30 years. And even if you said, well, gosh, it's not fair to look at some of those early years where they were going through a business model change and there was a lot of risk and the investment community couldn't understand it. Well, I would say, well, it's been very clear for a good portion of that time, maybe at least the last 20 years. And the NVR stock price performance has just been phenomenal.

31:05So we have this issue where the valuation looks optically higher, is optically higher, but the stock price performance has also been really, really amazing. So I would say the market has never really had the valuation correct for NVR. And it's a business that historically has had returns on invested capital well north of 30%. And even though it's traded at a big premium to the other home builders, it has still, during most of that time, largely traded at a discount to the average company in the S &P 500 business. And I would say it's a well, well above average company than most of the companies in the S &P 500.

31:53And albeit, it can be cyclical, right? When we came out of the great financial crisis, there were less homes being sold because we just had too much inventory. So we do need to be thoughtful around the cycles. But putting that aside for a second, NVR has taken all this cash flow and has just rebought or just repurchased many, many shares over time. And I won't get the number exactly right, but I think today NVR has maybe somewhere around 3.5 million shares outstanding, which is just an absurdly low number. And it's one of the reasons, of course, they could have chosen to split the stock or something at some point, but it's one of these unique stocks that has a really high share price, around$7 ,000 a share.

32:49But that share count is about as low as I could think of for a decently sized publicly traded company. And you're right, they've created a lot of value by just repurchasing their shares over a long period of time. I know you're a fellow fan of concentrated portfolios like myself. So I'm always interested in learning more about investors' past and why they settled on concentrated portfolios, because it's not something that you necessarily learn in school. I mean, it's something that you learn just from studying the greats yourself, I guess. So I'm interested in just knowing why was it that you settled on a portfolio, a concentrated portfolio of say, eight to 15 names that you're at now?

33:28You're right. We typically don't learn this at school. We normally learn about the benefits of diversification. And it's interesting because most of the literature I've read suggests that a lot of the benefits of diversification, especially if you're not investing in the same business across all the stocks, but you get a lot of the benefits of diversification once you hit 10 stocks or something around that. So that's one thing that I find interesting. But concentrated investing has always just felt very natural to me. It took me a while to be able to articulate that. But what I noticed over time was, for example, I worked at T.

34:13Rowe Price out of Harvard Business School. And T. Rowe is a fantastic firm. There, I was only covering a few industries. So I wasn't a generalist like I am today. And I was probably covering 30 to 40 companies in those industries where I was tasked with being the expert on these companies. Contrast that with what I was doing in my personal account, which at any period of time, I probably had 10 or 12 investments that I thought were really going to be exceptional. And that always felt fine. And I would say, look, with a lot of investing, there are many ways to make money. There is no one right answer.

35:00But I think a lot of investing is a personal journey to figure out what makes the most sense for each of us. And so somewhere in that 8 to 15 range is the sweet spot for me. And today at Rytale, I own 13 different positions. And it's fantastic. It allows me to concentrate my time on these names. When I find a new name, which I'm sure we'll spend some time talking about, I can compare it to the 13 I already have and try to find a new investment that will come in well above what I think the return potential of the average holding could be within that 13. And then when those investments do well, one of the benefits of a concentrated portfolio is that it can have a really punchy, impactful performance on the returns.

35:59And also no position is so big that I'm losing sleep about it at night or that when something goes wrong, because things will inevitably go wrong with some of these investments. We'll have an impact on the portfolio, but it'll have a modest impact. And then if we think really long-term, I would expect that it'll probably be more like a handful of these investments or maybe even a slightly lower number that will really have just the dramatic positive impact on the portfolio. So on the downside, if I have an 8 % position and it goes down 25 % and we lose 200 basis points or 2 % of performance, that may not be fun in the short term.

36:48But I think when we're looking back on it 10 years from now, we'll probably be talking about the companies that have grown to be multiples of the original value that we invested. And those will have a much bigger impact on the overall return profile. Robert Leonard A question I'm fond of asking professional investors like yourself is how they prefer to enter positions. Do you like taking smaller positions to start and then adding as you gain more and more conviction and knowledge of a business? Or are you just kind of piling money in as fast as possible to get to your desired, let's say, 8 % position size?

37:24Robert Leonard For me, it's situation dependent based on a few factors. One is, I would say, prior knowledge of the business and industry. So if it's a business that I really feel like I know well, or maybe I've invested in it in the past, that would maybe make me a little bit more comfortable in terms of making it a slightly larger position upfront. So that would be one factor. The second factor would be just how great of an investment do I think it might be. If it looks incremental to the portfolio, and like I said, trying to find ones that are not better than the 13th position in the portfolio, but hopefully more in the top half, which is another way that I think about margin of safety and avoiding incremental sinking.

38:14But if it really looks exceptional, that might argue for a larger position as well. But I've learned over time that no matter how much work I do upfront on a business and the industry that it's in and its peers, there are always things that I kind of overestimate or underestimate. And I learn more as I own the business and as I get kind of more reps with the company and just kind of understanding what they do. And so that is something that over time where I've said, hey, I'm open to starting off at the larger position. But a lot of times, I may just start with something that's maybe around a 5 % position where it's still a reasonably sized position.

39:04And over time, if things unfold positively and most of the things that I thought going in kind of play out, I'm totally fine kind of adding to the position, even if it's gone up a little bit, provided that I think the long-term opportunity continues to be there for exceptional returns. So I'm also interested in knowing, what is the desired market cap, let's say, of your dream business? I'm very flexible when it comes to market cap. But if I really were to say kind of the dream business. And I would hope that when you and I are talking again in 10 years, I would hope that I've found an extra one or two smaller businesses to invest in.

39:49And if I can do that, and I think I'll be able to over time, if I can do that, then who knows? A, that could imply that there's a longer reinvestment runway. If it's a smaller business, it may be less well-known, less discovered and trade at a less expensive valuation, that would be attractive too. So those are kind of all the positives. But I also go in with a fair amount of skepticism around smaller companies as well. Some companies are small and they tell an interesting investment story. But you look at the history and they've been small for a really, really long time. and old habits and industry structures and things, those are hard to change, not to say that they can't.

40:37When I'm going through and doing the analysis, I do want to be able to study the history of the business and how the returns on capital have evolved over time. And sometimes, not always, sometimes there's a bit more history and it's a bit easier to study for a business that's slightly larger. So I would say, I really am very open-minded and I don't mind investing in larger businesses that can still compound at the mid-teens or higher rate of return over a multiple-year period. That being said, I'm hopeful, as we talk in many years' time, that I'll have found one or two additional smaller companies that might have all the benefits of those larger companies, but maybe even have a longer reinvestment runway and higher return potential.

41:33And so just for the audience, what would you consider? Because different people have different definitions, but what would you consider a small company in terms of market cap? My smallest investment today is probably around 5 billion of market cap. So I would probably put a range on it of maybe 500 million to 5 billion in market cap, something like that. So depending on the levels of turnover that a portfolio manager has, they may have a great year making zero investments, or they may consider it a great year making dozens and dozens of investments. So you're obviously concentrated, so I can guess where the answer is going to be here.

42:10But how many new investments do you try to add per year? And what would a perfect year look like? I underwrite each position over a potential three-year holding period. If we were just to say, hey, what's 12 or 15 or whatever number of investments in the portfolio divided by three or something along those lines, it would suggest that maybe in a given year, there are only a couple of new investments. So I often describe it as saying, hey, I think it's probably zero to three new investments per year. I recently made a new investment, but prior to that, I really hadn't made one in about a year. So that's just one example from a very small sample of time.

42:57But the goal is really not to have a specific number of new investments a year. One, I would say the goal is really to just get more knowledgeable on different businesses and different industries. And each year that goes by to be able to share with you, hey, these are the industries where I feel like I've learned a lot over the last year. And that may be helpful for a new investment. It may be helpful for a current investment where I learned something or about some type of idea that I could apply to the rest of the portfolio. Or it may be some learning that really comes to fruition in several years of time when maybe a new opportunity comes up or the price drops a lot, whatever the case might be.

43:48There are a lot of ways that I think building that library and knowing more industries in a more knowledgeable way can just really, really benefit over time. The other thing I'd say about the topic of turnover is when I look back over my career, some of the times that have been most fruitful for finding new investments is when there are a lot of challenges and weaker performance in the market. The early period when COVID first happened in early 2020, That really just created some amazing investment opportunities where there was a great business and a great management team and a great balance sheet.

44:34And all of a sudden, for whatever reason, the stock was down 50%. And if you could get some level of conviction that the business had enough cash to survive a very challenging period of time, and that their competitive advantages were going to be at least as strong or maybe even get stronger, an example like that or that type of period where there's a lot of dislocation, there might be even more turnover because you just have this very rare opportunity to really upgrade the return potential of the portfolio. Those are rare, but they absolutely happen. And I want to be ready and willing and knowledgeable enough to act when those opportunities come up.

45:26Let's take a quick break and hear from today's sponsors.

45:46Billionaires to find our collection of shows. We Study Billionaires is our flagship podcast, and we've made a name for ourselves over the years by interviewing the best investors in the world, including Ray Dalio, Howard Marks, Joel Greenblatt, and many, many more. My colleagues, Stig Brodersen, Clay Fink, Kyle Greve, Preston Pysh, and William Green each hosts their own We Study Billionaires episodes and bring their own unique perspectives. A whole new world of insights awaits you, just go ahead and type in We Study Billionaires into your podcast app and see what you've been missing out on. Seriously, go ahead.

46:20I promise you'll like what you find. Bonus points if you show your support for our work by clicking follow. If something piques your interest, just start listening. No hard feelings. I'll be waiting for you back here. 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, but it's never too late to get smarter about stock investing from the ground up. At The Investors 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.

46:56With 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. To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks.

47:32And for a limited time, you can use code stocks15 for a 15 % discount at checkout. Not to be cliche, but building a market-beating portfolio really doesn't have to be a mystery, at least with the right tools. If you've listened to our podcast for a while, then you know we spend a lot of time learning from savvy investors. So why not use the same tools we do? With TIP Finance, you can. Screening for great companies, calculating intrinsic value, keeping up with legendary investors' portfolios, and more are all not just possible, but easy to do. TIP Finance was created by investors for investors.

48:10It's quite literally the tools we wanted to use ourselves when researching investments in a simple to use interface. You can get started by creating an account for free. Who knows, maybe TIP Finance will help you find your next 100 to 1 investment. Between the screener and Legend Investment portfolios to reference, I've gotten a ton of ideas from TIP Finance. What are you waiting for? Take the next step in your investment journey today with the right tools at your fingertips. Grab your device and type into your browser, theinvestorspodcast.com slash tip-finance to get started. That's theinvestorspodcast.com slash tip-finance.

48:51All right, back to the show. I wanted to move on to evaluation because you have some interesting evaluation methods that I wanted to go into. So you mentioned that you'll break down the internal rates of return of a potential investment using some simple bond math. So I'm interested, can you please detail this evaluation method for the audience? Sure, sure. And feel free to ask any questions if I get a little too in the weeds or I'm not describing it well. But simply, we're always trying to figure out what cash flows an investment is going to produce over its lifetime and then kind of value those cash flows.

49:26And one way to do that is to try to think about owning an equity like you might think about a bond. And so the way owning an equity can be similar to a bond is if you say, all right, well, what is the coupon payment that the bond kind of pays to the owner each year or a couple of times a year? And so I would say that's very similar to the cash earnings that the stock or the company generates. So the cash earnings yield for the business. And then the second component would be, okay, well, for a company, those earnings might grow over time. So what's the current cash earnings yield? And then how might we evaluate the future growth?

50:07So that would be to just keep it simple and think of it in two ways. And then we can further break down that growth component, which I think is a really fun thing to think through. And so that growth component, I would say we could break down into two factors as well. The first factor would be growth that the company can achieve without reinvestment. And so good examples of that type of growth would be something like Moody's bond rating business, where they have this dominant position in the market. There's probably going to be a little bit of volume growth in the market over time. Maybe it's 1%, 2%, 3%.

50:45And because they're so dominant and because having a rating from Moody's or S &P helps lower the interest rate that an issuer of debt might achieve, well, they could raise the price a little bit each year because it's still kind of a great value for the issuer of the bond. Moody's, they'll grow a little bit without arguably really needing to reinvest. Another example would be Visa and MasterCard, where they've grown for a long time just as so much of the world's payment has shifted from cash to credit cards and they have the credit card networks. That's the first component of growth. The second component of growth, some companies have both, some have one or the other, some have neither.

51:29But the second component is the reinvestment component. And so there, what I try to do is say, how much can this company reinvest each year? And at what rate of return can they reinvest? So to use some simple math, let's say a company could reinvest$100 at a 20 % rate of return. So you'd multiply those two numbers together, you'd come out with$20. So that's effectively$20 of new earnings. And then you could capitalize that new earning stream that is hopefully being created each year by the company's reinvestment and capitalize that at some earnings multiple. So to wrap it all up, I would say, you can look at this bond math and kind of say, all right, cash earnings yield plus growth without reinvestment plus growth from reinvestment.

52:22And I add those up and I get to a potential IRR for the investment. And that's one way I like to look at valuation. And it has been very beneficial for me, particularly thinking through the growth components and especially that reinvestment component. Because I think that is a piece of the analysis that often gets lost when investors are just talking about, well, company A trades at a 15 times PE and company B trades at a 20 times PE. And when you really try to go through some of the reinvestment math, it just kind of shows how great companies, even if they may look to be a little bit more expensively valued, can still be the better investment over many years.

53:13I love that point. Chris Mayer was telling me specifically about that, how you can look at two businesses in the same industry that maybe are competitors, and one might be just extravagantly priced on PE, price to earnings or whatever. But when you look at the ability to reinvest at high rates, it makes a huge difference. And you can pay optically a much higher PE multiple for one business, and it could still be the better deal than paying for the cheaper one. It's a fantastic point. And it's a lesson that I learned so many times over the years and learned it the hard way, where it's often easier, I think, especially when we're first exposed to investing, where if you're maybe studying three companies in the industry, well, why wouldn't you want to invest in the one that trades at a cheaper valuation?

54:06And especially if that one that is at a cheaper valuation, especially if there is a new management team or they're trying some new procedures that are going to help them close the gap to where that number one player is. And so you can look at one of those companies and come up with a case of, wow, well, their earnings are really going to improve and maybe the valuation will improve too. And that'll be fantastic. And what I kind of consistently saw over time, and obviously there are exceptions, But sometimes I'd come back a few years later and I'd look at that industry again and I'd say, well, gosh, that company that I thought was the best, it's still the best.

54:49It still appears to trade at a more expensive valuation. And it's been the best stock performance of the three companies. And so after making that mistake and learning that lesson several times, It was just a great learning and one that fits with who I am as a person. And just the same way that I want to try to continue to get better and have lots of good habits and disciplines that help me do that. I typically want to invest in companies that are very consistent and do a lot of little things well. And going through this bond math that I just described is one way to help put some numbers around something that can be very hard, which is like kind of a quality.

55:40It might be easy to say, well, this is the best company in the industry, but it's not always easy to say, okay, well, this is actually why based on the numbers, it might end up being the best investment. And that's one thing that's very important for me to try to think through. You've also mentioned that you do have a couple of other evaluation criteria that you use in just a discounted cash flow and using just multiples. You don't have to go too into deep depth into these, but I'm just interested, are you using all three of these in conjunction to make sure that your evaluation is directionally correct?

56:14Or do you weight one higher than others? I'm interested in knowing more about that. Absolutely. I think through all of them, For me, one of the areas of thinking through that bond math example, where I get uncomfortable is if the multiple is too high, if the current multiple is too high, or the cash earnings yield is too low. And so maybe there's an example, like if we think of a lot of software businesses a couple of years ago, when they were trading at 30 times sales, and you could argue that they were cashflow positive, but they were just kind of investing the cashflow through the income statement.

56:52But they're trading at these really, really high valuations. And so someone I think could look at some of this investment math and say, well, they are reinvesting at high rates of return and the industry that they're in is growing. And so don't worry about the cash earnings yield not being there. It could still be a good IRR. And so thinking through the current multiples are also putting the numbers through a DCF, it will probably make a potential investment like the one I just described. It'll be a good gut check that might say, well, gosh, it looks like it's going to be really hard to make money with this type of investment.

57:32So there's no kind of, I wouldn't say I use each of the different methods as a certain percentage of the decision because there's so much that goes into it. I need to feel like the company is high quality and is sustainable and hopefully improving over time. But I do like to think through those different methods as just a bit of a soundness check to say, does this seem reasonable? And if so, if more of them line up, then there might be a slightly higher chance that the investment ends up making it into the portfolio. So in an interview from March of 2023, you said that all your investments were in North America, most in the US with one being in Canada.

58:17So I'm just interested, is this a circle of competence thing or are you willing to eventually invest abroad if you know that the country that you're investing in has regulations that are supportive of shareholders? That last thing you said, Kyle, is incredibly important. I want to make sure that I understand the rule of law in any place that I would invest. And the US is one area where I feel like we do have really good laws. And it's a place where entrepreneurship is encouraged and intellectual property is largely protected. And those are kind of fertile ingredients that can lead to good kind of economic value creation over time.

59:00So you're right. Today, I have investments in the US and Canada. I feel like I have a good understanding of those places. I'm open-minded to investing in other geographies, but I would need to feel like I had a pretty good understanding that the country was more similar to the US than different. So is it possible that right tail, we could end up owning business-based in the UK or somewhere in Europe where I feel like we really understood things. Yes, I think that's definitely possible. I would say what's probably less likely would be to invest in an emerging market where, rightly so, there might be better potential for longer-term growth.

59:45But if I don't understand the rules that we're playing by, to me, it's just easier to avoid what I don't understand because there are so many great opportunities in the places that I do understand. So you noted in a previous interview that you tend to stay away from biotech and I'm 100 % on the same page as you hear, but I'm interested in knowing some other areas of the market that you've just flat out refused to invest in and briefly describe why that is. In biotech, it's fairly simple. I think understanding the science can be really important for a lot of biotech investments. And I've been fortunate to work with other biotech investors who are trained MDs, who've gone through medical school, understand the science, and I think can do a darn good job of saying, well, hey, the market seems to price in a 20 % chance that this drug will get approved or whatever the case might be.

1:00:42And I actually think it's like 50%. And if I have a bunch of these small bets where I think the odds are really aligned in our favor, then I'll do really well over time. And that's just not a place where I feel like I have the knowledge to invest there. Another area would be something like metals and mining or something that I think is very, very commodity dependent, where in general, when it comes to big macro factors, I think they're really, really hard to consistently get right. And for a mining company or maybe an oil and gas company, arguably the most important thing will be the price of the commodity.

1:01:28And one of the things that's kind of funny about the metals and mining topic is my first assignment at T-Row was actually covering metals and mining. And I had a lot of great experiences, got to meet a lot of awesome people and travel around the world and visit potential mines or mines that were in production. But oftentimes, these were small cap companies who were trying to build one mine, didn't have any in production, and they were just always raising capital, always telling a story. And there's so little they can actually control because they can't change the actual rock. It's either going to be maybe as good as they tell you it's going to be, or a lot of times not as good.

1:02:11I know mining is a big industry in Canada. And so I can see you likely have some experience with these companies. But that's just an area where I want to invest in companies where I think I can understand what their advantages are and their ability to repeat those and sustain those. And so these are just some areas of the market where I'm not well-equipped or the businesses aren't well-equipped to provide what I'm looking for. And I'll definitely miss some along the way because there will be great investments in these areas, but I'm totally okay with that. Yeah. It's funny you bring up me being in Canada and miners.

1:02:53Obviously, we have tons of miners, but I'm lucky I came across that amazing Charlie Munger quote early when I first started investing where he says, a mine is basically a hole in the ground with a liar on top. And so that's guided my view on mining. So I stay away from them for the same reasons that you listed. But now that we know what you try and stay away from, can you share with the audience what you consider to be in the center of your circle of competence? Yeah, I would say like what I said earlier, I'm constantly trying to widen that circle of competence and find other industries that I understand really well.

1:03:31Certain industries where I have found a lot of these positive attributes, I have owned a few companies that are effectively distributors, but serve different industries, different end markets. But sometimes you can find an amazing distributor that has a fragmented customer base and a fragmented supplier base. And to their suppliers, they're an extension of the sales force and can hopefully be very knowledgeable and a good representation of those brands. And to the customers, hopefully they can provide the right part on time, the knowledge to educate the buyer on what part they actually need and should buy.

1:04:14And if they do all those things well, then hopefully all their partners are really happy and they can earn a nice economic return too. So sometimes there are great distributors. There can also be ones that don't have these qualities. So distributors would be one, lots of areas of business services, software. So those are just a couple of areas where I have tended to find maybe more high quality businesses over time. And then there can also be other areas that maybe due to regulation or other areas can have certain moats. So I've studied the railroad industry in the US or some of the waste companies.

1:04:57And so there are lots and lots of different businesses and industries that can have some of these positive attributes. And then kind of like what we were saying earlier with NVR, that's one where I think maybe a lot of us would say, well, gosh, home building doesn't seem like a great industry. But then there's this one company in a cyclical industry that's kind of doing things in a different and special way. And that can be a really fertile area to find an investment as well. Jeremy, just want to say thank you so much for joining me today. So before we say goodbye, where can the audience connect with you and learn more about Rytale Capital?

1:05:35Absolutely, Kyle. I thank you. It's been a pleasure and I really enjoyed our discussion. If folks want to learn more about Righttail Capital, they can reach me in several different ways. My website is just www.righttailcapital.com. My email address is jeremy at righttailcapital.com. And I also post from time to time on LinkedIn and Twitter and other places. And really, I just I love to meet other folks who are similar kind of long-term like-minded thinkers who love investing. And that can be other folks who are running their own investment businesses or people who work in some of the industries I care about.

1:06:16Or maybe there's someone out there who is interested in learning more and potentially investing together. And I just love to meet kind of other great people who are trying really hard to get a little bit better each day. So So those are some ways that they can find me. 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 follow Millennial Investing on your favorite podcast app and never miss out on our episodes. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only.

1:06:56Before making any decision, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.