TIVP025: Smith & Wesson (SWBI): Deep Value — Locked and Loaded w/ Daniel Mahncke & Shawn O’Malley

29:09And still, it's worked for such a long time that you would think expanding into something that should still somewhat be your circle of competency would have been able at some point. and they just didn't make it happen. And it feels like they missed out on a lot of opportunities, either in their circle of competency directly or even going outside of it and basically capitalizing on their IP. And many, many episodes ago, I mentioned that after studying all these great companies with you together in the last weeks and months, I had previously underestimated the importance of a company's culture. And almost all successful companies we discussed had that culture of basically reinventing themselves and implementing new ideas despite the risks over and over again.

29:57And you mentioned how old Smith & Wesson is and it just seems they don't have that culture despite going through all those company changes. You just said they haven't been a family on business for about a century now and it just feels like all of these changes still didn't help with the culture at all. And viewers can probably tell this business can't be that great since we haven't yet mentioned any flywheel. And basically all the great companies we have discussed, we always went through their flywheel and how it helps shaping the business. And there just isn't anything that we could mention for Smith & Wesson.

30:33And maybe on the regulatory side, when I was discussing Visa, I mentioned how regulation can be a two-edged sword. So basically, it helps keep out competition, but simultaneously, it limits Visa's own business. The same goes for companies like Alphabet, whose virtual monopoly is being challenged in court again and again. And with both of those companies, regulation is a real risk. But with Smith & Wesson, we're talking about a whole different level of regulatory risk. So when you sell guns, there's this risk that you could be, for example, sanctioned by different governments because your products just ended up in the hands of different criminal groups or even terrorists.

31:19And all that regulators may limit you from selling some of your most popular products if they are deemed to be dangerous, which for guns is kind of prerequisite. But the general regulatory risks just feel heightened and more tangible than whenever you talk about, you know, Alphabet maybe being forced to spin off its Chrome browser or something like that. I think you're absolutely right. And it's not just limits on gun sales, but also litigation too. specifically the Protection of Lawful Commerce in Arms Act of 2005, protected firearms manufacturers from legal liabilities if their lawfully sold products were later used in criminal acts.

32:04And if that were to be repealed by Congress, that would just open this floodgate that could expose them to much, much more litigation whenever their products are misused. And that's not to say they aren't already facing a ton of lawsuits related to personal injury claims and product liability that just all divert time and money away from the core business. So maybe that's why they haven't monetized their IP. They're too busy fighting all these lawsuits. They also, just due to the nature of the products they produce, have a lot of trouble getting insurers to work with them, either for ethical reasons or simply because the risks facing the business can be so hard to price.

32:42After various mass shooting events over the years, for example, gun manufacturers have paid out tens of millions of dollars to settle allegations against them. And that just raises the cost of doing business. And that's why in 2020, he established a wholly owned insurance company to help them mitigate the risk of not being properly covered. So they're taking the risk seriously. But whenever you have to establish your own insurance business, you have to self-insure your operations. That's not a great sign. I've once heard that whenever any insurer is not even able to insure what you do, you're definitely in a business so risky that you probably wouldn't want to get involved in it.

33:23But we have spent a good deal of time now covering all of the downsides about this company. And there seem to be a number of those. But with all those out of the way, why don't you give us your full investment thesis? Because I don't think you would pitch this company today if there's not something that is really attractive about this situation. Let's do it. One of the things that initially drew me to this was Norbert Liu, who runs Punch Heart Capital. and is kind of this legendary protege in a way of Joel Greenblatt and who is invested in Smith & Wesson. It's a small holding, but he only has like four companies in his portfolio.

34:04And given his track record, anything he invests in catches my attention, even if it was a few years ago. He sits on his hands a lot. He's just so patient. So when he does do something, that's a signal to me that I need to look at what he's doing. And I should begin by explaining, though, that Smith & Wesson spent roughly$180 million over the last two years to relocate its manufacturing headquarters in Massachusetts to Tennessee, where state legislation is just much more favorable and where they won't be punished in the same way for producing firearms. The political environment is just much friendlier there.

34:41But maybe when Smith & Wesson was first getting started, Massachusetts was the best place for them to be. I don't really know. This$180 million move that was such a costly migration, as you can imagine, for a company that only has an equity value of a little over$400 million. And so that move created abnormally large CapEx over the last two years. And that has distorted their free cash flows. And with the down cycle and firearm sales, I think it's just made the business look much worse than it actually is. if you think of the headquarter relocation as this one-time business expense. And the reason I mention this is because when we get to the valuation, I'll walk through how I tried to calculate the owner's earnings for this company, which is a measure Warren Buffett kind of came up with to determine how much of a business's earnings are actually available to the owners of the business, which can be a different number from how accountants calculate net income.

35:39And as part of that owner's earnings calculation, you try to break out growth capex from maintenance capex, where maintenance capex are investments back into the business to maintain their current operating capacity, like maybe renovating an existing facility or replacing old equipment. Whereas growth capex are investments that, well, grow the company's earnings power by adding incrementally new machinery or production facilities. So long story short, when you look at a company's capex over time and you see these sudden spikes, that is usually growth capex. And it's a discretionary investment that in theory could just as easily be used to return capital to shareholders by way of dividends or share repurchases.

36:22But in this case, it's really a form of maintenance capex for Smith & Wesson that we treat as sort of a one-off expenditure since they're relocating existing operations. And so that immediately presents an opportunity where I think, okay, maybe there are investors out there, maybe the market generally is not fully understanding what's going on with Smith & Wesson's numbers. I totally get how that could easily become an attractive situation because of this, because it understates what Smith & Wesson can actually earn. And at the same time, an investment of$180 million on an equity value of$400 million just to relocate your headquarters just seems like a lot, even if the political tension might be a bit worse when they would stay where they are located right now.

37:10But still, for Smith & Wesson, it seems relatively easy to differentiate between maintenance and growth capex. But that's not always the case. So for high growth companies, for example, I'm always asking myself, is this actually growth capex? Or is this somewhat of a necessary expense to not fall back in the innovation race and then get irrelevant soon? So because if the second would be the case, I think there's an argument to make that at least parts of those capex are maintenance and not actually both capex. So while the difference between the two sounds simple in theory and practice, you can get into situations where the line is a lot more blurry than we just draw it right here.

37:55So maybe to once again explain why it's so helpful to treat capex differently. It's mostly because you could massively underappreciate the true earnings power of a business. If you assume growth CapEx to be reoccurring every single year. So take Amazon as an example. We just looked at it a couple of weeks ago. If you assume that all CapEx, which this year might actually surpass$100 billion, is necessary to run the business, then the economics of Amazon would look much, much worse than I think they are. The good thing for today is that it's pretty straightforward with Smith and Wesson. And there's virtually no growth CapEx at all.

38:35So that makes it a bit more easy for you and probably a bit more straightforward when we get to your investment case and the valuation. Exactly. And actually, like you said, besides these relocation costs, when you look at Smith and Wesson's CapEx over time, the way we know there's no growth CapEx is because it pretty closely tracks the company's recorded depreciation and amortization expense, which is an accounting number. It's not a real physical cash expense, but that just at a high level tells us that they're basically spending what they'd need to spend to just maintain their equipment and probably not much more than that with respect to spending more than what an accountant would say they need to maintain their current operations.

39:17And in other words, they're not trying to grow the business's ability to sell more firearms. Instead, they are sort of managing the business at its current capacity and looking to take advantage of surges in firearm sales and otherwise just returning capital to shareholders as much as possible, hence the 5 % plus dividend yield and the shrinking of their share count by more than 4 % per year over the last five years, which to some extent has come at the expense of their cash balance and financial stability. But this really touches on the core idea here and my investment thesis that it's taken me five minutes to build up to.

39:57Smith & Wesson is no compounder. I would expect that over time, their returns will mostly be flat with big up cycles and then big down cycles. And you can just look at their stock chart to see exactly what I mean. The business surges during certain 12 and 24 month periods. And then when it pulls all those firearm sales forward, sales fall off a cliff and the net result is that from a normalized earnings perspective, the company hasn't really gone anywhere. The intrinsic value isn't compounding. They're not expanding their earnings power. They're not doing growth CapEx. That's why we did the whole CapEx tangent.

40:32And for example, the stock is trading at basically the same level now as February 2007. 18 years later, if you faithfully rode along that whole journey, you'd have gone nowhere. And in the last few years, you'd have collected some dividends along the way, but the opportunity costs of keeping any money and Smith and lesson rather than, and I'm cherry picking, but still rather than investing in say Google or just to not cherry pick that invest in the S and P 500 more broadly, those were huge. Those are huge opportunity costs. So again, this is absolutely unequivocally not a company to hold for the longterm, no five or 10 year time rises here.

41:09And you might think, okay, well, why on earth would we want to invest in this? And the reason is just looking at its history. we know that there are these booms in firearm sales. People rush to try and own the stock when it's earnings jump. So at some point, the business will take off again. Firearm sales will pick up. They're not going anywhere. And because the business is currently experiencing a slump in sales and also these one-off CapEx costs that we talked about, the price is very depressed. And yet the stock might rise 50, 100, or even 200 % whenever sales pick up again. And that is sort of what you're waiting for.

41:48In the meantime, you're getting paid this 5 % dividend yield and the share count is continuing to decline. So you own a larger and larger slice of the company, positioning yourself to benefit even more the next time there is an upswing in gun sales. So that's the bull thesis. Gun sales will inevitably spike again. And if history is any guide, as we've seen a handful of times, so will Smith & Wesson's stock. And while you patiently wait for that next unknown uptick, which is why I said there's no catalyst, you're actually getting a nice shareholder yield. It's compensating you for the timing uncertainty of when the next big firearm cycle will come.

42:29And I don't know if that upturn in the cycle will come in six months or 18 months or longer. and that's why I would say this opportunity exists. Institutional investors on Wall Street, generally speaking, do not have the patience, assuming they're even allowed to invest in this thing, to wait for the unknown firearm cycle to come, even if we know it will inevitably come. And I think if you're willing to be patient and like I said, just collect those dividend payments along the way, you can ride the next wave up in the stock. Just looking historically, the stock has double, tripled, that can even 6x from some of these cyclical bottoms.

43:06And I'm not saying we're exactly at a bottom. I don't know. We might be close to it. Or that anyone could even, in theory, sell at the top of the next cycle, right? We're just drawing lines between the bottom and the top of the chart, which is easy to do. But again, we seem to be in a range where the stock is at the lower end of what you might call a normalized price-to-earnings ratio. And that tells me that this is likely an attractive time to buy shares. I should clarify that by saying that you can't do this with every cyclical company. There are a few factors that make the situation with Smith & Wesson unique.

43:41I have so many thoughts about this, and I think you will talk about this more in the future. So that's why I will only ask you, what are those factors for now? So please take us through them and then tell us why you think there might be a bottom at this current time. and perhaps you even have some insights into how large the next upright in the cycle will actually be. So is it a 2x or 3x? What is the opportunity there? Well, for starters, what makes Smith & Wesson unique, I'll say, is that not every cyclical company is being so aggressive about shrinking the share count and paying the dividends.

44:19As I said earlier, the time costs or the opportunity costs are the biggest pain when you're just waiting indefinitely. And so Smith & Wesson is very tangibly reducing those opportunity costs for investors as you await the next big cyclical move. And secondly, cyclical businesses are usually commodity businesses, which Smith & Wesson, I would say, is not necessarily. They're the most iconic firearm brand in the world. They have that potential to monetize their IP better that we talked about. But also just their profit margin is better than some of their competitors. Their gross profit margin is north of 38 % going back to 2015.

44:59And if you compare that to Sturm, Ruger and company, which is another major firearms manufacturer, their gross profit margin is nine percentage points lower over that same time, which I take as evidence that Smith & Wesson does legitimately have some pricing power that supports their profitability, meaning they're able to sell their products given their strong brand reputation well above their cost of goods sold with a higher premium than other gun manufacturers. So this is probably a slightly higher quality cyclical business than many others. And as such, that helps them to be able to pay such a high dividend yield and buy back so much stock at times, which is probably the most important factor behind why I think it could make sense to hold the company into the next upswing in firearm sales, looking at the stock at current prices, especially since we're already a couple years out from the last big upcycle during COVID.

45:57With the counter argument, and I always love to be my own devil's advocate, being that if we have a few more quarters of depressed sales, these dividends and buybacks might not be sustainable. So it's not guaranteed that you will get paid for your patients. If Smith & Wesson paid no dividends. You'd be earning no yield to compensate you while waiting for that next cycle. And if the next cycle takes longer to manifest than you expect, your opportunity costs will compound against you such that even if you can sell the stock at much higher price in a few years, the annualized returns might actually just be very average.

46:34The time costs of waiting for that payoff are very, very high, especially if the business isn't really compounding its earnings over time and isn't paying you anything in the meantime. And if you're instead just trying to time the cycle, that's just a much riskier and less fruitful game to play and not one I would typically want to play. But like I said, the current stock price has been down enough that you're actually getting a very attractive total return based on their trailing dividends and periodic share buybacks, especially when you consider that the company is very much under-earning right now.

47:07And for reasons beyond its control, they are selling much fewer firearms than what you might say is normal, which is artificially making the company's valuation look more expensive than it actually is. So it's just simple math, right? The current PE is 14. And for a stagnant company or one that may be even in structural decline, that is not an attractive multiple. But that multiple is based on the earnings of the last 12 months. And those are very depressed, low average results. If you use a more normalized earnings figure, reflecting that their earnings power across the entire firearms sales cycle, then the PE is probably closer to 10, which suggests a 10 % normalized earnings yield.

47:49And that is much more attractive. When the regular PE is higher, so not normalized, the stock is actually cheaper typically because earnings are so depressed. And whenever you're talking about cyclical companies, it's kind of counterintuitive. But when their PE is higher, so not the normalized PE. The stock is actually cheaper typically because you're looking at earnings that are depressed. You're looking at bottom of the cycle earnings. And again, with cyclical companies, when the PE is really low, again, counterintuitive, it actually means that it might be more expensive because their earnings are not sustainable.

48:26They're unsustainably high. They're above average and the market knows that. So it's not paying a premium for them. That pretty much goes against everything that you learn in your finance class. But There are some similarities to our Mercedes episode. It's also a cyclical company, but not in the commodity field. Its stock didn't go anywhere if you just held on to it for the last decades. It looks even worse than for Smith & Wesson, to be honest. And it's a strong brand that still does have pricing power. And the investment thesis is based on dividends and buybacks. The main difference from an investment perspective is that Mercedes really didn't have any catalyst or future event that could significantly increase its stock price.

49:08It was really about dividends and buybacks. Well, there's a good argument for Smith & Wesson for why the stock could make a more significant jump at some point when the cycle turns. And another difference probably lies in how the cycles work. I might have some ideas, but why don't you just go ahead and tell us what drives these cycles? Because if my ideas are not completely off, I'm guessing it's not the typical business cycle that for example works for Mercedes. It's definitely not the normal business cycle. It's not like interest rates fall and people go oh great I can afford a new house a new car and also a new gun.

49:46I actually know some people like that I bet they do exist but but broadly speaking that's not the case and before I go any further I should give a disclaimer again that we are going to have to mention these kind of political angles here and just know that I'm not intending to express any political opinions one way or another. My hope is just to reflect on the realities facing this industry that I've observed and then focus on the investment implications. So not making any political statements or insinuations, which is to say gun sales tend to be driven largely by political cycles and not economic ones.

50:20When Republicans are in the White House or control Congress, very overgeneralizing here, there's typically a belief that there's a lower risk of restrictions being put on certain gun sales. So there's less urgency to stock up on guns. And as a result, we tend to see fall offs when transitioning from times where Democrats have relatively more political power at a federal level to times when Republicans have relatively more political power. And it's also just not entirely the political cycle though. With guns, there's an element of disaster preparedness that drives people to buy them. And disaster fears can be driven by a range of things.

51:00Maybe it's worries about nuclear war or weather crises like major hurricanes or pandemics, as we saw with COVID, where anxiety about a potential breakdown of societal structure drove people to buy guns en masse. So whenever people are hoarding gold and canned food, they're also probably hoarding guns, which is what in part makes the firearm cycle somewhat unpredictable. You don't know what the next black swan is going to be that causes a panic. And when there are these publicized shootings that spur conversations about regulating firearms, this can also be unpredictable and very unfortunate events that do generate sudden upticks in sales.

51:41And like I said, these cycles are unpredictable in that I don't know when they will happen, but I'm pretty confident they will happen again. At some point, the Democratic Party will accrue more relative political power either in midterms or maybe the next presidential election cycle. And that will spark panic among certain populations about gun rights. Or there'll be an event that causes nationwide fear and drives people to buy guns for protection. Or there'll be a crisis that generates conversations about regulating firearm sales. Whatever it is, I can say with a pretty high degree of confidence that Smith and Wesson's business will take off again in the coming months or years.

52:20And if history is any guide, the stock will also take off too, which is why to keep beating home the point, I see it as a potentially attractive bet. But the tricky thing is I have no special insight into when or what that catalyst will be. And whether we like it or not, firearm sales are an enduring reality. and these patterns in their sales are fairly easy to observe. And when you layer over that possibility of sudden and dramatic sales increases in the future on top of a company that at current prices is already seemingly trading at discount prices and offering attractive shareholder yield, well, that's a very appealing recipe to earn at least 9 % or 10 % a year, but also much, much more if we catch the next upcycle.

53:07all. And of course, you never know when that upcycle comes. But one thing is a certainty, if your business is benefiting from catastrophes, they will come for sure. You never know when, but it's just a matter of time. And still, I got to say, as a non-American, and probably for many Americans as well, it feels surreal seeing these spikes in gun sales whenever tragedies like mass shootings or some form of catastrophes happen. But talking about these spikes and getting back to what that means for the business. I could imagine that the implications of such sudden increases in demand go beyond just swings in earnings and revenue.

53:47I mean, a company has to be prepared for such events. And preparation means having enough product to serve the demand. So basically, inventories filled way beyond the average or the usual demand. We've already talked about how boosted inventories can hurt companies, for example, in our Nike episode. Now, I guess the difference in the product they are selling matters. But getting to the bigger question here, which is basically, how does the volatility of firearm sales affect Smith and Wesson beyond swings in the financials? So for example, inventories, but also beyond that. Also, we're still kind of getting past the effects of all the demand that got pulled forward during the pandemic.

54:32Inventories jumped by$40 million as they tried to meet demand and overshot it. And then in 2024, inventories declined by$16 million as they tried to sell down all of that excess. But whenever you have a big excess inventory supply like that, it takes a toll on your working capital. And as such, companies often try to discount and write down the value of their inventory just so they can get rid of it. And this overproduction is an inevitability in a business where demand can be so fickle and comes in waves. Now with Smith & Wesson, I think management is probably right when they say they're not too concerned about them being able to sell inventory without discounting because this isn't fashion.

55:14Guns don't change that much and a six-month-old revolver can be sold just as easily as a new one probably. So they will eventually balance out their inventory, which is to say internally and at distributors, we're still working through a period of excess inventory. And that working capital pressure does not help with their debt load, especially at a time when there's still a lot of residual costs from their big headquarters relocation. If they did find themselves in breach of any of their loan covenants, well, that just creates more trouble with penalty fees and higher borrowing costs going forward.

55:50And definitely don't want to see that happen. And when you add in the leases for their manufacturing facilities too. The financial picture just gets murkier and murkier. Again, all the more reason that you wouldn't want to own this company long-term. I don't think they're in immediate credit trouble, but it is not the most inspiring balance sheet ever either. And their 2021 investor day, they said that they never wanted the cash balance to fall below$100 million. And well, they're sitting here today with just$26 million in cash. And it's kind of crazy to me that they knew they were over-earning during the pandemic period.

56:27They basically said as much on calls when their sales doubled. And instead of keeping any kind of long-term cash cushion, they very aggressively poured funds into buybacks when Smith & Wesson stock was expensive at kind of a higher point in the upcycle, leaving them now in a more vulnerable financial position. And it just seems like poor planning, poor capital allocation. They should be doing aggressive buybacks, assuming that they've budgeted the cash for it at the bottom of the cycle, like a period we're in now when the stock is the cheapest. The thesis then could really blow up here if for some reason the next gun sale cycle is abnormally delayed and the company's financials deteriorate further in the meantime, pushing them to cancel their dividend or maybe even falling into bankruptcy in a really extreme scenario, that that is a real risk.

57:20I always ask myself, is it because those management teams are good operationally, but just don't understand how the stock market works? Or how can you get the idea of buying back shares if it's very clear you're in a cyclical business and your stock is currently expensive? I mean, that's something that you should know as a manager of that business. But at the same time, they have been navigating these ups and downs in firearm sales for over a century and a half. So if anyone knows how to weather these cycles, it should be them. Even though we saw all these changes in the management team, they choose people who know how to run a business in that industry.

58:00And yet when I look at their dividend history, while they have been paying our dividends steadily and growing them since 2020, they only started paying dividends in 2020. So that's not a long history of dividends, especially for a company as old as Smith & Wesson. Not that we strictly follow Ben Graham, but his advice was to trust companies based on at least 20-year track records of dividend payments. That's why I've been more confident in Nike's dividend despite the operational headwinds that the company faces. Because if you spend decades paying out and growing your dividend, it says something about your commitment to do so.

58:40Hopefully, the statement though will not come and bite me in the next quarter where Naked will likely release some suboptimal numbers. So yes, I do rationalize my worst case fears here by remembering that they have been around for a very, very long time. And they haven't necessarily been paying dividends for a long time, but the business has been around for a long time. And they've been working around these unpredictable sales cycles for 170 years. And the point you're raising, which is a good one, is that it's not guaranteed that we sit here and get this simple narrative that I kind of outlined where it's like, yeah, we'll get this 5 % and growing dividend yield and maybe some sales buyback.

59:14And then we'll just catch the next firearm sale cycle and the stock will triple. And it's an easy moneymaker. And the more I've reflected on this as I've worked out my notes and as we've kind of talked it through here, I've soured on it. I've lost some of my enthusiasm. At first, I saw a company buying back a ton of stock, offering a substantial dividend yield with an iconic brand that seemed to be trading at a large discount to its normalized earnings and which would inevitably benefit from the next wave of fear amongst gun owners that drives them to buy even more guns. That was the super simple thesis in short.

59:52And with just a little patience, that thesis seemed like a tantalizingly easy way to earn a two or three bagger. And based on some of the posts I'd read about the company on the Value Investors Club forum, I really thought they were better capital allocators with a healthier balance sheet. And even as recently as a few years ago, they might have looked that way. But just the last two years have really changed my opinion. And as I dug into those more recent numbers, it's just been a disappointment. We spend so much time studying these companies that it's easy to forget that they really are the best of the best at what they do.

1:00:28Alphabet, Adobe, Airbnb. I mean, these are just really well-run companies that people pick at them for small things. But when we see what other management teams look like, it's pretty clear, hey, the folks running some of these big tech companies are pretty good. And I just call it a rude awakening whenever I look at these deep value picks and realize that there are good reasons that the market dislikes them. With Smith & Wesson, dividend payments over the last few years have come at well above 100 % of their free cash flows. And when I realized that, I just became way more skeptical about them being able to sustain their dividends without just getting lucky and having another random surge in firearm sales that sort of bails them out from really poor cash flow planning.

1:01:16And I'm doing a really good job of playing devil's advocate against myself here, Daniel. And it's a really lesson on why it's important to actually double check your assumptions. Don't just read a pitch or develop some idea at a high level and then act on it before you've thought everything through and verified it as much as you reasonably can. And like I said, I think it could be very easy to get tempted into buying this stock on the simple thesis that the dividend yield is great, the share counts decline, the PE is reasonable and normalized, and inevitably, gone sales will surge again. But once you dig into the numbers and see that the dividend yield looks shaky, all of a sudden, I feel much less good about being patient and waiting for a firearm cycle that I can't predict with any certainty.

1:01:55I don't want to be left holding the bag in what I you would think the more complex the company is, the more hours it should take researching it. But they are just different in quality. If you look at Alphabet, you see such a phenomenal company. And as you said, the management team is great, the businesses are great, and everything is working. So despite it being a more complex business, from an investing perspective, it feels easier to see what the company is doing and get an idea of how much it should be worth. Whenever you look at these smaller companies, these value plays, there are more factors playing into it that you don't necessarily see in the numbers or that you need to have some form of idea of how does the management tick?

1:02:43How do they think? Why do they do certain things that may not immediately look intuitive if you look at the numbers? So I totally get it. At a high level, the thesis sounds very promising. When you first told me about this company, I didn't know that you would pitch it, but it sounded like you were very intrigued. And I was happy when I heard you decide to pitch it, since I thought it might be a quote-unquote deep value that is maybe a bit too much for your taste. Now it sounds like you're not that convinced of this pick anymore. And while I see all the risks coming from the Worsling balance sheet, the inventories and the uncertainty about when the next upward cycle comes, I would have almost given Smith & Worsling the benefit of a doubt due to their century-long experience with these cycles and the almost certainty that the next spike is just a matter of time.

1:03:36And when that happens, the stock can be potentially a multi-bagger. But I can't get over the series of terrible management decisions. Buybacks at the heights of the stock price, publicly stating that the cash bonds would not go below$100 million just to end up at a quarter of that. And absolutely no vision for any expansion whatsoever. And as I said, I get the thesis at a high level and I can see why it would initially be attractive. But I agree it's kind of a lesson on the importance of verifying your assumptions, which I'm happy that you have done, because I could imagine many people just come across these kinds of thesis and not do the work to verify things for themselves.

1:04:22So I guess we won't be adding Smith & Wesson to our portfolio, but for the sake of continuing our learning here, do you want to just tell the audience and me how you would think about valuing Smith & Wesson? I think you already talked about getting to the owner's earnings and what do you actually see in the company? How did you value it? yes yes i've i've like you said lost some enthusiasm for smith and wesson over the course of our convo today and just in recent days as i was already reflecting on what i would say in our convo together and obviously i already had some second thoughts but i was still excited to at least talk it through with you and see where it landed for you and it sounds like we're in agreement and honestly i often start with one idea about an investment i'm just never sure what direction it will go in by the time I've wrapped up my research and we're done with the episode recording.

1:05:14It can go in different directions than it has for a number of these than what I expected when I first started. But to talk about the valuation, the idea was basically to do a few things. Firstly, average out their EBITDA, which is a measure of operating profitability, excluding interest taxes, depreciation, and amortization costs and try to get a normalized number across the firearm cycle. And I know EBITDA is kind of a dirty word. Buffett and Munger aren't fans of it. But in this case, it was kind of a cleaner way to look at things. And by doing that, I ballparked that Smith & Wesson was roughly earning 30 to 40 % less than what would be quote unquote normal.

1:05:59And then from there, I wanted to get a feel for their normal CapEx by backing out the one-time relocation costs that we talked about around their headquarters. And since there's no growth CapEx here, it's pretty straightforward to see that over time, their maintenance CapEx has been about$30 million a year under normal conditions, which I arrive at by looking at management estimates, but also just their historical depreciation costs on the income statement. And so when you subtract out interest costs in their debt and maintenance capex and then estimate taxes from that residual number, you can get a backdoor and very rough approximation of Buffett's owner's earnings.

1:06:37So with normalized owner's earnings at current prices, the yield is almost 10 % and that cash flow can go towards dividends while much of it has as well to share buybacks or reinvestments into growing the business, which they don't do much of. And even though that's a pretty attractive earnings yield, as we talked about, if you're doing 100 % plus of your free cash flow toward dividends, that dividend payment might not be sustainable. But still, if you can get any real growth in the normalized earnings of the business, because we're at such a depressed level, if it's from new product releases or new ways to monetize the IP or just getting lucky with the next firearm sale cycle, you could pretty easily underwrite a double digit expected return from current levels.

1:07:23That really only requires two to 3 % growth in their normalized earnings per year on top of the current normalized earnings yield, which is not a demanding projection at all. And so that's how you kind of think of say, okay, if my benchmark is an expected return of 12 % a year, We're probably right around that at current prices with a whole lot of asymmetric upside potential, which is why I initially thought the stock might be an attractive intrinsic value target at a buy price targeted below$10 per share. And while we've gone into a lot of the reasons today for why that may be too optimistic, weak cash position, no certainty on when sales will pick up, overspending on dividends and share repurchases, no plans to actually better monetize the business, poorly aligned management.

1:08:13And like I said, it's just wishful thinking to hope that maybe the business will be better run without an activist investor forcing some kind of strategic overhaul. And all that is to say, the sales volatility really, really hurts the quality of this business and makes it tricky to value it with any real confidence, especially with no ability to know on what timeline the next catalyst for gun sales will come. There's also just a lot of other things like regulation, lawsuits, and boycotts that they have to deal with that are beyond their control from an operational perspective that create hiccups for the business.

1:08:49So this was me taking a swing at a true value pick, and I don't really have any conviction in it anymore. So I'm sure you don't either. And we probably both agree that this is not even close to being a good fit for our portfolio, which is meant to be more long-term oriented. And one just last interesting thought about the company that I can't help but mention before we wrap things up today is that they kind of hedge against societal disruption. If there's another pandemic or some serious political turmoil over maybe another contested election, just something that fundamentally disrupts social cohesion, Smith & Wesson's sales are going to surge.

1:09:27And that could act as a hedge against most other companies seeing their businesses negatively impacted. And in markets, you hear about people using option strategies to go long volatility, meaning they benefit when there are big swings in the market. So you have another 2008 financial crisis, you actually make money. And in a way, Smith & Wesson is kind of like a way to go long social volatility. As the world around you crumbles if that were to happen you could make some good money by owning smith and wesson and so that is the purpose of a hedge and it's maybe not the best investment to make the anchor of your portfolio but something on the margins i'm not going to make the case for that perspective but i i get why people would own it and i wouldn't be surprised if that's the reason norbert lou owns it in his portfolio maybe it's my maybe it's my value bias but i don't dislike the situation I like the asymmetry that you also pointed out and that there are risks, fundamental risks to the company, but you have a company with such a long history of doing business and not going bankrupt.

1:10:37And you still have a company that has some cash. So you do know there's a cycle or an upward trend in the cycle coming. You have this asymmetry. You have a company that is around for a long time and the risks are kind of what you pay for when you go into this investment. There's a PE of 10, normalized at least. So I do still think it's an interesting opportunity. And I will keep an eye on Smith & Western just because I'm curious how it will play out. And perhaps if the price goes lower, there's even an argument to make just to revisit it or at least go a bit deeper, maybe looking at what the management did prior, how did they perform at other companies or anything like that.

1:11:19generally we haven't yet added any companies to the portfolio that would actually qualify as deep value plays and i wouldn't say that because we don't like them generally it's more so that the companies we've looked at until now also come with more downside risk than the great companies we otherwise look at like adobe or alphabet and i don't know how you think of it but i can imagine that these will be more interesting at a later stage in our portfolio. Currently, adding one or two percent positions feels a bit inefficient since we still have such a large pile of cash to deploy and we want to deploy that cash into high conviction bets like Alphabet, like Adobe.

1:12:03And once the portfolio has more positions and the cash pile gets smaller, we might integrate smaller positions that feel more like short-term value plays than high-quality compounders just because of their asymmetry. But I'm not saying we will do this in the future. It's just something that we might think about later on. No, I like the way you're thinking about it out loud. And it's fun to go back and forth because we are trying to build a portfolio together in public for everyone to follow along with. And so it's good for people to hear the thought process of how we would work through assessing an opportunity and the sizing of it and the risks that we want to take time horizon we're looking at how being honest about how our perspective will evolve over time where we're just biased you know we're humans we're biased by the fact that we have this huge cash pile so if there's something that we're not comfortable putting five or ten percent of our portfolio in it's like well this is not the best use of our time but once we have some of those core picks made and we've allocated a lot of that cash then we can kind of play around on the margins And this feels like something to play around on the margins with.

1:13:08And well, this has been fun for you to pick apart my ideas and for me to also pick them apart. But I'm ready to move on. I hope you learned a few things today and maybe got a little smarter about investing or just enjoyed watching me pitch a pick and have that kind of fall apart. But as always, let me leave you with a timely quote. the imitable Seth Klarman reminds us, value traps are cheap for a reason. Perhaps an inept and entrenched management, a poor history of capital allocation or assets whose value is an inexorable decline. That is arguably what Smith & Wesson looks like here, to me at least.

1:13:50A value trap where someone might roll the dice and get lucky, catching the stock at the beginning of an unpredictable firearm cycle, but otherwise not a winning pick for long-term investors who want to be owners of the businesses they buy stock in we'll see you all again next week