Tobias Carlisle (03:53):
I think it’s a funny rotation this one, because even though March 2020 was a big drawdown. I think it was more like a flash crash than the old school grinding bear markets that probably we’ve all seen a few of now. The 2002 bear market just went on and on and on and every rally gets sold. And the 2007, 2009. And I think I went back to Canada at one stage. I think there were 15 rallies over about 20 months that got sold and it’s that 15th rally that gets sold to a lower low that really breaks the heart. It’s not so much though, the scary drawdown at the start that is the hallmark of the bear market. It’s that sort of ongoing grind-down.

Tobias Carlisle (04:33):
We didn’t see that this time around. So I don’t know if that means that the cycle’s ended. I don’t know if we’re in a new cycle. I don’t know if any of it really matters. I just look at the way that the, not so much the factors, just I look at a broad range of ETFs that practice different strategies. And so what I have observed is that value has been pretty strong from September last year. I think it’s still going pretty well at the moment. I think size is the one that I think that probably the academics have written that off. It had done so badly. There’s no alpha in that strategy. It also ignores size as a factor. And of course, the moment that you say that size starts working again.

Tobias Carlisle (05:08):
I think they said the same thing about price to book too and press to book [inaudible 00:05:12] points out it’s the worst value factor out there, which means that when value is doing really badly, it seems to do pretty well. And it’s done pretty well again over the last six months, just by the nature of the stuff that fell into that bucket, the heavy assets without much cash flow coming off them.

Tobias Carlisle (05:26):
And then the quality factor is one that I find most interesting that it’s down still over a rolling three-year period. It looks really gnarly so the stuff that’s the low-quality stuff, which is stuff that’s got bad balance sheets and losing money has done really well. And it’s the high-quality stuff that’s so financed, good balance sheets, and good businesses throwing of cashflow that’s suffered and it’s all down. It’s still down. And it looks to me like, I think that at the point that starts turning the cycle matures a little bit and we go back into a more traditional kind of value quality market.

Tobias Carlisle (06:03):
I’m just interested because I know that Wes, I know that he tracks these things. You sort of track the academic factors. Wes, is that fair?

Wesley Gray (06:10):
Yeah. And we track them all, but yeah. I generally focus on the academic backed factors versus a lot more of the practitioner ones. But I think you nailed it. Momentum sucks, quality sucks, size rocks, value rocks, beta rocks.

Tobias Carlisle (06:25):
You got any thesis as to why that’s happening?

Wesley Gray (06:29):
No. You know me man, it’s just noise. It’s such a short horizon period here. This has happened. It’ll happen again. I don’t really have a great narrative beyond what you just explained there in how assets shifted through the pandemic and anything. It’s just people like junk and cheap junk. But that could also change. You just never know.

Stig Brodersen (06:53):
Jake, I couldn’t help but notice that you were nodding a lot more than I was whenever Toby was presenting his topic. So I want to throw it to you and hear your thoughts.

Jake Taylor (07:02):
I just had a question actually on, did you look at rates, say like 10-year treasury, how that’s maybe influenced some of this? Because that’s maybe been some of the argument is that rates have ticked up off of still incredibly low on any kind of historically informed basis but it seemed to correlate a little bit with bottoming of this value.

Tobias Carlisle (07:23):
I know Jake pretty well Stig these days. So when I see him nodding, that means I understand what you’re saying. I have a question about what you’re saying. So I don’t take that for agreeing with what I’m saying. I would say I just happened to have a look at the 10-year this morning, just because I’m sort of interested.

Tobias Carlisle (07:39):
It’s funny how when you pull back the 10-year treasury on a 10-year window, it’s crazy how flat and squashed down it is. It’s just right near the bottom of that long, long cycle down. It starts in ’82, is the peak and it runs all the way down to today. And then if you zoom right in, it looks like it’s run up a lot because it’s bottomed at 0.6 or 0.57 or something last year. And now it’s sitting about 1.56 or something like that, but it got as high as 1.73.

Tobias Carlisle (08:11):
I think that the narrative that it has some influence on value, I think is a good one and it’s probably right. I just think it’s really hard to show it in the data or at least I find it intuitively appealing. Like a lot of these things are really intuitive appealing. It’s just, I can never show them in the data. So you got to be wary of that, but it certainly seems like value has done better as the 10-year has crept up.

Tobias Carlisle (08:34):
The thesis for stuff that I’m trying to buy is always the same. It’s cheap and it’s got pretty good margins. It’s better quality than it looks. Even though my definition of quality excludes return on invested capital a little bit because I think it’s more main reverting, but you equally don’t want to buy the worst of the [inaudible 00:08:50]. The worst of the return on invested capital stuff because it’s all stuff that’s set up to fail. It’s like the biotech stocks that have never got a business, they’re just burning cash to try and find a compound that works or any of that sort of stuff that’s just created trying to find a business where really it’s more speculative.

Tobias Carlisle (09:06):
And like those things, there’s no main for them to return to. I don’t think you ever want to be in the very worst bucket of that stuff. That’s the way the portfolio is constructed. They’re cheap and they’re good but hidden. And then what happens after that is an emergent property of them and I don’t really have any control over that stuff. But I just like looking at the fact is because if my portfolios are doing badly, I want to understand the reasons why they’re doing badly. Is it something that I’m doing wrong or is it just some broader trend in the market that is, for whatever reason, higher quality, undervalued stuff is just not catching a bid because that happens sometimes, particularly in this market where it’s still a Wall Street, a bit speculative kind of option type market like AMC, which is the, I think it’s taken over as the main stock from GameStop. It’s now run-up. It’s like 4X over the last few weeks or something like that.

Tobias Carlisle (09:58):
And it’s not that because people are heading back to the cinema. So I don’t think so. I think it’s because it’s gone up a bit, so it’s gone up a lot more and there’s a lot of that happening in this market. And maybe that’s what always happens in the market, but it feels to me like it’s still a short-term value machine rather than a longer-term weighing machine.

Jake Taylor (10:15):
Yeah. I heard that AMC was trading at one times revenue. Oh, wait. That’s five years of cumulative revenue.

Tobias Carlisle (10:23):
Is that good?

Jake Taylor (10:24):
Yeah.

Wesley Gray (10:25):
I’d actually just like to ask Toby, okay, betting out a sample next year. Do you think value is going to keep beating momentum crazy names or what are you thinking?

Tobias Carlisle (10:35):
I think it’s impossible to know, but I just think that the only thing that I’ve observed in the market is once the trends get going, they just seem to go on for a long time. So I would’ve said that momentum or the expensive stuff probably had an unusually long run. And now that there has been some turn probably value just keeps ongoing for a while. Because I think as it works, more people are attracted to it and more people move away from the ARKs and the Teslas just because they’re down, they look like they’re going to keep on going down.

Tobias Carlisle (11:04):
And I think that that’s how trends happen in the market. I mean, I don’t know much about momentum, so you can probably fill me in a little bit more there about why momentum works. But it seems to me that when the trends get going, they do keep ongoing. We’re in a little value trend at the moment that the 12-month figures will be coming up in only three months. And then if the year looks good, then maybe more people invest in it. There’s a lot of narrative around value working at the moment. It’s in Bloomberg and on CNBC pretty regularly.

Wesley Gray (11:32):
Yeah, I agree. You’re spot on.

Stig Brodersen (11:35):
All right. So moving onto the next topic, this is a hard one because Wes wanted to talk about taxes. So because of that, I think Jake should have the next go.

Wesley Gray (11:46):
Save the worst for last Stig, I appreciate it.

Tobias Carlisle (11:50):
I actually think Wes has got a great topic. All right. Take it away Jake.

Jake Taylor (11:54):
Okay. Well, I thought it would be helpful, especially for younger investors who are being drawn into this market right now to find a touchstone that will help them guide them through potentially a difficult period. Now, I think the message that they might need to hear is that it’s not this easy normally to do this well. And when it starts going poorly, I’m sure Wes you can probably speak to this from your military experience of, you plan for all the ways that the things can go wrong and you have a mitigation plan for it before you’re in the middle of the firefight, right?

Wesley Gray (12:29):
Yeah. Of course. They call it SOP, standard operating procedures.

Jake Taylor (12:33):
So if you right now are waiting until to figure out what your plan will be when the proverbial S hits the fan, then it’s kind of too late. You should be thinking about it now. And what I am going to put forth is a little curriculum that you might do that would help get you grounded to be ready for when maybe things get difficult. And it’s going to be very, very Buffett-centric. And this is not because… Well, one, it’s because he’s been so generous with sharing all the things that he’s learned over the years. Two, he’s been incredibly successful. And then three, which I think Toby could speak to. I’m just not sure there’s anyone else who’s done it better. It’s historical his output and what he’s been able to create.

Tobias Carlisle (13:18):
Yeah, I agree. 100%.

Jake Taylor (13:20):
The first part, step one of this curriculum is to pick up the essays of Warren Buffett, which is someone… A professor took all of his writings and organized it by topic. And then you can just go and read through that and get the original source material. And this is a good lesson for anything actually that you’re researching is the closer you can get to the source material, the less interpretation bias there is of filtering it through someone else’s mind. So going to the root source as often as you can, is usually a good idea. So this is a good way of getting the best nuggets that Buffett’s ever written in 250 pages-ish, tremendous read. So start there and that’ll provide a good context.

Jake Taylor (14:00):
Now, after you’ve done that, to really get to a deep level of understanding of business, Adam Mead had this book that came out only a few months ago that’s called The Complete Financial History of Berkshire Hathaway. And he walks through all of the deals, every single year, what did the financials look like? What company did they buy? What was Berkshire trading at? How did the insurance perform? How did each of the subsidiaries perform? And you walk through year by year and you just get to see this story unfolding, this masterpiece that Buffett’s been painting for 50 plus years.

Jake Taylor (14:35):
So the first part of the book is about, actually pre-Buffett and the textile industry. And so you get through that kind of quickly, and then you start to get into Buffett and him making deals. And where it really gets fun, and this is where is going to provide the most value is that starting in 1994, the annual meetings are recorded and available to either watch on YouTube or you can listen to them on a podcast. So what I would do then is get up to 1994 in the book. That’ll give you a very nice intro into how things have been built so far. And then, read the 1994 section in the book and then watch the 1994 video.

Jake Taylor (15:13):
So Adam gives you all the numbers, he gives you all of the background that you would need, and then Warren and Charlie come in and they give you all the color about that year and then go and do 1995 together and then ’96. And you can work your way all the way up until this last year. And it’s just an incredible opportunity to learn directly from one of the absolute masters. And you’re as close to his feet as you can get to learn. If you do that, boy you’ll be a hell of an investor. And I think you’ll save yourself potentially a lot of heartache if you’re serious about this.

Jake Taylor (15:47):
Now, if you just want to make quick money and then also recognize that it can go away quickly, then that’s a different game, a different conversation. But if you’re serious and you actually want to be an investor, I’m not sure that there would be a better way to spend your time.

Tobias Carlisle (16:00):
I endorse that one. That sounds like an amazing… I’d love to spend the time doing it myself. I’ve got that book. I interviewed Adam on my podcast, he’s a good dude. [inaudible 00:16:10].

Jake Taylor (16:10):
Well, imagine how much work it was to write that too. I mean, he brought so much information together from so many places and then distilled it. I mean, just a tremendous effort. I applaud him for doing that for us. I would have loved to have that book exist, but it would have been impossibly painful to do it yourself.

Tobias Carlisle (16:27):
I think I said exactly the same thing to him. I was like, “I’m so glad you did it because it’s one of those books that somebody needed to go and do, but it’s just so much effort every time you think about it you just walk away from-

Jake Taylor (16:39):
Cry a little.

Tobias Carlisle (16:39):
Yeah.

Wesley Gray (16:39):
I’m a foundationally, a Warren Buffett fan. How did the heck do you get people to stick to the program though? Because a lot of times their advice is so intuitive and it makes all the sense in the world and they are right, but people repeatedly just don’t do it. You got any insights or what to read there for the advanced MBA?

Jake Taylor (17:01):
It goes back to the bigger part of this game, which is controlling your own mind. And what do you feed your mind? What are the environments that you create for your mind to operate in both from a biochemical level to the input of the stimuli that you give your brain? All of those things should probably be thoughtfully controlled for. And what it does is it helps you to… It’s like, if you don’t want to be a gambler, don’t go sit in the casino and stand next to the slot machine, right? Because you’re like, “Maybe I should put a quarter in. Maybe not.” Just don’t go into the casino and just keep yourself far away from it and then you don’t have to have as much willpower.

Jake Taylor (17:40):
On top of that, I would say that, probably the argument to be made that you may be wired a certain way that allows you to do it easier. And I’m referencing the marshmallow studies like some people are just able to not eat the marshmallow right away and they can wait for the second one to get to later. And then, William Green’s new book, he was interviewing Munger and talking about how, gosh, how do you handle all of this quotational stress in the middle of a crash? And Munger says, “I didn’t even feel anything. It’s not that I control it, I literally don’t even feel it. So there’s nothing for me to control.” And that’s probably a wiring thing as well. So we have our genes, but then we also have our input to our genes that we’d give through environmental control. Do what you can on the environmental side and hope for the best for yourself with your genes.

Tobias Carlisle (18:29):
If you’re trying to lose weight, at the same time you’re trying to do well in the stock market. You’re burning up some of your willpower on not eating stuff and exercising or whatever. And so you don’t have as much for the other stuff. For me, all that research shows that basically if you’re using willpower, you’re setting yourself up to fail. You have to put the bumpers down when you go to the bowling alley and just bowl with the bumpers down. Like you said, take the quotations off your computer, make it hard to pull up your numbers. Don’t track it tick by tick. All that sort of stuff I think is really the only way you can do it unless you’re built like Munger is.

Jake Taylor (19:07):
And to go back to that, going to the source material, Jim Chanos has this idea of what he calls the information onion. And so at the core of the onion where there’s the most truth is the actual SEC filings, right? This is what the company has to tell you. And then the next layer out from that is the company’s presentations and the annual report that they write and that’s the things they want to tell you. But maybe it’s a little bit further from the truth. Not in a lie necessarily, but just a rosier version of it.

Jake Taylor (19:37):
And then you move out towards sell-side research, which is going to be what someone else wants you to think. And then finally you get out into the cacophony of Twitter or WallStreetBets. And that’s just the pure rumor mill where who knows how far from the truth that actually is. So controlling where you spend your time and what part of the onion you’re eating, I think it makes a huge difference too, in the quality of the information that you are filtering through your brain.

Wesley Gray (20:05):
Another approach that I’ve seen people use effectively, it’s an inversion of what you said, which is to Munger is just setting up a gambling bucket on purpose. It’s like you do your 10% adventure bucket or whatever, and you just go crazy with no willpower. But then it causes you to lose focus on the 90% that is doing the old-school stuff. That’s maybe another technique.

Jake Taylor (20:31):
Portfolio cheat day.

Wesley Gray (20:33):
Yeah, yeah. But it’s a permanent cheat because you’re just going to blow it out the door, it’s, you’re just be bad and crazy bucket. To Toby’s point, maybe you exhaust that system one problem out on the money doesn’t matter. And then hopefully you can prevent yourself from touching the rational bucket. I don’t know.

Tobias Carlisle (20:53):
I’ve seen people use that approach and I’ve also seen people go the other way where they just won’t gamble on anything. They just won’t bet on basketball, won’t bet on horse racing, won’t play poker just because they’re like, “If I do it once, then it breaks the…” I’ve got this personal code where I don’t gamble and that includes all this other stuff. And in the stock market. So when I invest in the stock market, it’s a different system that I’m engaging, but I’ve seen both.

Wesley Gray (21:18):
That’s where I am. I’m fully abstinent on any negative expected outcome bet.

Tobias Carlisle (21:24):
Do you do it? Because when you walk into the casino, it’s just not fun. It’s not fun because you know that you’re just giving away money. There’s one bet that’s a fair bet in the casino run.

Wesley Gray (21:34):
No, it’s fun. That’s not the issue. It’s the, just don’t go there. It’s easier for me to abstain than to moderate.

Stig Brodersen (21:43):
Can I ask you, Jake? How did you experience March 2020? Having that mindset and just for people like March 2020, what’s going on? We had a coronavirus and for whatever reason, the market went up, but actually, they went down first. So that’s what we’re talking about right now. So we had Morgan Housel on the show here not too long ago. And he was talking about how being a stock investor is like being a pilot. It’s like 99% boredom and 1% sheer terror.

Jake Taylor (22:09):
Terror.

Stig Brodersen (22:11):
Like, that’s how it is. And so that’s really whenever you need to show your abilities, that’s that 1%. I guess Charlie Munger would also say, “You had to sit on your ass or sit on your hands.” Or whatever he was saying for the other 99%, which is actually also pretty challenging, but for that 1% of the time Jake, did you consult your Warren Buffett books, videos, whatnot or were you so prime that you were just sitting there and like, this too shall pass. Was that what you were telling yourself?

Jake Taylor (22:38):
There’s the bubble ultimatum, which is you can either look like a fool before the bubble pops or after it. And I had chosen at that point to look like a fool before, and I had a lot of cash coming into 2020, not because I knew there was a global pandemic on the horizon, but just because one, I just couldn’t find a ton of things to put to work that felt like not making that negative expected bet in the casino. So I was overweight quite a bit of cash.

Jake Taylor (23:07):
So coming in, I was like a kid in a candy store in March of 2020. It was amazing. All these businesses that I’ve been following for a long time and wanting to own, but just not at these prices became available. I bought a lot of things. Now, I didn’t buy enough because I had in my head this model that I think Toby even just mentioned early on was, typically when the bull market’s over, you’re probably looking at an 18-month average soul grinding down everyday type of outcome. And so I was prepared for that battle, which I knew was coming, maybe, actually, hopefully.

Jake Taylor (23:43):
My whole plan going back to the military thing that Wes was talking about, having that standard operating procedure, my plan set ahead of time before there was any pandemic was, I’m going to execute a lot of good buys over the course as we grind our way lower. Not a few perfect buys at the bottom. I’m just going to carpet bomb prices that I liked for companies that I’ve been following for a long time. And I got to execute a fair number of carpet bombs and picked up some things, but I didn’t get as much deployed that I would have liked. And then obviously it was just as Toby likes to say, it was like a golf ball off the cart path that just rocketed higher.

Jake Taylor (24:18):
And so the things we bought obviously did really well. I would have probably been rather down 50% instead of up whatever we were because man, I could have put more money to work at better prices, but you playing the game and the cards that fall and you can’t lament that that didn’t go exactly the way that you wanted and then you get ready for the next thing. So it was not difficult for me. I was ready for it. And I was happy that it came. But again, I mean, that’s because I had a plan already in place ready to execute off the shelf. And I wasn’t trying to come up with a plan on the fly.

Tobias Carlisle (24:52):
I will admit that it was really sweaty for me. And I’ll just say that because I have quantitative systematic proclivities, I’m forced to behave the right way through that process, even if I probably didn’t feel like it at the time. So I don’t have Jack’s level of zen. So I just have to do and run around myself where I just make it all work anyway. So even though I was panicking and sweating, it did kind of work out because it was forced on me or I forced it on myself beforehand, knowing that I’d be sweaty in the moment.

Stig Brodersen (25:25):
Wes, I think you previously told me that I couldn’t call you a quant. But with that being said for you, to have a very quantitative approach and you previously talked to us here on the show about something like momentum. It works because it works. Obviously, there’s a lot of other factors why it does work. But you’re very much looking at the data and not necessarily doing the fundamental analysis for you to find alpha.

Wesley Gray (25:46):
I’ve kind of reached a zen. I want to say I’m like Charlie Munger, but it just doesn’t affect me personally anymore. I’m not emotionally tied to market movements because my mind is so warped in some sense that it just doesn’t affect me. I don’t know why. I got to the stage of getting my ass handed to me so many times, I just do my systems. That’s what I do. Now that said, and to Toby’s point, I get cortisol through transmission from clients like teammates and other people because they’re not as warped and screwed up as I am. And so indirectly, I do have a little bit of empathy left in me somewhere, and when people are like, “Their whole life savings is gone.” And I can tell they’re very stressed out, it starts to affect me mainly because I don’t really care about the investment, but because I just feel bad that I can’t coach this person to just be calm. And I just feel like emotionally drained trying to be psychology for other people to not get so bent out of shape.

Wesley Gray (26:50):
For me, it was similar to Toby. It was just, I got cortisol via transmission from our clients basically. And now that’s just not fun to deal with. But me, personally, didn’t even think about it. I actually doubled down on value at the peak of the thing. I was like, I’ll probably lose 50% more, but this has gotten too crazy. And I never make calls. I only do that in my qualified account. It’s my gamble, which unfortunately is not that much. But that’s how I do it.

Tobias Carlisle (27:19):
Yeah. I remember that. You and Jack, I remember you tweeting or talking about that, so good call. Well done.

Wesley Gray (27:25):
Yeah, yeah, yeah. It was like March 22nd or something. We’re like, “All right, screw this trend following stuff. We’re going to ready to go all-in on deep value.” We’ve got intro month 50% drawdown, which is probably some sort of record. This is just crazy. But of course, we were wrong. Should have bet on momentum, which is the great irony of it. You always feel good. You’re like, “Oh yeah. How smart I was to buy a deep value.” And then it turns out, well, that was actually the wrong call. You should have bought the crazy momentum stuff that you would never have touched with a 10-foot pole.

Tobias Carlisle (27:59):
Yeah. After sucking for a decade, value then got the worst drawdown into it and then didn’t recover as well.

Wesley Gray (28:06):
Terrible. That’s life in investing, right? Simple but not easy.

Stig Brodersen (28:12):
The topic that everyone has been waiting for. Wes is going to talk about taxes. No, is actually a very fascinating topic. I shouldn’t bash Wes at all. It’s a great topic. So Wes, why don’t you take it away?

Wesley Gray (28:26):
Leave the worst for last Stig.

Stig Brodersen (28:28):
Right.

Wesley Gray (28:29):
But hey, if you care about your money and you like to keep more of it as opposed to giving it to the government, then you should pay attention to taxes obviously. And what I was going to do is just walk through a very simplified explanation of the difference in tax structure in between buying stock in your own individual account or buying it in a mutual fund or buying it in a hedge fund and how stock transactions work in an ETF. And so really unveil the man behind the curtain in why do people say ETFs are so tax efficient? So that’s the idea here.

Wesley Gray (29:05):
And so before we start with that, let’s do the most simple portfolio ever, right? Let’s say you have a portfolio and you buy one share of Microsoft and you do this in let’s say 2012. And all of a sudden you’re sitting here thinking, “Geez, Microsoft’s kind of expensive now. It’s gained 50X. I want to sell that and go buy Carnival Cruise Lines.” Let’s say. Well, if you do that in your personal account, the minute you sell, you’re going to have a capital gain realization, where you’re going to have to pay a chunk of that back to the government, and then you’re going to turn around with your proceeds and go buy your Carnival cruise.

Wesley Gray (29:42):
Same thing would happen in a mutual fund. The mutual fund manager would sell Microsoft, buy Carnival Cruise Lines, distribute via 1099 in a capital gain. In a limited partnership, which is usually how hedge funds operate, same problem. And actually, if you did that transaction in the ETF, where the ETF manager literally sold the shares. They would also distribute the capital gain. So what the heck is different about how ETFs operate?

Wesley Gray (30:11):
Well, structurally an ETF doesn’t trade with people out in the marketplace, right? You and I, and when we go buy an ETF at Schwab, we’re not actually buying it from iShares. We are buying it via a broker-dealer or a market maker, and only market makers, specifically, people designated as what they call, authorized participants can actually transact with an ETF company like iShares or what have you. And so what happens is let’s say that ETF owns that same Microsoft share. It’s just a one-stock ETF and it wants to go by Carnival Cruise Lines. But that ETF manager sits back and says, “Wait a second. I don’t want to be like everyone else, because if I sell Microsoft, I’m going to have to deliver a lot of tax to my clients. That’s crazy. We’re not doing that.”

Wesley Gray (31:01):
So what an ETF can do is it can transact in kind. And so what you would do is the ETF manager would create what they call a custom redemption basket, where that basket would include this one share of Microsoft. And that would be delivered in kind out to the market maker or the authorized participant. And in simultaneous to this asset, this Microsoft share being transferred out. Well, we have to have something of equal value coming in or the fund is getting screwed over.

Wesley Gray (31:31):
The simple way to think about it is, it would deliver in-kind shares of Carnival Cruise Lines. And so why does this work? Well, in-kind transactions are non-taxable. So when you redeem out through that custom redemption basket, that one share of Microsoft, that is a non-taxable transaction. That market maker or authorized participant who receives that share, would then turn around, sell it, get the cash, go buy the share of Carnival Cruise Lines on your behalf, and then deliver in kind to the fund Carnival Cruise Lines.

Wesley Gray (32:08):
And the way a fund accounting works is that whenever you receive an asset in kind, you receive it at its mark-to-market basis. Essentially ETFs have this ability to essentially cleanse capital gain and basis out of stocks, which is awesome. Because now if I run a buy and hold strategy, or sometimes want to trade and rebalance in the different names, I no longer have this issue where I’m always having to make a taxable decision. Where it’s like, “Geez, I would really like to sell Microsoft and buy Carnival Cruise Lines. But if I do that, I’m going to have to pay half of it back to the government, but I’m not going to do that.”

Wesley Gray (32:48):
Now in an ETF structure, you can just think optimally. There’s other constraints. We don’t have to worry about taxes. So it’s a wonderful way if you’re going to try to deliver some sort of active strategy or something that has turnover, all else equal, if you could somehow buy that or own that, or deliver that via an ETF mechanism, you’re just going to be able to deliver your clients a way better tax outcome in the context where you’re dealing with taxable money. So that’s basically the magic. You get rid of cap or basis in stocks via the ETF wrapper.

Jake Taylor (33:22):
Hey Wes, isn’t this the equivalent of the 1031 exchange in real estate?

Wesley Gray (33:27):
Very similar. And I usually call like ETFs, 1031 for stocks. But then a lot of people are like, “Well, what the heck is 1031?”

Jake Taylor (33:38):[inaudible 00:33:38].

Wesley Gray (33:38):
It’s the same idea. Yeah, you’re back to another one where they’re like, “Okay, what is that?” So yeah, same thing. Where in real estate, if you buy something like property, you can roll that basis into that new property and keep punting the taxes down the road. ETFs are obviously super tax-efficient, but they’re also super tax fair because if you go buy into a partnership or buying into a mutual fund like Sequoia is a good example and they owned stock, they bought at one, and now it’s worth 1,000.

Wesley Gray (34:06):
Well, when you buy that fund, you’re indirectly buying a tax liability that’s not even yours. Where the ETF basically says, “Hey, that’s not fair. Your tax situation should be managed on your behalf. And we don’t want there to be a negative externality problem where just because of dumb luck and success, the fund can actually hurt you. If you buy into them, you get to own someone else’s tax problem. That’s just crazy. So the ETF I think is just a fair way to… Basically, if you’re going to manage money on behalf of other folks, it’s a fair way to deal with the tax issues. So yeah. You should check it out if you’re not already doing it.

Tobias Carlisle (34:46):
You had this little blog piece on your site. This is going back a few years. Now, I don’t know if you remember this one or not. But it was comparing the returns from short-term capital gains to long-term capital gains to, I think it was buy-and-hold where you said, “This is the return that you need to get.” I think you said, “Sell it 15% buy and hold.” And then what that meant in long-term capital gains and short-term capital against. Do you remember that?

Wesley Gray (35:11):
That post is old now like seven, eight years now and the math always changes. But the simple idea is an ETF allows for essentially tax deferral. And so you have to figure out how much can you earn on whatever you’re paying out in tax today. And whatever you compound on that tax savings, in the end, is going to be the benefit. So if you’re a day trader, an ETF is worthless. It’s not going to help you if you’re buying and selling the ETF all day. But if your intention is to own a strategy for 20 or 30 years, or maybe die with it, pass off to your kids, the more you can keep the tax man and woman at bay, the better because that’s more capital you have with opportunity to compound.

Wesley Gray (35:54):
And so the assumptions about, well, how valuable is it? Is obviously highly contingent on your situation, tax rate, et cetera. But it’s important to know that once you’ve paid the tax out to the government, you’re never getting that back. Whereas if you have tax embedded like liability in your current book, there’s a million people you can hire that can help you figure out how to plan around that. And you have a lot of option value. And people always undervalue optionality, whereas you have no option value if cash is out the door and went to the feds. So I’m a huge fan of maintaining your optionality on tax planning front.

Tobias Carlisle (36:33):
You still got the float on it too that you can still earn on it, right?

Wesley Gray (36:35):
Yup.

Tobias Carlisle (36:36):
Buffett talks about it a little bit, that he’s got an outstanding tax liability to the federal government, but he’s still able to earn on that tax liability until they crystallize it.

Wesley Gray (36:46):
That’s right. And you can always lend against it too. So a lot of times people in insurance, if you have an asset that’s public and liquid. You can always go to your local friendly banker and say, “Hey, will you lend against my Tesla stock?” They might be willing to sit on the other side of that. And it’s another way to just get access to your capital or your float, than maybe do other things. But if you’ve paid it, you can’t do that. [inaudible 00:37:09].

Jake Taylor (37:10):
So would it be a good summary to say then that if you’re long-term committed to an active strategy, then ETF is definitely the rapper that you want to be in?

Wesley Gray (37:23):
Yes. And even in lowish turnover strategies, it’s pretty effective. But if you buy and hold individual securities for 20-year horizons, maybe it’s a marginal benefit. But it’s definitely important for anything that has any level of activity for sure.

Stig Brodersen (37:37):
Like you mentioned on the [inaudible 00:37:39] the other day, I feel I’ve been over-trading this year. I’ve bought two stocks and it’s bad. I really feel like I’m one of those Robinhood-kind of traders. I want action all the time. So I bought into two stocks this year. One of them is the stock I wanted to talk to you about, it’s the Franklin Covey and it’s not a full position. I’ve learned from my mistakes and started buying a bunch of old stocks back in the day before they slid like 80%.

Stig Brodersen (38:07):
So I learned a lot from past mistakes and what you quickly realize, and what you guys obviously know is that as soon as you own a stock, that’s whenever you actually learn about it. You can do so much research on that stock, but before you own it yourself and reading those statements with a different lens is really, really difficult. So I took a small position in Franklin Covey. And I wanted to hear your guys’ thoughts on that, especially why it’s a bad investment. Because I feel I’m a bit too excited about some of the good things about the company. And like they say, you should focus on the downside because the upsides typically takes care of itself.

Stig Brodersen (38:44):
Let me introduce Franklin Covey to you guys. And if you think that the name sounds familiar and then perhaps not at all. It’s because that’s the name from the author Stephen Covey, the author of the 7 Habits of Highly Effective People. And Covey Leadership was founded in 1985 and was then later merged with Franklin Quest in 1997 and since then have been selling training, leadership course materials. Now primarily it’s a lot of online stuff, but they also go live on the premises.

Stig Brodersen (39:11):
And since 2016, they have undergone a transition from primarily on-premises business to a subscription business that is increasingly digital. And that has also been accelerated by COVID. So whenever you look it up–and just in case you are looking it up, as you listen to this podcast–the numbers look ugly. Really, really ugly. This is definitely not a company that seems appealing. But if I can use Jake’s onion analogy, that’s trying to peel that onion and see what’s underneath.

Stig Brodersen (39:40):
And so what has happened since 2016, is that now 60 to 70% of the revenue or subscription-like service. And it would likely increase to 90% within a few years. And what they’re really focusing on is the subscription to the all-access past all of their content. So companies are paying tens of thousands of dollars for the services, sometimes more. Of course, depending on size of the organization. And on top of that, there’s a lot of extra services that they can then purchase. It could, for instance, be an onsite training or whatnot.

Stig Brodersen (40:09):
And so the incremental gross margin for that is 85% for the all-access pass. That is what’s growing right now. It’s grown with high teens. So interesting and [inaudible 00:40:20] for every sale they do, they do another 50% of that dollar amount in add-on sales. To fully understand the power, but also the pitfalls with Franklin Covey. You also need to understand a bit of accounting. So if you consider the fiscal year 2022 and keep in mind as you’re reading through this because this is a bit odd. Well to begin with, it’s probably a bit odd if you’re into accounting. But if you are into accounting, please note that the fiscal well year ends 31st of August.

Stig Brodersen (40:43):
So there’s just a bit of math you just need to focus on if you’re looking at some of the quarters and if you feel you want to mess up, with what happened with COVID. But anyways, you are only paying around 11 to 12 times free cash flows whenever you make the adjustments. It’s actually quite appealing and this is for a SaaS business that’s growing relatively fast. So why am I looking at 2022 already?

Stig Brodersen (41:05):
Well, not to make it more difficult as it may sound but if you ever analyze the SaaS business, you will look at the deferred revenue on the balance sheet. So you have a lot of revenue that has already been invoiced and is already signed, but you can’t recognize it as revenue before the service has been provided. And that deferred revenue is now more than $100 million and it’s growing rapidly if you’re looking into the SaaS part of the business.

Stig Brodersen (41:28):
Again, don’t look at the top line, look at what’s happening with the revenue for the SaaS business insight and keep in mind that incremental of that, we’re looking at something like 85%. So revenue retention, that’s 90%. How should we look at that 90%? Well, it’s all the rates right now that should be more than 100%. We all like that. We all like to grow revenue without getting new customers. But keep in mind, this is not your AI, something sticky kind of thing that you can never get out of. This is still training. This is leadership training.

Stig Brodersen (41:59):
And so with that in mind, the 90% is not directly comparable to a lot of other revenue retention rates that you see in the market right now. The stock is trading at $31 this morning. In my opinion, should be evaluated at least 60. And I would say even today, but what you would probably see happening here in the time to come is, it could be a potential compounder. They have converted now the North American business, but they’re also taking international business now and converting that into the same system. A lot of great things going on for this company.

Stig Brodersen (42:27):
They are building up the sales team, which is something I would really like to focus on. Being a small business owner myself, I know how difficult it is to build up a sales team. It’s really, really, really hard. The goal is, within the five-year period that they want their salespeople to sell $1.3 million annually once they’re fully ramped up. In the recent earnings call, they provided an update in that and said that the sales team outperformed the metrics by 20% better than expected. So you can go into [inaudible 00:42:58], which I’ll make sure to link to and see, what do we expect of the first year, second year, third year, and so on.

Stig Brodersen (43:03):
Again, as a business owner, I can just say, “It just never happens.” Your salespeople are never better than what you expect them to be. And so a few key metrics that I would like to pay close attention to, will the management succeed with this full SaaS business transition 2024? They’re targeting 90%. The reason why they’re not doing more than 90% is simply because a lot of the sales funding that they have is very much, they have someone to speak to the board. A one-time, one-off kind of fee. And then that’s the funnel that they go into a subscription base afterwards.

Stig Brodersen (43:36):
90% is probably the max, but can they go from this 60, 65 they are at right now up to 90%? That’s one thing. The second thing is, will we continue to see the lifetime value per account increase as it’s been in the past, and will it then also continue to have 90% plus of revenue retention? Especially a third thing I’m looking at is also, will we continue to see the growth in the subscription service? And so what you’re seeing right now, and the reason why the top line is flat and even a bit declining is that the legacy business is just being cut off and you just see the SaaS business just growing right now. So that was my pitch. That was all the good things. I do have a few bad things to talk about later, but I’d like to throw it over to you guys.

Tobias Carlisle (44:17):
I remember a pitch for Franklin Covey in 2009 and I didn’t buy it. And I just went back and looked at what it’s done over that period of time. And it’s 10 bags. So I don’t know if I’m qualified to answer too many good questions here.

Jake Taylor (44:30):
I did a fairly dive on it, probably three or four years ago. Met the CEO and I liked the model that seemed to be developing where they… I mean, so imagine that you’re just a leadership author or something, and you write a book about it. What’s another way for you to monetize the IP that you created? Well, you came up with Franklin Covey and make a little class for it. And then they can provide that in their all-you-can-eat buffet pass that they created and it’s zero marginal cost to them to add one more person to watch it. And it’s little Netflix adjacent in that way, except for training.

Jake Taylor (45:06):
I also ended up not buying it, not for probably any real good reason, but it was a very interesting model that was developing. There were some good things and it went a little bit into my too-hard pile and a little bit into, I want to see that some more execution first. And so that’s where I’ve fallen with it.

Stig Brodersen (45:24):
Thanks for the feedback. It’s tricky. You mentioned before Jake, is it kind of Netflix adjacent? That’s one of the things that they like to talk about. Actually, one of the things I talked about multiple times is that they expect that they will get to a point where content creation would be paid for. Because I don’t know if that’s ever going to happen, but they were like, “Hey, this is the mode that we have. People want to be in our company. They want us to be able to upsell their products too.” And so to be a part of all-access pass, why should we pay millions and millions of dollars to create our own content? If other people can be included in this and because of the upsell potential and the cost of the brand, they should actually be paying us.

Stig Brodersen (46:00):
And so that hasn’t happened yet. Being born a pessimist, I don’t necessarily think it’s going to happen. I just wanted to put it out there. I would say that one of the concerns that I do have with this and I have, well, I have a few, but the first one is probably the mode. I don’t necessarily think that the mode is as wide as they would like to say. It’s hard to sell something like leadership and personal development. One thing I really, really liked about this company was that they actually sold a lot of that during COVID, which was a bit surprising to me to see actually. You would expect that some of that would be the first to be caught. I don’t know how wide that modus. If you look at some of the competitors, you have decided to mention International GP, Strategy Corp LinkedIn Learning.

Stig Brodersen (46:46):
You have a lot of other great companies who’d also say, if you asked the management, “Do you have a great brand? Do you have loyalty?” They’d probably say the same thing. It’s just because of that we are now talking about from Franklin Covey, right? That’s the company we’re talking about. So I would probably be a bit concerned with that.

Stig Brodersen (47:03):
Another thing that I really don’t like is, as I was going through the 10K, I always liked to figure out how the management is incentivized. And it’s always a bit tricky because you hear about these million-dollar salaries and you’re like, “What’s the market rate?” It’s always a bit tricky. But one thing that I don’t like is that they have this adjusted EBITDA that they talk about all the time and they have these milestones about adjusted. They actually call it qualified EBITDA just to make it even more complicated.

Stig Brodersen (47:30):
And if you dig into what that means, I don’t necessarily think that you’re 100% aligned at all times with the management. That’s one of the things we definitely don’t want to see. There is actually a high inside ownership, but they also give themselves stock. So keep that in mind. And they use compensation consultants to figure out whether it’s how it should be. And like Jake was talking about before, how you should go through from 1994 at CNBC for The Annual Shareholder’s Meeting for Berkshire Hathaway, which I did. And I cannot remember how many times Charlie Munger said, “Do not hire compensation consultants.” I think that’s probably the only thing in the world he hates more than Bitcoin. This is a tough sell, right?

Stig Brodersen (48:10):
And so if you look at how they’re incentivized, they have these, in my opinion, quite conservative metrics. And you might say, it’s nice that they’re conservative. The management is conservative, but why wouldn’t you as management have conservative metrics if you’re being compensated by how much you are perform? There’s different things built into that. If we take some of the bigger accounts in terms of depreciation and amortization, those are real costs. If you look at how that’s been built up, yeah, there is a bit in terms of some of the billing with some of that where, that’s not so much the issue, but the rest of the cost is more or less real cost. And they’re spending millions of dollars right now. That’s of course being amortized, but the course material that they’re billing right now, but that costs millions of dollars. And so that’s not their target. That’s someone else’s money, right? That’s the investor’s money and that’s not how they’re being compensated. So that’s one thing I don’t like.

Stig Brodersen (48:58):
Another thing I don’t like and I think I mentioned before that I needed more to the bear case. And here I am just telling you guys how bad this pig is, but I’ve seen a bit too consistent restructuring costs. And I don’t like that. It’s just, I hate whenever you put things down, especially when they were compensated on qualified, adjusted EBITDA. You have that in ’15, ’16, ’17, and 2020. And it’s only like $500,000, 700,000, 1.4, and then 1.6 last year. It’s just one of those where I’m like, “Would you like your employees to just steal 100, then that’s okay. As long as they don’t steal $1,000.”

Stig Brodersen (49:34):
It’s more just like a slippery slope kind of thing. And if you read through the statement, why they made those changes? Why they set that money aside for the structuring cost is because they were making a transition into a subscription service. And I was like, “No, no, no, you did that in 2016 and talked about it in 2015. Why are you putting things down in restructuring costs this year?” Because you’re actually executing another strategy. I don’t know. There were just some red flags.

Tobias Carlisle (50:01):
Sounds like a good growth area for them. It’s compounding really nicely. Can I ask you a question about, I’ve just got the 30 Year Financials from Guru Focus that they run them all the way back to 1991. And from 1991 to 2000, it’s just this vertical ramp of revenue per share takes off. And then in 2000, it just completely reverses course and it spends the next 10 years at bottoms in 2009. And since 2009, it’s had this really nice run again. Although not as sort of vertical as it was in the initial period. I just noticed as part of it too. The last 12 months, it looks like revenue growth has gone back with 21.7% and everything else has gone backwards. Is that part of the transition or is that they are impacted by COVID?

Stig Brodersen (50:48):
Yes, and yes. That is a part of the transition, but also they’re doing so many things from the legacy business that’s on-premise, which has just been very, very difficult for obvious reasons during COVID. So that’s one of the reasons why we’ve seen that. So the way it’s built up is that they have an education business and they have an enterprise business, or a division. The education division has also transitioned into a subscription. And that has been quite difficult. They had a generous donor, it looked like the first few years. And now with the new rollout that’s coming out right now, there’s probably with the current administration, a lot of money for them to just have in terms of the type of programs they’re doing, but it’s left to be seen whether that’s going to happen. But if you do look into the different segments, not just those two divisions, you can just see the legacy business just being abbreviated last year. It was just tough.

Stig Brodersen (51:41):
Some of the international expansion has been tricky. So from Australia and for UK, it’s expected to be relatively easy to transition into this all-access thing. It’s a lot trickier in some of the other countries, specifically China and Japan, whether or not it’s developed, they don’t have the same digital setup. And so a lot of that has just been gone. It’s just done. It’s just not going to happen. So that’s just another thing to add to that.

Jake Taylor (52:06):
I always kind of wondered if it’s similar, at least in my opinion of Netflix, where you’re on a content creation hamster wheel. And what’s the shelf life of your inventory of new courses? I think there’s a fair amount of what’s popular today? It’s a little bit of a recent hits thing. All of which is to say that, you think that you’re going to be able to amortize all these content costs over a really long period of time. And maybe it’s a little bit more like vegetables on the shelf that they go bad within a shorter period of time.

Stig Brodersen (52:39):
My wife and I are re-watching Friends right now on HBO. So I don’t know if that’s a good example, but one of the things that they have been saying is that “Oh, this is timeless.”

Jake Taylor (52:50):
It is a good example because it’s one show out of the thousands of shows that aired during the ’90s. And most of them are worthless.

Stig Brodersen (52:58):
Right. Exactly. Whenever they were talking about, 7 Habits of Highly Effective People. I would say that the shelf life is probably better because it pertains to principles, which by definition are somewhat timeless, but it’s probably not as timeless as they’re trying to sell it to be. We still need new bells and whistles. I think last year they spent $5.4 million in new content creation that’s not being amortized. And you would be like, “Hey, if all the content is timeless, why you need to do that?” So I think that’s part of it.

Stig Brodersen (53:29):
Another part of it is that they spend a lot of money upgrading and making everything, not just digital because I think most things are that, but the whole portal right now, that looks much better than before. Let’s just go back to the Adam Mead book about Berkshire Hathaway. I would say that to some extent, as much as they’re trying to sell that, we’re building that mode. It’s like whenever they had those looms back in the day, and you’re like, “Yes, this is more efficient, but it’s not like LinkedIn are not upgrading this at the same time.

Stig Brodersen (53:55):
So it is a real capital expenditure one way or the other. And it is required for them to keep the lights on in the business. Can I ask you, Jake and Toby, you’ve looked at this before. Would you look at this again with what we talked about today? It’s still in the two hot pile, slash Stig’s just not smart enough to figure out that it’s too hard and he shouldn’t be looking at this in the first place?

Jake Taylor (54:18):
No. I don’t think there’s ever any reason not to look and see if you can learn something and often revisit things that like that saying that no man ever crosses the same river twice because it’s not the same water and he’s not the same man. And I think that same thing applies to the research process.

Stig Brodersen (54:36):
I’m doing a lot of skull bot-type thing right now also because I’m just building a position. So if you listen to this and you’re working for Franklin Covey or your company have been buying their products just hit me up on Stig on theinvevstingpodcast.com. I would actually truly love to jump on a call and just learn more about, is this product truly superior? One thing is that the management is telling me that it is, but all managements are totally incentivized I choose to say so. So if you have a really good bare case to this, especially if you’re working with them and using their products, I’d love to learn more. And hopefully, I can give something in return.

Stig Brodersen (55:10):
Anything else that you guys wanted to chat about?

Wesley Gray (55:14):
Just say, thanks Stig for reminding me why I don’t pick stocks anymore. Lots of brain damage.

Stig Brodersen (55:22):
It’s hard picking individual stocks. If you don’t love it… It’s probably people running a marathon and other people are like, “Why on earth would you put yourself through that? And you’re in pain. I can see you’re in pain.” And you’re like, “I just love the game. I need the game. I need to do it.” That’s the best way I can explain why I’m still picking individual stocks because you’re right Wes. It’s painful. It is.

Tobias Carlisle (55:47):
When we have the 10-year anniversary of this podcast and it’s up 10 times, then you can say that why I do it.

Stig Brodersen (55:54):
Right. Great. All right guys. As always, it’s amazing to have you guys making time to sit in here on the show. Jake, Toby, Wes, Wes if we start with you, where can the audience learn more about you?

Wesley Gray (56:06):
Alphaarchitect.com or just on Twitter at alpha architect.

Stig Brodersen (56:12):
Perfect. Toby.

Tobias Carlisle (56:13):
I have acquirersmultiple.com. And I’m on Twitter at Greenbackd, G-R-E-E-N-B-A-C-K-D. And my fund website is acquirersfunds.com.

Stig Brodersen (56:27):
Jake?

Tobias Carlisle (56:28):
farnham-street.com for our investment management firm. And then FarnamJake1 on Twitter and then Toby and I and Bill, and apparently, others lately do a little weekly thing where we get on and basically just give each other a hard time for an hour. And that’s called Value After Hour. Not too hard to find, I think, any three of us.

Stig Brodersen (56:51):
Wonderful. It’s a great podcast. So I just want to say that then if you’re really interested in value investing, that’s the place to go. Gents, thank you so much for making time speaking with me here today.

Tobias Carlisle (57:03):
Thanks for having us, Stig.

Jake Taylor (57:03):
Thanks, Stig.

Wesley Gray (57:05):
Thanks, Stig.

Outro (57:07):
Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional. This show is copyrighted by The Investors Podcast network written permission must be granted before syndication or rebroadcasting.