Stig Brodersen  05:58

Yeah, I think in consideration of that, Preston, and I’d like to this discussion about always thinking like an owner. And the real thought about you, Preston, actually, you talked about that so many times whenever you’re seeing a business, like how do they operate and the teaching from T. Boone Pickens now you can do this different ways. And what he did was more like an activist investor, if you can call it like that. You mentioned Carl Icahn. It’s somewhat the same approach, and you acquire a lot of shares. And you don’t like the management and then you struggle a lot, but then you might be able to realize some of the value in this company. I completely admire that approach. I think it’s good that some people are doing that.

I think I might be more into the Buffett’s style where he doesn’t do hostile takeovers because it also seemed like even though T. Boone Pickens was very successful with this activist approach, it also seemed like he suffered a lot personally, which I guess you do whenever you are fighting with other people. And one thing I like and this was just a short anecdote, but it just said something about corporate governance in the 50s and 60s. He was talking about the Union Oil Company out there in California and talking about how management’s looked at shareholders. He’s talking about the largest individual shareholder and Union Oil Company is used later to be Unocal, and he proposed a higher dividend. During the annual meeting, the CEO responded, “Why would we give away money to a bunch of people that we don’t know?” And I think that that was a horrible answer to give. But I think even today, you see a lot of horrible management decisions. So even though I might not do it myself, I think it’s important that we have people like T. Boone Pickens and Carl Icahn to fight the managements out there.

Preston Pysh  07:51

So his company, wrapping up his initial start to his career that gave him the notoriety and his name is… So the name of the company that he was running and operating and he found was Mesa. So what I found strange is after he sold Mesa, and I think that this happened in 1996 or 1997, is when he sold Mesa and it was like this didn’t end very well the way he sold it. He got forced out and it was an interesting part of the book to hear him talk about his leaving Mesa.

But he had obviously a very large amount of money after he was forced out and he started a new company. Did he go through a divorce at this point in time? I can’t remember where that lined up. I think so yeah, it all happened at the same time where he went through a divorce and him talks about all that part of it and the troubles and the just enduring, losing his company, and losing his family. So I appreciate his honesty and talking about that in the book. I think that that says a lot about him. Then after that, he went out and he started a new company called BP Capital Management. From what I can understand in the book, this was a futures company. It is out there trading futures contracts.

Stig Brodersen  09:04

Yeah. Well, there was a funny story about he had to take the license, right? He couldn’t be licensed to do it because he failed several times.

Preston Pysh  09:11

I forgot about this. Yeah, you’re right. Good. Tell the story, Stig. This is good.

Stig Brodersen  09:15

It was just like he wanted to start this company. And then someone, you know, patted him on the shoulder and said, “Well, you can’t just set one that up”. And clearly, you know, a guy like  Pickens who just set it up, like, “I’ll figure it out.” But he was forced to be licensed and couldn’t pass the exam. And people coming up to him saying, “Aren’t you T. Boone Pickens, did you write the book on commodities, the book on oil?”

Preston Pysh  09:37

Yeah. I think he passed on the third time of taking this commodities test that was required for him to get a license. And I love the fact that he told this in the book because, to be honest with you, I might have left that out of my book. But I was impressed that he told the story. I think that for how much of the other parts of the book that I thought were egotistical, I was happy that he left that in there because it was a funny story. It made him seem human, you know? In the book, he talks about the same person who was administering the test and just looking at him like, “Is this dude ever gonna pass?” And then on the third try, he brokered a deal with the person who was administering the test and he could use a calculator. He could have as much time as he wanted, even though it was a timed test and, on and on and on, and he did pass the last time.

Stig Brodersen  10:28

What you got to admire is that he was 67 or something like that. And like all the other guys, they were like the 20s whatever.

Preston Pysh  10:35

He was old at this point. So he’s this old dude who’s an oil tycoon just sitting in the room, taking this test with these 20 somethings, and could not pass it. So interesting start to his career at BP Capital Management did extraordinarily well as a futures trader.

Now, here’s where I find this interesting. So he started the company in 1997 and then 2006, so fast-forwarding almost a decade, he earned 990 million from his equity in the two funds. And 120 million from his share of the 20% fees applied to the fund’s profits. So I mean, he made a billion dollars is what it comes out to be. His net worth right now is about a billion and he’s given away a lot. I want to say $900 million, or something. Hold on here, I got the number. It’s close to, I want to say almost a billion dollars is what he’s given away. So what he’s a mash of the years is probably 2 billion. His net worth is around a billion, maybe a little shy of that right now.

So he made his money and he did it through futures and he did it in the oil industry. Now, what I find interesting is when you’ve listened to him in the news recently, and I’m talking in the last year, you go back to the start of 2015, that first-quarter second quarter when oil was getting punished. And T. Boone Pickens was on every national financial news network, saying oil is going to be $70 by the end of the year, oil is going to be $70 by end of the year.

Then, when you get into the deep, disgusting part of this oil glut that’s been happening when oil got into like the $30 range, he was still singing the tune oil is gonna be $70 by the end of the year. And he has been so far off the mark with this. I mean, not even close to being on the mark with this, that it’s not even funny. And if I was gonna say and who am I to say anything, especially when you’re dealing with a guy who’s accomplished an oil as much as him. But I think the thing that he’s missing is he’s not understanding the correlation in the relationship between currencies and commodities. I don’t think he gets that based on his recommendations and his comments in the past year. Now I could be completely wrong and that might be egotistical for me to say that but that’s where I think he’s making the mistake. So I’m curious to hear Stig’s thoughts on this.

Stig Brodersen  12:52

Yeah, I thought it was interesting too because I also had to look up T. Boone Pickens’ current view and the thing, Preston, and you sent me a video like a few months back when he’s sitting and discussing Carl Icahn. It’s fun because I can’t remember the last time I saw an interview or read something with T. Boone Pickens where he didn’t say like, “Oil is gonna rebound tomorrow.” But I guess people just laugh out there and say that that I’ve been saying the same thing on the podcast. So I think it’s interesting that he talks about how he looks at fundamentals when he is investing in oil. And he’s saying, “Even though I am a trader, to some extent, I don’t cut off my profit saying after a profit 25%. That’s not how I invest. I look at the fundamentals. I look at the weather, I look at storage, all of that.”

What I think is missing in the book is him more going to depth with how he actually… we’re looking at the fundamentals because I think I relistened to that, three or four times just to be sure I got it. And I didn’t get it.

Preston Pysh  13:51

So I had the exact same experience. I was listening to that part because when he gets into how I fundamentally look at creating oil futures, I mean, for me, that’s what I’m wanting to know, and here is his thought process. But you know what I took away from it, he just kept bringing up the weather the whole time. He just kept talking about how when the weather’s bad, and the weather is good, then you know, the price is going to move, because you’re gonna have a draw, and you’re gonna have an oversupply or undersupply. And I’m thinking that’s a short term thing. Like that’s a quarter trade, not a five-year play. And then like in the same breath, he turns around and says, “I hold and I let my gains run for five years.” I’m thinking this does not make sense. My impression of his BP Capital Management portion was just he hit the market at the right time. That was my that’s the way I took it. I was like, he hit the market at the right time. And just really, if he was in the market right now and trading BP, would he be getting crushed? Absolutely crushed. So do you agree with that analysis that do you think it was a little bit of luck?

Stig Brodersen  14:56

You know, I think it’s hard if you made so much money as T. Boone Pickens, to dedicate to say that it’s luck. But you look at how the fees were structures, he was charging 1.75% each year. it was so easy for him to attract capital, at least compared to your guy like down the street because he knew so many billionaires and multimillionaires back then. So it was so much easier for him to set up even though he says that he only had six employees from Mesa when he was starting. That was quickly 400 people because it was so easy for him to hire the right people, and all the employees and the company. And then he talks about this incentive fee of 20%, which is obviously extremely profitable whenever you start making, like the returns whether or not it’s luck. And I disliked what he said about how he wanted the incentive fee of 20%. I’m like if you’re charging almost 2% a year, do you need an incentive to provide good performance for yourself and you’re a shareholder self and to the other shareholders? It was just completely contradictory to what he has said like previously in the book.

Preston Pysh  16:02

Whenever I look at how commodity cycles, particularly in oil ago as far as the waves and the dips in the highs on it, when you look back, when he was in the commodity business, he was in the boom time of oil. You know, when you look at the housing crisis and all that stuff, oil did well from that timeframe from like 2000, call it 2001, 2002, until 2008. Please don’t take this out of context like I’m implying that that’s what T. Boone Pickens was because he is very accomplished as a manager in the oil sector before all this happened. But I’m just saying his timing was amazing.

Now, when we come out of this contraction that I believe that we’re approaching right now, let’s say in about a year, two years from now, I feel like oil will do just phenomenal again for another five to seven-year tear. And so I just see Pickens, the timing of when he stood up this BP Capital Management is being like right in that ripping zone of easy performance. So that’s my opinion. And then when you’re charging 20% fees on every profit that you make, I mean, it’s a little hard not to make money when you have that capital structure and you got a bunch of millionaire friends. So that’s my impression. I hope that I’m not being over-simplistic here. And I’m sure that I am.

So in the last part of the book, and I like this. I like the fact that he brought this up in the book. He talks about energy independence. So Stig’s gonna talk a little bit about some of these comments here.

Stig Brodersen  17:33

Yeah, that was definitely one of the discussions that I like the most and partly it was politically loaded. It was extremely interesting. And it might look like if you watch the news right now that the US is producing so much oil in which they are, that they don’t need to import, but the US is still importing a lot of oil they are importing, the most recent number of *inaudible is 6.8 million barrels a day.

Just to give you some numbers. For comparison, the US consumes close to 20 million barrels per day. It’s interesting that you will have, as a country like the US that might consume like 20 something percent of the world consumption oil, but still is only 5% of the population. So the US, the way it is structured is very dependent on oil. And one thing where I think he missed the mark is his distinction between energy and electricity.

Well, clearly, he knows what he’s talking about. But I think he made it sound very easy when he talked about his wind investments. So for instance, he’s saying that you will have one three megawatt wind turbines, and that can produce the same energy as 12,000 barrels of oil in a year. And while that’s true, I think he should mention that electricity is a form of energy. You can’t just replace fossil fuels with a windmill. And I think you could get that impression whenever you’re reading his book, and he places a lot of emphasis on renewables. I think I’ve been bashing renewables a few times before on the show. It’s not because I think renewables aren’t a bad thing. I think it’s great and I think it’s good for the environment, but I think he misrepresents how important they are.

Preston Pysh  19:11

Yeah, so Stig, I think that the point that you’re talking about is one of the reasons why Elon Musk has been able to take the energy market by storm is because what you just said as far as oil being different from electric energy and a different form of how you can convert that and transportation being reliant on oil because it’s portable, and it can move with the vehicle. That’s where Elon Musk has said, “You know what? You’re right. But let me tackle that problem and try to make it so that electricity can be transportable, and go on the move.” And that’s where he’s placing all of his emphasis and really, his hardcore technology, of his technological development of the products that he’s designing is so that electricity can be portable, and try to bridge that gap.

You don’t see other people going at it as hard as Elon Musk. Maybe he just has a better branding and marketing campaign than other people out there. But, you know, he’s the guy who’s trying to make that happen. And you can see that it’s paying off for him because he’s bridging that gap. But I’m sorry to interrupt and keep rolling.

Stig Brodersen  20:17

No, it’s a good point, because I was typing up some notes and had a section about Elon Musk. I think you bring up a good point because renewables have their limitations, and especially when the book was written. But still, today, because in general, you can store electricity in meaningful amounts, which also means that you can transport it, it has to be used right now. And you might be thinking about Elon Musk and Tesla and he has done some amazing research in terms of building batteries.

But I also got to say like, if you look at the effect of what they can store, it’s close to zero if you look at it from the broad American perspective. Now, that doesn’t mean that the technology is not there. It doesn’t mean that it’s something that could be better in the future, but as it is right now, it’s just very, very difficult. And I would like actually, without being too geeky, because I think I mentioned this on the podcast, I used to work in energy trading. I’d be managing some of this renewable energy. And it’s just evident for me to see the limitations because you might be thinking, “Well, isn’t the wind always blowing somewhere? Is the sun always shining somewhere? Couldn’t we just use that electricity?”

Well, the problem is that you have different limitations. So for instance, you have something like cables, you can’t just transport something in a cable that can be there. And you have power grids. So that means that sometimes you can transfer something to another power grid, which means that just because the wind is blowing in Oklahoma, that doesn’t mean that you could use it in New York. That’s just not how it works.

Preston Pysh  21:47

But instead, what you’re saying is that under the current infrastructure, it can’t take place. But we could, as a world, start developing more infrastructure handle those demands, if that would be something we try to move towards. It just wouldn’t happen quickly is what you’re saying. Correct?

Stig Brodersen  22:04

Yeah, in the power grid, you have to need to have the same frequency. So for instance, here in Europe, it’s a 50 hertz. So it needs to be stable. How will you have a stable electricity system when demand-supply changes all the time? You have higher demand during the day than during the night. So what we’re doing in the power grid right now, and we’ll probably do for a long time is that we figure out so what is the stable way of delivering electricity? That’s something like coal is huge in the US. It’s not politically correct, it also pollutes a lot. And if you start to clean it, it’s very, very expensive, but we’re using a lot of coal. We also use natural gas, but it’s because it’s a more stable resource, and we can store it and we can also transport it if we have to.

Preston Pysh  22:46

That’s one of the other things that Musk has taken on with these battery storage capacitors, basically, where he stores his energy when it’s in high demand or whenever it’s cheaply being produced. You can actually… The thing that he’s designing is a large battery power unit that you would put into your house that you could then store. And you could draw and charge that thing whenever the energy costs are cheaper. And you could then draw on it whenever the energy costs are more expensive. So it’s interesting that he’s trying to tackle these problems that Stig’s talking about. The issue is how do you go about distributing these to a very large audience that starts having an impact around the world where he’s nowhere close to that at this point?

Stig Brodersen  23:33

Yeah. And I think you bring up a good point here. Just to give you some numbers for comparison, so if you look at renewable energies, including hydro, wind, solar, that’s less than 10% of the global energy. And we see a lot of great developments here in the Western world. But then, here’s another thing: that’s not what the rest of the world uses. In China, they’re huge on coal, for instance. In the States, they use something like 10 to 12 times as much oil as they do. And China is on the way right now. So even though we might come up with a lot of great inventions here in the West, the rest of the world is evolving as well. And they’re not using the same technology, at least not yet.

Preston Pysh  24:12

So I think Stig’s point and he’s not coming out and directly saying this, but I think what Stig is trying to say, is next time you open up bloomberg.com, or you’re reading the Wall Street Journal, and you read some swoopy the article about how Elon Musk is going to change the world with energy and how it’s all going to be different in a year from now or three years from now, don’t buy into the hype. And I would agree with that. I think that it’s something that catches a person’s attention because it’s something new, and it’s something that’s changing the world and it is. But it’s not going to do it at the pace that I think some people think that it’s going to occur, especially in developing countries, and you go over to China and some other places. That is not going to happen quickly. That’s a change in mindset and culture.

Here in the US, we’re wanting to quickly adapt this and move in a different direction. But I can tell you, I think in the rest of the world it’s not as nearly guarded is something that has to happen quickly or soon.

So the important thing as an investor, when you’re looking at this is the trend and the delta and the changes that occur so that you don’t get left in the dust because eventually, I think a lot of this stuff is going to take hold, but it’s going to be decades from now. And you know when that pendulum is starting to swing the other way. And the only way you can do that is to look at the big picture. Look at those percentages and how they’re shifting from maybe gas, to electricity to whatever, okay? That’s for you to do your research on your homework. But you got to look at that trend and the direction that it’s going. I think that’s what Stig is getting out with his comments.

Stig Brodersen  25:43

Yeah, and just to round this discussion off about energy independence, we just got a confirmation from Gail Gail Tverberg, that runs Our Finite World. And for me, I’ve been following that blog for quite some time. For me, together with Morgan Downey and those two know each other, by the way, they were the two top authorities in terms of educating people about oil. It’s going to be an awesome episode. And before we’re moving on I also want to talk about, I wrote a blog post about the intrinsic value of oil calculated to be 75.6, which is just give you an idea of that’s probably not the right number if I put it on, you know, a decimal. But I come up with some arguments on why that might be the case. I’m just extremely curious to hear what you guys think about the model. And your take on oil as well.

Preston Pysh  26:28

So I’m curious, what would be the timeframe that you expect it to get to that price? Do you have any estimate on like how long it would take to get to $76?

Stig Brodersen  26:36

No, and this is the interesting thing because I’ve looked at time respect to 1970. And I should probably be completely upfront and say this is mainly the work of my colleague, Professor Morton Peterson, that has created a model based on *inaudible rule. And what *inaudible did in 1931, was that he said oil assets have some intrinsic value and the market is somewhat good at estimating its worth. But they’re just not right all the time.

So this model is looking at the development since 1970. And then saying, well, the market is probably somewhat correct since that time. So we don’t have a starting part in that sense. But how much should oil be valued at right now, if the market is somewhat efficient in the long run? That’s like the overall premise of we can’t say we haven’t like in a month, I don’t think you can have any model saying that or in five years, that’s just the fundamental value. It is like saying, I bought a stock, it’s worth $50, but I bought it at 20. When would that happen? I don’t know. But value is driving itself.

Preston Pysh  27:41

So one of the fun things about having a podcast and having a blog is we can float ideas out to the audience and then you guys go in there and comment and tell him why he’s wrong. So please do that. That’s what Stig is wanting you to do is read his blog post and maybe help him shape this thesis that he has and what he’s trying to develop. So with all of that said, that’s our long review of T. Boone’s book, “The First Billion” is the hardest thing… Stig is going to probably, you know, the title of his the first trillion is the hardest.

Stig Brodersen  28:13

Yeah, now that I estimated the intrinsic value of oil, the first person in the world. Yeah.

Preston Pysh  28:19

But that’s our review for the book. We also have an executive summary of this book that goes chapter by chapter and outlines everything that’s in it. So if you guys want to read the executive summary, and just skim through it and see what the book is all about, we send that out to everybody on our email list. So sign up on our email list. It’s 100% free. We don’t send out any spam or advertising or any of that stuff. So feel free to sign up on that and not have to worry about seeing anything from us other than two times a month. So let’s go ahead and take some questions from the audience. So Stig, well, whom do we got?

Stig Brodersen  28:50

Yep. And our first question comes from James Fiorina.

James Fiorina  28:54

Hi, Preston and Stig. So a couple of weeks back you had a fascinating discussion on your podcast regarding Exxon Mobil stock and specifically its buyback policy and now dividend policy. I was wondering to further elaborate on what you look for in companies pursuing buybacks or paying dividends. And more broadly, what red flags do you look for when looking at a potential investment?

Preston Pysh  29:14

Thanks a lot. So, James, this is a fantastic question. I think it’s a simple response to share buybacks. Look at it the same exact way of how you would buy stock yourself. So right now, when you look at the market, it’s highly-priced in the US, at least the US equity market, probably about a 4% return at current market prices.

So if a company is buying back their stock at that point in time, and they’re not doing other things with the money, and maybe, for me, I’d be investing in maybe a new product R&D, something like that, that’s going to give me a bigger return in the long run than 4%. I think that that’s a better use of your money.

Now, the company might not have a product to produce, there might be other implications, and that’s where you got to do your homework and dig in and see why they’re doing the stock purchase. But for the most part, if you’re buying right now and you’re a large-cap company in the US, you’re gonna get a 4% return with over the next 10 years annually at the current market price.

So the way you have to look at it when the company is doing it is you gotta look at the same context: would I be buying back stock? So let’s fast forward and say we just had a major drawdown in the US equity market, and it was offering much lower prices. If I saw a company buying back their stock, and they were safe, and they had enough money in their war chest to weather the downturn in the credit contraction if they were in that position, they’re buying back stock, I see that as a good thing because they’re compounding for me by using that as retained earnings. And they’re doing it in a tax advantageous way whenever they’re buying back stock as opposed to issuing dividends to me as a shareholder.

That’s one of the reasons why Warren Buffett doesn’t pay a dividend is because of the tax disadvantages and his ability to compound the money. So those are some of the key variables as far as I’m concerned, whenever I’m looking at a dividend versus a stock repurchase. There’s a lot of companies out there where I’d rather take the dividend because I don’t think their ability to compound the returns is that good. And so that’s where you might want to prefer a dividend over a share buyback.

Stig Brodersen  31:16

I think you were spot on, Preston, when you said it’s not so much about should it be buyback or should it be dividends. It is more a question of saying, “Where can the money best be put to use?” And as you also suggested, it might be retained earnings. It’s not like you can say, ‘Hmm, this company is good because they have been increasing dividends for 10 years.” It might give you a good indication of it’s a very stable company, but it doesn’t tell you that is the approach that puts the capital best to use.

And I think it would be unrealistic to look at a company and say, “Well, the stocks probably haven’t been undervalued for 20 years.” If I can go back and say well, the cut the dividend back in 2009, and it was going okay back then. But the stock was just really, cheap. For me, that’s not a red flag. I can see why it would be a red flag to a lot of people because they’re looking at dividends and saying, “Why would  they cut dividends?”

But I think the problem probably rather lies in the management, caring so much about a dividend cut and how it signals something wrong in the short run to investors and not look off for them in the long run. And it seems like it’s the same as giving your son a chocolate bar because you don’t want him to scream or whatever. It’s a question of what is best in the long run. And when you look more into dividends, you start looking at payout ratio which might be a good place to start and even more importantly, into the cash flow statement and the cash reserve on the balance sheet. Then you have a somewhat good understanding of how is it that they are using their cash? How safe is the company and how good are they to not store cash inside the company when they don’t need to?

Preston Pysh  33:01

All right, so let’s go to the next question. The next one comes from Wesley. And here we go.

Wesley  33:06

Hey Preston and Stig. My name is Wesley and just a bit of background. I’m a medical student. So I’ve never done any business courses in high school or university. So thanks very much for doing this podcast because it’s a great place for me to learn how to invest. So from your podcast, I’ve learned that you got to look at the PE ratio, you want to look at the APS, you want to look at also the board of directors. So that’s overwhelming, especially for someone who has no business background. So I was wondering if there’s one parameter that will tip you over towards buying or not buying a stock if there is that just one trait of a stock that will become the deciding factor in either buying or not buying the stock. Thanks very much for that.

Preston Pysh  33:45

So the best analogy and, Wesley, this is a great question. We hear this one a lot. And I love the fact that you’re you’re digging into business as a doctor. That’s pretty cool. So I used to fly helicopters. I’ve mentioned this a couple times on the show. So the Apache helicopter when you go in and you sit in this helicopter, there are so many buttons and knobs and, you know, you push the wrong thing and you might shoot a missile and you got all sorts of things happening inside of this cockpit. And it’d be like asking me to sit down in that helicopter and I have to fly it. But I can only look at one gauge, and I’ve got it, you know, I can’t look outside. I can only look at one gauge and I’ve got to fly it. And I tell you, I would never take that on.

And I’ll talk a little bit more with this analogy. So when you first start learning how to fly, you do a thing called instruments. When you are instrument flying what you do is you wear on your helmet, you put a visor down and the visor shield your ability to see outside of the cockpit, all you can see are your gauges. And this is an intimidating portion of your flight training, military flight training at least, that you have to rely on your instruments and you have to fly the helicopter from one airport to the other and you’re not allowed to look outside the windows at all. You have to only look at your gauges.

Let’s say my altimeter, I’m supposed to be flying at 1000 feet because of the obstacles on the ground. And that would be something that I would have done in my flight planning before I left. I’d be looking at that and saying okay, I’ve got to fly 2000 feet to miss every obstacle. And that’s just an example. So as I’m flying along, and I look at my altimeter, I might see that it’s 1050. So I’m a little high, I need to come down. So I adjust the stick to move down a little bit. But now I got to look at all the other gauges because maybe my airspeeds getting slow and I might start stalling. Okay, so I’m looking at all these different gauges, and I’m constantly going through them to see the changes, and I’m making small adjustments to the controls try to keep this thing just the float.

Preston Pysh  35:39

Investing in companies, in my opinion, is the exact same thing. You have to constantly look at all these different gauges know how something’s performing and how it’s getting to an end state that you want to achieve. So when you look at a company, there are some key metrics that I would say are those gauges that you’ve got to be looking at.

One of the most important ones is the earnings, the EPS, the earnings per share. Another one that uses the EPS, the earnings per share is the PE ratio, the E in the PE ratio is the earnings, the P is the price that you’re currently paying for that exact point in time. So what you’re doing is you’re comparing, okay, what is somebody on the market offering as a price to buy this stock, and then how much profit or earnings are there own it? So let’s say I paid $100 for a company that was earning 10 bucks. Okay, so I could expect the 10% return on that, my PE would be a 10. Okay, because the price is 100 divided by 10 is the earnings.

Those are just two small metrics that you’re looking at when you’re assessing the value of a company. So as you go further, you got to determine what those key gauges are for yourself as an investor. Stig and I came up with a checklist that you can download if you go to BuffettsBooks.com or you go to the Investor’s Podcast, we have little pop-ups and stuff for you to download this checklist.

But on that checklist, we laid out what we thought some of those key gauges were and some of those critical variables that you have to be able to continue to watch know that your company is on track and flying in the right direction. So it’s a long response. And I apologize if you didn’t like the analogy. I think that it makes sense from my vantage point based on my background, but I can’t give you just one metric. But if I was going to tell you one thing that’s, important, it’s the earnings on the company.

Stig Brodersen  37:32

Yeah, I think if I have to come up with one metric, it should be valuation. And that’s it’s the tricky answer because valuation is composed of so many other metrics, that it’s probably not fair for me to say. But the thing is important that whenever you buy something, you’ve just stopped with this simple notion of what is it worth and then go off from that. And the interesting thing for me is that no asset is so horrible that you wouldn’t buy it at the right price. At least that’s how I look at it.

And before I’m going to return to your question, I’m just going to mention Horsehead Holdings right now. It’s a very interesting company because they’re going through bankruptcy right now. And what’s interesting about that company is that the market cap is like 8 million right now. *KPMG I just read a report from them, they estimate the value to be between 801.4 billion. I don’t completely agree with their approach, but it’s interesting to see how much value they can find there. Guy Spier who invests in the company, he’s saying that the equity is an excess of $400 million.

So this is a special situation or what we call a special situation stock investing. It’s definitely not something I would like to recommend to a beginner, but it just underlines my whole point of saying that even though there is no promise that you ever see one cent if you buy like horrible looking assets, everything is a question that upside versus downside, and you can only lose what you invest. So that’s what you can lose, but what is the upside for you? And that relates back to valuation. So figure out how much is it worth? How much does it cost? And that’s the two factors where you should start your research. And that relates back to what Preston saying because what is it worth is just the cash the generate discounted back to today. So don’t look at a single key ratio. If you have to look at valuation, and then look at the key ratios that you use to calculate valuation based on that.

Preston Pysh  39:28

So I have one final follow up point to what Stig and I were talking about as far as the valuation when you talk about valuation on a company, you’re talking about a multiple that you’re paying on the earnings. So in the example that I provided with $100 company trading on the stock market, and it has $10 of earnings, you’re trading in a multiple of 10. It will take you 10 years to get back the principal that you initially invested through the earnings itself.

Now, where this conversation gets interesting and where people need to understand how valuations work. It comes down to the competitive nature and the competitive advantage of the business.

40:06

So let me take an example of Google. So when you look at Google, they have a huge competitive advantage just in the fact that when you go on the internet, what do you type almost out of just sheer habit, when you log on to any internet browser? You type in Google.com because you’re going to search for something. That act is a branding situation that has an enormous competitive advantage, that has been ingrained and indoctrinated into the world’s culture of how they use the internet. That is enormously difficult to overcome. That is a competitive advantage.

So for me, I’m willing to pay assuming that they make a lot of profit on that which they do. I want to say Google’s margins are 20%, maybe even higher 25% somewhere around there. Those are huge margins. Typically, if a company is doing well they’ll have 10% margins. If you’re in like a competitive industry, like the defense industry, maybe five to 7% margins. So those margins when you make $1, and you’re able to keep 30 cents of it, that’s a very big margin. And so I’m willing to pay more and pay a higher premium on those earnings for a company like that, and they can protect the margin. That’s the important part. I think they can protect that margin because of the psychology that’s built into it. That’s a competitive advantage.

So if you see that that competitive advantages and enduring one and Warren Buffett talks a lot about this enduring competitive advantage, that’s something worth paying maybe a premium for and that’s completely in the eye of the beholder. And that could change. There could be something revolutionary that comes along that would change it that maybe you all start using Yahoo. I don’t know what that could possibly be. I can’t quantify that. And that’s where you know you have something is when you literally can’t come up with quantification on how something could be destroyed or it could be challenged in a competitive market. But I think that that last part is very important when you’re talking about the price and the value that you think something’s worth, you have to tie in this qualitative piece into the quantitative analysis.

All right, so the next question we have, this will be the last one that we do comes from Eulala.

Eulala  42:16

Hi, Preston. Hi, Stig, thank you for putting in so much of your time to help us learn how to invest more responsibly. I recently saw your website and I’m amazed. There are very few websites out there that provide as much valuable investing education as yours does. And I so appreciate the executive summaries. I’ve been reading the Intelligent Investor since December, it is now late February. And even though I’ll keep reading it, it sure is nice to have your summaries around. I recently listened to podcast 36 with Joe Schmidt, talking about how he started his own stock exchange to help mitigate the negative components of high-frequency trading. And my question is, when I place an order, say to either buy equity or Buy or Sell an option, I have the opportunity to state the limit of how much I’m willing to spend, as opposed to accepting the market price. So I don’t understand how HFT would impact this. And this is what’s confusing me. Thank you for taking the time to read and answer my question.

Stig Brodersen  43:18

Wow, that’s a great question. The short answer is, you probably shouldn’t be worried about high-frequency trading, especially because you use limit orders. So just for anyone out there, a limit order is that you would say I want to pay 20 bucks for the stock. And if it’s not 20 bucks, you won’t buy it. And I think this type of order makes a lot of sense to me because I don’t want to place a so-called market order, which is the cheapest offer price that you can find out there and that someone else decides how much I should pay for my stock. And that is what you’re hoping for. And that’s also how high-frequency trading can influence the market price because if enough people see that you will go out and buy at whatever price is the cheapest, that’s when you have these really, fast machines that can just pull away from that price. And you’ll have to pay a higher price.

Obviously, don’t make that impact if you buy, call it a few hundred shares of $20 stock. But if enough people doing it, or if you have these big investors out there, or traders, they usually do this in blocks. So that might be buying 100 shares at the time, but they might have like 10,000 stocks under there, then they will move the market. And since they’re trading so frequently, they might be losing call it points .12%. But still, that’s a lot of money. If you keep making say a few hundred trades a day.

That’s definitely something you need to pay attention to. So I think for the normal trader, I think the game has somewhat changed. I used to trade on commodities exchanges a few years ago, and I could just see that it started to be more algorithm-based. And you’ll just see not only that the mind will be irrational but also that there was something else going on. Something was just happening so fast that you couldn’t have a real person doing it. And especially if it’s a thinly traded as something like commodities, and in this case, it was electricity, you will see a big drawback if you are using the old form of market orders.

Preston Pysh  45:17

All right guys, so that’s all we have for you this week. We enjoy doing the review of the book, “The “First Billion is the Hardest.” If you guys want to get our executive summary, sign up on our email list. If you want to listen to this book for free, go to our website and click on any of the links that we have for Audibles. And if you do that, the first book that you sign up for through Audibles will be completely free. You can take that as a gift from Stig and I.

The Audible service is through Amazon. So if you can find a book on Amazon that’s in the Audible format, which is pretty easy to do, you have access to probably the biggest library of audiobooks on the entire planet. We use Audibles for every single book that we use, and we highly endorsed that for people to continue to grow their knowledge.

If you guys are leaving us a review Have you on iTunes or Stitcher or wherever you guys are listening to the show, Stig and I just want to say thank you so much. We’re fastly approaching 100 episodes. And it’s mind-blowing and eye-opening to us that we’re that far along with our show. But it’s all because of the help from our audience. And we cannot thank you guys enough for everything that you’ve done to help promote our show, help bring it up in the rankings. I know we’ve been as high as in like the top 10 in the world for business podcasts. And that’s just so humbling. I can’t even tell you how humbled I am just stating that. That’s just crazy. And we just appreciate our audience and we just want you guys to know that so thanks for listening to this episode, and we’ll see you guys next week.

Outro  46:41

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