TIP177: MASTERMIND DISCUSSION 1ST QUARTER 2018
W/ HARI RAMACHANDRA & TOBIAS CARLISLE
10 February 2018
Before the recent 10% correction in the 1st Quarter of 2018, we saw more call options compared to put options by 2 standard deviations. We also saw the price at 3 standard deviations above the 200 Day Moving Average (DMA). On top of that, the Stock market is currently priced at levels only seen in 1929 and 2000.
With that said, we have assembled the Mastermind Group to talk about any opportunities that still might exist in the market that could out-perform the S&P 500 index. For Toby, Hari, and Stig, they talked about individual companies. Preston, on the other hand, talked about the first deep learning, artificial intelligence ETF that’s completely autonomous in its stock selections.
IN THIS EPISODE, YOU’LL LEARN:
- If the mastermind group likes two of Billionaire David Einhorn’s favorite stock picks.
- The risks and rewards from investing in cyclical stock picks.
- How to invest in private companies in India.
- About an Artificial Intelligence ETF.
TRANSCRIPT
Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.
Preston Pysh 0:02
After the first month in 2018, the market sure looked like it was unstoppable and the price was going parabolic. Before we saw this 10% correction, we saw more call options compared to puts by two standard deviations. In addition to that, we saw the price at three standard deviations above the 200-day moving average.
To put things simply, the stock market hasn’t been priced at the levels we’re seeing today since 1929 and the year 2000. With all of that said, we’ve assembled the Mastermind group to talk about any opportunities that still might exist in the market that could potentially outperform the S&P 500 index.
On today’s show, with Toby, Hari and Stig, we talked about individual companies, but my selection was a little bit different from theirs. Instead, I talked about the first deep learning artificial intelligence ETF that’s completely autonomous in its stock selections that was just recently rolled out in the last two months.
Hopefully, some of our ideas and our conversations help you think through the picks in your own portfolio and help you navigate the interesting times that we’re currently seeing in the markets. If you’re ready, let’s go ahead and get started.
Intro 1:15
You are listening to The Investor’s Podcast where we study the financial markets and read the books that influenced self-made billionaires the most. We keep you informed and prepared for the unexpected.
Preston Pysh 1:35
Alright guys, we got the Mastermind assembled again here for the first quarter of 2018. Let’s talk about the format that we’re using for our Masterminds for people who are joining us for the first time.
So each person brings a topic or a pic to the discussion. Then the group kind of goes around, kicks it around and tries to play devil’s advocate of why it might not be a good pick. After, the person who’s presenting it provides basically all the pro points on why it might be a good pick
Anyone want to go first? I think Toby told me he wanted to go first before we started the show. Was that right, Toby?
Tobias Carlisle 2:10
I don’t mind going first. I think I went first last time, but I’m happy to let you guys eat my dust and give it to you.
Preston Pysh 2:17
All right. Well, you do have a very strong background to say that after the last Mastermind because Toby recommended Gilead. I think that’s up 20% since you recommended it on the last show.
Tobias Carlisle 2:28
It’s something like that, but I think in the interest of full disclosure, we also have to mention assured guarantee, which has had a bit of a stuffing kicked out of it. I still really like a short guarantee, but it’s down what *inaudible*. It looks like it’s a little bit of a disaster.
I think that AGO assured guarantee is going to be okay. I like it where it is at the moment. I think it’s still really cheap. It’s still in my screens where it is, but just in the interest of full disclosure, I’m going to own up to that one too.
Preston Pysh 2:54
There you go. Okay, well, let’s hear what you got for us today.
Tobias Carlisle 2:59
My pick today is a funny one. It’s Micron Technology. The ticker is MU. It’s one that I have recommended on the Acquirers Multiple site on October 1, 2015. At that time, it was trading at $14.56. Right now, it’s trading a good deal higher than that. It’s at $42.49. It’s up almost three times. I’m about to recommend it again which might sound crazy.
I’ll tell you why I really like it. Market cap is $49 billion, enterprise value is about $53 billion so it’s got that $3 billion in excess of debt over its cash. It trades on a very low PE just under seven times. It trades on a very cheap Acquirer’s Multiple.
The problem with this stock is that it tends to be pretty cyclical. The earnings are up and down a fair bit. When I recommended that at $14, I think it was trading on roughly the same at Acquirer’s Multiple. It was trading 5.7 at the Acquirer’s Multiple lens. It’s up three times on the same Acquirer’s Multiple which tells you what the operating income has done over the last two years and a quarter.
That’s what happens with its stock. The operating income is up and down. It’s as close to as expensive as it has ever been.
The reason that I like Micron so much are two reasons. David Einhorn has a big shareholding in it and he is a super smart investor. He’s had that shareholding since I recommended in 2015. It’s not something that he’s necessarily buying now. It’s something that he was buying when it was 1/3 as cheap as it is now.
However, it’s still as cheap on a valuation basis as it was then. So I don’t mind. It’s in a semiconductor sector which is very boom bust and it’s booming, but it remains as cheap as it has been.
I think it’s an interesting stock. I don’t like really buying things at the very peak of a stock market run up. I don’t really like buying something three times higher than I’ve bought it in the past. However, if I look at that screen, in a market, it’s pretty tough to find things. I think Micron is interesting.
Preston Pysh 5:18
Toby, when I look at this, just the numbers. I’m looking at the top line, the revenue on it. It seems like the revenues are really all over the place. What’s driving these cycles for the semiconductor industry?
Tobias Carlisle 5:33
That’s the nature of the industry. It’s a little bit of a boom and bust. It’s the very end of the whip. The consumer end of the industry is always pretty stable. However, by the time you get through to the manufacturers, to the OEMs, it gets very volatile. That’s where these guys. It is very subject to those cyclical moves and so it’s a stock that does look cheap, when it’s actually expensive. That’s the main concern.
If you do a rough DCF on it, and these things are pretty tough to do discounted cash flow analysis on which I don’t typically love, because they’re always very… The DCF moves around a lot depending on the inputs that you use, but I think if you look at sort of the last 5 or 10 years of growth and you punch those statistics in, I think you get fair value for me something like this is around $70-90. I think at $42, it’s worth putting a small part of the portfolio in understanding that it’s a very cyclical stock.
Preston Pysh 6:31
What discount rate are you putting in to get that price that you just quoted?
Tobias Carlisle 6:34
I’m using a discount rate of 12%.
Preston Pysh 6:39
Going back to the revenues, like the thing I guess I don’t understand is I understand cyclicals, but when I’m looking at the revenues on this, you go to 2014 and 2015, you were looking at 16 billion for their revenues. Then 2016, just one year later, it dropped down to 12 billion. Then we saw a jump clear back up to 20 billion here in 2017, the revenues practically doubled.
I guess for a company that size, it just really surprises me. I guess my concern moving forward is, if we buy now at the highest revenue we’ve seen, what does this look like if that would drop back down to call it 60% of what we just saw in revenue for the coming year?
Tobias Carlisle 7:26
Yeah, it’s going to look a lot more expensive.
Here’s the thing. The revenue has been growing pretty consistently. The nice thing about Micron is it’s got a track record that goes back 30 years, something like that.
You can look at it like in the 1990s when it was earning $1 a share. Now, turning $18. This is in a revenue center turning close to $18 a share. It’s cyclical, but it has grown over that period of time.
It’s not my most favorite stock pick I’ve ever had on the show, because the market is getting tough to find stuff out there that is cheap. What I typically like is trough earnings, trough revenue and cheap on that trough. It’s definitely not that it’s cheap on like peak revs and peak operating income. It’s not something that I’m going to go to the stake to defend, but it’s in a tough market. I think it’s not a bad option.
Hari Ramachandra 8:16
Toby, this is definitely an interesting one for me because I pass through Micron Technologies headquarters every day on highway 237. It’s something familiar to me because it produces two important components on most servers: DRAM and NAND, which are the storage flash drives.
What concerns me and I think Preston pointed it out there, revenues can be quite cyclical or varying year over year. The reason being, correct me if I’m wrong, Toby, 64% of their revenue roughly, is from DRAM, which is basically an OEM product that they sell to folks like Intel. That’s where I think the buyer power is huge, like Intel and there are only a few.
For me, I think in the near term and long term, I don’t know how to see this talk, I think you’re looking at it from a valuation perspective in the current market. The risk I see is it is yet to be seen whether they will be able to capture meaningful market share in the NAND storage market.
That’s a bet that they’re making, because their DRAM is a commodity business and recently, Intel announced a $5.5 billion investment in building their own facility for memory chips. That’s the risk they have is they’re dependent on these big guys for a majority of their revenue.
Any thoughts on that, Toby?
Tobias Carlisle 9:49
I think that’s all dead, right? I agree with you 100%. I think if this was something that was trading close to fair value and I had to take a view on the business, I’d probably pass.
However, I do think that a lot of that is already discounted in the valuation. I think you’re sort of getting paid at this point. You get a pretty strong balance sheet. It’s got lots of free cash flow. You’re not paying very much for it. It’s at a cyclical peak.
At some stage, there’s going to be retrenchment in the valuations. It’s going to be a retrenchment in the business that’s getting done. That’s a real risk, but I’ve been saying that for close to six years now and I haven’t seen any of that.
Preston Pysh 10:27
If you’re continuing to hold, what would it take for you to change your mind? Would it be a specific price action that passes through a certain level? I’m just kind of curious how you think through that.
Tobias Carlisle 10:38
As a general statement, I always look at my opportunity set and where a particular stock is in my opportunity set.
Micron is one of those stocks that is often on the screen, just because it tends to trade at about the same multiple, regardless of what the earnings are doing, but it did disappear. The last 12 months sort of disappeared and it’s come back into the screeners.
I know it pretty well and I’ve seen it regularly over the last sort of 10 years. It worked for me when it was cheap on this multiple when I bought it. Then it sort of just rolled out of it 12 months later, as the long term capital gains taxes become available.
I bought it in October 2015, and then would have sold it late 2016, or maybe early 2017, to push the tax. It’s back again so it’s a different proposition when it was trading at $15. It’s sort of three times as much. It’s a much more difficult stock to own, but it’s not an easy market to find opportunities.
Stig Brodersen 11:33
Toby, I’ll try to make this question slightly more generic. We don’t all just pitch you off this stock pick. When I look at over the past 10 years, I can see and say for instance, 2008 and 2009 were two very rough years, then you have two years where luck was better followed by 2012 and 2013. It was then again bad. 2014 to 2015 was good again, and 2016 was bad. Now it looks like it’s in a good cycle.
guess in continuation of the debate that we had with the group here, more just general, how do you work with cyclical stocks and not just in terms of pricing and finding the fair value? I would assume that you can push the capital gains tax to get a lower rate for most stocks because after all the cycles or at least a few years.
Which indicators do you look for, I guess, to figure out where you are in the cycle and when to exit and enter? Perhaps not just about what is the operating margin. Do you have other indicators that might be more industry specific?
Tobias Carlisle 12:42
Yeah, I think that’s a really good question and very hard to do. I think if you look at any stage over the last… After the 2009 bottom, in the first quarter of 2009, at any stage over the last eight years or so eight or nine years, you would have thought looking at Micron that it was probably overdue for that downswing in the cycle.
It’s had a few bumps, but it’s never had that really low swing. I think that that’s why it’s continued to trade at a fairly low multiple because there has been that expectation that it’s going to pull back and it hasn’t happened so far. Like I said, it’s not my favorite pick and I do feel like it’s 3am in the casino and someone *inaudible*.
Stig Brodersen 13:32
Sorry for *inaudible*, Toby, that you had to almost go back on your stock pick.
Tobias Carlisle 13:37
I’m not going back to it, but I will say this: I still like AGO and Gilead. If this works out, then I’m going to pretend like I knew it was always going to work out. If it doesn’t, then I’m going to say I hedged it pretty well on that call didn’t I give you the verbal hedge?
Preston Pysh 13:55
Alright, Hari, let’s go ahead and hear your pick.
Hari Ramachandra 13:58
My pick is Fairfax India. It’s not Fairfax Financial, the mother company based out of Toronto. However, Prem Watsa was recently started a couple of years back. He created a new subsidiary called Fairfax India.
India, as you know, it’s growing at a rate of 6-7%, even if the government doesn’t do anything. It also has huge runways, like a couple of numbers I will throw out. Of course, we all know about India’s population of 1.2 billion, huge population of people below 30 and also in terms of penetration.
A couple of figures to keep in mind: the market penetration in India is 7-8% of GDP, which is one of the lowest. It’s even lower than Ukraine and insurance is 3.2% penetration.
All this kind of screams opportunity as the current government led by Narendra Modi is pro business and progressive. It is bringing into effect a lot of laws that are bringing India closer to many of the developed economies.
For example, we all have heard about demonetization and GST, which is a global service tag that made India’s taxation simple, but what we have not heard about is bankruptcy protection law, which was not there in India for a very long time.
They’re also working on clearing up debts in the banks. They have a huge focus on infrastructure. They have a ministry focused on infrastructure now.
All this gives Fairfax India ample opportunity to invest. It had done very well in the past couple of years of their operation. Some of the numbers I was looking at started in 2015, with a net total asset of close to 1 billion. That’s the capital there is initially, and they had to go and issue some bonds, as well as raise additional funds through equity issue. It’s because they had so many opportunities.
Today, their total net assets stands at 2.5 billion. Their income or revenue grew by 96%, in 2016 and then to 72% in 2017. So from 65 million today, it is around 480 million. Their net earnings also grew between 150-250% so they started with 40 million of net earnings. Today, they have 364 million in net earnings.
One of the interesting things for folks in the US who are not Indian citizens is it’s really hard to invest in Indian market. There are some restrictions for non-citizens investing in India.
Fairfax is a great opportunity, even for Indian citizens, because not only do they buy public companies in India. It’s a holding company, but they’re able to buy private companies in India.
It’s really hard to gauge their book value, but it is fair to say that their book value is much higher than $10-11 that we see today because of this issue of their private investments.
A few interesting facts about the Bangor International Airport is that they took a 38% stake initially for $385 million in early 2017, but then they went ahead and bought 10% extra stake and paid $125 for that in the next round. That shows the increase in the value.
That’s typical in India where land prices are increasing at a healthy rate, especially the Bangor International Airport. It is an interesting investment because it’s pretty much a monopoly and one of the fastest growing airports in terms of traffic. It’s the third busiest airport in India after Bombay and Delhi.
Similarly, they have made investments and other companies, which are either into speciality chemicals or into financial services. I suspect that they might make some investments in insurance as well because that’s a growing industry.
I know that even Berkshire Hathaway, Ajit Jain with Berkshire Hathaway Insurance is also very active in India. I don’t know whether they have made significant investments, but I do know that they’re interested in India as it’s a growth market.
So all this makes me interested in Fairfax in terms of long term holding. Today it’s selling at around $17. The stock price is around $17, 6-7 PE and its book value on the balance sheet is $10-11, which I suspect is less than the actual book value because of their private holdings.
Preston Pysh 19:02
I just want to quickly say that the ticker here in the US for buying this is FFXDF, if anyone wants to know and this is an over the counter traded equity position.
Something else that I wanted to point out, Hari, is it seems like they got a decent letter to shareholders here, a PDF, we’ll have a link to that in the show notes for people to go through because I think this is a really interesting pick. This is much different than something that we typically talk about on the show.
My immediate thought when you started talking about this, I was really interested in more of the managers, the people that are running this company. What’s the story about them? Do you know anything about them?
Hari Ramachandra 19:41
Good point actually. There is one negative however, not negative, but something that we should keep in mind. It’s interesting as Prem Watsa obviously is involved. However, the management team running in India, the main guy is Harsha Raghavan. He has a very good track record in India.
However, there is a management fee here so that’s an interesting twist to this company. There is a management fee of 20% above 5% *inaudible* rate that goes back to the parent company, which is Fairfax Financial.
Stig Brodersen 20:14
What do they get back, Hari? I know it’s owned by Fairfax Financial Holdings, but is the facility anything in terms of finance, operational, or is there any kind of value that’s flowing back to the subsidiary? How does this influence me as a shareholder?
Hari Ramachandra 20:29
It will influence me as a shareholder in terms of my net earnings, because part of the earnings is actually going to Fairfax Financial.
Stig Brodersen 20:39
Yes, so in this situation, whenever I look at the latest interim report, there’s a performance fee for the first nine months of 2017 of $84 million that basically comes from them or the market and then sending a transfer back to the parent company. Is that correct?
Hari Ramachandra 20:54
Yes, that’s correct.
Preston Pysh 20:55
Okay. It’s really interesting because it’s almost like it’s a private equity relationship with general partners and limited partners. Yet it’s kind of confusing to me, to be honest with you, the way that everything is structured. Toby, are you understanding all of it, because it seems really confusing to me?
Tobias Carlisle 21:10
When I look at investment companies, usually what I like to do is to buy investment companies at a discount to tangible books. Fairfax tangible book is $13.50 and the stock closed today, it’s $17.86.
The reason that you want to buy them at a discount to the tangible book in the ordinary course is because you have to pay that fee. You’re paying some fee for the management of the fund. It’s reasonably fat, in this case, 20% over 5% hurdle.
The reason is that you might want to pay a premium, so the premium here is about 30%, something like that. It is because you really love the manager and there’s no other way to get in with the manager.
The manager that you would love in this instance is Prem watsa, who I think is one of the best investors out there. I love what he does and I think he’s been one of the guys who’s correctly hedged into the 2008 drawdown. He made a lot of money then and he’s been very careful through this whole process.
For me, personally, if I was going to invest in something like this, I would want to be closer to Prem than the other investors. I would like to be in the Fairfax parent company.
So you’re getting India exposure, one step removed from Prem at 30% premium to tangible books where there’s going to be that carry going back. You’re really betting on Prem on getting it right and making a lot of money consistently over the long term, which he has been able to do.
However, I kind of think that the bet here is it’s not asymmetric, which is what I kind of look for. I think that this is definitely something that I would invest in at a discount to the tangible book.
I’m going to stick it on my watch screen and if it goes below $13.50, I’ll take a swing at it.
Preston Pysh 22:55
But you would never get access to this guy on a GP level, right?
Tobias Carlisle 22:59
Well, you can invest in Fairfax. Fairfax is the holding company. You can invest in that and you can invest in that you’re paying a premium right now. You can get it without the carry.
Stig Brodersen 23:09
Hari, when I saw this pick I was really impressed. I read through the shareholder letter. For me, that just speaks to the world about the company. It’s one of those where you just even though if you just skimmed through it, you can really like get a feel of whether or not they understand what they’re talking about. You might be like, “Well, sure, I mean, they’re the management. Why wouldn’t they understand what they’re talking about?”
It is just the way they talk about capital allocation. I think most people would be surprised how capital allocators sometimes, at least on paper, talk about allocating the capital. When I saw the outline that they have, I was very much convinced.
There are a few things that I don’t like. I definitely don’t like the performance fee. For instance, when I look here at the consolidated statement of earnings and I talked about the 84 million before, for the first nine months of 2017. So the net earnings before income taxes after this deduction would be 361 million. I mean, it’s definitely significant once you keep in mind that whenever you’re looking at something like this, you have your net realized gains and investments that would wildly fluctuate. It’s just another comment.
I also want to talk about, Hari, it really depends on you know when you sell and a company can look a lot more profitable whenever they sell and investment has gone well. Take it for what it is when I bring these numbers up, but it seems to be a very high tax that is almost short to be *inaudible*, even though it’s above a 5% threshold for the access to private companies in India.
Hari Ramachandra 24:37
Yes. I mean, the cost structure reminds me of Buffett’s partnership. I think Preston kind of pointed it to this as well as you can look at it as a GP or general partnership that you’re getting access to.
For me, the selling point here is access to India. As Toby mentioned, access to Prem in a way and the fact that prem has a lot of connections and context in India. He really knows what he’s doing.
The fact that in India the average mutual fund grows anywhere between 14-16%. That’s kind of an average mutual fund. Some of the good mutual funds are growing close to 19-22%. That shows the growth potential in India.
I expect that even after fees, the management fees, this stock would do well, in the long run, assuming that it has the same kind of culture and DNA that Prem Watsa brings in at Fairfax Financial. However, I also get Toby’s point about being careful about buying it at the right price closer to the book value.
Stig Brodersen 25:47
Hari, I think this is just a related question from the private companies that you talk about and that’s very interesting, because if you look at how the public company is priced right now. I mean, India is pretty expensive, if you just look across the board. Do you have any other vehicles, if you want to find the right managers to invest in private companies?
Hari Ramachandra 26:07
It’s really hard to say, investing in private companies, at least. I’m not sure if there are too many of them. There might be some and I’m sure there will be more coming up.
There are a lot of investors in the holding companies in the US, including Berkshire Hathaway, who are interested in India. So yes, opportunities might be available through other vehicles as well., but this is one of those direct vehicles which is focused on India.
Preston Pysh 26:36
There you go. Stig, go ahead and fire away your pick.
Stig Brodersen 26:40
My pick is AerCap Holdings. The stock ticker is AER.
AerCap Holdings’ business is to buy lots of commercial airplanes and lease them out to airlines. Right now, they have a very diversified portfolio with more than 200 customers in 80 countries. Alot of exposure in emerging markets too and it’s one of the world’s largest aircraft leasing companies. It is actually the largest independent one. There are more than 1000 aircrafts.
Full disclosure, I already bought the stock. It was a very significant position. Whenever I look at the industry and the business model, it’s more or less a spread business. They insure financing, as they would actually go ahead and buy the airplane. They would typically *inaudible* rates around 3-4%, depending on the maturity and then they will lease it out.
They currently have a healthy spread around 9%, which I found very attractive. So they have these buy in bulk deals with Boeing and Airbus, which is also one of the reasons why they can get a discount, but it’s more the financing really more than anything.
This is also a good deal for the airlines, at least it is responsible for the maintenance and service of the plane. I can obviously get the yield, but they also take the risk of the residual value of the plane.
The company is very efficient in *inaudible* fleet leased, basically they won’t go ahead and buy an airplane before they already know that they can lease it out. It’s average at 99.4, the latest quarter.
If you look at the competitors, the largest one would be GE Capital Aviation Services. It is approximately twice as big, but it’s not an independent company. Most of the competitors are trading at a higher PE ratio. I think the valuation that we’ll get to later would be very interesting for this company.
Whenever I look at how the company has issued shares and bought back shares, it kind of looks like it’s been all over the place. I would definitely encourage everyone to read through some of the statements where the CEO talks about how he is evaluating whether or not he should buy more planes or if he should buy back stock and devalue his stock.
I think just that you have a CEO talking about the value of his stock, like a capital allocator adds a lot of value too.
Now, if you look at the free cash flow, it looks absolutely horrible. First of all, it looks like it is all over the place and it looks like the earnings that you see doesn’t come out in terms of cash flow to the investors.
Now, this is really an accounting thing. The way that you very often see this calculation is that you have the operating cash flow, which is basically the cash flow that you make from the company’s core business. Then you take out the CAPEX
For a company like AerCap, that would typically mean that you have a negative cash flow because you will be buying a lot of airplanes, whereas for you selling those airplanes back whenever it’s further appreciated. That won’t be included in that number. So if you actually do the math on that, you are closer to a free cash flow of around $1 billion.
If I look at devaluations, just in terms of putting in the numbers, I assumed around 800 million dollar free cash flow was just… I don’t think it’s on the generous side and the 3% growth. Most likely it has another band of 6% and a flat as well a lower band for 25%, respectively. I end up around 9.5% at the current price. Sorry for the lengthy pitch. Please feel free to shoot.
Preston Pysh 30:23
Stig, my biggest concern when I saw this was exactly your last point: there was the free cash flow and the CAPEX on this. Whenever I look at the company, and you’re looking at the revenue, it has just been going wild for the last 10 years. It’s just been going straight up.
However, what I found really interesting was just in the last year, you actually saw the revenue contract by $100 million-ish, somewhere around there. It’s been flat.
When you look at the last year, the TTM on this is still flat. I guess my concern at this point, it seems like they have stopped buying new aircraft. I haven’t dug into this nearly at the level that you have, but it seems like they’ve stopped buying new aircraft back in 2015.
Their CAPEX continues to press higher and higher. Whenever I think of the airplane business, I think a lot of CAPEX in the sustainment of that fleet that they’re doing. This is very expensive stuff that they’re managing here. I would expect the CAPEX to continue to be pretty high.
I think that’s where when we’re looking at all the CAPEX that they spent over the last 10 years, it makes sense to see their revenue keep going like it was because they’re just buying so many new aircraft and it’s just adding to the fleet. Their revenue is going up.
What does CAPEX look like moving into the next 10 years, assuming that the fleet stays flat, they’re not adding to the fleet, and they’re gonna make their revenue fairly flat, assuming they’re not going to continue to add to the fleet? When we do that, what does the free cash flow look like? You said you think it’s 800 million? Is that what you said you think the free cash flow comes to?
Stig Brodersen 31:59
Yeah and that might even be like on the more conservative side. I don’t know. I mean, if you look at the past three years and you also include the proceeds from sale and disposal of assets, you get 2 billion, 1.6 billion, or 1.5 billion.
If you look at the trading 12 month, you just go into any service, I would say at negative more than a billion dollars. So it’s really important to read through the cash flow statements.
I really think it’s interesting what you said about the revenue and how they look at the CAPEX. One of the things is that they would buy the aircraft and that will be reflected, as you know, a CAPEX. The maintenance, whenever they lease out, they will go to the lessee, so they won’t carry that.
The other thing is, whenever you read through the latest earnings call, the CEO would say that right now he’s not looking to buy more aircrafts, because it’s been more competitive. At least he won’t be as aggressive partly because the *inaudible* debt both to shareholders, if you like by issuing more stock, but also that in general after the huge acquisition a few years back. They got to spend some time paying some of that debt back.
Also, you find that the stock price is very interesting right now, in terms of repurchasing stock. Tracking what has happened over the past few years has definitely been true to his word. It’s close to a 10% buyback yield despite investments he made.
Preston Pysh 33:15
When I’m looking at the cash flow statement, I’m looking at the depreciation. To me, it seems like maybe their depreciation is about 2 billion a year on the fleet. Would you say that that’s an accurate number? Just so we can kind of then look at whatever their operating income is and then subtract that out?
Stig Brodersen 33:38
That’s probably true. I’m looking here and I think it’s the latest 10k. Are you looking at Morningstar?
Preston Pysh 33:44
Yeah, I’m ballparking the numbers here, but I think that your 500 to 800 million and free cash flow estimate moving forward would probably be pretty accurate. I definitely did not dig into this at the level that you did.
I’m curious, Toby, would you agree with that conversation we just had? Are you kind of looking at the CAPEX being the main concern and what that steady state looks like moving forward?
Tobias Carlisle 34:07
I’ll tell you what my main concern with these sorts of businesses is: these things carry enormous amounts of leverage or not a great deal of equity. Then you have it in an industry that’s pretty cyclical, too.
Stig, had the baseball bat hang me on my cyclical industry, but my cyclical industry, I think, is less cyclical than this industry. It doesn’t have the leverage in it. This is one of those things.
Have you looked at this through a period like a recession like 2007 to 2009 and seeing what the free cash flow looks like? What are the customers doing through a period? Are they able to keep on making the payments on the leases? Does it survive through that period?
Stig Brodersen 34:53
Yeah, so for instance, if you look back in 2008, like the worst year they had, it was 97.7 and it was still a profitable year.
I’d like to add to all the betting that we did before, Toby. This is a huge position in David Einhorn’s portfolio. It is 10%, which is also one of the reasons why it came on my radar.
More recently, Mohnish Pabrai has bought a lot of this company over the past few quarters. Right now it is Pabrai’s third biggest holding in the US. Even though he might rather be invested in India, as we heard about before, I think it’s definitely a stock worth paying attention to.
Preston Pysh 35:35
I really like Toby’s concern here. When we go back, and let’s look at 2007-2008, they were doing about 1.1 to 1.2 billion for their top line. As soon as the recession hit, that got cut in half, so their top line went 50% of what it was whenever they went into a recession.
If that would happen today, as I thought through this company back then, they were 1/5, the size of the fleet that they’ve got today. And so, now that they’re five times bigger, how much more is that going to impact a larger company that’s leasing aircraft? Is it going to be 50%? Is it going to be greater or is it going to be less? I don’t know what that is, but I think that that’s a really important concern.
The reason is because if we take that revenue down from five, let’s just say it’s 50%, like it was during the last recession, and you go from 5 billion down to 2.5 billion. We already said that we think that their depreciation alone is going to be 2 billion before operating expenses and things like that. I think you really get into an interesting dynamic where this thing could be.
What company wouldn’t be impacted with the recession? I don’t know about this one. I guess I’m not as excited about it as you are.
Stig Brodersen 36:43
I think you and Toby, bring up some great concerns. If I look at how the revenue has been developing, you’re right. It’s a rock drop.
It’s not so that if we had that revenue, that you just have the same expenses and just be flat. So if you look at the worst year in terms of efficiency, it was 97.7%. That was back in 2008 when it dropped.
Of course, like since this is a lease agreement, if they should default on the payments, they will give the plane back and that could be sold off with this. That’s all part of the business. But you’re right. I mean, in terms of recession, the price won’t be as attractive as it would be today.
Tobias Carlisle 37:25
I was just going to say in support of you, if the company can maintain its current growth rate, and I can keep on doing what it’s been doing, I do think it’s very, very cheap. On a discounted cash flow basis, I do think you’re getting enough of a discount that it is well worth taking a swing at with a small position.
If it keeps on doing what it’s been doing, it’s worth like 120 bucks to 150 bucks, and it’s trading at $53. That’s enough of a discount that I would be prepared to take a swing at something like this even having said all that other stuff. However, I do think that you’re risking something like this is close to zero, so you need to size it like it’s money that you can lose.
Preston Pysh 38:04
But it’s not growing, Toby. I mean, up until 2015, it was. However, since 2015, it’s not growing.
Tobias Carlisle 38:11
It’s going to slide around, but it’s not going to be every year. It’s going to cycle. A few years ago, my screens were filled up with the airlines.
I was worried at that stage that airlines are one of those cyclical stocks that you look at the peak of the cycle and they look cheaper at the peak than they do at the trough. I’ve got Warren Buffett words ringing in my mind. He’s always nervous about airlines.
Now, this is not an airline. This is a leasing company so it’s one step further removed. It’s much closer to the whip end of the tail, because it’s sold to the airlines.
I do think that it’s enough of a discount on a DCF basis that it is worth taking a really close look at. It’s interesting. It’s just that you need to size this position correctly.
Stig Brodersen 38:50
Alright guys, so that was all I had for AER. Preston, of all the stock picks that we had here in the group. I think I look forward to yours the most.
It was definitely the one that was most out there. I don’t want to say it’s a bad stock pick. I just really did not expect that, especially not from you. I guess not from anyone here in the group. Please let us know what your pick is. What do you want to talk about tonight?
Preston Pysh 39:19
Let me start off by saying I do not own this, but I find it really just an interesting discussion. I look forward to seeing more of this in the future. The stock ticker for the one that I’ve got is AIEQ and this is an artificial intelligence powered ETF.
This is a Silicon Valley company that has made this. If you just type in AIEQ into Google, it’ll be the first thing. We’ll have it in the show notes, if you guys want to go to the homepage for the people that created this thing.
Every stock pic in this portfolio is being picked by a deep mind neural network machine learning algorithm. They used Watson for the programming on this. They just set it loose. This thing started trading on the 18th of October. Since its inception in the October timeframe, it’s done 9% since its inception.
To give people just an idea of where that’s at in the grand scheme of things, the S&P 500 has done 10% since that point in time, so it’s trailing the S&P 500 by 1%. So it’s in the red, as far as I’m concerned, underperforming the S&P 500 so far
However, let me just say that basically, the first three weeks that this thing went on the market, it got punished, absolutely punished. It just underperformed the S&P 500, every single day almost for the first three weeks.
Then it was like out of nowhere, this thing started taking off. If you look at it, after that first three week period, it has done 14.6% when the S&P 500 has done 11%. So it’s outperforming after that punishment period.
When you look at the price chart on this for the first three weeks, it was just straight down like a straight line down. Then out of nowhere, it just started taking off, which is kind of interesting, as far as I’m concerned.
What I really like about this is when you go to the page the company has all the information about it, every day they publish the holdings that the algorithm is picking, and it’s only long equities. From what I understand, it doesn’t go short. So it’s only buying long equities. It’s buying anything that it can find in the US stock market.
It has a cap of 70 picks maximum. I think on the minimum side, I might be saying this wrong, but I want to say it was 30 or 40 picks on the minimum side. So this is what’s awesome is so you can peek in there and you can see exactly what this thing is holding on any given day. You can pump it out actually into an Excel document right off of their web page.
What I found fascinating about this is the number one pick out of every stock that this thing could pick in the US, it’s number one top holding is Amazon at 4.11%. The number to pick that algorithm this computer has picked is Google at 3.65%.
When I saw that I was like okay, so those are like strong momentum picks. I was like maybe this thing is just doing straight momentum, but then whenever I scrolled down and I looked at some of the other picks inside of the portfolio, believe it or not, it owned GameStop. It is one of its top 70 holdings.
Right now it has 70 holdings in it. This thing purchased GameStop, which we all know is definitely not a momentum pick. If anything, that’s an anti momentum pick, because that thing just keeps going down. It’s coming up in this filter, once again, with this AI bot, which I just found fascinating.
Now, let me just say, when I first started looking at this probably a week or two weeks ago, GameStop was much higher in its holdings. I think it was holding about a percent of GameStop.
A week or two later, GameStop is now in its 69th holding position at .25%. So it’s been selling its GameStop position, because I think it found out that it was catching a falling knife like everyone else who’s purchased GameStop in the last year. I found that interesting though.
What’s really cool about this is I don’t think it has a preference to a momentum or a value, but I see some of the picks in here kind of resemble both strategies, which is fascinating.
The reason I bring this up isn’t necessarily because I’m telling people to buy this because this thing has a track record of about two seconds. I think it’s kind of a neat tool to just peek in there and see what the heck it’s holding and maybe why it’s holding what it’s got.
One other highlight before I throw it out to the group to kind of hear your thoughts on this is when I scroll through some of the holdings, I see some various financial companies in here as well. When you think about holding financial companies right now with interest rates going up, that would be a smart decision so I have no idea.
When you read some of the information on the site, I guess it’s even taking social media accounts in its data points. There are so many things. It’s reading all the 10Ks, the 10Qs. It’s looking at all the financial data. It’s taking in new stories. It’s taking in social media feeds. I mean, this is crazy.
Stig Brodersen 44:55
It says here that every day it processes more than 1 million filings, news articles and social media posts. I mean, obviously, they’re not telling us how they’re processing. Obviously, that would be their IP, but I think it’s very, very interesting.
How much of the turnover has been and how many times they’re just replacing holdings?
Preston Pysh 45:13
I haven’t tracked that, but I’ve peeked in at a couple different companies. I haven’t seen those companies fall out of the mix in the two or three weeks that I’ve been looking at this.
I mentioned Amazon and Alphabet being their top two holdings. Number 15 is Facebook. They have 2.38% of the portfolio is Facebook.
The one that I found fascinating that’s not on here is Apple. It’s not holding Apple. So For me, that’s pretty interesting, especially with all the news that came out that the iPhone 10 sales have been lackluster and everything else. This thing is not holding Apple, but it’s holding the other three big companies: Facebook, Amazon, and Google. GameStop too, man.
Tobias Carlisle 46:06
It’s like a rite of passage for every value investor. You come in and you buy a little bit of GameStop. Then you lose some money and you get a little bit smarter. Welcome to the market, buddy.
Preston Pysh 46:20
Hari, I’m curious to hear your thoughts. Is this something that you’ve heard about out there in the valley because this is from Silicon Valley?
Hari Ramachandra 46:26
Yeah, I’ve heard a lot about this and other AI approaches. A couple of things that I want to just throw out are like, its expense ratio is .75%. So it’s not cheap. Yeah.
The other thing is, it would be interesting to see how different it’s holding, like the top 70 compared to index funds. What’s the difference?
Finally, I am asking you about if I had to put your money in between Toby and this, which one would you choose and which one would you sleep at night peacefully?
Preston Pysh 46:59
Considering Toby hedges, my money’s on Toby.
Hari Ramachandra 47:04
What I liked about it is the *inaudible* as I said. I like to understand what’s the algorithm behind. You can kind of not try to reverse engineer the algorithm. Maybe you want it or how they are placing their bets.
Tobias Carlisle 47:18
I love the idea of a quantitative machine learning approach to the market. This thing’s probably been trained on both value and momentum data, which is why you’re going to see those value and momentum picks because those are traditionally the two best risk adjusted methods and most robust over the very long term. Doing those two things together is going to give it a very interesting return profile.
I was totally kidding before about the GME, the GameStop. One, I’m being rude that somebody is going to get GameStop right and buy that at the right time and make some money out of them. I say that because I’ve done that in lots of different stocks when I had to buy them over sort of three or five years before they actually found the bottom, but they did eventually get there. I probably lost money on balance over the whole period.
As a value investor, you kind of have to buy those off the run ugly things where everybody says you’re an idiot when you buy them and then they go down. Then you’re proven to be an idiot because enough of the time you buy them and everybody says you’re an idiot. They go up so much that then you get to turn around and say you’re wrong. That one made money and on balance, that’s basically how value works. You get to buy these things, even though they are falling knives.
The fact that Wtson is there for me says that’s pretty much a marketing gimmick. The ticker AIEQ, that’s a marketing gimmick but that’s okay. That’s part of what this business is: marketing. But I do think it will probably work.
The track record is far too short to say one way or another. If I look at my value and momentum screen, and I look at the way that it performed, it’s roughly done about the same thing. It’s up about the *inaudible* and it was down about the same amount through that period. That’s what I would guess they’re doing: value and momentum at 75 it’s a pretty good *inaudible.*
Stig Brodersen 49:03
Preston, when I did my research, I couldn’t see any kind of back testing. They talk about the performance of this algorithm in the past and it was always improving, but have they provided any kind of stats? For example, if you invest a lot in the EBIT or whatever that would be.
Preston Pysh 49:21
My dad and I got in a little bit of discussion about that exact comment. I told him I’m sure that they loaded up all the historical data going back 100 years when they were developing the base algorithm for this thing.
My dad said, “No, I think it’s just the last 10 years.” I said there’s no way that somebody out of the Valley would just use the last 10 years. Well, I went in and I read the prospectus on this.
In the prospectus., it says that the information is basically the way that it’s making decisions is only using data off of the last 10 years. My opinion is that they did a bunch of back testing. They basically loaded the algorithm in there based off of 100 years of back testing information and data and everything else that they would have fed it.
But then once they let it loose here on the 18th of October, I think that it’s only pulling information for the last 10 years for the picks that it’s assessing today, based on what I read in the prospectus.
Tobias Carlisle 50:21
One thing I would say about this is the good point in time backtesting data goes back to 1963. Every single quantitative system in the world is trained on the same data.
There’s a group called Euclidean who did the back testing for my most recent book, The Acquirer’s Multiple. They have written this great paper, which I’ll give you the link to so you can stick it in the show notes, where they looked at using AI trained on that same data to see what it would come up with.
Basically, what they found was that humans have hazed this data so much. There’s so much data mining going on already that AI can’t really find anything new that’s not already in the data.
I’ve spoken to guys like Pat O’Shaughnessy. I know you’ve had him on the show before. They’re one of the original quant shops. They’ve been doing it for a long time. They got a couple of 100 super smart PhDs in there who are grinding on this data all the time. There’s not much lift that anybody else can kind of dig out of this stuff.
It is possible that AI is going to do something like if you’ve seen that documentary on Go? It kind of comes up with this move that causes the guys who are experts in this to say humans have been playing this game for 1000 years. It turns out, we didn’t really even know how to play the game because the AI is doing something completely different. I
It is entirely possible if that happens, and this thing does figure something out. But so far, humans have gone over the data with such a fine tooth comb that I don’t think that they found anything new. It’s a very, very short time period. Ee won’t really know for probably 10 or 20 years,who’s doing better.
Preston Pysh 51:51
My frustration with this specific ETF, and I’m looking to see if they have other opportunities out there that do hedging… I’m just kind of surprised that the first thing that they launched is just a straight long. Maybe that’s a marketing thing, so that they can get this out there. Maybe not have too many products, funnel everybody into this. If it outperforms the s&p in the first year, then they can roll out other products that are completely hedged.
Would you think that that’s probably why they went about this the way that they did, and it’s only a long strategy, Toby?
Tobias Carlisle 52:21
Hard to say why they would do that. I personally would not launch a long only strategy into this market. You want to launch a long on this strategy in 2009 and 2010, not in 2017.
Stig Brodersen 52:36
When Preston sent this I looked it up, and as far as the expense ratio was three quarter percent. I thought this is a pretty smart move, because this is AI, so they really don’t have to tell anyone or convince investors what they do, because they can just say it’s AI. We all love that and they don’t need to disclose it.
Then you will just like to administrate a lot of money and get a lot of these. That would make a lot of sense.
I think one of the things I would really like to see for any ETF or any kind of quants strategy is really to say these are the historical results, obviously. These are the arguments why we think you will continue working.
I think it sounds amazing when I read that they had a million pieces of information in terms of every day in filings, media posts and whatnot. I think we can all see why that would move the markets, if not social media posts, then filings. But if that’s the argument, if it can be more detailed. I guess I’m more skeptical,
Hari Ramachandra 53:34
Stig, you’re onto something because as Buffett says, “If data or information is what made money, then all librarians would be billionaires.”
I think the problem with this fund is that they don’t talk about their investing philosophy, how they allocate their portfolio, but it’s all about gathering tons of data.
One other thing I want to just say is if they wanted to make it even more appealing to the market, especially folks in Silicon Valley, they should have said this is an AI based ETF that works on blockchain technology.
Preston Pysh 54:11
You’re right. They did miss an angle there.
Hari, sorry, I disagree with you on your other point, not the blockchain point. I think you’re exactly on par there with that. Maybe not today, but about a month ago, that would have worked really well, but I don’t know.
I disagree with you. I think that this thing’s ability to look at all the data points, and then come up with the correlations of all those various data points is something we have never seen before in history. I think all my personal opinion is that Buffett’s quote about the librarian thing is actually going to go up in smoke. I think people were actually going to see that in the coming 10 years.
I think that there’s a lot of power coming with some of this stuff and I think that this is just the tip of the iceberg of what we’re going to be seeing moving into the next credit cycle.
Tobias Carlisle 54:55
The reason why quant works, it doesn’t panic at the bottom.
Preston Pysh 54:58
Well, this is the other thing, if you were going to say that the data points are everyone would be a librarian kind of argument, then you go back to Toby’s point of the “Game of Go,” it doesn’t hold up. It just doesn’t hold up.
I mean, watching that video, and we’re gonna put this in the show notes. If you guys don’t know what we’re talking about here with this “Game of Go” and artificial intelligence, you got to watch this. This is mind blowing, in my opinion. My expectation, honestly, is that I think in a year from now, if we look at this ETF, I think it’s going to outperform the S&P 500.
Tobias Carlisle 55:32
It used to for short a period of time value and momentum can underperform for long periods of time. I would say, you need to give it probably 3-10 years to really work out what’s going on, but I’m with you. I agree.
Preston Pysh 55:44
You agree with me, Toby?
Tobias Carlisle 55:46
Yes.
Preston Pysh 55:47
Well, let’s go around the table. What’s your gut tell you?
Stig Brodersen 55:52
Please go first, Hari. I’m undecided.
Preston Pysh 55:55
Hari doesn’t seem convinced.
Hari Ramachandra 55:57
Yes, especially about the “Game of Go.” I think when we are talking about AI, we have to keep in mind that in machine learning, whether it’s “Game of Go” or chess. What happened between chess and Go is that the number of patterns of possible moves increased.
But it is, as George Soros says, markets have what he calls theory of reflexivity. The observer is the observee. In case of chess or any other skill, where you don’t have the observee interacting and doing something back. It’s not a complex system. So yes, I worked very well in those scenarios.
However, when it comes to complex systems, like the market, it’s different. There are humans involved. Economy is a complex system, stock markets are a complex system. That’s where I’m not totally convinced about the argument that you just feed data into the system and you’re sure that this will outperform the market.
As Toby said, I think we have to wait and watch. I’m not saying that they will not do well, but I feel we should hold back our judgment.
Tobias Carlisle 57:09
Hari is the guy in Silicon Valley, looking at all the baling wire and sticky tape holding together all the computers from the back end…
Preston Pysh 57:19
I think that’s what’s so surprising for me is Hari is the guy who is closest to this stuff. way closer than any of us, so that’s really surprising to me.
Toby, I’ve got a question for you on this. When we look at the way that this opened up on the 18th of October, there was a huge spike. The reason I’m asking you is because I know you’ve launched ETFs. You understand the mechanics of how these work.
There was a huge spike in the price where it jumped 3% in the first three days, and it just looks like because it was getting so much publicity on CNBC or whatever. These guys were all in the news and everything. Everyone’s buying this thing. Then you saw like a really strong correction for the coming two weeks or whatever, two and a half weeks.
Is that a function of basically the bot receiving all of this money and having to make a position as it’s receiving all these funds early on that it basically had to take a position? It was like it had a gun to its head to take a position in a very short amount of time, which wasn’t necessarily advantageous for it, and then had to recalculate and basically reboot the weeks after that.
Would you think that that is maybe why it’s so bad out of the gate?
Tobias Carlisle 58:32
No. It’s not big enough to impact the market in these stocks.
Preston Pysh 58:38
That’s not where I’m going with it. I’m saying, think of it like this, if I gave you a million bucks today, there are positions that you are eyeing that are at the right timing for you to kind of step into it. Then there are other ones that you wait to maybe take a position, you wouldn’t do it all on the very first day.
However, it seems like this thing was forced to take 40 positions on the very first day, do you think that that could have impacted the way that it performed?
Tobias Carlisle 59:02
No, these things are built to always be able to buy a portfolio, I can buy a portfolio tomorrow morning, I can buy one at midday, I can buy one at the close. You know the systems are built to buy portfolios all the time and to manage the portfolio. So it’s just a random chance.
However, sometimes the market is volatile. Just while I’ve got the mic just to go back very quickly to something that Hari was saying before. It’s interesting, you say chess and Go are closed systems and the market is an open complex system. When you look at the backtesting which these things are fed, I think that the market actually looks like a closed system to these things. That’s why I say everybody in the world acts on the same data from compustat to 1963 in the US, that’s an idiosyncratic market. Everybody’s getting the same results, value and momentum.
It’s possible that go and chess have more positions available to them than these things looking at those limited data. That’s a concern of mine. That’s like an existential question that I’m always worried about. Does the data set that I’m looking at training my systems on reflect what we’re going to confront in the future?
The answer is probably not. That’s a real concern for me, but the only advantage I think that I have is that when I look at it, my systems have been going back to 1963 because they’ve got that data back to 1963.
If you’re just a stock picker, in the market, your experience is limited to the period of time that you are personally in the market. You can only learn over time.
Now if you’re my age, you might have started in the early 2000s or late 1990s, that’s an idiosyncratic period in the market, would you be better off having trained back to 1963? What is artificial intelligence, less useful, because it’s got that long history than a human who has a much shorter history and they can make decisions based on anything?
Preston Pysh 1:00:55
When you think about their perspective, certainly going back 10 years to make the decisions that it’s making today, do you think that maybe that’s one of the reasons why they did it that way so they’re not so polarized by the way that everyone else in the markets makes decisions?
Tobias Carlisle 1:01:08
That might be just the data that they’re looking at, averages over 10 years. I’d be surprised if they’re only going back 10 years.
Preston Pysh 1:01:16
I was blown away by that, but when I read it in the prospectus, I didn’t know, I was just surprised. I was like you, I didn’t believe it.
Stig Brodersen 1:01:24
Alright, guys, I think that concludes our first Mastermind here in 2018. Before we let you guys go, we would really like to give you guys a hand off to the audience where they can learn more about you.
Hari Ramachandra 1:01:35
bitsbusiness.com.
Preston Pysh 1:01:40
All right. We’ll have a link for that in the show notes. How about you, Toby? Where can people find out more about you?
Tobias Carlisle 1:01:45
acquirersmultiple.com. Twitter is @greenbackd, which has a funny spelling and I will put it in the show notes.
Stig Brodersen 1:01:52
We’ll definitely do that, Toby. You are way too modest. You authored quite a few amazing books so we’ve got to put a direct link to them in the show notes as well.
Guys, that was all Preston and I had for this week’s episode of The Investor’s Podcast.
Outro 1:02:08
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