Preston Pysh  1:22  

All right, Stig, I’m going to throw it over to you for your pick, because I find this to be very brave, smart, and I’m concerned all at the same time. Go ahead. I want to hear this one.

Stig Brodersen  1:35  

I’m happy to say that, Preston, I am repitching Alphabet. Most people probably know it as Google, but the parent company is Alphabet. [This] is primarily Google, but there are also a bunch of other businesses. 

I completely get where you’re coming from, Preston, [given] the valuations we see right now with the FAANG (Facebook, Amazon, Apple, Netflix, and Google) stocks not looking to be any more expensive. You can be surprised [as to] why I am repeating Alphabet. 

I pitched this back first in November 2018 for the Q3 mastermind meeting. Since then it has outperformed the market. It has returned 26% compared to the S&P 500, doing 12%. I think it’s a very different type of pick than Spotify that I did last week. It is a tech company, but it’s a very different tech company.

 

Going back to what Preston said before, I would like to argue here that it has different downside protection than something like Spotify. However, you probably won’t see the same 50% soar as you saw the last pick here, since the last quarter. 

One of the reasons why I really wanted to repitch the stock is that being a value investor, we tend to learn to become contrarian and to think that we can be right even if the market is wrong. I guess what I’ve experienced in my own investment career is that I sometimes take it too literally. 

Often thinking for too long that if I had a different opinion with the market, it must be because I’m so much smarter, and it just takes such a long time for the market to wise up. That approach is very expensive in opportunity cost, because you could have invested something in a different and better business. 

I’ve also come to realize that often I just have to acknowledge that I was wrong. I have to move on with my life and sell that stock. I wanted to use that going into Alphabet because whenever I do see a stock that has outperformed the market like Alphabet, I really want to see if this is a chance to double down and see if my investment thesis has not been fully appreciated by the market, especially what we’ve seen here recently with a lot of great investors. Definitely not including me, but a lot of great investors building stakes. 

I think the most famous stake here recently is Seth Klarman, building a 5% stake in Google. This episode will come out on August 15th, which is the new time for the 13F filing. Let’s see what the so-called “superinvestors” are doing. 

I wanted to talk about another reason why I really wanted to repitch Google or Alphabet, which is that over the past 2 years, Google has been breaking out a lot more detailed information for the business unit, including YouTube Cloud and many other of the units specifically off the bat. There is a lot more information available that we didn’t have last time where we can unlock a lot more value. That was probably the longest introduction that we’ve had. Let’s pin to the actual pitch. 

If we look at how Google makes money, Google products are still the main source of revenue for Alphabet. The revenue compositions have gradually changed over the past few years. Google Search is now only 58% of the revenue, and part of it is that the Alphabet has simply just changed. The accounting broke out more separate units from that. That is part of the explanation. 

Whenever you think about how Google makes money, think about AdWords. Think about AdSense. Today, YouTube is 10% of revenue. This is a segment that has grown 33% year-over-year in Q1. It’s only up 6% a year-over-year if you look at Q2. That also includes a lot of COVID-19. 

Then you have Google Cloud, which is 7% of total revenue, but it’s grown 43% year-over-year. Also, they have a bunch of smaller units typically categorized in other Google revenue, which includes YouTube *Inaudible* advertising revenue on [Google] Play, which is up 26%, then you have other *Inaudible*. 

I usually give a more detailed explanation of the industry whenever I pitch a stock, which for Google still is online advertising, primarily through Search. However, I did that last time in Q3 2018. I’ll make sure to link to that in the show notes. In that space, not a lot has changed. I’ll get back to that because I actually think it’s a good thing. 

Facebook and Google still heavily dominate the space. Amazon has caught up a little, but they’re still way behind the two giants. Let’s talk about Google’s moat that comes in many different shapes and forms, talking specifically about Search that still dominates the market with more than a 90% market share. 

Some of that moat simply comes from brand recognition and people just going on Google for search by default. Interestingly, the mode of the most queries that Google has is really not doing a much better job than most of the competitors.

However, where they really have a moat, and why so many people use the service is also because 15% to 20% of the searches are so-called “unique.” There’s a huge difference there because Google has a data advantage. They get so much better search results on those queries. Speaking of data moat, I would like to emphasize that for a company like Google, it’s not really only the vast amount of data, which in itself is a moat. Whenever it comes to the amount of data there is a saturation point. 

Rather, I would say that it comes from the breadth of data of all the different platforms we have and how they’re able to process that in a central spot. Because data is not just your input data. It’s training data. It’s feedback data, and you’ll need all of that to maximize the value. Because of that, in many, but clearly not in all fields, Google really has a moat compared to most companies, including some of the big tech companies. 

Last time Hari introduced the terms, “China-proof” and “Corona-proof.” It was interesting the way he looked at that. I wanted to include that here in my pitch and start with China. 

There’s a clear distinction between competing in the West and competing in the East. If we do look at the Chinese giants like Tencent, Alibaba, and you can even say Baidu to some extent. Talking specifically about search, even though Tencent and Alibaba are sort of gearing up to make Baidu services less relevant because of what they’re doing with their ecosystem. They would have such a hard time competing with Google in the West, just as we saw Google have major issues in China, by the way. 

One practical example is something like Cloud. They’re just not competing about the same type of customers. You just have some customers going to Amazon Cloud or Google Cloud or Microsoft products, and then a completely different segment going after *Inaudible* in China and in the East. In terms of being “Corona-proof” advertising, it is expected to decline. They’ll be looking at around 5% in 2020, but still 30% up from 2019 to 2022. 

I remember going back to 2018, that I was so concerned about what we’re having with the next crisis. I don’t think we could have almost a more severe crisis than what we’re facing right now. Given that advertising is probably the first thing that’s been caught in the time of crisis, we’ve really seen advertisers feel that the pain has been in conventional offline marketing and not in the online. I think it’s quite astonishing to see the impact of *Inaudible* impact for a company like Google. 

From the perspective of a business owner, despite where you are on the microcycle, if you can track $100 in revenue from a $99 expense, [that] is still an easy decision to push through. That’s very important to understand whenever you look at revenue and the sustainability of advertising. 

Before I go to the valuation, I wanted to talk a bit more about some catalysts and sending that over to Hari, because if you look at Google, one of the big things that *inaudible* back in 2017 is the launch of the AI-first strategy.  

I’ll be the first one to say that you don’t hear anyone talking about that they have a strategy never to use AI. I do understand that it’s a buzzword for many companies more than an actual strategy. I wanted to see how that translates into Alphabet. 

Sundar Pichai said that we want our products to work harder for you in the context of your job, your home, and your life. That was the framework we saw the new strategy around. We saw Google Assistant as just one of many products we saw around that time coming out. This strategy in itself doesn’t really clear the no test.

Throwing that over to Hari. I’m curious to hear some of your thoughts about where you see some of Alphabet’s revenue coming from in the future. What [does] your more qualitative analysis say about Google and the disruption we’re going to see from AI?

Hari Ramachandra  10:19  

Stig, this is a great conversation. Also, your introduction covers all aspects of Google. I do agree with you that for the next 3 to 5 years, at least, Google is well-positioned in terms of qualitative aspects of the business. I think they have really strong moats in terms of their search engine for now. 

And of course, YouTube. They’re also making great progress in Google Cloud, which is not talked about. They are like the third most popular cloud platform. I think they’re making some good progress with Thomas Kurian. 

However, there are some issues or concerns that I have with Google, and they are more for the longer term. Number 1 is the optional factor that Google used to have. [For instance,] how they came up with new businesses. Looks like all the pieces are now kind of big, except for the self-driving technology, which people don’t really understand how to value, how it will change Google’s future revenue, and their position. 

There are some concerns in terms of what has happened in the past few years. I would say in the core business search, one of the developments that concern me is Amazon stealing their lunch for the most lucrative search keywords. Today, if I want to buy a product, I just go to Amazon directly. Not Google. Those were the ads that Google had the most expensive bits. So that’s number 1. 

Number 2, in terms of their AI, TensorFlow was one of the best ways they launched it. But there are other open-source and other platforms that have taken lead now. It reminds me of how SON used to be back in the day, when they were the ones to come up with the best technologies. 

If you see today’s operating system, especially anything that is Unix and Linux-based operating system, a lot of the underlying technologies were actually pioneered by SON, including Java, which they open-sourced, but they were never able to capitalize on it. 

There were other people who ate their lunch. When I look at Android [and] when I look at some of the progress that Google has made in terms of open-source AI, with TensorFlow, I don’t say that Google is SON. However, it’s very similar. 

Finally, with Larry Page and Sergey Brin not at the helm. I missed them. There is a difference between a founder-led company and execute to hired hand leading the company. There is definitely a difference in terms of the rigor and vibrancy. Having said that, this is all for the next 10 years, the concerns I have. But I would rather have Google in my portfolio than cash. That’s how I would say.

Preston Pysh  12:56  

Yeah, I agree with you on the Google versus cash comment, Hari. I got 2 questions for you based on some of the stuff you were saying. The TensorFlow keys, which is the algorithm or the open-source code that Google has for artificial intelligence, isn’t that business model more to push them into Google Cloud for processing? 

I’m kind of curious because your comments made it sound like other competitors are pushing developers into a different AI algorithm over TensorFlow. Is that because Google Cloud is too expensive relative to maybe using Amazon’s artificial intelligence software and in their cloud computing?

Hari Ramachandra  13:34  

That’s a great question, Preston. I think it’s not about whether TensorFlow is good. In fact, it’s really great and sophisticated. You’re right, the way Google wants to capitalize on their TensorFlow platform is to expose it through their Google Cloud. What I see the problem with Google, and some of that is being corrected, is in general, they’re focused on coming up with the best and most sophisticated technology, rather than focusing on the use case.  

For 90% of the customers [and] enterprises, they don’t need all the bells and whistles that TensorFlow offers. Books like Amazon Web Services and other companies are just good at identifying what the customer needs and offering those features to their cloud or platforms. Google has been struggling with that. That’s the difference. 

Preston Pysh  14:22  

The other question I had for you Hari was in driverless car technology. The software. I really don’t know anything about where Google stands in that race. Would you say they’re competitive? Who’s the front-runner? I’m curious to hear your thoughts on some of that.

Hari Ramachandra  14:38  

Good question. My knowledge here is also murky. I wouldn’t say I know who’s the leader there. But there have been divergent approaches that companies have taken. For example, Tesla. The approach of trial by error in a less sophisticated way. They went from 5 levels in self-driving technology. 

If you are level 5, and that’s what Google is trying to aim, then the power is completely self-driven in all conditions. You don’t even need a steering wheel. What Google decided to do is go for level 5 from the beginning. That’s the reason they have been taking a long time. This might pay dividends in the future. 

Companies like Tesla and other startups have the approach of gradually progressing through the levels. They’re making good progress because AI is more about data than the algorithms nowadays. The models can be really sophisticated. However, less sophisticated models can be more sophisticated models with lots of data. 

Kai-Fu Lee in his book, AI Superpowers, goes into detail about why this is the case and that’s what is happening in self-driving. So that’s number 1. 

Number 2 is they did have an early-mover advantage, but every year that goes by they’re losing it bit by bit, because there are many other companies getting into it. One argument or one option was that once they have self-driving technology, they can come up with something like Uber or Lyft. Or they can partner with Lyft because they want some stake in Lyft,  and then capitalize on that. That’s how they can basically get the platform. However, with other companies also making sufficient progress, I don’t know whether it will be Google *Inaudible* [who will emerge as the] clear winner. It’s really hard to say at this point.

Preston Pysh  16:24  

I just don’t know how they could catch up if you’re saying, in my understanding of how AI works. It is all about the data. There are training sets and pushing this as much data through the model as possible. You look at what Tesla is doing and how much data they’re capturing on all these different cars that are out there. 

I don’t know how Google is going to possibly be able to replicate that with all the hours of driving that Tesla was able to capture. My issue with this one, it’s a great company, obviously. Everyone knows it’s a great company. 

When you look at the margins, their fat top line [and] bottom line, you’re 21%. The top line keeps exploding higher. The macro-environment is adding more fiat into the system. We just pump $5-6 trillion into the system, it seems like all that printing goes straight into these FAANG companies. 

My only concern is when I look at the chart, it’s straight parabolic. I’m looking at Toby who’s totally relaxed, on vacation, and we appreciate him being here with us. He’s laying there, and he’s smiling. Toby, what do you think of the valuation on this parabolic chart?

Tobias Carlisle  17:30  

Google is my favorite business. I was really happy to hear Hari’s criticisms of it, because I’ve kind of fallen in love with Google a little bit. It’s such a spectacular business. It’s like this automatic money machine with these gigantically fat margins. Anytime you use the internet, you’re basically using Google. You go to the Google search bar to find something. Google gives you its picture of the internet directory; where to go. 

If you’re listening to music through YouTube or something like that, you’re on Google. If you’re using Gmail, you’re on Google. All of these things just kept so much of your life. I’ve got a Pixel phone, so I use a Google phone. 

There’s no question that it’s one of the best, if not the best business in the world. The other side fave them, *Inaudible*, like Facebook, Amazon, Alphabet, Apple, Visa, Microsoft, and MasterCard. They’re the best businesses in the world. Everybody else thinks that they’re the best businesses in the world. They’re expensive. 

The cheapest ones are probably Apple. It’s 27 times EV / Free Cash Flow and then Google, similarly. The 2 challenges with these businesses, they’re the kind of businesses where it doesn’t matter if you pay up. The worst that can happen to you is dead money for a decade. You don’t go anywhere while the market goes somewhere, but you’re not going to lose much money in them. 

The other thing is that Google’s really controlled by 3 people: Sergey Brin, Larry Page, and Eric Schmidt. All of the other shares are basically non-voting. You’re at the whim of those 3 guys. The 2 challenges for Google, there’s no question, it’s one of the best businesses in the world. The 2 issues for it right now are the valuation.

I agree, it’s when you say you prefer it to cash. I interpret that as I wouldn’t sell it here, but I wouldn’t necessarily buy it. I just buy a starter position to track it or just watch where it goes to. If it pulls back, I can buy more. 

The other challenge is corporate governance, [which] means if you’re worried about the way that it’s governed, the way that it’s run, there’s really nothing that you can do. You are along for the ride with those 3 guys. 

Preston Pysh  19:21  

Stig, I want to piggyback on what Toby just said. I completely agree with your comment. I don’t know that I’m buying it here, but I’m watching it to buy it if I get an opportunity at a better price point. The one thing that I’m looking at from a momentum standpoint is the MACD (Moving Average Convergence Divergence). I’m looking at the daily and the weekly MACD for all of FAANG,  and it appears right now at the start of August 2020 that a lot of the FAANG companies momentum is starting to fizzle out. 

I’m curious whether in Q3, we’re going to have another whiplash like we saw in March-April timeframe, where there’s some type of currency liquidity event that drops everything. We get a really violent correction,  and you get an opportunity to buy a company like this. That’s where I’m looking at it today. [It’s] an amazing company. You might have an opportunity to get it at a better price here in the coming quarter. I hope you can,  and I guess I’m looking for that opportunity.

Stig Brodersen  20:20  

Great comments. If I’m worried about anything, I’d like to get back to the valuation piece here a little. I’m definitely worried about Amazon. Hari, you kicked this off by saying that you just go to Amazon now. You don’t even stop with Google. 

Google has been doing Google Shopping for quite some time. After they included that into the search piece. It’s worked a little better. It doesn’t work as good as Amazon, but they have started to generate money from that. I guess the functionality of going into the Google Shopping universe is [it’s] just not as interesting as going to Amazon. For me, it might be that the ship has just sailed. 

The other thing that I’m thinking is also Google knowing so much about us. Is there a way that they can do it indirectly? Serve those ads to us or sell those products to us one way or the other? I think that’s the important key, not thinking about the next 3 to 5 years, more than likely the 10-year considerations that you talked about before. To me, it was very interesting. Whenever the CEO, Sundar Pichai, said that Google needs to be better in the context of job, home, and life. I think that statement is very inflation-proof. 

Now, I’m not one of those people who is thinking that we’re going into something like hyperinflation or anything like that. All that being said, I do see a lot of money being put into the system, and I am not completely sure it’s going to happen. 

It’s actually a very Warren-Buffett-way of looking at it whenever you’re talking about inflation. Where’s that value coming from? If you can do that, to me, that in itself is an extremely value inflation-proof system. Whatever you want to call that or whatever the macro-environment says. 

For me, going to the piece about valuation, I don’t really see a product or service that will replace advertising as a main source of revenue, but I do see multiple minor streams that when combined might make a huge difference. 

The most prominent of these is probably something like YouTube and Cloud. You might even say that YouTube to some extent is advertised-based. You have so many other products and other projects that are burning cash right now, and a few of them will turn into highly profitable businesses. I just see a lot of astrometric bets there. 

If you look at the owners, earnings for the companies just fall from the free cash flow because the growth cap is just so high for a company like Google. Of course, for a company with $166 billion revenue, it does take a lot to move the needle. 

Whenever I refer to a few units to be highly profitable, I’m not talking about a speech recognition service that costs $20 a month for $30 million users, but something bigger than that, which historically we’ve seen that Google has been able to pull off. 

Last time I pitched Google, [it was] in 2018. I used 15% as my projection for growth rates over the next 5-year period. Since then, we’ve seen growth in excess of 20% annually. It is tricky to come up with growth projections as always. With my assumptions [that] I’m probably looking at, I can see Preston smirking there, because I’m just about to say that if I use a Tuesday’s growth model, say, call the 20% for the next 5 years, and then a perpetual growth of 3%, I do arrive at a double-digit return. That is not how it’s going to play out. I’m not saying they’re going to grow 20%, but I’m also not saying it’s only going to grow 3% after 5 years. It’s probably going to be somewhere there in the middle.

Preston Pysh  23:37  

Having known Stig for many years at this point, he’s not one to ever brag. That was Stig very delicately bragging that at a 15% growth rate, he was underneath something that actually went 20%. He called this many years ago, so I give them a thumbs up and kudos that you deserve it.

Stig Brodersen  23:56  

Well, thank you, Preston. I just have to say that the humblebrag came much earlier. That was whenever I said that last pick actually went up 50% in 3 months. That was my humble brag,  and I got no credit for that. Anyway, [I’m] throwing it back over to you guys before we move on to the next picture. I don’t want to take all the time here for us today. 

I wanted to throw it over to Toby because I can hear myself saying weird things like a 50% growth rate and a 20% growth rate. I hear myself pitch the weirdest stocks that I would never do. I typically would do all machinery types of low-growth kind of thing. Now, I find myself teaching other things, and we do see more traditional value investors buying into big tech, not just as *Inaudible* like you mentioned before, but we do see a lot of that. 

Toby, for you being a devalue guy, and I do immediately recognize the difference between devaluing and value. I know it’s 2 different things. Is it because you have other investors who are now keeping up with the times? Let’s just call it that, or is it the Krishna value investors have lost their way,  because they’re just under so much pressure to outperform the market? At least not trail the market, like many have,  because they haven’t been in the stock. How do you see that?

Tobias Carlisle  25:18  

I don’t like *Inaudible* the definition because I don’t like Netflix, because it’s negative free cash flow. Tesla’s got some problems from a valuation perspective. There are a group of companies that are very big, very well established, [and] very good moats. Excellent returns and invest capital, excellent management, and that’s that. I call it a favor, the list of companies that I gave before. In order to value those companies, you have to come up with some reasonably aggressive assumptions,  and that’s been the challenge. 

Certainly for guys like me, what I tend to do is look back at historical [data]. Credit Suisse with Michael Mobizen has produced this document that shows you the rates at which companies have been able to stay at very high growth rates. When I say rates, it’s companies who sustain a 15% or 20% growth rate. What are the chances they can do it for 1 decade, for 2 decades, for 3 decades? And you come down to these vanishingly small numbers. You’re making these very low probability bets,  and you’re paying a reasonably high multiple for it. 

Having said that, if you look at these companies individually, it’s probably hard to see how some of them are not going to do that over a period of time. The challenge has just been for value guys to be a little bit more aggressive. Those who have done it have done quite well. Those like me,  who haven’t been as aggressive tend to be more conservative, haven’t done as well. I think he’s probably going to do very well, the underlying businesses. 

The question is going to be,  and this is the question that I always have: Can the valuation and the multiple sustain even though the business is going very well? If you think back to that first dot-com,  there were lots of really good companies, and I’m not even talking about the famous dot-com blogs. I’m talking about Disney.

Lots of big companies came into that peak. They still are very good companies,  but they were punished because their valuations were too high. It took them a decade to grow back into those valuations. There’s a little bit of that going on now. It’s driven by interest rates being too low. That’s all it is. 

You squash interest rates to 0%,  down to 3% free cash flow, yield becomes very attractive. A growing 3% free cash flow, you can’t get that anywhere else. Google is a better option than cash. You got 2 challenges. If the interest rates go up,  then you’ve paid too much. I have tended to be conservative,  and that’s hurt me. 

Stig Brodersen  27:27  

Thank you for your response to that. I really need to think a lot about this. I think around 7% of my portfolio, I tend to be quite a concentrated investor,  and Google is actually not my biggest stock pick. [I have] stock picks that [are] much more than 7%, which I don’t know [is] good or bad. But you really have to think about doubling down on something like Alphabet at this price level. Thanks guys for the feedback. I really appreciate it.

Preston Pysh  27:52  

Stig, just a final comment. I would look at your correlation,  too, if it’s a large percentage of your portfolio. I know on our TIP finance, we’re now doing that. We’re showing [data] compared to all your other stock picks. What’s the correlation look like in indexes or whatever, how correlated is that to everything else. Just as another consideration to try to keep it as uncorrelated to the rest of your portfolio, if possible. 

I’m going to go ahead and pitch mine real fast here. Mine is E*TRADE. The ticker for this is ETFC. I think anybody who listens to this show knows what E*TRADE is and pretty much understands their business model. The thing that attracted me to this one is 2 things: there’s a lot of volatility in the market, which typically means that there’s a lot more trading taking place and the numbers on this for me were really good. When I look at the numbers, the top-line more recently or in the last 3 years hasn’t really kind of exploded. It’s gone up. It’s been good. 

When I look at the free cash flows on the business, it’s doing really quite well when I go in,  and I do an intrinsic value on this. I do an IRR (Internal Rate of Return) on the free cash flows of the business,  and I do it in a conservative way moving forward. 

I’m coming up with a valuation that should pump out something in excess of 15% annually. When I look at everything else that’s on the market, I’m not finding too many things other than the finance sector that’s kind of pumping out IRR (Internal Rate of Return) at this level. 

I really like that E*TRADE is more focused in the trading realm than they are in like the J.P. Morgan type of Finance. You look at the revenue to their bottom line, that’s 33% margin. They’re a very healthy company. Good balance sheet. In general, I really like it. I think when I look at the momentum, the momentum comes in a positive trend. That’s all I got. It’s pretty simple. I like the numbers. I like the sector that it’s in and I like the conditions, the environmental conditions as far as volatility. I expect there to be a lot of volatility in the coming year. I think this is going to do well.

Stig Brodersen  29:59  

It’s a very interesting pick, Preston. If you look at how they make money to basically do that; 3 different ways. They have interesting comm they have commissions, fees, and service charges. Whenever I look at something like interest income, we have to talk about the low-interest rate. I can’t help but think that at the rates we are now, it can only go up which would be good for a company like E*TRADE. 

I’ve been saying that for 5 years. Most people have thought that we can’t go any lower. Still, it seems like it can do that. My guess is at this point in time, as much as I see the low-interest rates, I also don’t really see them going up. Obviously, there will be some sort of mean reversion eventually, but I don’t see that happening anytime soon, especially not what’s happening right now with the crisis. That’s probably not where the money is going to come from here anytime soon. 

If we look at something like commissions, we’ve seen a lot of disruptions here lately. That is probably also not a place where you see more money coming in. I’m not saying that it would just be completely gone. With the new players, you’ve seen everyone has been Robinhood. 

I think that’s a term that I’ve heard a few times. It’s a bit painful even for some of the discount brokers, who like each race, who came in and undercut the big banks. They’re getting disrupted the same way that they went into the industry. Then if you look at something like fees and charges, that’s an interesting one, too. 

I like to look at it in a very diff basis type of way. He says that he doesn’t want to talk about what’s going to change that’s too difficult for him. He’s more focused on what will stay the same for a very long time. He uses the example of faster delivery and low prices. That’s a very Amazon way of thinking. If you look at it for a company like this; there were fees, that’s one thing and commoditize financial service, that’s another thing. That’s some of the red flags that I see right now for a company like E*TRADE. Hari, you have a point there.

Hari Ramachandra  31:54  

Great points. I just want to add, your comment about Robinhood is quite prescient. That’s definitely a risk and especially now, every other company is driving down their admission fee. How will they expand their margins and their revenue? 

One thing I wanted to point out about E*TRADE is one of their strengths which is not well known is that they are the preferred vendor or brokerage for most of the companies to offer their employee stock option plans or RS use, restricted stock units (RSU). That’s very sticky. 

The volumes are huge there because of all these companies granting their employers to iterate. I have worked for multiple companies in the valley and invariably it has been a trade. I have not seen any other company. I don’t know how they managed it but somehow this seems to have some stickiness there. 

However, I also wanted to ask a question. There is a lot of rumor about a merger between E*TRADE and Morgan Stanley. Is that any factor while you’re looking into it? Would that be an arbitrage that you’re looking for in the short-term?

Preston Pysh  33:01  

I think anytime you see the numbers where these are at as far as how much margin and profit a buyer could capture, yes, absolutely. They’re a prime candidate to be purchased. Just think of all the data that they’ve got that would benefit as far as a merger for a company like Morgan Stanley. 

Yes, I think that’s definitely something that’s in the cards. When you look at the size of this company, it’s on the lower size for a large-cap. Their top line was $2 billion or $2.8 billion, something like that. It’s small relative to a lot of other things which makes it another great candidate for a buyout. 

When I’m looking at the IRR (Internal Rate of Return) the numbers are literally double, triple, quadruple what you find for other companies IRR (Internal Rate of Return) and it’s that size. It’s a prime candidate for a buyout. Just to address Stig’s comment real fast. When we look at Robinhood, they’re selling their order book to high-frequency traders. 

Is the trade exempt from that activity? I don’t know. They could be doing the same thing. I don’t know necessarily their corporate culture, whether [or not] they would entertain something like that. I’m sure if things got competitive enough where they start seeing a hit on their revenue, that could be another avenue that they could maybe step in and give Robinhood a run for their money. I don’t know. 

I think you have a lot of people that are not day traders that have accounts with E*TRADE that conduct a trade once a month. For the fee, it’s like, so what, it’s not a big deal. The hassle of them changing all of their information and their data over to another platform is way more friction than they want to deal with for the few trades that they can conduct on an annual basis. 

Stig Brodersen  34:48  

You bring up a good point. It’s definitely too sticky. Like working with brokers. You don’t want to switch brokers if you can avoid doing it. I definitely agree with that. What you see right now with brokers is what you’ve seen *inaudible* management field is that, no, you’re probably not going to switch from one vehicle to the next to save 10 basis points (BPS) but you just see an overall pressure on profitability. It’s just all becoming more and more commoditized. The due thing, that’s the effect that’s going to hit something like E*TRADE more than anything else.

Preston Pysh  35:20  

Toby? 

Tobias Carlisle  35:21  

I quite like E*TRADE. That’s a position that I’ve held in the fund. I like it for all the reasons that you like it Stig. It’s beaten up along with all the other financials. It’s still a really good business, generating lots of money, a really solid balance sheet, and it’s in a good place. In terms of being fairly low-cost compared to its competitors. 

The reason that we sold it was that it had this bid from Morgan Stanley. When they set the bid, it was at $58.74. It’s 1.0432 Morgan Stanley shares at the time that we rolled out of it, we just had better opportunities. 

I said it’s trading around $50. That’s interesting, I just can’t do the calculation right now but it would be worth working out where the bid is right now, what the bid is worth, and seeing because it’s one of those things where if the bid goes through, you do very well because you’ll get a good little return from here. If it doesn’t go through, it’s still really undervalued.

Preston Pysh  36:11  

I completely agree with you, Toby, I’m seeing it the same way. All right, let’s go ahead and go over to Toby for your pick.

Tobias Carlisle  36:19  

My pick is Berkshire Hathaway. It’s a popular pick on this podcast. Everybody knows that Berkshire has underperformed the market for the last 15 years. Basically, it needs no introduction. Warren Buffett, one of the biggest companies, it’s like a $475 billion market cap right now. There’s a little bit of float liability there. It ends up being a $540 billion enterprise value. 

On a valuation front, it’s very cheap. Questions are, is this something working in the portfolio from an insurance perspective and that’s why everybody’s being cautious about it? The other question is: Has Warren Buffett lost it yet? 90 years old. Is he too old? The only thing that I would say to the question of Warren Buffett, has he lost it? 

The greatest trade ever is Warren Buffett buying Apple. I’ll tell you why I think it’s the greatest trade ever. Apple was a completely known quantity at the time that he put the money in. He invested $36 billion which might be one of the biggest acquisitions. Probably one of the biggest acquisitions for Berkshire Hathaway, maybe one of the biggest investments ever made in the market. The stock is up almost three times since he put that position on. 

It now accounts for almost half of Berkshire Hathaway’s books. I don’t think there’s any question that he’s still the best investor in the market. The company is built by him to be resilient and to perform very well. I don’t see how you can lose in Berkshire Hathaway at this price. The only question is: Is there something in the book that we don’t know about? 

You have to trust management, that’s really the only thing you can do in insurance. I don’t think there’s any management more trustworthy in America probably but certainly in insurance. Even though they are quite old, the company is constructed in such a way that it should continue to do very well into the future. 

The fact that Buffett has absolutely nailed this apple trade recently, just as peripherally, still fully in command. I’m sort of astonished that the purchase, cheap as it is, it’s one of the easiest positions to put on in the whole market. Whatever happens next, if it’s a big drawdown or if it’s a big draw up, Berkshires from a valuation perspective, from a management perspective, and from a quality of business perspective, it’s one of the easiest decisions I have ever had to make.

Preston Pysh  38:33  

I know when I look at the numbers, Toby, they look very good. I’m not accounting for the look-through earnings. I’m coming up with 9% or 10% at the current price.

Tobias Carlisle  38:43  

In terms of fold return?

Preston Pysh  38:44  

Yes, and in terms of the IRR (Internal Rate of Return) that I’m doing on the company, I’m looking at the free cash flows and I’m making an estimate into the future and then basically taking the current price and solving for the percent that you’ll get without the look-through earnings. I’m already getting 9% to 10%. 

When you add those in there, especially if Apple’s taking up as much as the balance sheet, as we’re saying they are, you’ve got a lot there. There is risk in the insurance area especially if this global economy plays out in a very negative direction. I think it’s going to go in the coming year, you’re going to have massive insurance claims. 

There’s a lot of risks there. With that said, of all the insurance companies that are out there, I would put Geico at the top of the list. Just because I know how conservative they look at this and how they’re not chasing market share. They’re chasing protection for their shareholders at Berkshire and the operating subsidiary of Geico. All the insurance companies in the whole U.S. have that same risk as Geico.

Moving forward, as things continue to play out, they’re going to continue to adjust their policies and try to manage these risks as they pop up. I don’t see any particular risk being able to blow up all the assets under Geico. We know the one that Warren always talks about at the shareholders meeting but I don’t think that’s something that’s very realistic in the grand scheme of things.

Stig Brodersen  40:11  

Whenever I look at Berkshire Hathaway, I mentioned during the last mastermind meeting that *Inaudible* just added yet again, to my position. I’m probably not going to come with a huge bear scenario but I do think that there are a few different important things to note if you look about the performance. Buffett gets a lot of things thrown at him right now because of the lack of performance. 

If you look at the low since 2009, the S&P 500 and Berkshire, they’re more or less the same. What I looked up here was a 188% return to the S&P 500. A 181 for Berkshire Hathaway. It’s only here very recently that the S&P 500 called up. I do know that whenever you’re looking at Buffett’s track record, if that is what you’re comparing it to, clearly, you might be disappointed. 

As we talked about multiple times, They’re a bunch of reasons why he cannot keep up with that track record. I feel that Buffett is not getting enough credit. You mentioned the Apple deal before here, Toby. It’s important to understand diversification here. Buffett is famous for saying that diversification is a protection against ignorance and that there’s a case it makes a little sense if you know what you’re doing. 

A lot of people are saying, “Well, Apple is half of your equity portfolios” I feel is the wrong way of looking at it. He’s having to sit on so much cash. Everyone wants him to put that cash into use. He’s doing that, he’s outperforming everyone with that position, then people don’t like it. It is difficult to satisfy anyone. Buffett has been asked specifically about the diversification pot. 

Now, what he’s just saying is that this is just the third major company aside from insurance and his real interest. You can put in something like Berkshire Hathaway energy too. It’s just another great business that he is running. One deal that he’s been doing here with the recent quarter, I like what he did with Dominion, employing close to $10 billion. We’re looking at something around the $1 billion EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). 

We have this reservation about EBITDA. That was what was reported, especially with natural gas prices at historic lows. Buying something at a 10% multiple, it’s not screaming cheap but it looks like it’s a good value in a very warm Buffett type way owning the infrastructure of natural gas, he has to stay from 8% to 18% of the transmission on that. 

My question, sending it back to you, Tobias, is how much can this be a part of an investor’s portfolio? Something like Berkshire Hathaway. *Inaudible* call around that, I mentioned before that Google was 7% of my portfolio and it’s by far not the largest position to have that would be something like Berkshire Hathaway. What would it be for you Toby? Where would you feel that a retail investor should feel comfortable, who really understands Berkshire Hathaway wants it to be a huge part of their portfolio? How big should *Inaudible* get?

Tobias Carlisle  43:06  

That’s a difficult question to answer because it’s always going to depend on the individual and the other opportunities that they have. It’s hard but in the fund, I run 30 positions long, and I just equal them. Rebalance my quarterly basis. If I was to run a more discretionary portfolio, I wouldn’t probably run as many positions, and I’d have more concentration in some. 

The thing about Berkshire is that it’s reasonably steady. [It’s] certain 13% to 17% IRR (Internal Rate of Return). Mine’s a little bit further North because I included the owner earnings. You get $100 billion in cash, you got $100 billion in Apple, got a $500 billion market cap. 

You got the rest of the company, the rest of the businesses that I think are already worth more than where the market cap is. It’s a pretty easy decision on a valuation basis. The downside is very limited and it’s run by Bright managers. It’s one of the safer positions that you can put into the portfolio. 

The question is whether it’s going to give you the rip-roaring upside that some people are looking for. If I was to run a discretionary I’d put it somewhere between 10% and 15%, probably in my portfolio, but then I favor mother companies that I’ve listed a few times here. 

They’re harder to own on a valuation basis. I’d be inclined to have much smaller positions in them just so I could track them. I might have a 1% position in lots of those. I’m already getting looked through into Apple buying Berkshire. I get a big chunk of Apple, and I get it at a discount. I get Buffett managing it. I get all these other things thrown in for free. Berkshire is unlikely to blow up, to say the least. It’s a reasonably safe position. If you’re going to slice one up this is the one to slice up.

Preston Pysh  44:40  

All right, Hari. Talk to us about your pick here. Brookfield Property REIT.

Hari Ramachandra  44:45  

I cringed when I proposed this as my pick. This fig. The reason I’m pitching this is [because] sometimes [you have] to go where nobody wants to go, and Brookfield Property is right in the middle of it. It’s basically one of the largest operators of globally diversified quality assets. They include office and retail. The problem is retail because they have around 41% of their assets in retail. They have around $85 billion under management assets. 

They have been growing their assets under management quite healthily in 2015. There were $30 billion assets under management and today it’s around $85 billion. Obviously, I think Toby would be probably looking into it too because it has deep value written all over it. Toby, correct me if I’m wrong. 

Tobias Carlisle  45:35  

I do have some concerns with Brookfield, mostly in relation to corporate governance. 

Hari Ramachandra  45:40  

I do see that they’re trading at a deep discount to their power. The main concern is they do have a good financial liquidity position that they say they have around $6 billion in cash and undrawn credit lines. They feel they can withstand this 1 year or more of downturn, their tenants in office space are doing okay. 

They’re originally *inaudible*. There are around 9 years and 93% of them have a long-term lease in office space and most of their tenants are doing okay there but their retail is hurting. Their FFO (Funds From Operations) obviously has declined. Compared to last year at $1.39, this year is $1.48. This is not including their resale of that investment. 

There are a couple of unique things about Brookfield Property Partners. Unlike most reads, they engage in developing their property into what they call as Township. If they have just malls, they would wear townships around them and then basically develop it. Sometimes even resell some of the properties they already have. There is a constant flow of funds from the sale of their assets as well. That’s one thing that I found to be interesting.  

For me, the number 1 concern would be their high leverage. There’s like 13.8X debt to EBITDA and it has been increasing. Their payout ratio is quite high if I include the realized gains from the sale of assets at around 95% or close to 100% but if I exclude it, it’s way more than 100%. 

There is also a component of fee that their parent Brookfield Asset Management charges. Their base phase 0.5% of assets under management then there is an equity enhancement fee which is 1.25%. Then, there are incentive distribution fees. 

There are a lot of fees that one has to go through. That eats up into the returns that one makes and conflicts of interest because Brookfield Asset Management owns it. Their fee is such that it’s kind of tilted towards growth. They get more share of the growth hence they might be incentivized to take more risks. That’s some of the concerns I had. 

In conclusion, I wanted to bring it up here more to get an opinion from you guys. Is it worth looking at this price point? it’s more than 50% down. It used to be close to $20 beginning of the year and it’s now around $11. It was $8 something a few months back. It has come up and the broker has also offered to buy back their shares at $12. 

Then, they recently sent out tender to all their existing shareholders. Obviously, they’re seeing value in it so they’re confident to buy it back. Well, I was thinking the same about IBM when they were buying back their share. So, a disclaimer.

Tobias Carlisle  48:47  

Brookfield is one of those ones that is heavily discussed in the value community because it’s run by guys who operate a compound type, investors. The long side is always that there are some other parts and IP (Intellectual Property) valuation that you can come up with that makes it look very cheap. The criticism of that is that you base it a lot on what Brookfield tells you the assets worth and they tend to be a little bit aggressive with their valuations.  

It’s very rare that you see Brookfield trade close to NAV (Net Asset Value). I don’t think it’s traded at a premium to NAV because they are a little bit more bullish in their own assessment of those numbers. The fact that they’re buying back means it’s probably undervalued.

The big risks are it’s got a lot of leverage. Bidding that interest rates stay very low. The other one is that the corporate structure that I have is just mind-bending. Every time I try to get through it, it just puts me to sleep. I can’t figure it out. I’ve seen even reading somebody else’s assessment; it’s this interlocking web of multiple companies that make it very difficult to work out who owns what and why it’s structured that way. 

It’s one of those things where I see that sort of complexity and it just makes the hairs on the back of my neck, it gets my hackles up a little bit, makes me a little bit nervous. Why is it that complicated? Why have you built it that way? 

It’s possible their answer is just ad hoc. “As things have come up, we’ve had the money there, we’ve bought it.” That’s what’s created the structure. Not saying that there’s anything going on. It’s just whenever you find something going on in these companies where there’s some sort of fraud or self-dealing, they also have very complicated corporate structures because it’s a way of hiding what’s going on. 

I don’t know in relation to Brookfield. It’s just hard to get a bead on where it is. The complexity of the structure and the leverage and some of the questions about the valuation of their own assets make it too hard a basket for me.

Preston Pysh  50:30  

I just can’t see the valuation on the free cash flow side. You were talking about the net asset values which are just your assets minus your liabilities divided by the shares. What it really comes down to is: are those values that are being listed on the balance sheet really the valuations that we’re going to see moving forward into the future? When I think about those valuations of those properties, so much of the valuation is dependent on the free cash flows that those properties are able to kick off.  

I know from looking at our screener, our TIP finance when I’m looking at the small-cap companies, the momentum status on all of these small-cap companies is really bad. When we look at the indexes going up, we’re really talking about a couple of companies that are driving these indexes. 

All of this $5 to $6 trillion worth of printing that’s taken place. It’s all nesting itself into these tech companies. When you look at the smaller businesses that make up the leaseholders and the people that are fulfilling are sitting in these buildings; all those small businesses, they’re getting crushed. My expectation moving forward into the coming year is that it’s going to continue to persist. 

 If you have a lot of vacancies and you don’t have them filling these buildings, my opinion is that there’s an impairment in the valuation of those buildings. That’s my real concern on a fundamental level of the underlying assets of this company is that I think they’re overstated. 

When I look at the valuations on this, it really doesn’t excite me all that much. I see that there has been a little bounce from the March low. There might be something that I’m missing. As Toby said, the complexity of the corporate governance and what’s actually sitting on the balance sheet is the part that’s hard for me to understand. When I’m looking at what I’m doing a quick glance and I obviously haven’t spent a ton of time researching this. However, just from a very high-level standpoint, those are my concerns.

Stig Brodersen  52:30  

Generally, Hari, whenever everyone is running away screaming for something, I’m always curious. That’s something that just comes with the territory whenever you have a value investor. What I’ve also come to realize, especially over the last few years is that there’s often a reason why people are running away screaming. 

The counterargument to that, we had Ian Formigle on here last week from cross-reading, he talks about how space is a new luxury. That comes both with the malls that they have a 122 now and they have 134 office properties. 

I see that argument and everyone should definitely listen to a lot more of what he’s saying than what I’m saying. What goes into this is that: Yes, space might be a new luxury but you also have to account for not just the impairment. Preston was talking about the redeveloping costs because so many of those buildings can’t be used the same way. Even if spaces are a new luxury, it would have to burn a lot of cash before you see cash coming back again. 

Preston Pysh  53:30  

All right guys. I think that concludes all of our remarks. I want to give Toby and Hari a chance to tell people where they can learn more about you guys and check out some of your stuff.

Tobias Carlisle  53:41  

My fund is called “The Acquirers Fund (ticker: ZIG)” and I’ve also started managing another called the Deep Value Fund (ticker: DEEP), that’s going to be a small and micro-cap, deep-value fund. Deep value’s very out of favor at the moment. If you’re a mean reversion, contrarian-type investor, then take a look at Deep Value. It’s big enough at the moment. I also have a website, AcquirersMultiple.com and I’m on Twitter at @Greenbackd.

Preston Pysh  54:09  

Hari? 

Hari Ramachandra  54:10  

Thanks, Preston, Toby, and Stig for your feedback. Yes, I knew that this was something that I was on the fence [about]. That’s the reason I brought it up here to put it on the dissection table. You’re right, there is a reason why everybody is running away from this. My reason for looking into it is as Stig said, at any time when everybody’s running away, it’s time to just give a closer look at the positives I see as most of the bad news is out. At the same time, we don’t know how long this will last. 

Preston, you brought up net asset values might go down and Stig to you’re talking about how much capital they’ll have to put to redevelop those properties in case things change. There is a risk so I wouldn’t bet my farm on this but thank you. This was a good conversation and feedback.

Preston Pysh  55:00  

All right, Hari. Tell folks where they can learn more about you.

Hari Ramachandra  55:03  

As usual, people can find me on BitsBusiness.com, my blog and my twitter handle @harirama. Happy to engage in constructive conversations. 

Stig Brodersen  55:14  

All right guys, as we are letting Toby and Hardy go. We’re now transitioning into playing a question from the audience. This question comes from streaming. Here we go.  

Tremick  55:23  

Hi, Preston. Hi, Stig. My name is Tremick. I’m calling you from the United Kingdom. First of all, big thank you for your podcast. I’ve been with it since the beginning. I love to see your journey as investors. It’s fantastic. 

I’ve got a question about stock dilution. When I invest and I do fundamental analysis, one thing I don’t understand is why sometimes companies like Tesla issue more shares. Essentially they dilute my shareholding. The shares actually go up the next day and they continue to go up. 

How to factor this into the fundamental analysis: the risk that the company will be diluting your equity by issuing more shares to investors. Is that something that’s captured in some of the fundamental models of investing? Thank you so much for your podcast. Appreciate it. Bye.

Stig Brodersen  56:11  

It’s a great observation you make. Now, Tesla, in itself is a tricky example. We often talked about here on the show how Tesla sort of goes against everything we learned about value investing. For instance, Tesla took over the position from Toyota here recently as the world’s most valuable carmaker. That was not by having any earnings since it was founded in any fiscal year but it’s been through issuing stocks and taking on billions of dollars in debt. 

I’m not sure if that is the case study to understand what is fundamentally happening, when its companies issue stocks. What does happen whenever a company issues stock is that the individual stock price doesn’t have to go down in price by default. What it means is that the company raises capital and they will also have more owners to share the ownership of that company. 

But again, it’s from a higher base. The effect can both be positive and negative on the individual share. You can, of course, bring up the argument that it’s better if the company can generate cash flow. It doesn’t have to finance it through an issue of more equity but keep in mind that companies are at very different stages: you might have a growing company who needs it to turn profitable very soon or you might have a situation like with airlines who are a mature industry and used to be very profitable but now due to COVID-19 is not.

We all knew that they needed capital. Then the terms that you got weren’t that bad and the market reacted positively to that. You have to divide it up and say that in the first place, no, it was not great, that new capital. However, at the time that they made the announcement, the stock was already punished hard, everyone expected it. Everything else equal, it was actually not as bad as it could be [as a] scenario, which the market liked.  

It’s also important to understand that if we use the case study of airlines: the fundamental value of airline stocks is lower than in 2019. Not because of the dilution of the shares but because of the missing revenue and the bleak outlook. You can even make the argument that if airlines didn’t issue shares, they couldn’t get loans and they would go bankrupt. Dilution of stock, as mentioned, is not really a good or a bad thing per se, but it really depends on the specific circumstances for that deal. 

It could even be though this happens more often privately than publicly. That you have companies seeking capital. Not just for the sake of capital but as an add on also to get new investors in with know-how. *Inaudible* in valuation models.

Most valuation models use a per-share basis. It’s a great point to ask what happens if you now have more shares. As I mentioned before, the answer’s a little more complex because it does depend on which value the company would have after the issue of more shares, whatever happens with them when that equity has been utilized. That’s why if the market deems that in a positive light, you can see that you actually have the individual share price, even after the announcement will go up the price.

Preston Pysh  59:35  

Tremick, I’ll be honest with you, I don’t have too much to add beyond what Stig said because he really kind of covered all the bases. For people that might be looking at this with a fresh set of eyes and have no experience with it. I would just tell you at a very general and basic level when a company is going through this, they’re taking newly issued equity and they’re just turning it into a currency. They’re turning it into cash. In order to subsidize their inability to earn free cash flows, that’s really kind of the essence of what it’s at. 

Preston Pysh  1:00:07  

Whether they can raise capital through the issuance of debt or they’re going to do it through the issuance of more stock, that’s pretty much what they’re getting at. When you’re thinking about the valuation on that playing out or you’re concerned about a company doing that, in the future, the main thing you got to really look at is: do they have free cash flows? If they don’t, then they’re going to have to probably go down one of those two paths in the future. That’s probably a good indicator as to whether it is or isn’t going to happen. 

With respect to Tesla, specifically, there is no way Stig or I can provide you any type of advice as to why you might have seen some of the things you’re seeing on Tesla. This is a case study of case studies as to how this stock keeps moving and all the intangible things that the market seems to value on this one that I have continued to be surprised with. I can’t really add much value to critical thinking and some ideas on that one. I’ll leave it at that. 

But Tremick, outstanding question. I really enjoy questions like this and for asking such a great question, we’re going to give you a free subscription to TIP finance where it will help you do intrinsic value calculations. It will assist you in many different areas for momentum investing and helping you filter and find good value picks. We’re really excited to be able to give you that subscription for free. 

For anybody else out there if you want to get your question played on the show go to asktheinvestors.com. If your question gets played on the show you get a free subscription to TIP Finance.

Stig Brodersen  1:01:38  

All right, guys, Preston and I really hope you enjoyed this episode of The Investor’s Podcast. We will see each other again next week.

Outro 1:01:46  

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