John Huber (03:00):

So for me, I think the world, and I’ve talked about this, I think Toby and I talked about this on a podcast one time, but I’ve been thinking about this concept for a few years. I think the world is changing to a degree where the rate of change is much faster than it used to be in previous decades. And so companies, what that means is companies are changing much faster. And so I don’t think you have companies that will be able to exist on these static competitive advantages that they enjoyed for decades. Companies like Procter & Gamble had shelf space advantage that they lived off of for years and years and years. And the nature of business now is that barriers to entry are so much lower, and so you have upstart companies in all different industries that are able to take on incumbents that would have been unthinkable 20 years ago.

John Huber (03:52):

So I think you have a situation where the rate of change is faster, incumbent advantages are no longer, there are some exceptions but, incumbent advantages I don’t think are as strong as they used to be. And so you have to just come to grips with the reality that change is a constant. And so I think the best way to defend against that is to invest in companies that have the ability to change and that means thinking about management teams that are adaptable, companies that can quickly shift and I think those are the investments, those are the companies that will be best positioned to fight against the unknown which is the future. So that’s my thought on that.

Stig Brodersen (04:36):

That’s very interesting John, thank you for sharing that. And the issue I had for one of those quotes, those two kinds of people who lose money, those who know nothing and those who know everything. Whenever I think about guys who know everything, I think of you guys. I could say, talk to me about a really, really smart guy and I would say talk to Wes. If anyone, he would know his stuff. And not trying to pin you into a corner here Wes, so how do you not know everything? I guess that will be my question going into this.

Wes Gray (05:05):

Well I think the more you know the more you realize you don’t know anything else. And so I boil this question down to, what do I actually think I know. And I’ll assume I don’t know anything else. That’s a much easier question to ask than how do you know what you don’t know? I’m just going to invert it and say what do I think I know? And for me I wrote down three notes here. The first one is that incentives matter. And to John’s point, market is competitive so I do think no pain no gain is a pretty good mantra to live by in investing. And if you can’t identify where there’s pain to get your gains, you’re probably wrong or you probably don’t know something that you don’t know. So that’s a good rule of thumb.

Wes Gray (05:48):

And then the other one is, I got another note here it says “humans matter”. So sentiment matters, fear and greed do affect prices, and so that’s just to say that market probably isn’t perfectly efficient and there are maniacs out there. I know that, the problem is I don’t know how to time these maniacs. So you got to be ready for being patient.

Wes Gray (06:10):

And then the third one, which is living too close to Vanguard, is that fees and taxes matter a lot because I can identify perfectly how much those are going to cost me. And so [inaudible 00:06:22] and I can minimize those. That’s really important, especially on the tax side where I think a lot of people forget that 50% Uncle Sam carried interest is the biggest fee you’ll ever pay. So those are things I know. Incentives matter, humans matter and we should avoid fees and taxes. I don’t know anything else beyond that.

Stig Brodersen (06:41):

I think that was a good way of responding to that question Wes. So actually, let me followup on the third part you said there about fees. We are in a new environment right now, I don’t know if I could say new normal, it’s going to be such a cliché if I said that. It’s just crazy what we’re seeing right now, and we all are paying taxes on nominal gains, we all like to look at nominal numbers, not real numbers. So knowing that, how do you think about fees and taxes now? What has changed given the low interest rate environment that we are in?

Wes Gray (07:14):

The problem with being an asset manager in a world where the expected returns on everything are really low, is it’s one thing to charge 1% when you have a fixed income or just brain dead money paying you 5, 6%. Now that you literally have incentive to put your money in a pillow, because if you have a bond, a 10 year bond that pays 1%, well half of that goes to taxes, you’re down to 50 bps. Then you pay 50 bps in fee you’ve got zero with a lot of brain damage.

Wes Gray (07:42):

Why did I even hire this person to do anything with my money? So that obviously extends a little bit into people that do more risk like Toby, myself and John. But even for us that matters because maybe we had a high expected return of 15, 20%, now that all got chopped in half. Our fees, our infrastructure costs as a percentage of your potential gains are still relevant, but I feel really bad, and it’s going to be very interesting to see how advisors, fixed income managers and a lot of other people deal with this reality of why am I paying anyone in financial services anything right now? Because they’re not going to deliver anything after all their costs and the lack of transparency, liquidity constraints, et cetera. It’s going to be a tough business going forward I would say.

Stig Brodersen (08:32):

Toby, you’re looking at me right now like oh my God, I feel the same pain as Wes. It’s a tough world to be in and say I do more than the market. Or, what do you know? I know it sounds a bit provocative, but we’re friends so I guess I can throw it over to you like that.

Tobias Carlisle (08:50):

First let me confront the market. None of it makes any sense, and then you find some guys who succeeded and the way that I did it is I found Buffett and I found Graham, and so they’re value guys. So what their idea is, there’s a quantity that you can calculate that’s different from the market price, and if you put together, you look at the yield, you look at the rate of reinvestment in a stock that gives you a value for that stock and you can reverse that process, get some expectations about it.

Tobias Carlisle (09:18):

So rather than working on what I think it’s worth, just look at what the market thinks it’s worth. And then I can ask, is that reasonable? And where there are instances where I think the market is so far wrong that it’s worth betting on the market being wrong, and I could take Wes’ advice and say are they wrong because there’s a lot of pain here? Are they wrong because the market just doesn’t understand us there? There are many events where, option pricing for example, there are many events where there’s some binary event going to occur and the option is priced as if it’s Black Scholes, which is assuming that all possible outcomes close to the central tendency and more likely further away or less likely.

Tobias Carlisle (09:58):

I think that there are very small pockets of miscalculation in the market, and I do think that if you know a little bit you can get comfortable. Well then the risk that you run into in every single one of those is that you missed something, that the market knows more than you do. And so the way around that is just to diversify across enough positions so that if you’re wrong and then you’re given one … and you would hope that over time you would generate a little bit more return potentially than the market, or at least your process it a little bit more sensible than the markets which is just sizing into flood adjusted market cap, which really that doesn’t make a great deal of sense to me. As competitive as it is as an index to beat it really doesn’t make a great deal of sense to allocate money.

Tobias Carlisle (10:36):

So that’s how I do it. I just think about if I was a business guy sticking money into the market, and I only regarded the stock market incidentally stock market investing that gave me those opportunities, how would I approach the problem? I’d approach it like a business guy. I wouldn’t really care what the index does. I’d try and come up with a valuation. I know that I’m probably going to be missing some stuff and wrong on some stuff so I’ll just size down my positions and try and hold a basket open. I still think that over the very long term that’s a pretty good approach.

Stig Brodersen (11:03):

So let’s talk about having the right sizing in our portfolio. So right now I’m going through this amazing CNBC resource with Warren Buffett and Charlie Munger, and it’s all of the old Berkshire Hathaway annual shareholders meeting back to 1994. And in the 2008 morning session, these gentleman asked Buffett and Munger how aggressive can you build your precisions in your portfolio given that you have a maximum conviction? And Buffett talked about how he, multiple times, had 70-75% of his net worth in one investment. Now gents, what are your thoughts on that? Can we do that and should we do that knowing that we’re not Warren Buffett?

Tobias Carlisle (11:39):

Is that a correct statement for Warren Buffett? That probably is a correct statement for Warren Buffett. Is that a correct statement for me? No. And the world, is that correct for me? I would never set something up like that. There’s a point where I don’t have enough interest to keep on digging in and I think that Buffett, clearly when you listen to Buffett talk, he’s on a different level. There’s no point in my timeline of development as an investor where I get to where Buffett has been at any stage. So I’m never going to size like Buffett does, I’m just going to keep them smaller.

Tobias Carlisle (12:06):

I think that really the hardest thing about investing is just working out who you are, and as soon as you figure out who you are and you stop trying to do it like everybody else does it and just do it in a way that the only thing you have to do really to succeed is to stick with your conviction when something goes against you. And if you can do that you’re going to be okay. If you can’t do that, then you’re doing the wrong thing. It’s too big, you’ve got the wrong method. Where’s this has got some momentum, it doesn’t quantitatively but it’s got some … momentum just doesn’t appeal to me as an investment style. So I just can’t do it. If it goes against me I just wouldn’t be able to hold the position, and that’s exactly when you need to be holding it.

Tobias Carlisle (12:39):

True value, when it goes against you, you need to hold it. If you’re confident in the underlying and you can hold it, you’re going to do okay because that’s when you get the better performance. So I wouldn’t size like that, but I think it’s appropriate for Buffett to do it. I would still say 70% pretty big for Buffett. If you’re Buffett, but then again you’ll probably say I’ve got 99% of my money in Berkshire and that’s one stock.

John Huber (13:00):

When you think about slugging percentage, to use a baseball term, I think regardless of the type of investment approach you use, you can have a very … George Soros has this quote where he says something to the effect of, or maybe it was Druckenmiller, which is obviously a completely different investment approach than I think any of us use, but said something like, “Soros is right 30% of the time, but he just wins so much more on those 30% hits, the size of his wins are so much larger than the size of his losses, so he can compensate for that.”

John Huber (13:35):

And that’s really the same with Buffett. Buffett had a much higher batting average, but if you look at Buffett’s performance over the last 50 years you’ll see that a large percentage of his gains, even after the partnership years in the Berkshire, some of the biggest gains in Berkshire’s book value have come from a relative with few successful big investments. Like GEICO is one, Washington Post is one, Coca Cola is one. So some of them were public securities, some of them are wholly owned businesses, but that slugging percentage. I think Buffett is the same, Soros, the VC’s in Silicon Valley, that is I think a common denominator to a lot of successful approaches.

John Huber (14:21):

And then in terms of sizing, I was thinking about what Wes said in taxes and the frictional costs that go along with investment management. And you have to think of it like a barbell. You have to have one of two extremes, you either have to be extremely diversified and do what I think Wes and Toby do more of, which is a quantitative approach and you’re looking for, almost like an insurance style bet where you have, you’re taking advantage of the law of large numbers. You have a large sample space and value investing works over time. And so if you have a large enough sample space you can gain a small edge and you can replicate that over and over knowing that on average, low price to earnings, low price to book maybe; although, maybe that isn’t as relevant anymore, but a basket of value stocks will outperform over time.

John Huber (15:09):

And then at the other extreme it’s more of the concentrated approach, which is just the approach that I feel more comfortable with because I’m picking stocks. I think you have to be very selective and very patient, and then you just have to wait for something that makes sense to you. And to Toby’s point, I discovered this long ago, you can’t invest like Buffett, you can’t invest like Peter Lynch, you have to figure out your own style, your own circle of confidence and then you just have to wait for things that you understand. And once in a while, for me it’s very rarely, but once in a while I understand something and then I can take a swing at it.

John Huber (15:45):

And so I think you can improve your hit rate by being overly patient and just waiting for something that shows up that makes sense to you. But I think it has to be one of those extremes. You either have to be very concentrated and very selective, or you have to run some sort of a diversified approach that has a proven edge over a large sample space. Anything in the middle is just not going to work, especially when you layer on fees.

Stig Brodersen (16:14):

Well said John. So guys, let’s move to the second topic here of today and talk about cyclicality. We did have the pleasure of speaking with Howard Marks about his book Mastering the Market Cycle here on the show, and he emphasized the two rules of cyclicality. Rule number one, most things will prove to be cyclical, and rule number two, some of the greatest opportunities for gains and losses come when other people forget about rule number one. So starting with you Wes, how have you made or lost money in the market because of neglecting them? Or perhaps from having a deep understanding of cyclicality?

Wes Gray (16:48):

I first questioned the premise a little bit in a sense that you’re going to have a lot of survivor bias in claiming they’re cycles because that implies something came back. But what about all the other things that literally went to zero and blew up and you don’t read about anymore? So cycles clearly didn’t work there. But if you’re a survivor, a cycle is always going to be amazing because just keep buying US equity market. You’re a genius, you earned the 7, 8% equity return premium. But go ask all the other countries where on average you earn like 2% and you get your face ripped off most of the time.

Wes Gray (17:22):

So I would say I just question the premise of that in the first place, and then obviously all my wins go exactly in line with what he’s talking about in the value realm where you buy something that’s totally out of favor, total piece of junk and it makes money. But who cares about that? I would say the cycles that I screwed up the most are actually the opposite of that, momentum cycles where I can think of three examples in recent memory. One is in real estate. So my brother lives in Eagle, Colorado where I grew up, it’s in the mountains, in probably 2012 we had all these opportunities to buy different real estate properties out there. But of course, being value cheap bastard we’re like, no, it’s too high. Don’t want to get in. Of course we didn’t realize that’s a momentum trade and it’s only quadrupled with leverage and we’d be millionaires right now.

Wes Gray (18:16):

And of course most recently here, March 2020, me being a genius I’m like, this is the greatest time ever to buy value. I’m going to do that. And that kind of worked, but guess what? Should have bought momentum because it would have worked 10 times better. So for me all the cycles that I look back that I missed, everyone always, value guys always talk about cycles and point to value wins, but they’re not highlighting that the big wins, or the momentum cycles that we all miss. I think that’s an important thing for value people to think about is momentum cycles, not meaner version cycles.

Wes Gray (18:53):

What do you guys think?

John Huber (18:55):

Yeah, I think that’s a great point Wes. When you think about that real estate example you used in Colorado, that local market might have been at some inflection point where the true value was dramatically understated for whatever reason, and whether it’s people moving to the area or home prices are appreciating or whatever it was, but I think about Google as an example in the stock market, you could look back and I think Google did $20 billion in revenue in 2008 when the last real lengthy recession occurred before this past one. But the advertising market that year contracted 10%, Google’s revenue slowed. It was growing at 50% before the recession, it still grew through that period. I think their revenue grew 8 or 10% in 2009, which was a significant advertising downturn.

John Huber (19:50):

And it was just the fact that Google was such a small piece of the advertising pie at that point. They had $21 billion in revenue or something, and the advertising was $400 billion. So they had a 5% share of a big market, and they had a value proposition that was very clear cut and it was clear that they were going to be much, much bigger. And so those are businesses that are able to withstand the cyclical nature of the economy. And I think all businesses are cyclical to a certain extent, some more than others.

John Huber (20:23):

But the other way to think about cyclical businesses, or risk that you’re talking about, the risk of investing in something that’s cyclical is to think about the business itself within that industry. So I’ll use home building as an example. Most home build, all home builders are cyclical because the nature of real estate is cyclical. And so that implies some sort of risk to a typical home builder because most home builders have an enormous amount of inventory on their books, and what happens in a downturn is home sales slow, land prices often decline. And so home builders are left with a huge amount of inventory on their balance sheets that have to be marked down. And a lot of that inventory is financed with that, and so the balance sheets are often very risky.

John Huber (21:15):

But within that industry there’s company called NVR, and I’ve spoken about this company before, and it’s a stock that my fund owns. But it’s a very cyclical business, just like all the other home builders, but with one key difference and that’s that the balance sheet is much lighter. They carry far less inventory than most of the other home builders, and so what that means is their inventory turnover is much faster. They have about $1.5 billion in inventory and they turn that inventory about every two and a half months.

John Huber (21:46):

Lennar is the biggest builder in the country. They did about $22 billion in revenue last year. They have $18 billion in inventory, and they turn that inventory about once every year. So NVR’s turning its inventory five times faster. Lennar did about $3 billion in profits on $18 billion in inventory and NVR did $1 billion in profits on $1.5 billion in inventory. So basically what that’s telling you is NVR’s return on capital is about five times higher. And so it’s just a better business is another way of saying it.

John Huber (22:20):

But it’s got a variable cost structure and it’s much less risky when the downturn comes. They tie up their land using options, which is how they’re able to do it. They don’t put as much capital in the ground, they put a down payment on the land and if trouble comes then they’re able to walk away and just lose the option premium, just like a call option on a stock.

Wes Gray (22:42):

John just to push back, because I was talking about more sentiment cycles. Arguably these guys are positioned extremely poorly for a sentiment cycle they may be missing. Because wouldn’t you want to own the super operating leverage, maxed out, whoop it on home builder, versus the nimble, low inventory super fit one? Because if you can borrow for negative rates and there’s a sentiment cycle, I would argue you actually are taking a huge cycle risk bidding against the sentiment cycle by not buying the other one you mentioned. That’s the problem.

John Huber (23:21):

Yeah, exactly. And so the problem for most builders is they can’t get away from exactly the situation you’re talking about. So it’s two things, one is the inflation in land prices that happens over time. So in theory, you’re much better off owning land if land prices are appreciating at 2% a year because the nature of your slow turnover, the one benefit of slow turnover is that land, as it’s on your books, is going to be worth more when it leaves your books than the price that you paid for it a year ago. So that is true.

John Huber (23:53):

The problem is, and again this is why builders can’t seem to replicate NVR’s model, the problem is, one of it is incentives. All the builders, if you read the proxy statements, almost all the management teams are incentivized to produce absolute profits. And so the best way to produce absolute profits, not necessarily return on capital, just make more money, the easiest way to do that, just like Buffett says, the easiest way to make a savings account earn more money is just add more money to the savings account.

John Huber (24:20):

So builders are incentivized to just go out and buy more land, regardless of the returns that they can generate on that land because they’ll know that if they can, even if they earn 15% gross margins instead of 20, they’re going to be compensated for that at the end of the year because they can use other people’s money, the banks money, to go out and buy more land.

John Huber (24:38):

So it’s the inflation aspect of it and the incentive structure makes it very difficult for any other builder to copy NVR, but you’re exactly right that NVR is on the losing end of it in an inflationary environment, or in a big boom. And we’re sort of experiencing that right now in housing, which housing’s in a boom right now. Part of it’s COVID fueled, and part of it … the housing market’s been in a bull market for a number of years now, but yes, NVR earns smaller profits relative to what it could if it put the land on its balance sheet.

John Huber (25:10):

But, the benefit is when the next downturn comes, and it’s inevitable in housing, NVR is just going to be much safer. They’re much better positioned to survive any sort of downturn. And most of these builders are going to be fine, they’re going to survive fine. A lot of the builders have tried to, slowly tried to work towards a more asset like model, but again, none of them have been able to replicate what NVR has in terms of returns on capital, but they’re all trying to go that direction to de-risk their balance sheets.

Tobias Carlisle (25:41):

It’s just a slight philosophical difference. There’s one approach where, to investing, where you say I’m going to try and maximize the amount of return I can take per unit of risk that I take, which I think there’s only two sensible ways of doing this. I’m going to maximize the amount of return I can take per the amount of risk that I can take or, I’m going to try to not take any risk at all. And I know that there’s no way in the world you’re investing in the markets at all and not taking any risk.

Tobias Carlisle (26:07):

Look for situations where there is some returns still available there, and I’m going to try and only hit on those things. I think John’s more in that, he’d just rather not take any of the known risks that, if there’s a way that you can lose money it’s just not going to do it.

John Huber (26:21):

You have to be careful because, like we said at the top of this call, knowing what you don’t know there’s all kinds of uncertainty out there. But I do believe that when you think about surprises, it just seems, this is just an empirical observation, I don’t have data on this, but good surprises tend to happen more often to good companies, and bad surprises just tend to happen more often to bad companies.

John Huber (26:43):

And so I’m not in the game of trying to predict these cycles. I understand that business is cyclical. And so for me, I think Charlie Munger has his quote, “Sometimes the tides with you, sometimes it’s against you and we just focused on trying to keep swimming forward.” And that’s my view on it is sometimes the winds going to be at my back and sometimes it’s going to be a headwind, but I’m going to try to focus on investing in companies for the long run that I think have staying power and that are good businesses that I have a feeling that earning power is going to be higher in five years than it is now for example. I want to invest in those types of companies versus the real cyclical companies that have a huge amount of risk and much more volatility to their business. So I tend to avoid those types of companies.

John Huber (27:30):

It’s not that you’re taking risk because all companies have certain amounts of risk and things can change, which goes to my point earlier on you want to invest in companies that are adaptable to change. Stig and I talked about Facebook once, that’s a company that I think has proven its ability to adapt to changing environments. That’s a business that’s very difficult to predict 10 years out. It’s hard to know what that world is going to look like in 10 years, but the management team to this point, and this is not guaranteed, there’s no guarantee that this will be the case forever, but to this point I think they’ve done a good job at shifting and recognizing business risks that they faced as opposed to just putting their head in the sand and ignoring it. I think they’ve been very genuine about their desire to fix issues. I think they’ve had a lot of foresight in risks that their business has faced, and maybe is facing right now and they’ve adapted to those changes.

John Huber (28:26):

So that’s the other thing to think about is you want to, again, for my style of stock picking I want to invest in companies that I think can adapt to those changes and can have some sort of staying power through these cycles that will inevitably occur from time to time.

Stig Brodersen (28:40):

So I think that’s a great segue into the third topic here of today, which is all about risk. So, in typical whenever value investors talk about risk, they often refer to Warren Buffett’s comments on risk being a permanent loss of capital. That’s one, and the second one would be opportunity costs of not being invested in the best investment at the time.

Stig Brodersen (28:59):

And Howard Marks makes the obvious but yet profound observation that viewing risk as higher risk implies high return is just wrong by default. If a return is certain it’s by definition not risky. So kicking it back over to you Toby, how do you define risk and how is that reflected in your own portfolio and investment strategy?

Tobias Carlisle (29:20):

I subscribe to the Buffett definition of risk that you’ve got, the risk is that you lose such a material amount of money that you can’t recover from it. That’s the risk of ruin and not so much the volatility on the path to getting there. I didn’t answer the last question, but I would have just said the big cycle that has hurt me in particular was partly too by virtue of the fact that he’s got some value funds out there.

Tobias Carlisle (29:43):

This has been an extraordinarily long, bad run for value, and as Mikhail Samonov who runs Two Centuries, he’s got that research stitches together, free data sets including the Cowles Commission and the French data. We have thought we could sell that crazy thing where they’ve gone and looked at annual reports from 1825 onwards, looking at dividend yields plus Cowles Commission, which was priced to book French data which is priced to book in other things.

Tobias Carlisle (30:08):

It’s the longest, worst down cycle for value in 200 years. So that’s been difficult to invest through, particularly because it would have been so much easier just to go and pick a sexy tech company and let it run. And I can see which ones are, there are very good businesses there, I just think they’re very expensive in many instances. And if I didn’t care about risk and I was only trying to capture the return, I’d just go and light up on those things and it would make me feel good for several years until it gets to the end of the cycle and then it would feel terrible. And it would be like a betrayal of my own code, so I couldn’t possibly do it. But it would take away the pain in the interim.

Tobias Carlisle (30:48):

So the risk, that’s the way I define risk. I just don’t want to get … there’s two things. One of them is I don’t want to invest in something that I think is massively overvalued because I think that at some point it’s going to meet its value, and I also want to follow the rules that I’ve established because I know that those rules will keep me safe. So part of it is this intellectual, psychological part. If I keep on following the rules, then I haven’t betrayed the code and at some point when it comes back then, assuming that it does. If it doesn’t then I won’t be on the next one of these, next year it’ll be somebody else.

Stig Brodersen (31:17):

I think you bring up a good point Toby. You have to be true to yourself, and you probably couldn’t sleep at night if you loaded up on those tech companies. Then there are other investors that probably can’t sleep at night if they don’t have tech companies in their portfolio.

Tobias Carlisle (31:36):

Yeah, that’s fair.

Stig Brodersen (31:37):

Right.

Tobias Carlisle (31:38):

I’m not talking about Facebook in there by the way. I don’t want that to sound like I just came straight on John’s heels [crosstalk 00:31:43]. Because I think that those big old fangy, the fang, or whatever the current things like, funnily enough I think they’re reasonably, they’re not egregious those companies. I can see how people are buying them, it’s the other stuff in the middle that’s not yet proven that has the big hockey stick in the revenue line, and then the hockey stick magnified in the price line, the other ones that I’m talking about here.

Tobias Carlisle (32:06):

If you’re a MOMO go you might be riding those, and you might not know where to get off. So, can’t be too critical.

Stig Brodersen (32:11):

Yeah, that’s a really good point Toby. And when talking about risk, I would say personally, with the amount of money printing that we see right now, I find it very risky to hold cash. Partly due to opportunity costs due to asset classes competing with each other, but also partly due to inflation concerns. But let me throw it over to you Wes. How do you define risk and how is that reflected in your portfolio?

Wes Gray (32:35):

I think Toby did a good job saying that basically the main risk to any portfolio is really behavioral in some sense, because obviously there’s always fundamental risk where if you buy something that has a high chance of cash flow destruction, well that’s more well understood I think. But it’s this behavioral stuff that kills people. So it’s like either FOMO like you were saying, got to have cash and I should have bought Tesla. And then you may go take an action that ends up putting you in the wrong place. Then there’s chasing returns.

Wes Gray (33:06):

And so the solution to that risk is to form a religion, but the problem with the religion is now you get a lot of conviction. So I am now of the stance that we should believe in multiple religions and be religious about that, because that seems to be the only reasonable solution to solve a behavioral problem. That’s my latest stance and theory on the situation.

Stig Brodersen (33:32):

Well said Wes. I remember once thinking it’s definitely my religion that I should always have bonds, and to be fair, you would have made a killing in long term bonds. For this cycle that’s not what I’m saying, but I don’t know how many good arguments I can find for buying a 30 year bond given the negative interest rate or whatnot, or close to it at least here in Europe.

Stig Brodersen (33:51):

John, let me throw it over to you. How do you see risk?

John Huber (33:55):

I think, first of all I agree with Wes’ point. I don’t think you can be dogmatic about anything in investing, and so my view on risk is really simple. It’s just the risk of losing money is how I think about it. And I don’t think about volatility, I don’t worry about volatility. I define risk as the chance that I make a wrong decision or that you can think about risk in a portfolio or you can think about business risk, and we talked about some specific companies that I was talking about before, I think I look at risk when I’m thinking about investments by trying to analyze the risks of change, or the risk that the business I’m looking at might suffer some catastrophic change to their future free cash flow, and therefore the intrinsic value of that asset would be significantly changed.

John Huber (34:49):

So yeah, that’s how I think about risk. I think most investors would benefit from worrying less about sentiment shifts, less about volatility, less about what’s working right now or what’s not working right now and just think about individual companies and think about the risk to those businesses and just think more of just like Buffett says, I think thinking like a businessman, thinking like a part owner of whatever company that you’re going to buy stock in is the best way to think about investing.

John Huber (35:20):

And then that will lead you to think critically about the business itself. Not just the price you’re going to pay but the risk, like I said the risk to the business, what might cause a change in that business, what other companies could attack this businesses competitive advantage if it has one. Things like that.

Wes Gray (35:39):

I’ll just add one thing just because I understand what John’s saying explicitly. Is there is a risk that the market doesn’t agree with you at some level. Unfortunately as a value investor, there’s an assumption that gravity matters and that fundamentals wag the market tail. But it could be the case that actually that it doesn’t, and what drives fundamentals is actually prices. Go talk to some great, fundamental, amazing business with huge return on capital, but the guys been running, or gal, for 30 years and his cost capital is going to probably be 10 times more than Tesla.

Wes Gray (36:15):

So you tell me what matters. The momentum, or the fundamentals? And it gets confusing when you start really thinking about it too much, which is what I unfortunately have been doing. So, like I said, I like value as a great religion, but I also like momentum as a great religion too, and I just believe in both of them now.

Tobias Carlisle (36:34):

I’ve spent a little bit of time, because value’s worked so badly for so long, I’ve spent a lot of time thinking about what are the drivers of value. And I think the more I’ve spent time thinking about it the more I think that Buffett is right, that when you buy something you lock in a return and you get the yield and you get the underlying growth. And it really then doesn’t matter how the market treats it in the interim. That’s not entirely true if you’re managing money, you’ve got other considerations, then you’ve got this asset liability issue where you do have to perform; otherwise, you lose your assets. So it’s not necessarily applicable to professional investors, it’s just more for individual investors.

Tobias Carlisle (37:10):

You really have locked in the return that you get in the market. Now one of the risks to that is that you have a competitor who’s not economically rational, or who the market treats in a not economically rational way. And so this specific Tesla point, Musk’s cost of capital is virtually zero, and he’s competing with guys who have expensive costs of capital. And so that makes that a different dynamic, but I think that’s an unusual dynamic too. Most of the time what it is, is the business is … the kind of businesses that you want to find are the ones that are competitively advantaged that are going to chug along regardless of what everybody else does. And then if you buy those and you get the purchase price right, it doesn’t matter if they spend the next five years trading at a discounted value, if anything, that’s the best thing that can possibly happen to you.

Tobias Carlisle (37:54):

If you’re right and you’re confident that you got the valuation right, you just keep on buying. And then I know guys who, I know this son of a guy, his son is a little bit older than me so that the father who did this buying, he worked in not a particularly well paying job but he worked at this brewery in Australia. It was just perpetually cheap and it was a safe investment that was going to be around forever and he just put all of his money in this brewery and they’re an incredibly wealthy family by virtue of the fact that they bought one stock and kept on buying it and it was mostly pretty cheap for most of its life.

Tobias Carlisle (38:25):

So it can work and it’s not necessarily, at no point do you really get the great stock price performance. If anything you benefited from the lower prices, from the discount.

John Huber (38:34):

Yeah, because in the end if you believe stock prices correspond to intrinsic value over the long run, which I believe, and sometimes that can take quite some time. Longer than we might like, but over the long run I do think those two things converge. So the price will meet the intrinsic value, either intrinsic value will come down to the price or the price will come up to the intrinsic value.

John Huber (39:00):

If you’re truly trying to estimate Tesla’s intrinsic value, you would spend a lot of time thinking about how likely it is that Elon Musk’s salesmanship is going to continue to allow him to keep that cost of capital long enough to where Tesla can actually start producing free cash flow. And so I think the bearish arguments on Tesla for so long have been that’s not going to happen. The business is not profitable, it’s going to run out of cash, they won’t be able to access the capital markets in a downturn. And that probably would have been true if that would have happened. If they wouldn’t have been able to access cash at certain periods of time, they might not have made it. But they were able to make it.

John Huber (39:45):

So I think in that case it’s such a unique situation, it’s Thomas Edison in 1880 I think got JP Morgan to finance his operation and JP Morgan had his house wired, his own primary residence, and the thing burned to the ground. Or it didn’t burn to the ground, but it started on fire, and he didn’t even lose faith after the electrician came. I guess the electrician was so scared, JP Morgan, he was such an intimidating figure, he stayed up all night the night before, he was going to go back and meet with him and he thought he was going to get fired, lose his job and who knows what else. And Morgan told him, “Do it again, rewire it.” And so he rewired it, and Edison kept his access to Morgan’s capital and the rest is history.

John Huber (40:27):

So it’s a different type of investing again, but it’s sometimes you have to factor in those types of reflex, I guess I’ll call them reflexive components to the intrinsic value because those can in fact influence the future free cash flow generation. But for me, in the end, the value of any asset is the amount of future cash that it will produce, and that end can be a long time into the future. But at some point the market will come around to the price.

Stig Brodersen (40:54):

All right guys, I think it’s time to go to the fourth and last point here of today’s discussion. And the topic is advice to your younger self, and the three of you are all accomplished investors. You paid your dues making, I want to say plenty of mistakes, I don’t know if I’m getting ahead of myself whenever I say that, but most investors with a long record also make mistakes, and you also calibrated your strategy accordingly.

Stig Brodersen (41:18):

So knowing that, which type of advice would you give to your younger self when forming your investment strategy? And I was just about to say something goofy about not buying value stocks, and because I said that going into it I think that Toby should have the first go.

Tobias Carlisle (41:34):

Yeah, I think that’s a fair … I haven’t had any of the success yet, so I don’t really feel like I can go back and say, give the younger self some advice. The advice that I would give to my younger self is figure out how to value growth properly and then I think you’ll do a little bit better rather than being so wedded to value. I think that the mistake that I have made has been trying to not pay for growth, trying to get growth for free. But I think that there are instances where being better able to value growth would have worked better returns and probably it does work out for the best over the very long run.

Tobias Carlisle (42:04):

So I think that that would be the advice that I would give to my younger self, and actually I’m going to try to take that advice as my younger self now because hopefully I’ve still got another several, four or five decades left on the planet. I can still correct that error.

Wes Gray (42:17):

Yeah, I was going to echo Toby’s point. I have a note here, if I was going to give advice to my younger self I would just say experiment heavily in hopes that you have a wide bell curve of outcomes, and mainly so you can get humility and stop being so conviction oriented in your decision making, because it seems to me overconfidence is the number one driver of great results but more often than not results that you didn’t understand why you got them.

Stig Brodersen (42:44):

John.

John Huber (42:45):

I guess for me, yeah, focus on getting better every day. So trying to learn something new every day has been some of the best advice that I’ve received over the years. And so that’s something that I’m not just telling my younger self, I’m trying to do that now. Always trying to improve at this game, and always trying to be open minded. I think investing, and this goes to Wes’, a point Wes made a few minutes ago, but not being dogmatic about something. I don’t think you can clone another investor, I don’t think you can be, like I said before, no one’s going to be Warren Buffett. You can’t be Peter Lynch. Every investor has their own unique set of understanding, their own lens through which they view the world and I think just the way we’re wired as humans we’re going to all view things slightly differently.

John Huber (43:35):

And so we’re all going to have find our own way in business or in life in general, but certainly in investing there’s no one way to skin the cat. And so, I think that’s really helpful to keep in mind is to be open minded and to be willing to learn new things and to not get stuck or to be dogmatic about certain things when it comes to investing, because I think there’s a lot of that. For some reason there’s a lot of that in the investing world.

John Huber (44:04):

And then for me, I think the most critical thing that I’ve learned, and again this is, I still consider this to be quite early hopefully in my career, just like Toby said hopefully there’s a long runway ahead for all of us. But I think my empirical observation has been that the best investments in the stock market over time come from the best companies. And so, if you’re trying to be a long term investor, if you’re truly thinking of yourself as a part owner in a business, you want to own quality businesses that can compound value over the long run. Especially when you factor in things like taxes and other frictional costs that go along with turnover.

John Huber (44:45):

If you’re a long term investor you want to own good companies. I had an intern this summer who put together a list of the top performing stocks over the last 15 years and I chose 2005 because I wanted to see, the middle of the last cycle you see a lot of things. Like what’s the best performing stocks in this bull market? And that will, as we were talking about earlier, that’s going to catch a lot of these survivors that just didn’t, barely hung on, did not go bankrupt but survived, and you’re going to see a bunch of those types of winners if you start in 2009 or 2010.

John Huber (45:15):

But in 2005 is sort of the middle of the last cycle. And when you look at that list of the top 100 performers, they’re all really high quality companies that have survived over now two different recessionary periods. And so if you’re a long terms investor, if you’re thinking of the coffee can approach to investing, which is how I think about investing, then you want to own quality companies. And so my mistakes have always come from when I’ve purchased a stock that looked very cheap on the surface, but in reality it might have been 10 times earnings but it might have only been worth seven times earnings.

John Huber (45:51):

So I’ve made that mistake numerous times, and conversely some of the best investments I’ve made, and this is something that is not just 2020. 2020 is in vogue when it comes to this because there’s so much momentum, but where I was very convicted on a business but other investors questioned the valuation at that time. And so some of those investments have turned out to work very well. And so I think a business is not worth what it earned last year it’s what’s it’s going to earn over the course of the life of that business. And so I think that’s something to keep in mind as well. So just buy good businesses.

John Huber (46:27):

Obviously you have to pay a price that is discounted in order to achieve alpha in the stock market, but I think focusing on quality companies is, in my experience, the better approach. I think far more investment mistakes are made from picking the wrong business than paying too much for a great business. And you can make mistakes in both those categories, but I think the more catastrophic mistakes are from selecting the wrong business.

Stig Brodersen (46:53):

Yeah, that’s definitely true. If I could give advice to a younger self, it would be listen more to Toby. I always take up the two example of buying GameStop and Bed Bath & Beyond and we have that on record, and both times Toby said don’t do it and here are all the reasons why and both times I didn’t listen. And look what happened.

Tobias Carlisle (47:10):

Didn’t that work really well?

Stig Brodersen (47:11):

No, it really didn’t. I definitely caught it at the wrong time. So we had you on there with Jesse Felder and he made a fortune in Bed Bath & Beyond because he’s much smarter than me. So I bought it on the way down, apparently I misunderstood Wes’ momentum strategy, so I bought it on the way down. Jesse bought it on the way up. Low and behold, he absolutely made a killing in that. So I just wanted to say that.

Stig Brodersen (47:34):

If I can give my two cents to really a younger self and not just a few years back and listen to Toby, if I could give myself another advice it would probably be to … Buffett said that he bought his first stock at the age of 11 and up until that age he was just wasting his time. I kind of like that quote because Buffett talks about being a learning machine, and that’s definitely something that I haven’t practiced, definitely not since 11, that’s for sure. But I always understood the intention of compound interest and why we need to accumulate capital and then investing that, but I never really understood the concept of compounding knowledge before I got into my mid or late 20s. And I think that’s one of the things I would like to change.

Stig Brodersen (48:15):

And the other thing, and this is just something I would like to convey to our listeners too is really to read more. I think one of the mistakes that I’ve made as an investor is I speak to people and they’re smart people, they’re not necessarily as smart as you, but whenever you primarily speak to people, especially if you’re not too selective, they tell you things you already know, or they talk to you about things you’re not interested in or you don’t understand, you’re speaking too fast, they’re speaking too slow. Reading is just, you get it in just the right tempo, and you get just what you’re interested in. And it’s a lifetime of knowledge put into 200 pages or whatnot. That I haven’t done that before is just … I don’t know, definitely a waste of my time until then.

Stig Brodersen (48:54):

Guys, it’s been unbelievable talking to you about not just these topics but really having the chance to have the conversation going any type of direction that we want. Before we let you go we would definitely like to give you the opportunity to tell the audience where they can learn more about you and your companies. Wes, can we start with you?

Wes Gray (49:14):

Alphaarchitect.com, and just follow the blog and you can hit us on Twitter as well @alphaarchitect.

Stig Brodersen (49:21):

John?

John Huber (49:22):

Yeah, my firm is called Saber Capital and you can find the website at sabercapitalmgt.com, and I have a lot of the archives up there, published a number of blog posts. So you can follow me there and you can find me on Twitter as well.

Stig Brodersen (49:35):

Toby.

Tobias Carlisle (49:37):

Yeah, I’ve got acquirersfunds.com, acquirersmultiple.com. We’ve got the interview, John is up at the moment because it’s one of the most popular podcasts of the year. All that name recognition you got from [crosstalk 00:49:51].

John Huber (49:50):

Oh yeah, how did that happen?

Stig Brodersen (49:54):

Nice work John.

Tobias Carlisle (49:55):

That’s the best way to get in contact with me. Or through Twitter, I’m @greenbackd. It’s a funny spelling, G-R-E-E-N-B-A-C-K-D, I spend too much time there.

Stig Brodersen (50:04):

Amazing. Guys, thank you so much for taking time out of your busy schedule to join The Investor’s Podcast here today. I really hope we can do it again. Thank you so much.

Tobias Carlisle (50:14):

That was fun.

Wes Gray (50:14):

Thanks Stig.

Stig Brodersen (50:16):

All right, that was all that I had for you for this weeks episode of The Investor’s Podcast. Trey and I will be back next weekend with an interview with Lawrence Cunningham.

Outro (50:24):

Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permissions must be granted before syndication or rebroadcasting.