[00:02:47] Joseph Shaposhnik: An investor wrote a letter to him just as he started his fund and talked about how they were putting money aside for their newborn and they hoped that money would grow and grow into something that they could finance that newborn’s college experience and Will posted that letter on his wall.

[00:03:04] Joseph Shaposhnik: So all of us as analysts understood how seriously Will took his job and how seriously we should take our job. So he got a huge heart, super passionate about what he did. He was as close to Peter Lynch as you get at Fidelity. He took the same level of passion, energy, style in terms of earnings growth as his focus.

[00:03:26] Joseph Shaposhnik: And what I remember about him is he brought a very high level of intensity to his job. He, his style was to meet 10, 11 companies a day at Fidelity. And so at Fidelity, we had a whole floor dedicated to company meetings and I think Will lived on that floor and was there every day seeing one company after another and looking for the great ideas.

[00:03:49] Joseph Shaposhnik: He was all about focusing on great businesses that were getting better and so he would spend a lot of time with management. He would spend a lot of time understanding the stories, and he’d spend a lot of time asking basic questions. I can remember being in a meeting with him and the Chipotle management team on the IPO roadshow.

[00:04:07] Joseph Shaposhnik: He walked in and he asked them if they made burritos, if that was their business. He’d ask the basic questions, and he wanted to see how management would articulate their business and whether management really understood their business. He spent a lot of time focusing on investing with successful people.

[00:04:23] Joseph Shaposhnik: So he’d call it betting with billionaires. And so one of his approaches, one of his strategies was finding successful people and then doubling down on them and betting on them again and again. And that was a strategy that worked incredibly well for him. 

[00:04:37] Joseph Shaposhnik: I can also remember Will was a learning machine. He would learn and adjust and learn and adjust, and I can remember going to one of the Berkshire meetings with Will, sitting next to him and just watching him take notes throughout a three-hour meeting in a large stadium listening to Buffett. He was just learning and adjusting.

[00:04:58] Joseph Shaposhnik: And just over time, he became an incredible investor. And obviously, he’s, today he’s managing, I think, hundred billion in Contrafund, another 50 billion, and a couple of other funds at Fidelity. Just an incredible passion, a strategy that was focused on investing in good businesses only that were getting better, and a great heart and super passionate about helping his investors.

[00:05:21] Trey Lockerbie: What I’m curious about is if you saw a strategy that led to Will letting go of companies, what was the turnover like? Everyone wants to find these long-term holds. Was there a thesis that was broken along the way or some example that notify him that maybe informed you what to look for when you knew it was time to get out of a position?

[00:05:38] Joseph Shaposhnik: He was very flexible. If you provided him with facts that were different or contrary to the investment thesis, he would change. And back then his turnover was higher than it is today. So he was flexible and would change very quickly. I think great investors have a North Star.

[00:05:55] Joseph Shaposhnik: His North Star was always earnings per share, and so he was constantly assessing his confidence and maybe the analyst confidence level around where earnings per share were going to be a year, three years, and five years out. And if he sensed that story or that confidence or the actual earnings were shifting against the story, he was likely to make a change.

[00:06:17] Joseph Shaposhnik: He would stick with businesses for some periods of time. He could stick with them for long periods of time, but if he felt as though the story was changing or his North Star was shifting, he would certainly make a change. 

[00:06:30] Trey Lockerbie: And you were an expert in semiconductors at the time, and you were rolling up ideas to him that way, but then you mentioned Chipotle, right?

[00:06:36] Trey Lockerbie: These are very different industries. Was there a circle of competence involved with Will? Were there ideas that would flow up to him that you would obviously see were much more in his wheelhouse than others, and he would be careful about picking between the two? 

[00:06:50] Joseph Shaposhnik: Certainly. He was always looking for the great winners.

[00:06:55] Joseph Shaposhnik: So one of the areas he looked for the great winners in were in new issues. He was always looking at new issues because he thought these businesses could become big over time, and he was always thinking about, “What is the next Starbucks? What is the next Home Depot? What is the next Cisco?” Those are the businesses that he saw get really big over his time.

[00:07:17] Joseph Shaposhnik: So he had the ability to stay young and stay nimble and stay flexible at looking for the great winners as he saw them. The 10-Baggers, as Peter Lynch called them. And of course, that term persisted throughout Fidelity. So he would look for the early businesses or early in their maturity cycle.

[00:07:35] Joseph Shaposhnik: And of course, he was looking across all businesses, defined those businesses that could grow earnings per share at a high rate with managements that were high quality, that he could get comfortable with. He would stay away, he tended to stay away from the cyclicals. He tended to stay away from businesses that were low quality or low return on capital.

[00:07:54] Joseph Shaposhnik: And he tended to focus on technologies, consumer discretionary, somewhat consumer staples. Those were his key areas. 

[00:08:02] Trey Lockerbie: And another legend over there is Joel Tillinghast, and you were working under him at Fidelity for a while as well. He was a portfolio manager of the equities division there. Talk to us a little bit about your experience with Joel, what you picked up from him along the way.

[00:08:14] Joseph Shaposhnik: It’s interesting, Joel, Will, and Jeff Vinik, who ran Magellan at one point, all came out of the same analyst class at Fidelity in the early ’80s. So an amazing class of investors that came out together. Maybe that had something to do with their success, maybe it didn’t, but quite an amazing group of investors that all came out together and grew up together, I think under the influence of Peter Lynch. 

[00:08:38] Joseph Shaposhnik: So they learned from, the great one of that time. Joel was a great value investor, very much focused on valuation, very valuation-sensitive. And what I remember about Joel is he could run multiple value strategies inside of his fund.

[00:08:53] Joseph Shaposhnik: He was looking for high free cash flow yield. He was looking for small cap and cheap. He was looking for low EV to sales businesses, and he could piece all of that together and run multiple strategies in what, at the time I think was a 30 billion dollar small cap fund, which is amazing. Most small cap funds close at three or 4 billion.

[00:09:16] Joseph Shaposhnik: I don’t know what he’s running now, but I assume it’s quite a bit of money. But, in a portfolio that had that high level of assets, he could run multiple value strategies with the focus of being able to outperform in different market backdrops. He was very successful at doing that. 

[00:09:32] Joseph Shaposhnik: So when I think of him, I think of somebody who could follow a thousand stocks. Run multiple value strategies at the same time, and do that for quite a long period of time. So just, another legend over there who was influenced, certainly very influential in shaping the way I thought about investing.

[00:09:50] Trey Lockerbie: Now before you got into investing, you were an intern at Microsoft. I realized you always knew you wanted to get into investing. So I believe there was an experience you had with Bill Gates at his house for dinner that probably had a big impact on you, I imagine. What was that experience like being around Gates when, especially at a young age, how did Gates direct you on your investment journey when you ask them about it? 

[00:10:13] Joseph Shaposhnik: It was an amazing night. He invited some of the summer employees of Microsoft to his house for dinner. And of course, we didn’t really know what to expect and, it was a beautiful dinner out in his backyard on the lake, and I remember him coming down from his house and speaking with us and, as you mentioned, I had the opportunity to talk to him about investing, which was what I was really interested in. Microsoft, not that interested in it, but I remember him being incredibly fascinated by Warren Buffett. I remember him talking about how he spent a lot of time with Buffett and spent a lot of time reading about Buffett, and I remember him saying two things to me.

[00:10:50] Joseph Shaposhnik: The first one was that successful people in most ventures, start really early. So he had seen a study that he, I think, thought was important and he mentioned that to me and I think that was something that was super encouraging to me. ‘Cause as you mentioned, I started really early and the second thing he mentioned and emphasized was, that I should immerse myself in Buffett.

[00:11:12] Joseph Shaposhnik: And was fortunate to, at an early age, do that and to attend the meetings and read his letters and spend a lot of time studying what he did with the partnership, studying how he ran Berkshire and built Berkshire and just learned a lot by doing that. 

[00:11:29] Trey Lockerbie: So what about Buffett did you hang onto and then where did you find a path to diverge from?

[00:11:35] Joseph Shaposhnik: I think Buffett is so interesting because everybody takes something different from his incredible body of work. He is such a great teacher and also obviously a legendary investor that we all learned something different from him. 

[00:11:49] Joseph Shaposhnik: What I learned from him was when I analyze his success. To me, his greatest investing successes came from investing in high-quality businesses. And when I think of his great investments, I think of Coke, I think of Gillette and I think of Cap Cities. And when we go back and we study those investments, we find that he was willing to pay up for the great businesses of his time.

[00:12:14] Joseph Shaposhnik: So just as you think about Coke, I think he made the original investment in ’88 or ’89, and he paid, I think when we looked at it, 24, 25 times earnings, which was a 50% premium for the market multiple. Similarly, in some of these other high-quality business cases or high-quality businesses, he was willing to pay up for the great businesses that would compound at high rates and generate high returns for a long period of time.

[00:12:39] Joseph Shaposhnik: So my lesson from Buffett wasn’t that you should look for the cigar butts, look for the cheap businesses that you would hope or believe would turn around. It was to find the great businesses that generate high returns and great free cash flow and be willing to pay a little bit more for those businesses in order to partner with a great business and a great team.

[00:13:02] Trey Lockerbie: So while I love learning about Buffett and he’s my go-to, I always love learning about people you don’t hear about every day. You’ve had some mentors along the way who are well-known in their industries but might not be as well-known to, the masses outside of finance. So I’d love to learn a little bit more about your time being mentored by Brian Jellison who seemed to be this very amazing mentor to many people along the way and a very generous person with his knowledge and philanthropy and other things. He was a head of Roper Technology, so I’m curious how you came across his path and anything else you may have gleaned from him.

[00:13:35] Joseph Shaposhnik: I was fortunate to be the Industrials Analyst at TCW from 2011 to 2018. And at the time Roper was not called Roper Technologies, but it was called, I believe, Roper Corporation or just Roper. I think it was Roper Industries, and Brian became CEO of the company in 2001, and the company at the time was a billion-dollar market cap business.

[00:14:01] Joseph Shaposhnik: So billion dollar market cap maker of industrial pumps. So cyclical business. He had come from an industrial conglomerate before that and I think he learned all the things he didn’t want to do with Roper from working at a conglomerate. When he retired in 2018, Roper had a market cap of approximately 30 billion dollars.

[00:14:21] Joseph Shaposhnik: It was a 25x over that 17-year period of time. What I took from following him, we were fortunate to invest in 2012. We’ve been investors now for quite a long period of time, but what I learned from following him and reading everything that he had written is that it’s important to think differently, even as an industry, and to develop a North Star, so his North Star was focusing on cash return on investment. So he was focused on cash flow and the investment required to generate that cash flow. That drove all of his decision-making. So he had a business at the time when he took over it and had a relatively low cash return on investment, highly cyclical and relatively undifferentiated.

[00:15:08] Joseph Shaposhnik: And he spent the next 15 or 16 years transforming that business into a business that owned dozens and dozens of niche businesses that were highly recurring, and that generated consistently growing free cash flow. And I think that the focus on niche businesses is a real differentiator. He focused on niche businesses because he thought niche businesses attracted less competition and were more defensible.

[00:15:37] Joseph Shaposhnik: So his focus was on building these smaller but healthy, growing niche businesses that would generate cash flow, throw it off, give it to him, and allow him to reinvest it in other good businesses. For him, it was a progression. He moved the business from industrial-focused, which was a heavy capital intensity to industrial-focused with low capital intensity, so higher free cash flow.

[00:16:03] Joseph Shaposhnik: So he bought a bridge tolling business, which he’d consider to be industrial. So the bridge tolling business would sell tags, which were recurring, and that was a defensible niche. He then moved the business to a business that would invest in network-like businesses. So he bought a freight matching business, and then he progressed the business to healthcare consumables, and in the end, he began to focus on software.

[00:16:28] Joseph Shaposhnik: So his North Star was always cash return on investment, and the rate at which you could compound free cash flow per share over a long period of time in a defensible way. So he, over time transformed the business, and I think more recently, Roper has announced that they’re spinning off the remainder of their industrial businesses.

[00:16:49] Joseph Shaposhnik: So it was a full transformation that he presided over. And I think the other key lesson from Brian, just a great man was he certainly adopted a decentralized model, which of course is common for many successful businesses like this. And I think he studied Buffett. He studied the decentralization model that Buffett had adopted along with others, and that was incredibly helpful for Brian in being able to manage 35, 40 different businesses and to continue to be able to add on to those businesses and those platforms.

[00:17:21] Joseph Shaposhnik: So as I think about him, those are the key lessons and just think of him as somebody who would get up at an investment conference, and incredibly colorfully talk about why Roper was great, super differentiated, and why everybody else was way out to lunch and not running their business in the right way.

[00:17:41] Joseph Shaposhnik: So he’s just a really great CEO, a great guy to be around. And unfortunately, he passed away a couple of years ago, but just think of him incredibly fondly as somebody who certainly shaped the way we assess businesses, whether they’re industrial businesses or data analytics businesses, or software businesses.

[00:18:00] Trey Lockerbie: So it sounds like he was influenced by Buffett, but maybe Charlie Munger as well on that last point there.

[00:18:05] Joseph Shaposhnik: That’s right. I think that’s right. 

[00:18:07] Trey Lockerbie: So with all of these experiences and these different strategies you’ve come across, what conventional wisdom have you come to disagree with, especially the ones that we’re all pretty familiar with. I imagine there’s some that stood out to you that said, you know what, this doesn’t actually jive with me or my strategy. 

[00:18:23] Joseph Shaposhnik: I think that there are several. The first one is from our perspective. I had been an analyst covering the most cyclical industries, semiconductors, then industrials, then chemicals. And so I had seen what it was like to invest in deep cyclicals, businesses that had limited moats, and businesses that were super capital intensive.

[00:18:47] Joseph Shaposhnik: So one of my key takeaways is, predictability is far more important than a low starting valuation. If you can’t predict the business or where the earnings are going to be in a year or two, you can’t determine whether the business is fairly valued or not. So as I think about just the sheer number of variables that go into what impacts the stock, it’s enormous, and I think about all of the analysts that were studying Facebook and how they couldn’t anticipate that Apple was going to come in and disintermediate the ad model. I think about everybody that was studying Intel and AMD and I think that almost nobody 10 years ago would’ve predicted that AMD would be larger than Intel or the same size.

[00:19:34] Joseph Shaposhnik: And I think that the data indicates that half of the S&P won’t be in the S&P 500 in 15 years. So for us, it means that we’re really focused on narrowing the number of variables down to a number of variables that we can actually get our arms around in order to predict where the business is going to be.

[00:19:54] Joseph Shaposhnik: So we focus a lot on recurring revenue and businesses that are in defensible niches. We think that if a business has substantial recurring revenue, it decreases the risk that we’re going to be wrong in assessing where the free cash flow will be in a year or two or in five years. And so it’s one incredibly important element that we think reduces the risk of making a decision.

[00:20:17] Joseph Shaposhnik: So I think one of the first unconventional lessons is predictability is as important as a low starting evaluation. I think the second key takeaway as we think about conventional wisdom and what’s important is limiting your turnovers. So as I think about, and I think about that in a basketball context.

[00:20:37] Joseph Shaposhnik: The great Mick Cronin, UCLA’s current basketball coach, he talks about the importance of limiting turnovers and he brings it to a mathematical formula, which I think applies to investing. He says, if you have fewer turnovers and you have more rebounds than the other team, you’re likely to have more possessions. And you’re likely to have more shots. 

[00:20:58] Joseph Shaposhnik: So I think the same rule applies to managing a portfolio. If you can limit the number of businesses that decline substantially, you’ve got a much better chance of outperforming. If your portfolio is constantly taking significant drawdowns in positions, it’s much harder for your winners to overcome those declines and for you to deliver good performance.

[00:21:20] Joseph Shaposhnik: So I’d bring it back to basketball and limiting your turnovers, which in investing means trying to narrow the magnitude of the outcomes with the investments that you make in order to reduce the investments that are going to hurt you the most. So again, that goes back to predictability, defensiveness, and we’ll get to free cash flow, but free cash flow as well.

[00:21:42] Joseph Shaposhnik: I think the third key unconventional lesson is that what we’ve found is that cheap businesses are usually cheap for a reason. Inexpensive businesses, particularly those that generate low returns on capital and that is incredibly capital intensive. They tend to not be long-term winners, and so if that’s your focus, you’re always focused on trying to buy them cheap and then ride them when the business improves and then sell them before the capital intensity ramps up again, or the story gets more difficult, or the economy goes the wrong way. And so that creates a significant tax bill for investors. And it creates another job for the investment manager, which is you have to now take that money and find another place for it.

[00:22:29] Joseph Shaposhnik: So that’s difficult. From our perspective, why not just buy a great compounding business that will get better over time and one that you don’t have to sell? The fourth at a five is that free cash flow is king. It’s not EBITDA, it’s not revenue, and it’s not earnings. We think that free cash flow physically moves stock prices.

[00:22:47] Joseph Shaposhnik: It allows companies to reinvest in projects. It allows companies to buy in their shares and increase your ownership, assuming you’re not selling. It allows a company to buy other businesses and improve those businesses and hopefully add value to the franchise itself. So for us, free cash flow per share is our North Star.

[00:23:10] Joseph Shaposhnik: And as we think about building a compounding machine, which is what we focus on, building a compounding machine, we are focused on finding those businesses that can compound free cash flow per share at the highest rate with risk under control. And so for us it’s not about revenue growth or EBITDA or necessarily earnings, it’s about what the business generates at the end of the day, which is free cash flow.

[00:23:33] Joseph Shaposhnik: And the last key, I think, the unconventional lesson is that if a stock has doubled or even tripled, you haven’t missed it. When you think about the great compounding businesses, the great businesses of our time, as you think about Microsoft or Starbucks or Meta, when it was great, or some of these other businesses. These businesses, go up many folds.

[00:23:56] Joseph Shaposhnik: If you look at Roper, Roper went up 25-fold over the course of that period of time. You could have bought it at the second ending of the story. You could have bought it in the fifth ending of the story and you would’ve done remarkably well. 

[00:24:07] Joseph Shaposhnik: So one of the other lessons is the great CEOs, Bill Gates and Larry Ellisons, the Jeff Bezos of the world. They’re not selling after the stocks doubled or the stocks tripled. They’re holding onto these great businesses for long periods of time. So I think the key conclusion is if a stock is doubled or even tripled and the story is getting better over time, you haven’t missed it. And it may be worth your time to look at it. 

[00:24:33] Trey Lockerbie: Okay, so now let’s talk about Joseph Shaposhnik, because you have had this incredible run in your career so far, and you’re just getting started, but you’ve been running the TCW New America Premier Equities Fund, which is benchmarked against the Russell 1000 Growth Index, and the fund has produced 15.84% since its inception versus the Russell’s 12.3%, so 3.54% of Alpha.

[00:24:57] Trey Lockerbie: I want to dive into a few of the top holdings of the fund and some of them are especially interesting because they would be considered “overweight” in a lot of other funds. So you were talking about looking for companies that avoid disruption. I find this so interesting because technology is built to be disrupted in a way, but they’re also the most asset-light businesses with that throw off the most free cash flow.

[00:25:18] Trey Lockerbie: So there’s almost sometimes this trade-off, and I always find it interesting to study these types of companies who can have monopolistic, let’s say attributes or potential monopolistic attributes, but then also might be at risk of being thrown out by something else. Your point about Facebook and Apple a minute ago stands out.

[00:25:35] Trey Lockerbie: So the top holding here is Constellation Software. And I first learned about Constellation when I was interviewing Larry Cunningham, who’s the Vice Chair of the board. But I never took a great deeper look at it from that conversation. So I’m hoping to come back to it now and learn from you about what makes Constellation such a great business.

[00:25:53] Joseph Shaposhnik: Our strategy, as we’ve talked about, is focused on investing in predictable growth businesses that generate consistent free cash flow, partnering with management teams that treat shareholders. As partners, businesses that have a track record of great reinvestment of their free cash flow and the opportunity to do more of that and businesses that traded a reasonable multiple of free cash flow. Constellation is the embodiment of the free cash flow compounding machine.

[00:26:23] Joseph Shaposhnik: As you may note, it’s an owner-operator of several hundred vertical market software businesses across many different industries. 70% of revenues are tied to long-term maintenance contracts on the software that is embedded with customers. And it’s a decentralized business that has hundreds of Constellation Software leaders across the world looking for great investment opportunities and acquisition opportunities.

[00:26:48] Joseph Shaposhnik: And it’s a business that’s compounded free cash flow per share at 30% for I think 20 years or so with a very unusual formula of some organic, but mostly inorganic growth. I think the ideal business generates high returns on capital with the core business and then has the opportunity to reinvest the cashflow that it generates to generate more high returns or to continue to generate high returns on invested capital.

[00:27:18] Joseph Shaposhnik: And for us, we are always looking for defensiveness and this business gives us great defense. Super diversified, 70% recurring revenue, critical software, which is difficult to replace. Niche focus, not looking to compete against the biggest software players in the world. 

[00:27:36] Joseph Shaposhnik: So as an example they sell software to golf clubs, they sell software to bowling alleys, they sell software to construction equipment makers, window repair shops, basic software for basic customers. So we love the defensiveness of the business. In the great recession of 2009, they continue to grow free cash flow. They continue to generate reasonable growth.

[00:27:57] Joseph Shaposhnik: The defensiveness is incredibly attractive. No customer concentration, super diversified, highly recurring. And as importantly, run by one of the great capital allocators of our time, Mark Leonard. And so Mark is a very unique individual. He spent his life studying the great compounders and building a business that worked for him but embodies all of the lessons of the great compounders.

[00:28:25] Joseph Shaposhnik: So he’s studied Buffett. He studied ITW. He studied Jack Henry. He can tell you everything about those businesses, and he built this incredible, decentralized business that has a culture that works, that has a culture that takes care of the customer and has the ability to expand out and decentralize the capital allocation decisions to the farthest flung employee if that’s in Japan or in São Paulo or in Spain.

[00:28:57] Joseph Shaposhnik: All of those individuals and those teams are empowered to make investment decisions and acquisitions, and I think that’s given Constellation an incredible advantage over the software-focused private equity firms in the US domicile private equity firms who are competing for similar assets as well.

[00:29:16] Joseph Shaposhnik: It’s allowed Constellation to buy very small businesses and do many small acquisitions, which for large businesses is time-consuming, but for a company that has decentralized in decision making, it allows that to occur efficiently. And what we found is that those small acquisitions tend to deliver the best returns.

[00:29:37] Joseph Shaposhnik: And so that has allowed Constellation to deliver incredibly high returns on capital. So give you a sense, today the business generates about 40% returns on capital, and it deploys all of its free cash flow to acquiring other businesses. So just incredible. A good business in the United States might generate 18% returns without diluting those returns with acquisitions.

[00:29:59] Joseph Shaposhnik: This business has been able to generate 40% for a long period of time while redeploying all of its excess free cash flow. So it’s an incredible compounding machine run by an exceptional manager who runs it very conservatively and has an incredible record. So it’s something we’ve been very comfortable with.

[00:30:16] Joseph Shaposhnik: And as you mentioned, it’s been our largest holding now, I think for five or six years. And as you talked about, it’s been between 10 and 15% of the fund for a long period of time. That’s a bit unusual. We think that it provides us with great downside protection and we just have great confidence in the durability of the model and the team.

[00:30:37] Trey Lockerbie: And speaking of the team, another point that’s worth noting is the level of insider ownership of the company. So that currently sits around, I believe, 3.5 billion worth of ownership, and that clearly shows major skin in the game from management and I imagine that’s another point you look at when you’re studying management, and something to give you a little bit more reassurance.

[00:30:58] Joseph Shaposhnik: We certainly do, and I think one of the other key tenants of ours is to look at what management incentives are. So we spend a lot of time looking at the proxy and analyzing what their incentives are. And one of the great parts of the Constellation incentive structure is that management and employees are required to take their cash bonus and purchase shares on the open market.

[00:31:21] Joseph Shaposhnik: And hold those shares for three years. So Constellation has never issued options. And they’ve never issued shares to employees. So I think share count has been 21 million shares since the IPO in 2006. So his focus on caring for investors and incentivizing employees to invest in the business is unusual.

[00:31:43] Joseph Shaposhnik: And for us, it’s just so special that everybody is really invested in the success of the company. And as a corollary to that, Mark doesn’t like when the stock gets too high or out of whack relative to what he thinks the fundamentals are. He doesn’t really do investor meetings and he doesn’t do a conference call anymore.

[00:32:02] Joseph Shaposhnik: So if you want to see him, you have to go to the shareholder meeting. The first shareholder meeting I attended, which I think was in 2016 or 2017, the stock was around $600 a share, and he was actively telling those in the audience and he thought the stock was too expensive. And stocks, now, I think, I don’t know where it is today, but it’s I think 2,900, correct me if I’m wrong on that. At 600, he was telling us it was too expensive. I remember a year after that, I came back to the meeting and he said the same thing. The stock was maybe at 800 at the time, and he thought the stock was too expensive. So I think that indicates that he’s very focused on the fundamentals and making sure that the stock doesn’t get out of whack and not be promotional.

[00:32:46] Joseph Shaposhnik: But I’ve also found, it is very unusual that a management team thinks their stock is too expensive and if they say something that unusual, it’s worth paying attention to. To me, it was something that was attractive and consistent with his understated personality and the way he ran the business, but it certainly was something that you don’t hear very often.

[00:33:05] Trey Lockerbie: Yeah, I wonder what Mark would say today because, at the time of this recording, the stock is currently at $2,316, which is essentially, its all-time high. It only hit this level right at the end of December 2021, much like a lot of companies who are hitting their all-time highs right before the bear market began.

[00:33:22] Trey Lockerbie: But what’s so remarkable about this stock is how quickly it’s recovered back to, its all-time high, even after 2022. 

[00:33:29] Joseph Shaposhnik: It is. And when you look at what’s occurred underneath the business, it’s a little bit less remarkable. I’ll tell you why. Number one, the business always is traded at a moderate free cash-free yield.

[00:33:41] Joseph Shaposhnik: So today it trades at a four and a half-percent free cash flow yield on 2023 free cash flow. And it never really gets expensive, so it tends to trade on the fundamentals and number one because so much of revenue is recurring, organic revenue doesn’t fluctuate to a great extent, but I think number two, through the pandemic and coming out of the pandemic, Constellation continued to execute extremely well, and the stock went down with the market but has since come back primarily because I think in this environment, they say the stock market is a voting machine in the short term and a weighing machine in the long term. The stock market has become more of a weighing machine. This year and last year relative to in ’21 and in ’20, it was more of a voting machine. 

[00:34:27] Joseph Shaposhnik: So because it’s so cash-generative, the market, I think has given it a little bit more credit and has allowed the business to come back. It was not one of those businesses that was driven by revenue growth or the metric that dominated the post-pandemic rally.

[00:34:42] Joseph Shaposhnik: So I’m not that surprised that it’s come back as well as it has. I think they’ve done a really good job of growing the business in the pandemic and through the pandemic. So if you look at the performance, businesses continue to grow at, this year it looks like it grew 25, 28%, it’s going to continue to grow at a high rate.

[00:34:59] Joseph Shaposhnik: And the stock, I think is representing the fact that all of that is translating into good free cash flow growth. 

[00:35:05] Trey Lockerbie: So that’s an interesting point about its cheapness, if you will, with the four and a half percent free cash flow yield, multiple, and it’s a 50 billion dollar company and its PE is sitting at 75, right?

[00:35:16] Trey Lockerbie: Which is pretty high. I think no matter what kind of business you’re looking at, it would be considered high, even though this is a very established business with strong earnings. So for a company like this, that’s especially more mature and a tech company, if you will, knowing that you don’t emphasize valuation when you’re looking at these numbers, what metrics should investors focus on if it’s not the PE ratio?

[00:35:36] Joseph Shaposhnik: I think that at least on the forward basis, it trades closer to 32 times earnings, which is not low by any means. Our focus is, our North Star is free cash flow per share and a multiple of free cash flow per share. So the way we assess businesses is we’re always looking at what the free cash flow per share is for these companies on a forward basis.

[00:36:00] Joseph Shaposhnik: And the rate at which we think those businesses will compound free cash flow per share in the future. So we’re always looking at, as we think about making investments and as flows come in, flows come out, we’re always looking at what’s the best return on our capital? At what rate can we generate compounding with a particular business, and what’s the multiple of free cash flow per share that we will have to pay to get that rate of compounding with Constellation today as we look at the market?

[00:36:28] Joseph Shaposhnik: And we look at rates, we tend to think that the current multiple or the current yield of four and a half percent is relatively attractive relative to the other opportunities for capital in these protected, durable compounding businesses that we focus on. So we’re not particularly concerned about the current valuation.

[00:36:49] Joseph Shaposhnik: And I think that relative to the other options in the multiples on free cash flow, it continues to be something that is attractive. 

[00:36:56] Trey Lockerbie: So there’s another holding that reminds me a little bit of Constellation I want to talk about, which is FactSet, it’s almost like another semi-niche tech software type of company if you will.

[00:37:06] Trey Lockerbie: I’m wondering if this is a smaller version of Constellation that could grow up to be something more like a Constellation if you will because it’s only around a $420 stock at the moment. It’s about a 15 billion market cap. Talk to us about what FactSet does and why you’re drawn to this as well.

[00:37:20] Joseph Shaposhnik: FactSet, as you probably know, and anybody in the financial services industry probably knows the business, it’s a leading provider of financial data, economic data, to financial professionals around the world. It’s a subscription service that many of us use to find information on businesses.

[00:37:36] Joseph Shaposhnik: Company has over 180,000 global users and 95% of revenues are generated through subscriptions. Those subscriptions are fairly expensive. I think what’s also attractive about the company is that it’s grown revenues for 42 consecutive years and earnings for 26 consecutive years as a public company. So we appreciate the consistency of the company and what we also appreciate is the recurring revenue nature of the company.

[00:38:05] Joseph Shaposhnik: And I want to take a minute and step back and just talk a little bit about the way we look at recurring revenue. We think not all recurring revenue is created equal. Oftentimes recurring revenue is divided into subscription recurring and transactional recurring. So I’ll give you an example of both.

[00:38:21] Joseph Shaposhnik: A transactional recurring revenue business would be one of the credit bureaus, where there’s only three credit bureaus in the United States and normally if somebody’s credit is being run for a mortgage or something credit related, you have to ping two out of the three bureaus for a score.

[00:38:37] Joseph Shaposhnik: But if mortgage activity declines, that revenue will decline as well. So that’d be considered transactional, recurring revenue In the case of facts that it’s a subscription recurring revenue business where somebody pays a subscription on an annual basis for the use of the product. And oftentimes it’s multi-year subscriptions in the case of FactSet.

[00:38:58] Joseph Shaposhnik: So we think that there’s a real difference between the two. And of course, we favor subscription recurring because of their durability and predictability. It’s been a business that we’ve owned primarily ’cause we’re attracted to the predictability of the company and the fact that the business generates 40% or so returns. And fantastic, predictable free cash flow growth. 

[00:39:18] Joseph Shaposhnik: So from that backdrop it’s attractive for us. And I think one of the key triggers for us was a new CFO coming into the company who had come from other businesses like FactSet. And our impression is that Linda Huber is going to do a great job in getting a little bit more control over the cost of the company.

[00:39:40] Joseph Shaposhnik: Perhaps improving the capital allocation decision-making and continuing to position the company to generate predictable, free cash flow growth and revenue growth for a long period of time. So it’s a great business that has performed really well over the years. It’s a business we really understand because we use the product and it’s a business that we think is very durable and predictable. So it really fits our approach. 

[00:40:03] Trey Lockerbie: You mentioned the hiring of a CFO. A lot of major companies in this industry, or I guess in software, et cetera, tech are laying off people at the moment, getting ready for this impending recession everyone’s talking about. Meanwhile, this company’s hiring, it would appear. Are you seeing differences like that in the news or are those indicators, if you will, of stronger businesses or companies that are more supported or more set up to succeed in a period we’re heading?

[00:40:27] Joseph Shaposhnik: I think that the businesses that have tended to lay off people in tech have generally been those businesses that have seen demand pulled forward because of the pandemic.

[00:40:40] Joseph Shaposhnik: Satya Nadella talked about that on the Microsoft call a couple of nights ago. It may have been, I think, two nights ago, where he’s seen customers optimize their spend because they’ve made such strong investments in IT over the last couple of years, driven by a pandemic pull forward.

[00:40:56] Joseph Shaposhnik: So I think at the same time, those software companies had to invest in people and grow their staff to respond to the demands that customers put on them. Over the last couple of years. As I see it, companies are just making an adjustment to bring their staff back to a more normalized level. But as we look at the data on employment or tech businesses, their companies are not bringing their staffs back to a level that looked like the 2020 or 2019 level.

[00:41:26] Joseph Shaposhnik: There’s someplace in between 2020 and where they were at the end of this past year. So there’s been some modest reductions. I think we tend to think that they’re going to be muted generally in the case of FactSet because of its business in supporting financial professionals with great market data.

[00:41:44] Joseph Shaposhnik: It wasn’t particularly impacted by the pandemic negatively or positively. So we don’t, we tend to not think that there’s going to be much of an impact there or much of an impact from the customer base as well. 

[00:41:56] Trey Lockerbie: Yeah and to your point about Satya Nadella and Microsoft, they announced 10,000, I think layoffs recently, which is only about 5% or so of their overall employment.

[00:42:04] Trey Lockerbie: And if you were looking at it through the eyes of Jack Welch at GE, I believe he would cut 10% annually, just as a rule of thumb. So you’re right, it could be looked at as a very reasonable move or something almost prudent or practical. 

[00:42:16] Joseph Shaposhnik: That’s right. 

[00:42:16] Trey Lockerbie: So switching gears a little bit, I want to talk about semiconductors because they’ve received such a large amount of attention over the last few years, especially after supply chains broke down and semi shortages began to affect what felt like nearly everything.

[00:42:29] Trey Lockerbie: Berkshire Hathaway even recently took a stake in TSM and others seemed to be following suit. But given your background, I wanted to get your opinion on the space, and if you had to pick a top semiconductor business to invest in today, which one would you choose? 

[00:42:44] Joseph Shaposhnik: I think that the semiconductor industry has evolved significantly over the last several years.

[00:42:50] Joseph Shaposhnik: It continues to be, I think, an attractive place to look for ideas, but we’re always very cautious about investing in semis. Because they’re at the edge of technology change, and so we generally stay away from businesses that are undergoing technology change. Buffett has a line where he says, generally, the best investments or the best businesses are those businesses that are doing something somewhat similar to what they’ve been doing over the last couple of years.

[00:43:19] Joseph Shaposhnik: So with semis, it’s always a challenge because product cycles tend to be very short. And there are a lot of smart people that are driving a lot of innovation in semi, so they tend to be a little bit more difficult to predict in general. So we’re very selective if we make an investment there.

[00:43:35] Joseph Shaposhnik: We have been investors with Broadcom and Hock Tan for a number of years, and I think that so many incredible attributes to Hock and to Broadcom, but one of the key think features of the approach at Broadcom is a real humble approach to running the business. They’re not looking to make the hot new product that will take over the world.

[00:44:03] Joseph Shaposhnik: They’re looking at making incremental changes to their existing franchises to make them better and respond to customer needs. So what’s attractive about Broadcom is that they’re involved in 30 key markets, which they call franchises, where they’re the dominant provider of the technology, and it tends to be areas that are relatively unattractive for the fastest growing semi companies.

[00:44:29] Joseph Shaposhnik: So they’re the dominant player in hard disk drive is not the sexiest place to be in semis. They’re the dominant provider of chipsets that go into cable set-top boxes, and they’re the dominant player in fast-growing networking equipment as well. But they generally take a conservative approach to investments, and they generally take an incremental approach to R&D and development.

[00:44:53] Joseph Shaposhnik: So we like the fact that they have these dominant niches that provide them with a level of recurring revenue that provide them with a level of stickiness and protection. And we like the fact that they’re not out there competing against the heavyweights in the cutting-edge areas of semis. And I think as important, Hock Tan has proven to be an unbelievably gifted capital allocator and investor.

[00:45:20] Joseph Shaposhnik: Some of the greatest CEOs are the greatest investors. Hock and his team have built a business basically in 2009, the IPO, a billion dollar, $2 billion market cap company. Broadcom today is, I don’t know, the 30th largest company in the S&P 500, a couple hundred billion dollars in market cap. And they did that by identifying the fact that the semiconductor industry was too fragmented, unconsolidated and an industry that Hock believes grows at GDP plus a couple of points. And because that needed to be consolidated and he took a strategy of consolidating the industry over the last 15 years or so that allowed him to put together these strong niche businesses.

[00:46:09] Joseph Shaposhnik: And also, allowed him to now pivot when the environment for acquiring semiconductor businesses turned against him. As you may know, he tried to acquire Qualcomm and the US government blocked that deal, and I think that he paused, looked at the opportunity set in semis, and decided that the opportunity, the valuations and semis were too expensive and that the attractive deals were no longer available to him. And so instead of giving up, he looked elsewhere and applied his principles to software. So he then acquired CA Technologies and a couple of other software businesses, which were synergistic with his semi business.

[00:46:53] Joseph Shaposhnik: He was able to drive significant returns from those in acquisitions. And so now his business, assuming he closes the VMware deal, is going to be 50% semis and 50% software. And a business today that generates 60% plus free cash flow margins. So it’s the most profitable semi business on earth, and it’s the business that is probably the most predictable of all.

[00:47:19] Trey Lockerbie: I mentioned Berkshire buying TSM, but given your background, I’m curious to hear your thoughts on Berkshire’s purchase of Precision Castparts because you were an analyst on that space as well for a long time and have intimate knowledge of that company. In your opinion, where did Buffett go wrong here and how are the company’s future prospects looking?

[00:47:37] Joseph Shaposhnik: Nobody bats a thousand and of course, he’s the greatest investor of our time. But I think it shows you that we all can make mistakes, and I think with Precision Castparts, what was evident to us as analysts was that Precision was losing market share to its competitors and that Precision operated in an incredibly difficult and competitive space.

[00:48:02] Joseph Shaposhnik: So in addition to that, the business was highly reliant on just a couple of customers. So if you lost those customers, if you lost Rolls-Royce, or if you lost Saffron, or if you lost GE, you were in deep trouble as a company. They certainly had enormous amounts of market, of power over PCP, and I think that it’s a lesson for all of us to assess the competitive position of a company carefully before making a decision. And I think that would, that’s the difficulty. I think that the macro environment also went against the story. Precision has a significant amount of exposure to energy and the energy patch went south after the deal as well.

[00:48:45] Joseph Shaposhnik: But I think the key lesson from that acquisition, Is that the competitive dynamics were deteriorating before the deal was announced and had been deteriorating for quite a long period of time. And I think that it’s so important to not invest in a situation where the competitive dynamic is going against you.

[00:49:06] Joseph Shaposhnik: And as Peter Lynch would say, wait for the data to go your direction before you make the investment. Some would say that the market revalues stocks before you can see the proof of that. But most of the time you have enough time to assess the situation in the new data and determine that the story’s getting better, there’s still time to make the investment.

[00:49:29] Joseph Shaposhnik: So I think the learning lesson is that if the competitive dynamics are deteriorating, just wait and see how the story plays out before you step in.

[00:49:38] Trey Lockerbie: And look for companies with diversified revenue streams, as you’ve highlighted through a few of your examples here today, I really encourage everyone to look at the New America Premier Equities Fund from TCW.

[00:49:49] Trey Lockerbie: Joseph, before I let you go, I want to give you an opportunity to hand off to the audience where they can learn more about the fund and about you and a couple of other things you might be working on or where you want people to learn more about the fund or about you. 

[00:50:00] Joseph Shaposhnik: Of course. It’s been so much fun to be with you and congratulations on all the success of the podcast. They can find more information about us, myself, and TCW at tcw.com and of course, there’s fun information available there as well. 

[00:50:14] Trey Lockerbie: Fantastic. Joseph, I really appreciate your time and I hope we can do this again soon. Really fascinating portfolio you’ve got here and I’m going to be digging a lot deeper here, so I appreciate the time and let’s do it again.

[00:50:24] Joseph Shaposhnik: So much fun. Thank you so much, Trey. 

[00:50:27] Trey Lockerbie: All right everybody that’s all we had for you this week. If you’re loving the show, don’t forget to follow us on your favorite podcast app, and if you’d be so kind, please leave us a review. It really helps the show. If you want to reach out directly, you can find me on Twitter @TreyLockerbie.

[00:50:39] Trey Lockerbie: And don’t forget to check out all of the amazing resources we’ve built for you at theinvestorspodcast.com. You can also simply Google TIP Finance and it should pop right up. And with that, we’ll see you again next time. 

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