[00:02:17] Tobias Carlisle: So, I prefer to focus on very long-term metrics like the Shiller PE ratio, which adjusts for the business cycle and inflation by looking at earnings in inflation-adjusted terms and comparing them to the index. This metric has been indicating overvaluation for a long time. Similarly, metrics like Tobin’s Q, which compares the replacement value of assets to their market value, and Buffett’s measure of comparing total market capitalization to gross national product, all point to significant overvaluation.

[00:02:48] Tobias Carlisle: The reason for this overvaluation is primarily the persistently low interest rates we have experienced. As Warren Buffett has mentioned, when you lower interest rates, it acts like gravity on assets, causing them to rise. Conversely, when interest rates are raised, assets tend to decline. Currently, the United States is in a hiking cycle with interest rates, although central banks and people, in general, don’t prefer hiking. They do so to prevent the negative impacts of inflation, which erodes purchasing power and disproportionately affects the poorest individuals whose income relies heavily on the CPI basket.

[00:03:26] Tobias Carlisle: The necessity to hike rates arises from the potential consequences of extensive bailouts and money printing carried out in recent years, which can lead to runaway inflation. This backdrop sets the stage for a challenging scenario. Looking back at previous periods with expensive markets, rapidly rising interest rates, and significant inflation, we can draw comparisons to the 1950s or the 1970s. In both cases, equities did not perform well.

[00:03:54] Tobias Carlisle: As for near-term stock market performance, it’s difficult to predict. However, historical patterns suggest that there have been significant market crashes in similar environments, followed by prolonged periods of low returns. I have held the view that we are heading into such a scenario for some time now, but it hasn’t materialized yet. Therefore, one should take this historical perspective with a grain of salt. I’m aware that many individuals believe the market peaked at the end of 2022 or the beginning of 2023, and since it is now mid-May, we are approaching 18 months from that peak.

[00:04:33] Tobias Carlisle: If you look back a year, the stock market is now slightly higher than it was a year ago. So, does that mean we have hit a bottom and that we will experience a mild drawdown followed by a return to all-time highs? I think it’s difficult to envision that scenario because earnings are likely to decline for a while. Even from the current point, I anticipate further earnings decreases. Therefore, for the stock market to reach all-time highs, it would require multiple expansion driven by declining interest rates, which is a challenging outcome to foresee.

[00:05:12] Tobias Carlisle: It’s worth noting that while Jay Powell and others may initially claim that interest rates will remain unchanged or increase slightly, they will likely start cutting rates as soon as the market begins to crack. However, historically, when the market starts to decline and central banks initiate rate cuts, it doesn’t have an immediate substantial impact. It appears to be more of a psychological influence that develops over time. My suspicion is that we are now in the latter stages of this drawdown, and it is typically during this phase that the most severe declines occur.

[00:05:50] Tobias Carlisle: I have discussed the ten-three inversion frequently. It pertains to the Treasury yield curve, where the short-dated treasuries, such as the three-month Treasury, and the long-dated treasuries, like the 30-year Treasury, are considered. Under normal conditions, the yield curve slopes upward, indicating that as you move further into the future, each treasury yields a slightly higher return due to increased risk factors and uncertainties. However, when an inversion occurs, often referred to as contango, the front end of the curve yields higher returns than the back end. This suggests that investors have near-term concerns and are hesitant to hold long-term securities, resulting in a sell-off and increased yields on shorter-dated treasuries. The ten-three inversion specifically refers to the situation where the yield on the three-month treasury is higher than the yield on the 10-year treasury.

[00:06:44] Tobias Carlisle: Ken Harvey, a researcher, has conducted studies on this simple yet effective metric. His research, which he presented in his 1986 PhD, analyzed four instances prior to his work, and he found that the inversion of the yield curve accurately predicted every recession.

[00:07:01] Tobias Carlisle: And since his research was published in 1986, there have been four additional instances of inversion, and in each case, an inversion has preceded a recession without any false positives. This suggests that it tends to predict some form of deflationary event in the near future. Currently, we are back in an inversion phase, which started on October 25th of last year.

[00:07:26] Tobias Carlisle: Historically, the period from the inversion to the official declaration of a recession has ranged from six months to 15 months, with an average of 12 months. This would imply a potential declaration of a recession around April 25th or October 25th, with January 25th, 2024 being a possible date as well.

[00:07:47] Tobias Carlisle: If we examine past stock market behavior during recessions, the drawdown tends to be twice as severe as it would be in non-recessionary periods. On average, the drawdown during a recession amounts to approximately 40%, compared to around 20% in the absence of a recession. Considering all of this, I’m not making any specific predictions, but rather pointing out the existing conditions.

[00:08:12] Tobias Carlisle: We currently have a stock market that has been in a drawdown for approximately 17 and a half months, nearing 18 months, coupled with an inversion. Historically, when an inversion has occurred, we have experienced a recession within a period of six to 15 months, with 12 months being the median. Therefore, from mid-May to around October, there is a reasonable chance of some significant events occurring.

[00:08:38] Tobias Carlisle: However, it’s important to note that these conditions do not guarantee specific outcomes. Major drawdowns are rare events and notoriously difficult to predict. That being said, I believe it is prudent to exercise caution during this period. There is a reasonable chance that better prices may be available in the near future.

[00:08:59] Robert Leonard: At the Berkshire Hathaway annual shareholders’ meeting this year, there was some discussion between Warren, Charlie, and a question from the audience about the future opportunities and potential for value investors. I was hoping you could paint some color around what was said, more of the context, and then I’m interested to hear your views on what you think the future of value investing looks like.

[00:09:26] Tobias Carlisle: Yeah, that’s not a new thing from Charlie. He’s said that a number of times, and it’s true. The more competition that there is for, you know, at one point, it was Benjamin Graham who wrote the sort of the first book that was like a scientific approach to value investment that came out in 1934. And then he taught Buffett.

[00:09:50] Tobias Carlisle: And Buffett was, uh, famously the only student who got an A plus in his class. And so there was a period of time where Buffett was buying these sub-liquidation companies that were way, way too cheap, one times earnings, and actually pretty good companies, and he got very, very good returns. And that seems to have sort of ended around 1969, and he transitioned from Buffett Partners, which was his hedge fund, into Berkshire Hathaway.

[00:10:20] Tobias Carlisle: And Berkshire Hathaway had a different sort of approach to the Buffett Partners approach because he was then trying to buy better businesses. You know, he famously transitioned into Amex, C’s, and Coca-Cola, and now Apple. And so these are much better businesses that it’s necessary to pay up for a little bit.

[00:10:42] Tobias Carlisle: So valuations have certainly gone up, and that has meant that the way that investors approach the market has had to, people have had to adapt. I think that opportunities will always exist because opportunities exist. Because people do silly things in the markets, and I don’t think that we’re getting smarter as a species.

[00:11:04] Tobias Carlisle: I don’t think we’re getting smarter as investors. I think that the markets are expensive, and that means you have fewer opportunities, but you’re also not under any obligation to swing at anything in the market. You can sit there and wait for your price. And there have been lots and lots of really silly prices, and I think that despite the fact that I was just saying before that I think the market’s very overvalued.

[00:11:34] Tobias Carlisle: I do think the market’s very overvalued, but I also think there are. We’re sort of at this, the spread between the most overvalued companies, sorry, the spread between the market and the most undervalued companies is as wide as it has ever been. It’s wider now than it was in 2000. It’s wider now than it was in 2009 at the bottom, and both of those periods saw very, very good returns for value.

[00:12:04] Tobias Carlisle: The problem is that when people look at the companies that are in the very undervalued basket, they say, “I don’t wanna own those companies” because, for one thing, it’s a lot of energy. We don’t know if the energy companies’ earnings are sustainable. They tend to be quite cyclical, so the value basket currently is filled up with companies that people don’t wanna own.

[00:12:30] Tobias Carlisle: But that’s always the case. Definitionally, value is stuff that people don’t want to own, and it’s too cheap relative to what it’s earning. That’s where the opportunities come from. So you have to be prepared to sort of ignore what everybody else says, buy these things when they’re cheap, and then hold them, whatever happens. And I know you’ve got a few examples that we’re gonna discuss in a little bit, but that’s one of the reasons that I’m quite quantitative and systematic in my approach, which means that I sort of tend to focus on financial statements rather than what economists or management or other investors or sell-side analysts or buy-side analysts or anybody has to say about these things.

[00:13:19] Tobias Carlisle: Because what they say about these companies is the reason why they’re cheap. I already know all of the reasons why these things are cheap. The way that you invest, though, is you sort of have to put those opinions aside and look at what the financial statements actually say, and then it’s the age-old problem that confronts any sort of science anywhere.

[00:13:44] Tobias Carlisle: We’re trying to guess what the future looks like based on what the past looks like, and to the extent that the future doesn’t follow the rules of the past, then I’m gonna be wrong on these things. But if the future continues to look like the past, then some of these companies will get some attention. Again, the stock prices will go up, and they should perform, and so I think that the opportunity for value at the moment is extraordinarily good. The reason why it doesn’t look so good value as a strategy is because these multiples relative to the rest of the market are so stretched. It’s been going against value since sort of 2010.

[00:14:31] Tobias Carlisle: I might post these little charts on my Twitter feed all the time, saying, just updating, saying the spread is unbelievably wide. Again, when you’ve got that sort of headwind all the time as an investor, the returns are gonna be flat, but at some point, flattered down. At some point, that spread starts closing.

[00:14:53] Tobias Carlisle: And when that spread closes, then the tailwind turns in, sort of the headwind turns into a tailwind, and I think you’ll see a lot of value outperformance. So I’m incredibly optimistic. I’ve never seen an opportunity set like this in my lifetime relative to the rest of the market. And I think that if you look at what’s happened in the past when we’ve seen something comparable to this, early 2000 would be comparable, value did very well.

[00:15:25] Tobias Carlisle: The rest of the market was flat, and it took a decade for that to sort of work its way out to the point that from 2000 to 2015, by 2015, the spread was very, very tight. When the spread is very tight, you want to be in the better companies. There’s no advantage, there’s no discount to being in the less good companies.

[00:15:50] Tobias Carlisle: That’s harder to be a handicapper, which is sort of what I’m trying to do. I’m not trying to buy the best company in the market. I’m trying to buy the best opportunity, which is a combination of the prospects of the company, plus the price that you’re getting for those. And I think that that second part is the bit that folks sort of forgot a little bit over the last few years. It’s not just trying to buy the best company. You’re trying to buy the best return, which may be the second best company, but at a really good price.

[00:16:32] Robert Leonard: How do you see the opportunities with deep value or your mean reversion strategy? 

[00:16:37] Tobias Carlisle: One of the reasons that I am excited about the prospects of a crash is, I mean, I hate to say that because I know that it’s unpleasant periods of time to go through, but for my strategy, it’s an early-cycle strategy. Value is an early-cycle strategy. Deep value is an early-cycle strategy. When the crash comes, there’s no high. There’s this sort of idea, this received wisdom that value does better through a crash, and I don’t think that’s actually the case.

[00:17:11] Tobias Carlisle: I think that comes from people looking either at 2000 where value didn’t draw down as much, although in 2009 it certainly did draw down roughly in line with the rest of the market, or it comes from slicing, like looking at a year. So looking at January to January one, one year to December 31 in the same year, and then comparing that, those periods, just because value tends to recover first, so it gets the big bounce before the rest of the market bounces. And then it would appear that it hasn’t drawn down as much or it’s up slightly over that period.

[00:17:53] Tobias Carlisle: I think that we will draw down in line with the rest of the market, but then we’ll come out of the bottom, sort of likely leading the first value. Deep value just tends to be first out of the gate. It tends to be the thing that’s bought first. And I think that’s one of the reasons why I’m not worried about a crash so much, and I’d welcome it. That’s what creates the opportunities, and that will be what creates the outperformance for value on the other side.

[00:18:29] Tobias Carlisle: And if you look at markets around the world that have a similar setup to the one in the States and in a lot of the developed markets around the world, Japan is the obvious example where quantitative easing is a term that was invented in Japan. They had an extremely expensive stock market in the early 1990s, and that stock market still hasn’t recovered something 30-something years later.

[00:18:56] Tobias Carlisle: They had very low interest rates. They’ve never put their interest rates up, and I suspect the States will drop their interest rates back down again. The government has a huge portion of the economy. Nothing has really worked in Japan except for value. The simplest price ratios, price-to-earnings, price-to-sales, price-to-book, have all been quite good.

[00:19:19] Tobias Carlisle: Those mean reversion strategies do work in a market that goes sideways because you can buy these things when they get too cheap and they rise to average valuation. You rebalance the portfolio back into things that are too cheap, and that ratchets the portfolio up, and that works. It doesn’t matter if the market sort of goes sideways as long as you’re able to buy things that are too cheap and sell them when they get back to fair value.

[00:19:51] Tobias Carlisle: So I’m incredibly optimistic and excited about the prospects for deep value in particular, even though I think that it’s highly likely that the indexes are gonna struggle for probably 10 years.

[00:20:04] Robert Leonard: Last time you were on, you talked about how Meta, for people who don’t know, previously Facebook, was on your screener, and it looked very cheap on your Acquirers multiple.

[00:20:16] Robert Leonard: And I checked before our conversation, it’s not on your screener anymore because it’s gone up almost a hundred percent. I’m thinking since we talked, so I’m guessing that’s probably why it’s not on the screener anymore. And I want to use this company as an example of how we can think of using this strategy in your screener.

[00:20:39] Robert Leonard: Is this an example of a company that was cheap on your Acquirers multiple metric, and it was in your screener for that reason? And now, since it’s appreciated so much in price, it’s no longer cheap on that metric anymore?

[00:20:56] Tobias Carlisle: Right? So that’s exactly what’s happened. I think about this time last year, Meta came in.

[00:21:02] Tobias Carlisle: And I think it was like $150, something like that. It was very, very unpopular at $150 because it had been $300, I think it had been north of $300, and so it was at least down 50% from there. At that point, it was one of the cheapest 10% of stocks in the large cap, sort of in the Russell 1000, which seems crazy because if you looked at the underlying business, they’re still adding users all the time.

[00:21:34] Tobias Carlisle: They’re generating more revenue all the time. There’s very little hard assets in that business to generate extraordinary returns, and it all turns into cash flow that basically falls to the bottom line. The concerns were Zuck has this fixation on the metaverse, and he was investing a huge amount of money into this Metaverse idea, and there was a risk that that was gonna be completely wasted. I think even if all that money is completely wasted, it’s still a very, very cheap company. They could have paid that capital out as a dividend or used it to buy back stock. It’s the same effect. As it happens, I don’t think it’s wasted.

[00:22:20] Tobias Carlisle: Anyway, if you, at the time, I was running screens where I just looked at different things that were happening. So one of the things that I like to look at is just how much a company is investing relative to its depreciation and amortization, so what does its CapEx look like relative to its depreciation?

[00:22:42] Tobias Carlisle: There are only a handful of businesses that really invest a great deal more than their CapEx. Now, often the question is, to what extent is CapEx growth CapEx, and to what extent is it maintenance CapEx? So growth CapEx hopefully leads to growth maintenance CapEx. Obviously, it’s just to continue earning what you’re currently earning.

[00:23:05] Tobias Carlisle: Facebook was a standout on growth CapEx investment because it vastly exceeded its depreciation and amortization. Now, I don’t know to what extent some of it is maintenance, some of it is CapEx. I can’t really tease it out, but if your CapEx vastly exceeds your depreciation and amortization, it’s likely that a lot of it is growth CapEx.

[00:23:28] Tobias Carlisle: They were still earning a huge amount on the top line, and they were reinvesting a lot. I happen to like both of those two things, provided that the CapEx, the growth CapEx, actually leads to growth, which it seems to be in Facebook’s instance. So it’s a good example of just ignoring what everybody else says, as it happens.

[00:23:52] Tobias Carlisle: Meta fell from $150 and bottomed, I think, at $90 or maybe $88 or something like that. It was absolutely friendless at that point, and I think it was one of those stocks that people felt like they had been justified not buying at $150 because it fell to $90. We bought it at, I think, $156. That might have been the first price that we paid, and we were still buying.

[00:24:21] Tobias Carlisle: We rebalance on a quarterly basis. And when a position goes down, we just rebalance it back to equal weight if it’s still in our universe, things that we want to own. And I think we bought it two or three more times. We increased the size of the position as it went down. And then sub $90, it finally sort of found its bottom and it started bouncing again.

[00:24:49] Tobias Carlisle: I don’t know where it is today, but I think it’s north of $200. So for us, it worked out really well, and it was just a good example of ignoring what everybody else says, focusing on the financial statements, and letting the positions sort themselves out. It was an easy decision for me because the financials were so good.

[00:25:13] Tobias Carlisle: And then on top of that, I’d say Zuckerberg is a proven investor. He’s the owner-operator of that business. It’s a mind control machine, and he’s a Harvard sociopath who’s going to use it to make a lot of money. So I felt pretty good about the bet, even though it was going against me. I felt like all I could see was multiples coming in, which, you know, that’s par for the course for being a deep value guy.

[00:25:45] Tobias Carlisle: That’s what my entire book looks like. Multiples are coming in all the time, but the underlying businesses are still pretty good. And I think that we’re about to go into a period where the multiples won’t come in as much. We’ll go into a period where multiples start expanding, which is traditionally what happens.

[00:26:07] Tobias Carlisle: The big difference between, let’s say, two portfolios, is that a quality investor might look for something that is growing very rapidly, and they’ll find that those growth rates largely sustain. But the multiples tend to come in as a broad statement across that cohort, based on all of the testing that I have seen.

[00:26:29] Tobias Carlisle: That tends to be what happens. So you are guessing that it’ll grow faster than the multiples will contract. Because all businesses have this mean reversion over time where their growth slows, profitability reduces somewhat, and the returns on invested capital mean revert down. The value portfolios, on the other hand, have the opposite effect.

[00:26:51] Tobias Carlisle: The growth tends to go from negative to slightly positive, and the multiples tend to expand. Then all of the metrics start looking better. The returns on invested capital start improving. Everything starts improving, and that is mean reversion. And when people see that through successive reports, that tends to be why the multiple expands, the business starts growing, and that’s where I try to be.

[00:27:17] Tobias Carlisle: Historically, the research shows that tends to be the better place to make your bet. It’s much more forgiving at that point. You can be wrong on a few things and still, as a portfolio, do pretty well. So I think that the last few years have been anomalous for value. Historically, it’s done very well, despite what Charlie says.

[00:27:41] Tobias Carlisle: I see all of the signs of mean reversion still being there. It’s just that multiples have been running against us, and at some point, they’ll go the other way. And when that happens, everybody will be a deep value investor again.

[00:27:58] Robert Leonard: In Meta’s case, the mean reversion happened quite quickly. You could argue, and you know it was in your screener, and then it was out.

[00:28:08] Robert Leonard: So, how long do typical mean reversion trades last?

[00:28:12] Tobias Carlisle: The research seems to show that undervaluation leads to excess returns going out to about five years, but the returns are asymptotic. This means that the bulk of the returns are in the first year, then there’s a smaller amount in the second year, less in the third year, even less in the fourth year, and even less in the fifth year.

[00:28:37] Tobias Carlisle: By the sixth year, you should expect to get about a market return. The challenge for hold-forever investors is that they have to find something that is predictive beyond five years. And as far as I’m aware, there’s nothing, high returns on invested capital, which is what we all want to hold, is not necessarily what you want to buy because when you buy them, they tend to mean revert down.

[00:29:05] Tobias Carlisle: So you’re trying to buy things where they’ll be mean reverting up, which is what you find in value. So five years, but the bulk of it is in the first year. The way that I do it, I’m not, so Buffet characterizes himself as buying wonderful companies at fair prices, and he seems to have been very, very good at selecting those things that continue to grow and compound beyond the short term.

[00:29:35] Tobias Carlisle: And I think really what he’s achieved is he buys these great businesses when they’re at deep value prices. And then he gets that mean reversion in the first few years. So you think about his Apple position, where it was one of the cheapest 10% of the market when he bought it. Again, I’ve written about Apple a few times because it’s a funny sort of stock that was quite cyclical for a while.

[00:30:05] Tobias Carlisle: It doesn’t seem to be so cyclical anymore. The price more than the actual underlying, but it had this iPhone replacement cycle that happened every two or three years. So I wrote about it in 2013. It was one of the cheapest stocks in the market. It was also a very, very good stock at the time. And then, you know, it did quite well over the next three years.

[00:30:33] Tobias Carlisle: But then it went back into another one of its sort of three-year annual reversion to value territory. And it was again in the cheapest 10% of stocks. That was when Iron Horn and Icahn took a position. Einhorn said they should turn their cash into create this security called an iPref, which would have paid out some money. It’s just a financial engineering way of getting some credit for the additional earnings and the money that you have in the business. Icahn was much more direct. He said, “Just go and buy back a whole lot of stock,” which they ultimately did. They undertook the biggest buyback that the market had ever seen at that point. They did it as quickly as they possibly could. They were earning so much cash. When they completed it, they had a huge cash pile. Again, it got cheap again in about 2019 for whatever reason, in the cheapest 10% of stocks again. Buffett bought a giant position. He paid $40 billion or $36 billion, I think, and it had gone up three times. About 18 months later, it’s now like a five-bagger or something crazy for him on a gigantic investment like that. What he does though is he buys these things that have that deep value mean reversion in them. So he’s going to get that two or three times return over a short period of time, over the next three to five years. But then beyond that, it’s still a very good business. It has a very good ecosystem. It’s earning high returns on invested capital, growing, and throwing off cash, returning cash all the time. They’ve just announced another $90 billion buyback, which I think is a nice illustration of the difference between Buffett’s approach and Icahn’s approach. Icahn sort of buys a big position from the outside and screams at them until they do a buyback. Buffett buys a big position and then from the inside clearly has the same conversation but doesn’t attract as much ill feeling, perhaps. And they have another $90 billion buyback. So I think it’s a good illustration of getting a little bit of both, getting the mean reversion of the deep value companies and also getting the subsequent growth. I think that it’s much, much more difficult to do than it looks from the outside. It’s not just a matter of every quality investor finding a moat in every single business that they look at that’s earning high returns on invested capital. But if you look at it as a cohort, there really are many more high returns on invested capital than there are moats because most things have a business cycle or a business life cycle even where the business cycle is when times are good, they aren’t a lot. When times are bad, they don’t end much.

[00:33:43] Tobias Carlisle: The business life cycle entails a period of very high growth, followed by a phase of high profitability with lower growth. It is during this transition point that multiples tend to be slightly lower, and that’s when Buffett tends to buy these companies, as they become cash cows and return capital to him.

[00:34:05] Tobias Carlisle: For example, he recently purchased Oxy, an energy company. The reason he seems to have been attracted to it, which he explicitly mentioned in his Berkshire presentation, is because of a slide from Oxy’s own presentation that showcased the amount of capital they were returning to investors. Buffett doesn’t want them to reinvest in the pursuit of future earnings, particularly considering the energy cycle and the challenges of extracting oil, such as deep offshore drilling and short-term solutions like shale deposits. Companies with access to these deposits are likely to experience a period of overearning.

[00:34:43] Tobias Carlisle: However, the risk lies in management teams across the industry reinvesting all their earnings in pursuit of more earnings down the road, resulting in overpayment. To counter this, Buffett has made the slide public, emphasizing the importance of returning capital rather than reinvesting. He’s building pressure on them to avoid such reinvestment and instead return the capital to him for redeployment elsewhere.

[00:35:07] Tobias Carlisle: The challenge for quality investors lies in finding businesses that truly continue to earn beyond that point. It’s much harder to do than most people realize. To navigate this challenge, my approach is to target companies from the deep value pool, as some of them have the potential to transform into compounds.

[00:35:28] Tobias Carlisle: It’s kind of hard to believe, but I’ve been doing this for long enough now that I’ve seen it happen over and over again. They’re, they’re cheap because people don’t think they’re very good businesses, but at some point they transition. They either figure it out or the industry matures or whatever happens, or the business gets access to some asset that they haven’t had previously, and they start overearning.

[00:35:56] Tobias Carlisle: I think that we’re likely to see some of those businesses go through a normal business cycle and overearn. I hope that I own some of them, but I tend to be a buy and sell guy when I get that initial year or so return. And I think Met is another very good example of that, where we were buying it about this time last year.

[00:36:23] Tobias Carlisle: We bought it a lot as it went down. We’ve trimmed since it’s gone back up, and as you point out, it’s now left the screen, so it’s probably likely that it leaves the portfolios in due course here.

[00:36:39] Robert Leonard: When it comes to deep value and your screener and the acquirers multiple, what are other things you look for in terms of quality for companies you’re gonna buy that fit your valuation criteria that I just mentioned?

[00:36:54] Tobias Carlisle: Yeah, I like to see businesses that have a long period of operation. It’s a real business that has been earning money historically. They’ve gone through a rough patch, like energy, for example. Energy businesses, when they get going, will resemble software as a service with massive returns on invested capital. They grow quickly and generate a significant amount of free cash flow. People tend to avoid them because the past 10 years may look terrible due to overinvestment in shale, which reduced returns. Additionally, there has been an ESG push, leading to a lack of investment, but that situation will eventually change.

[00:37:35] Tobias Carlisle: I don’t know when exactly. The problem with value is that it’s a terrible timing tool. It’s not good at predicting when any of these things will happen. All you can say is that something is undervalued, and if the underlying business continues to work, then it’ll be fine.

[00:37:55] Tobias Carlisle: So, if you think about the things that you would consider as a business owner (I run a small business and think like one), there are certain requirements. Firstly, you need cash flow. Accounting earnings are great, but businesses live or die based on cash flow. So, I always like to see a significant amount of cash coming in the front door.

[00:38:19] Tobias Carlisle: Then, I’d like to see what management does with that cash flow. Are they reinvesting it into good projects? Are they using it to buy back undervalued stock? Are they using it for overpriced acquisitions? Are they using it to pay themselves too much? All of these factors indicate management’s attitude towards shareholders, and that’s important because they have the first look at the cash flows. If they waste them, it won’t translate into value for shareholders. However, if they utilize undervaluation to buy back stocks.

[00:38:54] Tobias Carlisle: It can really turbocharge returns for investors, and you can find many examples of companies in the market where the underlying business is shrinking. The underlying business is going backwards, like O’Reilly or AutoZone, or many of those businesses are in that sort of HPQ, which is the Pure Packard, you know, the printer business, like not the enterprise, not the sexy part of the business, not the services, but the printer business where.

[00:39:23] Tobias Carlisle: I’ve got a printer. I think I paid 300 bucks for it about three years ago. The only stuff I print out is stuff for the kids to color in. It’s hardly used for business at all. Everything’s done in PDF. Now, I know that it’s a dying business, but they’ve been so good at buying back stock. The stock has done very well, and it’s a stock that I have owned, but I don’t currently own, and there are lots of companies like that.

[00:39:57] Tobias Carlisle: So I like big fat buybacks of undervalued stock where they’re generating lots of cash flow because over long periods of time, that will lead to very good performance, and it tells you what sort of management team you are dealing with. You’ve got a management team that is thinking like an owner, and that’s really the key.

[00:40:21] Tobias Carlisle: That’s why you know Zuckerberg, for all of my joking criticism of Zuckerberg, he is a good businessman, and he does run that thing for the shareholders for the most part. So they’ve been very good at buying back stock when it was cheap. He’s figured out at some point here that the metaverse probably isn’t the direction that everybody’s going.

[00:40:45] Tobias Carlisle: It sounds like AI now is the if he’d said AI 18 months ago, they probably would’ve been fine, but instead he said the Metaverse. Now AI is very, very popular. They’ll probably say AI a lot now coming up. But the point is that whatever happens, they’re doing the right thing because they’re buying back stock, they’re running their business pretty well.

[00:41:10] Tobias Carlisle: They’re generating lots of free cash flow. They’re doing the right things with it. So that’s the way that I think about it. Just what would I do? What would a business person do if they’re in there looking after the shareholders? And to the extent that they’re doing those things, I think that that makes them much better bets than otherwise.

[00:41:35] Robert Leonard: How important is the portion of returns in the deep value strategy of buyback yields, companies buying back shares, whether they buy it at a high price, a low price, and also from the dividend yield? How important is that, or how much of a piece of deep value investing is that?

[00:41:56] Tobias Carlisle: I think, in aggregate, share buybacks are terrible for investors because share buybacks tend to be done when there are many more examples of companies that are overvalued and they see some weakness in their share price, and they’re just used to these share prices going up over time, and they think that to sort of prop up the share price.

[00:42:20] Tobias Carlisle: What they will do is conduct a buyback at a very high level, and you can see there are all these calls for, if you follow Tesla at all, you know Tesla’s now free cashflow positive. I still think Tesla’s been something that’s defied my expectations, so I should be very careful when I’m commenting on Tesla because I know a little bit, but not a lot.

[00:42:47] Tobias Carlisle: But let’s just excuse me while I give my 2 cents out of it, Tesla somehow made the leap from not making very much money to sort of generating free cash flow. So it seems hard to tell as financial statements are very difficult to parse for me, but it seems that it’s generating free cash flow just because the stock price has come back a little bit.

[00:43:14] Tobias Carlisle: There are all these calls for them to use that free cash to buy back stock, which I think would be an absolute disaster for them. They’re much better off reinvesting in the business to the extent they have any real free cash flow. It’s still too expensive to do buybacks. This is what every other management team does.

[00:43:38] Tobias Carlisle: They do these buybacks at too high a level, and they tear up value when they do that. You’d much rather have the cash than have them buying back stock. If the stock is very undervalued, though, it has a different effect. The cash buys more value. It’s worth more than a dollar. A dollar of cash is worth more than a dollar of value in a buyback because you can buy these things back undervalued and it concentrates the value of the business.

[00:44:11] Tobias Carlisle: The business doesn’t shrink the cash, which wasn’t being used anyway. It’s used to shrink down the size of the company that owns the business. And so the shareholders who remain get to own a bigger portion of the business. And if they do that over a period of time in series, you can find there are lots of companies that are very good at buying back shares, and they’ve shrunk their share counts by enormous amounts.

[00:44:42] Tobias Carlisle: Assured guarantee is a great one, “AG” is the ticker. You can look at the shares outstanding coming in all the time on that business, and they publish in their reports what they think their adjusted book value is because it’s an insurer. They publish adjusted book value, which is a pretty good proxy for what the actual thing is worth.

[00:45:07] Tobias Carlisle: And they’re trading at a big discount and buying back stock. That’s something that should work out over a long period of time. I don’t hold AG, by the way, I just use it as an example. It’s something that I have owned in the past and watched buybacks. Not so much you, you’re right in the sense that it’s short-term in the sense that it doesn’t really do anything for the ongoing business to do that. Some of the cash goes out the door, but for shareholders, it tells you something about the management team, and it actually does improve the value of the shares that you currently hold.

[00:45:51] Tobias Carlisle: So for those two reasons, I’m a big fan of buybacks done at undervaluation. And because our screens are imperfect, my screen is particularly simple because it’s only one metric: EV/EBIT. Then I screen out some of the things that I think are frauds or earnings manipulators and so on.

[00:46:11] Tobias Carlisle: But what remains is a very broad swath of the market. And so it might help to do some additional work in there, looking for cash flow and other things like that. But we’ve got this thesis for the companies that are in that screen, that they’re undervalued. And I love to see it confirmed by a management team who says, “Yeah, we think this is undervalued too. We’re announcing a material buyback. We’re gonna use genuine free cash flow or cash that we have sitting around that’s not being used in the business to buy back stock and shrink it down.” It tells me the management agrees that it’s undervalued. It tells me that they have the free cash flow to do something about that, or they have the cash sitting there, and it tells me that they’re thinking about the other shareholders, and those are three very good things.

[00:47:11] Tobias Carlisle: If you only screen on share buybacks or total shareholder yield, which is the same sort of idea, and you just buy the best, the ones that have the highest yields or the biggest buybacks relative to the size of the business, that strategy will outperform the market.

[00:47:30] Tobias Carlisle: So I like it. In addition to my own sort of undervaluation, the two together are very powerful, so I like it a lot as a strategy. It’s supported empirically, and I think it’s supported intuitively.

[00:47:45] Robert Leonard: I believe I heard in a previous interview you’ve done, it might have even been with us, that you exclude heavily shorted companies. Is that correct?

[00:47:55] Tobias Carlisle: I do. Shorts are smart. Shorts are very good at ferreting out things that might not be obvious to long-only investors like me. Sometimes there are things in the business that aren’t obvious from the financial statements, and I think short interest is a really great way of finding those things out, so it’s supported empirically.

[00:48:17] Tobias Carlisle: There’s lots of research on this, and I have conducted my own research. Heavily shorted stocks just don’t do very well. They tend to underperform the market. That doesn’t mean you want to be short those stocks because heavily shorted stocks have a lot of competition for shorts. The borrows are very expensive.

[00:48:39] Tobias Carlisle: You can be short squeezed. You don’t want a lot of people in there agreeing with you. When I used to short, I used to screen out from my short screen also the most heavily shorted stocks for that exact reason. Because I don’t want to be, you know, one of the things I think as an investor, the way that you get good returns is you buy things that people aren’t paying attention to.

[00:49:09] Tobias Carlisle: It’s too boring. It hasn’t done anything for a long period of time. It’s too scary. It’s in a business that nobody wants to be associated with. You look silly if you buy it. Those are all things that are great. It also works on the short side. They get crowded. You don’t want to be in a crowded short. But you don’t want to be long something that’s a crowded short either because the shorts are probably right.

[00:49:40] Tobias Carlisle: I just use it as a sort of, it’s my market gauge of, are there things out there that silly longs, that for whatever reason they pass the valuation filter and the buyback filter, but there are some smart shorts out there who have figured something out about this business that I can’t see from the outside. So I just use their skill. They’re actually putting, it’s not just an opinion.

[00:50:09] Tobias Carlisle: They’re putting their money down to short these things, like they have some skin in the game. So, I think it’s a very good metric, and I, I use it to avoid landmines that should have been obvious. Having said that, you know, it’s very rare that short interest excludes something from the kind of companies that I’m buying.

[00:50:32] Tobias Carlisle: Cause the kind of companies that I’m buying tend to have cash on the balance sheet, very free cash flow, generative and conducting a buyback rather. That’s not a company that you wanna be short for the most part. And they’re not. They just tend to be different universes. But I do these things because, and I include in that, I do.

[00:50:57] Tobias Carlisle: So, I use these statistical measures of earnings manipulation, statistical measures of financial distress, statistical measures of fraud, and you find that they all tend to be coalesce together. You don’t need to go and do any earnings manipulation if you’re not in financial distress. If you’re doing really well, there’s no need to manipulate the earnings.

[00:51:20] Tobias Carlisle: There’s no need to commit fraud. It’s the financial distress that drives them to do desperate things. And so when all of those things are together, and I include the short interest in there just in case for whatever reason, it just misses all those other screens. But there’s something in there that you should know about that somebody else has figured out and they’ve put money down and bet on it.

[00:51:49] Tobias Carlisle: That’s a good thing just to, just to avoid it until the short interest drains away. Maybe it’s a short-term issue, it’ll come back into the screen eventually, maybe it’s fatal, and then you’ll have just avoided a donut. But yeah, I think it’s a good metric.

[00:52:07] Robert Leonard: So what’s an alarming percentage where you might be worried or it would cause red flags?

[00:52:16] Robert Leonard: If you see this amount of short interest, what? What percentage is that for you? 

[00:52:20] Tobias Carlisle: I actually don’t know the answer to that because the way I do it is I just exclude the most heavily shorted stocks in the market. So I think I only exclude, like, the 1% that are most heavily shorted, which, in my bigger universe, which is the thousand, 1% is 100 stocks.

[00:52:41] Tobias Carlisle: And in my 2000-stock universe, 1% is 200 stocks. So it’s whatever all of the shorts have basically decided is most shorted. And, you know, I ran the Zig when it first came out, was long short, and so I had a short screen in there. And the names that were most heavily shorted didn’t make it into my short screen.

[00:53:06] Tobias Carlisle: I don’t really know what they were either, but shorts are always present in every single stock that you own. It’ll be 5, 10, 15, and that’s sort of meaningless. It’s when it gets up to, but I don’t know, it varies a little bit because the conditions for shorting are a little bit cyclical too sometimes, and we’re probably gonna go into a period now where it’s gonna become very difficult for shorts.

[00:53:35] Tobias Carlisle: You know, there’s some political unease with the shorts in the banks because banking is a confidence game, really. And I mean that in both senses of the word “banking.” Regional banks have got some problems because offices are so beaten up post-COVID. Office occupancy rates are still at like 50% compared to where they were pre-COVID.

[00:53:58] Tobias Carlisle: It’s gonna take a long time for that to work its way out, but there are many buildings that can’t pay their interest, and all of that debt is held by regional banks. The big increase in rates has meant that a lot of those books are underwater. I have a list of those banks, and it started with Signature, Silicon Valley, First Republic.

[00:54:24] Tobias Carlisle: There are others in there like Pack West Ally, all of these things. And I’ve just watched them go down that list, and each one of them, you know, it started with the most egregious examples, and as each one topples, the next one sort of comes into the crosshairs. And so the regulators say, “Well, that’s because, you know, the shorts are kind of causing this.”

[00:54:51] Tobias Carlisle: It’s not the shorts at all, but, well, as soon as there’s some political will to stop the shorts, then the short interest metric is not going to be as useful as it was before. So we saw this in 2008, 2009—they banned shorting. I’ll do it again when this market gets crazy. The day that they banned shorting will be one of, who knows what could happen in the market. It could be up or down 10% easily because that might be a signal that we’re in some real trouble, and it might also be a signal that people are gonna be forced to cover.

[00:55:33] Tobias Carlisle: It’s coming. We’re not there yet, but that’s why short interest as an absolute metric—I don’t really know, and I don’t really look at it. I just try to exclude the ones that are most heavily shorted, knowing that there will be periods of time like we’re about to go into where the metric might not be as useful as it has in the past.

[00:55:59] Robert Leonard: How do you think about with your investments, either potential ones or one, do you currently own? How do you think about insiders selling? Are you not too concerned with it because maybe it’s just a personal thing. Maybe they need some money to buy a house or pay for their college fund for their kids, or whatever the situation is.

[00:56:14] Robert Leonard: So it’s not. Too big of a deal, or is it sometimes alarming? Like what are those situations where it might be alarming? 

[00:56:21] Tobias Carlisle: Most executives are sellers most of the time, so it’s hard to tease out what is selling because something bad is going to happen and what is selling because they’ve had a little bit of a windfall, such as restricted stock units or options, and they’re just taking the cash.

[00:56:41] Tobias Carlisle: However, when they get options, the options have a strike price, and they still have to pay the strike price. Not everyone has large amounts of cash flowing around to pay the strike, so they tend to be sellers just to cover the strike on the options. Selling is a very tough indicator to draw any information from because they sell for various reasons.

[00:57:06] Tobias Carlisle: For example, they may sell to buy a house, buy a car, or pay the strike. A better source of information is when they’re buying because they only buy for one reason, and that’s because they think it’s undervalued. However, even with buying, one must be careful because it’s hard to distinguish between options being converted and executives actually using their own money to buy stock.

[00:57:33] Tobias Carlisle: I don’t use insider trading as a metric. However, if I were considering an individual stock that I really wanted to invest a significant amount in, outside of my portfolio, I would look at what insiders are doing. In those cases, I would be looking for signs. For example, in the case of Moderna, you can examine the selling activity. Those executives knew that they had a short-term opportunity to sell all their shares. Moderna was one of the vaccine producers, and it was clear that the demand was temporary. Those businesses that benefited from Covid were selling off their stocks rapidly.

[00:58:13] Tobias Carlisle: If I saw every executive selling all their shares, it would give me pause. However, I believe that, for the most part, executives are not great at understanding the value of their own businesses.

[00:58:27] Tobias Carlisle: Funnily enough, I know that, which is why they buy back stock at too high a price, and it’s also why they sell stock all the time. It’s a rare executive who truly understands the value of the business, and typically, they are the owner-operator, the main person there, the entrepreneur, the founder, or a very skilled investor in their own right.

[00:58:52] Tobias Carlisle: Warren Buffett would be a prime example of such an executive. He’s a… and there are other individuals like him, owner-operators and investor types, whom I pay attention to. However, for most other executives, I believe their actions are largely noise.

[00:59:08] Robert Leonard: As we wrap up the show today, before I let you go, tell the audience where you want them to go online to find, you get your books, your information, your content, where should they go?

[00:59:18] Tobias Carlisle: I have a website called acquirersmultiple.com, which includes links to my books, a screener, and possibly a link to my Twitter account. My Twitter handle is @Greenbackd, spelled G R E E N B A C K D, which is a humorous spelling choice. If you search my name on Amazon, you can also find my books there.

[00:59:41] Tobias Carlisle: Additionally, I manage a firm called Acquirers Funds. One of the funds I manage is called Acquirers Fund, with the ticker symbol ZIG. This fund focuses on midcap and large-cap deep value investments in the United States. I also manage another fund called Deep, which focuses on small and micro deep value investments in the states. I believe that both of these funds present unusually good opportunities at the moment because we have observed several years of weakness, resulting in highly compressed valuations in this segment of the market.

[01:00:17] Tobias Carlisle: While there may be some additional volatility to navigate before the situation stabilizes, I anticipate that the next three to five years will be particularly favorable for deep value investing.

[01:00:29] Robert Leonard: Awesome. I’ll be sure to put a link to all your resources in the show notes below. For anybody that’s interested, just swipe up in your favorite podcast player.

[01:00:37] Robert Leonard: You can click the links in the show notes below, or you can go to the investors podcast.com, find all the links there as well. Tobias, thanks so much. 

[01:00:44] Tobias Carlisle: My pleasure. Thank you very much for having me. It’s always a pleasure. 

[01:00:47] Robert Leonard: All right, guys, that’s all I had for this week’s episode of Millennial Investing, I’ll see you again next week. 

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