Clay Finck (02:25):

To help set the stage for our conversation today, could you start off by walking us through what you call your survivor and thriver framework that you put together for your fund?

Jeremy Deal (02:36):

Well, first of all, let me start by saying that our approach to investing is we’re not trying to make money by just trading stocks. There’s really kind of two ways to make money in the market. One is through trading and another is through buying and holding great businesses or just buying and holding and letting the value of that business compound. So, we’re in a business where our strategy is around the idea that we want to pick businesses that we can own for long periods of time, because they have the ability to compound fundamentally at a rate that we think will help give us a chance, at least, to outperform the S&P 500 without leverage. And so, that’s what we’re looking to do.

Jeremy Deal (03:19):

Our goal is not to make money by trading stocks. Our goal is to make money through the fundamental appreciation of individual businesses that we own. And so, the timeframe will be anywhere from three to five plus years. And we’re looking for businesses where there’s substantial potential that is not priced into the stock. And so it’s, I think, more common for funds and investors to think about what might be in for the moment like, hey, this stocks, what’s in is this, or we’re rotating out of that and buying this or now is the time to buy European equities, or now is the time to buy X, Y, Z natural resource, or now is the time to short this or that.

Jeremy Deal (04:02):

And so, our approach being, we want to pick a handful of businesses we can get to know well and a handful of businesses that we feel that over a longer period of time, we can develop a substantial competitive advantage in owning those businesses. We have a framework for owning them and call that framework the survivor and thriver framework for owning a business.

Jeremy Deal (04:23):

So, it basically comes down to four key characteristics for a business that are separate from valuation, but really refers to quality. And these aren’t hard and fast rules per se. It’s just more of a guiding light that helps us achieve two things. One, it helps us achieve not drifting too far out of that guideline and buying something just because it’s cheap. And secondly, it helps us to hold on to businesses, to hold on to great companies, when it’s difficult. When everybody else is selling, or when those businesses are no longer in favor. Because inevitably if you’re going to buy and hold a business for a period of time, it’s going to go through periods of trading fully valued, sometimes even premium to what it’s worth and at a discount to what it’s worth.

Jeremy Deal (05:10):

So you need a framework for continuous ownership of a business that is not just based on near term price movements or near term price targets. And so, the survivor and thriver framework is sort of like a guardrail to think about a business as we’re researching and thinking about, does a company still kind of fit our framework for continuous ownership or has something changed and it needs to be sold?

Clay Finck (05:34):

How did you come to develop these investment philosophies? Our overall economy and investment landscape has changed over the years. So, sometimes what we’re looking for in a business needs to change a bit with it. I know your philosophy is looking for businesses that are positioned to thrive in tomorrow’s economy. And you’re looking out for those strong and tangible assets that businesses have built, and of course, assessing management as well. So, how did you come to develop this framework?

Jeremy Deal (06:02):

The first criteria that we’re looking for is a business model that is adaptable and relevant in tomorrow’s economy. And the point of that is, do we want to make sure that we’re not investing in something and getting over excited about its price when looking out in three to five plus years, that it’s really just a melting ice cube or has a declining advantage or that is not really as relevant in what we believe to be tomorrow’s economy. So, it doesn’t necessarily mean that we’re investing in tomorrow’s technology per se, and technology is a sizable component to our portfolio. But it just means that we want to buy something that we feel will be more relevant because it is growing. It will become a bigger business in the future, not a smaller business.

Jeremy Deal (06:46):

And so in order for something to become a bigger business in the future, it needs to be more relevant in tomorrow’s economy. And maybe that means that the economy shrinks, but this business stays the same. But in actuality, it generally refers to a company that can grow its market share and has a competitive advantage that allows it to grow and fend off competition and compound its value over time. So, there’s a lot of businesses that we’ve studied in the past that helped us kind of come to that particular conclusion.

Jeremy Deal (07:17):

And one of my favorite companies to talk about is not a company that we own, is Nike. If you would’ve bought Nike in 1984, after Phil Knight signed Michael Jordan for, I believe, it was $500,000 and it was an amount that people just had never heard of a brand signing an athlete for that much money, especially an athlete like Michael Jordan at the time who was somewhat unknown or somewhat unproven. He was clearly the best and incredible athlete, but he was not anywhere near who he became.

Jeremy Deal (07:46):

The stock fell by about half. And so, what I think investors didn’t see at the time was that Nike was not just a shoe company, but it was creating a category. And when you walked around a city in the early ’80s or the mid-’80s, it wasn’t common to see 80% of people, 80% of men, wearing tennis shoes on a Saturday. It wasn’t common to wear athletic apparel outside of the gym. So what was happening was not only was Phil Knight an incredible innovator, but the return that came after that 1984, signing a Michael Jordan was something like 165,000% return adjusted for dividends.

Jeremy Deal (08:26):

And that didn’t come because he bought the company, he bought the stock cheap. I mean, it probably did help that the stock halved between 1983 and 1984, roughly, on a dividend adjusted basis. But the return, that 160,000% return came from the innovation of Nike creating a category that just didn’t exist before.

Jeremy Deal (08:47):

Not that we’re looking for brand new categories, but that was a situation where if you just looked at the business as, oh, this is just a shoe company and the shoe company, if you couldn’t differentiate between what Nike was doing and what other shoe companies were doing, or what other athletic companies were doing at the time, then you wouldn’t have been able to see the value. Because it’s not like the company got so cheap that you just had to own it for the price. But even if it did get cheap, even if it did trade for something ridiculous, this like two times free cash flow, which I don’t believe it ever did, but if it did get that cheap and that’s the reason you bought it, you wouldn’t have had the ability most likely to continue owning it.

Jeremy Deal (09:24):

Because if the only reason you bought it was because you didn’t really have a view on if the company would be more relevant in the future than the past then you probably would’ve found yourself selling it when it became fully valued over the course of the next two or three years. And you would’ve missed out on the vast majority of the return of the business. So, I know it’s popular today for a lot of companies to talk about they’re being more relevant in the future than the past. And it may sound cliché, especially with some of the more popular technology businesses. But I do think that it is very important because in business, you’re either moving forward or you’re moving backwards. There’s really nothing in between. You’re either dying or you’re growing.

Jeremy Deal (09:59):

So regardless of what kind of a company that we look to invest and regardless of what they do, whether it’s a food business, whether it’s a hotel, whether it’s a software business, whatever it is, we want to have a strong view that everything that the company is doing is to ensure they become more relevant in the future than in the past. Not just kind of hang out and be the same and sell the same number of widgets in five years or even less number of widgets in five years than it did five years before.

Clay Finck (10:28):

I think one of the biggest struggles for some of the value investors I work with or talk about investing with is figuring out a value on some of these technology companies. We don’t have to get into the specifics of some of the ones in your fund, but I see a lot of technology companies that either have like a higher price to earnings or maybe even negative free cash flow. So how are you able to determine a proper valuation on some of these trends you’re looking at where the companies you own are the leaders of those trends?

Jeremy Deal (11:03):

Yeah. We have two portfolio companies that are consumer technology businesses that probably screen expensive, I guess. But I think it all goes back to anything you invest in. If you’re going to make a long-term investment, you kind of need to have a framework for thinking about, well, what is this business doing to build its competitive advantage? And how is the addressable market for this company look net of competition in 3, 4, 5, 10 years.

Jeremy Deal (11:31):

I mean, the market is a discounting mechanism. So over time, if the company makes fundamental progress that’s substantial, it will be reflected in the price. So, one of the criteria that we have is we want to see that a business is self-funding. So, if we look at a business and say, wow, we think that this potential here is significantly undervalued and we think that revenue, cash flow, unit economics, whatever it is, it can be number of widgets sold, number of users could be five or 10X more in the next decade. We want to do some math and say, well, how much is it going to cost the company to achieve that?

Jeremy Deal (12:08):

And if we think that the company has to access the capital markets or raise money through debt or equity, and that’s a critical part of achieving that, then that’s not a business that is necessarily investible for us because it introduces capital markets risk, which we don’t necessarily want to take. I mean, it’s great when stocks are really expensive and it’s easy for companies to sell a stock to raise money to grow, but we want to invest when we believe that the company, regardless if they’re showing gap net profit or not, has an internally generated cash flow to fund a minimum amount of growth that we think would allow the company to get what we think it can go to achieve its objective that we can see as we understand it, as we’re modeling for over the next several years.

Jeremy Deal (12:48):

So it doesn’t mean that when a stock is overvalued, the company shouldn’t take advantage of those prices and raise some capital. Or if it’s a company that can access the debt markets and sell bonds 20 year, 15 year debt at 1% or one and a half percent interest. I mean, look at companies that we own in the past, I mean, like Charter Communications is able to sell bonds and we sell super long term debt at interest rates that were at one point little over 1%. Hey, if they can do it and use that to do buybacks, whatever, Godspeed, right. Get after it and do it. But it can’t be a critical part of bridging that gap between where they are today and where they need to go, where they need to be, in 3, 4, 5 years. And when that discount is really wide, it becomes a value investment in our mind because we’re purchasing a business what we believe is a substantial discount to its intrinsic value over our time horizon.

Jeremy Deal (13:41):

So, if it was easy to figure out valuation then, things would be efficient. And I do think it’s easy to figure out valuation in the short term. I mean, anybody can screen and look at a business and say, wow, it’s overvalued or undervalued today. Or, it’s relatively easy to kind of look at consensus on a well-known business and determine what you think it’s going to do in the quarter, as far as revenue or profit or how the debt profile of the business is going to look in a quarter. There’s no competitive advantage there. But what’s hard is to use the market, the stock market, as a way to purchase a stake in a business and align yourself with the tip of the spear kind of 1% leadership team or even founder, and kind of come to some sort of idea of like, what are they doing and how is this going to look in a few years?

Jeremy Deal (14:29):

I think that’s hard and that’s how we spend our time. I think it’s very hard to have an advantage by simply screening for a cheap company. Actually, I think, there’s no advantage there. I think anybody can hit a button and screen for a company with a dividend or a company trading an old bank that trades for a discount to book value that doesn’t tell you anything. And so, this idea of just mean reversion is not part of our investment framework. I mean, it was many years ago, but it’s definitely not the way we look at the world today.

Jeremy Deal (14:54):

So, one of the first things we do is look at it and say, well, can we understand what this business does today? Can we have a grasp on their competitive advantage? And can we get a grasp on why that competitive advantage is sustainable? And then, the second thing we do is take a look at the addressable market. Is the addressable market for this product or this service misunderstood? Is it much bigger or is this product going to gain market share? And the market doesn’t necessarily grow, but for some reason they’re going to gain market share in a way that’s not priced into the stock.

Jeremy Deal (15:23):

So, the research then starts maybe there at a high level and then moves down and deep, deep into the business, down into its peers, down into the sector. So we want to spend a lot of time in and around those sectors, in and around those industries to understand the sectors we’re in and the industries we’re invested in to understand, do we have this right? Is it a moving target? Or did we really miss something here? And so, price is important, but if you’re going to own a business, if you’re going to use the stock market to make a long term investment, I mean, we’re managing multi-generational capital.

Jeremy Deal (15:56):

So, we’re in a different position, I think, than traditional hedge funds that need to make the month or make the quarter, or even make the year in order to retain capital. So the vast majority of my family’s worth is invested in our fund. And so we run it with that mindset of like what would I do with my money? And what I think is risky and dangerous is to try to make short term bets based on market sentiment and where things are going. So, our focus on trying to figure out how a business is going to look in several years, it is more difficult than just screening for things. Yes. And then trying to fill in and justify why you think that’s a good investment.

Jeremy Deal (16:32):

But it’s more along the lines of look, we want to buy and hold this for three, five years and what’s the probability it’s going to outperform the S&P on a fundamental basis because it appreciates fundamentally in a way that allows it to do that. So it’s, I guess, you think of it as how would you act or what would you do if you bought control of a business? I mean, what does a private equity fund do? It buys a business and has a 5, 6, 7, 10 year time horizon. I mean, they don’t just kind of go on vacation, but outside of operational things, you’re kind of deeply involved in understanding what industry did you invest in and where is this going?

Jeremy Deal (17:06):

You’re at trade shows. You’re monitoring your competition. You’re talking to customers. You’re doing surveys. Your understanding where we can improve. What’s changed? What are the opportunities in the market that are evolving that we’re taking advantage of or not taking advantage of? So, the focus of the investment process is much more on the individual business than it is on the market or macro stuff. Because macro stuff comes and goes but what is continuous is unless the business goes out of business and goes to zero, the business will hopefully survive over time horizon. And what we want to make sure is that it not only survives but thrives.

Clay Finck (17:45):

Yeah. It always takes me back to the extreme example of Amazon. I was two years old when Amazon went public in 1997. But to my knowledge, over the years, Amazon was always expensive when looking at traditional metrics such as PE and price of sales. They weren’t optimizing for those metrics though, since they were in growth mode and reinvesting all of those profits back into the business. One of the quotes we talked about pre-show was Price is a Liar by John Burbank. What do you think John was getting at with this quote?

Jeremy Deal (18:16):

Yeah. I met John Burbank. And that quote that he used to say that all the time. And I think, generally speaking, price is a function of kind of what people believe something it might or might not be worth within a time horizon that they’re comfortable making a bet that day. It doesn’t make a lot of sense that a company, at the beginning of the day, is worth a hundred. And then by the end of the day is worth 95. The valuations, intrinsic value doesn’t generally change 5 or 10% in a week or a day. So price, a lot of times, is a reflection of sentiment in the market. So, if you let short term price determine the narrative, then you find yourself kind of just on the front lines of the rest of the market and almost handicapped, in a way, neutered, from an ability to make a long term bet because you’re at the whim of the herd.

Jeremy Deal (19:09):

So, we operate from this idea that price, in any given moment, it doesn’t necessarily tell you much about a business, but over time it does. I mean, Ben Graham was obviously the most famous for saying that over time in the short term, price is a voting machine, but the long term it’s a weighing machine. Buffet kind of built his whole career on that mindset and then buying businesses that he could buy and hold for really, really long periods of time. And like I said earlier, if you’re going to do that, if you’re going to own a business for 5 years or 10 years, if you’re going to own Starbucks since ’92 and achieve that 32,000% return or whatever it’s earned, including dividends over that time, you’re going to have to own it fully valued for a great deal of its life. I mean, businesses don’t just sit undervalued and compound at the same time for 30 years, it just doesn’t happen.

Jeremy Deal (19:58):

They go through periods of looking fully valued depending on how you look at it. So is price important, but price definitely does not tell the whole story. And more modern or technology asset like businesses fall much more into that because a lot of them don’t pay tax. A lot of them have a lot of long term reinvestment opportunities that are big and with long runways, I mean, maybe not all of them. But when businesses have a really long runway to reinvest at incrementally higher rates of return, they’d be crazy not to take advantage of that, right?

Jeremy Deal (20:28):

So, when a business has that long term opportunity, like you talk about Amazon, and I missed, I mean I’m guilty of missing it, when you can’t peel back the onion and say, wow, what’s really happening here, you miss stuff because it doesn’t necessarily show up in gap earnings because gap earnings does a really terrible job of measuring the intrinsic value of a business, especially in the short term.

Jeremy Deal (20:51):

I mean, you don’t see Google search engine isn’t sitting on Google’s balance sheet. I mean, you can’t look at the book value of Google and make a determination of, is this overvalued or undervalued? What is the search engine sitting there at? Or what is the Nike swoosh or the Starbucks logo? What is that worth? I mean, that’s not a line item that you can discount. Operational excellence and execution risk, for example, isn’t in earning statement, isn’t in the cash flow statement. These are things that you can’t get screening for a business and just simply looking at a snapshot of accounting because they’re just not going to tell you.

Jeremy Deal (21:26):

So you need a framework, whatever that framework is, whatever your objective is, you need a framework if you’re not just trading stocks. There needs to be a framework for how to measure and come up with something that’s just not sitting there in short term accounting because yeah, you’ll miss a lot.

Clay Finck (21:42):

I’ve been putting a lot of thought into this accounting idea where earnings are essentially understated because the company is simply reinvesting back into the business. And that is being shown as an expense on the income statement. Are a lot of the businesses you’re invested in using this playbook where they aren’t really optimizing for earnings today so no matter how you look at it, they aren’t going to look cheap using traditional metrics?

Jeremy Deal (22:07):

Well, it’s an opportunity to consumer tech businesses that really fit that bucket. And I know they’re kind of the topic of people who love to talk about kind of technology in general. But I’m not a technologist per se. I’m interested in value situations where I believe the potential of the business or the earning power is dramatically misunderstood, whether it’s because the addressable market is understood and the competitive advantage or the competitive advantage is misunderstood in a business or both. And I can figure it out. I can just clearly see and it just kind of hits me over the head like, wow, that’s obvious. And it’s sort of already happened, but we’re just now, in the business, in the harvesting phase. And yeah, of course it’s not going to be in the numbers. Why would that company pay tax when the opportunity to reinvest is still high?

Jeremy Deal (22:47):

So, I think if you go back in time, some of the best performing companies, companies that I admire, a company like JB Hunt, which is an old trucking company, it’s been an incredible compounder. It’s something like more than 20,000% return, including dividends since the mid-80’s or Danaher, which most value investors are largely familiar with. Companies are going through a transition like that they’re making a shift where they have an opportunity to invest in a way that’s nontraditional.

Jeremy Deal (23:13):

Domino’s Pizza is another example. The beginning of the.com boom, when the internet came out, they were the first company pizza business to say, wow, what an opportunity to be able to sell pizza online. And I think the retail food analysts were probably really skeptical of that and they had a view on Domino’s based on the price of cheese and the consumption of pizza and the market share over Pizza Hut or something. And maybe the tech guys that looked at Domino’s said, wow, this is just a pizza company.

Jeremy Deal (23:39):

But in reality, it was led by a team that was willing to be on the forefront of the internet revolution and basically be the first company that allowed one of the, at least that I know of, at scale that was able to kind of set up the first online pizza delivery. You could pay for a pizza with a credit card online and being the first to do that, being market leaders in that. And leveraging technology at the time to be more than just a pizza company, but to enhance the experience and make it a better experience for the consumer in a way that made them better. And that wasn’t going to be reflected in the income statement necessarily, but you would’ve seen a lot of debt that the company had at the time and yeah, they didn’t prioritize paying out a dividend or something.

Jeremy Deal (24:18):

I mean, they used that money to invest in new things and be on the forefront and it paid off and to own Domino’s at that time. The current company has been public since the early 2000s but whether the private equity fund or whatnot, that’s … The history of Domino’s is somewhat checkered as far as the original ownership. And then it was backed by private equity and it was taken public and it may have been public more than once. I’m not sure. But again, not a company I own, and I’m not an expert in that. Just sort of read a few articles on it.

Jeremy Deal (24:45):

But the story resonates with me that why they’ve been so successful. I mean, the stock is up over 6,000% since 2004, I believe. Why they’ve been able to outperform. And it’s because they had a reinvestment opportunity that was unique and they were willing to invest in that even if it took 3, 4, 5 years for the return to make itself apparent in an after tax kind of the income statement.

Jeremy Deal (25:09):

So, I think that’s critical if you’re going to buy and hold a business that has a long runway to reinvest in itself. And at the end of the day, there’s only a few things you can do. When a board has a bunch of cash, you can either return it to shareholders, right? You can do a buyback or you can do a dividend or you can look up as a say, wow, we have this really interesting, unique opportunity in our business that we’ve either pioneered or it’s just a happenstance. We can reinvest in that.

Jeremy Deal (25:35):

And if that reinvestment is in the form of people, which in a modern business, that’s really what’s the driver of a lot of value. So, if you look up and say, wow, we have this incredible opportunity, but we need to hire another 200 or 300 engineers over the next five years. And those 200 or 300 engineers are hundreds of thousands of dollars a piece because they’re best in breed or whatever the case. Yeah. It’s going to show up as an expense and it’s going to look kind of ugly on the income statement until that produces returns. Again, you need to have a framework.

Jeremy Deal (26:02):

One would need to have a framework around investing in that particular company to be able to understand it beyond just crack and open the 10Q and scanning the results and saying yay or nay.

Clay Finck (26:16):

I love that answer. And another idea I’ve heard repeatedly is that the future is really unknowable. And part of your investment philosophy is identifying businesses with significant competitive advantages that have a larger total addressable market than what the market gives them credit for. So I’m curious, how are you able to develop conviction on the long term total addressable market of a business with accuracy if the future is just so hard to predict?

Jeremy Deal (26:45):

And I agree with that. Let’s just back up a minute. When you make an investment in any business, you are investing in the future, you’re not investing in the past. So I think it’s an enormous risk, an enormous risk, to just assume that whatever happened in the past will happen in the future. Because what we know for sure is the future will be different than the past. So when I started out, I did a lot of mean reversion investing. And then, I was really gravitating towards distressed investing early in my career because it was a way … Like I could get kind of ahead of the market and invest in things, I think, were uninvest able by the average investor, because we could get an advantage through a lot of research.

Jeremy Deal (27:24):

And through that experience, through investing in upside down balance sheets or really big transitions that the market mispriced or just couldn’t invest in because they felt less certain. What I learned is that doesn’t really matter what you invest in, you don’t know the future. So you may really believe that you have insight. You may have talked to every single customer. You may have talked to every single supplier. You may have talked to every single kind of ex-employee or whatever. You read all the transcripts, or you did a ton of interviews, expert network interviews.

Jeremy Deal (27:54):

All it means is you have like a picture. You’re always sort of feeling around in the dark. But I think when you’re investing family capital, multi-generational family capital, and it is harder to take market trading oriented risks. It’s harder, at least for me to say, hey, I think that the price of X,Y, Z company or this sector is a good sector bet for the quarter or for the year. I think that that’s dangerous because you’re now betting on market sentiment.

Jeremy Deal (28:21):

So, if you’re not doing that and you know that the future is going to be different from the past and that’s the beginning of all investing and you’re going to buy something and hold it. What I think you have to do is to be able to divide it out into some period of time and have a framework for monitoring that investment. So, what you’re not doing is saying, well, I’m just going to go away for five years and go travel for five years and come back and let’s see what happen. You have to develop a framework to say, okay, what do we know? What is knowable? Well, there are certain things that are knowable about a sector.

Jeremy Deal (28:50):

I don’t think you could have gone back to Starbucks in 1992 and projected that it would be common for Americans to drink coffee at Starbucks at a coffee shop. Most Americans consume coffee at home and it was Folgers and a coffee pot like I grew up going to my grand mom’s house. There’d always be a half burnt pot of coffee, maybe pot number three. And it had that kind of burnt coffee smell. And she’d be like, oh, grab yourself a cup, grab another cup of coffee. That’s how Americans consume coffee.

Jeremy Deal (29:16):

And Howard Schwartz said, “We’re going to change that.” He went to Italy. And he said, “I think that we can create a coffee shop with flavored drinks or different kinds of drinks that will resonate with Americans,” And fast forward, we can’t imagine life without our Starbucks now. I mean the kind of average middle American that probably wouldn’t have gone out to a coffee shop and spent $2 or $3 on a cup of coffee in the Midwest in the early ’90s or the ’80s wouldn’t have imagined that this is a normal part of a society and your daily routine to go get maybe a Frappuccino or something.

Jeremy Deal (29:45):

And so, you wouldn’t have been able to say in 1982 look forward, hey, in 20 years, this is how it’s going to be. And I think that’s what’s misunderstood about investing. We’re not just taking a bet that the world will look a certain way in 20 years, but it’s about looking at what’s happening in the business. It’s about going and visiting a store. I wasn’t investing in 1982, but I imagine you could, just going back and reading some of the earlier annual reports of Starbucks when they went public and looking at the vision, what was Howard’s vision for Starbucks? And you could measure it. You could say, wow, this is what they’re doing. You could go visit a store and see, I mean, even 10 years ago, or 15 years, 20 years ago, you could go into a store and see that it was crowded, a Starbucks store, and see it was crowded.

Jeremy Deal (30:24):

And you could take that into consideration. You could sense some change that maybe your aunt who never had been to a coffee shop or never thought it was worth paying $2 or $3 for a flavor drink is now all of a sudden go buying one or two things. You can see that change and you can measure on a quarterly or a half year or annual basis. And you can look at the way a company’s investing. And you say, wow, this concept was successful. This store in this city was successful. And now they want to make that three stores. And you can say, well, is that a good idea? Well, probably because the first store worked in this location and the next three stores are in this neighboring location. There’s a high probability that those work. And then you can monitor those stores and say, wow, those are working too.

Jeremy Deal (31:01):

And now they want to grow this by 10 more stores in an adjacent city or to a city with similar demographics. And I think it’s a slow process, or while they made a mistake moving too quickly into this international market where they don’t appreciate the style yet. They’re not ready. People are still drinking coffee in a different way. And okay, they made a mistake in that country. So they’re pulling back, oh, wow. That’s interesting that they learned from that mistake and they’re going to reallocate in this way. So it’s just like owning anything, it’s unknowable but you can develop a framework for measuring short term success and short-term wins against a long-term goal. And that’s what we’re trying to do. And I think that’s what any real business investor is doing, whether you’re in public markets or private markets, hey, what is a long-term and what’s a dream?

Jeremy Deal (31:44):

And that’s great, but how does that look next quarter? Maybe not necessarily in after tax earnings, but if we’re creating a new category, do people like it? How is it being accepted? And finding a way to measure it that’s maybe outside just the typical consensus gap, earnings matrix. And by the way, I think that’s the same, like I said, you would want to do anything. You were trying to get ahead and trying to understand something beyond just what’s happening today that’s how you would … If you’re going to make an investment in a home, for example, and you saw that everybody in the town was leaving the town and even the last McDonald’s left the town because there were just no people left. But boy, that house is super cheap and you can buy it for $20 a square foot and only 500 miles away.

Jeremy Deal (32:30):

And this XYZ major city, things are selling for $500 a foot. Well, you don’t have to be a genius to look up and say, well, what’s really the bet here. If you’re the last person in the town and there’s only 10 people left in the town and it used to be this hustling bustling town. And that’s the reason you’re getting the price you’re getting. There’s a high probability that that probably won’t change in the next 5 or 10 years or so. You’re just looking at business for what it is. It’s a daily grind. It’s messy. Are they making progress? Is there business progress? Is there fundamental progress? And absolutely, you can have fundamental progress without showing gap after tax earnings in a business that’s not just fully mature

Clay Finck (33:12):

Relating to the gap accounting piece, I think a lot of investors are stuck looking at what used to work. Value investors always used to look for those stable companies with high free cash flows. Well, that method of investing might not be as effective anymore, at least, as it used to be. And a lot of these technology businesses are just being valued in a completely different way.

Jeremy Deal (33:34):

They are. And that’s an opportunity and that’s an enormous opportunity. I mean, if you think about the number of people in finance that can read a basic income statement or a basic balance sheet, it’s pretty high, right? It’s kind of like accounting 101. But the number of people that can do research and look at something a little more in depth is less. The amount of people that can spend full time on a handful of businesses that they can get to know better than the average investor is even smaller. The number of investors that can not only marry that with a long term time horizon is even smaller than that. So, I think, it’s an enormous advantage to have businesses that are asset light that are difficult to account for change in the business or traditional accounting covers up a lot of progress. It’s an enormous advantage to be able to do that.

Jeremy Deal (34:28):

I have a friend, Jeff Henriksen, that runs a fund called Thorpe Abbots Capital, and I don’t want to put words in his mouth, but he has a really interesting framework of looking at the opportunity that a business has to reinvest in itself. And I really resonate with this. And he talks about in one of his earliest letters, he talked about Amazon and showed in a graph. And if anybody knows who he is and wants to Google him, it’s a really interesting framework for looking at this.

Jeremy Deal (34:54):

One of the things he looks for is the change in gross profit. And so, the ability of the business to reinvest it’s internally generated cash flow, netting out any money received in the sale of assets or the sale of stock or whatever, and how that changes and the growth of gross profit. And he has a really interesting chart in this letter that shows how they deconstructed the value creation that was happening at Amazon for many, many years, and how the market missed it.

Jeremy Deal (35:20):

And then, all of a sudden, the market just caught up with it and just basically reverted back to reflect the intrinsic value that was being created at Amazon. A lot of people say, oh, it couldn’t have been known. What was happening at AWS wasn’t knowable and all that. And maybe that’s true, depending on how far back. Nick Sleep talked about his insight into owning Amazon, which I think is very profound and widely discussed today, which was the idea of scaled economic shared, something like that. And Costco has similar economics. He also owned Costco.

Jeremy Deal (35:50):

And there’s different ways to look at a business. It’s not just producing gap earnings, but the idea of kind of looking at a business as saying, wow, is it not paying tax because it has the opportunity to reinvest at incrementally higher rates of return? Or is it not producing cash flow because it’s just burning money, hoping that someday, the business makes sense and the business will work? And so there obviously are those businesses out there and several of them are public where you could argue that god, they could spend money till now to eternity and maybe never get traction and we don’t know. But I think you can find businesses that just have an enormous opportunity to reinvest capital at incrementally higher rates of return.

Jeremy Deal (36:32):

And that runway is so significant that even in rising interest rate environment that it just doesn’t because the opportunity is just there. And they have that competitive advantage to hold the line to be able to make those returns and finding a framework like Jeff talked about in the case of Amazon back in time to seeing the change in gross profit and in netting out … Change in gross profit as produced with internally generated cash flow and finding a way to measure that as a return as looking at it through historical lens was absolutely spot on for approximating or binding away as one of the approaches as a pure financial pure kind of spreadsheet type of perspective, without digging into the value of AWS, which would’ve been a different route or. Or Nick Sleep’s view on the Amazon business in general of the opportunity of taking scaled economics and sharing them.

Jeremy Deal (37:21):

But from a pure financial perspective, I mean, I think there are ways to see that. You just have to be able to do more than just take a very basic look at kind of after tax earnings or free cash flow. You need to be able to have a metric and say, well, what are the units of economics happening? What is happening in this business? And can they fund it themselves? And how does this return on investment look like? And for all of our businesses, we build a model and we say, well, what do we think they’re earning on incremental investment?

Jeremy Deal (37:46):

And we obviously believe that the money is much better spent reinvesting in and itself because it has the opportunity than it is being returned to shareholders. But as a small fund, meaning a fund with less than maybe 10 billion dollars to deploy, there’s just so much opportunity to find a handful of businesses that you could get comfortable with as a small fund that do have a really interesting opportunity to reinvest. Because as businesses become more mature, the opportunity for them to reinvest declines.

Jeremy Deal (38:15):

So, I won’t name individual companies, but there are many old, old economy businesses out there that are maybe well known consumer brands, food brands, whatever. They can’t really invest more than X. They make a hundred dollars and the maximum they can invest in CapEx is to maintain their market position is $20. And then they pay out 75% of that in a dividend, or there’s a buyback. And so, kind of the most you could hope for is the stock declines a little bit 20% or 30%, and then they can do a buyback maybe with that, or maybe they don’t do a buyback at all. But if you go back in time, those businesses, at one point in their history, had an opportunity to reinvest 100% of their gross profit or the earnings of the business, the cash flow generated in the business.

Jeremy Deal (39:02):

I mean, all the great businesses have had that opportunity in the past where they would be like, yeah, we have this opportunity to build another, to expand to another 20 countries. I mean, look at Coca-Cola for example, and I’m not saying that they’ve run their course by any means. But Coca-Cola back in the ’80s when Buffet invested had an enormous opportunity internationally, for example, to invest. And I don’t know how he got comfortable with Coca-Cola’s ability with all the local knockoff soda brands and emerging market countries back then.

Jeremy Deal (39:31):

But I have a sense he loved the product and he saw how unique the experience of drinking Coke was compared to the competition. And how the taste resonated in the palette and didn’t leave an aftertaste that allowed you to go back and have another one. And it was just a very drinkable product. And the company was so well run and at a scale where it could expand internationally. And so, looking back, I would imagine the opportunity was, wow, the opportunity is huge internationally, but it’s the opportunity to invest in those emerging markets and internationally and expand and not just return 100% of the capital to shareholders.

Jeremy Deal (40:04):

I mean, if Coca-Cola had looked up in 1985 and said, no, we’re done. We’re just going to return all of the cash flow we earn in just one big dividend every year. They may have had some dividend. They had a small one at the time or whatever. But if they just said, we’re done. We just want to get our stock price up. So we’re just going to return all the capital. Well, they wouldn’t be who they are today. Having the opportunity to reinvest at incrementally higher rates return or at least a rate of return that’s very attractive relative to interest rates and where interest rates are going is a critical piece to buying a company, to investing in a company that you think could not only survive, but thrive for many years.

Clay Finck (40:42):

How concentrated do you want your portfolio to be? And how did you land on that level of concentration? You mentioned earlier, you want to own a handful of businesses. So I’m curious, what your thoughts are around this.

Jeremy Deal (40:54):

We have around 10 positions because investing is hard and the more companies you have in your portfolio, the less you’re going to get to know those companies. There’s only so many great ideas you have. There’s this sayings that your 15th best idea is not as good as your 6th best idea. And that makes sense. I don’t think there’s any right recipe. I mean, what makes sense to me is to focus on a handful of businesses that you can develop the confidence and to own when it’s hard to own them because it’s going to be hard to own any stock at some point in its history. So all the people today that are piling into the trade of the day, the reason they won’t probably be in that stock or that sector in three years from now, let’s say, or even six months from now, is because the confidence. They don’t have the confidence necessarily to hold that business for a long period of time.

Jeremy Deal (41:47):

So there’s probably people that are a lot smarter than me that can develop that confidence over 25 or 30 or 50 companies. But because we’re not using the stock market as a way to buy and sell and trade our way to a return and we’re looking to earn that return through the fundamental appreciation of a business. It’s just difficult to have a diversified portfolio. I think that’s why Buffet always had such a concentrated portfolio. I mean, going back to the original, back when he took over Berkshire Hathaway, I think, if you look at the original portfolio of the first insurance company he bought, which was National Indemnity, the exposure had to GEICO was quite large and maybe two or three other positions was quite large.

Jeremy Deal (42:25):

And it’s because that’s where he had conviction. And that’s where he felt like he had a competitive advantage in making whether I think it was a combination of the stock and the preferred at the time, 20 plus percent of National Indemnity’s portfolio in those early days. And I think to gain that kind of confidence to own something when it is out of favor, because it will be out of favor. In our companies, in our funds presentation, we say, we expect everything we own to decline by at least 50% one time or more during the time we own it. And that’s because if you’re going to buy something and hold it, it’s going to decline.

Jeremy Deal (43:01):

It doesn’t live perpetually in favor. It will go through periods of time. Part of our portfolio today is really in favor. And that part of our portfolio was really out of favor for the first year and a half, two years that we made particularly one investment, a large investment. And then, we have another part of the portfolio that you can imagine that the consumer tech portfolios, two positions that are out of favor. And those were very much in favor in a couple of years ago. I made the investment before them, but they’ll be a period when they’re back in favor.

Jeremy Deal (43:32):

And so, you have to be able to develop that confidence to buy and hold something that you believe that, in our case, that can survive and thrive. And it’s hard to do that with 30 companies.

Clay Finck (43:43):

I really respect that high level of concentration as it obviously requires high levels of conviction in each position. And back to another Buffet idea, he has that punch card idea where …

Jeremy Deal (43:55):

Yes.

Clay Finck (43:55):

… 10 punches, you’ll think about investing a little bit differently rather than thinking, hey, I’ll just throw money in this company just because it’s going up. To transition a little bit, I’m curious, how often have you decided that you were wrong about an investment thesis and maybe talk about what that experience was like and how you came about those conclusions.

Jeremy Deal (44:17):

It’s a great topic because I don’t think people talk about their loses enough. I mean, I’d say the lens that I use to look at a business today and investment today is absolutely a derivative of all the mistakes that I’ve made as a manager and even in private investing prior to that. And it’s a combination of mistakes that were made even after the framework was put into place. And so, yeah, I’ve had many, many, many mistakes, but kind of at the highest level, I did this exercise maybe three years ago where I looked at every investment, the fund is made in the last 11 years, which hasn’t been that many. But what is the portfolio? What those companies look like if we would just continue to hold them?

Jeremy Deal (44:57):

And the first thing that popped out is, wow, the lower quality businesses that were traded cheap are actually still cheap today. Maybe they popped quick and we had the chance to sell the hot potato onto the next guy. But the higher quality companies continue to compound and outperformed not only the index but even our fund quite substantially. So buying low quality businesses just because they were cheap and chasing them probably was the mistakes of a mission. And then that along with selling high quality businesses and missing out on the bulk of the return, knowing that we had the investment thesis right, that’s the worst part.

Jeremy Deal (45:34):

Knowing you had the investment thesis right but selling it because you felt the valuation was “full,” that’s painful. So, not waking up and the business had totally shifted gears and like, oh god, if we would’ve just held it, but that was unknowable. I’m talking about selling something that was knowable, at least, or was part of the original investment thesis but selling it just purely based on valuation, not being just overly attractive, that was a series of continuous mistakes.

Jeremy Deal (45:58):

And those added up over time were, by far, the biggest, I guess, if you had to bucket them into mistakes since inception. But there have been several home run mistakes, if you will. And the real big mistakes are compounded by other mistakes. So, it’s not just buying the wrong business, it’s finding a way to continue to hold that wrong business or justify holding onto it. And so, I’d say the biggest mistake I’ve ever made was a company that I was also very public about owning it.

Jeremy Deal (46:28):

And I just had felt pressure to come up with a presentation or a deck to showcase our research to potential investors. And I had a lot of conviction around a business that felt somewhat mediocre or even low quality or commodity. But at the end of the day, it was a duopoly and almost a monopoly in its situation. And it was enormously undervalued. And that valuation, all I saw was, wow, the valuation is here. And if it was fully valued, that’s a 10X or whatever above what we paid.

Jeremy Deal (47:01):

And that lens caused me to ignore the warning signs that so many people that also had owned the stock and saw this presentation that we did, it was very public, would email me and say, yeah, but what about this controlling shareholder? I think that they’re not aligned at all with the minority holders here. And I think that they don’t have your back. I would look out below, oh, no, no, no, no, no. Because when something is cheap and you’re trying to convince yourself to own it, and you’ve also become very public about it and you’ve talked about it, it is harder to change your mind.

Jeremy Deal (47:34):

And so I’d say, this was one of our biggest mistakes. Not only was it a large position, but in fact, it was very cheap and it did have the characteristics that we thought it had as far as its market position made it almost a monopoly. And it was a duopoly kind of business. But the fourth criteria of our survivor and thriver framework today is a significant alignment of interest between the controlling shareholder management and the minority holders.

Jeremy Deal (47:56):

And we absolutely did not have that. And in the end, the controlling shareholder, we felt, took advantage of minority holders and actually forced a buyout of the business at a very, very distressed price. And I don’t want to go into it too much because the past is the past. But not only was the mistake hard to swallow because we had become so public about it. And we had actually even attracted capital because the idea just looked so incredible. And our research really was good. It was very unique research, but it wasn’t enough to overcome the fact that there was zero alignment between minority shareholders and the controlling shareholder, who found an opportunity through the structure, through the unique ownership structure, of the business to take advantage of the price at the time and force a buyout.

Jeremy Deal (48:41):

So, the repercussions of that were we had a horrible, horrible year. We actually didn’t lose very much money on the investment. But people started associating us with this company and we ultimately had to sue the company. And as a result of that, we did get a higher price than the buyout, but it was just a horrific experience. It sucked up all of my time and then some for many, many months. And it’s just something I’d never want to repeat again. So, even though we did have this survivor and driver framework, we didn’t talk about it as openly, but part of that experience caused us to really dig into the framework and go public with it and really talk about it openly and say, look, we need to have some bumpers to make sure that this doesn’t happen again.

Jeremy Deal (49:27):

It doesn’t mean that we won’t make mistakes again, but we don’t want to make mistake that could be prevented for some very obvious things. And for example, a company being very, very over leveraged or mismatched balance sheet, upside down balance sheet. We’ve invested in those things, some in our prior life and done well in some and some we just totally lost out. And looking back, it was somewhat stupid. We had part of the thesis right. But we missed something that was right in front of our face switch was, yeah, you’re right. They do have this awesome opportunity if the balance sheet looked a little different and you can’t overlook that.

Jeremy Deal (49:58):

In the case of our biggest mistake in the last few years, it was a misalignment of interest between the controlling shareholder and the minority holders. So yeah, I mean, it happens and we probably have mistakes today in the portfolio. We have something today that I kind of was thinking, well, probably had too much of it went down a lot, not just because of valuation, but just for other reasons specific to that company. But, yeah, there’s going to be mistakes, but we have gotten better, I think, at managing those mistakes through understanding why they were a mistake looking back and saying, could this have been prevented by making sure that whatever investment really met our criteria?

Jeremy Deal (50:36):

And I feel like we’ve gotten better, but that doesn’t mean that there’s not probably embedded mistakes today or more mistakes on the horizon.

Clay Finck (50:44):

Yeah. And part of your mission is to embrace mistakes and continually improve. And that’s just timeless advice and something I find a lot of value in. Jeremy, Thank you so much for coming onto the podcast. Before we close out the episode, where can the audience go to connect with you and JDP Capital Management?

Jeremy Deal (51:04):

Yeah, jdpcap.com is our website. And you can fill in your information and get our updates. So, we do two letters a year. And if you’re interested in more than that, I think it’s a fit. I mean, our fun presentation is available on the website. If you’re interested in more information than that, you can send me an email. So, information is there at jdpcap.com and, yeah, I appreciate the time and thanks again for having me.

Clay Finck (51:27):

All right. I hope you enjoyed today’s episode. Please go ahead and follow us on your favorite podcast app so you can get these episodes delivered automatically. If you’ve been enjoying the podcast, we would really appreciate it if you left us a rating or review on the podcast app you’re on. This will really help us in the search algorithm so others can discover the show as well. And if you haven’t already done, so be sure to check our website, The Investorspodcast.com. There, you’ll find all of our episodes, some educational resources as well as our TIP finance tool that Robert and I use to manage our own stock portfolios. And with that, we’ll see you again next time.

Outro (52:04):

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