Clay Finck (02:44):

I ran into your YouTube channel and I knew you’d be a fantastic guest. And you recently had a video talking about the current market volatility and it was pretty timely with what we’ve seen in 2022 so far. So what are some of the things investors should keep in mind during a market correction?

Tom Botica (03:03):

Yeah, it’s really interesting. So my investment strategy is very much kind of bottoms up stock picking, trying to focus on individual businesses, buy them at a discount to intrinsic value, as I’m sure many of the guests have explained on this podcast before. So it was a little bit unusual for me get probably slightly more macro in a video like that, and talk about broad market valuations and volatility, and fluctuations, and stock prices, and things.

Tom Botica (03:27):

But I think for whatever reason, people do tend to just suddenly kind of detach themselves from what their core strategy was when these things start to happen. So I sometimes go in recording those videos feeling a little bit like the grumpy old man, just trying to calm people down, where they’re kind of running around like headless chickens and things.

Tom Botica (03:44):

So yeah, the fundamentals of what I said in that video are fairly straightforward. What we’re trying to do, assuming that you’re a long-term investor, I guess if you’re a trader or speculator or something, it’s maybe a little different, but if you’re someone like me, I’m in my late 20s now and plan to be investing in stocks for a very long time. And I guess what I really want to do is accumulate as much ownership in great businesses as I can. And if I can buy those great businesses at cheaper prices than I could yesterday, that’s a positive thing from my perspective.

Tom Botica (04:15):

A little bit of short-term pain. I think as long as you’re a net buyer of stocks, over the long-term can be quite beneficial. I personally have sort of a watch list of investments that I’ve studied the companies over time. I think many of them are relatively simple businesses and are going to be larger in 10 or 20 years than they are today. And what’s always kind of held me back is just the price I pay for them. I’m maybe a little too cheap to pay up for some of these companies sometimes.

Tom Botica (04:39):

So it’s a really good opportunity when we do have volatile markets for people to refresh their memories on maybe some of the companies that they might have looked at 12 or 18 months ago, maybe update some of the evaluations. And then as I think we’ll get into maybe later in this episode, I have like an investment checklist that I kind of work through to try and keep me rational through these periods of time as well.

Tom Botica (04:58):

So I think certainly, if you’re someone that wants to liquidate your portfolio or something in the next year or two, obviously you don’t want stock market crashes at all, and that’s probably an asset allocation issue more than anything. I don’t think you should be in stocks if you have that kind of mindset, but I think it creates a lot of opportunity for the long-term buyer.

Clay Finck (05:16):

Yeah. I really like those points you hit on, stock market corrections tend to give really good buying opportunities. It’s a good chance to revisit your watch list, and to add onto that, something you mentioned in your video is that no one can really predict these corrections. There are so many factors that go into the market. No one can really accurately predict when these are going to happen. So we should always look to just buy great businesses at fair prices. And when those good opportunities come along, be ready to pounce on them.

Tom Botica (05:48):

Yeah, absolutely. We can look back through history and say, “Well, it would’ve been a great idea to be buying stocks very heavily in the financial crisis or in the tech bubble,” but the trouble is we don’t know about those kind of key points in time till a couple years after the fact. So you have to just take the opportunities that are presented to you and try and think with a clear head and a rational mind as much as you possibly can.

Tom Botica (06:11):

We are all human beings and we’re not quite as kind of savage, emotionless investors like a Warren Buffet or a Charlie Munger, but we can try our best to be.

Clay Finck (06:19):

Yeah. You’ll hear from these people that you call super investors, call it Warren and Charlie, or some of the others that you talk about a lot on your channel, and many of them are a part of the value investing community. They talk about investing with a margin of safety. Could you talk to our audience about what it means to invest with a margin of safety?

Tom Botica (06:40):

Yeah. That’s a concept that originated from Ben Graham and The Intelligent Investor, probably I think in the 1930s or ’40s, The Intelligent Investor came out. So that’s been a concept that’s definitely stood the test of time, and essentially, the margin of safety is all about trying to protect yourself from downside. And typically, that’s done by paying a price that’s less than you think that particular asset is worth. And this doesn’t just apply to stocks, apply to bonds or real estate, or whatever kind of cash producing asset you might be buying into.

Tom Botica (07:10):

And we hopefully all know the basic maths that if you experience a 50% loss, you then have to make a 100% gain from that point to kind of get back to where you started. So protecting downside is very important. There’s an old Buffet interview from the late 1980s I think it was, where he talks about, “The first role of investing is don’t lose money, and the second rule is don’t forget the first rule.”

Tom Botica (07:30):

So that’s really what margin of safety is all about. It can kind of take a few different forms. So if you’re investing in a company with a lot of physical assets, say a real estate business, for example, maybe you are buying into that company at less than what you think that real estate portfolio could be liquidated for. Maybe you are doing more of a discounted cash flow type analysis where maybe the company doesn’t have a lot of physical assets, like perhaps a Facebook or a Google, or something. Really, the value of that is largely intangible, and it’s about the cash flow, that computer code at Google and so on, can produce over time.

Tom Botica (08:04):

So you’re really looking at it similar to how you might assess a rental property and you’re saying, “This is the amount of cash I expect that particular company to throw off over time and what’s an intelligent price to pay for that?” And a margin of safety is simply paying less than what you think is a rational price to be paying for that asset. So it has kind of a nice double benefit, hopefully if your analysis is correct that is, of protecting from downside, but also potentially creating extra upside as well.

Tom Botica (08:29):

The typical modern portfolio theory sort of approach is in order to get higher returns, you have to take higher risk. And it’s not really common to get kind of these asymmetric situations with low risk and high return, but that’s what Buffet and Munger have been doing their entire careers. And they’ve done it by buying a $1 for 50 cents, is a very common way of putting it. So that’s how I think about margin of safety.

Clay Finck (08:53):

That makes sense. I think some important points there are, you’re determining what you think the business is worth, and then you’re comparing it to what the market is offering you. So if Apple’s trading at 160 bucks a share and you think it’s worth 200 or 250 bucks a share, then you might consider buying that because it’s trading at a price that is below what you believe it’s worth.

Clay Finck (09:16):

If you believe Apple’s worth 160 and is trading at 160, then you likely wouldn’t be purchasing that because there’s no advantage and there’s no margin of safety. And I think another important point there is adding conservatism to every purchase you’re making with your investments. So if you think Apple’s worth 200 bucks a share and it’s currently trading at 160, then that adds some conservatism, whereas the term margin of safety comes in.

Tom Botica (09:40):

Yeah, absolutely. I think it’s important to take a conservative view when you’re doing valuations. Again, it’s kind of another layer of margin of safety in these things. There are businesses like an Amazon or an Apple where… maybe not Amazon, that’s had a couple of, I think, 90% drawdowns at certain periods time, but perhaps even then it was still a good idea to have bought it at the top, on the dot-com bubble.

Tom Botica (10:00):

There’s businesses where you could have paid almost any price and it would’ve worked well, but to me, that’s a much more difficult game than kind of just hitting base hits, I guess, to give you a classic Buffet baseball reference. I think that’s an easier game than trying to hit home runs with high flyers and paying high valuations.

Tom Botica (10:17):

And intrinsic value calculations, I think there are formulas you can run and so on, but I think it’s important to build in those layers of conservatism. Just because you can run numbers in a spreadsheet or something, I think that sometimes gives people a false sense of precision. Intrinsic value is not something that’s on a financial statement or that you can calculate to several decimal places. Again, if Warren and Charlie were analyzing Apple, or even maybe Berkshire Hathaway did to understand when they think buybacks might be a good decision, they both know Berkshire Hathaway extremely well, and I think the two of them would come up with a different intrinsic value number for that same company.

Tom Botica (10:52):

So it’s part art, part science. And I think we are really not trying to buy a $1 for 95 cents. I think that gets into margin of error territory rather than margin of safety. We’re really looking for the big discounts and the big opportunities, the fat pitch as Buffet might describe it.

Clay Finck (11:10):

Now, like I said, you study many of these big investors, some others include Guy Spier, Mohnish Pabrai. You actually had Guy Spier on your show recently and I thoroughly enjoyed that conversation. And many of these guys develop an investing checklist. Why do you think it’s important that investors use a checklist when selecting companies to buy?

Tom Botica (11:32):

Yeah, so the checklist is a relatively new development for me, and it’s something that I picked up from Mohnish Pabrai and Guy Spier. They’ve both talked and written pretty extensively about the use of checklists and investing, and it’s really about trying to avoid mistakes I would say. I’m sure you’ve experienced this and a lot of other people listening in have experienced this, and I’m no exception either.

Tom Botica (11:53):

I can research a company, maybe I read a write-up on Value Investors Club or something and I get super excited about a particular company. And then I almost want to kind of rush out and buy it without perhaps having done the complete work on that particular situation. So a checklist is really just a way to slow you down and stop you from making errors that you or potentially someone else that you like and admire, mistakes that they may have made in the past.

Tom Botica (12:15):

So I have an evolving checklist. I think there’s about 30 or so items on there at the moment. And it’s really just to make sure that I think through these certain points, and I think checklists are quite individual. They have to be things that you personally maybe tend to forget about, or that you may have messed up on in the past with a particular investment.

Tom Botica (12:34):

So for me, it might be things like what has the share account done over time? Is there excessive dilution that I haven’t even gone into the financial statements and looked at? What does their debt maturity profile look like over the next few years? And can they service that debt comfortably? What’s management compensation look like? Do their incentives align with shareholders, or are they incentivized to maybe make decisions that might be really beneficial for the short-term performance of the business, but maybe harm the long-term performance?

Tom Botica (13:02):

These are all the types of things that I add to a checklist. Another one that’s been really useful for me recently actually, is instead of buying this new stock, would I rather just own more of an existing investment? That’s something that’s tripped me up in the past. I’ve put money into my third or fourth best idea or 10th best idea or something, rather than putting more money into my first or second best idea.

Tom Botica (13:20):

So those are things that I’ve stumbled on in the past or messed up on in the past, and those kind of go on the checklist. And then there’s also the whole idea of ideally, it’s much cheaper to learn from other people’s mistakes than your own. Admittedly, those lessons get set into your head a little bit more when you make the error and you lose the money, but there are common mistakes that large, well-respected investors have made through their careers.

Tom Botica (13:42):

And if we can learn from their mistakes before we go out and make them ourselves just to see that lesson, then that’s quite a useful approach as well. So I also have a few of those types of items on the checklist. One from Guy Spier, for example would be, is the business basically very reliant on the price of a particular commodity, for example? And if the price of that commodity were to move up or down 50% because commodities can move pretty wildly, does that kind of break the investment thesis? Those types of lessons.

Clay Finck (14:10):

Yeah. You mentioned adding to your third or 10th best idea instead of investing in your first, and it makes me think of balancing a portfolio, and how I balance my portfolio is something I’m contemplating all the time. Especially when it comes to like index funds and individual stocks, I kind of set a rule for myself. My 401(k) through my work. I just have that invested in index funds and I don’t really touch it and invest it in anything else.

Clay Finck (14:36):

So you kind of alluded to this earlier. Do you only invest in individual stocks or do you balance out with index funds as well? I’m curious what your take is on this?

Tom Botica (14:47):

My perspective on that has changed a little over time. So I’m based in New Zealand. We obviously have slightly different setups with retirement accounts and things over here, but I basically do the same as you and my… what we call KiwiSaver, equivalent of a 401(k) or IRA or something over in the US. That’s basically just an index funds. Part of that is because the options for investment are very limited over here and that’s kind of the best option I have.

Tom Botica (15:10):

So that’s what I’ve done. In some ways, I think about that as maybe a little bit of an insurance policy. Maybe if I’m not as good at picking individual companies as I think I am, I’ll still have something sitting there. And then outside of retirement accounts, I have had ETF investments that I’ve made in the past, and those still sit in my portfolio.

Tom Botica (15:28):

I’ve never touched them. I just got them set up to reinvest dividends and that sort of thing, like a lot of people do, and that will snowball away as a portion of the portfolio, but more and more I’ve become comfortable with putting money in individual companies. I don’t know that it’s the right strategy for everyone. I think you have to really enjoy studying businesses and value in businesses, and reading annual reports and listening to conference calls, and studying industries and so on.

Tom Botica (15:53):

And to me, maybe I’m just a bit of a nerd, but I find that really fun. I know a lot of people don’t. Indexing is a great option for people that don’t necessarily enjoy that stuff that will probably get most people to the finish line. I think actually consistently contributing money to investments in many ways is a lot more important than the actual returns that you generate. And I think a lot of people sometimes forget that, but I enjoy studying individual businesses. And that’s the vast majority of my portfolio now, is individual companies outside of retirement accounts at least.

Clay Finck (16:23):

Yeah, I think it just reminds me, some people just do it for the love of the game. They love studying businesses and that’s just what they love to do. And one of the items that’s been on my mind recently is the past few years, a lot of the overall stock market’s growth has been in just a few names, something like a handful of companies account for a fourth of the S&P 500’s gains.

Clay Finck (16:46):

When it comes to the stock market, I sometimes have a hard time justifying my stock picks because it’s so difficult to beat the market, which isn’t always some people’s goals. Sometimes they just want just steady returns over time and not such a bumpy ride, but I’m curious what your thoughts are on that topic? Is it worth the effort to try and pick individual stocks, especially nowadays with all the different market forces that are going on, that really can make it more difficult?

Tom Botica (17:14):

Yeah. It’s been a really interesting time. More or less if you had owned Apple and Amazon and Google as a big chunk of your portfolio, you’ve probably outperformed. And if you hadn’t, there’s a pretty reasonable chance you’ve kind of underperformed. That’s really been the story of the last decade. So that’s a really good argument for indexing because you automatically get exposed to the really, really large winners that drive a lot of the returns. But on the other hand, there’s going to be periods of time where probably the exact opposite happens.

Tom Botica (17:40):

Maybe you have a handful of extremely large companies that make up a third of the index or a quarter of the index or something, and maybe they just go sideways for five or 10 years. That’s something that has happened and will happen again, I’m sure. And then that’s probably a period of time where you’re better off kind of looking under the hood a little bit of something like the S&P 500, and hunting around in some of the smaller companies, and doing well.

Tom Botica (18:01):

The ASX over in Australia has been a pretty good example of that up until the past handful of years, the ASX performance for the overall index has not been spectacular, but there have been people who can kind of look under the covers at individual companies and find great businesses. And a part of the reason why the ASX has done that is because it’s very commodities and banking kind of heavy, but there are a handful of tech and software companies, and high return on capital type businesses that have done well.

Tom Botica (18:28):

So it probably depends on the market a little bit and I try and set myself the framework more around a particular hurdle rate. So that’s going to be different for different people, but maybe I’m going out there and saying, “When I make an investment, conservatively, I want to be confident that I can get 10% a year out of this business,” or whatever that hurdle rate is for you.

Tom Botica (18:48):

I think that’s probably a better approach for most people. I’ve got the compound 26 shirt on, which is Mohnish Pabrai’s number plate, because his hurdle rate was 26% a year [inaudible 00:18:56]. So I think having those absolute return kind of hurdle rates can be a very useful sort of mental model in markets like this. And over the long-term, I think that kind of plays out pretty well.

Tom Botica (19:07):

The stock market performance for the S&P 500 has just been spectacular the last decade, and I guess the just basic maths will tell you that that’s probably not going to continue forever, and returns are likely to come back to worth a little bit. So that’s where hurdle rates can be really handy.

Clay Finck (19:21):

You mentioned the Australian market and that makes me want to bring up the international piece. You live in New Zealand, I live in the United States. As someone who lives in New Zealand, I’m curious how you view investing in the US versus other countries?

Clay Finck (19:36):

If I’m buying an individual stock, I almost always have home country bias because I’m most familiar with the US. There are many great companies here and I think investing outside the US can introduce these additional risks that really, I can just avoid by just simply sticking with the US. How do you approach investing in the US, in New Zealand, investing in other countries? Are you mostly a US focused investor or how are you approaching that?

Tom Botica (20:04):

Yeah, I’ll invest more or less anywhere if I think I have a good enough understanding of the culture and the business. I think the culture part is probably the hardest bit to fill in if you’re not really familiar with that country. For people outside of the US, most people can get there on the US culture pretty easily, I would say. We are exposed to a lot of US companies and maybe it’s not the best way of understanding the US, but we get a lot of film and media and so on, come out of the US and things. So I think we get a pretty good handle on kind of what the US is all about. So that’s kind of a simpler enough one for me to get my head around. And then New Zealand, New Zealand’s obviously kind of my backyard and I’ve been to Australia a few times as well, and very similar culture to New Zealand so I can get there on a lot of those kind of companies as well.

Tom Botica (20:49):

So I’ll look anywhere. As it stands right now, the bulk of my portfolio is actually in the US. That’s more of a consequence of just the opportunities that have come up more than anything. The US has some great resources like 13F filings, for example, where we can see what great investors are buying. And that’s a really good way to kind of source ideas and that has led to more investments in the US for me. But if something came up in New Zealand and Australia, I would actually probably prefer to buy those.

Tom Botica (21:14):

There’s some tax differences for me, between buying something in New Zealand and buying something in the US. In the US, for example, you guys have the effectively like double taxation, when you get paid a dividend, the company pays money on the profits, and then you pay money on the dividend as kind of personal income.

Tom Botica (21:29):

We don’t have that in New Zealand. When we get paid a dividend, we have something called an amputation credit that kind of comes along with that dividend, which is essentially like a tax credit to avoid that problem. Australia has the same thing. They call it franking credits over there. When I buy an Australian company, I can’t actually benefit from those franking credits.

Tom Botica (21:44):

So there’s a few things to kind of keep in mind around that from a technical perspective, and taxation and so on, but I’ll look more or less anywhere if I think I could get my head around it.

Clay Finck (21:54):

Yeah. That makes sense. I hear of many people in the US that are looking international to try and find that additional value. There’s been a lot of talk and chatter lately about China, and people are kind of hammering down on Charlie Munger on his Alibaba pick, and some other people are invested in Alibaba as well. Is China a market you’re interested in at all? I’m curious what your take is on them?

Tom Botica (22:18):

Yeah. I have an investment in Alibaba as well. So you take this with a grain of salt, I guess, when you hear my answer, but China, I think is probably one of those ones that is really starting to get on the fringes in terms for me being able to understand the culture, and that sort of thing. For that reason, I think investors probably have a simpler time sticking with the really large, more well-known Chinese companies like an Alibaba or maybe a Tencent or a JD.com, that sort of thing.

Tom Botica (22:44):

When you start getting into Chinese microcap territory, that is basically an automatic no for me. It’s just really hard to understand what the competitive dynamics might look like in a microcap Chinese FinTech company or something. So those are kind of an easy pass for me, but I think with the larger companies, you can get your head around these things.

Tom Botica (23:04):

With companies like Alibaba, there’s been some great books written, there’s interviews with a lot of the insiders of the company. Obviously previously, Jack Ma, but he’s less and less kind involved with the core Alibaba business now. So I can kind of get there on those larger companies.

Tom Botica (23:20):

The other thing is that, and Charlie Munger said this at The Daily Journal meeting a couple of days ago, the large companies in China are just flat out cheaper than the similar types of businesses in the US. And of course, there’s risks that come along with that. A lot of people will know about the VIE kind of structure when you buy into something like Alibaba, where you are really buying like a derivative type ownership of Alibaba through a Cayman Islands entity.

Tom Botica (23:47):

So there’s certainly additional risks, but the companies by and large are cheaper. And assuming that if you have a view that these risks aren’t going to materialize, and that’s something that people can debate all day long, but if you have a view that these risks are kind of a little overblown, then if they’re cheaper and they’re potentially even slightly better businesses as well, that can lead to better long-term returns if you’re willing to swing at those things.

Clay Finck (24:11):

Yeah. It really just takes the additional research to really understand the business and the environment it’s in, and like you mentioned, the culture as well. Let’s shift our attention to a business you believe has a ton of margin of safety as we discussed earlier, and that’s Seritage Growth Properties.

Clay Finck (24:28):

This is a holding that Guy Spier and Mohnish Pabrai have, according to our TIP Finance tool. I think this is an interesting pick that I don’t think investors will find too often nowadays. Could you tell us about what Seritage Growth Properties does and how it even came up on your radar?

Tom Botica (24:48):

Yeah, sure. So a slight correction there on the Mohnish Pabrai front. So Mohnish Pabrai does still have a holding in Seritage, but he’s actually recently been selling out of it. So he has a large enough stake in the company to be forced to file a 13G filing, which is basically if you own more than 5% of the shares outstanding, you have to report any activity in terms of buying or selling those shares much more quickly than something like a 13F. I forget the exact length of time, but I think it’s within four or five days, something like that, they have to file a 13G.

Tom Botica (25:18):

So in January, Pabrai sold about 26% of his position in Seritage, and just kind of two days ago, literally as we are recording this, he sold about two-thirds of what he had left after that January sale. So it seems that Pabrai’s on the way out, which is quite interesting. Guy Spier, his YouTube channel with another investor called Matt Peterson, who runs a relatively small fund, but with a phenomenal track record, and those guys were still talking kind of quite positively about Seritage, both of them are in that position.

Tom Botica (25:47):

So the Pabrai sale is an interesting one to me. I sort of wonder whether it’s an opportunity cost thing, and he’s maybe found just something more interesting, and maybe Seritage was a kind of lower conviction idea for him, I’m not a 100% sure. I know if you follow Pabrai on Twitter, you’ll know he’s just been to Turkey and maybe he found something interesting over there, I’m not too sure, but that’s kind of the super investor ownership.

Tom Botica (26:08):

In terms of the actual business, Seritage is the one that’s been floated around kind of value investing circles for a number of years now. And it’s been a pretty poor performer. It’s basically a rate to real estate investment trust that was spun out of Sears pre-bankruptcy. So they currently own about 170 properties, largely ex-Sears stores when the spinoff first happened, which I think was about 2015 or so.

Tom Botica (26:31):

A lot of the real estate was still rented out to Sears, and Sears tenants were paying about $5 a square foot in annual rent. And the story at Seritage basically is they are redeveloping and even densifying a lot of these different sites. Oftentimes you have sort of a big portion of land with the Sears store in the middle and huge parking lots kind of around it. So in many situations, they’re bowling those over, putting up a partner buildings or larger retail complexes, and that sort of thing. And like I say, densifying it, so there’s more leaseable area for new tenants. And the new tenants over the past few years have been paying about four times the rent. They’re paying sort of $20 a square foot, even pushing close to $30 a square foot in some cases recently.

Tom Botica (27:12):

So that’s kind of the story with Seritage. They’re still very much in this redevelopment phase. They’re kind of selling off some of the properties that they view as less attractive for redevelopment. They don’t think they can earn high returns on deploying cash into those properties. And they’re taking the process from those sales and putting them into their larger premier developments, and that sort of thing.

Tom Botica (27:32):

So that’s the process and it’s very much still playing out, and the stock has been getting slaughtered as they’ve been going through it. So I think for the longest time, Seritage kind of floated around anywhere from maybe $30 to $50 a share, that sort of range. When the pandemic hit, it went all the way down to as low as I think, about $5 a share, and that’s kind of when Pabrai was buying, maybe in the $5 to $7 range.

Tom Botica (27:54):

Guy Spier was actually in it pre-pandemic. So he was probably in somewhere in that $30 to $50 range. And currently, I think it trades at $9 or $10. So it’s still very much down there. I’ve recently gone through the exercise of literally one-by-one getting comparable sales for every address that Seritage has. So I’ve got no affiliation with this company or anything, but there’s a website you can go on. And there’s a few of them.

Tom Botica (28:17):

There’s one called Crexi, was the one I used. And you can basically take an address for a Seritage property, throw it into Crexi, and get comparable sales starter. So you can look for similar size properties with a similar use. Oftentimes just down the street, there’s been a huge amount of sales while human commercial real estate recently. So there’s pretty good comparative sales, some kind of data out there.

Tom Botica (28:36):

And when I kind of went through that process and tried to value each of these properties, I was landing on kind of roughly about $4 billion in real estate for Seritage all up. They’re quite heavily indebted. So they have about $1.6 billion in debt to Berkshire. They actually paid off, I think $150 million of that recently. I apologize if I’m saying too many numbers here and it’s confusing people listening, but we have about $4 billion in real estate. We have, call it $1.6 billion in debt to Berkshire, little bit of preferred stock in there as well.

Tom Botica (29:04):

But I guess what I’m landing on kind of after going through all that work is a liquidation value for Seritage Growth Properties, if they were just to sell everything today, pay off the debt and distribute the proceeds to shareholders, north of about $30 per share versus a current stock price of $9.

Tom Botica (29:20):

Now there’s a few things hanging over Seritage maybe, which we can get into with the debt and the development kind of timelines and so on, but that’s sort of the current situation. So it seems like a lot of margin of safety at the moment, although Seritage does currently have negative cash as they go through this redevelopment process. So it’s very heavily shorted. There’s clearly a lot of people that have the view that Seritage is just going to burn money right through to bankruptcy and that’s kind of how it’s going to play out, but if you have a view that they can come out the other side of this okay with a lot of cashflow in real estate, then the upside looks pretty attractive too.

Clay Finck (29:54):

You had mentioned off air that there’s a property in Texas that accounts for much of the real estate that they own in terms of the market value of that real estate. Could you talk more about that piece of land specifically?

Tom Botica (30:08):

Yeah, sure. And this is one of those developments that has a ways to go. So one of my subscribers actually… This is one of the cool things about doing YouTube is one of my subscribers actually did a drive by of the Dallas property the other day and sent me some photos. So it’s quite cool to have a little bit of intel kind of in the region, but yeah, so like I said, SRG has about 170 properties. Within the 170, they probably have about five or six that are really going to drive a lot of the value for shareholders, assuming that they can get through this redevelopment process.

Tom Botica (30:38):

One of them is a property in Dallas, that’s really the big one. There’s plans that you can look up in terms of what they think that might look like. That’s what they call one of their premier mixed use properties. So it’ll be a mix of apartments and retail, and I think potentially some office as well, and that is planned to be about 2,000,000 square feet in leased build area.

Tom Botica (30:58):

So if you start to try and arrive on some of the values of what something like that could be worth, 2,000,000 square feet times, looking at market rents in the area for a blended kind of average rent across all these different types of real estate, maybe $25 a square foot. Cap rates on that type of real estate are probably conservatively, 7%, something like that. You could argue it’s closer to 6%, which is the equivalent of like a higher PE ratio, I guess, just in real estate terms.

Tom Botica (31:27):

You could quite easily land on that property being worth half a billion dollars potentially, and I just mentioned that I think the 470 properties are worth maybe $4 billion, and if half a billion is coming from one property, that’s pretty serious for Seritage, and that’s not the only premier development. That’s definitely the biggest one, but there’s a handful that will definitely drive a lot of the value for SRG.

Clay Finck (31:48):

Yeah. You mentioned that one property itself could be worth half a billion, and the stock right now is trading at something like $400,000,000, $500,000,000. So just that one property out of the 170, what are they developing that property in Dallas to be specifically? Is it apartment buildings, or what is that there?

Tom Botica (32:06):

I’d have to refresh my memory on the exact plans, but my understanding is that’s going to be a mix of things. So from memory, it’s going to be about 400 or 500 apartment units, quite a bit of retail space, and something else that I’m blanking on as well. I can’t quite recall if it’s office or another use, but it’s a whole mix of things. And that’s kind of the theme across all of their premier developments.

Tom Botica (32:25):

And yeah, like you say, the market cap is about 400,000,000 or 500,000,000 at the moment, but you’ve got to keep in mind the debt, they’ve got $1.6 billion in debt. So the enterprise value is closer to low $2 billion, something like that.

Clay Finck (32:37):

Yeah. Good point. My initial reaction when hearing about a company like Seritage, many of these value investors are saying the liquidation value is well above what the stock is currently trading at. My question is why? Why is the market valuing it so much lower than where it’s at? The market doesn’t have any free lunches according to the efficient market hypothesis, so what are the risks with Seritage?

Tom Botica (33:02):

Yeah, it’s a funny one. I always try to take the Munger idea of invert, always invert. So I actually have a video on YouTube that people can look up called something along the lines of Why Seritage Growth Properties Sucks? And I just went through all the reasons, all the things that could possibly go wrong. And yeah, there’s definitely some hair on it.

Tom Botica (33:21):

I don’t quite know what else to say. There’s a lot of debt, $1.6 billion in debt to Berkshire. They have recently renegotiated the terms on that, but it is quite expensive debt. I think they pay about 7% interest on that debt. They have an additional $400 million they can borrow from Berkshire, which they haven’t drawn down on yet. And they can only borrow that if they meet certain net operating income targets, but in the meantime, they still pay 1% interest on that debt.

Tom Botica (33:45):

And previously, all of that was due, I believe it was mid-2023, and Seritage is not going to easily be able to come up with $1.6 billion in cash, unless they liquidate a lot of their properties really fast. And their intention is to liquidate properties, to fund redevelopment projects and so on. So that’s definitely something hanging over them.

Tom Botica (34:05):

Like I said, they’ve renegotiated that debt structure a little bit. So now $800 million is due mid-2023. So only half of that amount, rather than the full $1.6 billion. And the other $800 million is due mid 2025, I believe. So that gives them sort of an extra two years of runway. And the CEO, Andrea Olshan has been at the helm maybe 18 months now. She has given a lot more clarity to shareholders on what their actual plans are.

Tom Botica (34:31):

There’s a document you can now look up for Seritage. I think it’s the Q3 financial supplement, which lays out every single property. And it says, “These ones are going to be retail. These ones are going to be apartments. These ones are just categorized as other,” which to me, that means they’re going to be sold to generate funds for the redevelopments. Previously, we didn’t have that. So that’s very useful from an evaluation perspective.

Tom Botica (34:49):

There is a lot of concerns about just the sheer price of redevelopment. We see every single day at the moment on financial media about supply chain issues and raw material costs, and so on. So the developments are likely to be more expensive and probably take longer than initially planned. Eddie Lampert owns about 40% of the shares, more or less through some of his partnerships, and people have mixed views on Eddie Lampert. So that’s kind of hanging over it as well.

Tom Botica (35:17):

And there’s been negative cash flows for a long time, and I think in a lot of ways, people have kind of just given up on Seritage and they’ve either thrown it in the two hard baskets, or they just maybe can’t see the light at the end of the tunnel. I’m not sure, but it’s certainly not risk free.

Tom Botica (35:31):

It reminds me a little bit of BP a few years ago when they had the big oil spill, and these numbers won’t be right I don’t think, but it should give you a feel for the situation I think. Let’s say BP was trading at roughly $40 a share kind of pre-oil spill. And it very quickly shot down to about $20 when that happened. There are a lot of people that had the view that it was going to zero. There are a lot of people that had the view that this is a short-term event. They’ll pay some big fines, but it’ll probably go back to $40 after that.

Tom Botica (35:57):

So you have sort of people in two camps. They think it’s either worth $40, or they think it’s worth zero. And what we know for sure is that it’s definitely not worth $20, but that’s where the market had priced it. So I think there’s maybe a similar situation happening at Seritage, where you’ve got two people on different sides of the aisle on the market price, kind of just land somewhere in the middle.

Clay Finck (36:14):

One of the questions with Seritage I had was I see so many of these companies end up getting bought out, especially when they’re trading at a value much lower than their current market price. So say someone buys the shares that they think it’s a great deal, 20 bucks. It trades down to $9 where it’s at today, and it ends up getting bought out at a premium, call it $12. Is that a concern for you at all? Or is that even a possibility for Seritage?

Tom Botica (36:39):

Yeah. Guy Spier has done a talk on this exact topic, and he listed that as what he thinks is the biggest risk at Seritage. He thinks that there’s a chance he gets kind of bored under essentially. I don’t think that anyone would have the capacity to do that other than Eddie Lampert because he owns a huge amount of the shares.

Tom Botica (36:58):

So if anyone tries to buy out Eddie Lampert at these prices, he’s probably going to say no, but there’s a chance that Eddie could do it. So I think that is one of the larger risks in terms of the upside disappearing for SRG.

Clay Finck (37:10):

Now, Tom, you’ve looked at the liquidation value of Seritage, but I would think they want to try and go towards the path to profitability. They’ve had negative cash flows over the last few years. When do you expect that to turn positive? Is it a couple years, four years? What are you thinking on that?

Tom Botica (37:28):

It’s a little bit of a tough one to say exactly. I would be very surprised if it’s not within the next two years sort of. It’d be nice if it was as soon as possible, but I’d sort of think it through what’s realistic. It looks like the first stage of some of the bigger developments should be online either right at the end of 2022 or early 2023. They are going to continue to sell some properties and a lot of those empty buildings right now which are bringing in no rent, but still do have some kind of carrying costs. So we’ll drop off some expenses from that.

Tom Botica (38:01):

And then the other part of the equation which makes it kind of tricky from a cash flow perspective is they may get to a point where they’re sort of profitable assuming that they have no more capital expenditure. Like if they were just to pause all redevelopments, cash flows would be positive, but they’re still going to have to recycle a lot of capital out of the properties that have been sold, and to funding newer, rather expensive developments. So some of the work that other investors have done on this, like Matthew Peterson is a guy that’s done a lot of work on this topic and he still thinks Seritage has about $800 million kind of for spend on redevelopments, and I think that number involves some debt servicing as well.

Tom Botica (38:37):

So it’s really hard to pin down exactly, and they haven’t given exact guidance on this, although they have started to be more detailed in some of their redevelopment timelines. So yeah, I’m hoping those cash flows turn sooner rather than later, but I’d be surprised if they were fully cash flow positive in the next six to 12 months, but not too long after that, we should hopefully be turning the other direction.

Clay Finck (38:59):

Will they need to be issuing more debt to cover all of these construction costs coming up, and redeveloping these properties?

Tom Botica (39:09):

Yeah. The debt is kind of one thing that’s definitely hanging over them. They have been quite clear in saying that they want to move their finance from sort of the overall Seritage Growth Properties level with the big loan from Berkshire, down to more of an individual property kind of financing level. They did an investor presentation mid to late last year, kind of suggesting that they thought with their kind of debt to book value type ratios, they should be able to get property level financing and more of the 4,5% interest range, versus 7% that they’re paying now.

Tom Botica (39:39):

Perhaps the equations changed a little bit with inflation potentially driving some higher interest rates. We’ll just kind of have to see how that one plays out, but they still do have a lot of liquidity they can make available from selling property. So when I went through that property by property valuation exercise, all of the properties listed in the category kind of other, which again, I view as kind of properties to be sold, it looks like they have approximately kind of $800 million that they can make available from selling those properties.

Tom Botica (40:07):

And of course, that’s not something they can just grab tomorrow. It is a process to sell a large number of properties, but that’s definitely a lever they can pull and will likely pull. And so to answer your question, I think there will probably be a shift in debt from down to the individual property level, whether the actual total amount of debt goes up or not. I would be surprised if it goes much higher than where it is now, but I don’t think it’s completely out of the question, and they’ve already paid off a small amount of debt.

Tom Botica (40:35):

So they’ve paid off about $150 million of that $1.6 billion. So I think that’s something that we’ll continue to see certainly leading into mid ’23 when the big $800 million in debt payments is due to Berkshire.

Clay Finck (40:48):

That’s interesting. Now, the stock was trading roughly $38 a share prior to the COVID pandemic. And today, like we mentioned, trades around $9 a share at the time of this recording. Why hasn’t the stock recovered to go anywhere near the pre-COVID levels? Is it the markets not liking the commercial real estate it has, or what do you thinks going on, on that front? What has changed from then to now?

Tom Botica (41:17):

Yeah, it’s really unusual to me actually. And obviously, all this stuff is simpler in hindsight, but the pre-pandemic prices kind of look a little rich to me. I’m talking liquidation value numbers potentially lower than where it was trading pre-pandemic. So perhaps that’s part of it that it was kind of a little rich at that stage. We have seen the likes of Pabrai start to sell and he’s a big owner in the overall company. So perhaps that’s put some downward pressure. And Pabrai is the shameless cloner and there’s a lot of people that shamelessly clone Pabrai as well. So perhaps there’s a bit of flow on effect of kind of a lot of people selling there.

Tom Botica (41:50):

In terms of the actual story at Seritage, from my view, it’s been increasingly positive. The new CEO has given us much more clarity on what they intend to do with the different redevelopments versus scaling. They’ve given a lot more clarity, and when I say a lot, they’ve said they want to move down to the individual property level financing. “We think we can get 4,5% interest.”

Tom Botica (42:10):

That’s kind of in contrast to the previous management, they didn’t even say anything to do with debt. “We have a loan from Berkshire and it’s due in 2023 or whatever,” and that’s kind of all we got. So to me, I think the story at Seritage has only really improved in the last 18 months. So it is very strange to see the price kind of still at a level where it’s at now.

Tom Botica (42:31):

I wonder if it’s rising interest rates potentially flowing through to commercial real estate prices. Maybe there’s some fears around that just in real estate stocks generally, that are keeping SRG a little depressed, and they are very leveraged. So if we have a 10% move in commercial real estate prices, that’s going to be exponentially greater for the [inaudible 00:42:52].

Tom Botica (42:52):

So hard to pin down exactly what Mr. Market’s thinking, of course, but those are a few things that come to mind, alongside perhaps higher construction costs for the redevelopments as well.

Clay Finck (43:03):

Right. That is interesting. Now my final question about Seritage. I think of what Warren Buffet does. He likes to get ahold of great businesses at reasonable prices, and pretty much hold them for a very long time, but I’d be surprised if that was the case with Seritage for you. So do you have a price target in mind which you’d consider selling your position? Or how do you think about that?

Tom Botica (43:26):

Yeah, that’s an interesting one. And it’s funny you bring up Warren Buffet. We haven’t mentioned it in this podcast, but Warren Buffet did own 5% of Seritage. I’m not sure if you knew that or not. There’s actually a couple of different share classes at Seritage. So there’s the class A shares that trade publicly, and then there’s Eddie Lampert’s operating partnership units.

Tom Botica (43:42):

So if you combine those together, there’s about 55,000,000 shares, but in practice there’s less class A shares outstanding 50 odd million, and Eddie Lampert can convert those on a one-to-one basis from his operating partnership units into class A shares. So when he’s sort of done that conversion, I think that’s diluted, or at least from a 13G filing perspective, I think that’s diluted Buffet under that 5% threshold, who doesn’t have to report anymore.

Tom Botica (44:05):

So it’s a little bit tricky to say whether he actually still owns it or not, but I think he was certainly in there at some point. And it’s interesting because he’s on the other side of the equation with debt from Berkshire. So he’s got involved personally on the ownership of SRG and then with Berkshire on the debt side.

Tom Botica (44:19):

So that’s interesting, but yeah, in terms of long-term plans for SRG, there’s kind of two ways to value these real estate companies. So there’s the comparable sales data kind of process, which I’ve gone through recently, and then really, the best way to be doing it once we have cash flowing real estate is to value it based on that cash flow, understand how much rental yield that SRG is throwing off, put in market kind of cap rates on that, and then subtracting other debt, just like you might value a rental property really.

Tom Botica (44:47):

And there’s still, I think… Well, there’s still a lot of uncertainty about exactly how much cash Seritage could potentially throw off. So the selling decision in the short-term for me, I think it would be a little bit of a miracle personally, but if it’s somehow shot close to what I think the liquidation value is in the short-term, I would reconsider.

Tom Botica (45:05):

Longer-term, I think once we have a much clearer understanding of what cash flows kind of SRG throws off, we can get a more concrete understanding of what it might be worth, and then I’ll have to reassess. So selling is a lot harder than buying. I don’t know if that really answers your question, but those are the things that I’m kind of thinking through, at least with this one.

Clay Finck (45:25):

Tom, I really appreciate you coming onto the show. I really enjoyed this conversation. Before I let you go, where can the audience go to get connected with you?

Tom Botica (45:36):

Yeah, I appreciate you inviting me on. I have a few different kind of platforms that I put content on. The main one is definitely The Investing With Tom YouTube channel. I sort of post two to three videos a week on all things investing, with the odd kind of personal finance video thrown in there.

Tom Botica (45:50):

I’ve recently started The Investing With Tom Podcast, which is only kind of a project I kicked off last year, but had the opportunity to speak to some great guests. William Green, for example, who I know you guys are working with now, and also just had Guy Spier on the podcast last week, which was kind of a surreal experience to be perfectly honest with you. But I do have The Investing With Tom Podcast as well, which you can find on all the standard audio platforms, Spotify and Apple Podcast, and so on.

Tom Botica (46:16):

And there also is a video version of that on YouTube. You can follow me on Twitter @TomInvesting. I’m getting a little more active on Twitter. And the final one I’ll just plug briefly is I actually have a collaboration YouTube channel called Punch Card Investing where I’m one of five YouTube kind of value investor types that get together once a week and do kind of a one hour livestream on a particular topic.

Tom Botica (46:39):

So we’re going to do one about four or five hours after us recording this year podcast. We’re going to be talking all about the recent 13F updates and that’s always fun to get some live interaction, and kind of take questions from people watching as well.

Clay Finck (46:52):

Good stuff. I’ll link all of that in the show notes. And those two guests, you mentioned William Green, I had him on the Millennial Investing Podcast. He’s a fantastic guest and I listened to your conversation with Guy Spier on your podcast. I’m happy to see your podcast is doing well, and it’s just a really fun opportunity to chat with these, “Super investors.” So Tom, thanks again for coming on.

Tom Botica (47:13):

Yeah, I appreciate it. This was good fun.

Clay Finck (47:16):

All right, everybody. 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. And if you haven’t already done so, be sure to check out our website, theinvestorspodcast.com. There, you’ll find all of our episodes, some educational resources we have, as well as some tools you can use as an investor.

Clay Finck (47:36):

And with that, we’ll see you again next time.

Outro (47:39):

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Outro (48:00):

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