[00:03:12] Rebecca Hotsko: So for our listeners who just need a refresher on this, can you break down what this is? 

[00:03:17] Tobias Carlisle: Buffet is well known for. He’s a value investor, first of all, so that means that he’s trying to identify companies that are trading for less than they’re worth, and then to buy them with the idea that over time mean reversion takes the underlying value to the price, or vice versa, the price of the value.

[00:03:36] Tobias Carlisle: He has said many times that given that value is a very broad church, there’s a lot of different ways that you can invest in value, and what Buffet is looking for is a company that grows over time. You’re getting the improvement in the intrinsic value at the same time that you’re hoping for the discount between the price that you pay and the intrinsic value to close.

[00:03:55] Tobias Carlisle: And so what he has said is that he looks for wonderful companies at fair prices. So he defines a wonderful company as a company that has a high return on invested capital. So that’s the amount of money that the company earns scaled by the amount of money that it has that is invested in the business to generate those returns.

[00:04:14] Tobias Carlisle: Businesses, that software as a service tend to have quite high returns on invested capital because there’s not a lot of capital in the business. On the other hand, you might look at something like a manufacturing company, like a car manufacturer’s a billion dollars to set up a plant. Every time you sell a car, it has to be able to earn relative to the amount of money that you’ve invested in that business to generate those returns.

[00:04:35] Tobias Carlisle: So it’s just a way of comparing, allowing better businesses. You should expect to pay up a little bit more for better businesses. That’s the. The problem is that when you come to test that and you don’t have buffet’s, sort of supernatural ability to identify these companies that can sustain those high returns and are invested capital, the market is very good at sniffing out these sort of super economic profitability, and so they’ll [00:05:00] be, it’ll induce a lot of competition in businesses that aren’t cyclical businesses.

[00:05:04] Tobias Carlisle: So for example, oil filled services or energy, just as an entire sector. There’s been a lack of investment in energy over the last decade bec for a variety of reasons. ESG mandates some legislation. Some of it’s just the price of the commodity. When it’s hard to generate returns in a sector and there’s discouragement from investment, you’ll find that over time there’s not as much invested into the entire sector, which leads to this period of sort of higher returns for those people who are in that sector and that super normal profitability might show up as a high return and invested capital.

[00:05:36] Tobias Carlisle: But really it’s a cyclical part of the cycle. It’s the business boom part of the cycle that encourages a whole lot of investment back in. People drill more holes, people retool old wells, thorough wells that are marginally. Expensive than others. They all come online, and so the price is pushed back down again by virtue of how much money is invested in it.

[00:05:54] Tobias Carlisle: It’s not a simple process to say, we’re just going to buy wonderful businesses, fair prices. [00:06:00] If you’re looking for a simple approach, a quantitative approach, it’s better to say, we’re going to try and buy fair companies at wonderful prices, which is to say, let’s just say we have no ability to figure out how high quality these businesses are, and we can talk about this in a little bit.

[00:06:16] Tobias Carlisle: For the most part, that does seem to be the case. Statistically, historically, it’s extremely difficult to find sustained high returns and invested capital. I think I’ve often said that it, it looks like it’s about 4% of businesses, statistically, quantitatively, have this sustained high returns and invested capital.

[00:06:33] Tobias Carlisle: I saw a Charlie Mungo is reported to have asked this question of one of the, the Ted, Ted or Todd, one of the guys who invests one of the newer guys at Berkshire who’s investing Berkshire Capital. They said, he asked them, what percentage of businesses do you think will be better in five years time? What percentage of s and p 500 businesses?

[00:06:51] Tobias Carlisle: And say it was Todd. His response was, I think it’s about 5% of businesses. And Manus said it’s about 2% of businesses. And so what my [00:07:00] response is 4% of businesses, I think that sits about halfway between the two. Statistically speaking, that’s about the. So what we’re saying is if we have no ability to predict what the future is going to look like, and it does seem to be that there is some evidence that that is in fact the case, nobody really knows what’s going to happen.

[00:07:17] Tobias Carlisle: If you don’t know what’s going to happen, then you want to get as many factors on your side. If you have a good outcome and you’ve paid modestly for a business, you tend to have an outsized return in the. If you have a bad outcome for a company that you’ve paid up for, you have an outsized return in the other direction.

[00:07:33] Tobias Carlisle: So basically what my approach is just to say, let’s be honest about what we do know and what we don’t know. How do we protect ourselves in those circumstances? And the way that I say that you can protect yourself is by paying as little as possible and not trying to work out which really are the better businesses, but otherwise, because you’ll find that it’s quite confounding, it’s quite hard to sort of predict these things into the future.

[00:07:55] Tobias Carlisle: At least that’s, that’s what my research shows. 

[00:07:58] Rebecca Hotsko: And I really loved reading about your strategy, which I want to dive into next because it’s like what you just mentioned. Everyone loves learning and reading about buffet. I learned so much, even from reading your book about his strategies and just the way how he was just so active at first, if an investment wasn’t going his way, he bought as much.

[00:08:16] Rebecca Hotsko: Stock and he made it go up and he took control. He was part of the board and so we like learning about it, but sometimes for investors in our position, it is hard to implement that same strategy. And so if there’s something that we can do with less effort for as much, if not more reward, I think most of us would be on board for that.

[00:08:35] Rebecca Hotsko: I think. Now, I would love for you to share your acquire’s multiple strategy and kind of your thinking behind that and explain to our listeners what that is. 

[00:08:45] Tobias Carlisle: I did some research that resulted in a book that came out in 2012, and that book is called Quantitative Value. I partnered with a guy who was doing his PhD at Booth, which is a Chicago School of Business, sort of regarded as the best quantitative school in the States.

[00:08:59] Tobias Carlisle: We went and tracked down every bit of industry and academic research that we could find on fundamental investment, so valuation. Business quality, things that identify statistical fraud, statistical earnings manipulation, statistical financial distress, various things like that that you may not be able to say conclusively whether these things exist.

[00:09:22] Tobias Carlisle: But if you have a variety of these metrics indicating, so for example, there’s a famous case study about Enron. Everybody knows that Enron is a fraud, but for a long period of time it was sort of regarded as a very, in much the same way, many of the businesses that have sort of had the gigantic collapses over the last few years have been found.

[00:09:41] Tobias Carlisle: To be probably not as good underneath as they looked on the outside. If you’d applied these statistical measures, you might have found that they were weaker than they appeared externally. So I always, as part of my strategy, I always run sort of a, a fitness check on the universe, and it’s just to make sure that we’re not finding any statistical earnings manipulation, which is kind of a gateway drug to [00:10:00] fraud.

[00:10:00] Tobias Carlisle: And you never find them without financial distress because healthy companies just don’t need to do it when they have the cash flow problem. They know that they need to raise money. A bad quarterly report means that they’re going to lose that ability. So they’re always very careful about, you know, they sort of manage their financial statements a little bit and some bigger companies do it too, and it’s just good to be aware of that because it can impact the valuation of those businesses.

[00:10:23] Tobias Carlisle: So once we’ve sort of excluded those from our universe, then we look in our universe at on a valuation basis first. So we just use simple price ratios. We tested in quantitative value. We tested everything from price, earnings, price, book ev, cash flow, EBITDA to enterprise value and EBIT to enterprise value.

[00:10:41] Tobias Carlisle: And we just ran a horse race over the full data set to see if you had used any single one of the one of these metrics, which one did the best. And it turns out it was e ev, ebit, which is my acquirers. And then we can, there’s a variety of ways that you can treat that. You can reduce that to a universe of, say, 20% or 10% of the entire [00:11:00] investible universe.

[00:11:00] Tobias Carlisle: And so then you know that you’ve got these companies that are, there’s no indication of any fraud. We’re looking at companies that are very cheap, and so within that universe of companies, Now we find the ones that are the better ones that might be worth owning, and so you can dig through those and use a variety of metrics for cash flow, generation on assets, ability to convert revenues into cash flow, revenues into gross profits, all of those sort of things.

[00:11:24] Tobias Carlisle: We use a variety of those metrics, but the main driver of it is the acquirers multiple, which is just a measure. It’s just worth breaking it down a little bit. Anytime you buy a business, on one hand, you’re getting, you’re getting really the stream of cash flows that come back into that business from here until the failure of that business really, and what you pay for it.

[00:11:43] Tobias Carlisle: It’s not just the equity, which is the stock price multiplied by the number of shares that are outstanding. You have to treat that in different ways. So if you bought a house, And you paid a million dollars for that house, you need to put down a $200,000 deposit for that house, and then you borrow the 800.

[00:11:58] Tobias Carlisle: So the $200,000 deposit is the equity, that’s the market capitalization, but the total purchase price of that house is a million dollars. And if you don’t account for the mortgage, then you’re missing a lot of the iceberg sort of sitting below the waterline. And it’s important to note that that’s out there.

[00:12:15] Tobias Carlisle: It also creates these opportunities. Some of these businesses have a lot of excess cash on their balance sheet. It would be like going into that house and finding a safe, and inside the safe there’s $500,000, and so your actual purchase price then is a million plus the 200 you put in minus the 500 that you got back.

[00:12:31] Tobias Carlisle: So you actually paid half price. So we’re looking for things that are. It’s very rare, honestly, that you would find a safe filled with half a million dollars, but it is quite common to find other things that should be included as debt. So you would find minority interest, for example. So if you own 80% of a business, you account for it all in your financial statements, but you need to back out the minority interest.

[00:12:53] Tobias Carlisle: And so that’s one way of doing it. They just take it out as a lump sum, just need to be aware that it’s in there. And then preferred [00:13:00] stock and other things that I’d like preferred stock convertible notes and those. Sometimes these are carried in the notes to the financial state. Basically we’re just trying to capture all of the obligations, all of the liabilities, plus the purchase price to see what an acquirer would’ve paid for this whole thing.

[00:13:15] Tobias Carlisle: And then on the other side, we look at the operating income, which is what they generate. And comparing those things on a like for like basis allows us to see which of these businesses are in fact cheaper, which are more expensive. And it seems that, roughly speaking, over time, The more cash flows that you get for the lower the price that you pay, the better the returns that you get.

[00:13:34] Tobias Carlisle: So it’s just paying lower prices for earning streams, generates higher returns. Everybody knows that. But this is just another data point that sort of agrees with that. That’s the strategy. 

[00:13:44] Rebecca Hotsko: It’s just so fascinating hearing you talk about it and describe it in the book because it flips back to, so Warren buys wonderful companies at fair prices, but then this is to buy fair companies at wonderful prices.

[00:13:57] Rebecca Hotsko: And the really astonishing part was [00:14:00] the return differences when you took out the need for high profits or high return on invested capital. Can you talk a bit about what you found the performance difference was between yours and Warren Buffet’s strategy in your back test? 

[00:14:15] Tobias Carlisle: The magic formula is a quantitative expression of what Buffet does without his business analysis built into it.

[00:14:22] Tobias Carlisle: So it just says, if you looked at the universe that he might possibly buy from Mrs. Joel Greenblatt’s approach, it’s just to say, let’s say we would wait half of it to the quality of the business, and he’s going to define that by operating income, ebit operating income on the invested capital. So the more dollars that it earns per dollar invested in the business, the better the business is, the more wonderful the business.

[00:14:44] Tobias Carlisle: And then on the other hand, he’s going to look at the cheapness of it, and he’s going to use the same metric that I like to use, which is “The Acquirer’s Multiple”, say EBIT on enterprise value. And he weights them each equally without sort of. I admire the way that he approached the problem. I think he, he, he approached it the right way [00:15:00] and he found that over the full dataset and that, I can’t remember the numbers exactly off the top of my head, but he’s found that he did get material outperformance by buying and holding these things for about a year and rebalancing the portfolio of the end of the year.

[00:15:13] Tobias Carlisle: And he looked at it over 14 years. We back tested it in, in the book from 1963 to 2011, and we found the same thing. We tested it to the gold standard for academic testing. It generated very good returns, and it was on a risk adjusted basis too. So volatility adjusted to the extent that that equates to risk, which, you know, lots of people don’t think that it does, and I tend to agree with them, but it is a sort of standard way of discussing these things.

[00:15:38] Tobias Carlisle: The magic formula did produce a better risk adjusted return than the rest of the universe. And so I looked at that and I thought, that’s all well and good, but what happens if you, what is the contribution of each of those two parts? What does the return and invest capital contribute to the performance?

[00:15:56] Tobias Carlisle: And what does the acQuire’s multiple contribute to the performance? And when we tested it over [00:16:00] the full dataset, we found something a little bit surprising, and that was that the valuation metric, which is the acquirers. It generates much more return than the magic formula, and that’s because the return on invested capital metric actually reduces your returns, or it delivers a return about in, in line with the market, which is basically noise.

[00:16:20] Tobias Carlisle: So it’s surprising, but what that says is that paying up for quality tends to not be a good idea, and you tend to get better performance just buying the cheapest stuff in the market because you don’t know what’s going to happen. So that crop of businesses are going to have some good luck and some bad luck, and it seems that the collection of luck seems to favor the acquirers multiple over the magic formula.

[00:16:42] Rebecca Hotsko: I want to  dive into this, the reasons behind this outperformance, because one thing that you outline in the book is meaner version. That’s a big topic and theme throughout your book, and I think it’s kind of underappreciated in investing sometimes, and it ties into the reasons behind your performance. I was hoping you could explain that a bit for our listeners.

[00:17:04] Tobias Carlisle: Mean reversion is a funny beast and it manifests in lots of different ways and I, I make it clear in one of my books, I may have done it in this one, that there are lots of different types of mean reversion. So there’s a mean reversion where with parents that have some unusual features, so say you get too tall, parents, it’s not the case that their child tends to be taller than them again, otherwise you would have this phenomenon where you’d have increasingly tall people in a population increasingly short.

[00:17:30] Tobias Carlisle: What happens instead is that people who are very tall may have just had an accident of getting several very tall genes all together, and their partner may be the same. What tends to happen is that the progeny of tall people, and this is a Francis golden observation, they just tend to be closer to the mean.

[00:17:48] Tobias Carlisle: They tend to be closer to the average height. There’s this idea in statistics as well, that as you increase the size of the population, so you might take a sample and it might give you some sort of characteristic about the [00:18:00] population, a mean or a standard variation or something like that. But let’s just say it’s the average.

[00:18:04] Tobias Carlisle: As you take more samples and you get bigger samples that more closely approximate the population, your error rate or your, the quality that you’re identifying will tend to revert closer to the population means. So that’s another type of mean reversion. There’s a mean reversion in financial markets.

[00:18:20] Tobias Carlisle: That’s a little bit funny though. It’s sort of, this is the one that I’m talking about, and this is found in economies. It’s found in industries, it’s found in stock price, it’s found in business. And that idea is essentially the same thing, that as you find these unusual data points, and so one of those unusual data points might be an unusually high return on invested capital.

[00:18:41] Tobias Carlisle: As you find these unusual data points, what happens is over time is they tend to trend back towards the mean. And this is, we can show this lots and lots of different ways, but one of the ways that we show it is we can take every company in some universe, say the Russell 1000, so that’s the thousand largest businesses traded in the states.

[00:18:57] Tobias Carlisle: Rank them all by their return on invested capital [00:19:00] and then divide them into 10 buckets. So the top bucket would be the highest return on invested capital, and that would be earning a very high return set could be in the average of like 40% a year. And then the 10th bucket would be the worst return on invested capital.

[00:19:13] Tobias Carlisle: And that might be a negative number. And so if you then run this experiment forward, and so you look each year, you find that the highest earners tend to trend back towards them, mean they earn less on invested capital every. And the worst performers tend to do a little bit better. They earn more on invested capital.

[00:19:30] Tobias Carlisle: So if you’re looking for an improvement in business, You’re much more likely to find it in the businesses that aren’t doing very well with the low return on investors capital. This is basically the idea of mean reversion. So you can take advantage of it by, if you find a business that’s cheap, but you think that the business hasn’t looked very good for the last few years, and if you were to then extrapolate that performance into the future, that this would be a losing investment.

[00:19:53] Tobias Carlisle: It seems that what is much more likely provided this as a business that’s actually earned money in the past, and that’s, it’s a worthwhile [00:20:00] distinction making to. They tend to go back towards the mean, they mean revert. So the business itself will do a little bit better. And then the discount to the valuation that you are getting will close as well.

[00:20:11] Tobias Carlisle: So you’re getting two things working for you, improvement in the business and closing in the discount. And that tends to generate all of the returns for for value. And if you can imagine on the other side, if you’re overpaying for these things, the business is sort of, it’s not going to be as good next year or as good the year after that.

[00:20:26] Tobias Carlisle: And over about 10 years, most of the excess performance gone other than in about 4% of opportunities. And they’re very, very hard to identify prospective. So my, my approach is just to say, well, if I don’t know what the future looks like, I’ll be conservative in the, in the way that I value these things, and I’ll try to buy the ones that will benefit from mean reversion rather than sort of have a headwind.

[00:20:46] Tobias Carlisle: I’ll find the ones that’ll have a tailwind and I’ll try and pay as little for them as possible. That’s basically the approach. 

[00:20:53] Rebecca Hotsko: So when I read this book, it made me think that we’re often taught that good [00:21:00] investments are ones that you just look for good businesses with, high return on, invested capital, high return on equity, great profits.

[00:21:07] Rebecca Hotsko: But on the other hand, if we find a cheap business that looks very cheap for a reason, it’s a bad business, declining profits, bad management, we would say, that’s a red flag. I want to stay away from. But then your approach describes that no mean reversion actually means that it’s likely that those businesses will do better, and then it’s likely that we’re overpaying for the good business.

[00:21:28] Rebecca Hotsko: I guess if some of our listeners are value investors and kind of follow that stock picking approach, how can they reconcile these research with their approach? 

[00:21:38] Tobias Carlisle: I think the more I became aware of the importance of it’s really the competitive advantage that enables those high profits, high returns to persist into the future.

[00:21:50] Tobias Carlisle: I’ve read Buffett’s letters quite a few times, but when I go back and I read them, it’s become increasingly clear to me the amount of time that he spends dedicated to explaining the competitive advantages in the [00:22:00] businesses that he owns. And that’s really the. You can do a lot of work to identify the competitive advantage, which is the thing that allows the business to earn the high returns on invested capital and hopefully sustainably.

[00:22:11] Tobias Carlisle: So I still think it’s incredibly difficult to do it, but that would be one way that you could reconcile the too, that if you, if you wanted to buy the better businesses, The other thing is to say there are these factors in market. So a factor is value is a factor. That’s, that’s defined o often as price to book value, but value as sort of a philosophy where you can get a PR sheep on any price to any ratio or any sort of.

[00:22:35] Tobias Carlisle: That’s one way of identifying value. And then you might look at quality as another factor. So quality can includes return and invested capital, but it’s also the quality of the earnings, the ability of the company to generate cash flow and so on. So when I talk about factors, I’m sort of using these as there are academic papers that explain how these factors are used.

[00:22:53] Tobias Carlisle: So quality as a standalone factor doesn’t seem to depend too much on the valuation of those [00:23:00] businesses. So if you wanted to pursue that kind of approach, The way to do it would be, I think, to go and look at those papers and to make sure that your own approach sort of marries with those papers. But what I like to do is to use a little bit of a blend of both, but my bias is towards value because I think it’s a very good strategy.

[00:23:16] Tobias Carlisle: It’s had a period of underperformance. So I think that there’s likely some mean reversion in the strategy itself. So before, when I listed out the economy and the industry and individual c. And stock market results. There’s also mean reversion factors. So values had a bad run. It’s probably primed for a good run.

[00:23:33] Tobias Carlisle: Momentum’s had a very good run. It’s probably going to have a worse run in the, in the near future. Quality has had a, a mixed sort of run, but it did very well. It hasn’t done as well recently. So quality can work or, so this, that’s the sort of statistical approach, or you take that approach where you, you spend a lot of time thinking about the competitive advantage of the.

[00:23:51] Tobias Carlisle: A business like an energy company is unlikely to have much competitive the, or whether it has a competitive advantage or not is irrelevant because what it’s selling is a [00:24:00] commodity and it has no control over the price of oil. For example, we know that because there were negative prices for oil not that long ago, two years ago when there was an oil glut.

[00:24:08] Tobias Carlisle: Now there are very high prices for oil because there’s been underinvestment in What the challenge is, you have to know what game you are playing. If you are a quality investor, if you like buying those high return type business. And if that’s what you’ve been trained to do, then you should be spending your time thinking about competitive advantages.

[00:24:26] Tobias Carlisle: If you are more statistical and you’re like quality as a, as a strategy, you could, IM implement that, or you could just take the no nothing approach, which is basically my approach to say I have to be very honest with myself about my ability to predict the future, which I know it’s very low, it’s not much.

[00:24:42] Tobias Carlisle: My response to that is just to buy these things that are cheap and sort of let the cards fall where they may in the aftermath. 

[00:24:49] Rebecca Hotsko: You touched on so many things there. I have a few follow up questions. First on the factors, I’m curious, I have implemented a factor-based investing strategy for a while now, and when reading about your strategy, it did remind me of kind of a factor strategy.

[00:25:05] Rebecca Hotsko: I’m wondering how the acquirer’s multiple, does it have additional screens, different than factor investing or is it kind of layering on those, your screening for those certain factors? 

[00:25:17] Tobias Carlisle: The factors aren’t really set in stone. They’re sort of, everybody has their own interpretation of a factor. There are lots of different versions of value factor.

[00:25:26] Tobias Carlisle: The value factor is regarded as price to book value, but there would be no quantitative investor who only uses price to book value. They would all be doing some variation of checking to see if it’s cheap relative to every aspect of its business. And then they may be looking at other metrics that are health of the financial statements, the health of the business, and so on.

[00:25:46] Tobias Carlisle: And then within that universe of value, there’s all of these different implementations too. There’s really no agreed upon formula for any of the factors. It’s just that you know that at the beginning of the stock market, [00:26:00] Boom, it tends to be the best time for value. So there’s a crash, and then value seems to do very well out at the bottom.

[00:26:05] Tobias Carlisle: And then as value comes to the end of the stock market, boom. For whatever reason, value investors seem to pull back and value seems to underperform, and it’s more of the momentum and perhaps the quality guys who do better towards the end of the cycle. So when I say implement a factor portfolio, what people will do is they’ll, they’ll come up with their own definition of the fact that they’ll figure out what they’re going to do.

[00:26:24] Tobias Carlisle: They’ll just take know. If you wanted the quality you could use. Cliff Asne has a paper from a QR called Quality minus Junk. Q M J is their factor. You could find the performance of that factor and then marry that factor with another factor that you know that performs at a different time. So value and quality go very well together.

[00:26:42] Tobias Carlisle: Value and momentum go very well together. Perhaps momentum and quality wouldn’t go so well together because they tend to perform at the same time and underperform at the same time. So the, the way to approach a factor investment is just to understand how the factors work and then get enough diversification so that what you are [00:27:00] expressing in your portfolio, and you can do this through an ETF as well.

[00:27:02] Tobias Carlisle: You don’t need to do it by going and mixing your own formulas up in the, in your house and trying to figure that out. The easiest way is probably to find the quality ETF or something like that. Then just to understand how they perform and to rebalance sufficiently regularly so that when quality’s doing really well, you’re rebalancing away from quality into value.

[00:27:20] Tobias Carlisle: When value’s doing very well, you’re rebalancing away from value into quality. It’s probably not something that people want to do much at home, but it’s worth understanding it because sometimes something happens and you can’t work out why the portfolio has done something weird on that day, and it might just be that your stock is very popular in some factor portfolio and something has impacted the factor and so that’s why it’s sold off.

[00:27:41] Tobias Carlisle: That happens quite regulate that influence of factors. This very powerful because of the expression of those factors through various hedge funds and ETFs and. So that’s, I would just say understand what the factor does and and how your construction of it might differ from the more popular implementations of.

[00:27:58] Tobias Carlisle: Because 

[00:27:58] Rebecca Hotsko: when I was reading through your [00:28:00] strategy, I was trying to think of what factors this could be exposed to, because the, when you remove the high return on invested capital and you get better returns, that seems so counterintuitive. And then I was trying to think of if that could be explained by factors or what ex.

[00:28:16] Rebecca Hotsko: Explains that returns because mean reversion is one big explanation for it, as you already talked about reverting to the more normal level. But then I was wondering if it could be explained by like the quality factor where low growth in book equity is shown to perform better than companies with high growth in book equity, which is the investment factor in such things like that.

[00:28:38] Rebecca Hotsko: So then I was trying to like scratch my brain and think about if that was a strategy “The Acquirer’s Multiple” was kind of following or what was going on. 

[00:28:47] Tobias Carlisle: If you think about the value factor is price to book value. And the reason that people like book value or academics like book value in particular is because from quarter to quarter there’s not much variation in book, it should be reasonably static, whereas earnings are all over the place.

[00:28:59] Tobias Carlisle: [00:29:00] So low earnings might not indicate a problem with a business or a low price or low earnings giving you a high price to earnings ratio. So you’ve got to explain it. If you have like a hundred thousand dollars in book value, which is our shareholder, And we have earnings on that book value of say, $5,000.

[00:29:17] Tobias Carlisle: So that’s not, that’s a 5% return on equity. That’s not a very good. If we know though, that that’s a pretty good business and at some point in the future they’ve had some bad year this year, we know they’re going to have very good years in the future. We might be prepared to pay $50,000 for that a hundred thousand dollars in equity.

[00:29:33] Tobias Carlisle: So our price to book value is one half. We’re $50,000 of a hundred thousand dollars, but our price to earnings ratio is 10 times. And you might say, well, 10 times it’s expensive for this business. What it doesn’t account for is the fact that the business will earn more next year. Next year, the 10 times is going to go from earning $5,000 to $10,000.

[00:29:51] Tobias Carlisle: So it’s no longer on a 10 PE from when we bought it. It’s only a five PE because it’s $50,000 on $10,000. That’s the five pe. The problem [00:30:00] with all of these sort of metrics is again, you have to sort of understand a little bit what the metric does and why it works the way that it does. So my metric EV on ebit, it’s a flow metric.

[00:30:10] Tobias Carlisle: So if we think about energy as another example, if you’d seen energy getting cheap in the end of 2020, I think it was, and when, when oil had its negative print, if you’d then gone and looked at those businesses, they weren’t earning very much money. So they were cheap on a price to book value basis, but they wouldn’t have been cheap on an acquirer’s multiple basis because they didn’t generate enough operating income.

[00:30:31] Tobias Carlisle: If you wind 40 and they’ve all started generating quite a lot of operating. Now you’re in a position to value them on an acquirers multiple basis. So the acquirers multiple is like a year late to that. That doesn’t sound ideal. That sounds like a bad thing. And it, and it kind of is. It means that we’re always going to be slow to those types of businesses.

[00:30:48] Tobias Carlisle: But another thing that it does is it keeps us out of businesses that aren’t earning. And so that’s important. So I think sometimes, well, it might not be a good idea to pay for a high return on investor. Might also [00:31:00] be a good idea to avoid the very worst return on invested capital. And these might be companies that have never earned any money before.

[00:31:06] Tobias Carlisle: And that’s really what the acquirers multiple does. We’re already saying these are businesses that have operating income, and that’s an important way of eliminating a lot of the, if we eliminate a lot of businesses that don’t generate any operating income, which is what we’re saying that we’re going to do, the things that are left over are worth own.

[00:31:22] Tobias Carlisle: So we’re buying them cheap on an operating income basis, but they do have operating income, and so we’ve already excluded all of the ones that don’t have operating income. So that’s part of the reason I think that it does perform quite well. So it’s not a pure value factor where you’re using book value, which is static and wood.

[00:31:38] Tobias Carlisle: Pick up on those things that are transitioning from not earning to earning. It keeps you out of those. So you might miss out on those sort of great hero calls where you get to say, I was in energy when it was not earning any money and now it’s earning a lot of money, and look how smart I am. But instead, you’re in these businesses that even in the worst of times, look, this thing is still earning money, it’s still generating.

[00:31:58] Tobias Carlisle: Nobody wants to pay for it [00:32:00] because they can see all of the bad stuff that’s happening in the industry. But my view is, well, I don’t know if this is all of the bad stuff that’s happening in the industry, and it’s still generating operating income. In the future, it may generate more operating income. So the low price that I’m paying now will turn out to be a very low price in the future.

[00:32:17] Tobias Carlisle: And that’s essentially the philosophy really of the acquirers multiple that you’re trying to buy businesses that even the worst of times they’re generating some operating income. They’re pretty cheap. We don’t know what’s going to happen, but we sort of know that on average the portfolio does tend to work out over.

[00:32:33] Rebecca Hotsko: And I really like what you said about this approach is that you know your limitations. You don’t have to be the best stock picker. You don’t have to be the best company fundamental analyst. You just follow the approach and you buy enough where mean reversion kicks in and historically it’s expected to lead to higher returns.

[00:32:55] Rebecca Hotsko: And I’m just wondering, you mentioned the one thing on Buffett’s approach where if investors go that. That his approach works because he’s just such a phenomenal business analyst. But I’m curious if investors are going that route. What are some things that don’t end up being true moats? Like what are things investors kind of mistake for being true advantages?

[00:33:18] Tobias Carlisle: One of the problems is that over time the market evolves and things that were regarded as being moats in the past are not. It’s, there are lots and lots of businesses that look like they have moats. Once the moat is crossed and all of that ability to gen, or once the competitive advantage is eliminated, and that ability to generate the supernormal returns is gone.

[00:33:38] Tobias Carlisle: Then it’s very unlikely that they get it back again in the future. But you are often paying a premium price for those supernormal returns. So one of the exercises, this is sort of built into my models, but one of the exercises that I do is if you have something that’s earning, say two times more than the average, so the average company in the s and p 500 earns about 13.3% return on invested capital.

[00:33:57] Tobias Carlisle: And so if you find a business that’s earning more than [00:34:00] that, you know that you’ve got, potentially you’ve got a special kind of business that it’s able to earn higher returns than. But you can see if that special business has a higher return than normal, then it, it’s also worth more than normal. And so it should trade at a premium to the average PE in the s and p 500, which might be around 19 times right now.

[00:34:18] Tobias Carlisle: Something like that. People might buy that thinking that they can generate good returns going forward if they can sustain this high returner in invested capital because it is true that the longer you hold, the closer your own investment return. It trends towards the return and invested capital. So over the short period of time, your return is dictated by the multiple that you pay, but over time, it becomes the return and invested capital.

[00:34:42] Tobias Carlisle: So the reason that that’s important is if we also know that businesses have this tendency to mean revert. So the return and invested capital drops. It makes sense that say it’s earning two times the average business and it’s worth two times on a multiple basis. If in 10 years time it’s earning the same amount as the [00:35:00] average business, it’s also going to be only worth the same amount as the average business.

[00:35:04] Tobias Carlisle: So if I’ve paid twice the multiple and over 10 years, the multiple mean reverts down to the market multiple. What are the chances that I’ve actually made money over that period of time? And it turns out that often it’s pretty low 10 years for, for mean reversion in most businesses. That’s about right.

[00:35:21] Tobias Carlisle: That’s about how long it takes on average, other than this very small portion, other than about 4% that earn these supernormal returns forever and ever. You can think about that. Michael Mob does this research all the time where he brings out, here are the businesses that were able to earn supernormal returns over the last decade, and it’s backwards looking.

[00:35:38] Tobias Carlisle: What are the chances that those are the same businesses in 10 years time? It’s very low and often the best kind of investment opportunities are not the ones that have the supernormal returns on equity. It’s just the ones that are doing a little bit better than average. And they might be, you know, the companies that make up is a great business.

[00:35:54] Tobias Carlisle: Some of the, the businesses like that where they’ve got a little bit of recession [00:36:00] protection built into them, that when, when times get really tough, people will still go. They can justify going buying expensive lipstick cause it’s a smaller purchase, whereas they might not go, might not gone by Tesla when times are really.

[00:36:11] Tobias Carlisle: So they have a little bit of this inbuilt protection in them, and people are quite habitual. They like their brand, so if they like a particular brand, they tend to, it’s just easy to keep on going and buying that same brand. So you want to take advantage of those kinds of behaviors, things that will survive through a recession, because getting a zero on anything that you’re invested in is catastrophic.

[00:36:30] Tobias Carlisle: You should assume that you’re going to get some, but you should always keep everything small enough so it won’t. And then looking for things where there is that habit and repeatability. So Starbucks is a great example. We all know that coffee’s addictive. People who like their coffee. It’s the little treat that you can get once or twice a day.

[00:36:47] Tobias Carlisle: That’s a great habit. Starbucks is one of those businesses that has earned very high returns for most of it’s life. So it’s funny, it’s not the businesses that are the superstars that tend to be the ones that really do manage to sustain these high. It’s businesses that you might overlook them a little bit because they’re so, they’re ubiquitous, they’re common.

[00:37:05] Tobias Carlisle: You see them everywhere all the time, and you, they’re just sort of part of the landscape. But they are the ones that do tend to generate sustainable high returns and invest capital over time. But you also have to be careful. You have to bear in mind that at any point in time they can mean revert back down to an average business.

[00:37:20] Tobias Carlisle: And so you should buy them with that in mind, where if they do sustain those high returns and invest capital, you generate this great return. If they. He’s still going to get roughly a market return, which I think is what Buffet does. He pays about. So when he buys Apple, he pays 10 times for Apple. And at the time there was a lot of debate about how great Apple was.

[00:37:38] Tobias Carlisle: Not so much anymore. 

[00:37:40] Rebecca Hotsko: I think it’s interesting because the tech stocks obviously fall into this category of the double digit growth. A lot of people want to own them because the past 10 years, even now that they’ve gone down, we’ve heard buffet buy more Apple. It still just makes me wonder, we can’t extrapolate that growth into the future.

[00:37:58] Rebecca Hotsko: And what are your thoughts on kind of the tech companies? 

[00:38:02] Tobias Carlisle: Well from that universe there will be some. So if the Tech Rec 1.0 from.com 1.0, those businesses are Cisco and Oracle. Microsoft was Tech Rec 1.0. Microsoft’s has been in tech res earlier than that too. but.com 1.0. There were many businesses that were.com darlings, and Amazon is another great example.

[00:38:22] Tobias Carlisle: Businesses that trade very, very expensively and then had this incredible collapse in their stock prices. May have had a little bit of a step back in their financial statements too. I’m not entirely sure. I think that Amazon was profitable at that point. So the challenge is finding the ones, one that can survive because out of that universe of companies, there were many that didn’t make it, and they’re, they’re kind of well known now, but I can’t think of one off the top of my head.

[00:38:44] Tobias Carlisle: But you’re much more likely to have an end to a business that doesn’t have a long operating. Or an ability to generate some cash flow. So if you were to go through the ones that have had businesses that are down very substantially since this most recent bust, one way to find the ones that are likely to [00:39:00] survive if they’re generating free cash flow, if they’re able to do that, then that means that they’re not reliant on the market for financing.

[00:39:06] Tobias Carlisle: There’s a very good chance that they’re around, like that’s an important part of the conversation. If they’re still here in three to five years and they’re still pretty good business. It’s possible that they will and that they’re cheap enough now that all of the expectation is kind of drained out of it.

[00:39:19] Tobias Carlisle: So over the next decade, it’ll be the performance of the business that will drive the returns for the people who invest in it at this point. And if you can buy them cheaply enough that you get that good performance, then you probably do quite well. But you just need to be careful that it is in businesses that are generating free cash flow, there’s self-financing and that you’re not overpaying.

[00:39:35] Tobias Carlisle: because even though something’s down 80 or 90%, it could still very well be overvalued. You need to look into the fundamentals and make sure you’re not overpay. 

[00:39:43] Rebecca Hotsko: Because it makes me think we go back to our conversation of mean reverting and how return on invested capital typically is mean reverting. A lot of these companies, they were above market average for return on invested capital.

[00:39:55] Rebecca Hotsko: So it just makes me wonder if those are an example where now we’re in the mean reversion cycle, [00:40:00] and then I guess how investors can actually disentangle, which won’t be, that’s million dollar question and the hardest thing and you never know until we can look back on history, which ones were actually the 

[00:40:11] Tobias Carlisle: winners.

[00:40:12] Tobias Carlisle: It’s hard to do it prospectively. I think that the secret is survival. If you survived through a period of time, then the upside tends to take care of itself. The challenge is when you’re buying things that they’ve got a lot of debt, they’ve got some debt payments due, they’re still not generating cash flow.

[00:40:27] Tobias Carlisle: The stocks down 90%. They may very well solve all of those problems and run up another 10 times over the next 10 years. There will be businesses that will do that. It’s just very, very hard to identify those companies perspective. I think your life has made so much easier if you are just separating at the universe into the things that are earning money already, generating free cash flow.

[00:40:47] Tobias Carlisle: It’s great if the original management team is still there, the founders are still there. They’ve got skin in the game. They’re personally invested in the success of the business. They just tend to make better decisions, and that is the case. [00:41:00] I know that it’s a little bit, it’s sort of everybody hates meta at the moment, but if you were to take the name of the financial statements, it’s still a phenomenal business.

[00:41:09] Tobias Carlisle: It’s still a really good business. Now the question is, is all of this competition? Is this sort of general ick feeling towards Facebook and all of the competition that’s coming in from TikTok and so on, will that destroy the franchise completely? I don’t know the answer to that, but you’re getting this price right now, which says that if that doesn’t happen, you’re going to do very well.

[00:41:28] Tobias Carlisle: And I have no ability to predict the future. So my view is that if you had a basket of meta, you’d probably be in pretty good shape because Mark Zuckerberg’s still there. He’s the founder. He still owns a lot of stock in the business. He’s still the C E O. He’s still interested in its performance. Whether the Metaverse works or not, I have no idea.

[00:41:45] Tobias Carlisle: I don’t think it’s going to work. But I don’t know much about tech either. So meta is a good example of the sort of thing that I would tend to buy cause it is cheap on an acquires multiple basis. It’s in my screen. It’s still a very, very good business. It’s still found the lead. They’re [00:42:00] doing a little bit of a buyback.

[00:42:00] Tobias Carlisle: They generate free cash flow. The question is always, and this is the hardest part about this type of investing, I hear what everybody else says about Meta, and for all I know, they’re all completely right. It’s possible that they’re all complete. It’s likely that they’re all completely right in every single business that I look at that are Intel is another one.

[00:42:18] Tobias Carlisle: Intel is a fantastic business, generates lots of return, lots of growth, high return, and invested capital. But there may be a generation behind all the other chips that are out there and they may never catch up, so that might be fatal for Intel. Every single business has this cloud over it, and it has this question about its ability to work as well in the future, and you have to be able to find some way to cross that bridge and resolve the issue.

[00:42:42] Tobias Carlisle: And the way that I do it is just say, I don’t know. But if I buy enough of these things where they do look pretty good and they do look pretty cheap, then probably the market is overreacting and these things probably work. That may not work out, but that’s my, that’s sort of my statistical approach to it.

[00:42:58] Rebecca Hotsko: I love that approach. And if some of our listeners are thinking they like the sounds of that approach as well, how can they implement your strategy? Can you talk about the two ways that our listeners could use your approach? I know that you’ve done all the work for us and you’ve created the screeners available on your site.

[00:43:17] Rebecca Hotsko: Can you just walk us through your approaches? 

[00:43:20] Tobias Carlisle: So there are two, there’s a, you can use the screens on the website. I have a free screen for the largest thousand businesses in the States, and when you go through, you’ll see all the problems with all of those businesses. I know that there’s problems with those businesses and that’s why they’re cheap and that’s why they’re in the screens.

[00:43:35] Tobias Carlisle: We have paid screeners for smaller businesses in there too, which have historically generated slightly higher returns. I also run two ETFs. I have an ETF called the Acquires fund, which is mid-cap, large cap domestic US equities. We have 30 of these positions and it includes meta intel, dominoes, those sort of names that you recognize, the names, you probably know what’s wrong with them, but they are very cheap on a statistical basis and over [00:44:00] time, I think that that is the important.

[00:44:02] Tobias Carlisle: And I operate a small and microfund called Deep and Deep has a hundred positions because small and micro companies just tend to be, they have less resources. They’re not quite as professionally managed. The business models aren’t as secure as some of the bigger businesses. They tend to only have one business line rather than multiple business lines.

[00:44:19] Tobias Carlisle: The bigger companies do. So I have smaller holdings in each one of them, and we’re really relying more on the performance of the factors that if you could pull up morning staff for any of the ETFs and you can look at the ETFs in in mornings. So you’ll see that we score very high on quality and we score very high on value, which is probably what you’d expect after this conversation.

[00:44:36] Tobias Carlisle: But that’s, the portfolio is sort of relying on the performance of those factors. And I think over time that’s likely to be a pretty good bet. But it’s early days. 

[00:44:46] Rebecca Hotsko: So there are a few different screeners on your site. So there’s like you mentioned, large cap ones and then there’s small cap and there’s a few paid ones.

[00:44:55] Tobias Carlisle: The two paid screeners are an all investible universe, which is, it’s about the largest half of all companies. And I think the cut, the cutoff is variable a little bit depending on what is happening in the market, but I think it’s two or 300 million below two or 300 million. It’s hard for anybody really to invest in them because they can trade at wide bit, ask spreads.

[00:45:13] Tobias Carlisle: They may not trade all the. And then there’s a smaller microcap screen, those two screen, and there’s a Canadian screen as well. All those screens find companies that are well off the beaten path. They’re really unusual businesses that they’ll pull up and because they’re overlooked by most investors and we already know that they’re cheap, they tend to generate pretty good returns over time.

[00:45:32] Tobias Carlisle: Not every year. And I should just point out, we’ve been through, I’ve got 200 years of data. Going back to 1825 that show the performance of value through these various different manias in the market. And we’ve been through an unusual, this has been an unusual period in the market. We’ve had very high returns for about a decade, and then we had the sort of blow off top where we saw prices that we’ve really only seen once before, and that was in the.com boom.

[00:45:57] Tobias Carlisle: We were much more expensive than 1929, which sounds [00:46:00] crazy to say. So this has been an unusual period, and through this period, value underperformed pretty substantial. But I think that since we’ve say arc, the Kathy Wood ETF as a representative of the Growthier Company’s Profitless tech, that peaked in February, 2021 and it’s fallen pretty consistently since then.

[00:46:21] Tobias Carlisle: And value has sort of been on the other side of that trade. And so value has started doing pretty well in the late 2020. And increasingly, well, we’re going through like a, some sort of drawdown now, but these things happen and it’ll, it will dissipate. And then it’s likely to be a very good period of performance for value because it tends to work best outta the bottom of the bus.

[00:46:40] Tobias Carlisle: So now is a good time to become a value. 

[00:46:43] Rebecca Hotsko: Yeah, the valuation gap. I just saw a graph the other day where it’s just at the all time high between value and growth, and so it’s maybe finally values time to shine. 10 years of underperformance now 10 years of outperformance. Hopefully, 

[00:46:58] Tobias Carlisle: I’ve been saying it for, since at [00:47:00] least about 2015, but I thought it was juice.

[00:47:02] Tobias Carlisle: So it’s been a long time, but it really, the, the spread got wider than it it’s ever been before, and it has now started closing, which is, as you point out, the difference between the most overvalued and the most under. I’m very, very optimistic. I’m excited for the next 3, 5, 10 years in value. I think it’s going to be a a good time.

[00:47:19] Tobias Carlisle: So for these 

[00:47:19] Rebecca Hotsko: value picks on your screeners, just a couple more things for implementing this strategy. Do investors buy every single company on the screener, and then how do they think about when to sell them? What’s kind of the rules behind that? 

[00:47:33] Tobias Carlisle: It’s up to each individual investor. We have some recommended guidelines on the site.

[00:47:37] Tobias Carlisle: I think that the best thing to do is to buy. It depends on how much time you want to spend doing. Not everybody wants to be doing this stuff all the time, and some people love it and they want to be doing it all the time. You should rebalance the portfolio about once a year at a minimum. So you buy your 20 names or 30 names, you equal weight them.

[00:47:56] Tobias Carlisle: So you put the same amount of money into each and then you just let the portfolio run [00:48:00] for a year. And then one year later you look at your portfolio and you want to make sure that you hold if your capital gains tax, if you have to pay capital gains tax, you want to make sure that you hold for long-term capital gains and you want to take short-term capital losses.

[00:48:15] Tobias Carlisle: So you sell less than a year for the losses, and you sell for more than a year for the gain. But you can be much more involved in that too. So I rebalance the portfolios of the funds quarterly and we rebalance them back to equal weight. You don’t necessarily have to do that. You can also use them more like a screen where, so if you’re going to do it quantitatively, you just buy everything.

[00:48:35] Tobias Carlisle: You buy the cheapest 30 in the screen, or the cheapest 20 in the screen. If you want to be more, if you know a little bit about business and you know a little bit about investing and you want to use it like the screen, that’s perfectly fine too. You can go through and sort of cherry pick up. The only thing is that the research seems to show that cherry picking does worse than just buying the entirety of the screen.

[00:48:55] Tobias Carlisle: There’s lots of different research and the reason why many and varied. Mostly it’s just that [00:49:00] we tend to pick out the things that everybody else avoids too. We avoid what everybody else avoids, and that’s why they get so cheap. And at some point the financial statements just get too good and they’ll publish a, they’ll publish a report that everything’s not as bad as we all fall through was, and they’ll be up a lot on that day.

[00:49:15] Tobias Carlisle: And it happens over and over, and it still happens to me to this day. It’s very, very hard to buy some of the bad ones, but really they are the ones that you want to. 

[00:49:23] Rebecca Hotsko: Is there an optimal amount that we should buy? Because I know you had 30 companies in your sample in the book. Is that kind of the 

[00:49:30] Tobias Carlisle: optimal number?

[00:49:31] Tobias Carlisle: There’s a lot of research on this. I wrote a book called Concentrated Investing, which was exactly about that point. It depends a little bit on who you are. So the academics would say they’re looking for the additional company that you buy. The point at which adding an additional company to your portfolio doesn’t improve your returns.

[00:49:50] Tobias Carlisle: Happens somewhere between 20 and 30. So 20 names seems to be enough diversification, but the more concentrated you are, the more volatile you are your portfolio. So [00:50:00] the more it moves around. 20. You do seem to get pretty good performance with a lot of volatility. At 30, you get comparable performance with slightly less volatility, so the optimal is somewhere between 20 and 30.

[00:50:11] Tobias Carlisle: You can get away with 20. If you don’t feel comfortable putting 5% into, you know the ugliest name in the list. Which is sort of the way that I think about it a little bit. I reverse it. How much money am I prepared to lose in each of these little things? Make it 30. And so putting, you know, you’re putting a little bit over 3% into each.

[00:50:27] Tobias Carlisle: And then if you’re completely wrong and it goes to zero, it’s 3% and you, the rest of the portfolio, because you, you’re not looking for performance from any individual stock. You’re looking for the performance of the portfolio overall . Which is why you can buy things that are a little bit scarier than average, you know?

[00:50:45] Tobias Carlisle: So meta that might look really scary. And I agree with you. I don’t know how that’s going to work out, but it is cheap. And so I don’t mind having 3.3% of the portfolio in there. 

[00:50:55] Rebecca Hotsko: And I think that’s a good point to just kind of wrap it up on is that it is, you refer to it as a deep value strategy, right? And so that by definition means it is higher risk .

[00:51:06] Rebecca Hotsko: You’re taking higher risk for a higher expected return. And so I think for investors, that is something to consider, that fear of risk averse or this, you don’t want to take much risk then this isn’t maybe the strategy, but if you’re willing to hold things long term and you understand that it is deep value strategy, then.

[00:51:22] Rebecca Hotsko: This is, I love the approach and I’m excited that I got to talk to you about it more today. I’ll make sure to link your website in the screener in the show notes. But other than that, where can the listeners connect with you and learn more about you and everything that you do? 

[00:51:39] Tobias Carlisle: I’m on Twitter greenback to G R E E N B A C K D.

[00:51:44] Tobias Carlisle: It’s a funny spelling and acquire as multiple, acquire as funds. There’s a link to the ETFs that I. And then on Amazon, you can find my books under my name. There’s, they’re all up there. You can probably get away with reading “The Acquirer’s Multiple”. That’s really, that’s a into a fifth grade reading level.

[00:51:59] Tobias Carlisle: You can read it in two hours. It’s a pretty good summary of all of the other things, and it’s a pretty good overview of, of what I’m trying to do. If you really want to dig into the weeds and quantitative value is the place to go. That’s where we publish all the statistical papers that backed everything else up.

[00:52:13] Tobias Carlisle: It’s hard to read. If you’re a masochist, then that’s where you want go. 

[00:52:17] Rebecca Hotsko: Perfect. Thank you so much for coming on Tobias. That was great. 

[00:52:21] Tobias Carlisle: My pleasure. Thanks for having me, Rebecca. I appreciate it . 

[00:52:25] Rebecca Hotsko: All right. I hope you enjoy today’s episode. Make sure to subscribe to the show on your favorite podcast app so that you never miss a new episode.

[00:52:34] Rebecca Hotsko: And if you’ve been enjoying the podcast, I’d really appreciate it if you left us a rating or a review. This really helps support us and is the best way to help new people discover the show. And if you haven’t already, be sure to check out our website, theinvestorspodcast.com. There’s a ton of useful educational resources on there, as well as our TIP Finance tool, which is a great tool to help you manage your own stock portfolio. 

[00:53:00] Rebecca Hotsko: And with that, I will see you again next time. 

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