Adam Seessel (00:03:03):
Not really, Trey, to put a fine point on it. I’m a bottoms-up stock picker. And I really believe what Peter Lynch wrote 30 years ago. He wrote these books when I was getting ready to go on to Wall Street and they really inspired me. And when I was going to write my book, I went back and reread them. And the thing that stuck with me the most about what he said was that superior businesses in the end win in the real world and that victory is over time reflected in the stock market. And it’s the same with mediocre businesses. They will fail or languish and that performance will be reflected in the stock market.

Adam Seessel (00:03:40):
So, the economic cycle is going to do what it’s going to do. Macro is going to do what it’s going to do. Interest rates are going to do what they’re going to do. There’s going to be wars. There’s going to be plagues. There’s going to be pandemics. There’s going to be recession. But if you have a strong business with a strong customer value proposition and a moat to protect that business, you are going to win, period. And that’s really how I approach the market.

Trey Lockerbie (00:04:04):
That makes all kinds of sense to me. And I thought it was an interesting point, because there’s a lot of doom and gloom out there. In fact, I’m seeing indicators showing that people are very fearful in the markets and there’s a lot of talk of recession and we may in fact be in a recession, but I think Bill’s point is more or less that we are in a recession almost by default on a technicality in some ways, because inflation being where it is. And the problem with that is that it can be a self-fulfilling prophecy to some degree, right? Once people hear that we’re in a recession, they might decide to travel less or they might try and penny pinch a little bit more.

Adam Seessel (00:04:38):
Sure.

Trey Lockerbie (00:04:39):
It might actually manifest into a worse recession, but to your point, I love this perspective of just sitting back and letting the market do what it does and just focusing on the micro. And the more I study macro, the more I’m actually in agreement with you.

Adam Seessel (00:04:53):
Look, Trey, there’s a reason they call economics the dismal science. I mean, because it’s a thick in the weeds. I think that’s the reason that investors like Bill Ackman and Joel Greenblatt like the book is, because it’s very common sense, very down to earth. On the one hand, it takes a big macro trend, which is the rise of technology and the digital age, which is a macro trend. I mean, that’s definitely a macro trend. We’re in a time of technological change that we haven’t seen in at least 100 years, since Henry Ford and the Model T. On the other hand, it’s very micro in the sense that “Okay. In that context of technological change, how can we profit from it?” And the way to profit from it is to focus on individual digital businesses that have competitive advantages.

Trey Lockerbie (00:05:40):
And the competitive advantages are really important in this environment, because you have to have pricing power, right? With that inflation going up, you’ve got to have a moat so you can increase your prices and keep up with it. Not all businesses can.

Adam Seessel (00:05:53):
Yeah. It’s funny. When inflation reared its ugly head early this year, I went back and read Buffet’s writings on inflation, because like many value investors, he’s my guru. And it was in the early ’80s when inflation was at its apogee and he said, “The two things you need are pricing power, like you said, and capital light business models.” So, you don’t have to invest a lot of money in plant as the prices are going up. It’s getting more and more expensive to build property and plant and equipment. So, which businesses have pricing power and are capital light? Tech.

Adam Seessel (00:06:26):
So, it’s a great period to stop and reflect. And if your listeners have time, I do recommend they pick up the book, because it does take the secular trend of technological change and it applies to how we can make money in the market. And right now, a lot of companies are getting slaughtered in tech and they deserve to be slaughtered because they have no competitive advantage. But then there are a few, sub 5% that do have competitive advantages and they’re also getting slaughtered and those are the ones I’m buying.

Trey Lockerbie (00:06:58):
Well, one in particular there and we’re going to talk more about this company, I think, in a minute. And I want to just preface all this by also saying we’re going to dive deep into your framework and how we can recalculate earnings on these tech companies to make better sense of them. But one that comes to mind is Alphabet. And when you look at their earnings, they are what they are to your point and they keep their prices really low. And that’s what tech is usually good for. But I hope no one from Alphabet is listening, but my whole life revolves around Google. My point is that, even if they raise the price from $1.99 to even 100 bucks a month, I’d probably pay it.

Adam Seessel (00:07:30):
Most of their products are free, but as you say, they enable your life and make your life so much better, faster, cheaper. As I say in the book, that’s the mantra of tech, better, faster, cheaper. And I quote this study done by an economist. I think he was at MIT at the time where he went and asked consumers, “How much would you forego of your income in order to keep a service?” So, I think Facebook was $400 and WhatsApp was $700. And Google Search was $17,000 a year, which is 30% of an average person’s income. Now, it’s just a theoretical question. I’m sure people wouldn’t pay $17,000 a year for Google Search, but it did directionally indicate how, as you say, valuable these tech companies in general and Google Search in particular have to come in our lives.

Trey Lockerbie (00:08:21):
So, a lot of these tech companies get often misvalued, because of these metrics that everyone’s using for different kinds of businesses that are more manufacturing involved or just more traditional in general. And I want to stick on this topic of GDP and how it relates. I was recently having a discussion with Jim O’Shaughnessy and we were breaking down the calculation of GDP and why it’s becoming less relevant. In a much similar way that you describe some of these metrics in the book, GDP is also influenced by manufacturing businesses and they’re not really factoring what the tech sector is bringing to the party. So, what are your thoughts on how GDP is calculated today and how would you calculate it given the strategies you outline in your book?

Adam Seessel (00:09:03):
We’re not measuring important economic developments in our economy and it’s precisely because they’re very hard to measure. Every time tech makes something better, faster, cheaper, it doesn’t necessarily get recorded in the stats. And you just have to understand that these measures like GDP and generally accepted accounting principles, which I talk about in the book, they were built for the industrial age. They were built for a time when GM and US Steel ruled the landscape. So, I think the economists, the econometrics people, the accounting people need to update these systems to account for tech.

Adam Seessel (00:09:40):
I mean, even things like inflation, I think inflation has been benign for 40 years. I think a lot of it has to do with tech. Tech is so disinflationary. Before Google, we needed encyclopedias. Before Google, we needed Google Maps. Before WhatsApp, you needed to spend a fortune to call India. Now, it’s free. So, all these things tamped down pricing because tech builds better mouse traps, better, faster, cheaper mouse traps. And that’s a big, big, big disinflationary force on the economy that although I’m no expert, I feel pretty sure it’s not being measured.

Trey Lockerbie (00:10:18):
To that point, I mean, it’s a very archaic method they’re using as I understand it. They’re essentially putting people in the field. I think it’s roughly 500 people across the country, just with an iPad taking surveys of folks. And you’d think this day and age, they could just source from Visa or MasterCard or some company to actually see what spending is really doing, but instead, we’re taking these very arbitrary approaches. It’s mind boggling in a way.

Trey Lockerbie (00:10:42):
The only reason I bring it up and I’m sticking on it is because it seems to be driving so many big narratives in the market. I mean, with the recession and how it relates to inflation, et cetera, et cetera. But beyond that, I want shift focus a little bit to the frameworks that you outline in your book. So, first of all, I’d like for you to start off with just describing or walking us through this very simple BMP checklist.

Adam Seessel (00:11:06):
Well, this is a checklist I devised for myself over the years. Like an airline pilot, that’s where the checklist started actually, the cockpit. So, they avoid error prior to takeoff. Have you done this? Yes. Have you done this? So, my investment checklist, as you say, revolves around three central variables, the quality of the business, the quality of the management, and then the price you’re being asked to pay. So, BMP for short. So, as I say in the book, those are the three most important variables and in my experience to superior invested. So, business quality is the most important metric. If you start out with a crummy business, it doesn’t matter what you pay. The business will fail and degrade and eventually go out of business.

Adam Seessel (00:11:47):
So, at some point, no price is cheap enough to buy a failing business. You have to have a business that has competitive advantages. You have to have a business that has a secret sauce, an edge. Buffet called it a moat. If you don’t have that, capitalism is so fiercely competitive that its excess profits will be competed away relatively quickly. So, quality of business, business quality is the most important. After that, there’s management. In the book, I say Google probably has a better business pound for pound than Amazon, totally asset light. Every incremental search is potentially 100% profit margin. You can’t say that about every incremental package that Amazon delivers, because they have to build at a certain point more warehouse space.

Adam Seessel (00:12:32):
So, Google is a better mouse trap as a business, but Amazon has been the better stock. And that’s because Jeff Bezos is the greatest tech manager out there. He started at a hedge fund. So, he understands these financial concepts. He was an electrical engineering major, but then he also started his career at a hedge fund. So, he’s married old school business principles with new age. He understands the digital economy, but he also understands the principles of gravity in terms of what drives value in a business. So, management’s very important. And then price and price is also extremely important. I wouldn’t call myself or I couldn’t be able to call myself a value investor if I didn’t think price was the veto question.

Adam Seessel (00:13:16):
So, you’re going to have a great business and you have a great manager, but if the price isn’t right, you’re going to have a crummy investment. So, you have to be very careful about what price you pay. And as you suggested earlier, a central problem that I wrestle with in the book is these tech companies have looked expensive since they IPO-ed and yet they’ve appreciated thousands of fold. So, that leaves us with an existential question. Either we’re do over .com bust like we’ve never seen before or the metrics that we’ve used to calculate price are wrong. And I conclude that the second premise is true.

Trey Lockerbie (00:13:53):
I totally agree about Bezos and he’s also a student of Buffet probably, not surprisingly. I also want to just highlight something really small throughout there that we’re going to get into a little bit later around price, but you described it as the price you’re being asked to pay. And this to me is similar to the declaration of independence here in America, where you have the right to a pursuit of happiness, right? Not so much happiness, but the pursuit of it. Similar with price, that little reframing you just did there almost subconsciously is so important because you’re remembering that “Hey, the market is just offering this to you. You don’t have to take it.” I think a lot of people get tripped up there. Very interesting. All right.

Trey Lockerbie (00:14:33):
So, you highlight in the book that, I’m quoting now from the book, roughly half of the US market’s gains since 2011 have come from the tech sector. Since 2016, roughly two-thirds of the market’s appreciation has come from tech. Now, this was going up to 2020. So, it’s probably even gone a little bit more than that with the COVID boom we saw. So, obviously, tech is not going anywhere anytime soon. So, if we’re to look at tech companies from the lens of a value investing framework, what are some of the most compelling advantages from this tech sector in particular?

Adam Seessel (00:15:10):
Well, there are many, Trey. I mean, let’s first start with probably the most important one, which is tech companies don’t produce anything physical. Their raw materials are zeros and ones. And so, they have no cost of goods to put it in accounting terms. Coca-Cola is probably the best late 20th century business model. Their cost of goods was sugar and water and then they had to sprinkle pixie dust over it to make people believe that Coke is the real thing. And tech companies don’t have to do that. Tech companies don’t even have to buy sugar or water. They just hire engineers and a bunch of laptops and off they go. There’s no physical cost of good.

Adam Seessel (00:15:50):
So, an average tech company, a good tech company, or a software company will put up 80 to 90% gross margins. So, they’ll immediately have a 30% point head start over even the best of the consumer package company, even better than those. So, then you continue with a Coke parallel. Coke is a branded company. When they want to expand, they actually have to physically expand into Indonesia or South Africa. They have to build plant, bottling plant, and rent trucks, vending machines. They often have subsidiaries to it, but still, it is capital intensive.

Adam Seessel (00:16:30):
When Google wants to expand in its geography, they don’t have to build any plant. They don’t have to move anything around except zeros and ones. I mean, some engineers somewhere hits deploy and boom, new geography. So, it’s very high margin because they have no cost of goods. It’s very high return on capital because they have no few physical assets. And then you get into things like once people have figured out that Google is the best search engine, people standardize on it. So, there’s network effects. So, the more people that use Google, the more advertisers want to advertise on Google and Google has more money to make their search network better. This virtuous circle goes around and around.

Adam Seessel (00:17:10):
Airbnb says more guests create more hosts and more hosts create more guests. So, you have this winner take all or winner take most dynamics that you see in categories like online search and e-commerce and social media and short-term home rentals. So, for many, many reasons, these companies are just the biggest, baddest economic beasts ever created. I mean, they’re just really, really powerful business models, asset light, high margin, and people tend to standardize on them. Google makes seven times more money than Coke does. And Google’s only been around 20 years.

Trey Lockerbie (00:17:49):
You outlined here in the book that if Ford wants to grow its business, it must invest $10 to produce $1 in profit. Coke requires about $6 and Facebook only $2. I mean, that’s dramatic and that really helps put it into perspective.

Adam Seessel (00:18:06):
It’s pretty insane.

Trey Lockerbie (00:18:08):
You also have this theory in the book that I agree with where a lot of millennials know about technology naturally but not markets and older wiser investors know a lot about markets but maybe not so much technology AKA Buffet or someone like that. So, I think this stems from this lingering effect of the .com bubble mixed with the 2009 global financial crisis, where a lot of millennials got really, I guess, gun shy with the markets in general. They probably didn’t have that natural inclination to go learn about it. So, when you hear about Amazon having a PE ratio of nearly 100, you might be inclined to just make a snap judgment that we’re in this bubble similar to the .com bubble, but maybe outline for us how far tech has really come since its first bubble.

Adam Seessel (00:18:56):
Well, first of all, I’m really glad you picked up on that point about the millennials. I say, millennials understand tech but they’re afraid of the markets and older people like me understand markets but they’re afraid of tech. And the book is really my attempt to come to terms with tech and I write there that my son who’s a 26-year-old software engineer is one of my best teachers. When he can keep his patience with me, that is. Yeah, look, I mean, what I say in the book is to millennials, I understand why you would be shaken by the markets. You’ve had the, as you say, the.com bust and you had the great financial crisis. Then you had the pandemic. You’ve had three major crises in your life. So, I said, I get it. I understand.

Adam Seessel (00:19:38):
But on the other hand, be rational, look at the data. I mean, have your emotions, of course, but then move to the data, which says it since 1988, which is the mean year of the millennial birth years, the stock market has compounded 11% a year, which is better than it has over the last 100 years. So, the market remains the best place to build wealth. And there’s sections in my book about crypto and meme stocks and ESG investing. And all of them, I think, are basically people being disaffected by the markets and trying to find some alternative. I’m proposing in the book, look, my alternative is invest in what you know, which is tech. And you have an edge over me. You, Trey and your millennial friends, have an edge over me because you understand TikTok better than I do.

Adam Seessel (00:20:28):
You understand this stuff better than older people like me. So, use your edge. Then we’re getting into the more technical stuff about price. But I say in the book that I think Amazon’s average PE multiple since IPO was 150 times earnings on reported earnings. And for about a third of their life, they have not had reported annual earnings. They’ve had losses. So, as I say in the book, Bezos would’ve folded up his tent a long time ago if those numbers were right. It’s just they’re wrong and the GAAP financials are wrong. We’ve got to make adjustments into the numbers, because as you suggest, Trey, Google, Alphabet, I mean, take your pick. These companies are not going away. I mean back 20 years ago, yeah, there was a .com bust.

Adam Seessel (00:21:17):
But as I said earlier, Alphabet makes seven times more than Coke now. Are those profits are just going to evaporate? What. Amazon sells more as much stuff, maybe a little more now than Walmart. These companies are here to stay. Now, there is a secondary .com bus going on in the market now in mid ’22, a lot of companies came public, SPACs, their story stocks. They’re not making money. They don’t have any competitive advantages. Carvana comes to mind.

Adam Seessel (00:21:47):
Those stocks are getting crushed and those stocks probably deserve to be crushed. You have to make a distinction between temporary impairments of value and permanent impairments of value. So, that’s the babies and the bathwater, and that’s the trick right now is to find the babies. And if you make these price adjustments, you’ll see, in my opinion, that stocks like Amazon, Google are exceedingly cheap.

Trey Lockerbie (00:22:13):
I think it’s important to note that you’re not advocating to invest in tech just for tech’s sake. These companies are just as prone to severe competition as any other industry and you were talking there about the competitive advantage. In Buffet’s term, being a moat is easy to understand, but I’ve actually found that putting it in practice can be a little bit elusive. So, Elon Musk recently said that moats are irrelevant because all that matters is innovation. So, that’s a distraction in some ways. So, how do you determine if a business has a strong moat?

Adam Seessel (00:22:45):
Well, that’s a good question and a multi-layered question and you’re absolutely right. 90+% of all tech businesses are going to go the way of 90%+ of business in every other industry, doomed to failure or mediocrity. I mean, anyone who’s spent any time in the business world knows it’s brutal out there. It’s the Hunger Games, man. I mean, people are going after one another. Especially in tech, I mean tech is especially brutal to move fast and break things. So, you’ve got to have a secret sauce and I read Elon Musk’s comments and I thought about him. He’s absolutely right that innovation is critical, but like many things Elon says, it’s a little disingenuous.

Adam Seessel (00:23:29):
So, Tesla, for example, has a couple of moats that I’m sure he would hate to give away. I mean his first moat is his brand, right? He has 100% brand recognition. Tesla’s an amazing brand and he’d hate to give that competitive advantage away, his brand. And the second moat he has, which is less obvious, is because they make, I think, two-thirds of all electric vehicles and they’ve scaled up like a classic manufacturing business, their unit costs are 25% less in the competition.

Adam Seessel (00:24:00):
So, he has a secondary moat, which is he has a low cost model. So, he can say all he wants that moats don’t matter. But if you went to him and said, “Okay, well, we’re taking away your brand and we’re taking away your cost of that,” he’d be like, “Wait, wait. Okay, wait a second.” It’s like his bid for Twitter. He takes it back. But anyway, to your question about moats, actually find it easiest, Trey, when I think almost like a 12 year old. I don’t overcomplicate it. You may be over complicating things in the sense of just ask yourself, “Who’s taken a run at this company historically and failed?” Or you could even say, “Who could take a run and game theory it out? How could they tunnel under the moat?”

Adam Seessel (00:24:46):
So, let’s take four companies and I won’t dwell too much on them, but let’s take four discrete companies and we can go through the moat or lack thereof. So, Google or Alphabet, which us used to be called Google. So, Microsoft spent $15 billion a year trying to beat Google and Search. They have a less than 5% market share, less well known. Amazon took a run at Google and Search. Some years ago, Bezos hired the guy who wrote the first search engine, developed the first search engine for Yahoo, and said, “Build me a search engine so we can compete against Google.” A couple years later, the guy quit and he left for Google. He went to Google. Apparently, Bezos had a huge temper tantrum.

Adam Seessel (00:25:28):
So, after that, he said, “Treat Google like a mountain. You can climb it, but you can’t move it.” So that’s the business. That’s like the archetypal moat. Bezos didn’t say moat. He said mountain. You want a tank. You want battleship. Pick your metaphor, but you want a business that competitors have tried to go after and can’t or game theory it out. Amazon, same, 50% share of e-commerce. Walmart six or seven years ago said, “We got to get into this game.” They tanked margins by a lot. They spent a lot of money on e-commerce. You know what their market share is now of e-commerce?

Trey Lockerbie (00:26:06):
6%.

Adam Seessel (00:26:06):
7%.

Trey Lockerbie (00:26:07):
Yeah, that’s close. Yeah.

Adam Seessel (00:26:08):
7%.

Trey Lockerbie (00:26:09):
I read your book.

Adam Seessel (00:26:09):
Yeah, right. Yeah. So, anyway, if Walmart, the biggest retailer on earth, tries to make a run at Amazon and has a less than 10% share, pretty good sign that it’s hard to replicate that business. So, then the other two that I’ve never liked and I’ll tell you why and this is just all trying to help you and your listeners develop thought patterns for moats is I’ve never liked Netflix. It never made sense to me. I never understood what Netflix’s moat was. They make movies and put them online for people to stream. Anybody can do that. So, that’s what I thought, and sure enough, that’s what’s happening. I mean, Hulu, Apple, Amazon, Paramount, Disney. I mean, keep going.

Adam Seessel (00:26:59):
And some of these companies actually have an edge over Netflix because they have original content. They have content libraries they don’t have to keep spending on. So, Disney has a huge back catalog. They can just put out there and the costs are already spent. So, I never got Netflix. And I think, look, Netflix might appreciate. They might figure it out. And by the way, if they start moderating their content costs, I’ll be interested. But until then, it’s an arms race. It’s an arms war. It is literally Hunger Games, where they’re all out there saying, “I’ll spend 10 billion. No, I’ll spend 15 billion on content. No, I’ll spend 20.” And it keeps going up and up and up. Who wins? The consumer, but not the company.

Adam Seessel (00:27:41):
And then the other one I’ve never liked, which is getting its comeuppance, is Facebook. Facebook has many of the characteristics I’ve described, network effects and winner take all and asset light and so on and so forth. But on the other hand, Trey, they never had the best social media site. No one ever goes, “Oh, it’s awesome.” You and I would never rave, I don’t think, about Facebook the way we would rave about Google, right? It’s just like people are on it because people are on it and that makes them very vulnerable. And if you look at the history, WhatsApp came along, people started getting on WhatsApp, Zuckerberg bought WhatsApp. Instagram came along, people started getting on Instagram, bought Instagram.

Adam Seessel (00:28:24):
And then when people figured out that he was buying out his competitors, TikTok came along. He couldn’t buy TikTok and TikTok is now taking users. So, you have to have an edge. You have to have secret sauce. And those are just a few examples of how I think through whether you have a moat, whether your business is protected for 10, 15, 20 years. And we can talk about others if you want.

Trey Lockerbie (00:28:48):
But even to that point, right, Facebook has now 3.5 billion users. I mean, half the world’s population more or less. And so, that has to be worth something. Obviously, to your point, people are on it because people are on it. But the level of disruption, I think, just from that network effect being so far ahead is worth probably quite a bit.

Adam Seessel (00:29:10):
Well, I think not to pick a bone because there’s still a lot of numbers, but I think Facebook as a company has three billion monthly users and two billion are on blue Facebook. So, it’s only two billion. It’s still a lot of people to your point. But, Trey, those network effects can unravel as fast as they ravel. I mean, network effects happen very quickly. And when they unravel, they unravel very quickly. I mean, we’ve already seen this. Look at Yahoo. Remember when Yahoo used to be the biggest search engine and then Google just made a better, faster, more relevant one. All of a sudden, down the tubes.

Adam Seessel (00:29:49):
So, if people decide to congregate elsewhere besides Facebook, it’s going to get over real quick. And it seems like that’s starting to happen with TikTok. And I think that’s why the company is now called Meta. He’s making this $10 billion a year bet on an unproven technology. Could work, could be huge, could have first mover advantage, but I don’t bet on miracles. I bet on moats and we’ll see what happens in the Metaverse. But right now, his core business is very vulnerable and I think he knows it.

Trey Lockerbie (00:30:23):
Yeah. I’d be curious to see their active users and I imagine that’s declining. I, for example, have a Facebook. I haven’t touched it in probably five years. So, I wonder how many people are like that to your point. All right. So, I’d like to dig in a little bit on the accounting issues at hand. You mentioned the GAAP accounting rules that everyone is regulated by on the stock market. The intention for this is to try to standardize financial reports across thousands of different businesses with very different business models, but what are some of the biggest flaws from using GAAP on tech companies?

Adam Seessel (00:30:59):
Well, you just have to start in the historical context, Trey. GAAP, generally accepted accounting principles, which is what the SEC basically requires all companies in the US to follow was promulgated in the 1930s after the depression. The federal authority said, “We need to standardize accounting so that investors know what’s going on.” And in the ’30s, General Motors, US Steel, Ford, coal companies, they were the big companies out there. And so, the rules were built around industrial companies. The central problem, which we’ve talked about here and there so far, is that in accounting, the definition of an asset is an expenditure by a company that has a projected life of more than one year.

Adam Seessel (00:31:44):
So, if you build a house, that’s an asset, not an expense, because you’re going to live in your house for more than a year. But your water bill is an expense because you use your water immediately. So, an expense is categorized as something that has less than a one year useful life. So, factories have a 20- to 25-year useful life roughly depending on the factory. So, if I spend $100 on a factory and I’m US Steel or General Motors and it has a 20-year useful life, every year, I expense $5 of that $100, right? A hundred divided by 20 years is $5 a year in expense, but R&D expenditures, which are the lifeblood of tech companies, R&D in the sense is the plant. It is the factory. It is the wheel, the engine room of a tech company.

Adam Seessel (00:32:30):
Well, accounting rules now say that all those expenses must be the vast majority. Ninety some percent must be expensed immediately. So, if you’re an industrial company and you have $100 of revenue and you expend $100 on a new plant, you only expense $5 of that. So, your profit is $95. But if you’re a tech company and you have $100 of revenue and you spend $100 of R&D because all those $100 are immediately expensed, your profit is zero. So, tech companies have underreported earnings basically because of the outdated tech accounting rules. They will change, I think, but until they change, we, as intelligent investors, need to make adjustments.

Trey Lockerbie (00:33:16):
And to your point, as we just mentioned, with Facebook investing tens of billions into the Metaverse, I mean, those are immediately expense, even though that technology could live on and produce revenue over years to come.

Adam Seessel (00:33:29):
It’s a good point and I would argue that they should be expense. And if you think about the history of R&D, back in the ’50s and ’60s, all R&D was a moonshot. It was like some guys in the back with a beaker and stuff, figuring out whether they could come up with a great new product. So, of course, it should be expense over one year. But now with these giant companies, Google spends a lot of money tweaking its search engine. They tweak the search algorithm twice a day to make it better, faster, more relevant, to keep the moat durable, to throw sharks and alligators in the moat, to make sure that nobody can get that.

Adam Seessel (00:34:08):
But all those expenditures are expensed. And of course, the expenditures on their search engine has a multi-year life. It’s obvious, but not if GAAP doesn’t recognize that. So, every dollar that Amazon spends on its e-commerce website, expense every year. What are you talking about? Of course, it has a multiple year life. It’s building out the moat. So, R&D expenditures used to be speculative and some still are speculative, but many, many, many are not.

Trey Lockerbie (00:34:38):
Interesting distinction there. So, now you can start to imagine that there’s likely a different method we should be applying to tech companies to find their true value, which you’ve described here. And I’d like for you to walk us through the concept of what you call earnings power and also harvest mode and describing those two different strategies. Let’s use Amazon as an example.

Adam Seessel (00:35:01):
Basically, the theory of the concept, Trey, is that comparing Amazon to a mature company like Wells Fargo is like comparing an apple orchard in the spring to an apple orchard in the fall. One is ready for harvest. Wells Fargo is ready for harvest. It’s not going to grow a lot. Well, the basic bank. It’s mature. So, yes, they spend money on marketing and this and that, but they’re basically in profit maximization mode. They’re trying to bring every dollar they can down to the bottom line. So, their margins are going to be very high. Digital companies are in the opposite camp. They’re like an apple orchard in springtime. The apples aren’t ripe yet. You don’t want to pick them. You want to be plowing money back into the fertilizer and pruning and all that stuff.

Adam Seessel (00:35:48):
Amazon just now caught up with Walmart in terms of retail spending. They only have a 5 or 6% share of total US retail spend here in this nation and 1% of worldwide retail spend. So, they have enormous headroom to grow. So, they’re going to reinvest in their business. So, when you take the accounting problems, which we just talked about, and then you take the reinvestment opportunities, basically, their profits that they’re reporting are not at all what their earnings power could be. And I define earnings power as a latent underlying ability for a company like Amazon or Google or any tech company really to produce profits when they get to harvest mode like Wells Fargo. So, we can walk through the segments, if you want, of Amazon. I don’t know how deep you want to go.

Trey Lockerbie (00:36:36):
Let’s go deep. Yeah. So, what you’re saying right there is essentially, we have go back to GAAP accounting, where you’re trying to standardize all businesses to each other. What you’re essentially doing is standardizing high growing tech companies with late stage mature businesses, right? So, you’re just making it apples to apples comparison. So, by doing that, let’s go through Amazon, maybe even the rough P&L, and describe exactly what you’re talking about there.

Adam Seessel (00:37:01):
So, Amazon has two main segments. They have the cloud segment, Amazon Web Services, and then they have everything else, most of which is e-commerce related. So, they report Amazon Web Service as a 30% margin, which is a healthy margin. So, there’s no need to make adjustments there, but their e-commerce or everything else besides AWS, if you just look at the annual report in 2020, which is when I really got conviction on Amazon, their e-commerce margin was 2%. That’s what the GAAP financials wanted you to believe. Walmart’s margin was 6%. So, if you believe that Amazon’s e-commerce margin was 2%, then you were basically saying Amazon is less profitable than Walmart. That’s what the financials were forcing you to believe.

Adam Seessel (00:37:47):
And if you believe that, then I don’t think you should be in the business, because it’s absurd that a brick and mortar retailer would have three times the profitability of an e-commerce retailer who has no stores and who does all their business online. So, I walk through the segments in the book and I say, “Well, e-commerce, at least 6%, because that’s what Walmart is.” So, I get into the 9, 10% range, I think, for e-commerce. Then I go to physical stores. They own Whole Foods and subscriptions. And those are both very low margin businesses. Subscriptions they use is a loss leader.

Adam Seessel (00:38:23):
They give me Prime video and they give you Prime video just to cement us into the Prime retail ecosystem like, “Oh, I’ve got Prime video. What a nice little add-on.” So, that they can make off us in e-commerce, but those have a very low margin. But then there are two very high margin segments, which are really recent segments. There’s what they call the third-party seller segment where they’re not buying the books and the electronics and the printers and the Swiffer WetJets and keeping them inventory. Amazon’s not. They’re using their platform to say to other merchants, “Hey, roughly 5 out of every 10 searches online for shopping come through amazon.com. Put your products on our website and we’ll sell them for you and we’ll take a little cut.”

Adam Seessel (00:39:10):
That’s an enormously profitable business because they’re not buying the cost of goods. They’re not buying the inventory. They’re just using their platform as a platform. So, that’s very asset light. And so, the best comparable there is eBay, which is similar to sitting there, letting people transact goods. And those margins are 25%. So, I ascribe a 25% margin to third-party sellers. And then the best one is because 50% of all people come to Amazon to search for goods online, all merchants, consumer product companies, everybody wants to advertise on the website.

Adam Seessel (00:39:46):
So, their advertising businesses right now are running 34 billion a year, which is almost assuredly, pure profit, but just to be conservative, I put a 50% profit margin on that. So, when you add up all those segments, the e-commerce margin is not 2%, which is reported. The e-commerce margin in my estimate is 15%. So, it’s 7X. So, when I was looking at Amazon, the multiple on a reported GAAP basis was 90 times, but on an adjusted basis, on an earnings power basis, it was 15 times. And so, that sounds pretty good. So, I bought a lot during the pandemic.

Trey Lockerbie (00:40:24):
I love that. And just a quick note there about your rule of finding things that are under a 20 price to earnings ratio, because that’s essentially a 5% yield and we’re going to come back to that. But anything under that, it seems like it’s pretty strong. So, even a 15X multiple is very appealing, I would imagine.

Adam Seessel (00:40:43):
Yeah. And I make the point in the book and it’s an important point. Financial analysts, it’s not a precise exercise. It’s not like we’re aerospace engineers where we’re trying to get to a millimeter or the plane will fall out of the air. You want to get in the ballpark. Buffet said, “I want to be directionally accurate,” or “It’s better to be generally right than precisely wrong.” You can play with these estimates that I make.

Adam Seessel (00:41:07):
I show in the book, I outline all my work and say, “Well, just tell me that you don’t think that the e-commerce margin is 10. It’s 5 or whatever and play with it. It actually doesn’t make that much of a difference.” I think it moves the multiple from 15 times to 18 times. So, 15 times, 18 times. I mean, that’s still below the market multiple for a way above average business. So, you don’t want to be too cute about it. You just want to get in the ballpark.

Trey Lockerbie (00:41:36):
So, sticking with that BMP framework you outlined earlier, we’ve talked a lot about the business element, right, the B. I’d like to move to the M, the management. Sticking with Amazon, you were talking about how Bezos was maybe the best manager to ever live it would seem. I think Buffet and Munger would agree with you on that. I’d like for you to provide some frameworks for the audience of how to actually measure management quality as well. So, walk us through the two questions or hurdles you use to determine if a company has great management.

Adam Seessel (00:42:07):
Yeah. I mean the two things I say in the book, Trey, are, “Do they act like owners?” Because there are basically two managers of companies and this is especially true in publicly traded companies where the rewards of being a manager are very, very high. So, the one kind of manager acts like they actually own the business. And I talk in the book about Tom Murphy, this great manager that Buffet knew and trusted, who ran TV stations and then ABC and then for brief time, Disney. He didn’t own a lot of stock, but he was just this old school guy that believed that he was a steward for the shareholders and he got rich. I mean, look, he got wealthy, but he never got obscenely wealthy. He never saw the company that he was running as a vehicle for his own personal enrichment.

Adam Seessel (00:42:57):
He believed that he was running it for the shareholders. And if he ran it for the shareholders, they would reward him. He would reward them and everything would work out. Now, the second kind of executive, which is all too common in publicly traded companies, is the guy who’s there or the woman who’s there for 5 or 10 years from age 55 to 65 and they’ve got 10 years. They’re not playing defense, but they’re playing not to lose. Just keep it in the middle of the fairway, don’t do anything stupid, and basically get paid as much as you can. Get the board to give you as much stock comp and perks, airplanes and life insurance and security details and the perks go on and on. And these people do not act like old time stewards.

Adam Seessel (00:43:45):
Carl Icahn has this great image of these guys are like the caretakers of a giant English estate, but instead of taking care of the estate for the owners, they’re just skimming as much as they can. They’re taking the sheep and they’re taking the milk and they’re taking the barley or whatever. And you want to look for a manager who really acts like an owner. Owning a lot of stock is a good sign, but it’s not always the right sign, because Murphy didn’t own a lot of stock but he acted like an owner. And some guys or some women own stock, but they’re ignorant of the drivers of value. And so, they ruin shareholder value. They want to act like owners, but they don’t know how to be.

Adam Seessel (00:44:23):
And that’s the second characteristic that I talk about in a book. Are they financially savvy? Do they understand the drivers of value? And it’s not like you have to be some financial whiz, but you do have to understand a few basic principles and the central one, which is return on capital. So, it is this very simple calculation where you have the assets that you’re required to generate the profit and then the profit. So, this is what you talked about when I said Ford has to spend $10 of assets to generate $1 of profit. So, their return on capital is 10.

Adam Seessel (00:44:56):
Coke, if you put in all the bottling plants, which they put off balance sheet, but that’s just a trick to try to trick investors to think that they’re more asset light than they are, but the rating agencies required Coke to put all their bottling assets on the balance sheet. So, if you look at that, one over six, their return on capital is 16, 17%, which is good. Anything in the teens is good, but Facebook was one over two, 50% return on capital. So, you want a high return on capital businesses and you need to understand. I’m going to invest X and I’m going to get Y. There’s got to be a cold bloodedness to your management.

Adam Seessel (00:45:35):
I quote this guy who runs this great aerospace company called HAECO in the book. He’s like, “Yeah, I happen to be in the aerospace business, but really, I’m just in the cash generation business. And the aerospace company that I run happens to be the vehicle.” All good managers think that way. They just want to say, “I’m investing X and I’m getting Y. What do I have to invest? What am I getting? And if it’s not a good investment, I’m not going to do it. I’m not going to do it because it’s cool or because I built an empire to myself. I’m going to do it because I’m a coldblooded manager who knows how to drive value.” And that’s what you want to look for.

Trey Lockerbie (00:46:12):
Yeah. I actually highlighted that quote in the book about being in the cash flow business. What a great line. And you’ve actually inspired me to refocus on return on capital, because I’ve shifted my focus when I’m talking about quality of management. I shifted over to the interest coverage ratio and the reason for that is I read Toby Carlisle’s book, a good friend of our show here, called Deep Value. And he essentially shows that Joel Greenblatt’s magic formula, which of course is the earnings yield and return on capital, actually performs better if you simply just remove the return on capital component. Meaning, just buying cheap stuff works.

Trey Lockerbie (00:46:48):
And when I talked to Tom Gayner, he said, “The best way to look at management is by the level of debt.” So, when I hear you say, “Are they financially savvy?”, I feel like what you’re alluding to maybe there is the amount of their stewardship, right? Because if you’re just leveraging up the business, chances are you’re probably not that mindful of the actual long term effect of that. So, with that, I’m curious to know if the debt levels or interest coverage ratios, things like that weigh into your thinking when you’re talking about quality of management.

Adam Seessel (00:47:20):
Not really, Trey. Tom Gayner is a good friend of mine and a great investor and I admire him. I don’t know the conversation, but I mean the fact is that some businesses can afford very high levels of debts and some can’t. So, the general rule of thumb is the steadier the business, the more debt you can put on it. So, consumer products companies, which don’t have highs and lows, can take a lot of debt and that actually improves not the return on capital, but it improves the return on equity, which is a related concept. Whereas cyclical businesses, airlines and manufacturing companies cannot take on a lot of debt, because you could have a lot of debt and then the recession comes and you can’t pay off your debt.

Adam Seessel (00:48:03):
So, Tom Murphy, who I write about in the book, he carried tons of debt. He would lever up to buy a company. Then he would use the cash flow for the TV stations to pay the debt down. Then he’d do it again. He couldn’t find anything to buy. He’d buy back his own stock. So, he ran with a lot of leverage. By the way, insurance companies are leveraged vehicles. What do you think an insurance contract is? It’s a form of debt, right? I’m the insurance company. I sell you a policy. I’m on the hook to pay you the claim. So, I don’t actually think that’s a good marker.

Trey Lockerbie (00:48:37):
Really fascinating. Thank you for that. So, a new standard metric that most executives use, especially in tech companies nowadays, is the lifetime value over the cost of capital. Buffet was even early in this, it would seem, when he was first investing in GEICO. Walk us through what Buffet was doing there, the two metrics themselves, and what is actually telling you when you’re dividing the lifetime value by the cost of capital.

Adam Seessel (00:49:03):
Well, I’m so pleased you picked up on that, because it’s a relatively obscure concept that not a lot of people get, but it’s extremely important to tech companies. And it goes back to the outdated accounting rules, Trey, in the sense that Intuit, which is another great company that I own, that I talk a lot about in the book we haven’t spoken about, but they use lifetime value over customer acquisition costs a lot. Because when they spend marketing dollars to get new QuickBooks customers or new TurboTax customers, they think of it as an asset. They think of those expenditures as having more than one year of useful life, because if they can capture a customer, that customer will be with them for multiple years because TurboTax is a very sticky product, right?

Adam Seessel (00:49:51):
Once you start doing your taxes on TurboTax, hard to get off. Once you start running your small business on QuickBooks, hard to get off, hard to rip those guts out of the back office. So, they know that if they spend a dollar on customer acquisition, they want to get multiple dollars of revenue over the lifetime value of that customer. So, it’s customer acquisition cost in relation to lifetime value. So, Intuit like many tech companies wants to spend a dollar of marketing spend and they think that they’ll get… The hurdle rate is $3 of lifetime value of customers.

Adam Seessel (00:50:30):
So, if I spend $100 million of marketing TurboTax, I’m hoping that over the lifetime, the customers I acquire from that marketing spend will spend with me $300 million. And let’s just say that the profit margin on those customers is 20%. That’s probably low, but let’s just say 20%. So, $300 million of revenue at a 20% margin is $60 million of profit and I spent $100 million to get it. So, that’s a 60% return on capital, $60 million over $100 million. But that never shows up in the financials because all those marketing dollars were expensed immediately. So, this is one hack that tech companies use to say, “Yeah, the GAAP’s wrong. These are not expenses. These are long live assets that we’re creating. And so, we’re going to rejigger the financials to think about it correctly.”

Adam Seessel (00:51:23):
Not correctly the way GAAP tells me, but correctly the way businesspeople think. Buffet has done this. He bought GEICO’s public company in 1995. He bought it for Berkshire. GEICO the last year they reported financials made $250 million in profit and spent $35 million in marketing. When he bought the whole company and he could control it, he said, “To hell with this. This is such a great product. I’m going to tank my profits in GEICO and spend like a drunken sailor on marketing, because I know that those marketing spend like Intuit will have a positive lifetime value.”

Adam Seessel (00:51:59):
So, in 1999, he spent $250 million on marketing in GEICO. He spent the entire profits of the company four years before in marketing. So, does that mean they were “making no money”? Well, according to GAAP, yeah, but he knew that that was baloney. And he wrote about it in the annual. He said, “Yeah, the profits look like they’re down, but the intrinsic value is going up.” And this is what tech companies understand. I mean, tech guys are engineers. They are quants. They measure everything.

Adam Seessel (00:52:35):
So, if you find a company like Intuit or Amazon, where the management really knows what drives shareholder value, they’re going to adjust the financials and run their company according to economic reality, rather than GAAP financial reporting. As I said, Bezos should have shut that company down a long time ago if he believed GAAP, but he was making all these adjustments like Buffet did with GEICO and Intuit’s doing with LTV to CAC. It’s interesting.

Trey Lockerbie (00:53:06):
I’m glad you brought up Bezos there, because I was just going to say that I imagine that’s one of the metrics that kept his composure when in the .com bubble, it went down 94%, I think, at one point. So, you have to be looking at the dashboard and saying, “Actually, the business is improving dramatically and the return on capital is amazing.” All right. So, we’ve done the B and the M. We want to move on now to price, the P in the BMP equation. Now, as I mentioned earlier, you’re looking for a minimum of a 5% yield. We were talking about the PE of 20. With inflation and interest rates both now rising, I’m just curious, does your playbook change to reflect the new environment we’re going into?

Adam Seessel (00:53:45):
Well, it’s an excellent question, because rising interest rates compress or depress multiples, because net press and value and all that stuff. Not that I had a crystal ball, but I knew that when I wrote the book, which was at the peak valuations, I knew that valuations would probably come in. So, I feel comfortable still with 20 times. Twenty times free cash flow or earnings power is a 5% free cash flow earnings yield. So, if I’m getting paid 5% day one and then the business is going to grow, so year two, I make 6%, and year three, I make 8%, and year four, I make 10%, I think 5% is a fine place to start and I’m okay with it.

Trey Lockerbie (00:54:28):
I also had another curiosity. You mentioned Roku in your book and their price recently soared up to $480 and is now backed down in the 80s as of today. Is this an example of when we should as value investors back up the truck and load up?

Adam Seessel (00:54:43):
I wish I’d learned about Roku earlier, because Roku has very interesting business dynamics. I mean, they’ve basically interposed themselves between the streaming services, Netflix and Amazon and the viewers. They say, “We’re our connection and we’re a toll bridge because we have the biggest share of streaming devices. We’re going to charge you to go over our toll road to get to the consumers.” Now, I haven’t studied it intensively. So, I don’t know the answer about Roku backing up the truck, but I know the question, which is the same question you always want to ask yourself. Is their business sustainable?

Adam Seessel (00:55:22):
Are they going to be able to withstand the competition that is definitely coming for them, just like people came for Google to try to steal their riches because there’s a lot of money there, or are they just going to go the way of GoPro? GoPro was a great stock. People loved it and then competition came along. How differentiated is a selfie stick really? So, you look at GoPro stock price, which I put in the book. It’s a disaster. So, I don’t know the answer to Roku, Trey, but I know the question which is, “Do they have a moat?” And that’s what you should be asking yourself. And by the way, if you can’t figure out whether they have a moat, they don’t have a moat.

Trey Lockerbie (00:56:00):
Great point. There’s a sentence in your book that stood out to me, where you essentially claim that the stock market is not like Emerald City, where there’s this Wizard of Oz hiding behind a curtain pulling strings. And we have had lots of differing opinions on this show about that thing. I’m more in the camp of thinking that the market’s performance is strongly influenced by the Fed’s actions or even the anticipation of them. Is this sentence essentially writing off macro in a similar way, similar, I guess, to how Buffet would advise?

Adam Seessel (00:56:32):
Well, I don’t think Buffet writes off macro and neither do I. I mean he says and he’s right, that interest rates are the single most important determinative of stock valuation. So, in that sense, it’s rational that the market decline as the fed is now lower raising interest rates. But on the other hand, he’s right and Peter Lynch is right that it’s not a stock market. It’s not an abstract thing. It’s a market of stocks, and I encourage you and your listeners to think about it like a grocery store. You just walk in there and you see what’s on sale. You see what’s good merchandise on sale. You walk into a grocery store, you know a good deal, right? You know when the avocados look good and are well priced and you know when the raspberries look crappy. It’s the same. It’s the same.

Adam Seessel (00:57:25):
So, markets are going to do what they’re going to do as we said in the beginning, but in the end, superior businesses prevail. I mean, look at Apple. From 2010 to 2020, the stock market did nothing, right? It was the lost decade. The beginning of the decade, you had the .com bust. At the end of the decade, you had the financial crisis. The S&P was flat, but Apple was up by multiples. Why? Because they had a good business, and I’m not just being cavalier or flippant. It really is that simple and it really does pay in my experience and in my opinion to go back to first principles and think about it like a 12 year old.

Trey Lockerbie (00:58:05):
Another reason I ask is because Jeremy Grantham once said on this show that bear markets start with these termites and that the termites eat away at the tech companies first. And we actually saw this exact thing with this recent downturn. So, it makes me wonder, do you think the rise of tech over the last decade was highly correlated or caused by just the amount of cheap credit that we had available to us?

Adam Seessel (00:58:27):
I think the answer to that is pretty obviously, no. I mean, anyone can come up with a good sound bite about termites and this and that. Good investments don’t start with sound bites. They start with analysis. So, the reason tech companies have appreciated so much trade has zero to do with interest rates. It has zero to do with macroeconomic factors. It has to do with two things. One in the last 10 or 15 years, technology has hit critical mass to where broadband connectivity was robust and computing power became affordable so that everyone could afford a smartphone. So, that’s number one. Technology just hit critical mass.

Adam Seessel (00:59:11):
Number two, a certain select group of companies figured out a way to make loaded businesses out of these tech trends, including Apple, including Google, including Amazon, including Airbnb, including Adobe. Just go down the list. You probably know ones that I don’t know, but this has nothing to do with interest rates or easy credit. This has to do with harnessing technological change and then making it an incredible consumer product that people love and trust and will never leave.

Trey Lockerbie (00:59:45):
I really appreciate that perspective and I really enjoyed this book. It’s going to be, I think, my new most recommended book. It’s called Where the Money Is. Adam, before I let you go, where can our audience learn more about you and the book and any services or resources you want to share?

Adam Seessel (01:00:02):
Well, Trey, first of all, thank you for the kind words. I know you read a lot of investment books, so that’s high praise from you. I really appreciate it and I’m touched by it. In terms of me, even though I understand social media, I really don’t like being on it. So, you can go to Amazon and buy a copy of the book, of course. Or if you want to support your local book seller against Darth Vader, then go to local book seller. Simon & Schuster has a webpage on my book with the reviews from Bill Ackman and Joel Greenblatt and also links to local book sellers.

Adam Seessel (01:00:34):
And then the one service that I use, the one social media service I use because I like it… It’s pretty lowkey. … is LinkedIn. So, if people want to hit me up on LinkedIn, I’ve had several really nice chats with readers and happy to connect with people who want to learn more about how to invest in the digital age. Because it’s an important question. I think in many ways, it’s the important question. We’ve got this century old value discipline and then we’ve got this incredible technology that’s come from nowhere in the last 10 or 15 years. How do you put them together? How do you synthesize the two? That’s what I’m trying to do. That’s what the book’s about.

Trey Lockerbie (01:01:10):
It’s a very powerful concept and very powerful tools to use moving forward. Adam, really enjoyed it. Thank you so much again. Congrats on the book.

Adam Seessel (01:01:18):
I did too, Trey. Thanks so much.

Trey Lockerbie (01:01:21):
All right, everybody. That’s all we have for you this week. If you’re loving the show, don’t forget to follow us on your favorite podcast app. And if you feel like leaving a review, it really helps the show. You can also reach out to me directly on Twitter, @treylockerbie. I highly encourage you to check out all of the resources we have for you at theinvestorspodcast.com or simply Google TIP Finance. And with that, we’ll see you again next time.

Outro (01:01:43):
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