Podcast Transcript - Tobias Carlisle

You may know that Tobias from his own podcasts, The Acquirers Podcast or Value: After Hours, or as the founder and managing director of Acquirers Funds. In his second appearance here at the TVP, he and Juan discuss the role of data in investment strategy, forecasting probabilities and looking back at a year in Value since the announcement of the vaccination for Covid 19.


Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

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JTR: Tobias Carlisle, welcome back to The Value Perspective podcast. It is a pleasure to have you here again. How are you?

TC: Thanks, Juan. Such a pleasure to be back. It is great to see you again. I am so happy to be back on the Schroder’s value podcast. It is one of my favourites – and so is the firm.

JTR: Thank you very much for the very kind words. For those who do not know you or have not listened to our first episode – which they should! – can you please give us a little bit of background on how you came to be the investor you are today?

TC: I am Australian. I started out as a corporate advisory lawyer in the early 2000s and my first day of work was the peak of the dotcom boom – or ‘dotcom 1.0’. So I saw the wreckage and, while I thought I was going to be doing venture capital work, I ended up doing a lot of M&A and buyout work and liquidations and activism – although we did not have a name for that then. But they were like corporate raiders from the 1980s, who had come back. And I just found it all fascinating.

So I read my Graham and Dodd to understand what those guys were doing and thought it was unlikely we would ever see anything like that in the market again. But it turns out you do see deep-value type opportunities come around on a semi-regular basis – the ‘1,000-year storm’ rolls around about every seven years and then there is lots of value around. So I just started reading around it and researching it at the same time as I was working as a lawyer.

I came to San Francisco in the US and met my wife, went back to Australia for a little while then came back to the US and we have been here since 2010. And I have been running this firm, and building this firm up, to use the strategies that probably a more traditional value investor would use – so I am much closer to the Graham and Dodd end of value than I am to the Buffett end.

But Buffett is now the midpoint – I think value has stretched well beyond Buffett into this much growthier territory. We can talk about what that means but, basically, I think it is the extent to which you believe the growth rates will persist and the extent to which that factors into your valuation. I think this is where the more modern value guys have been much more willing to accept these higher rates of growth at face value, and have ridden that wave.

And the more traditional value guys, who are perhaps more conservative, look at those valuations based on those very high rates of growth and think, if we go and look at our base rates for high rates of growth for very big companies, we will see it is a very small handful that can sustain those rates of growth. And we all know what they are because they are Microsoft, Amazon, Alphabet – that is Google – so the ‘FAANG’-type names.

And what a lot of investors in the market now do is they look for the next Amazon ... and Amazon is a good example because it under-earned for a long time and did not make a lot of money – and that was Jeff Bezos doing that on purpose, trying to suppress the amount of tax it paid, running it like a private company, reinvesting and then AWS comes along and they become wildly profitable.

And so I think a lot of investors now have that mental model where they say, well, you can find these companies that do not really earn and, at some point, they will figure this out. Google, too, was like that – I think Google went public before it had figured out click-based advertising. I am not entirely sure but it was around that sort of time and it was not clear that was going to be as wildly successful as it has been.

So I think investors now use that mental model. They say, well, we can find these things that have these tremendous rates of growth and we can forecast some sort of mature margin from that, and then we can see that these things are going to be incredible earners. I think the base rate for that is quite low and I tend to be at the more conservative end, where I prefer that the cash flows are nearer-term.

Often, when you do that, you are buying lower rates of growth and so part of the way that I make money is through some mean reversion in the security’s price-to-valuation and also in terms of the company as it goes through its business cycle. There are some times when they look really ugly and, paradoxically, that is a really interesting time to buy because, as they do better through the cycle, they become more attractive and they look like better businesses.

So that is my approach in a nutshell – I am a more conservative, more traditional value-type investor and that has been an absolutely terrible place to be for about a decade. We have had this discussion before around that idea of Marc Andreessen that ‘software will eat the world’ – that software layer will extract all of the value and all these other businesses just cannot compete.

The question is whether that is a secular change that just continues on from here to eternity, or whether that is a little bit more cyclical – in which case, you and I are going to be doing a little bit better. And I think we have seen perhaps a little bit of a change back to the way that we invest. So I am happy to talk about all of that.

JTR: It pains me, the perception that valuation is riskier than any other strategy. Here on The Value Perspective, we are Grahamites at heart as well –we are closer to Graham than ‘current Buffett, closer to the Buffett of the late 1950s and early 1960s than the Buffett of today. And, at its inception, value was very tangible – you looked at the balance sheet and, if the price of the shares was trading below what you could get if the balance sheet was liquidated, you had all that. So the incorporation of the growth rate was not as meaningful at the beginning – and growth is, in its nature, speculative. It is one of the most difficult variables to forecast in the whole valuation equation and so people who are counting on the growth rate to be exponentially high or go on, in perpetuity, at X level beyond the base rates or what historical norms have said – they are playing quite a risky game, we believe.

TC: I could not agree more – but it has been a game that has been very well rewarded for a long period of time now. You can start sounding like Chicken Licken – warning the sky is falling and the sky is never falling  and obviously we are going to talk about that. It is an unusual time in the markets that we have gone this long without a crash. I do not regard March 2020 as a crash – I think I thought it was going to be the real thing at the time but it was probably more like a flash crash that immediately recovered all-time highs and now we have proceeded well above those highs.

My definition of a bear market is where you go sideways for 12 months and then you have this stomach-churning rollercoaster ride down where you go down 50%. And then you spend another six months or so finding new lows and you do that 14 or 15 times and, by the 16th new low, you just think this thing is never ever going to recover – and, of course, that is the point when the last person does not believe it will ever recover. That is when it starts to recover. That is what happened in 2000 and that is what happened in 2008/09.

Graham says you should not be forecasting growth – you should look at that trend and turn that into an average of earnings power. That might be a little bit too conservative. It does seem there is some persistent growth in some businesses and that, I think, was Buffett’s great innovation – that he was able to identify those companies that had genuinely good businesses with some ‘moat’ protection. There are very few of them and it is very hard to identify them scientifically and repeatedly and it is Buffett’s great genius that he has been able to do that.

But when you hear him talk about the way he does these things, I do not think there are many mere mortals who have the recollection or the intellect or the time in the market ... I have been to meetings where I will ask him, say, to talk about the traffic snarl in the Chicago rail yards and extemporaneously, off the top of his head, he will give this five-minute analysis of that. I had not even heard of that thing at the time. He reads so broadly and that is what it takes: you have to understand where all the chess pieces are on the board all the time – and what they are worth and how they move together. And it is a very difficult thing for most mere mortals to do.

JTR: I totally agree. You are a very data-driven investor. You have studied business strategy for many years – you have written books on it, actually, and I understand you are in the process of writing a new book, which I am going to ask about in a bit. Has the way you think about value evolved over the years or do you still think about it under the same optics – and, within that, has value’s struggle over the last decade changed anything for you?

TC: I am always learning and always open to new ideas. I have tried to incorporate into my process those ideas I think are robust and repeatable and I have learned new things as it has gone along. I am data-driven in the sense that I do a lot of back-testing I like to take an idea – you know, do very high rates of growth in revenues or earnings translate into very high rates of growth in stock-price performance?

No, they do not. And that will be shocking to a lot of people. But that is been a very well-known thing for a long time – you can read Jim O’Shaughnessy’s What Works on Wall Street, you can look at all the testing. But in recent times, that has been probably the best indicator of how well a stock price will perform – and when I say recent times, I mean 2015 to date, which is a long period of time in the market.

I think it is right that is about 10 years of underperformance for the value guys. The other criticism of the deeper-value guy – and I alluded to this at the start – when you talk about mean reversion in stock prices, what you are saying is that I am relying on the stock-price performance to generate some of my return. And they would say that is not what you should be doing – that is not real value investing. What you should be doing is looking at the underlying value of the company and you are looking at the improvement in the value of the company over a longer period of time. That is the thing that does generate more return than the change in the multiple.

But, over shorter periods of time – so out to about five years, which is a reasonably long period of time in a human lifetime – a lot of that return is the change in the multiple that folks are prepared to pay for stocks. So when you look at the things that are predictable, they are more the change in the multiple than in the underlying improvement in the business or the underlying moves in the business.

And the reason for that is, when companies become super-earners – when they become economically super-profitable – it attracts competition from adjacent businesses and adjacent industries. Everybody wants to earn more on what they invest in the market, including those businesses. So it is unusual for that very high rate of profitability to be sustained. But perhaps there is some change in that network businesses do seem to be become more valuable as the network grows. So that is a Google-type business – it would be hard to supplant Google search.

The way all of these businesses have been toppled in the past is the attack is oblique – it is not an attack directly along the line of business they run. If you think about Microsoft with Windows, Windows is still the standard and lots of folks use it but now there are other reasons to own other operating systems – for example, Macs are just more attractive-looking, easier to use, a little bit cooler – and those things do factor in.

Then we all went mobile and so it shifted away from Windows a little bit again, and then search came along so now we all mostly interact with our computers through the browser – everything is through the browser. So that again has changed the nature of that business and I think that will continue to happen. It is very, very difficult to predict where the incursion will be made and how your business will be toppled.

So, if you are little bit more conservative, what you can do is you can say, well, I do not want to pay those very high multiples for something. Let’s take Microsoft as an example: it is very hard for me to see how Microsoft gets unseated at the moment – everybody has got Word Excel. They have got the Office Suite. Most people are still on Windows-type machines.

You look at the stock-price performance over the last decade and it is absolutely phenomenal but what people forget – and I went to these conferences in 2010 and 2011, when people were pitching Microsoft – is Microsoft had an 11% free cash-flow yield; it had had its first year of revenue decline; it had a CEO people did not really like and then a CEO nobody had ever really heard of.

And so you had to invest at that point with those conditions, where it was not a great-looking business, it looked like it might be in decline and you had an untested CEO. And then you had to hold as it progressed from an 11% free cashflow yield to a 3% free cashflow yield, where it is roughly about now. And you had the benefit over that period of time of rapidly-growing revenues as they transitioned from people buying Windows once and for $500 or whatever to paying $10 or whatever now for each person for your Office suite on a monthly basis. So they earn $120 a year rather than $500 every three or four years.

It is a totally different business and there is no way in the world you foresaw that coming – and then you had to hold through that entire period of time. So really the way folks made money out of Microsoft was by starting out buying it as a deep-value company and then holding it as it transitioned and never selling. It is a tough ask, I think ... I can imagine buying it on 11%, free cashflow but it would be very difficult for me to hold it on a 3% free cashflow and I do not own it. That is the challenge.

JTR: One example you mention in one of your books, which I have never heard anyone else talk about, is how in 2002 Apple was actually trading below its net working capital, once you discounted all its debt and cash on the balance sheet, and it would have been very difficult for anyone to take a view that Apple was going to become the company it went on to be years later.

TC: And many times in between then too. The question has always been, how sustainable is this? Will people continue to pay $2,000 for a cell phone and lock themselves into this ecosystem where, once you have the software, it might make sense to have Apple TV, an Apple laptop, an iPad, a Mac on your desk – and I have all of those things. I have bought all of that stuff and I am part of that ecosystem.

But as you say, it was very difficult to foresee that happening in 2002 when it was net cash. But also, through that period of time, every time the new cycle comes around for a new phone, is it true that people will then transition to the new phone? Or will they try something else? I have transitioned away from the cell phone to a Google phone because it works better with my Google business suite of Gmail and all the things I use.

Other people will do those things too so the question is hard to answer for me when they are very, very expensive – but, when they are cheap, you have that optionality built into them where not a lot has to go right for this investment to work out. I am not relying on this continued superiority – what I am relying on is just the market recognising that this thing is better than it appears and then you have all that upside. You are not paying for that upside but, if it eventuates, then you are the beneficiary of it.

JTR: You are the host of two of the most successful financial podcasts of the last few years – and I have to say I am a fan of both. I really like Value: After Hours, and we have had Jake Taylor on the podcast as a guest. It is super-interesting and you guys have done something really fun, entertaining and different – and you complement each other very well. From a process perspective, what have you learned over the last three years from the many guests you have had, and even the conversations you have had with Bill Brewster and Jake, that have helped you to deal with the uncertainty every investor has to face every day.

TC: Thank you very much. I do not know how true that is but I will take the compliments! It has been great – both of those podcasts are very useful learning tools. Jake is so steady and steeped in that Buffett/Munger way of thinking that it is very good to bounce ideas off him and he will say, you know, with a little bit more patience, maybe this thing will just work out and maybe it is going to be OK.

Probably the toughest time was after we went through ... we all knew the market was very, very expensive and we knew something was going to come along to pop that balloon. And then it looked like we had the crash – and value does worse than anything else on the way down. So the market goes down 35%, value goes down 50%. And then everything else rockets up the other side – except for value and we underperform out the other side as well!

For me, that is the darkest time I have ever seen – I thought, maybe it really is broken, maybe it cannot come back. And I would talk to Jake about that pretty regularly on the podcast – and outside of that as well. And his view was, you know what, if we look through – which is what we are supposed to do – at the underlying, you can see the businesses are still generating good cashflows, they are buying back stock and it becomes inevitable at some stage that the market recognises this and you basically just have to survive to that point.

And I really think that is the key to value investing because you must have this divergent view of what the market does – you must diverge from the market in your performance. Now, sometimes you are going to diverge negatively and that is the thing that really tests value investors – can you stomach holding a different portfolio and underperforming, when it is so obvious that if you just go and buy the ‘FAANG’ stocks, you are going to do much, much better than everybody else? And that is an easy decision to make.

So it is good to have the ‘temperament’ part of it. The rational part is an easy part today, it is the irrational part, where you worry about whether you are doing the right thing – that is the really difficult part. So, from that perspective, that was great.

I also made a point of getting guys on the podcast, who were more growthy-type investors, to talk to them and see if I could get something from their process. And I certainly did, there are things that I learned – more about businesses – that I probably did not understand up to that point. I do not think it really changed my process much because I take those ideas and then I go back and test them – you know, are big margins a good thing?

I wrote in Quantitative Value, in 2012, that big margins are a good thing in a business so I knew that to be the case. But it was good to just get that reinforcement that, if you go through a period ... you know, quality as a factor is distinct from value as a factor – I have always said that. I really think they are both part of the same thing but they are definitely different. You know, one is a multiple – that is value – and then quality is a question of return on assets, transmission of revenue into cashflows, profitability, steadiness of those returns, and those sort of things.

Quality, to me, is more a question of how good is the business? And value is a question of what are you paying for that business? And so when you combine them together, which is really what I try to do – to do both of them at the same time – it is the quality that will help you more in a period of time like we have gone through than the value.

Value, for whatever reason, cannot keep up with the market. It makes total sense to me that when the market gets speculative, people want the more glamorous, fast-growing names and definitionally, as a value investor, you are not in those names. As [hedge fund manager] David Einhorn points up, two times overvalued is irrational, but three times overvalued is no more irrational than two times overvalued. It is just still irrational.

So you cannot bring your value mindset to that and try to articulate why one is worse than the other – it is not. And then three times can proceed on to four times and in the case of some companies like Tesla, you can just go up 20 times, and it makes no difference. Everybody who I know who is not a value person is just – I take my kids to school, there are Teslas everywhere; I talk to people about what they own and everybody owns a Tesla. And everybody has done very well out of Tesla.

And when they look at that stock price and they look at the number of times and how long everybody has been warning it is overvalued, it is very, very hard for them – impossible for them – to understand why Tesla is so dangerous at this point, because everybody who has warned them about it for years and years and years has been proven wrong.

But I think that, if you are a security analyst, there are a lot of problems with Tesla, right? You cannot get two consecutive quarters together and analyse the financial statements – like, that is a big red flag. In addition to that, it is expensive; it is not a great business; it is a metal-bender – all of these things So, when Tesla is flying high, we are just going to look silly and that is just the way it has got to be.

So I have taken all of those bits and pieces from those guys, I have gone back and tested them and thought about it. So from those two perspectives, I always want to learn something new and I always want to try to be equally open-minded and sceptical about that – and the podcast just helps me work that out in real time.

JTR: One thing you mentioned in this conversation, which also comes up regularly on the podcast, is the use of base rate. It is quite important and a lot of investors use them. Michael Mauboussin came out with a research paper quite recently where he was saying that Amazon had rebased the growth/revenue line base rate. He was referring to a piece he had written in the past where he argued it was impossible for Amazon to keep on growing the way it was, based on the base rate – and it did. Do you have any thoughts on that?

TC: Yeah. Amazon was $100bn and did a 45% year on that $100bn base – so just absolutely bonkers numbers that defies the base rates. Having said that, it is still one company. It does not necessarily mean that you throw out the base rates. I think Buffett and Charlie Munger would have said that retail has always been a really tough business. Retail is a great business – it is just that the competition comes along and it is always this industry-shaking, game-changing competition.

And they will point out, at one stage, we started out with a mom-and-pop type stores and then it became bigger stores right near the tram stop and then it became big-box retailers that could be further away but they were offering discounted prices – so a Walmart-type business – and now it is just Amazon is the retailer that comes out top. I do not know what the next iteration is – it could be Shopify, with Amazon like the Empire and Shopify is helping the rebels! And each individual can compete more ferociously than Amazon can in totality, because each individual is more incentivised for their own little part of the business than Amazon. You shop through Amazon and there is a lot of junky stuff in there. Who knows how the next iteration goes? But there will be a change, inevitably, at some point in the future. And that is the tough thing about retail – it is always this ground-breaking change. So I do not know that the book is closed on Amazon yet but it is certainly base-rate defying.

JTR: That is interesting. One recurring topic on this podcast is probabilities – and I like the way Jake Taylor and Annie Duke frame it where, if you believe sales on margins are going to be x% and you set your probabilities for the forecast at, say, 50%, then with enough data, that means that five out of 10 times that should be the expected result. If you are over or underestimating, that is a signal that should help you better calibrate – but this sounds easier said than done. Have you incorporated probabilistic thinking as part of your process as an investor? And how do you think about?

TC: Yes – my whole process is probabilistic – from the very start – but it is all research-based. And the two broad areas of focus for me are always – how do we get better at forecasting what a business will do in the next quarter, year, three years, five years? And then how do we position ourselves – what is an appropriate amount of money then to pay for some of these forecasts?

And I do not know if the forecasting ever gets any better but definitely, if there are changes in the market and Amazon is a new data point that needs to be incorporated, it does change the distribution, it does change. I do not know necessarily now that I would assume that sort of fade that I would have just automatically built into most models in the past. Now, I might say, let’s not assume a fade – let’s just keep on updating as we go along and see where we are. And if that fade manifests, then we need to start incorporating it into our model.

So I think the only thing you really can do is look at the conditions that exist right now and forecast in the very short term. It is a funny thing. It is easier to forecast three to five years out then it is to forecast a quarter to a year out, I think, because over that period of time it becomes more – does the stock price follow the underlying business? And do you have enough of a discount so you can get paid and generate a reasonable return?

The other thing is, the market is so expensive and there are so many expensive companies in the market, you probably do have to walk back your return expectations. I am always looking at the portfolio and I can tell what we are earning on assets, what we are reinvesting, what we are expecting to get out of the portfolio as a whole and where I think the portfolio can grow to in the next year. What the market will pay for that – that is a very difficult thing to say.

But I would rather say, let’s buy this at a discount to what the market is assuming for everything else, than let’s pay a premium for what the market is assuming for everything else, because I still think you probably get the benefit of the mean reversion, if you are buying at a discount, rather than you get the dis-benefit. Or you are probably going to see some mean reversion if you are overpaying – you are assuming that these companies are going to stay as strong as they are.

So I can look at [Ark Invest CEO] Cathie Wood’s portfolio. She has exceptionally expensive companies – and they are very good businesses, though, for the most part; there is a lot of high returns on invested capital. But the multiples now are so high that I think, if she has no change in the multiples in her companies, they will earn about 4% compound. If there is a multiple rerating down, which I think is a reasonable guess over five years, because they are so expensive, then, those numbers could become 1% or slightly negative.

Whereas, if I look at the value portfolios, I think the expected returns, based on reinvestment and flows, are much higher – so teens kind of numbers. And then,  if you expect some mean reversion on those, then maybe potentially even a little bit higher than that again. So that would direct me more to value at this point in the market.

So the base rates are always first and foremost in my mind. It is always a probabilistic approach. We know we are going to be wrong on about half of the businesses we put into the portfolio – it does not really bother me. If we are going to be wrong, we are going to update, we will move some of them out – and the ones we are right on will hopefully make up for the ones that were wrong and then a little bit will outperform.

I think that is the only way you can approach it because, if you become too deterministic about these businesses, you get locked into them. There are all these behavioural errors, if you do that – you keep on waiting for the turnaround and they never do and that is the traditional value trap. I have had my fair share and for sure and certain I am going to have a lot more. And I think you have to have them in the portfolio – otherwise you are not going to get the ones that are much, much better than everybody thinks.

JTR: We are recording this episode to mark the one-year anniversary of ‘Vaccination Day’, which many value investors celebrate as the turn of value. I am really worried I am jinxing something here! So I want to refer to something Annie Duke also said, which is that, when an investor makes a mistake, the whole team will get together and try to analyse what went wrong. Did they miss something on the fundamentals of the company? Was the position wrong? What were the risks and did they underestimated them? But she also made the point that, when something goes right, people do not do not go through that exercise. And they should because that is part of the process. Did you get it right because of process or did you get lucky? And if it was process, did you size it correctly? Was your investment position correct or could you have had a better outcome if the size was higher? We thought that was really interesting – and maybe one other thing value investors tend to do a lot is we tend to sell too early. So, as a value investor, is there any way we can fight against that mindset of being too focused on what can go wrong and fail to think about how well things could go on and make the most out of it?

TC: My process is to get lucky – that is my whole approach! The post mortem for things that go well – yes, most people do not do it. It is totally overlooked and, really, the whole reason I started on this process – and making process so much more important than the outcome – was my experience through 2008 and 2009 was very good but ... I was in a whole lot of net-nets in 2008 and 2009 and they all did very well.

And everybody knows that was a very good period of time for that very deep-value style. But I went back after I had had a good year and I looked at the universe of things I could have held versus what I actually did hold, and I found I had extracted about a third of the value I could have – and so it would have been a stupendous year. It was an unusually good year – I have never had a year like it since and I do not think I had had one beforehand – but the year could have been about three times better than it was.

And that was really the thing that started me on this – you do need to eliminate these little biases you have. And so I am a believer in that. Now, we are very, very process-driven. We have a very, very strict process for the way things are implemented so I am really not that important to the way things operate. I am the keeper of the process rather than somebody making investment decisions or anything like that.

So if I was not here, the process would continue on without me – and I like that approach because there are good days and there are bad days, right? Some days you show up and you are very happy and everything feels great. And you feel aggressive, the sap is up and it feels like a good time to be in the market. And other times you come in and there is other stuff going on. It is overcast, it is a bad day. Do you want to be making investment decisions on whether the sun is shining or not? Probably not but it is hard – I feel it.

So I am 100% in agreement that process is essential and that applies whether you are doing well or badly. If you are overshooting, that is great – but there is still an error there. And you have got to figure out that error. The really difficult thing, having said all that, is there is wild variation in the market – they will tell you the market returns 9% a year but the number of years you actually generate 9% is vanishingly small, right?

It is a tiny, tiny number. Most of the time, the margin is 20% plus or minus – that is like a 30% to a negative 10%. So have you done something good if it is a 30% year? Have you done something bad if it is a negative 10% year? No, that is well within the range of expected outcomes. One of the things I really find helpful is to look back over 200 years of data and there is a great bit of research by Michael Siminoff, who did this two centuries of value, where he stitched together this research. And when you go back and you look at those things, you say, well, this has nothing to do with me at all – this is just this what the market does. So I am a bystander. I am just trying to participate along and I recognise that, next year, we could be down 50% or up 50% and that is totally within the range of expected outcomes.

JTR: That is a good segue into my next question. We recently saw a webinar on ‘the psychology of the sell’, where the point was made that people spend so much time on the buy decision  and not nearly so much on the sell. And the data in the analysis showed people give up good performance numbers by not selling correctly. How do you go about it?

TC: Yes. It is one of those things that is hard because, as a value guy, you are always buying when things look really bleak and you have an idea where the valuation is. And then if you get lucky enough that it turns around, and it does sort of approach your valuation, and you sell at your valuation, you have inevitably left the rest of the performance on the table – because the market has looked, oh, this thing is up over the last three years, likely that continues on, and the speculators will grab it, and they can push it up a lot higher than you thought was a sensible amount of money to pay for that thing. And so you are going to kick yourself for the fact you did – oh, I should have just held on.

I have been doing it for long enough that I have also seen the reverse where it gets to the price and you do not sell and then it is down 50%. And you think, well, I should have sold it when I had the opportunity. So I have just built that into my process now.

But I have a slightly different approach because I think you want to be a value buyer and a quality holder. So while it is overearning relative to its assets and you are still getting a reasonable return in there because there are other considerations, tax considerations – not so much in the vehicles that I run but, for many other people there are tax considerations ... it is worth holding because there is an enormous amount of tax alpha, which is just delaying or shifting to long-term capital gains. All of those things generate a lot of return for you.

So I have a very strict process but I like to go back and look at the things I have sold and see how well they have done – and I always sell too early. Everybody does just – it is just a fact of life and it is just the way the markets are. Sell the price you plan to – the only thing I consider an error is not following the process.

JTR: We had a guest on the pod – Anthony Ball, who was one of the first guys to do private equity in South Africa. Now he and his colleagues do activism in South Africa, which we thought was really interesting, because activism has not really worked outside of the US – and, in an emerging market country, they seem to be doing quite well. And at the end of the pod – it is all about process, of course, but he made the point that process is important – but both the best investment opportunities and the worst mistakes come from not following process. And there is a little bit of truth to that. And you see that with Buffett or Graham with GEICO or the 3G Capital guys, when they bought the brewery in Brazil, where there is an anecdote that they paid a very high price and no-one believed it was a great transaction but it went on to be their best investment ever and it took them to a whole different level.

TC: I would say it is still a function of process, right? Like Graham’s – everybody knows Graham made most of his money out of GEICO rather than the net-net buying. But does that not just say to you, well, maybe you should be focusing on opportunities that look more like GEICO and less like net-nets, because net-nets have this problem where you are 100% relying on stockmarket price reversion and that is a ‘greater fool’ theory – I need the next guy to pay more than I did for this thing to work. And if he does not do that, I am out of luck.

And so Graham, in his most Buffett-like investment, buys GEICO, which is a pretty good business that grows over time and has all of these embedded competitive advantages in its DNA because it is set up that way. And that is how he makes all his money. I would say, well, then make your process to buy more GEICOs and fewer net-nets. We have lots and lots of stockmarket history data now from all around the world – you can go and look out the sort of things that have worked and the things that have not worked. And I think that, universally, everybody agrees, value is a pretty good way to approach it.

The quality factor is always a mix of different things but you can use AQR’s definition of ‘QMJ’ – ‘quality minus junk’. That is pretty good definition of quality so work that into your process. That is what I try to do. Over the very long run – and I hope that I make it to the very long run – I try to follow the things that have worked in the past. I assume that the future is – mostly – going to look like the past. It is not going to look exactly the same – business is going to change, we are going to have different business models and different approaches to investing and interest rates and inflation are going to go up. But we have seen that before, too – we sort of know what happens in that instance. And, in that instance, if those things happen, you do not want to overpay for stuff – you want to be paying a reasonable amount for a pretty good business.

It is almost inevitable that your best investment and your worst investment is going to come outside your range of expectations – you buy a lottery ticket and win the lottery, it is going to be your best investment but I do not think that is a very good process. Equally, on the other side, with your worst investments, there are going to be a lot more of those – the other lottery tickets you bought and they did not work out. That does not follow the process either and you have zeros on all of those. I have just made enough mistakes now from not following my process that I only regard it as a mistake to not follow the process.

JTR: That is a great analogy. I cannot lose the opportunity to ask for your thoughts around the ESG wave that has been going through the asset management industry and the investment world in general over the last three years and has gained a lot of momentum lately. Do you think ESG in the context of investing creates or negates opportunity for value investors?

TC: This is very difficult conversation to have – primarily because we are all going to disagree on the definition of ‘ESG’. It is a very personal approach and ‘environmental’ is going to break down in one way, ‘social’ is going to break down in another way and ‘governance’ is probably the one we can mostly agree on.

You have probably got a governance process as part of your investment approach and so do I. And the ‘E’ and the ‘S’ – however, you feel about the underlying morality or whatever of those ideas, the way I think about it is it creates a path for attack for the business. So, if there is enough political will to achieve an end on the ‘E’ or the ‘S’ ... take cigarette smoking – I do not know whether that falls under any of those but, when the courts can make a connection between smoking cigarettes and cancer, then that is always going to create an avenue for legislature or judiciary to attack that business.

And that is why they tend to trade at a discount – they have made payments in the past, they probably will have to make other payments in the future. It is analogous with social media, potentially – are they going to be able to make a connection between the damage to somebody's mind and their use of social media? I do not think it is a stretch to see some sort of court challenge in the US by a speculative lawyer doing that and achieving something and maybe the legislature grabs that.

So, whether you think about them as risks that exist now or contingent risks on something happening in the future, it is worth paying attention to. As an investment strategy, as a product, there is nothing that attracts scammers more than getting somebody to pay for something where the benefit is a little bit more amorphous than just, here are the returns for the last five years. They can say, it does not really matter what the returns are because we are achieving a charitable end or an environmental or a social end, so just pay us the fat fee and we will deliver those to you.

There is a new book coming out by Larry Swedroe on ESG. I have ‘blurbed’ the book and so I have had an opportunity to read it. And Larry has a great approach to it, where he is – just let’s look at what the claims are, let’s look at what the returns have been. It is a complicated question because there are so many different approaches to it. So it is not going to be resolved any time in the near term.

But I do think it is worthwhile considering the potential avenues of attack. There is a reason why Facebook is cheap at the moment and that reason is there is a large number of people who feel it is causing some societal harm. And if they can persuade a legislator in the US to do something about it or if they can find a jury or a judge that will answer that question, then that discount may turn out to be warranted, because it is going to be paying out some money in the future. But it is a very, very difficult thing to sort of handicap at this point. It is a tough question.

JTR: If a lot of people in the market decide for whatever reasons, their own ethical choices, that they do not want to own certain businesses in certain industries, and then they ask for those businesses to be divested from portfolios, does that create an opportunity?

TC: They will generate a higher return, yes. If you pay less for the same stream of cashflows, you are going to generate a higher return. That is the case. But the question is, is there some sort of contingent risk there that manifests in a big payment that negates that discount? And is that discount then warranted? That is the question I am trying to grapple with. And I think, in some respects, that is what I have been working on with the book – you know, the attack you do not expect is always the one that hurts you the most, because you can protect yourself against all the attacks you expect. And that is what everybody does.

If you are in a walled city, it is very, very hard to scale the walls but it might be a plague inside the city that brings you down. It is this thing that you cannot anticipate, that is the thing that hurts you. Buffett’s great skill, I think, has always been to imagine these things that have never happened before and to position himself in a way ... there is a story he told his two insurance managers to take down their exposure to the World Trade Centre – not because he thought that anything was going to happen but because he thought they had too much exposure.

And I think that is the approach – have we taken on too much risk where I do not know if anything is going to happen but, if something does happen ... and I think that is the approach I try to take on these avenues of risk. We do not necessarily know how this risk manifests but we know that it could. And if the magnitude of the impact is so great that it could materially affect this business for an extended period of time, then maybe the discount is appropriate and that is just one thing that you find uninvestable as a result.

JTR: That is very interesting. We are coming to the end of our discussion and we always ask our guests two questions. The first one is a book recommendation but, before you give us that, I would love to hear a little bit about your new book, if that is possible, and when it is coming out. And the second question is an example of a decision where the outcome was poor and you can identify that as down to process rather than bad luck.

TC: Like everybody else, I went through the pandemic and I was running a business through the pandemic, and it was all so incredibly nerve-racking. It just got so bad that I started reading philosophy and, while it had never resonated with me before, for the first time, I understood what some of these thinkers were grappling with.

Sun Tzu is the one I have read every five years since I was in high school and, every time I read it, I said, I do not get why everybody likes this book so much – I cannot understand a single thing that is going on here. You know, if you are going across a salt marsh and you are attacked, get your back to the clump of trees – I encounter that every single day when I am going to school with the kids. So that was a particularly useful piece of advice but nothing else and it was very hard to understand what was going on in that book.

But I read some other works – there is a writer-philosopher, Colonel John Boyd in the US, who came up with OODA [observe–orient–decide–act] Loops and various other things. And he was talking about Sun Tzu, in that context, and he said, there are these other things that lead up to the engagement that you need to think about – you know, is everybody in accordance with what we are trying to achieve here?

So there were all these other little soft things I had never really considered before that I found very helpful. And, when I started reading that, it branched out into these other ideas about grand strategy, which is how nation states deal with each other, and philosophy the Stoics and the Taoists and their ideas. And so it could be total shit – I do not know. I am still battling my way through this thing, trying to work out whether it is worthwhile or not. I do not know if it will ever see the light of day or not, because it is kind of cringeworthy at the moment. This is always my process, where the first draft is trash and I try to edit it down into something that is practical and useful. And I am still at the point where it is trash and it is not practical or useful yet. So if I get it to practical and useful, it will see the light of day, and if I do not, it will not – I will just keep on talking about it forever.

Still, my book recommendation is along those same lines: Devil Take the Hindmost: A History of Financial Speculation, Edward Chancellor’s great book. Maybe everybody has already read it because it has been around for a long time but it is a particularly good book to read, because he talks about all these speculative episodes that have happened since the 17th Century.

And every single one of them has resulted in the same way – there has been a big bust and everybody in them cannot see the bust coming. And then the bust happens and everybody wakes up as if they have snapped out of some sort of daydream. And they look back and they think, what were we thinking at that time? And I certainly remember the dotcom boom and the dotcom bust and whatever we are calling the 2007/08/09 credit crisis and the housing mania and the stockmarket mania that went along with it.

I think we are in another one now. We are in some sort of mania driven by very low rates and there is nowhere else to invest and probably the outcome is going to be the same as well. And we will wake up and we will say, why are we paying 50x sales to some of these software-as-a-service businesses – that makes no sense. So I think it is just a good reminder – it is good to know the market can go down or up 50% in any given year and you should be positioned so you are still in business if you do go down 50%. So there is a little bit more risk out there than you may appreciate if you have only been in the market for the last 13 years or so, which is an unusually long period of time.

And the example of a decision that ended badly due to bad process rather than bad luck?

I talk about this pretty regularly because it is still fresh in my mind. Jake Taylor, my co-host on  Value: After Hours did this research in 2015, where he looked at the spread between the most overvalued companies and the most undervalued companies. And he wrote this blog post saying, this is the worst opportunity set for value in 25 years, which is as far back as this data went. I took that blog post and I rewrote my own version of it and linked him up. And I read through that and I just then continued to be a value investor for the next six years – and suffered as a consequence.

What I should have done at that stage is taken the next step – and I try to do this now – and say, well, and then what does that mean? What are the implications of that? How can we position ourselves for that? So I think that value did exceptionally well from the bottom – 20002, once the dotcom carnage had cleared until about 2015, 2016, 2017, 2018 ... depending on how much ‘quality’ you had in your portfolio.

And it was a victim of its own success. It got too expensive – even though hose value stocks were still at a discount to the better stuff, it was not a big enough discount and you were paid better to go and pick up some better businesses at a slightly higher multiple. And I think that was the mistake that I made.

I do not want to time the market in the sense that, next time it happens, I am going to go and try and buy better-quality businesses. I just want to take that process so it makes no difference to me what the market looks like. Some of it, I think, is unavoidable. All the best value firms, I think, ran pretty well until 2017 and then just hit a wall as the market got speculative from 2018 – pretty much until about a year ago. And it was that little ‘air pocket’ that had a lot of us questioning whether we were doing the right thing or whether we had missed something.

You cannot change your process because of those speculative episodes. Go back and have a look and there are many, many, many of them in the market and, if you change through those things and you get smashed up on the other side, you are better off staying with your process.

But that signal in 2015 was one that we wrote about – and we both missed – and I tried to probably get a little bit more quality in my portfolio as a result of that. So I will buy better things when they go on sale. But that is something that Buffett told everybody to do about 30 or 40 years ago so there is no innovation there!

JTR: That is very interesting. Tobias Carlisle, thank you very much for being part of The Value Perspective podcast.

TC: Thanks, Juan – it was so much fun.


Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

I joined Schroders in January 2017 as a member of the Global Value Investment team and manage Emerging Market Value. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet, I was a member of the Customs Solution Group at HOLT Credit Suisse.  

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