Speaker 1: Welcome to Inside Active, a podcast about active managers, goes
Speaker 1: beyond sound bites and headlines and looks deeper into the processes, challenges,
Speaker 1: and philosophies and security selection. I'm David Cohne, i lead
Speaker 1: mutual fund and active Research at Bloomberg Intelligence. Investing often
Speaker 1: involves making forecasts about an uncertain future. Portfolio managers spend
Speaker 1: enormous amounts of time trying to predict earnings, economic conditions,
Speaker 1: competitive dynamics, and market sentiment. Yet for many businesses, those
Speaker 1: outcomes can change quickly, making even the best forecasts difficult
Speaker 1: to sustain. One way to reduce that uncertainty is to
Speaker 1: focus on companies whose businesses are inherently more predictable. Firms
Speaker 1: of occurring revenue, strong customer retention, discipline, capital allocation, and
Speaker 1: durable competitive advantages can provide investors with greater confidence and
Speaker 1: long term cash flows even as markets become more volatile.
Speaker 1: That doesn't eliminate risk, but it can change where investors
Speaker 1: choose to take it. Today, I wanted to explore what
Speaker 1: makes a business truly predictable, why recurring revenue is such
Speaker 1: an important part of the equation, and how those ideas
Speaker 1: translate into portfolio construction, security selection, and long term investing.
Speaker 1: So joining me to discuss that is Joseph Seposnic, portfolio
Speaker 1: manager of the Rainwater Equity ETF ticker RW. Joseph, thank
Speaker 1: you for joining me.
Speaker 2: Thank you for having me.
Speaker 1: David, So you often say that most businesses can't be predicted.
Speaker 1: What led you to that conclusion and how's it shaped
Speaker 1: your entire investment philosophy.
Speaker 2: Well, I want to take you back to my start
Speaker 2: in the industry. I started at Fidelity and I joined
Speaker 2: out of undergrad. I went to Berkeley for undergrad and
Speaker 2: I came to Boston and my boss said, you're from California,
Speaker 2: so you must know something about semiconductors. So they gave
Speaker 2: me research coverage of the semiconductor industry back in two
Speaker 2: thousand and five, small cap semiconductor businesses. Those businesses are
Speaker 2: not the businesses of today, which are great businesses with
Speaker 2: lots of customers, tremendous demand, and a very bright outlook
Speaker 2: for the future. Back then, they were very small companies
Speaker 2: with just a couple of customers, and they were kind
Speaker 2: of going in and out of business. And I had
Speaker 2: I had research coverage of these small, small companies and
Speaker 2: they were very unpredictable. I can remember I hosted a
Speaker 2: company of a I hosted a meeting with the CFO
Speaker 2: of a small chip company supplying chips to the flat
Speaker 2: tanel display market, and he was talking about how great
Speaker 2: his business was and how everything was going well, and
Speaker 2: they had they had approximately three customers at the time,
Speaker 2: So we had the meeting. A couple of days later,
Speaker 2: they reported quarterly results and the stock went down sixty
Speaker 2: percent in one day. And all I can say is
Speaker 2: I was very happy that I didn't recommend that business,
Speaker 2: but I was also shocked into paying attention and trying
Speaker 2: to understand what could make businesses not have that outcome occur,
Speaker 2: What could help me as an analyst understand the types
Speaker 2: of businesses that are susceptible to being crushed and broken
Speaker 2: in the way that company was crushed and broken just
Speaker 2: a couple of days after my meeting and update with
Speaker 2: the CFO. So I had research coverage of semiconductors at
Speaker 2: the time, and then I was given research coverage of
Speaker 2: software businesses a year or two later. I found those
Speaker 2: businesses to be somewhat better businesses and more predictable, but
Speaker 2: that memory always stuck with me. I joined TCW a
Speaker 2: couple of years after that, and I was given research
Speaker 2: coverage of another cyclical sector, the industrial or chemical sector,
Speaker 2: and I had to grapple with this same issues cyclicality
Speaker 2: cash flows that were all over the place, difficult to predict,
Speaker 2: sector and in market. In the course of studying businesses
Speaker 2: in the industrial space, I came across a Maverick CEO
Speaker 2: who transformed his traditional industrial company it was called Roper
Speaker 2: Industries now called Roper Technologies, from a traditional pumps and valves,
Speaker 2: meat and potato semi business into a business that had
Speaker 2: some recurring revenue healthcare associated with it. They acquired these
Speaker 2: businesses and then he took another step to acquiring a
Speaker 2: freight matching software business, so kind of a hybrid between
Speaker 2: industrials and software, and then progressively into software, transitioning this
Speaker 2: cyclical industrial business into a more recurring revenue software and
Speaker 2: services company. And that stock was one of the best
Speaker 2: performing businesses in the industrial sector for the time period
Speaker 2: that I'd covered industrials at tc WE, approximately eight years,
Speaker 2: eight years or ten years or something like that. So
Speaker 2: these experiences and my discussions with him really influenced my
Speaker 2: style as an analyst, and I began to gravitate to
Speaker 2: more predictable businesses. Oh you know, I think one other
Speaker 2: experience also was very certainly shaped me. I looked at
Speaker 2: performance of Nvidia in twenty twenty two, not that long ago,
Speaker 2: just four years ago, and in twenty twenty two, Nvidia's
Speaker 2: insiders sold several hundred million dollars worth of stock as
Speaker 2: the stock declined about fifty percent that year. They were
Speaker 2: coming off demand that was falling off on kind of
Speaker 2: an overbuild of the bitcoin complex, and so they were
Speaker 2: taking it. In twenty twenty two, one year later, and
Speaker 2: videos shares were up tenfold, tenfold. So management had been
Speaker 2: selling hundreds of millions of dollars of shares as the
Speaker 2: stock declined fifty percent in twenty two, and in twenty
Speaker 2: three the stock was up tenfold. The smartest management team
Speaker 2: in the world, or at least one of them, couldn't
Speaker 2: foresee where its stock would be just one year later.
Speaker 2: It was a reminder to me and to many others
Speaker 2: that this business is very difficult, and predicting where most
Speaker 2: businesses will be is a very very difficult approach. In
Speaker 2: twenty fifteen, taking all of my learnings as an analyst
Speaker 2: and my evolution as an investor. We launched a fund
Speaker 2: at TCW which focused on investing only in predictable businesses.
Speaker 2: We called it Predictable Growth Businesses, and over that nine
Speaker 2: year period of managing it, we found that this approach
Speaker 2: could generate really, really strong returns for investors and do
Speaker 2: that in a very risk controlled way. Our thesis was,
Speaker 2: if you invest in businesses where the business model itself
Speaker 2: is geared toward recurring revenue sources, management is more likely
Speaker 2: to manage this business in a way to where they
Speaker 2: can accurately match expenses to revenue and they can appropriately
Speaker 2: put together a capital structure for the business because they
Speaker 2: can kind of see where revenue and cash flows will
Speaker 2: be over the next couple of years. So inherently the
Speaker 2: business is less prone to being disrupted and it's less
Speaker 2: prone to having management mismanage expenses or the balance sheet.
Speaker 2: We also found that these businesses, because of their inherent characteristics,
Speaker 2: were easier for us to value. It was harder for
Speaker 2: us to screw up. Valuing businesses where you could see
Speaker 2: the cash flows over the next couple of years, you
Speaker 2: could more accurately forecast what the businesses should be valued
Speaker 2: at and they therefore make an investment conclusion. And so
Speaker 2: these businesses had these inherent advantages. I think that the
Speaker 2: last advantage that we identified is that recurring revenue businesses
Speaker 2: give the management team the ability to play offense in
Speaker 2: a way that most companies can't. When you know where
Speaker 2: your cash flows will be over the next couple of years,
Speaker 2: it gives you the confidence to make investment decisions in
Speaker 2: your business, maybe more aggressively, and to make inquisitions of
Speaker 2: synergistic businesses that can help you both improve the moat
Speaker 2: that you've that you've built with your company and maybe
Speaker 2: expand your moat into the future as well. So those
Speaker 2: were some of the advantages that we see with recurring
Speaker 2: revenue businesses. And you know, there was a an update
Speaker 2: to the famous Hendred Best in Binders study that came
Speaker 2: out a couple of days ago, which I think is
Speaker 2: also important to point out. Obviously it's a very famous
Speaker 2: study by Best in Binder And you know, a couple
Speaker 2: of the conclusions were, number one, four percent of all
Speaker 2: stocks generate all of the markets returns in excess of
Speaker 2: the of the of I think the tenure treasury. That's
Speaker 2: one of the interesting conclusions. But I think the second
Speaker 2: interesting conclusion is he looked at and I think we
Speaker 2: could post this of course, or share this with you.
Speaker 2: He looked at the stocks over the last one hundred
Speaker 2: years that had the highest cumulative returns compounded returns, and
Speaker 2: if you look at the top three, they happen to
Speaker 2: be Altria, Vulcan Materials in Kansas City, Southern All three
Speaker 2: businesses compounded at sixteen and a half percent, fourteen percent,
Speaker 2: and fourteen percent over very long stretches of time one
Speaker 2: hundred years, one hundred years, and ninety six years. And
Speaker 2: all three of these businesses have substantial amounts of recurring
Speaker 2: revenue associated with them. So it's an approach that I
Speaker 2: think has been tested over time, but there hasn't been
Speaker 2: a strategy that has exclusively focused on only investing in
Speaker 2: recurring revenue companies.
Speaker 1: So if we go deeper, how do you actually define
Speaker 1: recurring revenue? You know? In other words, you know what
Speaker 1: truly separates a recurring revenue from a company that just
Speaker 1: simply appears stable.
Speaker 2: We bucket recurring revenue businesses into two categories. Number one,
Speaker 2: the traditional subscription recurring revenue company. There's a subscription associated
Speaker 2: with their business. That would be a business like Bloomberg,
Speaker 2: business like Netflix, a software business that has substantial maintenance
Speaker 2: associated with the product. That's the traditional definition of what
Speaker 2: a recurring revenue business is. The second type of recurring
Speaker 2: revenue business is what we would describe it as transactional
Speaker 2: recurring and transactional recurring businesses would be a credit bureau
Speaker 2: where there are only three credit bureaus in the United
Speaker 2: States and all of the economic activity in the United
Speaker 2: States essentially goes through those three credit bureaus. It's transactional
Speaker 2: because alums will fluctuate based on economic activity, but it's
Speaker 2: recurring because there are only three pipes, and if you
Speaker 2: want to get an answer, you've got to go generally
Speaker 2: to two out of three every time, and sometimes three
Speaker 2: out of three to get a decision. You could think
Speaker 2: of the ratings agency businesses in the same way. You
Speaker 2: could think of the aftermarket aerospace parts industry as a
Speaker 2: similar analog. You sell the original equipment part to Boeing
Speaker 2: or air Bus, and then the plane flies for thirty years,
Speaker 2: and you're the sole source provider of the replacement part,
Speaker 2: so as activity keeps going over the years. The airlines,
Speaker 2: the airline operators and the airlines have to come to
Speaker 2: you for that specific part and they can't go anywhere else.
Speaker 2: Those are the the two categories of businesses that we
Speaker 2: focus on that can also take the form of local monopolies.
Speaker 2: Is you could think of the waste collection waste management
Speaker 2: businesses that have local monopolies as being very very recurring,
Speaker 2: revenue oriented businesses. And I think a great example on
Speaker 2: the aftermarket aerospace parts industry is if you think of
Speaker 2: a very basic part on a plane, The most basic
Speaker 2: part of the plane, I would say, is the seat belt,
Speaker 2: and the next time you're flying, if you flip open
Speaker 2: to the back of your seat belt, you'll see that
Speaker 2: the provider of the seat belt is a company called Amsafe.
Speaker 2: Amsafe has been making seatbelts for many, many decades, and
Speaker 2: it was acquired by a company that is in our
Speaker 2: portfolio called Transdime. You would think that a seatbelt is
Speaker 2: a pretty i don't know, regular part on a plane
Speaker 2: that you could replace pretty easily, not particularly expensive, but
Speaker 2: it happens to be because of the way we regulate
Speaker 2: air travel, quite a established position and one that is difficult.
Speaker 2: It is very difficult to replace am safe position in
Speaker 2: the seatbelt market. The reason for that is that the
Speaker 2: seat belt needs to be certified with the FAA, the
Speaker 2: seat belt with the type of seat or the seat manufacturer,
Speaker 2: of which there are a couple, they have to be
Speaker 2: certified in a system, and the seat the seat I'm sorry,
Speaker 2: the seat belt, the seat itself and the position of
Speaker 2: the seat on the plane also has to be certified
Speaker 2: as well. So the cost of re certifying a seat
Speaker 2: belt is incredibly high. So amsafe has a very strong
Speaker 2: position on planes and has the ability or has substantial
Speaker 2: pricing power because of the way we regulate parts on
Speaker 2: planes and travel today. So as you can imagine if
Speaker 2: you look at other parts on a plane, they are
Speaker 2: also to the extent that they are sole sourced and proprietary.
Speaker 2: They have really really strong long term businesses and very
Speaker 2: very strong pricing power and not surprisingly, very very strong
Speaker 2: recurring revenue for many, many years. That's the type of
Speaker 2: business and type of part that we really like.
Speaker 1: So when you're finding these businesses, what other characteristics do
Speaker 1: you look at that basically have to be present before
Speaker 1: it makes it into your fund.
Speaker 2: Well, we only invest, as we talked about, in recurring
Speaker 2: revenue businesses that generate substantial free cash flow and have
Speaker 2: a dominant market position. The businesses have to be selling
Speaker 2: a critical part or service, critical product or service, so
Speaker 2: you won't see us invest in any discretionary businesses. Generally
Speaker 2: we avoid consumer facing businesses, and so we're trying to
Speaker 2: build this durable compounder of free cash flow that over
Speaker 2: time will create a snowball of free cash flow which
Speaker 2: physically moves the value of stocks and the underlying portfolio
Speaker 2: forward over time. Our view is that stocks are driven
Speaker 2: at the end of the day by the free cash
Speaker 2: flow that they generate, and our view of free cash
Speaker 2: flow is what physically moves stock prices. It isn't revenue,
Speaker 2: it isn't earnings, it's not but at the end of
Speaker 2: the day, it's the free cash flow that the company generates.
Speaker 2: And so we're looking for businesses that sell something that's
Speaker 2: very important to the customer, have very very few competitors,
Speaker 2: and generate substantial amounts of free cash flow. The second
Speaker 2: element of what we look for is we really believe
Speaker 2: that management is incredibly important. I remember when I was
Speaker 2: at Fidelity, it was strongly emphasized to us as young
Speaker 2: analysts to stay close to our companies, and we spend
Speaker 2: a lot of time talking to management. And what I've
Speaker 2: found over the years is that being aligned with great
Speaker 2: management is as important as being aligned with a great business.
Speaker 2: I found that bad management can ruin a great business,
Speaker 2: and that great management can enhance even an average business.
Speaker 2: So for us, when we think about management and assessing management,
Speaker 2: we're looking for a couple of key elements. And I
Speaker 2: think that these elements are relatively underappreciated because a lot
Speaker 2: of people say, oh, we look for great management. But
Speaker 2: for us, we go back to a quote that Warren
Speaker 2: Buffett gave in a talk that he gave to the
Speaker 2: University of Omaha, I think in the early eighties, where
Speaker 2: he said when he's when he's analyzing or assessing a
Speaker 2: management team, he said he's looking for one word, a fanatic.
Speaker 2: And when we assess management and management teams, we are
Speaker 2: looking for fanatics. Fanatics for us, I mean individuals or
Speaker 2: teams that are committed to their business. They're not just mercenaries.
Speaker 2: This business is a part of their life. It's a
Speaker 2: part of their psyche, it's a part of their makeup.
Speaker 2: And so when we meet with them, we're trying to
Speaker 2: understand is this business just something that they work on
Speaker 2: because it generates a nice stream of income for them,
Speaker 2: or is this business something that is really important to
Speaker 2: them and they are fanatical about it. One of the
Speaker 2: ways you can determine that is obviously looking at the
Speaker 2: track record, which we spend a lot of time looking
Speaker 2: at the track records of management teams, but we spend
Speaker 2: a lot of time meeting with them to try to
Speaker 2: understand that are they a fanatic. The second element that
Speaker 2: we look for, to the extent that we can determine
Speaker 2: that they are fanatics is do they have the right
Speaker 2: incentives in place to create shareholder value over time? And
Speaker 2: of course all management teams have incentives in place. Many
Speaker 2: management teams are highly compensated. But the question is is
Speaker 2: the compensation are the compensation metrics that have been laid
Speaker 2: out for the management team consistent with creating value for
Speaker 2: shareholders and for and for customers and and UH and
Speaker 2: for employees. And we find very often that the metrics
Speaker 2: that are laid out in the proxy really don't have
Speaker 2: a great deal of connection to creating shareholder value over time.
Speaker 2: In other words, there are very often UH in the
Speaker 2: types of businesses that we look for management is incentivized
Speaker 2: to grow revenue, maybe even to grow profit. But if
Speaker 2: there isn't a connection between growing revenue and generating higher
Speaker 2: returns on capital or compounding free cash flow over time,
Speaker 2: what you'll see is companies acquire revenue maybe in products
Speaker 2: which create revenue growth, but not a lot of profit
Speaker 2: or cash flow growth, and over time, those companies don't
Speaker 2: create as much value as companies that can link revenue,
Speaker 2: free cash flow, and returns together to create an incentive
Speaker 2: structure that incentivizes the management team to balance those elements
Speaker 2: and hopefully improve and grow them over time. And we
Speaker 2: think the growth of cash flow and return on invested
Speaker 2: capital and the top line is the combination that really
Speaker 2: is beneficial to the company and to shareholders. And the
Speaker 2: third element that we look for when we assess a
Speaker 2: management team is their capital allocation track record. Because we
Speaker 2: invest in these durable, recurring, revenue, cash generative companies, it's
Speaker 2: really important that the management teams have the capability of
Speaker 2: being great CEO investors, as we call them. Are they
Speaker 2: great investors because they're generating all of this cash flow
Speaker 2: and are they investing that well? You know, today a
Speaker 2: lot of people are asking that question of Microsoft, in Amazon,
Speaker 2: and Google, the great hyperscalers of our time. They generate enormous,
Speaker 2: enormous operating cash flow, and the management teams today are
Speaker 2: allocating that enormous sum of freak or operating cash flow
Speaker 2: to building out their presence in AI, their presence in
Speaker 2: the cloud. And the question is will those companies generate
Speaker 2: sufficient returns on the hundreds of billions of dollars of
Speaker 2: capex that they're investing in just this year. And so
Speaker 2: it's very important as we assess our management teams to
Speaker 2: be aligned with great investor management teams who have a
Speaker 2: capability have a track record and a capability of being
Speaker 2: able to reinvest the free cash or that they generate
Speaker 2: into projects or capital investments that will create more cash
Speaker 2: flow for investors over time. So that's generally what we're
Speaker 2: looking for in businesses. And then once we found these businesses,
Speaker 2: we like to hold on to the winners for a
Speaker 2: long period of time. We've found that there's a significant
Speaker 2: amount of persistence for winning stocks, and because of that,
Speaker 2: we try to hold on to these businesses for many,
Speaker 2: many years.
Speaker 1: I do want to go back to cash flow for
Speaker 1: just a minute. You know, many growth managers focus on
Speaker 1: revenue growth. You know, you're obviously focusing on cash flow growth.
Speaker 1: Why do you think cashflow is actually, you know, ultimately
Speaker 1: the better north star in terms of growth.
Speaker 2: Well, I think that at the end of the day,
Speaker 2: the value of your business is the are the future
Speaker 2: cash flows that you will generate out into the out
Speaker 2: into perpetuity, discounted back to the present. I wouldn't place
Speaker 2: free cash flow as the driving factor for each business
Speaker 2: at different places in its maturation cycle. Obviously, early stage
Speaker 2: businesses must generate revenue and the cash flow hopefully will
Speaker 2: come over time. But for the types of businesses that
Speaker 2: we focus on, the companies I would say that have
Speaker 2: already won, they should be in the mode of generating
Speaker 2: cash flow and either returning that cash flow back to investors,
Speaker 2: which we generally don't favor, or doing something with that
Speaker 2: with that cash flow, which will be quite productive. I
Speaker 2: would also say that cash flow, unlike many of the
Speaker 2: other metrics that you cite revenues, EBITDA, earnings, adjusted earnings
Speaker 2: adjusted EBITDA, all of these adjusted adjusted metrics that management
Speaker 2: likes to put in front of us, cash flow is
Speaker 2: not adjusted. Cash Flow is just cash flow and It's
Speaker 2: one of the purer measures of how a business is
Speaker 2: performing and whether it's creating any value at all. Many businesses,
Speaker 2: or some businesses that don't generate much in the way
Speaker 2: of cash flow and don't generate much in the way
Speaker 2: of growth, you know, you kind of wonder what is
Speaker 2: going on there. But the businesses that do generate a
Speaker 2: lot of growth and generate a substantial matter of cash
Speaker 2: flow and reinvest that cash flow effectively are businesses that
Speaker 2: are going to create a lot of value for investors,
Speaker 2: particularly if they can continue to grow and make great
Speaker 2: investments with their capital.
Speaker 1: You know another thing, I note your website frequently mentions
Speaker 1: fewer surprises. Do you think or do you believe avoiding
Speaker 1: negative surprises is ultimately more important than finding the next
Speaker 1: big growth company.
Speaker 2: I think they're both very, very important. When I was
Speaker 2: running the old fund, I talked about addition by subtraction.
Speaker 2: When we look back at, you know, our annual performance,
Speaker 2: we always think about, could we have made one less
Speaker 2: mistake that year? And if we had made one less
Speaker 2: mistake that year, you know, our performance would have been
Speaker 2: substantially improved. And so what we're trying to deliver for
Speaker 2: clients is a better better outcome relative to the to
Speaker 2: the broad market, with risks that are substantially lower than
Speaker 2: that of an investment in the broad market index. So
Speaker 2: because of that, we favor these businesses, which, in our experience,
Speaker 2: generate fewer surprises because they're inherently more predictable and more reliable.
Speaker 2: And they are generally managed by individuals and teams, which
Speaker 2: have incentives to constrain the animal spirit, influence or impulses
Speaker 2: that management teams can have, but also incentivize them to
Speaker 2: play offense and to grow the business. So hopefully they're
Speaker 2: not taking excessive with their recurring revenue company, but hopefully
Speaker 2: they're also incentivized to grow this business and therefore generate
Speaker 2: a more predictable outcome than most companies will over time.
Speaker 1: Okay, another thing that caught my eyes. You know, your
Speaker 1: willingness to hold meaningful cast positions when valuations aren't attractive.
Speaker 1: In today's investment world, you know, managers often feel pressure
Speaker 1: to stay fully invested. How difficult does it to have
Speaker 1: that patience?
Speaker 2: Not particularly difficult. We stay very disciplined in looking for
Speaker 2: the types of businesses that we've historically invested in, and
Speaker 2: there are times when we see great opportunities, and there
Speaker 2: are times when we're in between opportunities, and there are
Speaker 2: times when there aren't a lot of opportunities. Today, we
Speaker 2: think that there are a substantial amount of opportunities in
Speaker 2: the recurring revenue area of the market, and valuations today
Speaker 2: are probably more attractive than they've been in the in
Speaker 2: the ten years I've been a portfolio manager and operating
Speaker 2: UH this strategy. So I think there's a lot of
Speaker 2: opportunity UH in this area of the market. And I
Speaker 2: think that because the the the AI cycle has captured
Speaker 2: the attention of so many market participants. What's happened is
Speaker 2: that the AI associated businesses and and beneficiaries of AI,
Speaker 2: so kind of tangential beneficiaries of AI, have have generated
Speaker 2: enormous amounts of earnings growth in the last couple of
Speaker 2: years and are projected to generate enormous amounts of earnings growth.
Speaker 2: And that has essentially created this giant move of capital
Speaker 2: from the more predictable, steady, eddy durable businesses to all
Speaker 2: the way over to all of these fast growing AI beneficiaries,
Speaker 2: and that's created a much lower multiple environment for these
Speaker 2: still durable recurring revenue businesses because all of the capital
Speaker 2: has rushed to the other side of the market, much
Speaker 2: like occurred in nineteen ninety nine, when all the capital
Speaker 2: rushed to one side of the market created lots of
Speaker 2: value and what people call the anti bubble side of
Speaker 2: the market. And I think I would not call the
Speaker 2: current market a bubble, but I would say that the
Speaker 2: dynamic of capital rushing to one end of the market
Speaker 2: that's generating a lot of earnings growth right now, but
Speaker 2: it's uncertain that that will continue, has created a lot
Speaker 2: of opportunity on the other end of the market'sctrum, and
Speaker 2: that has made us extremely excited.
Speaker 1: So in your career, obviously you talked about at the beginning,
Speaker 1: you know, the different sectors you are covering. Is Rainwater
Speaker 1: fundamentally sector agnostic or are you finding recurring revenue businesses
Speaker 1: clustering in certain industries or sectors.
Speaker 2: It's both. It's sector agnostic, and we find a lot
Speaker 2: of clustering. We certainly can go across sectors, and we have,
Speaker 2: but there are sectors that we have historically found great
Speaker 2: opportunities in and they inherently have the combination of very
Speaker 2: very strong business model, very very strong recurring revenue moat
Speaker 2: and management teams that are really talented at maximizing the
Speaker 2: opportunity of that particular moat. And so for us, that
Speaker 2: happens to be in aerospace, where you have these really
Speaker 2: unusual regulatory barriers, and so we've invested in Gero Space,
Speaker 2: run by probably the greatest industrial CEO of our time,
Speaker 2: Larry Kulp, who built Danaher, and he's optimizing a really
Speaker 2: strong recurring revenue engine business. We've found other great businesses
Speaker 2: in the aftermarket aerospace parts part of the industry, but
Speaker 2: we've also invested in totally different parts of the market,
Speaker 2: like stock exchanges, which are basically a tolling business on
Speaker 2: economic activity. So we own the Tel Aviv stock Exchange,
Speaker 2: which we've owned now for a while and has probably
Speaker 2: been our best performer, and we view that as a
Speaker 2: royalty on economic activity on it for a particular country.
Speaker 2: In that country, that happens to be the only stock
Speaker 2: exchange that operates. Obviously, we have multiple stock exchanges in
Speaker 2: the US, and so that's an example of a transactional
Speaker 2: recurring revenue business. Clearly there actually there's both subscription and transaction.
Speaker 2: You pay subscription to be listed, and then you pay
Speaker 2: as transactions occur. So it's really a very very beautiful business.
Speaker 2: So you could think of the industrial sector certainly an
Speaker 2: area where overrepresented. You can think of some of the
Speaker 2: other attractive sectors aside from stock exchanges, waste management, as
Speaker 2: we talked about as a sector that we've liked, railroads,
Speaker 2: there's certainly a sector that we've liked. Certainly, the data
Speaker 2: analytics businesses like the credit bureaus have been businesses that
Speaker 2: we've liked, and all of them have the characteristics that
Speaker 2: fit this unique approach that we followed for a while.
Speaker 1: I just want to move on to valuation for a
Speaker 1: few minutes. You had mentioned the recurring revenue businesses make
Speaker 1: it easier to look at valuations. You know, I think
Speaker 1: a lot of investors worry about paying already or forty
Speaker 1: times earnings for quality compounders. How do you determine when
Speaker 1: a great business has become too expensive or you know?
Speaker 1: Or is it ever? Can they become too expensive?
Speaker 2: Well? I think that the evidence of the last couple
Speaker 2: of years in the software industry points to the fact
Speaker 2: that they can become too expensive, and they can. They
Speaker 2: can also be a very paranoil like concern that they
Speaker 2: will be disrupted as they are expensive. So that has
Speaker 2: been a double whammy, uh to that end of the
Speaker 2: of the market. But certainly businesses can become too expensive,
Speaker 2: and we spend a lot of time thinking about that.
Speaker 2: Generally speaking, if a business is performing well, its management
Speaker 2: team is continuing to operate as as they said they would,
Speaker 2: particularly in the area of capital allocation, and the company's
Speaker 2: market position continues to be strong, we are reluctant to
Speaker 2: sell out the position purely on valuation. Now, if the
Speaker 2: valuation becomes extreme, we certainly would would reevaluate the business.
Speaker 2: But I think the other the other part of the
Speaker 2: equation or side of the coin is you're always thinking
Speaker 2: about whether this idea is better than your next best idea,
Speaker 2: and as you are making those trade outs, as we're
Speaker 2: making those trade offs, certainly valuation plays a role in
Speaker 2: helping us determine whether one opportunity is more attractive than
Speaker 2: the other. But generally speaking, we hang our hat on
Speaker 2: investing in the really, really durable business that we believe
Speaker 2: will keep compounding free cash flow, as opposed to hang
Speaker 2: our hat on a low evaluation in hopes that that
Speaker 2: will bail us out over time. Generally, we'll lean to
Speaker 2: the to the first type and less so to the
Speaker 2: second type. Though of course you're always looking for more
Speaker 2: value for your dollar and a lower valuation for every
Speaker 2: unit of compounding that you think you can get.
Speaker 1: Okay, you know, if we have this conversation ten years
Speaker 1: from now, what would happen? What would have to happen
Speaker 1: for you to say that rain Water was a success?
Speaker 1: Is it, you know, outperforming or is there kind of
Speaker 1: a broader objective you're trying to achieve for your investors.
Speaker 2: Well, our objective is to is to change the lives
Speaker 2: of our investors. So we have today, you know, over
Speaker 2: a thousand investors we believe in the fund, and hopefully
Speaker 2: we'll attract more investors, and our our mission is to
Speaker 2: generate really really strong returns for those investors, as we
Speaker 2: did in the prior fund, and do that while keeping
Speaker 2: them out of trouble and ensuring that we managed a
Speaker 2: portfolio in a responsible way that keeps risk under control.
Speaker 2: And if we can do that, we think that we
Speaker 2: can positively impact hopefully thousands and thousands of lives over time,
Speaker 2: which I think will be incredibly satisfying to all of
Speaker 2: us on the Rainwater team. It reminds me of the
Speaker 2: great Will Danoff, a portfolio manager of Contrafund at Fidelity,
Speaker 2: kept taped on his glass wall outside of his office
Speaker 2: for all of us analysts to see, and it was
Speaker 2: a letter that he received from a couple that had
Speaker 2: just had a newborn and had informed him that they'd
Speaker 2: started the new born's college fund and had invested in
Speaker 2: Contrafund in hopes of growing that college fund and preparing
Speaker 2: for the eventual college experience of their child. And I
Speaker 2: think about that all the time. And our responsibility is
Speaker 2: as investors is to do a great job on behalf
Speaker 2: of our clients. And so in ten years time, our
Speaker 2: goal is to change many, many thousands of lives and
Speaker 2: help those people live better lives and hopefully their children
Speaker 2: have their children live better lives. That I consider it
Speaker 2: would be a great success for the Rainwater Equity TF definitely.
Speaker 1: And I just have one more question before I let
Speaker 1: you go. If an investor is listening today and you
Speaker 1: want them to remember just one thing about your investment philosophy,
Speaker 1: what would you hope it was.
Speaker 2: That's a great question. I think our fundamental belief is
Speaker 2: that most businesses can't easily be predicted, and therefore let's
Speaker 2: just invest in the segment of the market that can
Speaker 2: be predicted. And that segment of the market that we
Speaker 2: believe can be predicted are businesses that operate a recurring
Speaker 2: revenue a business model. It could be subscriptions, it could
Speaker 2: be transactional recurring, it could be a local monopoly. But
Speaker 2: those types of businesses over time can generate excess returns.
Speaker 2: And partnering the business model with the fanatic management team
Speaker 2: together creates a combination that we think is very very
Speaker 2: powerful and provides investors with an alternative to the broad
Speaker 2: market indexes which are heavily weighted to a single theme.
Speaker 2: Obviously he's been a very very powerful theme, but doesn't
Speaker 2: provide them with a whole lot of diversification. I like
Speaker 2: our approach because we believe it will generate strong returns
Speaker 2: over time, but it also presents investors with a way
Speaker 2: to diversify some of their capital from the broad market
Speaker 2: indexes that are very concentrated, and presents them with hopefully
Speaker 2: businesses that will experience fewer disappointments and hopefully solid results
Speaker 2: over a long period of time.
Speaker 1: Well, unfortunately we need to end here, but this is
Speaker 1: great Joseph, thank you again for joining me today.
Speaker 2: Thanks for having me was so much fun, and.
Speaker 1: I also want to thank our listeners. If you like
Speaker 1: the episode, please share it, subscribe and leave a review.
Speaker 1: And if you'd like to see more of our research
Speaker 1: on the terminal, go to bifund, Go for US Fund
Speaker 1: and Active Research until our next episode. This is David
Speaker 1: Cone inside Active Old Tom