Speaker 1: Welcome to Inside Active, a podcast about active managers that
Speaker 1: goes beyond sound bites and headlines and looks deeper into
Speaker 1: their processes, challenges and philosophies and security selection. I'm David Cohne,
Speaker 1: i lead mutual fund and active research at Bloomberg Intelligence.
Speaker 1: Today my co host is Michael caspar Us, small cap
Speaker 1: and sector strategist at Bloomberg Intelligence. Mike, thank you for
Speaker 1: joining me today.
Speaker 2: Thanks David, So, you and.
Speaker 1: Gina recently published a note about the fair value model
Speaker 1: you know in the S and P five hundred is
Speaker 1: part of your twenty twenty five outlook. Can you give
Speaker 1: our listeners a brief overview of the fear value model?
Speaker 1: You know how the S and P five hundred is
Speaker 1: currently valued, and you know possibly how it's affected by
Speaker 1: the mag seven.
Speaker 2: Yeah. So our fair value model just for a bit
Speaker 2: of background on two different regressions trained on data between
Speaker 2: twenty twenty sixteen. We've been running it out of sample
Speaker 2: pretty much since we started here at Bloomberg. The left
Speaker 2: hand side of the model, or what I call the
Speaker 2: left hand side of the model, is a regression on
Speaker 2: estimated year ahead PE. The other side of the model
Speaker 2: is for next twelve month EPs growth. And what we
Speaker 2: do is we input consensus rate and macro expectations into
Speaker 2: the model and see what it spits out. Here at
Speaker 2: Bloomberg Intelligence, all of our models are data driven, so
Speaker 2: we're happy to use consensus in it, and it's available
Speaker 2: for clients on bi stocks Go if you'd like to
Speaker 2: download a copy yourself and enter in your own estimates.
Speaker 2: But nonetheless, with those macro own rate consensus estimates in there,
Speaker 2: you get about a nineteen point one times multiple on
Speaker 2: the S and P five hundred. You might be saying, well,
Speaker 2: that's well lower where we are today on the whole index,
Speaker 2: But what's really going on is the mag seven is
Speaker 2: driving a lot of the valuation premium in the S
Speaker 2: and P five hundred, And if you were at it instead,
Speaker 2: envision what the SMP equal weights multiple is. Back when
Speaker 2: we did it, the trailing PE was about twenty point
Speaker 2: three earnings and eighteen point four times forward earnings, So
Speaker 2: nineteen point one pretty much smack dab in the middle
Speaker 2: of those two. On the other side of the model
Speaker 2: next twelve month EPs growth, macro rate consensus would only
Speaker 2: imply about six percent EPs growth. That's well below what
Speaker 2: the bottoms up consensus is for the whole index. But again,
Speaker 2: just looking back at what the equal weighted index has
Speaker 2: forecast for itself, you're getting pretty close to that instead.
Speaker 2: So it's really been an outsized influence of the max
Speaker 2: seven on the S and P five hundred, driving the premium,
Speaker 2: driving the earnings growth at least of late, and consensus
Speaker 2: would expect that gap to narrow over twenty five and
Speaker 2: twenty six, driving a lot of the great rotation that
Speaker 2: we've seen since June at least. But I will note though,
Speaker 2: that we did a bit of a deeper dive into
Speaker 2: the economy and downloaded some of the tables from the
Speaker 2: BEA and combining pretty much all of the tech and
Speaker 2: tech related industries and comparing that to gross output. Those
Speaker 2: industries are only about fourteen point six percent of the
Speaker 2: whole economy, and this is really what's driving a lot
Speaker 2: of that issue or a detachment between our model and
Speaker 2: what's going on in the S and P five hundred,
Speaker 2: because our model is very macro based. Meanwhile, if you
Speaker 2: look at the S and P five hundred, and we
Speaker 2: did it on a BIX classification, which is Bloomberg's industry
Speaker 2: classification system SMP five hundred tech by itself is thirty
Speaker 2: percent of the S and P five hundred, So a
Speaker 2: lot of the reason why macro estimates and the rest
Speaker 2: is detaching from SMP reality right now.
Speaker 1: Nice interesting, So I think it's a great time to
Speaker 1: introduce our guest today. Christopher Davis is chairman and portfolio
Speaker 1: manager at Davis Advisors. He is manager of the Davis
Speaker 1: Large Cap and Financial portfolios. Welcome Chris, thanks for joining us.
Speaker 3: Thanks you so much, David. Mike, I'm glad to be here.
Speaker 1: So before we get into your background and investment philosophy,
Speaker 1: can you add your thoughts to what Mike said? You know,
Speaker 1: how are you seeing the S and P five hundred
Speaker 1: valued right now?
Speaker 3: Well, I think it surprises me. I think Michael's exactly
Speaker 3: right to break out, you know, sort of what is
Speaker 3: it like without the mag seven and so on? The
Speaker 3: median We sometimes think about the median stock and usually
Speaker 3: when you get this sort of very top heavy, concentrated,
Speaker 3: huge pe dispersion, that's sort of a signal that the
Speaker 3: average stock may be more attractive. But when you couple
Speaker 3: that market characteristic with what we would say is a
Speaker 3: very trans transformational time in the economy where a lot
Speaker 3: of traditional business models may be much more at risk
Speaker 3: than they used to be. We think the simple knee
Speaker 3: jerk reaction to rotate into value may be a little
Speaker 3: short sighted. You're going to have to be very specific
Speaker 3: when you look at all of the underlying transformation happening
Speaker 3: in the economy and monetary geopolitics, a high technological disruption.
Speaker 3: There are a lot of models that have been carved
Speaker 3: in stone for fifty or sixty years that are looking
Speaker 3: more and more fragile. So it's a very interesting time
Speaker 3: to invest, definitely.
Speaker 1: So you know, I'd like to take a step back,
Speaker 1: and you know, we'd love to hear your hear about
Speaker 1: the beginnings of your investment career.
Speaker 3: Well, I mean I was, you know, born on third base.
Speaker 3: I didn't hit a triple. You know, I was lucky
Speaker 3: that my grandfather was a spectacular investor. He started in
Speaker 3: about nineteen forty eight or forty nine with money that
Speaker 3: he had borrowed from his wife's family, So talk about pressure.
Speaker 3: And he turned that one hundred thousand dollars into eight
Speaker 3: hundred million by the time he died, all of which
Speaker 3: went to charity. By the way. He did not believe
Speaker 3: it inheritance. So you know when people talk about Warren's
Speaker 3: children or something like that, I know the feeling. He said,
Speaker 3: he didn't want to rob us of the opportunity of
Speaker 3: making an honest living. So and then my father was
Speaker 3: also a great investor, and he started at the Bank
Speaker 3: of New York and then started the Mutual Fund Company
Speaker 3: in the nineteen sixties in the Go go years, a
Speaker 3: time of hot tech and telecom, and he had sideburns,
Speaker 3: and you know, the seventies was such a humbling time
Speaker 3: that in a sense, we put together both of what
Speaker 3: I think of as the real sort of heart of
Speaker 3: each of their investment philosophies. I would say it was
Speaker 3: a similar investment philosophy but applied in two different eras.
Speaker 3: And that really has become the heart of what we do.
Speaker 3: So I grew up, you know, I used to say,
Speaker 3: I grew up at our table with advice like, oh,
Speaker 3: never trust a bear market rally on a Friday. So
Speaker 3: it's a very narrow family business sort of dynamic. But
Speaker 3: of course what really mattered the most, David is is
Speaker 3: both of them loved what they did. They just saw
Speaker 3: you know, this opportunity to study businesses, to study success,
Speaker 3: to look at the business as the people, to be
Speaker 3: able to co invest alongside into these great sort of
Speaker 3: growth companies, generational wealth builders. Was such an exciting way
Speaker 3: to live versus being a creditor, being a lender, being
Speaker 3: a banker. And so I just grew up lucky to
Speaker 3: have been sort of immersed in this from a young
Speaker 3: age by two people that loved what they did for
Speaker 3: a living, and that that has made an enormous business,
Speaker 3: enormous difference in sort of my own career path.
Speaker 1: That's great, kid. You know, if we talk about the
Speaker 1: Davis investment discipline, is I mean that's that's growth stocks.
Speaker 3: Well, it's funny you say that. I think we so
Speaker 3: predate this distinction between growth and value that we sort
Speaker 3: of rejected. Right. We think of ourselves as value investors.
Speaker 3: We never we never bought a business we thought was overvalued, right,
Speaker 3: And growth is a component of value. A business that
Speaker 3: can grow profitably is more valuable than one that doesn't grow.
Speaker 3: But there's no difference in the arithmetic, right, Any business
Speaker 3: is simply worth the present value of its future cash flows.
Speaker 3: And what we would say is the trouble is often
Speaker 3: growth investors are very complacent about the durability of a
Speaker 3: growth rate, and we're very skeptical because capitalism is vicious,
Speaker 3: and when somebody has high returns and high growth, it
Speaker 3: attracts competition. And if you need ten or twenty years
Speaker 3: of growth to get your money back, that can happen,
Speaker 3: but the probabilities are very low. So in that sense,
Speaker 3: we're very skeptical of the momentum style growth investing that
Speaker 3: has sort of characterized a lot of aggressive growth type managers.
Speaker 3: We think they're complacent about the durability of growth. They
Speaker 3: underappreciate the viciousness of competition and dislocations and disruptions. So
Speaker 3: in that sense we firmly in the value camp. But
Speaker 3: on the other hand, we also recognize that what Warren
Speaker 3: Buffett used to call cigar butt investing. You know, finding
Speaker 3: a net net something that's got a book value of
Speaker 3: one hundred and is selling at eighty and you think
Speaker 3: you can't lose money, Well, of course you can if
Speaker 3: the company's not liquid eating and if they continue to
Speaker 3: reinvest your earnings at three or four percent return on
Speaker 3: incremental capital, that's going to be a classic value trap.
Speaker 3: So we think that companies that have durability and resiliency
Speaker 3: are very valuable if they can grow over time, So
Speaker 3: we sort of land between the two. In our hearts,
Speaker 3: we think of ourselves as value investors, but I never
Speaker 3: bought a company that I thought was going to be
Speaker 3: earning a lot less five or ten years from now
Speaker 3: than it is today. So in that sense, we end
Speaker 3: up back in the growth camp.
Speaker 1: That makes sense. Actually you want to dig even a
Speaker 1: little deeper and specifically kind of focus on the Davis
Speaker 1: New York Venture Fund and the Davis Select Us Equity ETF.
Speaker 1: Tickers are n y vt X in d USA. For
Speaker 1: our listeners, can you kind of walk us through you
Speaker 1: know what happens when you're you know, in the investment
Speaker 1: process when you look for companies.
Speaker 3: Well, really our core strategies, which exactly as you say,
Speaker 3: our large cap approach has a certain characteristics that make
Speaker 3: sense given that background. We talked about about being in
Speaker 3: our heart value investors, but wanting that sort of durable
Speaker 3: growth as part of that equation, because what we would
Speaker 3: say when we put that all together is there very
Speaker 3: few companies that embody both of those characteristics. So we
Speaker 3: end up with a portfolio that is highly selective, right
Speaker 3: where we may have you know, thirty companies being you know,
Speaker 3: eighty percent, forty companies being eighty five percent or so
Speaker 3: of ninety percent of the assets of the funds. So
Speaker 3: a concentrated approach, because we really, in essence, we are
Speaker 3: rejecting sort of nine out of ten companies that we
Speaker 3: look at in the S and P. Five hundred and
Speaker 3: owning a portfolio of thirty to forty out of the
Speaker 3: five hundred. So it's a very selective approach. But the
Speaker 3: result of that selectivity is we own a portfolio of
Speaker 3: companies that today trades at about thirty five to say
Speaker 3: thirty five percent discount to the sorts of averages that
Speaker 3: Michael was talking about in the market today, so trading
Speaker 3: at fourteen fourteen and a half times earnings versus a
Speaker 3: market at let's say nineteen or twenty. And yet and
Speaker 3: yet our companies have grown their earnings over the last
Speaker 3: five years at a rate that is essentially the same,
Speaker 3: maybe even slightly higher than the averages. So we call
Speaker 3: that a value investor's dream when you're able to, in
Speaker 3: a sense, have both of those and that's what we
Speaker 3: see today, and that selectivity is sort of a core
Speaker 3: characteristic of what we do, and of course it reflects
Speaker 3: the fact that we're the largest investor in our own strategies. Right,
Speaker 3: we eat our own cooking, you know. This is we
Speaker 3: think of it as trying to build generational wealth. So
Speaker 3: we're not interested in some sub index how do we
Speaker 3: do versus We're interested in building wealth over time and
Speaker 3: so owning a relatively small number of durable businesses with
Speaker 3: resilient long term growth, purchased at attractive prices, run by
Speaker 3: managers that have sort of equal parts. We think of
Speaker 3: integrity and industry and intelligence. That's the sort of formula,
Speaker 3: and it's messy putting it into action. But we've been
Speaker 3: at it a long time. I guess I became the
Speaker 3: manager here in I think nineteen ninety four something like that,
Speaker 3: So it's been We've gone through some interesting markets in
Speaker 3: that time, and the fund itself having started in nineteen
Speaker 3: sixty eight or sixty nine, that's getting to be some
Speaker 3: real mileage.
Speaker 2: I got to ask about multiples a little bit, since
Speaker 2: large segments of the markets are concerned about it, do
Speaker 2: you share that concern? Are you more in the camp
Speaker 2: that productivity gains might make up for the.
Speaker 3: Well, no, I'm absolutely just you know, it's so funny
Speaker 3: because it's often, you know, the end investor is thinking
Speaker 3: about multiples in isolation, and I always think it's better
Speaker 3: if you invert the multiple, just turn it upside down
Speaker 3: and you get what we call the earnings yield. So
Speaker 3: what that means is just to make it easy, if
Speaker 3: you're paying twenty times earnings, you're getting a five percent
Speaker 3: earnings yield. Now you can buy a bond and get
Speaker 3: a five percent yield. So the question is, well, why
Speaker 3: the hell would you own inequity, which is riskier. You're
Speaker 3: the last call on the cash that the business produces,
Speaker 3: below all of the creditors, So why you take a
Speaker 3: comparable multiple. Well, the answer is because I think it's
Speaker 3: going to grow over time. But remember that five percent.
Speaker 3: If it grows ten percent a year, that sounds great,
Speaker 3: But you're only up at five and a half percent
Speaker 3: the next year. Now, depending what you use for a
Speaker 3: discount rate, you may be treading water. Now if you
Speaker 3: start in our portfolio at a fourteen or fifteen times
Speaker 3: or all of a sudden, you're starting with a seven
Speaker 3: or a seven and a half percent yield right now,
Speaker 3: that yield growing it. You know, let's say you know, seven, eight, nine,
Speaker 3: ten percent. All of a sudden, it's seven, it goes
Speaker 3: to seven, seven, it goes to eight and a half,
Speaker 3: it goes to nine point four. And you see the
Speaker 3: power of compounding over time. Now, because we're very low
Speaker 3: turnover investors, we tend to own these businesses a long time.
Speaker 3: That earnings yield over time is how we look to
Speaker 3: generate our return. We're not predicting changes in the multiple,
Speaker 3: but we do think when you start at a high
Speaker 3: multiple or a low earnings yield, you need a lot
Speaker 3: of growth just to get to the risk free rate.
Speaker 3: You started thirty times earnings, had three percent, you got
Speaker 3: to double it just to get to six. Right. So
Speaker 3: that is the mindset we have is instead of thinking pe,
Speaker 3: which is sort of an abstract idea, think about the
Speaker 3: earnings yield and then think about how long if you
Speaker 3: owned one hundred percent of that business, how long do
Speaker 3: you have to own it just to get to a
Speaker 3: ten percent return? Right? And then if it's a business
Speaker 3: where you're paying fifty sixty times earnings, so you're starting
Speaker 3: at one one and a half percent earnings yield, and
Speaker 3: you say boy that's got a double two or three
Speaker 3: times before I even get to a ten percent return. Well,
Speaker 3: that could happen. But once companies are quite large, you
Speaker 3: know a lot of people are gunning for them, and
Speaker 3: you could get a lot of competition. And you look
Speaker 3: at you know, as we look out at this world
Speaker 3: of AI, you know, look at all the obvious winners
Speaker 3: in the early days of the Internet. Most of them
Speaker 3: don't exist anymore. Yahoo, Netscape, I mean, Cisco's a shadow
Speaker 3: of what it was. I mean, those those were the
Speaker 3: absolute sure thing winners. You know, well into the dawn
Speaker 3: of the Internet. It wasn't like they it was still
Speaker 3: in a fort you know, you were about eight years, nine,
Speaker 3: ten years into the Internet, and those were the obvious
Speaker 3: winners to everybody. And of course no price was too high,
Speaker 3: and you were essentially, you know, if you had that
Speaker 3: portfolio pretty well wiped out. And so we think there's
Speaker 3: a lot of danger when people are trying to predict
Speaker 3: winners early, paying huge prices with an enormous amount of
Speaker 3: success booked in because that one percent errings yield, you know,
Speaker 3: to get it up to a ten percent errings yield,
Speaker 3: you need a lot to go right over a long
Speaker 3: period of time, and capitalism is vicious, so it's not
Speaker 3: quite so easy. So as I say that, I think
Speaker 3: is when I think about multiples, invert it, think about
Speaker 3: earnings yield, and then it starts making sense. When investors
Speaker 3: think about their returns going forward, the earnings yield is
Speaker 3: the right starting point, and then you've got to think about, well,
Speaker 3: why should it be higher a year, two, three, five,
Speaker 3: eight years from now. I mean, after all, there are
Speaker 3: some wonderful companies that are earning a fraction of what
Speaker 3: they earned ten years ago, and that sort of dislocation
Speaker 3: and disruption. You know, people underestimate, and you've seen some
Speaker 3: consumer stallwarts. I mean, we look at what's going through
Speaker 3: wonderful companies like Laughter or Anheuser Busch or or Diagio.
Speaker 3: I mean, these are great, durable companies, but you know,
Speaker 3: their earnings have been killed and their multiples have come
Speaker 3: way down. And so again we don't think the value
Speaker 3: side is a safe place in a tumultuous world, and
Speaker 3: within growth can be a very complacent place to be,
Speaker 3: and so you've got to navigate this tightrope that we
Speaker 3: think is what selectivity allows.
Speaker 1: You had mentioned management as one of the things you're
Speaker 1: looking at. And so you know you mentioned integrity, but
Speaker 1: are there other attributes that you look for in management teams?
Speaker 3: Well, the danger of we tend to lionize. Investors tend
Speaker 3: to lionize with the presses help you know, managements after
Speaker 3: their businesses have done very well, and there's what we
Speaker 3: call a halo effect, you know, where you retroactively say, oh,
Speaker 3: it must have been the great management. And so there's
Speaker 3: a lot of subjectivity. And what I would say is
Speaker 3: we try to create a mosaic to understand and I
Speaker 3: would expand the word management to say culture, to really
Speaker 3: understand what is the culture. Why is it that you
Speaker 3: could have two companies selling the same regulated product, headquartered
Speaker 3: almost in the same city, with the same market cap,
Speaker 3: where their product has to be filed with regulators so
Speaker 3: they can't have a secret sauce, and one of them,
Speaker 3: over a course of about twenty years, grew at twenty
Speaker 3: one percent a year and one of them grew at six. Now,
Speaker 3: the examples that I'm using are Ohio Casualty and Progressive.
Speaker 3: They both sell auto insurance. Essentially, they're both headquartered in Ohio,
Speaker 3: not far apart. I think one was in Columbus and
Speaker 3: one in Cleveland. But yeah, I'm a New Yorker, so
Speaker 3: it's close enough. And you know, and of course the
Speaker 3: difference was culture. Progressive had a totally different mindset as
Speaker 3: a company, a spectacular management, a culture of quantitative excellence,
Speaker 3: service excellence, urgency, discipline, creative thinking, I mean, amazing for decades.
Speaker 3: So when we try to evaluate management, I said, we want,
Speaker 3: you know, integrity, intelligence and intensity in a sense. But
Speaker 3: when we build that mosaic, what are we looking for, Well,
Speaker 3: we're looking for clues. Of course, we visit almost every
Speaker 3: company we own, you know, so we're trying to see
Speaker 3: do they keep a good team together. We're looking at
Speaker 3: their accounting choices. David Michael, that's an interesting one. You know.
Speaker 3: Gap is a very wide measure, and you just say, look,
Speaker 3: if somebody ran a private business and you're reporting your
Speaker 3: income to the tax authorities, I'm going to assume you're honest.
Speaker 3: But if you're honest and you're reporting your income to
Speaker 3: the tax authorities, you choose accounting policies that minimize current
Speaker 3: reportable income, right, So you expense things aggressively, use short
Speaker 3: amortization schedules and short depreciation accelerated depreciation schedules. You may
Speaker 3: defer revenue, you'll put up reserves. You know, you'll do
Speaker 3: everything you can to make it look like the company
Speaker 3: is not earning a lot of money. Now, if the
Speaker 3: same company reports its earnings to a perspective buyer, they
Speaker 3: may choose the opposite policies, again legal but very aggressive depreciations.
Speaker 3: They may start capitalizing a lot of software, R and
Speaker 3: D things that they could be expensing. The concept that
Speaker 3: we're trying to get at here was one that my
Speaker 3: grandfather talked a lot about. It was called owner earnings. Right,
Speaker 3: if you own the business, you reinvested enough to protect
Speaker 3: the core and maybe grow at the inflation rate. Everything
Speaker 3: else you have discretion over. You may choose to expand
Speaker 3: your business, but then what's your incremental return on that capital.
Speaker 3: You may choose to pay big dividends. You may take
Speaker 3: that money and say I'm going to go buy a competitor.
Speaker 3: But whatever it is, when we look at the business,
Speaker 3: that's the mindset we look at. So the capital allocation decisions,
Speaker 3: the accounting choices of the management, the ability to keep
Speaker 3: and retain good people, how do they communicate with us?
Speaker 3: I mentioned progressive Peter Lewis, the CEO of Progressive, wrote
Speaker 3: every in your report himself. You know who else writes
Speaker 3: their in your reports? Well, I mean, of course Berkshire
Speaker 3: marcl Let's see, Jeff Bezos did not many. You could
Speaker 3: probably count on two hands the fortune five hundred CEOs
Speaker 3: that take the time to write their own annual report. Well,
Speaker 3: that's a signal. That's a signal that they view their
Speaker 3: shareholders as a partner, They think of themselves as entrusted
Speaker 3: with shareholders' equity, and they're giving an accounting. So they're
Speaker 3: all these sorts of tiles that we build around evaluating
Speaker 3: a management. The proxy is a great place to look.
Speaker 3: You know. Is it an interesting that Exxon has a
Speaker 3: compackage as I recall, that vests something like ten years
Speaker 3: after retirement. Right, that's a very that tells you a
Speaker 3: lot about the culture of that company. There's not another
Speaker 3: company I've ever known that's done that. So we're building
Speaker 3: a mosaic to try to get a sense of culture,
Speaker 3: of the durability of a culture. Uh. You know, and
Speaker 3: the press is a terrible way to start that because
Speaker 3: the president almost always a halo effect. We're looking for
Speaker 3: those outsider type of CEOs. Understand capital allocation, understand excellence,
Speaker 3: don't fool themselves, keep the egos in check, keep great people,
Speaker 3: you know, value, have a stewardship gene. That's but it
Speaker 3: is the most fun part of the job. It is
Speaker 3: the most because in a market that's pretty damn efficient,
Speaker 3: you have to look for pockets of inefficiency, and one
Speaker 3: of them is crowd psychology. Obviously, when you get a
Speaker 3: stampede out of an area, sector or a company, you
Speaker 3: can get real inefficiency. Think of Meta just a couple
Speaker 3: of years ago. I mean, the company didn't change, but
Speaker 3: it was down and at a market cap smaller than
Speaker 3: home Depot, with two billion customers and the number of
Speaker 3: customers growing in every one of their businesses, and not
Speaker 3: just what I well, the number of users growing. So
Speaker 3: you had grown users on all three platforms and growing
Speaker 3: engagement per user on all three platforms. And yet the
Speaker 3: stock was down seventy percent because everybody said, oh, you know,
Speaker 3: your grandmother looks at Facebook, but you know the kids
Speaker 3: are all on TikTok. It was just headlines. But or
Speaker 3: Mark Zuckerberg's an idiot because he's spending money on you know,
Speaker 3: the new computing platform. Well, there's a good example of
Speaker 3: if a CEO is willing to defer earnings, right, so
Speaker 3: there's a guy who is not maximizing current reportable income.
Speaker 3: We view that as a good sign. Right. So anyway,
Speaker 3: those are all examples at management. But it is obviously
Speaker 3: one of my favorite parts of the job.
Speaker 2: Yeah. So are there any you know, sector ideas that
Speaker 2: are jumping off the page at you any anywhere where
Speaker 2: You're seeing a lot of you know, stocks that look
Speaker 2: really exciting going into twenty.
Speaker 3: Oh yeah, Well, Michael, I mean this is one that
Speaker 3: goes way back in family lure. My grandfather only invested
Speaker 3: in financial companies and he called, he said, within this
Speaker 3: vast sector, there are growth stocks in disguise, And so
Speaker 3: I used the Progressive example. You know, that was an
Speaker 3: incredible growth company for thirty years, forty years, but it
Speaker 3: was disguised as a property casualty insurance company. Well, we
Speaker 3: started our financial sector fund. I think I started it
Speaker 3: in nineteen ninety maybe Now that was partly because I
Speaker 3: had worked at another firm and when I came to,
Speaker 3: you know, work with my father, I said, look, you know,
Speaker 3: nepotism is a dangerous thing, and you know, we don't
Speaker 3: want to be employer of last resort for people with
Speaker 3: the same last name. But that was back in the
Speaker 3: late eighties early nineties. So what was happening in the
Speaker 3: world then, Well, we had gone through the SNL crisis,
Speaker 3: and so banks snls were hated. Right, There's a huge
Speaker 3: commercial real estate debacle, and our feeling was there were
Speaker 3: enormous opportunities to find durable growth companies in a sector
Speaker 3: that was widely out of favor. Now you come up
Speaker 3: to today, the memories of the financial crisis are still
Speaker 3: so vivid that banks remain even though they've had a
Speaker 3: nice move, they remain I think, without question the best
Speaker 3: combination of durability and low valuation and so and this
Speaker 3: idea that people don't differentiate between banks. Oh I like banks,
Speaker 3: I don't like bank. There's huge differences in culture and
Speaker 3: business model and valuation. And so that's when I started
Speaker 3: our financial fund. I started it because I said, within financials,
Speaker 3: we should be able to find companies that have below
Speaker 3: average valuations above average growth prospects. And that strategy has
Speaker 3: outperformed the S and P five hundred for thirty years,
Speaker 3: right only only in financial stocks. Now you can't acial
Speaker 3: index underperformed the S and P five hundred, so you
Speaker 3: have to be very selective. So that's the theme we
Speaker 3: really see in our large cap strategies today. That is
Speaker 3: one of the anchor themes. And if you want names,
Speaker 3: I mentioned Progressive. So today the analogy I would use
Speaker 3: for progressive is Capital One. Capital one is a fintech
Speaker 3: company disguised as a bank. It's still run by the founder.
Speaker 3: I think it's the sixth largest bank in the country.
Speaker 3: The founder started it. I think he was the top
Speaker 3: of his class at Stanford Business School. He started a
Speaker 3: technology company without a single branch, without a brand, and
Speaker 3: built it into one of the largest banks in the
Speaker 3: country using data science. Right. They just they basically said,
Speaker 3: how do we target and offer to David who has
Speaker 3: a different interest in a credit card than you have, Michael,
Speaker 3: he's a big spending revolver. You're a prudent points gatherer,
Speaker 3: you know, whatever it is. And so and Rich Fairbanks
Speaker 3: still runs that company, and by the way, still writes
Speaker 3: his own in your report. And so there's a company
Speaker 3: at nine or ten times earnings with a return on
Speaker 3: equity that I think has been you know, I don't
Speaker 3: want to make up them number, but I want to
Speaker 3: say that it's been thirteen or fourteen percent for twenty
Speaker 3: five years. They will understate earnings when they're growing aggressively
Speaker 3: because of the foolish nature of the what bank accounting
Speaker 3: has come that forces you to put up all the
Speaker 3: reserves you ever expect when you make the loan. Anyway,
Speaker 3: some complex accounting there. But so I love that. You know,
Speaker 3: we've had a big holding in Wells Fargo for a
Speaker 3: long time. It's the cheapest of the big banks relative
Speaker 3: to the quality of the franchise. It's been a long,
Speaker 3: sluggish turnaround, but it's getting there. I love Markel, you know,
Speaker 3: it's just a fabulous boutique insurance company that's got a
Speaker 3: lot more going with it. But so financials is sort
Speaker 3: of a good example of a theme. And then i'd
Speaker 3: give you one quick second theme just to say, you know,
Speaker 3: people overvalue that smooth, steady line of earnings. They think
Speaker 3: that makes them feel safer. You know, we always say
Speaker 3: we prefer a lumpy fifteen percent to a smooth twelve
Speaker 3: And so you know, a company like applied materials or
Speaker 3: certain types of industrial companies where the earnings are lumpy
Speaker 3: in any year or two, but over time they're just
Speaker 3: compounding machines. I mean, I've studied applied materials since nineteen
Speaker 3: ninety six, and you know there's nobody in a garage
Speaker 3: that's going to figure out how to do chemical vapor
Speaker 3: deposition better than applied materials. So you know, they're an
Speaker 3: arms dealer to a massive growth industry. And you know,
Speaker 3: Taiwan Semi cannot build in videos chips without spending a
Speaker 3: fortune buying applied materials machines, and we like that that model.
Speaker 3: So that's a lumpy company and people undervalue it because
Speaker 3: they don't know what it's going to earn six months
Speaker 3: or a year from now. But what we do know
Speaker 3: is it's going to earn a lot more five and
Speaker 3: ten years from now that it earns today.
Speaker 2: Yeah, you've got me nodding along as a strategist that's
Speaker 2: had financials at the top of a sector model for Yeah.
Speaker 3: I love that.
Speaker 2: Yeah, and a big follower small cup stocks my entire career.
Speaker 2: You know, regional banks or the dog that works the
Speaker 2: tail there.
Speaker 3: So it's injure that Michael, though, on one quick aside
Speaker 3: on banks is that the whole first half of my
Speaker 3: career in financials, we own small cap financials because they
Speaker 3: just fed at the carcass of these idiotic large financials
Speaker 3: that you know, it was amazing how every time there
Speaker 3: was a hiccup in any sector, somehow city lost, you know, billions,
Speaker 3: and these small you know, you could have a well
Speaker 3: located branch in Iowa, and you could have a lower
Speaker 3: cost of funds and better credit quality because you know,
Speaker 3: in a bank, the number one biggest cost is interest.
Speaker 3: The number two biggest cost is the cost of foolishness
Speaker 3: right making loans and not getting paid back, or pricing
Speaker 3: insurance policies, and usually those were not correlated to size.
Speaker 3: But I will say that I do think something really
Speaker 3: has changed in financials. The technology costs have gotten so
Speaker 3: high and the compliance costs have gotten so high, and
Speaker 3: both of those are scale advantages. So I'm looking at
Speaker 3: the gap. I'm looking into some mid size financials. We
Speaker 3: did buy some during that crazy First Republic, you know,
Speaker 3: Silicon Valley Bank, Mayhem. There were some people that got
Speaker 3: thrown out with the bathwater. But boy, it is amazing
Speaker 3: the cost of simply regulatory compliance and technology are so
Speaker 3: huge that it's not surprising that the biggest banks have
Speaker 3: continued to gain share, share of profits as well as
Speaker 3: share of deposits.
Speaker 2: Yeah, definitely. So just moving on from that idea, do
Speaker 2: you think that there's adorable rotation away from tech stocks underway?
Speaker 2: We've kind of seen it since June, but hoping.
Speaker 3: That I now know that you said durable, but I
Speaker 3: thought you said adorable. Do you think there's some adorable
Speaker 3: tech stocks? You know, tech is like financials. It's sort
Speaker 3: of a silly grouping because the models are so different.
Speaker 3: Whenever I hear in and you know, I don't know
Speaker 3: what you call them. It's not an anacronym or what
Speaker 3: is it when you an acronym? When you you know,
Speaker 3: like bricks, you know, Brazil, Russia, India, China. I mean
Speaker 3: as if those countries have anything to do with each other.
Speaker 3: Totally different political systems, different valuations, different currencies, different central bags,
Speaker 3: different industrial outlooks, different trade relations, different geopolitics, and yet
Speaker 3: somebody called them bricks and said you got to own
Speaker 3: the bricks or not own the bricks, right, And then
Speaker 3: of course you know we saw it in now the
Speaker 3: Magnificent seven. What was it before when it was what
Speaker 3: were this group of tech stocks call when you had Netscape.
Speaker 3: I mean, oh you know the anyway it was four horsemen.
Speaker 1: Well, no, there were the four horsemen, but it was
Speaker 1: it was like an acronym or something like that.
Speaker 3: Yeah. Yeah, it had like fang fang. Look at us.
Speaker 3: We've already forgotten fang.
Speaker 1: You know.
Speaker 3: People put group these things together. And of course investing
Speaker 3: is the art of the specific, right you just it's
Speaker 3: each company stand on its own. And you look at
Speaker 3: any grouping of stocks and you fast forward five or
Speaker 3: ten years, and there's enormous dispersion, and uh it's usually
Speaker 3: just you know, a shorthand for whatever's gone up a
Speaker 3: lot in recent times. And uh so, uh so, I
Speaker 3: would say tech is too broad a sector. And of course,
Speaker 3: the the index folks have done their best to spread
Speaker 3: it out so that it doesn't look like, oh, we'll
Speaker 3: call you Google, we're going to call that media, and
Speaker 3: we're gonna we'll call this one technology, and we'll call
Speaker 3: this communications. I mean, but but what I would say
Speaker 3: is that certainly momentum has had one hell of a run.
Speaker 3: And the funny thing about momentum is that it works
Speaker 3: so well that people just go along with it, and
Speaker 3: yet it defies common sense right. If you go to
Speaker 3: the grocery store and the cost of stak has gone
Speaker 3: up every week for six months, you don't want to
Speaker 3: buy more, you want to buy less. And of course
Speaker 3: the price you pay is a determinant of your return.
Speaker 3: If you pay a higher price for the same stream
Speaker 3: of cashflow, by definition, you have a lower return going forward.
Speaker 3: And yet the theory of momentum investing that the more
Speaker 3: it's gone up, the more attractive it becomes. It simply
Speaker 3: works until it doesn't. Now, I once had a colleague
Speaker 3: that I worked with, and I liked him a lot,
Speaker 3: but we had to part ways and we got very
Speaker 3: frustrated at one another because he was always looking for
Speaker 3: a system. And I have a sign on my wall
Speaker 3: it's a Las Vegas pit boss. And the Las Vegas
Speaker 3: pit boss said, we said limos for guys with systems.
Speaker 3: But he said to me, you know, so he wanted, Oh,
Speaker 3: I look at the fifty two week down list, and
Speaker 3: then I look from you know, and I find an
Speaker 3: algorithm and it worked a lot of his stuff worked,
Speaker 3: so I but I wouldn't do it, and he said
Speaker 3: he got so frustrated. He said, look, Chris, if I
Speaker 3: had a blind monkey in my office, and every day
Speaker 3: the monkey pointed at the stock charts, and every day
Speaker 3: it pointed to a stock, and that stock went up
Speaker 3: every day, day after day, week after week, month after month,
Speaker 3: year after year. You get five years of the monkey
Speaker 3: never missing once, and you still wouldn't buy that stock.
Speaker 3: And I said, of course I wouldn't. It's a blind monkey.
Speaker 3: Like we have the savings of life, savings of teachers
Speaker 3: and you know, people that have worked their whole life
Speaker 3: to save, and the idea that, well, it works, so
Speaker 3: I may as well capitulate and go along with it,
Speaker 3: even though the math doesn't make any sense to me.
Speaker 3: We're just not going to do it. And that means
Speaker 3: there are worlds like we've been in a lot of
Speaker 3: the last ten years, where we're going to produce good
Speaker 3: absolute returns, but we're going to lag on a relative
Speaker 3: basis because we're not getting on that wagon. But the
Speaker 3: one thing I'll say is, you know, just because everybody
Speaker 3: else was doing it really feels stupid in retrospective, it
Speaker 3: goes wrong. And I think the blindly indexing because it
Speaker 3: has worked so well where you're automatically putting in the
Speaker 3: most money into what's already gone up the most. I
Speaker 3: think in retrospect, there are a lot of fiduciaries that
Speaker 3: may feel foolish that they were saving, you know, twenty
Speaker 3: basis points of fees and just outsourcing stock selection to
Speaker 3: a momentum strategy. Now, that may be sour grapes, and
Speaker 3: the index has certainly been a monster, but there have
Speaker 3: been other times that it was hard to beat. There's
Speaker 3: a manager I admired, Jim Gibson, who had performed the
Speaker 3: index for seventeen years leading up to the year two
Speaker 3: thousand and for eighteen years, he was ahead for eighteen years.
Speaker 3: You know, you can get some pretty dramatic changes, and
Speaker 3: so you know, I'm not predicting that, but we're we're
Speaker 3: not changing our approach either.
Speaker 2: I was just going to say that that brings up
Speaker 2: an interesting research idea. You know, driving some of those
Speaker 2: outliers that we're seeing in the index, right, everybody piling
Speaker 2: their money into the SMP index fund all the time,
Speaker 2: driving the max seven higher.
Speaker 3: Well, and remember to think about what they're selling to
Speaker 3: do that. To the extent they're replacing an active manager,
Speaker 3: you're getting idiosyncratic selling into momentum buying. So it's a
Speaker 3: feedback loop there too, which will lead it to outperform
Speaker 3: even more, which will continue the feedback loop. And you
Speaker 3: know the nature of feedback loops is that they're very,
Speaker 3: very hard to model, but they always collapse, right, So
Speaker 3: you just don't know when.
Speaker 1: So I was going to ask, you know, we've talked
Speaker 1: about what you like, and you know what you don't like.
Speaker 1: You know, when you have a stock in your portfolio,
Speaker 1: is it, you know, reaching its valuations something that would
Speaker 1: trigger you to, you know, want to find something new,
Speaker 1: or you know kind of you know, sell part of
Speaker 1: it or.
Speaker 3: Well, this is where value investors struggle, right, you know
Speaker 3: we cut the flowers in water the weeds. Now part
Speaker 3: of that is, you know, the prudent man rules. You know,
Speaker 3: how how big a position do we want to let
Speaker 3: our winners become? Right, If we start with a four
Speaker 3: percent position and all of a sudden we've got an
Speaker 3: eight or nine percent position, do we let it go
Speaker 3: to twelve? Do we let it go to fifteen? Do
Speaker 3: we let it go to eighteen? So that's a very
Speaker 3: delicate balance. Now I can tell you if I managed
Speaker 3: my own money, like my own account, right, I put
Speaker 3: my money in the funds. If I manned my own account,
Speaker 3: I probably wouldn't sell because I'd say, I, you know,
Speaker 3: I don't need to pay the tax. And but you know,
Speaker 3: going back to the idea of that teacher that has
Speaker 3: life savings, with us, maybe having twenty percent in one
Speaker 3: stock is just too risky. So we do have to
Speaker 3: ballence that cell discipline. We never have price targets, but
Speaker 3: we do have valuation. We have an IRR mindset, and
Speaker 3: when an IRR gets down to three percent, four percent,
Speaker 3: five percent, you know, you start thinking, well, if we're
Speaker 3: going to hold this, we must think there's something wrong
Speaker 3: with our IRR model, because otherwise, why are we accepting
Speaker 3: that return? And the answer is usually when we've sold
Speaker 3: those and been wrong, it's because an IRR model has
Speaker 3: a really hard time capturing something that can grow for
Speaker 3: twenty five years. Right. It's just I mean, we sold Costco.
Speaker 3: We're the largest shareholder of Costco for more than a decade,
Speaker 3: and it's a glorious company, but at twenty two twenty
Speaker 3: three times earnings, it just felt like that is we're
Speaker 3: starting with a four or five percent IRR and you're
Speaker 3: getting closer to store saturation. We don't know what store
Speaker 3: saturation is, but we just know we're a lot closer
Speaker 3: to it. And it's just, you know, the multiple has
Speaker 3: expanded another fifty percent, and the sales grew way more
Speaker 3: than we thought, and they were more successful internationally, and
Speaker 3: so we need to be open to where our IRR
Speaker 3: model misses that sort of the durability or the duration
Speaker 3: of the growth. As I said, you don't want to
Speaker 3: bet on twenty year growth being sustainable, but when it is,
Speaker 3: oh my god, you make so much money in that
Speaker 3: last five years because you know, those last few doubles
Speaker 3: are such a multiple of your initial start. So we
Speaker 3: do you know, the ir mindset does force us to
Speaker 3: sell evaluation, and certainly for the last fifteen years that's
Speaker 3: almost always been a mistake. But over the course of time,
Speaker 3: we think it's part of our duty. You know, we're
Speaker 3: you know, we feel we haven't owned Nvidia for the
Speaker 3: last three years, but we're you know, we're neck and
Speaker 3: neck with the market over that last two or three years,
Speaker 3: and so I'm proud of what we've owned and how
Speaker 3: it's done. And we've just had to have the discipline
Speaker 3: to recognize that watching other people, you know, hit extreme
Speaker 3: low probability winners. Should you know, as I say that
Speaker 3: the number one investment made by anybody this year is
Speaker 3: going to be some guy that bought a lottery ticket
Speaker 3: and wins one hundred million dollars. Nobody will get a
Speaker 3: return like that on any other investment. That will be
Speaker 3: the highest IRR and one year I RR. But it
Speaker 3: doesn't mean it's a good approach just because somebody did
Speaker 3: it and it worked. So we've got to stick with
Speaker 3: what has worked for us for fifty years.
Speaker 2: Yeah. I hate answering this question myself, but I got
Speaker 2: to ask it. Given how much stocks have gone up
Speaker 2: in the last two weeks, have any of your investment
Speaker 2: thesis has changed due to the election results?
Speaker 3: Well, you know, I've got a really good schooling in this.
Speaker 3: In I can't remember if it was the first or
Speaker 3: second Clinton administration when Hillary became the healthcare bizar, and
Speaker 3: basically there was a belief that the existing sort of
Speaker 3: health insurance industry was going to be gutted. Now, the
Speaker 3: same thing happened again with Obamacare. If you were to
Speaker 3: look at a list, I have not done this, so
Speaker 3: you guys would have to fact check me on this,
Speaker 3: But I would bet if you were to look at
Speaker 3: sort of the top stocks of the last twenty years,
Speaker 3: you know, from Clinton to today, I would bet United
Speaker 3: Health is on that list. And you would have bet
Speaker 3: there were so many opportunities when you would have said,
Speaker 3: oh my god, the changing political tides are going to
Speaker 3: destroy that business. And by the way, maybe rightly. So.
Speaker 3: You know, it's a strange industry to have employers buying
Speaker 3: health insurance for their employees, but it has proven unbelievably resilient.
Speaker 3: I mean, if you think about the war on tobacco.
Speaker 3: We don't own tobacco, but it is amazing that Philip Morris,
Speaker 3: it may have been the best stock for the last
Speaker 3: fifty years. So there is a tendency to really overreact
Speaker 3: to politics. And it's not that the changes won't be
Speaker 3: incredibly important, it's just they'll be likely unpredictable, and so
Speaker 3: you know, I would certainly say the likelihood of government
Speaker 3: spending coming down seems low, of deficits coming down seems low,
Speaker 3: and higher deficits with a low interest rate environment doesn't
Speaker 3: make sense to me. I think modern monetary theory is
Speaker 3: one of the great idiocies to be foisted onto a
Speaker 3: responsible nation. The idea that if you have the reserve currency,
Speaker 3: the amount of debt and the amount of currency issue
Speaker 3: doesn't matter. Well, that's true until you're not, until doing
Speaker 3: so makes you not the reserve currency. So it's a
Speaker 3: tautology and it's a very dangerous one. So you know,
Speaker 3: I would say I am always well I'll quote my
Speaker 3: you know, wonderful friend, Morgan Housel, who said, you know,
Speaker 3: it's really good to save like a pessimist, but invest
Speaker 3: like an optimist. And that's sort of my mindset. You know,
Speaker 3: I don't think anybody on Earth thought there would be
Speaker 3: a pharmaceutical cure for diabetes five years ago, and the
Speaker 3: implications to the health system of that in twenty thirty
Speaker 3: and twenty thirty five are so huge, and it's not
Speaker 3: impossible to think of that happening for Alzheimer's or Parkinson's,
Speaker 3: and you know, you could end up with medical deflation
Speaker 3: and that changes the whole medicaid outlook. And so, you know,
Speaker 3: black swans are not always bad. In fact, I would
Speaker 3: say black swans are evenly distributed. They're just large. In fact,
Speaker 3: they've actually had a positive skew over the course of history.
Speaker 3: It's just we remember the bad ones much more. They're
Speaker 3: much more vivid that good ones tend to play out
Speaker 3: over a longer period of time. But I would say,
Speaker 3: you know, I sleep like a baby, waking up every
Speaker 3: three hours, crying and scared. But you know, we're substantially
Speaker 3: fully invested, and we own many companies that are in
Speaker 3: their second century, and many and a number that are
Speaker 3: in their third century. Remember Bank of New York was
Speaker 3: founded by Alexander Hamilton. It's still in the same business, right.
Speaker 3: That's an amazing, amazing thing. So that focus on durability
Speaker 3: does matter a lot in an uncertain time. I sure
Speaker 3: as hell don't feel safe for owning a piece of
Speaker 3: paper that's an iou from a guy with a printing press,
Speaker 3: you know, who can just print pay me back with
Speaker 3: you know, printing more paper. So I sure like owning businesses.
Speaker 3: I think of them as inflation protected bonds where the
Speaker 3: coupon is a little volatility, But you know, the durability
Speaker 3: of the underlying business is what really matters.
Speaker 1: So we're running out of time. But I actually have
Speaker 1: one more question for you. You know, whether this was going
Speaker 1: back to the beginning of your career or anything, you know,
Speaker 1: recent would have been some of your favorite investment books.
Speaker 3: Oh god, that is well. We have a value investor
Speaker 3: library here, so well it it of course, it depends
Speaker 3: on the audience. I bribed my children, my god children,
Speaker 3: my nieces and nephews hundreds of dollars each if they
Speaker 3: would read Morgan Housel's The Psychology of Money. I think
Speaker 3: it's a book that is so valuable, and it's it's
Speaker 3: a book for for people to understand how, in essence,
Speaker 3: saving and investing buys you time and freedom. That's it does.
Speaker 3: It's not about ferraris. It's about the ability to do
Speaker 3: what you want when you want right that that's what
Speaker 3: wealth is. And so helping recast that I think is
Speaker 3: hugely valuable. So I'll put that in what I'll call
Speaker 3: a psychology type of book. I would say. Boug Shrevanissan
Speaker 3: wrote a book called Americana that is a breath taking
Speaker 3: sort of history of capitalism in the US, one industry
Speaker 3: at a time, starting with the Mayflower Compact and ending,
Speaker 3: you know with this semi the internet. I think by
Speaker 3: going through railroads and canals, you know, how did these
Speaker 3: industries get built, who financed them, who were the drivers?
Speaker 3: What about you know, so that's sort of fascinating for
Speaker 3: just sort of reminding you of how powerful our model
Speaker 3: is and how well it is worked for how long.
Speaker 3: So and then I'll give you maybe a last one.
Speaker 3: It's got a terrible title, but I think it's especially
Speaker 3: good in the world that we live in now, where
Speaker 3: fear and anger have been monetized, right, so, you know
Speaker 3: the nature if you want engagement, you need the best
Speaker 3: way to get people to pay attention is to scare
Speaker 3: them or make them angry. That really locks them in.
Speaker 3: And you know, we used to have pretty clumsy tools
Speaker 3: to do that. Now we have sniper rifles to inject
Speaker 3: fear and anger into each person individually. And the result
Speaker 3: of that, of course, it's bad for the civilization, but
Speaker 3: it's also very bad for investors. And so there's a book.
Speaker 3: I can't remember the author, but I can remember the
Speaker 3: title because it's a terrible title. It's called The Power
Speaker 3: of Bad. But I think it's an incredibly useful defense
Speaker 3: against this tendency to be so convinced that things are
Speaker 3: getting worse and therefore the world is ending and it's
Speaker 3: just And it has some very practical recommendations of how
Speaker 3: to adjust your news intake to sort of be more
Speaker 3: aware of what is happening that is positive and how
Speaker 3: to recognize that that power of bad is being inflicted
Speaker 3: on us. So that's a good range of three. But
Speaker 3: I could go we could spend the whole podcast talking
Speaker 3: about about books and but those would be three off
Speaker 3: the top of my head.
Speaker 1: Good Slutch and well, this was a great discussion. Thank
Speaker 1: you again, Chris for your time.
Speaker 3: Oh, thank you both. David. Michael is so glad to
Speaker 3: be here. I really appreciate your time.
Speaker 1: And thank you Mike for serving as my co host.
Speaker 2: Yeah, thanks both to you. This is great.
Speaker 1: Until our next episode. This is David Cohne with Inside
Speaker 1: Active