1 00:00:06,400 --> 00:00:09,719 Speaker 1: Hello, Odd Lots listeners, It's Tracy Allaway. Before we get 2 00:00:09,720 --> 00:00:12,760 Speaker 1: to today's show, I have a bit of news. It's 3 00:00:12,800 --> 00:00:16,239 Speaker 1: something I'm really excited about. Odd Lots is hosting its 4 00:00:16,320 --> 00:00:20,280 Speaker 1: first ever live event on Thursday, September nine in New 5 00:00:20,360 --> 00:00:23,880 Speaker 1: York City. Join me and Joe Wisenthal as we host 6 00:00:23,920 --> 00:00:27,200 Speaker 1: an all star lineup of guests to talk about everything 7 00:00:27,280 --> 00:00:31,200 Speaker 1: from white collar fraud to sovereign debt and much much more. 8 00:00:31,760 --> 00:00:34,440 Speaker 1: This will be a group of new Odd Lots guests 9 00:00:34,479 --> 00:00:38,680 Speaker 1: plus a few old favorites. Will also have live finance, 10 00:00:38,760 --> 00:00:43,280 Speaker 1: the music, as well as drinks and just overall great conversation. 11 00:00:43,840 --> 00:00:46,320 Speaker 1: Details of the lineup are going to come out very soon, 12 00:00:46,600 --> 00:00:48,879 Speaker 1: so keep listening to add blots to learn how to 13 00:00:48,920 --> 00:00:53,560 Speaker 1: sign up to see us live on Thursday September in NYC. 14 00:00:53,960 --> 00:01:13,800 Speaker 1: Joe and I both hope to see you there. Hello 15 00:01:13,880 --> 00:01:16,920 Speaker 1: and welcome to another episode of the Odd Lots podcast. 16 00:01:17,040 --> 00:01:20,560 Speaker 1: I'm Tracy Alloway. My co host Joe Wisenthal is away 17 00:01:20,600 --> 00:01:23,399 Speaker 1: this week. I happened to be on a work trip 18 00:01:23,480 --> 00:01:27,360 Speaker 1: to Australia. I've never been before. It's fascinating. I have 19 00:01:27,520 --> 00:01:30,920 Speaker 1: big plans to meet a koala, but beyond that I 20 00:01:31,000 --> 00:01:34,160 Speaker 1: also happened to be in the country for a momentous 21 00:01:34,240 --> 00:01:38,440 Speaker 1: historic occasion, which is the benchmark Australian bond deald dipping 22 00:01:38,440 --> 00:01:41,400 Speaker 1: below one percent for the first time. I was also 23 00:01:41,480 --> 00:01:43,760 Speaker 1: there when the Reserve Bank of New Zealand opted to 24 00:01:43,840 --> 00:01:46,760 Speaker 1: cut rates by fifty basis points, which was something that 25 00:01:46,880 --> 00:01:49,520 Speaker 1: shocked the market. And just a couple of hours later 26 00:01:49,720 --> 00:01:52,120 Speaker 1: we had rate cuts from the Central Bank of India 27 00:01:52,400 --> 00:01:55,120 Speaker 1: and also the Central Bank of Thailand as well. So 28 00:01:55,360 --> 00:01:59,120 Speaker 1: clearly we are in another cycle of fresh monetary easing. 29 00:01:59,480 --> 00:02:03,040 Speaker 1: And along with these lower yields and interest rates around 30 00:02:03,080 --> 00:02:08,040 Speaker 1: the world come lower bank stocks. Bank valuations are trading 31 00:02:08,080 --> 00:02:12,720 Speaker 1: at historic lows, partly because of concern about bank's ability 32 00:02:12,800 --> 00:02:16,000 Speaker 1: to make profits on lending when rates are this low. 33 00:02:16,560 --> 00:02:19,120 Speaker 1: And who better to talk about all of this than 34 00:02:19,520 --> 00:02:23,160 Speaker 1: John Hampton of Bronte Capital, someone who's been writing about 35 00:02:23,200 --> 00:02:25,840 Speaker 1: the financial markets for a very long time on his 36 00:02:25,919 --> 00:02:29,280 Speaker 1: blog and also invests in them through a long and 37 00:02:29,360 --> 00:02:36,560 Speaker 1: short hedge fund. John, it's so nice to meet you 38 00:02:36,600 --> 00:02:40,839 Speaker 1: in person. Finally, thank you. I'm a little a bit 39 00:02:40,840 --> 00:02:43,720 Speaker 1: in ore of that requirement to speak about it generally 40 00:02:43,760 --> 00:02:46,600 Speaker 1: because I like to speak about these things rather specifically. 41 00:02:47,440 --> 00:02:50,320 Speaker 1: Um I started my career in financial markets as a 42 00:02:50,360 --> 00:02:53,840 Speaker 1: bank analyst. So once upon a time I read more 43 00:02:53,919 --> 00:02:56,600 Speaker 1: or less every bank account for every major bank in 44 00:02:56,639 --> 00:02:59,800 Speaker 1: the world, and along the way I decided that they 45 00:03:00,120 --> 00:03:04,560 Speaker 1: largely not very good businesses. There are exceptions. There are 46 00:03:04,840 --> 00:03:10,679 Speaker 1: extremely good oligopolies in some countries Canada, Australia, Scandinavia. There 47 00:03:10,720 --> 00:03:15,160 Speaker 1: are a few banks that have large captive businesses that 48 00:03:15,240 --> 00:03:18,280 Speaker 1: should be very cheap to run. The trust banks come out. 49 00:03:19,200 --> 00:03:22,679 Speaker 1: But as a general rule, most banks are not very 50 00:03:22,680 --> 00:03:26,320 Speaker 1: good businesses, but they mask themselves as pretty good businesses 51 00:03:26,360 --> 00:03:29,919 Speaker 1: most of the time. How do they do that Well, Firstly, 52 00:03:31,000 --> 00:03:34,360 Speaker 1: they're very powerful because they have access to large amounts 53 00:03:34,360 --> 00:03:38,360 Speaker 1: of money, and being powerful means that you just get 54 00:03:38,400 --> 00:03:41,920 Speaker 1: a lot of press. Journalists seem to be too interested 55 00:03:41,920 --> 00:03:45,360 Speaker 1: in bankers. The world seems to be too interested in bankers. 56 00:03:45,520 --> 00:03:49,600 Speaker 1: The second reason is that you can deceive yourself for 57 00:03:49,600 --> 00:03:53,640 Speaker 1: a very long time running a bank. Banks are quintessentially 58 00:03:53,760 --> 00:03:57,520 Speaker 1: estimate machines. And thirdly, every now and again they really 59 00:03:57,520 --> 00:04:01,960 Speaker 1: are very profitable. We're looking at the moment it banks 60 00:04:02,080 --> 00:04:06,920 Speaker 1: across the world except in the United States, basically at 61 00:04:06,960 --> 00:04:10,360 Speaker 1: thirty yellows a lot of the European banks. And it's 62 00:04:10,360 --> 00:04:12,840 Speaker 1: not just Deutscher thirty year lows. If you look at 63 00:04:12,880 --> 00:04:14,760 Speaker 1: sock Jan it's at a thirty year low. If you 64 00:04:14,800 --> 00:04:18,960 Speaker 1: look at credit agricol ubs, the English banks, they're all 65 00:04:19,000 --> 00:04:22,400 Speaker 1: at thirty year lows. And I live in a world 66 00:04:22,400 --> 00:04:26,680 Speaker 1: of extremely expensive stocks, and so suddenly I feel like 67 00:04:26,760 --> 00:04:29,159 Speaker 1: I want to be a bank analyst to give just 68 00:04:29,440 --> 00:04:34,240 Speaker 1: because you know, these things look cheap. So I've been 69 00:04:34,240 --> 00:04:37,560 Speaker 1: puzzling myself a bit about bank margins for a while. 70 00:04:38,520 --> 00:04:40,560 Speaker 1: Now I'm going to lead you back to an article 71 00:04:40,640 --> 00:04:46,919 Speaker 1: that was appeared in The Economist on January and the 72 00:04:47,040 --> 00:04:49,640 Speaker 1: article is just comical when you read it now. It's 73 00:04:49,680 --> 00:04:53,920 Speaker 1: called the Lloyd's Money Machine. And at the time, Lloyd's TSP, 74 00:04:54,160 --> 00:04:57,800 Speaker 1: as it then was, was the thirty five biggest bank 75 00:04:57,839 --> 00:05:01,240 Speaker 1: in the world by assets and the biggest bank in 76 00:05:01,279 --> 00:05:04,919 Speaker 1: the world by market cap. Ten years later Lloyd's was 77 00:05:05,000 --> 00:05:09,880 Speaker 1: essentially UK government property. But this was it wasn't ordinary profitable, 78 00:05:09,920 --> 00:05:14,640 Speaker 1: it was ferociously profitable. To pick an example, if you 79 00:05:14,640 --> 00:05:16,760 Speaker 1: look at the banks in the world at the moment 80 00:05:16,920 --> 00:05:20,240 Speaker 1: and do say revenue to risk weighted assets, you see 81 00:05:20,279 --> 00:05:23,400 Speaker 1: the Japanese banks at the lowest end and revenue is 82 00:05:23,440 --> 00:05:26,600 Speaker 1: sub one percent of risk weighted assets. Then there are 83 00:05:26,600 --> 00:05:30,040 Speaker 1: the German and Italian banks, and the English banks get 84 00:05:30,120 --> 00:05:32,599 Speaker 1: up to about two and a bit descent. And the 85 00:05:32,600 --> 00:05:34,760 Speaker 1: English banks are in the order that you would expect, 86 00:05:34,880 --> 00:05:38,919 Speaker 1: with Royal Bank of Scotland being the thinnest and Barclays 87 00:05:38,960 --> 00:05:43,920 Speaker 1: being the fattest margin and the margin actually just matches 88 00:05:44,000 --> 00:05:47,599 Speaker 1: the stock prices, right, And then sitting in the middle 89 00:05:47,680 --> 00:05:50,400 Speaker 1: is sort of these American banks at about four and 90 00:05:50,400 --> 00:05:54,039 Speaker 1: a half five percent, and then with an outlier, and 91 00:05:54,080 --> 00:05:56,240 Speaker 1: the outlier is the one you'd expect, which is the 92 00:05:56,279 --> 00:06:00,080 Speaker 1: most revenue focused retail bank in America, the one it 93 00:06:00,240 --> 00:06:04,680 Speaker 1: would do anything to, including steal from you, to get 94 00:06:04,720 --> 00:06:09,840 Speaker 1: more revenue, and that's which is just the fattest margin bank, 95 00:06:10,200 --> 00:06:12,279 Speaker 1: and at about the same sort of revenue to risk 96 00:06:12,320 --> 00:06:16,599 Speaker 1: weighted assets you see the Canadian banks is about six percent. 97 00:06:16,720 --> 00:06:19,120 Speaker 1: And then the fattest margin banks in the world are 98 00:06:19,160 --> 00:06:22,400 Speaker 1: the ones that speak in my accent, right, and it's 99 00:06:22,480 --> 00:06:24,960 Speaker 1: just this really good oligopolic. But if I go back 100 00:06:24,960 --> 00:06:31,520 Speaker 1: to this article, Lloyd's revenue to risk weighted assets at 101 00:06:31,560 --> 00:06:36,320 Speaker 1: that time was eight c Lloyd's in the UK made 102 00:06:36,360 --> 00:06:40,839 Speaker 1: more money than the Australian banks do now. It was 103 00:06:41,000 --> 00:06:48,000 Speaker 1: just astonishingly profitable. And over the next ten years, English 104 00:06:48,000 --> 00:06:50,480 Speaker 1: bank margins went down, and then they went down a 105 00:06:50,520 --> 00:06:52,280 Speaker 1: little bit more, and then they went down a little 106 00:06:52,320 --> 00:06:58,000 Speaker 1: bit more, and eventually you had the wonderful institution called 107 00:06:58,040 --> 00:07:01,760 Speaker 1: Northern Rock which was the protagonist in all of this. 108 00:07:02,600 --> 00:07:06,920 Speaker 1: And Northern Rock ran mortgages at about sixty bits of 109 00:07:06,960 --> 00:07:11,720 Speaker 1: margin and about twenty five bits of cost, and eventually 110 00:07:11,760 --> 00:07:13,960 Speaker 1: they got down to twenty bits of knit margin leave 111 00:07:14,000 --> 00:07:17,760 Speaker 1: at sixty times to produce an eighteen centirow it. But 112 00:07:17,800 --> 00:07:20,760 Speaker 1: they managed to do this in a low but positive 113 00:07:20,760 --> 00:07:26,520 Speaker 1: interest rate environment. I understand why English bank margins collapsed 114 00:07:26,520 --> 00:07:31,440 Speaker 1: and why Lloyd's collapsed in the answer was, well, there 115 00:07:31,480 --> 00:07:34,440 Speaker 1: was a large whack of competition. The banks will blame 116 00:07:34,440 --> 00:07:36,600 Speaker 1: it on new regulation, right and the fact they have 117 00:07:36,680 --> 00:07:38,760 Speaker 1: to hold more capital and they can't eke out that 118 00:07:38,840 --> 00:07:43,440 Speaker 1: much money per capital plus low interest rates predated that, right. 119 00:07:43,560 --> 00:07:49,520 Speaker 1: This was pre crisis lloyd Lloyd's was ferociously profitable in 120 00:07:50,560 --> 00:07:53,480 Speaker 1: its revenue to risk weighted assets was north of eight 121 00:07:54,360 --> 00:07:56,800 Speaker 1: by two thousand and eight. It's revenue to risk weighted 122 00:07:56,800 --> 00:07:59,960 Speaker 1: assets was sub you're talking the beginning of two thousand. 123 00:08:00,040 --> 00:08:03,960 Speaker 1: It that night after September two, two thousand and eight, 124 00:08:03,960 --> 00:08:06,960 Speaker 1: it was subject. And the problem is that when your 125 00:08:06,960 --> 00:08:10,400 Speaker 1: revenue to risk weighted assets went down that far, even 126 00:08:10,520 --> 00:08:14,760 Speaker 1: small credit losses blew you up. Right Now, the beauty 127 00:08:14,800 --> 00:08:18,320 Speaker 1: of the American banking system was that the revenue to 128 00:08:18,400 --> 00:08:21,040 Speaker 1: risk weighted assets never went below about four and a half. 129 00:08:21,960 --> 00:08:25,280 Speaker 1: During the crisis, there was the banking sector had three 130 00:08:25,800 --> 00:08:28,320 Speaker 1: thirty billion, I think was the number of pre tax 131 00:08:28,360 --> 00:08:31,320 Speaker 1: pre provision income. And if you've got a trillion dollars 132 00:08:31,320 --> 00:08:33,640 Speaker 1: of losses, you can write that off over three years, 133 00:08:33,679 --> 00:08:36,200 Speaker 1: and as long as you can extend and pretend enough, 134 00:08:36,240 --> 00:08:39,040 Speaker 1: you never actually go sub profitable. And they raised a 135 00:08:39,040 --> 00:08:41,360 Speaker 1: lot of money, and they sort of came through the 136 00:08:41,400 --> 00:08:44,600 Speaker 1: English banks didn't have enough revenue, and the German banks 137 00:08:45,000 --> 00:08:48,760 Speaker 1: spectacularly didn't have enough revenue, right because that the German 138 00:08:48,760 --> 00:08:51,200 Speaker 1: banks are the thinnest in the world. But all of 139 00:08:51,240 --> 00:08:58,599 Speaker 1: this margin collapse happened in a positive interest rate environment. Recently, 140 00:08:58,640 --> 00:09:01,600 Speaker 1: the most interesting thing I've seen is by a guy 141 00:09:01,640 --> 00:09:05,439 Speaker 1: called Shannon mcgonachy who runs a fund for Horseman Capital 142 00:09:05,679 --> 00:09:08,920 Speaker 1: and japan focused fund. He's an Australian. I've never heard 143 00:09:08,920 --> 00:09:12,160 Speaker 1: of him before this interview, but he was running through 144 00:09:12,280 --> 00:09:15,920 Speaker 1: Japanese regional banks, which are the lowest margin banks in 145 00:09:15,960 --> 00:09:20,120 Speaker 1: the world. And he says, and I haven't verified the number, 146 00:09:20,120 --> 00:09:22,080 Speaker 1: but I believe him because it sort of matches my 147 00:09:22,720 --> 00:09:26,880 Speaker 1: on the ground observations that the average interest rate achieved 148 00:09:27,000 --> 00:09:30,520 Speaker 1: on a new loan in a Japanese regional bank this 149 00:09:30,640 --> 00:09:34,360 Speaker 1: year so far has been sixty eight basis points, and 150 00:09:34,400 --> 00:09:37,319 Speaker 1: it costs more than sixty eight basis points to administer 151 00:09:37,400 --> 00:09:40,280 Speaker 1: the bank. You've got to have branches, you've gotta have staff, etcetera, 152 00:09:40,920 --> 00:09:45,439 Speaker 1: and so on increment on current business. The Japanese banks 153 00:09:45,520 --> 00:09:49,840 Speaker 1: are loss making before credit losses. They don't even need 154 00:09:49,880 --> 00:09:52,440 Speaker 1: a credit loss to lose money, right If they have 155 00:09:52,480 --> 00:09:57,920 Speaker 1: credit losses, that's just extroduced to the capital destruction that 156 00:09:57,920 --> 00:10:00,320 Speaker 1: it doesn't show in their accounts and Lorea's and is 157 00:10:00,400 --> 00:10:04,240 Speaker 1: that they have a bunch of reason the ways of 158 00:10:04,640 --> 00:10:08,400 Speaker 1: turning capital gains into interest income, the most obvious of 159 00:10:08,440 --> 00:10:10,800 Speaker 1: which is that they've held a lot of jgbs because 160 00:10:10,800 --> 00:10:13,520 Speaker 1: they have loan deposit ratios of sort of point six 161 00:10:13,559 --> 00:10:17,080 Speaker 1: point seven they've held a huge number of jgbs. As 162 00:10:17,160 --> 00:10:20,200 Speaker 1: rates have come down, they've got huge capital gains. They've 163 00:10:20,240 --> 00:10:23,840 Speaker 1: been clipping those capital gains all the time and calling 164 00:10:23,840 --> 00:10:27,480 Speaker 1: it interest income, so they look like they're marginally profitable 165 00:10:27,520 --> 00:10:30,040 Speaker 1: at the moment that they're in fact marginally loss making 166 00:10:30,160 --> 00:10:33,440 Speaker 1: before credit losses. So instead of making money on actually 167 00:10:33,520 --> 00:10:36,960 Speaker 1: extending loans to customers or corporates in the way that 168 00:10:37,040 --> 00:10:39,640 Speaker 1: they used to, they're making most of their money through 169 00:10:40,120 --> 00:10:44,360 Speaker 1: asset price increases that then get booked as interest income 170 00:10:44,600 --> 00:10:47,800 Speaker 1: that will run out, and then they will make losses 171 00:10:47,840 --> 00:10:51,559 Speaker 1: on extending lines. His simple view is there's no price 172 00:10:51,600 --> 00:10:53,520 Speaker 1: that you can buy these at their point to book, 173 00:10:53,559 --> 00:10:56,760 Speaker 1: and that's a value trap. So is the banking business 174 00:10:56,920 --> 00:11:01,040 Speaker 1: just broken at interest rates that low. That's what is 175 00:11:01,160 --> 00:11:06,000 Speaker 1: clearly the case in Japan, and is what the market 176 00:11:06,120 --> 00:11:08,760 Speaker 1: is telling you about the big mega banks in Europe. 177 00:11:10,400 --> 00:11:13,240 Speaker 1: The flip side is that you know there are banks 178 00:11:13,280 --> 00:11:17,920 Speaker 1: in Europe in oligo baalistic markets that are still got 179 00:11:18,040 --> 00:11:24,040 Speaker 1: fairly fat margins which have also come down. So you know, 180 00:11:24,080 --> 00:11:26,760 Speaker 1: if I'm going to beat myself up the stock on 181 00:11:26,800 --> 00:11:30,800 Speaker 1: the portfolio, the two stocks that I own that have 182 00:11:30,960 --> 00:11:35,640 Speaker 1: bugged me. Most have been Spensker Hundle's Bank, which is 183 00:11:35,760 --> 00:11:40,920 Speaker 1: a very well run, highly oligobalistic Swedish bank, and Allied 184 00:11:40,960 --> 00:11:44,480 Speaker 1: Irish and Allied Irish is a less well run but 185 00:11:44,520 --> 00:11:49,560 Speaker 1: even more oligo ballistic Irish bank. And Irish banking margins 186 00:11:49,559 --> 00:11:53,080 Speaker 1: are very nice right there, about the same as US 187 00:11:53,120 --> 00:11:56,720 Speaker 1: banking margins. They're not as rich as Australian banking margins, 188 00:11:56,800 --> 00:12:00,320 Speaker 1: but there are many times you know a big French 189 00:12:00,920 --> 00:12:03,600 Speaker 1: or a big German bank, or even a big English 190 00:12:03,679 --> 00:12:07,040 Speaker 1: bank yet that they're still drowned to trading. At point 191 00:12:07,120 --> 00:12:10,280 Speaker 1: six book, I'm trying to work out why I'm wrong. 192 00:12:10,720 --> 00:12:14,000 Speaker 1: We've we've had a demonstration of margins collapsing even in 193 00:12:14,000 --> 00:12:17,120 Speaker 1: a positive interest rate environment, and that's called English banks. 194 00:12:18,480 --> 00:12:21,520 Speaker 1: And we have a demonstration of margins completely and utterly 195 00:12:21,520 --> 00:12:24,280 Speaker 1: collapsing in a negative interest rate environment, and that's good 196 00:12:24,280 --> 00:12:28,760 Speaker 1: in Japanese regional banks. And I'm wondering whether I'm just 197 00:12:28,840 --> 00:12:32,000 Speaker 1: insane or not. But that's my little frustration at the moment. Well, 198 00:12:32,960 --> 00:12:35,080 Speaker 1: so how would you explain it? Then? Is the is 199 00:12:35,120 --> 00:12:37,960 Speaker 1: the market wrong? That would seem to be the simple explanation. 200 00:12:39,080 --> 00:12:41,920 Speaker 1: Every time I've been confident that the market is wrong, 201 00:12:41,960 --> 00:12:45,400 Speaker 1: it tends to beat me in the head I think 202 00:12:45,440 --> 00:12:50,840 Speaker 1: it's wrong. I rang up Shannon mcgonicky after this, and 203 00:12:50,920 --> 00:12:54,080 Speaker 1: I tried to go through right just because I wanted 204 00:12:54,120 --> 00:12:57,400 Speaker 1: to work out whether any of the margin collapse that 205 00:12:57,640 --> 00:13:00,480 Speaker 1: and the methods of hiding it that he could see 206 00:13:00,480 --> 00:13:05,560 Speaker 1: in Japan we're applicable to my Irish banks. And the 207 00:13:05,600 --> 00:13:08,720 Speaker 1: answer was no. But that doesn't mean that I'm not wrong. 208 00:13:09,600 --> 00:13:11,560 Speaker 1: I am enough of a stock picker to know I 209 00:13:11,600 --> 00:13:14,440 Speaker 1: can be wrong any day of the week, and believe 210 00:13:14,480 --> 00:13:17,120 Speaker 1: me the moment I think I'm wrong, And if any 211 00:13:17,160 --> 00:13:21,320 Speaker 1: of your dear listeners will tell me why, then I'll sell. 212 00:13:21,320 --> 00:13:24,480 Speaker 1: These positions. Are not allergic to them, but they are 213 00:13:24,600 --> 00:13:26,840 Speaker 1: very tempting. And the reason they're very tempting is that 214 00:13:26,880 --> 00:13:30,520 Speaker 1: almost everywhere you look in this world, particularly in North America, 215 00:13:30,600 --> 00:13:35,480 Speaker 1: you see assets at extreme prices. Right that we have 216 00:13:35,559 --> 00:13:41,160 Speaker 1: a situation where the market really does believe that low 217 00:13:41,240 --> 00:13:44,360 Speaker 1: interest rates are here here to stay, and that economies 218 00:13:44,400 --> 00:13:47,800 Speaker 1: are relatively are going to be relatively weak. So things 219 00:13:47,880 --> 00:13:52,720 Speaker 1: that have highly deterministic cash flows that you can value 220 00:13:52,920 --> 00:13:57,120 Speaker 1: off the low interest rates are priced at very high levels. 221 00:13:58,120 --> 00:14:02,240 Speaker 1: My favorite example of this is Visa. Visa trades that 222 00:14:02,400 --> 00:14:05,079 Speaker 1: last time I looked at seventeen times revenue. I think 223 00:14:05,120 --> 00:14:06,960 Speaker 1: the markets down a bit this week, so it might 224 00:14:07,000 --> 00:14:11,520 Speaker 1: be only sixteen times revenue or fifteen times revenues. Yeah, 225 00:14:11,559 --> 00:14:14,600 Speaker 1: there's a famous quote from Scott McNally at the end 226 00:14:14,679 --> 00:14:17,080 Speaker 1: of the It's one of the quotes that I almost 227 00:14:17,320 --> 00:14:19,800 Speaker 1: pin on my wall at the end of the of 228 00:14:19,920 --> 00:14:23,440 Speaker 1: the tech bubble, which said that, you know, at the 229 00:14:23,440 --> 00:14:25,720 Speaker 1: height of the tech bubble, Sun was trading at ten 230 00:14:25,720 --> 00:14:31,280 Speaker 1: times revenue, And dear readers, what were you thinking, you know, 231 00:14:31,880 --> 00:14:34,080 Speaker 1: at ten times revenue. In order to get a ten 232 00:14:34,120 --> 00:14:36,800 Speaker 1: percent return, I've got to return a hundred percent of 233 00:14:36,960 --> 00:14:40,840 Speaker 1: revenue to you in cash, which means that I don't 234 00:14:40,840 --> 00:14:42,760 Speaker 1: have any staff, which is kind of hard when you're 235 00:14:42,840 --> 00:14:44,960 Speaker 1: running a tech company and they don't have any inputs, 236 00:14:44,960 --> 00:14:47,360 Speaker 1: which is kind of hard when you're selling computer boxes. 237 00:14:48,040 --> 00:14:50,720 Speaker 1: And I don't pay any taxes, which is kind of illegal. 238 00:14:51,880 --> 00:14:54,240 Speaker 1: And that I can maintain all the revenue without any 239 00:14:54,400 --> 00:14:57,320 Speaker 1: R and D expense, which seems a little improbable. What 240 00:14:57,360 --> 00:15:00,520 Speaker 1: were you thinking that ten times revenue was the sort 241 00:15:00,520 --> 00:15:05,440 Speaker 1: of number that said this is insane. Now Here, I 242 00:15:05,480 --> 00:15:08,520 Speaker 1: have Visa, which is a very fat margin business. I'll 243 00:15:08,560 --> 00:15:10,920 Speaker 1: admit it's a very fat march in business, trading at 244 00:15:11,320 --> 00:15:15,640 Speaker 1: sixteen or seventeen times revenue, and yeah, it's got two 245 00:15:15,760 --> 00:15:20,000 Speaker 1: thirds margin. Half half of Visa's revenue drops to the 246 00:15:20,040 --> 00:15:22,480 Speaker 1: P and L, and all of that is spent on 247 00:15:22,520 --> 00:15:27,440 Speaker 1: either dividends or buybacks. It's an incredibly cash generative machine. 248 00:15:28,440 --> 00:15:31,120 Speaker 1: But it is one point seven times the price that 249 00:15:31,160 --> 00:15:35,080 Speaker 1: Scott McNelly said was insane. Is the difference between now 250 00:15:35,240 --> 00:15:39,320 Speaker 1: and past markets That in past markets, valuations used to 251 00:15:39,360 --> 00:15:43,640 Speaker 1: be self limiting. At some point someone would go, you 252 00:15:43,680 --> 00:15:46,280 Speaker 1: know what, the stock is far too expensive and I'm 253 00:15:46,280 --> 00:15:48,840 Speaker 1: not going to buy it. Whereas now because so so 254 00:15:49,000 --> 00:15:51,840 Speaker 1: much of the profit that you make by investing is 255 00:15:51,880 --> 00:15:55,600 Speaker 1: basically momentum and a price increase. No, nothing, that's just 256 00:15:55,680 --> 00:15:59,240 Speaker 1: got to be wrong. Nothing is as as expensive as 257 00:15:59,320 --> 00:16:03,400 Speaker 1: the worst as second tier tech stocks were during the 258 00:16:03,400 --> 00:16:05,640 Speaker 1: tech bubble. If you go have a look at the 259 00:16:05,640 --> 00:16:09,600 Speaker 1: biggest five or six tech names during the tech bubble, 260 00:16:09,600 --> 00:16:11,400 Speaker 1: and you brought them now and you held them to now, 261 00:16:11,440 --> 00:16:16,000 Speaker 1: you've actually made an acceptable return. If you went and 262 00:16:16,160 --> 00:16:21,800 Speaker 1: looked at names twenty to thirty in March two thousand 263 00:16:22,800 --> 00:16:26,360 Speaker 1: and you held them to now the result is an unbelievable, 264 00:16:26,440 --> 00:16:33,040 Speaker 1: spectacular wipeout. Right, there are names that were hugely important 265 00:16:33,120 --> 00:16:35,920 Speaker 1: then that don't mean anything to you now, Like I 266 00:16:36,120 --> 00:16:40,120 Speaker 1: two Technologies. There was a period where the too hottest 267 00:16:40,120 --> 00:16:42,600 Speaker 1: tech names in the world, where I too Technology and 268 00:16:42,720 --> 00:16:47,760 Speaker 1: JDS Uniphase and I two Technologies had a market cap 269 00:16:47,800 --> 00:16:50,800 Speaker 1: of two hundred and twenty billion and j D s 270 00:16:50,920 --> 00:16:54,880 Speaker 1: Uniphase was to eighty billion. Now, the various parts of 271 00:16:54,960 --> 00:16:58,480 Speaker 1: j DS you are still available and if you actually 272 00:16:58,480 --> 00:17:00,960 Speaker 1: add them up, there's probably went to your thirty billion 273 00:17:01,000 --> 00:17:04,080 Speaker 1: market kept there, so it's not the complete insane way about. 274 00:17:04,800 --> 00:17:07,320 Speaker 1: I think I two Technologies were sold at the end 275 00:17:07,400 --> 00:17:13,000 Speaker 1: for seven million. If you go back to the second 276 00:17:13,119 --> 00:17:17,200 Speaker 1: tier tech names, they were just insane, right, That is, 277 00:17:18,600 --> 00:17:22,080 Speaker 1: if you actually had revenue, like Cisco. Cisco was one 278 00:17:22,119 --> 00:17:24,080 Speaker 1: of the first ones to break, and the reason it 279 00:17:24,119 --> 00:17:25,720 Speaker 1: was one of the first ones to break is that 280 00:17:25,800 --> 00:17:27,879 Speaker 1: it actually had revenue and it told you the world 281 00:17:27,960 --> 00:17:29,919 Speaker 1: wasn't quite as good as you thought, and so they 282 00:17:29,960 --> 00:17:33,040 Speaker 1: stop went down a lot. Right, There was that period 283 00:17:33,200 --> 00:17:36,480 Speaker 1: where profits were about you in a really good bubble. 284 00:17:36,520 --> 00:17:38,439 Speaker 1: Profits are a bad idea because then you have a 285 00:17:38,440 --> 00:17:41,800 Speaker 1: fantasy about it. But the tech bubble got to the 286 00:17:41,840 --> 00:17:44,879 Speaker 1: point where revenue was a bad idea, right, because then 287 00:17:44,920 --> 00:17:47,720 Speaker 1: you'd have a fantasy. You couldn't write what you really 288 00:17:47,760 --> 00:17:52,639 Speaker 1: wanted to measure with something like eyeballs, potential growth, potential growth, 289 00:17:52,800 --> 00:17:56,280 Speaker 1: And if you bought the stuff that was the second tier, 290 00:17:56,359 --> 00:18:00,400 Speaker 1: then the wipeout was far more spectacular. That was much 291 00:18:00,440 --> 00:18:05,280 Speaker 1: more overvalued than anything i'm seeing now. That said, all 292 00:18:05,640 --> 00:18:08,640 Speaker 1: the old economy was priced at seven or eight times earnings. 293 00:18:08,800 --> 00:18:12,719 Speaker 1: There the years two thousand to say two thousand and 294 00:18:12,800 --> 00:18:17,200 Speaker 1: six were the years in which the naive champion bearded 295 00:18:17,280 --> 00:18:21,440 Speaker 1: self righteous value investorout the FORMT. I know a few 296 00:18:21,440 --> 00:18:24,960 Speaker 1: of them. I'm sorry, the bearded self righteous value investor. 297 00:18:25,400 --> 00:18:28,200 Speaker 1: Is that their official name? No, but that's what they are. 298 00:18:28,480 --> 00:18:32,560 Speaker 1: You see them. They were they're just cheap and they 299 00:18:32,600 --> 00:18:36,400 Speaker 1: liked buy cheap stocks, right, and they're very obsessed by 300 00:18:36,480 --> 00:18:41,240 Speaker 1: pe ratios. Several of them owned things that looked cheap, 301 00:18:41,320 --> 00:18:44,639 Speaker 1: like Jase Bank and right. They also wear cheap suits. 302 00:18:45,400 --> 00:18:47,920 Speaker 1: They'd like to be buffet acolytes, and they all meet 303 00:18:48,000 --> 00:18:51,320 Speaker 1: up at the Berkshire Meeting. I've been been to this 304 00:18:51,400 --> 00:18:54,800 Speaker 1: Berkshire meeting. Several of these people are my friends. Right, 305 00:18:55,119 --> 00:18:58,840 Speaker 1: they're almost the cliche of they start with the valuation 306 00:18:59,600 --> 00:19:03,080 Speaker 1: and they'd buy almost any old economy stock at seven 307 00:19:03,160 --> 00:19:05,919 Speaker 1: or eight times earnings, and for the next five to 308 00:19:06,000 --> 00:19:11,480 Speaker 1: seven years they just did wonderful, right, They outperformed like crazy. 309 00:19:11,880 --> 00:19:14,600 Speaker 1: And a lot of the things that they owned were 310 00:19:14,760 --> 00:19:19,960 Speaker 1: cheap and bad. So the same people often. You know, 311 00:19:20,000 --> 00:19:21,920 Speaker 1: if I take a look at long Leaf, which is 312 00:19:21,920 --> 00:19:25,919 Speaker 1: a fairly decent, well known mutual fund, I don't think 313 00:19:26,000 --> 00:19:28,399 Speaker 1: they have beards, but it falls into the same camp. 314 00:19:29,359 --> 00:19:32,280 Speaker 1: Long Leaf owned a whole lot of things that look 315 00:19:32,400 --> 00:19:35,119 Speaker 1: cheap and went to zero, right, the sort of general 316 00:19:35,160 --> 00:19:39,560 Speaker 1: motors stuff, and you know, sometimes cheap as cheap for 317 00:19:39,600 --> 00:19:42,560 Speaker 1: a reason. But at that time, the whole old economy 318 00:19:42,680 --> 00:19:45,920 Speaker 1: was cheap, and if you just bought the old economy, 319 00:19:46,240 --> 00:19:48,560 Speaker 1: you did really well. And you know, some of the 320 00:19:48,640 --> 00:19:52,399 Speaker 1: misvaluations in were crazy. You go have a look at 321 00:19:52,440 --> 00:19:56,360 Speaker 1: the New York Times or any other newspaper. And newspapers 322 00:19:56,440 --> 00:20:00,439 Speaker 1: hit their highest valuation ever in two thousands, just as 323 00:20:00,480 --> 00:20:04,280 Speaker 1: their business model was about to dismantle. And I actually 324 00:20:04,280 --> 00:20:07,119 Speaker 1: asked somebody at one stage, a sort of check analyst, 325 00:20:07,359 --> 00:20:11,439 Speaker 1: why all these newspapers were valued so highly. And the 326 00:20:11,520 --> 00:20:14,720 Speaker 1: answer came back, looking at me weirdly, is it? Well, 327 00:20:14,760 --> 00:20:18,760 Speaker 1: they have websites, don't they? People look at their websites. Right, 328 00:20:18,760 --> 00:20:21,560 Speaker 1: There were tech plates at that time because they all 329 00:20:21,600 --> 00:20:23,840 Speaker 1: of them were going big on the internet in some 330 00:20:23,880 --> 00:20:27,080 Speaker 1: way or each other. The overvaluation this time is not 331 00:20:27,200 --> 00:20:31,720 Speaker 1: as bad as that time. It's just broader. Right in 332 00:20:31,880 --> 00:20:35,840 Speaker 1: that time, if you just did the naive thing and 333 00:20:35,880 --> 00:20:38,960 Speaker 1: bought the ten times earnings or nine times earnings old 334 00:20:38,960 --> 00:20:43,439 Speaker 1: economy stocks including there, I say at Wells Fargo, you 335 00:20:43,680 --> 00:20:49,720 Speaker 1: just did fabulous, right. And the most naive, self righteous 336 00:20:49,800 --> 00:20:53,160 Speaker 1: value investor, the one that seems to think that any 337 00:20:53,160 --> 00:20:56,680 Speaker 1: growth stock is risky but value stocks are not, right, 338 00:20:56,960 --> 00:21:02,479 Speaker 1: did great guns for five kids? Mhm this time? You 339 00:21:02,520 --> 00:21:05,480 Speaker 1: know I want to be a self righteous beard and 340 00:21:05,600 --> 00:21:08,800 Speaker 1: value investor, I really do. But the only things that 341 00:21:08,840 --> 00:21:12,840 Speaker 1: look cheap, thanks, And I've just given you you know 342 00:21:12,920 --> 00:21:16,800 Speaker 1: my angst feeling about them, my own two banks. I 343 00:21:16,840 --> 00:21:20,080 Speaker 1: also earn a little slither of a company called Power 344 00:21:20,119 --> 00:21:24,760 Speaker 1: Corps Corporation of Canada. None of this I've ever disclosed. 345 00:21:24,920 --> 00:21:29,760 Speaker 1: For that they they look really cheap, and I don't 346 00:21:29,880 --> 00:21:34,520 Speaker 1: think they're problematic. The problem with cheek stocks is cheap 347 00:21:34,520 --> 00:21:37,760 Speaker 1: stocks are often problematic, and you can get yourself very trapped, 348 00:21:37,800 --> 00:21:42,080 Speaker 1: as every beard and value investor is once discovered. Okay, 349 00:21:42,119 --> 00:21:44,600 Speaker 1: so talk to me about how you actually go about 350 00:21:45,240 --> 00:21:50,440 Speaker 1: selecting companies in an environment of ultra low interest rates 351 00:21:50,480 --> 00:21:55,480 Speaker 1: as we've discussed, but also generally broad high expensive valuations. 352 00:21:56,200 --> 00:21:58,880 Speaker 1: Actually I tend not to start with the valuation at 353 00:21:58,920 --> 00:22:04,040 Speaker 1: all my general view, as I start with the business. 354 00:22:04,240 --> 00:22:07,480 Speaker 1: And there are some business models that you just want 355 00:22:07,480 --> 00:22:09,879 Speaker 1: to own at some stage. The best business model in 356 00:22:09,880 --> 00:22:14,080 Speaker 1: the world is will develop global scale, will share the 357 00:22:14,119 --> 00:22:18,199 Speaker 1: better scale scale with their consumers. And it's also the 358 00:22:18,240 --> 00:22:20,840 Speaker 1: hardest business model in the world twine, especially as a 359 00:22:20,920 --> 00:22:24,840 Speaker 1: hit as a bearded value investor. And the reason is well, 360 00:22:25,160 --> 00:22:29,240 Speaker 1: the iconic example is, of course Amazon. But if you 361 00:22:29,280 --> 00:22:32,520 Speaker 1: look at Amazon in two thousand and two, it just 362 00:22:32,640 --> 00:22:38,040 Speaker 1: sold books, It made small losses, it was growing very fast, 363 00:22:38,800 --> 00:22:42,399 Speaker 1: and if Jeff Bezos had told you where he was going, 364 00:22:42,800 --> 00:22:47,800 Speaker 1: he would have sounded insane. Right now, it wasn't in 365 00:22:47,880 --> 00:22:50,520 Speaker 1: Jeff Bezos's interest to tell you where he was going, 366 00:22:50,720 --> 00:22:55,760 Speaker 1: because if he told you, he sounded insane. People and 367 00:22:55,800 --> 00:22:59,440 Speaker 1: to some weirdo out there, they might think, oh my god, 368 00:22:59,480 --> 00:23:02,399 Speaker 1: I want to get there too, and so he'd induced competition. 369 00:23:03,280 --> 00:23:06,840 Speaker 1: If you're Jeff Bezos in two thousand and two, the 370 00:23:06,960 --> 00:23:09,520 Speaker 1: job is to grow as fast as possible, subject to 371 00:23:09,560 --> 00:23:11,439 Speaker 1: the constraint you don't run out of cash, and you 372 00:23:11,480 --> 00:23:14,000 Speaker 1: want to get big before or your competition get there. 373 00:23:15,680 --> 00:23:18,240 Speaker 1: And the problem with that from a value investors perspective 374 00:23:18,320 --> 00:23:21,879 Speaker 1: is the optimal profitability is zero. So what you have 375 00:23:21,960 --> 00:23:25,360 Speaker 1: to do is buy a high growth, zero profit company 376 00:23:25,480 --> 00:23:28,879 Speaker 1: that doesn't tell you what it's directions. This is the 377 00:23:28,920 --> 00:23:31,720 Speaker 1: hardest thing in the world to do, but I'm always 378 00:23:31,720 --> 00:23:35,200 Speaker 1: on the lookout. Right. Problem is I don't have any 379 00:23:35,840 --> 00:23:38,639 Speaker 1: right um that that. Well, I have a few, but 380 00:23:38,680 --> 00:23:40,640 Speaker 1: I don't want to talk about them. And the other 381 00:23:40,680 --> 00:23:42,200 Speaker 1: thing is if I told you what I thought about 382 00:23:42,240 --> 00:23:45,000 Speaker 1: them might sound insane. The other thing is that if 383 00:23:45,000 --> 00:23:46,800 Speaker 1: they don't not go in that direction, I want to 384 00:23:46,800 --> 00:23:51,359 Speaker 1: sell them before the d rate. So it's not in 385 00:23:51,400 --> 00:23:53,600 Speaker 1: my interest to tell anybody for the same reasons it 386 00:23:53,720 --> 00:23:57,080 Speaker 1: wasn't in Jeff bezos Is interest to tell anybody. The 387 00:23:57,240 --> 00:23:59,560 Speaker 1: second sort of model that I look at all the 388 00:23:59,680 --> 00:24:04,680 Speaker 1: time is what we call the trifecta. If you are 389 00:24:04,800 --> 00:24:09,760 Speaker 1: a small but important part of the big thing, you're consumable, 390 00:24:09,880 --> 00:24:12,320 Speaker 1: and you have a high switching cost, you make a 391 00:24:12,400 --> 00:24:15,880 Speaker 1: packet of money. The problem with these trifectors, and I'll 392 00:24:15,920 --> 00:24:18,200 Speaker 1: give you a nice example, is an English one called 393 00:24:18,320 --> 00:24:24,959 Speaker 1: Crowda right, which we own and Croda makes active ingredients 394 00:24:24,960 --> 00:24:26,960 Speaker 1: for cosmetics. It does a lot of other things, but 395 00:24:27,000 --> 00:24:31,359 Speaker 1: the original ingredient product was active ingredients for cosmetics. It 396 00:24:31,440 --> 00:24:36,280 Speaker 1: turns out there are recipes almost every face cream that 397 00:24:36,400 --> 00:24:41,159 Speaker 1: can answer the medical question visibly reduces the appearance of wrinkles, 398 00:24:41,840 --> 00:24:45,639 Speaker 1: has it in it ingredients that are extracted from war Greace. 399 00:24:47,400 --> 00:24:53,000 Speaker 1: Now there are Egyptian recipes for war Greace makeups or cosmetics. 400 00:24:53,640 --> 00:24:57,200 Speaker 1: And they were stuck, and so the woman would put 401 00:24:57,320 --> 00:25:00,439 Speaker 1: this really smelly face cream on and sleep somewhere a 402 00:25:00,440 --> 00:25:05,960 Speaker 1: long way away from her husband. Helena Rubinstein, you may 403 00:25:06,000 --> 00:25:08,639 Speaker 1: not know, was in Australia. She grew up in sheep 404 00:25:08,680 --> 00:25:13,040 Speaker 1: Country and western Victoria, and she originally started making cosmetics 405 00:25:13,080 --> 00:25:16,480 Speaker 1: from Greece. She extracted from sheep sheep sheds in Australia. 406 00:25:17,280 --> 00:25:21,920 Speaker 1: It also all stunk. The first company that pulled out 407 00:25:21,960 --> 00:25:25,880 Speaker 1: the active ingredient was Croda, which was a little company 408 00:25:25,920 --> 00:25:28,760 Speaker 1: in Ghoule, East Lancashire and sheep Country in the north 409 00:25:28,800 --> 00:25:32,000 Speaker 1: of England. And you will know the name of it. 410 00:25:32,000 --> 00:25:36,159 Speaker 1: It's Landlord, but there's about seventy derivatives of Lanoline and 411 00:25:36,280 --> 00:25:40,320 Speaker 1: Landeline is the basis of the modern face cream industry 412 00:25:40,640 --> 00:25:45,520 Speaker 1: because it made a face cream that worked and instink. 413 00:25:46,600 --> 00:25:51,840 Speaker 1: Now Crowda has a fairly high switching cost. Sheep do 414 00:25:52,040 --> 00:25:55,000 Speaker 1: things that are nasty. They walk through paddocks which have 415 00:25:55,359 --> 00:25:59,240 Speaker 1: herbicides and pesticides in them, and if you are not careful, 416 00:25:59,320 --> 00:26:02,320 Speaker 1: you'll get her decides and pesticides into the face cream. 417 00:26:02,760 --> 00:26:05,520 Speaker 1: And a sort of bad day for a Lorreal brand 418 00:26:05,640 --> 00:26:11,120 Speaker 1: manager might be um recalling your product because it has 419 00:26:11,200 --> 00:26:14,960 Speaker 1: pesticides in it. So if you're the Loreal brand manager, 420 00:26:15,000 --> 00:26:17,280 Speaker 1: you want to be really sure of the provenance of 421 00:26:17,320 --> 00:26:21,119 Speaker 1: your supply chain. Croda buys almost all the war grease 422 00:26:21,160 --> 00:26:23,199 Speaker 1: from all the sheep in Australia, in New Zealand, ad 423 00:26:23,240 --> 00:26:25,760 Speaker 1: buys it in China and it's small batch processes that 424 00:26:25,840 --> 00:26:28,359 Speaker 1: and it does the chaos monkey type testing where it 425 00:26:28,359 --> 00:26:32,400 Speaker 1: puts contaminants in it to make sure that the tests 426 00:26:32,440 --> 00:26:36,199 Speaker 1: final the contaminated batches as well, right, so that it 427 00:26:36,640 --> 00:26:39,720 Speaker 1: knows and it's never had a product recall, and it's 428 00:26:39,760 --> 00:26:42,679 Speaker 1: testing procedures are extremely rigorous. And if the question is 429 00:26:42,720 --> 00:26:45,720 Speaker 1: do you pay twenty five cents for the commodity one 430 00:26:45,840 --> 00:26:48,639 Speaker 1: or fifty cents for the crowd for the Croda ingredient 431 00:26:48,720 --> 00:26:52,040 Speaker 1: in your fifty loreal face cream, it's a no brainer 432 00:26:52,080 --> 00:26:53,879 Speaker 1: for the lore L brand. Actually, they're going to buy 433 00:26:53,880 --> 00:26:57,479 Speaker 1: the Croda product problem for a potential. Right, So you 434 00:26:57,600 --> 00:27:01,000 Speaker 1: have a small part of the big thing. It's the 435 00:27:01,040 --> 00:27:04,160 Speaker 1: critical ingredient. It has lots and lots of pricing power 436 00:27:04,200 --> 00:27:07,200 Speaker 1: because the brand manager doesn't want to change. The other 437 00:27:07,240 --> 00:27:09,560 Speaker 1: thing is the brand that it's selling to is an 438 00:27:09,600 --> 00:27:13,200 Speaker 1: incredibly fat margin product. So when you're selling a fat 439 00:27:13,240 --> 00:27:16,879 Speaker 1: margin ingredient to a fat margin product company, you just 440 00:27:16,920 --> 00:27:20,000 Speaker 1: sort of make double margin. And Crowder maybe the best 441 00:27:20,080 --> 00:27:23,440 Speaker 1: chemical company I've ever seen. I start with a model 442 00:27:23,520 --> 00:27:25,760 Speaker 1: like that. The only problem is that Crowder also trades 443 00:27:25,800 --> 00:27:28,639 Speaker 1: at five times revenue, and revenue is not growing very fast. 444 00:27:29,359 --> 00:27:32,200 Speaker 1: And it is a chemical company, right, It's not quite 445 00:27:32,359 --> 00:27:35,240 Speaker 1: the ten times revenue that Sun was at the height 446 00:27:35,280 --> 00:27:39,199 Speaker 1: of the dot com bubble, but it ain't evaluation that 447 00:27:39,240 --> 00:27:44,320 Speaker 1: should make you comfortable. Now, the way we choose stocks 448 00:27:44,600 --> 00:27:49,520 Speaker 1: hasn't changed, which is that we start with the business model. Right. 449 00:27:49,560 --> 00:27:51,600 Speaker 1: I'm not interested in owning a bank, but I am 450 00:27:51,640 --> 00:27:55,560 Speaker 1: interested in earning a bank in an oligobalistic market, right 451 00:27:55,680 --> 00:27:59,439 Speaker 1: because there's something that it's got. I'm not interested in 452 00:27:59,480 --> 00:28:02,359 Speaker 1: owning a modity chemical company, but I am interested in 453 00:28:02,400 --> 00:28:05,560 Speaker 1: owning a specially chemical company that has something that makes 454 00:28:05,600 --> 00:28:09,080 Speaker 1: you not want to change to the competitor. We start 455 00:28:09,119 --> 00:28:12,879 Speaker 1: with that, and then we go to the valuation. And 456 00:28:12,920 --> 00:28:15,000 Speaker 1: the problem is at the moment that every time I 457 00:28:15,040 --> 00:28:19,120 Speaker 1: go to the valuation, I start getting this slight queasy 458 00:28:19,240 --> 00:28:23,399 Speaker 1: feeling in my stomach. I used to get uncomfortable buying 459 00:28:23,480 --> 00:28:26,480 Speaker 1: specialty chemical companies at two and a half times EV 460 00:28:26,640 --> 00:28:30,719 Speaker 1: to sales, and I now get uncomfortable buying them at 461 00:28:30,760 --> 00:28:34,640 Speaker 1: four times EV to sales. Specialty chemicals is an area 462 00:28:34,680 --> 00:28:37,800 Speaker 1: that I know a lot about, and I can't find 463 00:28:37,800 --> 00:28:40,440 Speaker 1: anyone that I like that's trading it less than four 464 00:28:40,480 --> 00:28:45,560 Speaker 1: times EV to sales. And this is true of business 465 00:28:45,600 --> 00:28:48,560 Speaker 1: after business in the area that I have genuine expertise. 466 00:28:49,720 --> 00:28:52,760 Speaker 1: Now I know that there must be some cheap sector 467 00:28:52,840 --> 00:28:55,960 Speaker 1: out there, but it's not one that I have expertise 468 00:28:56,000 --> 00:29:00,360 Speaker 1: in except for banks, and banks are a scared one 469 00:29:00,480 --> 00:29:04,920 Speaker 1: because with banks, when you're wrong, you're really, really, really wrong. 470 00:29:05,560 --> 00:29:07,720 Speaker 1: If if I go back to that article in The 471 00:29:07,760 --> 00:29:11,920 Speaker 1: Economist which basically described Lloyd's as having the problem of 472 00:29:12,040 --> 00:29:15,000 Speaker 1: just generating way too much capital and making way too 473 00:29:15,080 --> 00:29:18,160 Speaker 1: much profit. And it had so much profit that it 474 00:29:18,200 --> 00:29:20,560 Speaker 1: didn't know what to do with door right, and so 475 00:29:20,640 --> 00:29:23,320 Speaker 1: it was buying back stock or giving it to shareholders 476 00:29:23,320 --> 00:29:27,240 Speaker 1: in huge gobs. If you told me that ten years 477 00:29:27,320 --> 00:29:29,560 Speaker 1: later that bank would be bankrupt, it would not have 478 00:29:29,600 --> 00:29:33,480 Speaker 1: believed you. If I'm wrong about Crowder, it's going to 479 00:29:33,640 --> 00:29:36,800 Speaker 1: d rate by half. If I'm wrong about a bank, 480 00:29:37,600 --> 00:29:40,160 Speaker 1: I'm going to get a big fat zero. The other 481 00:29:40,240 --> 00:29:44,520 Speaker 1: thing is that changes the risk management. You know, there's 482 00:29:44,520 --> 00:29:47,760 Speaker 1: a Warren Buffett saying that if you liked at ten dollars, 483 00:29:47,800 --> 00:29:49,720 Speaker 1: you should really love it at six dollars, so you 484 00:29:49,720 --> 00:29:56,680 Speaker 1: should buy more. And every Harry faced value investor does that, right, 485 00:29:56,800 --> 00:30:00,440 Speaker 1: That is they buy on the way down the As 486 00:30:00,440 --> 00:30:05,560 Speaker 1: a famous photo of poor Tutor Jones, there's a young guy, 487 00:30:05,600 --> 00:30:08,840 Speaker 1: he's a trader, and in the back of his picture 488 00:30:08,920 --> 00:30:11,280 Speaker 1: is that it's just stenciled on a piece of paper 489 00:30:11,320 --> 00:30:15,200 Speaker 1: hanging crooked in the office is the phrase loses average losers. 490 00:30:16,560 --> 00:30:19,440 Speaker 1: And at one end of the world you have Warren 491 00:30:19,440 --> 00:30:21,680 Speaker 1: Buffett that says, if you loved it at ten dollars, 492 00:30:22,160 --> 00:30:24,000 Speaker 1: you should be buying more at six. And at the 493 00:30:24,040 --> 00:30:27,640 Speaker 1: other end you have poor Tutor Jones saying loses average losers, 494 00:30:28,200 --> 00:30:31,520 Speaker 1: and they're both right. In times, Harry chested value Harry 495 00:30:31,520 --> 00:30:36,880 Speaker 1: faced value. Investors also Harry chested Ones get themselves into 496 00:30:36,960 --> 00:30:40,360 Speaker 1: trouble by doubling down and doubling down and doubling down again. 497 00:30:40,640 --> 00:30:43,080 Speaker 1: The most famous example, of course, is Bill Miller, who 498 00:30:43,160 --> 00:30:46,720 Speaker 1: doubled down on a I G many times to bankruptcy. Right, 499 00:30:46,800 --> 00:30:51,000 Speaker 1: and Bill Miller had a record where he outperformed the 500 00:30:51,160 --> 00:30:54,080 Speaker 1: S and P I think for eighteen straight years and 501 00:30:54,120 --> 00:30:58,760 Speaker 1: then gave back all the excess performance in one Right now, 502 00:30:58,960 --> 00:31:16,920 Speaker 1: I don't want to be building You're right, John, you 503 00:31:17,000 --> 00:31:19,800 Speaker 1: mentioned buy backs, yes, And I want to ask you 504 00:31:19,840 --> 00:31:22,520 Speaker 1: about this because it does feel like at a time 505 00:31:22,840 --> 00:31:26,760 Speaker 1: when there is ample liquidity in the system and people 506 00:31:26,800 --> 00:31:29,280 Speaker 1: talk about money essentially being free, and at the same 507 00:31:29,280 --> 00:31:33,720 Speaker 1: time you have sluggish global economic growth, you do see 508 00:31:33,720 --> 00:31:37,600 Speaker 1: a lot of companies doing buy backs or raising dividends 509 00:31:37,640 --> 00:31:40,720 Speaker 1: because they don't know what else to do with their money. Apparently, well, 510 00:31:40,960 --> 00:31:42,720 Speaker 1: not knowing what else to do with your money is 511 00:31:42,760 --> 00:31:45,560 Speaker 1: actually the sort of half of the course for really 512 00:31:45,600 --> 00:31:48,480 Speaker 1: good companies. And you know, if you have a look 513 00:31:48,520 --> 00:31:52,840 Speaker 1: at Crowda, it's roes whatever it is, it's a very 514 00:31:52,880 --> 00:31:55,840 Speaker 1: big number. It's return on assets is enormous, but it 515 00:31:55,880 --> 00:31:58,680 Speaker 1: can't grow. So what's to do with its money? That 516 00:31:58,760 --> 00:32:01,080 Speaker 1: does an acquisition or and it in the dividend or 517 00:32:01,120 --> 00:32:05,800 Speaker 1: buy back. It is very rare that you find a 518 00:32:05,920 --> 00:32:10,360 Speaker 1: really good business with really fast growth prospects. Right. So, 519 00:32:11,040 --> 00:32:15,440 Speaker 1: in fact, historically the companies that I liked by generally 520 00:32:15,480 --> 00:32:20,040 Speaker 1: generate excess cash and they generally return it collectively. The 521 00:32:20,120 --> 00:32:24,760 Speaker 1: markets insane at this If you look at aggregate buy 522 00:32:24,800 --> 00:32:28,440 Speaker 1: backs over the last thirty years, buy backs are highest 523 00:32:28,440 --> 00:32:31,960 Speaker 1: when the markets high and their lowest when the markets low. 524 00:32:32,800 --> 00:32:35,960 Speaker 1: The stock market went into net issuance mode during the 525 00:32:36,040 --> 00:32:38,880 Speaker 1: GFC when the stock market was at its all time low, 526 00:32:39,600 --> 00:32:42,480 Speaker 1: and at the moment it's at all time record buy 527 00:32:42,480 --> 00:32:47,840 Speaker 1: back levels. So whilst they like companies that do buy backs, 528 00:32:47,880 --> 00:32:50,400 Speaker 1: I'm quite aware that on average, buy backs are done 529 00:32:50,480 --> 00:32:54,560 Speaker 1: very badly, and they're done badly by some of the 530 00:32:54,560 --> 00:32:58,000 Speaker 1: companies I like as well. At this time, I'd be 531 00:32:58,200 --> 00:33:01,880 Speaker 1: very jauned us about a company that's incurring debt buy backstock, 532 00:33:02,240 --> 00:33:04,240 Speaker 1: because you know you could have done that a lot 533 00:33:04,280 --> 00:33:09,040 Speaker 1: more rationally a while back. I have examples of companies 534 00:33:09,080 --> 00:33:12,080 Speaker 1: that have brought backstock beautifully over the years. If you 535 00:33:12,120 --> 00:33:15,760 Speaker 1: have a look at the tobacco companies, the tobacco companies 536 00:33:16,200 --> 00:33:19,040 Speaker 1: for years and years and years traded at a very 537 00:33:19,080 --> 00:33:22,560 Speaker 1: sharp discount because people thought tobacco was a bad idea. 538 00:33:23,000 --> 00:33:28,400 Speaker 1: They're right. Tobacco sales have the number of Americans smoking 539 00:33:28,440 --> 00:33:32,200 Speaker 1: has halved over twenty five years, and Philip Morris is 540 00:33:32,240 --> 00:33:34,920 Speaker 1: like a ten x or fifteen x, some big number. 541 00:33:35,440 --> 00:33:38,200 Speaker 1: And the reason essentially is that they got some pricing 542 00:33:38,240 --> 00:33:41,560 Speaker 1: power and they brought back lots of stock at cheap prices, right, 543 00:33:41,680 --> 00:33:44,360 Speaker 1: And that works all day. At the other end, you 544 00:33:44,440 --> 00:33:49,240 Speaker 1: have a company which was very admired once and made 545 00:33:49,280 --> 00:33:51,440 Speaker 1: the mistake of buying back a hundred and thirty billion 546 00:33:51,480 --> 00:33:54,480 Speaker 1: dollars of stock over a decade and a half. Who 547 00:33:54,560 --> 00:33:59,680 Speaker 1: is that General Electric? Of course, had General Electric only 548 00:33:59,720 --> 00:34:02,160 Speaker 1: bought back a hundred billion dollars of stock, not a 549 00:34:02,240 --> 00:34:05,960 Speaker 1: hundred and thirty. We wouldn't be having this discussion about 550 00:34:06,040 --> 00:34:09,600 Speaker 1: General Electric. It would still be a perfectly okay company. 551 00:34:09,800 --> 00:34:12,160 Speaker 1: It would certainly would be a less good company that was, 552 00:34:12,280 --> 00:34:15,720 Speaker 1: And it's clearly made missteps along the way, the biggest 553 00:34:15,760 --> 00:34:19,080 Speaker 1: of which is probably buying Alston. But you know, you 554 00:34:19,120 --> 00:34:22,040 Speaker 1: can argue about what the missteps are. One of the missteps, 555 00:34:22,040 --> 00:34:25,719 Speaker 1: for instance, is selling all the brands. And once upon 556 00:34:25,760 --> 00:34:28,920 Speaker 1: a time there was a g appliance in every household 557 00:34:28,920 --> 00:34:31,560 Speaker 1: pretty well in the Western world, and that was a 558 00:34:31,680 --> 00:34:35,840 Speaker 1: pretty good branding exercise. And now those g appliances don't exist, 559 00:34:35,840 --> 00:34:37,200 Speaker 1: and they just got rid of them because they were 560 00:34:37,239 --> 00:34:39,439 Speaker 1: low margin businesses. But to got rid of mind ship. 561 00:34:40,000 --> 00:34:41,960 Speaker 1: There are all sorts of little mistakes that they made 562 00:34:41,960 --> 00:34:44,080 Speaker 1: along the way, but the biggest mistake by far was 563 00:34:44,200 --> 00:34:47,839 Speaker 1: they just brought back way too much stock. Right, and 564 00:34:48,000 --> 00:34:50,640 Speaker 1: G is my poster child for a company that has 565 00:34:50,719 --> 00:34:55,319 Speaker 1: impaled itself on stock by backs. And you can go 566 00:34:55,480 --> 00:34:58,759 Speaker 1: back to that tree and I've got it. It's a 567 00:34:58,800 --> 00:35:03,759 Speaker 1: wonderful document. The three and activists pitch for G when 568 00:35:03,840 --> 00:35:07,720 Speaker 1: G was about thirty dollars a share. Essentially, the pitch 569 00:35:07,880 --> 00:35:10,640 Speaker 1: was the same as every other activist pitch, which is 570 00:35:10,680 --> 00:35:13,719 Speaker 1: that they should leave her up and by even more stock. Right. Well, 571 00:35:13,760 --> 00:35:16,520 Speaker 1: had they followed that advice, G would now be a 572 00:35:16,520 --> 00:35:20,719 Speaker 1: big fat round zero. G is your poster child or 573 00:35:20,840 --> 00:35:25,680 Speaker 1: bad buy backs. I've got a longish list of companies 574 00:35:25,840 --> 00:35:28,680 Speaker 1: that have brought themselves back to a balance sheet which 575 00:35:28,719 --> 00:35:32,319 Speaker 1: I would consider single B, and often they're often they're 576 00:35:32,400 --> 00:35:35,480 Speaker 1: rated single bit. If you go back through long periods 577 00:35:35,480 --> 00:35:39,680 Speaker 1: of history, the ten year cumulative default rate for companies 578 00:35:39,800 --> 00:35:44,640 Speaker 1: rated double B is about thirty. The ten year cumulative 579 00:35:44,800 --> 00:35:49,000 Speaker 1: default rate the company's rated single B is about and 580 00:35:49,040 --> 00:35:51,319 Speaker 1: you know the rating agent, and I'm going to get 581 00:35:51,320 --> 00:35:54,319 Speaker 1: the exact words here. The rating agency definitions are kind 582 00:35:54,360 --> 00:35:58,520 Speaker 1: of interesting. It's investment grade if under the wide range 583 00:35:58,560 --> 00:36:05,720 Speaker 1: of circumstances it's going to repay. It's junk or double 584 00:36:05,760 --> 00:36:10,480 Speaker 1: B if there are reasonably likely circumstances in which it 585 00:36:10,520 --> 00:36:13,719 Speaker 1: won't repay you. In other words, you'll get repaid if 586 00:36:13,719 --> 00:36:17,840 Speaker 1: something doesn't go wrong. The CS they invert that, which is, 587 00:36:18,160 --> 00:36:21,239 Speaker 1: under the wide range of circumstances you won't get repaid, 588 00:36:21,480 --> 00:36:25,439 Speaker 1: and that the shorthand is you will get repaid if 589 00:36:25,480 --> 00:36:31,120 Speaker 1: things go right, and the credit market is almost always 590 00:36:31,160 --> 00:36:34,440 Speaker 1: open at the triple B level. When the credit market 591 00:36:34,440 --> 00:36:37,480 Speaker 1: closes at the triple B level, the economy has very 592 00:36:37,520 --> 00:36:42,759 Speaker 1: real and very sudden problems. The credit market is sometimes 593 00:36:42,760 --> 00:36:46,760 Speaker 1: open historically at the double B level, and it's almost 594 00:36:46,800 --> 00:36:50,520 Speaker 1: never open at the triple C level. This cycle, I 595 00:36:50,600 --> 00:36:55,480 Speaker 1: have seen triple cs issue debt many times and single 596 00:36:55,560 --> 00:36:59,960 Speaker 1: bs issued debt a lot. Now, the maths of it historically, 597 00:37:00,360 --> 00:37:03,520 Speaker 1: and again these are very rough numbers because the junk 598 00:37:03,600 --> 00:37:07,560 Speaker 1: debt people will probably laugh at my naivity here, But 599 00:37:07,640 --> 00:37:11,440 Speaker 1: the maths of it is that triple bees used to 600 00:37:11,520 --> 00:37:15,719 Speaker 1: trade at about three hundred basis points spread over treasuries, 601 00:37:15,800 --> 00:37:18,640 Speaker 1: So you've got paid three hundred three ten basis points 602 00:37:18,640 --> 00:37:24,279 Speaker 1: a year for holding it, but you had at cumulative 603 00:37:24,320 --> 00:37:26,480 Speaker 1: default over ten years, so you'd lose three and a 604 00:37:26,520 --> 00:37:28,360 Speaker 1: half percent of than a year, but you'd get a 605 00:37:29,360 --> 00:37:32,920 Speaker 1: recovery on that. So the cost of it of earning 606 00:37:32,920 --> 00:37:35,080 Speaker 1: the junk debt in credit was about one point seven 607 00:37:35,120 --> 00:37:37,120 Speaker 1: percent a year, and you've got about three percent a year, 608 00:37:37,160 --> 00:37:40,280 Speaker 1: so that there's one point three percent carry for owning 609 00:37:40,320 --> 00:37:44,360 Speaker 1: junk debt. That's a reward on a diversified portfolio. It 610 00:37:44,400 --> 00:37:47,880 Speaker 1: makes some sense as a banker. You got to the 611 00:37:47,960 --> 00:37:52,400 Speaker 1: point here where looking just at historic numbers, that carry 612 00:37:52,400 --> 00:37:56,000 Speaker 1: went to zero. This is of course irrational because the 613 00:37:56,080 --> 00:37:59,759 Speaker 1: defaults all happen at the wrong time. If you held 614 00:38:00,160 --> 00:38:02,439 Speaker 1: triple B double B is for a very long time, 615 00:38:03,239 --> 00:38:05,719 Speaker 1: you've got that one point seven percent on average, but 616 00:38:05,840 --> 00:38:08,799 Speaker 1: you've got all your defaults selectively in two thousand and 617 00:38:08,840 --> 00:38:12,120 Speaker 1: two and two thousand and nine. Cash in two thousand 618 00:38:12,120 --> 00:38:14,480 Speaker 1: and two and two thousand and nine is worth more 619 00:38:14,480 --> 00:38:17,280 Speaker 1: than cash in two thousand and six and two thousand 620 00:38:17,400 --> 00:38:21,960 Speaker 1: and nineteen because you can turn that cash into money 621 00:38:22,200 --> 00:38:26,360 Speaker 1: into the market at very low valuations. Right, So whilst 622 00:38:26,360 --> 00:38:29,799 Speaker 1: you've got a premium over a very large periods, the 623 00:38:29,800 --> 00:38:33,720 Speaker 1: premium wasn't well timed. You really want to make money 624 00:38:34,080 --> 00:38:36,759 Speaker 1: at bear markets, so you can use that money to 625 00:38:36,880 --> 00:38:41,120 Speaker 1: buy things. It's really important. One of the problems with 626 00:38:41,160 --> 00:38:43,759 Speaker 1: businesses that lose money in bad times is that they 627 00:38:43,760 --> 00:38:48,320 Speaker 1: lose money at the wrong time. Liquidation businesses, by contrast, 628 00:38:48,800 --> 00:38:51,080 Speaker 1: make money at the wrong time. So you know, the 629 00:38:51,120 --> 00:38:54,480 Speaker 1: extreme version of that is Charlie Manger's company, the Dow 630 00:38:54,719 --> 00:38:59,120 Speaker 1: News Wire, and it publishes bankruptcy notes. It's a legal 631 00:38:59,280 --> 00:39:03,320 Speaker 1: public share that you and Charlie owns. Charlie Manger, not Birkshire, 632 00:39:03,360 --> 00:39:06,320 Speaker 1: own's a very large amount of the company. And Charlie 633 00:39:06,360 --> 00:39:08,520 Speaker 1: is the chairman of the board and he has an 634 00:39:08,520 --> 00:39:11,200 Speaker 1: annual meeting where all the hairy jested value investors go 635 00:39:11,360 --> 00:39:14,960 Speaker 1: and hairy faced value investors go and they all listened 636 00:39:14,960 --> 00:39:18,279 Speaker 1: to Charlie and Charlie dolls them out wisdom. But the 637 00:39:18,320 --> 00:39:20,840 Speaker 1: real trick with that company is it makes okay money 638 00:39:20,840 --> 00:39:24,520 Speaker 1: over a cycle, but it makes it all when bankruptcies art. Right, 639 00:39:24,560 --> 00:39:27,239 Speaker 1: it's like a hedge for the macro economy. Yeah, but 640 00:39:27,560 --> 00:39:31,319 Speaker 1: then you've got Charlie Manger as your investor. So they 641 00:39:31,360 --> 00:39:33,239 Speaker 1: made a whole lot of money when the when the 642 00:39:33,280 --> 00:39:37,720 Speaker 1: markets were really low, and Charlie went and bought things 643 00:39:37,760 --> 00:39:40,480 Speaker 1: with it, right, And in fact, if you go look 644 00:39:40,520 --> 00:39:42,960 Speaker 1: at it, it brought almost all of its Wells Fargo 645 00:39:43,040 --> 00:39:46,080 Speaker 1: on a single day, one day from the absolute bottom 646 00:39:46,080 --> 00:39:49,160 Speaker 1: of the Wells Fargo stock price. And the real trick 647 00:39:49,239 --> 00:39:51,399 Speaker 1: to that business is not only does it make money 648 00:39:51,400 --> 00:39:53,360 Speaker 1: at the right time, but you have a really wise 649 00:39:53,440 --> 00:39:57,520 Speaker 1: guy who invests money at the right time. Right the 650 00:39:57,560 --> 00:40:01,720 Speaker 1: dollar doesn't care much how you make it. It cares 651 00:40:01,800 --> 00:40:07,319 Speaker 1: like crazy when you make it. So talk to me 652 00:40:07,600 --> 00:40:12,400 Speaker 1: about excesses in the debt market, which you just described, 653 00:40:13,160 --> 00:40:17,359 Speaker 1: and how that impacts the stock market which you invest in. 654 00:40:17,400 --> 00:40:20,359 Speaker 1: And I'm thinking of one of your most famous calls here, 655 00:40:21,040 --> 00:40:26,640 Speaker 1: which would be Valiant. Valiant was a series of opaque accounts. 656 00:40:28,000 --> 00:40:33,240 Speaker 1: It had all the famous adjusted earnings, and you could 657 00:40:33,320 --> 00:40:39,759 Speaker 1: not work rationally from the adjusted earnings back together. You 658 00:40:40,360 --> 00:40:43,759 Speaker 1: just had to trust them on that. The other thing 659 00:40:43,800 --> 00:40:47,120 Speaker 1: about Valiant was that it was trading at ten times sales, 660 00:40:47,880 --> 00:40:51,640 Speaker 1: and it was buying companies at ten times sales. And 661 00:40:51,719 --> 00:40:55,600 Speaker 1: ten time sales is my favorite magical number. You really 662 00:40:55,800 --> 00:40:59,080 Speaker 1: really need to be good to justify ten times sales. 663 00:40:59,719 --> 00:41:04,880 Speaker 1: That Scott McNally quote is just burned into me. You 664 00:41:04,960 --> 00:41:08,400 Speaker 1: had this thing trading at ten times sales, buying things 665 00:41:08,440 --> 00:41:11,720 Speaker 1: at ten times sales with accounts that made no sense. 666 00:41:12,400 --> 00:41:14,720 Speaker 1: The first thing we did was we tried very hard 667 00:41:14,880 --> 00:41:18,440 Speaker 1: to reconcile the adjustedy adjusted a bit the number to 668 00:41:18,480 --> 00:41:22,919 Speaker 1: their bit the number, and we found instances where they 669 00:41:23,000 --> 00:41:26,000 Speaker 1: were like, there's no if saw butts about this. The 670 00:41:26,840 --> 00:41:29,480 Speaker 1: first one we found was a trivial one. It was 671 00:41:29,520 --> 00:41:35,160 Speaker 1: the Galderma Royalty. They had bought a business essentially from 672 00:41:35,200 --> 00:41:40,319 Speaker 1: Nestle from Memory and they were selling stuff that goes 673 00:41:40,320 --> 00:41:44,040 Speaker 1: in women's lips to make their lips puppier. But every 674 00:41:44,080 --> 00:41:47,520 Speaker 1: dollar of sale they had to send five five cents 675 00:41:47,520 --> 00:41:50,040 Speaker 1: of that just a small amount back to Nestle because 676 00:41:50,040 --> 00:41:52,759 Speaker 1: they owed them a royalty. When they are working their 677 00:41:52,800 --> 00:41:55,960 Speaker 1: adjusted A bit throughout, they didn't include that. Now it's 678 00:41:56,000 --> 00:41:58,680 Speaker 1: an expense. Every dollar you sell you have to send 679 00:41:58,719 --> 00:42:00,719 Speaker 1: five cents back. If you sell extra dollar, you have 680 00:42:00,760 --> 00:42:05,000 Speaker 1: to send five cents back. Now they capitalize their estimated 681 00:42:05,080 --> 00:42:08,560 Speaker 1: value of that and amatize and excluded it from their 682 00:42:08,560 --> 00:42:12,440 Speaker 1: adjusted dedicta. Right. Then we found another one that was 683 00:42:12,480 --> 00:42:14,560 Speaker 1: like that, and another one that was like that. Can 684 00:42:14,600 --> 00:42:16,799 Speaker 1: I ask you on this point though, because whenever I 685 00:42:16,840 --> 00:42:19,960 Speaker 1: have a conversation about adjusted earnings, what some people will 686 00:42:20,000 --> 00:42:22,880 Speaker 1: say is, well, what does it matter because you have 687 00:42:22,960 --> 00:42:27,759 Speaker 1: the gap numbers there anywhere? Valiant wasn't making gap profits right. 688 00:42:28,120 --> 00:42:30,880 Speaker 1: In fact, I always feel like pulling them up right now. 689 00:42:31,400 --> 00:42:34,719 Speaker 1: But the first gap profit that Valiant made was after 690 00:42:34,800 --> 00:42:38,680 Speaker 1: it blew up, and in fact it was it was 691 00:42:39,040 --> 00:42:43,440 Speaker 1: writing off deferred tax liabilities and writing off earnouts right, 692 00:42:43,480 --> 00:42:48,560 Speaker 1: there were no gap profits. Without adjusted earnings, Valiant looked 693 00:42:48,640 --> 00:42:52,160 Speaker 1: unprofitable and would have been judged as such by the market. 694 00:42:52,520 --> 00:42:56,719 Speaker 1: There are times that adjusted earnings make sense. I'll go 695 00:42:56,920 --> 00:43:00,800 Speaker 1: right back to the very beginning of my stock picking career. 696 00:43:01,520 --> 00:43:05,080 Speaker 1: This was a very very much bearded value investor thing 697 00:43:05,160 --> 00:43:08,640 Speaker 1: that a twenty two year old might think about. There 698 00:43:08,680 --> 00:43:13,239 Speaker 1: was a company in Australia called Byron, and Byron invented 699 00:43:13,280 --> 00:43:17,919 Speaker 1: the process for making synthetic emeralds, which is in fact 700 00:43:17,960 --> 00:43:20,280 Speaker 1: that these things have turned up to be kind of useful. 701 00:43:20,400 --> 00:43:22,640 Speaker 1: If you could make them large enough, you might make 702 00:43:22,760 --> 00:43:26,280 Speaker 1: a set synthetic sapphire as a screen from mobile phone, 703 00:43:26,400 --> 00:43:30,399 Speaker 1: which would make a sort of unscratchable screen. Um. They 704 00:43:30,400 --> 00:43:35,359 Speaker 1: are used for the nose cone of cruise missiles, and 705 00:43:35,400 --> 00:43:38,440 Speaker 1: the reason that their work is they're extremely hard and 706 00:43:38,480 --> 00:43:42,000 Speaker 1: abrasive and the military doesn't care what they pay for them. 707 00:43:42,320 --> 00:43:44,720 Speaker 1: But you can run the guidance system through the nose 708 00:43:44,800 --> 00:43:47,040 Speaker 1: cone of the missile, so you can see through it 709 00:43:47,080 --> 00:43:49,600 Speaker 1: without putting. You know, it's a sort of unbreakable window 710 00:43:49,680 --> 00:43:54,400 Speaker 1: on a missile that's going extremely fast. But these were 711 00:43:54,440 --> 00:43:58,279 Speaker 1: originally jewels, and I can only remember the numbers in 712 00:43:58,320 --> 00:44:01,880 Speaker 1: price push in per share, but they'd spent about a 713 00:44:01,960 --> 00:44:07,680 Speaker 1: dollar eighty per share building this whopping big plant, and 714 00:44:07,760 --> 00:44:10,720 Speaker 1: they were amortizing the plant off, which was about twenty 715 00:44:10,719 --> 00:44:15,520 Speaker 1: cents a share a year. They had these enormous projections 716 00:44:15,600 --> 00:44:17,400 Speaker 1: for how much money they were going to make about 717 00:44:17,440 --> 00:44:21,680 Speaker 1: selling these synthetic sapphires, and that didn't work out that way. Firstly, 718 00:44:21,719 --> 00:44:24,480 Speaker 1: the Russians copied the plants, so you could buy synthetic 719 00:44:24,520 --> 00:44:28,880 Speaker 1: sapphires from other places, and the military establishment copied the plants, 720 00:44:29,000 --> 00:44:34,200 Speaker 1: and they also started selling synthetic sapphires. And then women 721 00:44:34,239 --> 00:44:37,759 Speaker 1: started looking down their nose at synthetic sapphires anyway, and 722 00:44:37,800 --> 00:44:39,920 Speaker 1: so you didn't get a big price premium for them, 723 00:44:40,120 --> 00:44:42,879 Speaker 1: even though they were flawless. You've got a discount for them. 724 00:44:43,200 --> 00:44:46,319 Speaker 1: In fact, a sort of flawed natural sapphire traded at 725 00:44:46,320 --> 00:44:50,840 Speaker 1: a premium to a flawless, beautiful synthetic one. So the 726 00:44:50,920 --> 00:44:54,200 Speaker 1: company never was never going to recover. In fact, it 727 00:44:54,239 --> 00:44:57,440 Speaker 1: was going to lose money. But it was making about 728 00:44:57,440 --> 00:45:02,239 Speaker 1: eight cents a share of operating cash flow, offset by 729 00:45:02,400 --> 00:45:05,200 Speaker 1: the admortization of this plant, So I was declaring losses, 730 00:45:05,560 --> 00:45:07,480 Speaker 1: but it had built up about twenty cents a share 731 00:45:07,520 --> 00:45:11,200 Speaker 1: of cash. After all, the debt was trading at twenty 732 00:45:11,239 --> 00:45:14,319 Speaker 1: cents and was making seven cents of cash flow a year. 733 00:45:14,840 --> 00:45:18,480 Speaker 1: Was going to make losses forever now, the beau. The 734 00:45:18,520 --> 00:45:23,360 Speaker 1: first adjustment was just adjust out the depreciation because it 735 00:45:23,440 --> 00:45:25,680 Speaker 1: was a plant that I didn't pay for. I was 736 00:45:25,719 --> 00:45:28,000 Speaker 1: paying twenty cents a share. The people who paid for 737 00:45:28,040 --> 00:45:31,200 Speaker 1: the plant paid a dollar radia ship from my perspective 738 00:45:31,200 --> 00:45:33,719 Speaker 1: of the earnings for seven cents a share right for 739 00:45:33,760 --> 00:45:36,120 Speaker 1: the next ten years. And that's roughly how it turned out, 740 00:45:36,120 --> 00:45:39,000 Speaker 1: except some rich guy bought control of the company and 741 00:45:39,040 --> 00:45:42,319 Speaker 1: diverted the cash flows for his own years. But there 742 00:45:42,400 --> 00:45:46,200 Speaker 1: was a perfect instance where I should ignore the gap accounts, right, 743 00:45:46,280 --> 00:45:48,200 Speaker 1: and I should just look at what's really going on. 744 00:45:48,960 --> 00:45:52,440 Speaker 1: And the world is full of those instances, right, But 745 00:45:52,480 --> 00:45:55,839 Speaker 1: it's also full of people who, like Valiant, will ask 746 00:45:55,920 --> 00:45:59,480 Speaker 1: you to ignore the Galderma Royalty. Now, the Galderma Royalty 747 00:46:00,000 --> 00:46:04,680 Speaker 1: absolutely patently obvious that you shouldn't ignore it. And you know, 748 00:46:04,760 --> 00:46:06,880 Speaker 1: when you're late in a ball market and people are 749 00:46:06,960 --> 00:46:09,959 Speaker 1: hyping things, they'll ask you to ignore the most silly things. Ever, 750 00:46:10,719 --> 00:46:13,520 Speaker 1: Byron was the example of a company which was loss 751 00:46:13,560 --> 00:46:15,759 Speaker 1: making as far as the eye could see and was 752 00:46:15,800 --> 00:46:19,239 Speaker 1: still worth a lot of money. So what would you 753 00:46:19,440 --> 00:46:21,680 Speaker 1: And this is probably going to be the last question, 754 00:46:21,760 --> 00:46:25,080 Speaker 1: but what would be your one piece of advice for 755 00:46:25,160 --> 00:46:27,960 Speaker 1: people who have to put money to work in the 756 00:46:28,040 --> 00:46:32,680 Speaker 1: market right now? With all this going on, you're asking 757 00:46:32,719 --> 00:46:36,000 Speaker 1: someone that's finding extremely easy to find shorts at the 758 00:46:36,040 --> 00:46:41,080 Speaker 1: moment and extremely hard to find longs. How I invest 759 00:46:41,200 --> 00:46:45,760 Speaker 1: long at the moment? This is not an easy question. 760 00:46:47,200 --> 00:46:49,800 Speaker 1: If you go back to the height of the tech bubble, 761 00:46:50,760 --> 00:46:53,560 Speaker 1: if you've bought the top ten five names and you 762 00:46:53,680 --> 00:46:57,160 Speaker 1: held them to now, you did okay. If you bought 763 00:46:57,280 --> 00:47:05,759 Speaker 1: names five, you did terrible. It feels bad to pay 764 00:47:05,800 --> 00:47:09,719 Speaker 1: a big price for quality, but in retrospect it's worse 765 00:47:09,840 --> 00:47:13,520 Speaker 1: to pay an even bigger price for a junk. Right, 766 00:47:13,640 --> 00:47:17,400 Speaker 1: So my gut reaction is probably leave half of the 767 00:47:17,440 --> 00:47:21,200 Speaker 1: money to do something else with right, and in some 768 00:47:21,239 --> 00:47:25,759 Speaker 1: sense rebalance A sixty forty portfolio would be a reasonable 769 00:47:25,800 --> 00:47:30,400 Speaker 1: assumption and actually pay out for quality, because I think 770 00:47:30,600 --> 00:47:33,840 Speaker 1: you'll not, because you do better paying up for quality, 771 00:47:33,880 --> 00:47:36,920 Speaker 1: but you'll probably lose less, which is as you know, 772 00:47:37,080 --> 00:47:40,400 Speaker 1: and you know over very long periods of time. My 773 00:47:40,520 --> 00:47:43,719 Speaker 1: guess is the quality stocks will still produce returns that 774 00:47:43,800 --> 00:47:49,239 Speaker 1: are adequate. If your idea of adequate is low single digit. Well, 775 00:47:49,239 --> 00:47:53,120 Speaker 1: on that happy note, John Hampton, Franti Capital, thank you 776 00:47:53,160 --> 00:47:55,320 Speaker 1: so much for being on offline. Thank you for having 777 00:48:09,080 --> 00:48:11,720 Speaker 1: this has been a special edition of the Odd Thoughts 778 00:48:11,760 --> 00:48:15,160 Speaker 1: Podcast down Under. You can follow me Tracy Alloway at 779 00:48:15,239 --> 00:48:18,640 Speaker 1: Tracy Alloway on Twitter. You can also follow my co host, 780 00:48:18,840 --> 00:48:22,279 Speaker 1: Joe Wisenthal at The Stalwart and you can follow our 781 00:48:22,360 --> 00:48:25,520 Speaker 1: guest for the episode on Twitter, Mr John Hampton at 782 00:48:25,800 --> 00:48:30,080 Speaker 1: John Underscore Hampton. You can also follow his blog Bronti 783 00:48:30,200 --> 00:48:34,279 Speaker 1: Capital dot blogspot dot com. You should also follow our 784 00:48:34,320 --> 00:48:38,680 Speaker 1: producer Laura Carlson at Laura M. Carlson, and you should 785 00:48:38,680 --> 00:49:01,960 Speaker 1: follow all of Bloomberg Podcasts at podcast on Twitter, st