Chit Chat Stocks - Investing Power Hour #61: Ranking Portfolio Quality; Big Tech R&D Bets; Private Equity Winter?

Episode Date: June 4, 2023

The CCM Investing Power Hour is a live-streamed show every Thursday. On the show, Ryan, Brett, and a rotating list of guests have an unscripted discussion on a variety of investing topics. You can watch the show on our YouTube channel here: https://www.youtube.com/c/ChitChatMoney Follow the show on Twitter: https://twitter.com/chitchatmoney Subscribe to our newsletter: https://chitchatmoney.substack.com/ ****************************** Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Welcome to the CCM Investing Power Hour, otherwise known as the Chit Chat Money Investing Power Hour. This is number 61. You got to get the number right here as we get into the

higher numbers. This show is where we do or talk about anything in financial markets, whether it is stocks, philosophy, current market events, business updates, mergers, whatever, other investors, portfolios. My name is Brett Schaefer, and I'm joined as always by my co-host, Ryan Henderson. These go live every Thursday, 12.30 PM Eastern time on our YouTube page. You can watch the replays there or listen to the replays weekly wherever you get your podcast. Ryan, how are you feeling this week as we close out earnings season? I think we're, yeah, we're done. It's kind of for the software people now, but besides that, we're kind of done with earnings season. So I guess, how are you feeling? Not just with that,

but in general. I'm feeling good. Yeah, I am feeling good all around. I think it's nice to be past earnings although it is kind of a quiet period we try to find like current events i think for these shows generally to discuss and so these weeks can be a little tough but there is some interesting stuff out there that i was able to find and we've got to be a little more creative i think in weeks like this but um feeling good in general yeah i think the only company the only notable company still reporting salesforce reported last night um who else u-haul reported any other big ones yeah it's a lot of those software ones you got stuff like crowd strikes you got stuff like um mongo db you got a lot of those software names

that are on that crow rated calendar uh yeah and if anyone thank you for the comment james good one um let me just message him here yeah what okay what are your topics today then i'll go through what mine are and then we'll actually go through them. I think they're going to be fun. So like I said, you got to be a little more creative for shows like this or kind of in less newsy week. So I'm going to be talking about my first topic is how big should a position be? So kind of on the portfolio construction side of things, how to weight different positions, how to think about weighting them, because it's really, I feel like this has been, it's kind of one of those things that's so important to your returns,

but there really isn't a great formula for it to, to kind of come out with the right balance because a lot of it is, you know, personalized. What are you willing to accept kind of risk wise and where are you comfortable? And so we, I kind of went through it. Um, I went through this fun ranking activity that this was inspired by Alex Morris, friend of the show, also known as the science of hitting. And he goes through this fun illustration. So I went through it for all of our holdings. And I think it raises some interesting points. It has more of a focus on kind of long-term ownership and business quality, but I'll go through some of that. And then I guess NVIDIA can't go another week without talking about nvidia uh they did an equity raise so i'll uh maybe touch on that

but uh yeah that's pretty smart yeah there's some gaming there's some gambling stuff gambling revenues came out from nevada and then there was a funny moment on a conference call too which we could talk about that all right yeah then i did see that the percentage payouts to gamblers in Las Vegas are going down, which means the take to the casinos are going up. So guys, everyone out there, PSA, we need to stop. We can't stop let this happen. You can't go to Vegas and just be a patsy all the time. But I guess that is kind of the point.

My topics are going to be an update on private equity. There's a great post from Verdad Partners. I think that's how you say it. It doesn't look great, but I'll get into why. And then I have Big Tech Big Bets, which is a piece from Matt Ball, always a provocative writer talking about the big tech research and development costs from Google Cloud, Amazon Alexa, Facebook Reality Lab, of course, and then connecting it back to Microsoft and Apple as well. probably won't hit everything on that, but I think there are some fun discussion topics. So as we get a few people joining here, what do you want to hit first? Why don't I dig in on the portfolio stuff? Cause I think it's me, it's maybe our veggies

a little bit kind of less newsy, less exciting, but a good practice for us. All right, go right ahead. So, like I said earlier, this was inspired by a friend of the show, Alex Morris, and it's basically just kind of a ranking practice where the goal here is to assign a score, so add a quantitative component to qualitative judgments. So basically, this was something that Ensemble Capital, I think, was the initial kind of creator of, at least that's where Alex Morris kind of got his inspiration for it. And he tweaked it a little bit to basically rank each one of your holdings on a one, two, or three, so three being the best, one being the worst, across four different categories. And so the four different categories are number one, five-year expected return, two, strength and sustainability of the moat, three, predictability of business profitability, not predictability of its ability to grow. So we've got expected returns, moat, predictability of profits, and then quality of the management team. does that kind of is that all make pretty sense okay you see yep and this is all from alex's most

recent write-up so i recommend going and checking out his his sub stacks it's always informative but i went through them for our holdings and our holdings are public if people want to check them out archcapitalfund.com you can you can see yeah just we just do a quick little table on the website that i'm crazy once a month right yeah i'll try well that was kind of a that was an inside joke yeah the uh but you know i guess i don't know how to maybe we could share the screen but it's kind of a wonky table i kind of just went through and i'd be curious on your thoughts and i went through the management teams and only we have what 13 holdings yep only three of our holdings got a score of three in my opinion uh on management on management

which i guess is fairly concerning but that's i don't know uh maybe maybe so we'll look into a little more okay so your three were nelnet iac amazon now then i see are really bets on management because those are two conglomerates-ish that we bought that we think are cheap. And the other one is Amazon. So I'm curious why you said those three. And then maybe I'll have a question on some other ones that I may have debated with myself of whether to put a three.

Yeah, I mean, with Nelnet and IAC, like you said, it's basically bets on management themselves. So it's not surprising that those are threes because you're basically betting on the capital allocation skills of those managers. Amazon, I think they've just ingrained a good culture of, and maybe it's floated a little bit away from the old days, Amazon, but still being, I don't want to say cautious because they're definitely not cautious, but a little more pragmatic around their spending than maybe some of the other big tech companies.

it's very focused on you know trying to find home runs which some of the times i think it's really stupid but you know that's the point is uh some of these things may work out a lot of them will not um and so i think management's done a good job i think um ceo there the new ceo has done okay despite performance not being great yeah it was a tough situation i mean he got thrown and right when they were hitting the cyclical top on retail and really the cloud somewhat during the pandemic. Yeah, and he's been around for, I mean, he's new to the CEO seat, but he has managed parts of Amazon that have done really, really well.

And so I don't think it's all, like if you were just ranking him as a manager based on all his performance prior to CEO, you'd probably give him a three. here's a here's a question from uh commenter james is insider ownership a factor in that management rating did you care about that at all not in terms of no i mean usually it is usually the managers that do better have large insider ownership because they're obviously incentivized to do well, I think, but that was not a factor in me assessing the quality of management because you could own the whole company and still be a shitty manager or still

be a bad executive. You know what I mean? Like that, that this is supposed to be two separate, you could have a, you know, a fifth category that says like, you know, alignment or something like that. Maybe that, you know, ownership would matter a little more, but I think this is supposed to be independent of ownership okay that makes sense yeah anyway i don't want to go too long on this i guess um well here's here's here's what i want to do is basically like look at some that i may have chose differently and i think one that i may have put because i kind of agree on your ones you know google like yeah like it's such a good business that it's honestly the management team being not that great is you know put them with amazon shoes and i think they would be like

wow, this is actually hard to run. Autodesk, yes. I mean, we know their capital allocation struggles with, again, a phenomenal business. EA, I may have put that at a two because the execution there has been pretty strong over the last five years. Although, again, we have talked about maybe publicly, but their cashflow hasn't really grown. I think the two that I may have put at three instead of two and you had them at two are dropbox and nintendo what do you think i don't know if i'm ready to give nintendo management a three after the mario movie and after tears of the kingdom is going to be a billion dollar profit generator the best game ever apparently there's still there's still some things they struggle with

sure yeah um yeah i mean they've they've done a good job diversifying their ip but let's keep in mind if we're considering miyamoto within the management team there we're judging him based on his track record which is like 35 years obviously he's been very creative but to have shareholder returns been good over 35 years yeah probably not so i guess maybe it could it could go up to three it's definitely candid to go up to three maybe five years from now but it's two for the time being that's kind of our thesis is it'll go up to three five years from now right i mean i think that furukawa has been in there for less time so you know maybe he's maybe he could potentially get a three but still they are in the middle i

think of that cloud transition still um and so kind of proving that they can do that uh effectively and kind of turn this into a more recurring business is it's still up in the air uh i guess the only other one i mean expected returns there's a company there's a couple of companies that we own that are maybe not the best businesses and by not the best businesses i i mean frankly they're not very good businesses but they are three times earnings yeah they're just deep value so the expected returns are really high that's kind of we're more willing to take on risk with some of of those. So those got a lot of threes across the board on expected returns. But for Moat, I only gave four companies a three on Moat, and that's Nelnet, Google, Autodesk, and Amazon.

Would you give anyone else a three? I think I would give, and maybe this is because I'm much more bullish on Nintendo. I think I would give Nintendo's Moat a three because I don't think, yes, like the world could kind of go away from their family-friendly gaming, sort of a way that Disney might get disrupted by kids playing other stuff and just watching YouTube a lot, right?

But I think their defensibility within family-friendly gaming IP is pretty unmatched, but I don't think the emote is as strong as Autodesk or Google or Amazon, And then Nelnet is a very unique one where it's, again, we hate to use the Berkshire comparison, but it's a culture moat that we think is pretty darn unmatched. But I agree across the board. And what did you get for low ones on moat here?

Oh, I mean, a lot of the shit codes we own, I guess. Well, yeah, but yeah, of course, like Arbor Diversified, which is a total deep value one, Silicon Motion, again, a merger arbitrage one, which is unique. we don't need to talk about those. I was going to say Dropbox and Ally. I'm curious why you gave those one. I think I maybe could have give Dropbox a two, but we've kind of talked about this. We talked about this last week where it's definitely not a never sell business. If it got up to 20 times earnings, it would probably be kind of sell territory for me. And a lot of the reason is because even though they might be able to sustain their current customer base and potentially raise prices on them over the years,

I think that space, their competitive positioning against the big tech players is slowly declining. Potentially, potentially, yeah. It's not showing up in numbers yet, but the threat is obviously there. Yeah, I mean, you look at it on a new user basis. If you're someone who has never heard of cloud storage or doesn't know where to keep their files and you're doing this for the first time, where are you going to go? I think if you asked me that 12 years ago, Dropbox might have been number one. Now, I think it's probably Google Drive or Office 365 or whatever.

I think it's called OneDrive now. I just don't think Dropbox is number one. kind of lost their competitive positioning over the years however i do think they can kind of kind of sustain their current user base so that's kind of why can you choose zero on any of these or no no that's not part of it i think it was just supposed to be one to three okay uh maybe i guess you could tweak it and call call some of them zero ally i don't i mean there is some competitive advantages there but at the end of the day they are still a bank i thought you have a one and a half yeah yeah there's just some advantages i think to having a massive bank like a chase

that has some physical footprint obviously there's advantages to being online only because you get some of the cost advantages but um i don't know to go out and say that they're competitively advantaged against bank of america or chase seems wrong um okay let's move to i don't want there yeah expected returns is a tough one i don't really know if we want to talk about that but what about because obviously the ones we own we think are going to be high right um somewhat most of the time and i guess maybe you know there's someone here that might be a little bit lower where you go hey maybe we should not own this but predictability let's go to that one i'm seeing two threes and then four two so why don't you go through the threes first and why you thought that

maybe i can see any changes or anyone that i would disagree with so i may have like the definition of what we are going for here a little mixed up but basically i'm just saying like the predictability that profits will be higher in five years um and then at the same time like being able to predict where profits would be with a lot of the companies i think there's so much like fluctuation in earnings that it's hard to predict so the only ones i gave threes were google and dropbox because they're probably the most predictable businesses just in terms of like okay google search will grow probably whatever internet gdp and it's unit economics are not going to get Right. And then Dropbox is just like, I don't know, you grow users 4% a year,

increased prices gradually, margins at 35%. They've pretty much laid that out and it seems very achievable. But the rest of these, just kind of going through them, there's a lot of factors that are outside of their control. So Nelnet, the only reason I say earnings are kind of unpredictable or less predictable with Nelnet is just because they've got a bunch of options or kind of hedges put in that we don't know what they're going to be worth. And they tend to reinvest that capital. So you have no idea what the bottom line is going to look like. But the rest of these, I mean, Match Group, can you say with certainty that it's going to be above a certain part in five years? I can't really do that. I don't know

what tinder tinder is going to look like in five years uh the rest of these i don't know i mean nintendo i have no idea the switch could lose some pizzazz and and they could you know pull them pull a nintendo a nintendo of the past and kind of ruin their earnings power the rest of the amazon who knows yeah if you would have guessed that they'd be doing break-even earnings in 2023 three, I think people would be very surprised. Do you think this is revealing to our general investing strategy is where we go for companies where they are unpredictable earnings and people are afraid to invest, but we're confident more in the competitive advantages and the management team. And that's where we can sometimes find opportunities. I think that is a bit revealing

and maybe is a good way to, not the entire strategy is that, but that is definitely a factor in what investments we're looking for. Yeah. I mean, we're willing to take on, I think, more risk in favor of upside. And if you just look out at this practice or this kind of force rankings approach, 75% or three out of the four categories are focused on quality. Some of the best returns could be just from those deep value businesses we have where the quality so low, but if there's some sort of a re-rating, the returns can be better than a lot of the other ones, even though it might have the lowest cumulative score. Basically, if we could put the expected returns out of one through six, it would very much

change the cumulative rankings. I actually was going to say, you have a question here, what's good, what's bad about it? I kind of think the expected returns maybe should have a higher weighting, maybe at six, just because that is so important. And it's hard to, I think it's more, you need more than three categories there, but yeah. We have a comment from Alex. He joined that said bias, but love today's topic.

And then we have another follow-up question at the end, but if you have any other questions, topics you want to discuss for this, this one. no it's uh i mean it's a fun practice i think to go through but yeah it does reveal i think a lot of um first of all it maybe makes you realize some things that you've put on the back burners for a while for example for me ea's one of the lowest on a cumulative scoring it's and we've both kind of i don't know maybe soured on it a little bit over over the years that we've owned it Mainly on expected returns.

Although I might disagree with you on management. I might put that at two, but expected returns. Yeah. It's the only one he had at one. That's just because their growth hasn't been really that strong. Yeah. I mean, it forces you to take a hard look kind of at your holdings, but there is obviously we have, we maybe prioritize upside a little more than some other investors.

And here's what I think can be a problem here. And you have the cumulative rankings, and I think it can be a good one where you kind of look at valuation versus what you have on this cumulative score. But sometimes I think the opportunities are in the companies where, and yeah, management is all qualitative perception. And I guess the predictability and moat are as well, but it's, it's where the, and again, this is kind of what I talked about where we kind of, I guess it kind of revealed where we, we target some opportunities is we look for where the perceived moat is low and the perceived predictability or earnings potential is low and where we disagree. So it's more like that, that quote from, I believe it was Todd Combs recently that everyone's been hyping up where it's, where's the moat going to expand five years from now. So I think that can prevent you from saying like, look, this is a dynamic situation.

And one of the most important things is if earnings predictability and the competitive advantage, which I guess tying together, expand over the next five years, and you can buy at a cheap price. I think that this sort of system can discount that, but it's not going to encompass everything for your investing philosophy. James Goodwin asks, question for the end of the section, would you size your positions differently if you were only managing your own capital basically or would we go more concentrated i mean that's a really good question and i've thought about it before because my roth ira

doesn't look the same as my as the fund granted it's like i care less i think about my roth ira because i'm not like trying to focus on performance i'm just kind of like and it doesn't doesn't matter, for 40 years, 30, five years? Maybe. I think that's an important question. Maybe. Yeah. And here's the thing. The goal of us as 20-something investors is different than the goal of your clients. So yeah, definitely. It might be slightly different, but the type of stocks we'd own would be the same. I think the companies we'd own would be fairly the same. I'm sure there may be a couple that Ryan would maybe own on his own. There's a couple that I might own on my own. That basically, because when we buy something, we both have to agree,

obviously, but, and the position sizing might be slightly different, but I don't think it'd be too different. It just might be slightly more concentrated just because it's one investor versus two. Yeah. The other thing is, and maybe it's just because I don't really look at my Roth IRA that much. I think I've looked at it like three times in the last year and it's only when I like add some money to it. I think I would be, I think I'm probably more risk averse in the fund or, or maybe more cautious in the fund. I only have three holdings in my Roth IRA, but like I said, it's, it's, I'm just really kind of I don't know. It's like an afterthought. So I'm not really given a whole lot of thought to it. And most of the time with the holdings I have in my personal

money, it's stuff where it's like, okay, if I don't look at this for five years, like I forget to, it's such a durable business that it'll probably be around and I can think about it then. Whereas with the fund, even, and I know being active can kind of lead to more mistakes. we are kind of monitoring it on a regular basis. And we've actually, I think, benefited from that where there've been times when we've been more active, we doubled down at certain points and that's been successful for us. We've sold earlier than maybe we would have in our personal fund. So yeah, there's definitely a different approach and maybe just more care in general given to the fund, but I, it is an interesting question. I appreciate that. All right. Last follow-up from

James. And he says, would you go for smaller companies in the personal account? I don't think so. Not really. I don't, I think smaller in the fund probably. Potentially. Yeah. And when it, with personal accounts are again, always personal with mine, I'm kind of in a set it and forget it mode. So I'm looking for stocks that I don't have to track very much. And I, for us, we've discuss this, we think there's a lot of things to worry about in investing or when you're managing a portfolio or building something out. I think worrying about explicitly saying, I'm going to go for small stuff. I'm going to go for large stuff. I'm going to go for value. I'm going to go for blank. You can do that a bit, but it can be a bit dangerous to kind of over categorize

yourself and over just have so many factors that you're considering like, oh, is this the optimal time to be in small cap value emerging markets is a good example i think honestly there's been a lot of takes out there that seem very smart like that that actually could be a fantastic opportunity right now but i think in general saying i'm going to be that guy i'm going to be that investor is it's not helpful and it can maybe just overload your brain what do you think brian i think that's right and i think there's some advantages to having sort of a two-person structure running the fund where maybe my worst impulses get checked yeah and vice versa yeah like if you know if there's a bad quarter management says something stupid on a conference call and i

like you know kind of makes me angry taking the time and having someone to kind of check it and say you know this isn't necessarily the right time to sell let's be a little more uh yeah one One of the explicit rules we have is that we both have to agree to sell, which means that we better be darn confident when we buy that we have that, you know, that it's a, like, that's some sort of artificial friction that we put in, that I think is helpful. All right, let's talk some other topics. What do you have? I think this one will be fun. It is an update on private equity. Ryan, you can click the link if you want any of the info. Here is from Verdad Partners. Maybe if anyone is interested, I'll link it. Actually, why don't I just link it in the chat and anyone can comment or if anyone's watching later or now for the few people can look at it. Um, okay. So basically what they did, they are a, I believe an investment shop. I don't know much about them. Apologies to for dad. I'm sure you are watching this or listening to this later, but they do a lot of good research. I subscribed to their newsletter. It's free. And it's usually

quick summaries with really good data. The summary of the PE market is earnings look bad and interest payments are skyrocketing. So I won't go through their data set on how they did this, but again, getting data on private equity companies is harder. So they took a subset of private equity companies that have gone public, right? Private equity-backed companies that have gone public. So basically standard PE firms or VC firms, and they looked at that cohort, which is fairly large, and used that as a basis for how the entire private equity market is doing. And they kind of said, this might actually be biased to being better because the better companies typically go public. So first, there's a few big points they had. First, the good revenue

growth for these companies is outpacing the S&P 500. I think that makes sense because generally, when you skew with a few of these VC-backed ones, they might have some tail contributions that are really impactful. Second, though, is the bad. EBITDA margins, and they define this as GAAP EBITDA, which is basically just standard. I think there's not technically GAAP EBITDA, but basically just taking the really basic earnings and then subtracting out interest, taxes, depreciation, amortization. EBITDA margins for their cohort of PE-backed companies have collapsed to close to 0% versus a 20% average for the S&P 500. So actually, they have a chart in this post where the S&P 500 EBITDA margin has been fairly steady

over the last four to five years. But on these PE-backed companies, it's generally the margins have gone in the wrong direction. I think the question I think a lot of smart listeners are asking themselves right now is, but wait, aren't these companies fueled by debt with high interest payments? And the answer is yes.

So if you look at this chart here, I think it'll be a good one to show. It'll be super easy to show. One second. And I'll describe it. It's just a bar chart with two things on it. you look at one of their figures here, they have one bar, which is PE, VC, their cohort, and then the S&P 500 median. And they have interest costs as a percentage of EBITDA

for the PE or VC cohort, it's 43%. So 43% of their EBITDA is going to interest payments. For the median S&P 500 company, it is only 7%. So that's going to be a giant headwind, and maybe EBITDA isn't the right number to use here. And then lastly, if we look at their leverage ratios, Iranian- Do you think that's higher than normal? Because, I mean, I bet on a regular basis, private equity and, well, more so private equity, a greater percentage of their EBITDA probably goes to interest expense than S&P, even when it was like zero rates, right? I don't know. I don't remember if they had it, but I'm guessing it's higher than the last 15 years.

If we look at other notes they had, median leverage of this group of companies is 4.9 times. So I think that's just a leverage ratio. But if you exclude those that have no positive net debt, so basically those really conservative balance sheets at some of those software companies, at some of those giant VC-backed companies, the leverage ratio explodes to 8.8 times, which is a drunk bond, triple C rating. And what they mentioned here is that interest rate hikes haven't been fully reflected in the numbers yet. So my question to you, Ryan, as someone who I know well does not know much about the PE market,

same as me, private equity, not much at all. This doesn't seem good. I feel like the industry is going to struggle. It's not a question. Okay. Did PE, private equity, potentially peak with interest rates? Was it such a boom because interest rates were low for so long? Potentially, my thought here is, well, first of all, I'm really unfamiliar with the private equity space. Do most of these guys, gals, firms use variable rate debt? I believe so. The thing about it, it's like Blackstone, right?

That's the biggest one. KKR, we've talked with John Rotonti, if you kind of remember those interviews. Oh, they kind of recycle their debt, so it's going to rise no matter what over time. that's why it hasn't been fully reflected yeah and generally i know there's probably some nuance there but yeah maybe i think the thing to understand here is if you work at a company that's owned by private equity probably expect layoffs oh that's a good point if they haven't happened already yeah they're gonna i thought they're gonna have to do that yeah here's what people talk about there's the the cliff assness quote about volatility laundering you don't have

to go into that whole big thing about how the returns might not be as good as they're they're stating if we look at kind of you know the trajectory of profit margins the trajectory of interest expenses which are going to probably put their true cash flow numbers into the negative territory unless they really trim costs i can the the you know the alternative asset the private equity outperformance continue? I feel like it's hard to imagine that happening. How does it continue? Well, more AUMs. No, no. I'm talking about the outperformance for the clients. Oh, yeah. It seems unlikely, but I think what you get is, especially right now, you have a lot of people that are probably frustrated with public equity

returns. There may be looking for alternatives even after the month of may. Well, I mean, okay. Maybe not as much recently, but alternative asset managers have seen big inflows. Yeah. Capital. Yeah. Trend. Yeah. Now some of those have, what do they call it? Structure.

I think there was the one with – who was the company that raised from the Cal Pension or whatever? Blackstone. Yeah. You're talking about the weird – And they gave them guaranteed returns above a certain threshold or there was a floor to their guaranteed returns. So maybe they're painting it a little better than it might actually be. But I think, for one, private equity are good salesmen. And they do a really good job raising capital.

If we've seen anything over the last 20 years, it's those alternative asset managers being able to raise money at- Hey, Ryan, you're dodging the question though. Are the returns going to be, did the returns peak? But valuations are lower. I don't think so. Let me check. Let me check.

Let me check. Let me look at their- I'm not talking about the asset managers. I'm talking about the targets acquisitions. So who they're trying to buy, don't you think- i mean if they're buying out public companies they're okay the sample that verdad used trades at 22.4 times pro forma ebitda which is the fake ebitda um the cohort the pevc public company cohort um while the s p 500 trades at 13.6 times gap ebitda so the disparity here is huge so

i think that's what i'm saying that's what i'm saying so they're saying that they're they're the companies that then go after to acquire are trading at cheaper valuations than they were two years ago. So yeah, they might not have the same- Preston Pyshke But they're not, they're not- Preston Pyshke I thought you just said that. Preston Pyshke Okay, here, let me explain it. The sample they used because of the earnings deterioration is trading at 22.4 times pro forma EBITDA, which if you kind of go for a true earnings multiple, it's probably slightly higher.

We'll just use that. It's fine for this illustrative example. The S&P 500 is trading at 13.6 times GAAP EBITDA. If these companies that are trading in the public markets are trading at that number for that cohort, this is what generally you would assume they're acquiring these companies at. If you acquire them and you think that the earnings are deteriorating, the interest rates are skyrocketing, they're eventually going to trade in line with the S&P 500, it's hard to see how they don't get giant multiple compression. Robert Leonardus I guess I was thinking of private equity takeouts. So I was assuming that if you use the S&P 500 multiple as a proxy for private

equity buying out public companies, I know that's not the general private equity asset. I don't think that's how it's going to work, but. I mean, you don't think that just across the board, all assets in America over the last three years have come down? Oh yeah, generally. But remember with interest rate payments it's it's a much tougher environment so well if you're raising from investors then the interest rate uh yeah but the acquisitions are not the acquisitions are generally from investor money plus a bunch of debt i just think it's hard i don't know how returns are positive over the long term for these from this time period yes you know from other time

periods or four you know starting on a four basis it's just the numbers aren't gonna work and yeah they can get more aum sure i was gonna say can you just mix your funding higher towards that's that's what i'm saying right now the returns still don't work i i don't think unless you believe that they're for some reason isn't going to trade at a premium forever. I don't know. Here's a question that I have. There's a lot of ways to go here. And I think just saying that- Really? Well, I disagree though. What way is there to go? How do the numbers work? Okay. Let's say in 2020, you were making an acquisition with 75% debt and 25% investor

commitments. If interest rates are higher and you mix the funding sources to 50-50, because it's a lower cost of capital. Your IRR is going to be way lower. For the investors or for the... For the investors, yeah. That's how the numbers work. I believe, look, again, we're not... I think we might be talking above our pay grade here.

The reason the debt is used is to juice returns for investors. And the... Yeah. my my thought is it's a good time to be an alt okay yeah debt costs will go up but you're getting assets probably at much more distressed prices than you were three years ago well here's what i think verdad partners is saying is i i had that perception right like yeah people are like oh stuff is cheaper i think what they're saying is it's actually not

they ran the numbers and it's not actually cheaper assets across the board are not cheaper i just don't have time believing that the their sample their sample let me say it again their stuff trades at 22.5 times fake earnings the s&p 500 trades at 13.6 times gap ebita which again whatever it's going to be even more favorable if you compare them on a true earnings basis, because remember, this cohort has much, much higher debt. So the forward returns are going to be weaker unless for some reason, this cohort of PE and VC backed companies can grow their earnings at a way, way higher rate. The numbers just will not work. I guess we'll see.

all right what else we've got a little long on it uh big tech bets okay so matt ball uh wrote a very dense piece in a good way i mean in a good way lots of numbers on spendy research made by big technology companies so he uh and he he's a very provocative writer i'm sure you can find it that's very popular piece some of the stuff i will say in this post i'm not i don't agree with a lot of it But again, he is a provocative writer, and I think that's a good thing. He very much sparks debate. Let's see. Good quotes.

I just got to get my notes in line here. He estimates that at Meta's Reality Labs, they could hit a cumulative $80 billion in losses at some point over the next couple of years, and that it will need to generate a hundred billion dollars in cash over the next decade or give or take to be successful do you think like what's the probability of that i would say 10 we can't say zero i'd say 10 or less i mean okay what sort of traction has it had so far honestly do you know anyone that uses this on a regular basis or at all yeah i remember uh did i don't think i mentioned this on the show is someone my friend was talking and they said hey i used we

used to play the vr golf game on oculus and we'd play for 30 minutes and then you take off the glasses and you would literally puke so it's kind of a deterrent it doesn't and maybe they can fix that over time but it's still i they are trying to force product market fit i don't think people are asking for this i agree and i don't think there's we'll see they said they're about to do a new product announcement so i always worry a little bit in the back of my mind when these companies when we say something like that right before they announce something because i worry that they're going to do a game change you know and make it oh it's finally arrived but it never has happened yet um i think the chances that this generates 100 billion dollars in cash over the

next decade are probably i'm dead serious like close to zero percent 100 billion dollars in cash yeah like one percent yeah i mean nothing's zero but yeah but one percent in when you're betting is basically zero um okay here's his next take i think this is a fun one he thinks that apple can revitalize ar and vr agree or disagree i'm a skeptic i am a skeptic so i just don't think people are asking for this yes if there was some world where there was like these ar glasses that were like somehow simultaneously not invasive to what you see in the real world and could also be like an iphone in front of your eyes and you could go through things and you can make calls and it could be just like perfect growth yeah sure maybe but but i honestly am skeptical people

even would want that if it was seamless because it's just very annoying and if people compare it to the watch and the airpods and stuff like that those are not invasive whatsoever and in fact the apple watch is mainly a style thing i mean the phone's not the iphone isn't invasive like yeah sure people probably get distracted but you can look down you can put it back in your pocket you know i don't know it's not that hard it's a weird when zuckerberg went on joe rogan and he's like oh that was a fun that's a fun episode and joe rogan was like that is so these so these glasses couldn't someone just kind of be a creeper and just like start taking pictures and he's like yeah well that's a problem but you could put uh you know we're gonna put a flash on it and then

he's like kind of they just put a piece of tape over it oh yeah yeah i guess it's like okay this is like maybe isn't what people are clamoring to have the uh yeah i totally agree and i think what hurts some of the tech research divisions is they get um silicon valley brain they get deep computer hardware brain and we saw with bill gates the other day where he's really hyped up on this ai stuff and i think i would be too if it was driving my stake in microsoft to be worth you know 20 30 billion dollars more in a year um but he said that's you know in the next few years we'll never be using amazon or google uh and i was like yeah that is just a classic tech brain where you don't actually understand okay yeah yeah you just don't

don't like understand actually what consumers want i bet bill gates uses bing just out of like just to feel just to feel good about himself of course of course wouldn't you wouldn't you i mean we we use this because we're shareholders sometimes and that's mainly for anecdotal evidence but you feel i do it for a little until i figure out like it's just not worth it yeah oh yeah of course yeah but yeah i think apple honestly look they're about to launch this thing when the podcast releases it will be the day after so we could totally have cold take here because they could again change the game um we have a comment here from samir saying apple might validate the vr xr space soon i think that's what a lot of people are saying because typically they

don't release something unless it's good but i just don't think people even want this stuff i agree okay i 100 agree it just go ahead i don't i'm not sure what this fixation is on ar vr glasses it's to me it's never been that appealing as a consumer first of all like I don't think everyone just wants to become a glasses wearer like most people don't wear glasses just because

it's a phone doesn't mean you know like all of a sudden I'd want to wear glasses yeah like okay what's the value of me having like I'm working out and I can have the glasses on and I can just be on what Twitter

like that sounds terrible and working out with glasses on that's yeah it's just distracting like the times when you you would be like this would be a time when you could use it when you're not using your phone it's just times when you would it would be a distraction you don't even need to use it so i think the phone is here to stay for a long time and that's very bullish for it's it's actually you know apple's trying to look i don't know like that's good for them honestly and it's good for google but okay here's one that's going to make you probably cringe and be upset. He estimates, Matt Ball, the same piece, that Alexa has cumulatively lost

$43 billion for Amazon. Here's a quote too about how little usage or actual return on invested capital they've got. Here's the quote. One 2022 report from Consumer Intelligence Research suggested that only 25% of Alexa owners have ever used the device to make a purchase. Internal documents reviewed by The Information in 2018 showed that only 2% of users had made a purchase in the preceding 12 months, suggesting that even the disappointing 25% share was almost certainly inflated by one-time purchases, likely by new owners trying it out. What do you think here. Here's what I worry about with AI

and then, sorry, I'll let you go, or I'll let you have your take. I worry about these new large language models, this new AI stuff is going to inspire Amazon to lose 50 more billion dollars in Alexa. Well, they

are, they've been doing some layoffs in the Alexa division, but I worry that this is going to reinvigorate them and say, wait, there actually is an opportunity here when there isn't. it's no first of all i am a little skeptical that the numbers are accurate i i don't know i just don't even know how you arrive at that number because it's never been given out um but i do think he's in terms of the cumulative losses for alexa like who knows

he said it's generally going to have some volatility here or variability he he says it's hard because they haven't given out but he gives some decent trajectories and based on employee counts it yeah it might not be exactly 43 billion could be 30 could be 50 but generally it's big yeah i mean it seems like a waste of money i've never purchased anything with an alexa it doesn't seem there's still alexa messes up a lot of my very did you hear that no just pick just pick me up oh oh see yeah that's why i don't like the device i don't like these i don't like these things they yeah yeah uh because of that i honestly think they're a net negative for for my life if i was using them

the device with a woman's name um gets some of my sort of mundane requests wrong so the idea of me purchasing something through that device uh kind of concerns me so i'm a little reluctant to make a purchase through it um and i yeah it does not surprise me that that's a very uncommon use case i think the most common use cases are playing music making lists and there was one other one someone had done a study on it at one point um and all of them were just like zero revenue requests hey maybe if amazon was the leader in amazon in music with amazon music and stuff like that maybe if they were as big as spotify they you could argue that there could be a big enough trajectory to have a good ecosystem there but it's actually so bad at music that geez like

it forces you to go in and put your spotify account in because they just if you give a request, it's like play this radio or something. Amazon just plays just horrendous recommendations in my experience. So I don't know. Yeah. I think Alexa is a waste. It was exciting to me to see the layoffs in that division, not for the layoffs, but because hopefully they can reallocate those resources to something more useful. And so far what they've said around AI spending, I like, which is, you know, investing in the AWS capabilities, helping developers on that side, that seems like a perfect spend.

It could be, I think, look, again, these guys are managing way bigger businesses than we are. We're just people talking. But Google and Microsoft, the two big cloud competitors, have their own consumer large language model products. I feel like it'd be great if Amazon, yeah, they could embed something into Amazon retail, Maybe it could be helpful.

But if they said, we are not going to compete directly with you, we're going to be the third party here, and you come to us, you're not going to be helping Microsoft or Google. I think that could be a great value proposition. Similar to how Microsoft won a lot of retail competitors for Amazon. We've got a little over five minutes. Here's the last one here. I think this is a good one to close it out.

Alphabet at Google Cloud, he estimates cumulative losses, which is pretty easy because they actually put those in now. He estimates cumulative losses at Google Cloud have now hit $35 billion, but a key distinction here is that Google Cloud is now profitable. Do you think, I don't know, what do you think on this? Because he says it's going to take years and years to recoup this investment. I kind of think as an investor, I look at it as, well, what is the market going to value this company at? What earnings multiple?

If you get what I mean, it's not really about, yeah, you want positive ROIC over the long term, but I still think they're getting that. It's not really about the upfront cumulative losses when the moat here is strong. But yeah, I feel like that's a positive for, say, Alphabet. And we're seeing Waymo too. Waymo. He didn't hit that in the piece, but they probably invested at least $10 billion into that, if not more. And we're finally seeing commercial progress on that. I kind of came away more positive here on Alphabet and Apple with their R&D efforts and new products. I'm sure Google's had their fair share of losers as well.

Oh, 100%. What was it? Luna? Was Luna theirs or Amazon's? Luna is the cloud gaming from Amazon. Stadia was the cloud gaming from Alphabet, both giant failures but here's the thing stadia's shut down luna apparently we're still cooking they're still doing it for some reason the uh with alphabet i think google cloud is it actually an example of the advantage that big tech can have it's a good um kind of use case to point at and say this is what can happen when there's a big market opportunity and big tech has both the chops and the resources to throw money at it endlessly

because the economics are good on the other side of it. We've seen that with AWS. And I think them being able to pour $35 billion in losses into that, I think we're going to probably see them reap a lot of that back in cash flow over the next five to 10 years, they have not only the capital to make big bets like that and have it turn out right, but they have the time to make big bets like that because of their other core operating divisions. So I think Google Clouds, I don't know how he painted it in the article, but I think that's an example of a big bet gone right potentially. Yeah. He painted it pretty neutral, But I think it's more of like, well, if you invested earlier, 10 years ago, you might not think the same way as someone like us trying to invest now at the inflection point, potentially.

But I think one big takeaway I had from this piece is that Apple and Google, with their platform advantages, it gives them so much optionality. And it has such a strong moat because both with Alexa and Meta and Microsoft, too. They have tried to attack with billions upon billions of dollars, these ecosystems, these platforms that Apple and Alphabet have built, and there's been no dent. And I wonder if they're impenetrable. Yeah, I think it's possible. We got three minutes. So I want to talk about my second piece of news, which is NVIDIA's equity raise.

So everyone knows, I think anyone that's paid attention to the stock market at all knows NVIDIA's stock absolutely soared after its first quarter results that they posted on May 24th. It wasn't necessarily the first quarter results that drove the stock performance, but it was the Q2 guide. And the stock was up. It's almost a triple in the last six months, which is staggering considering where it came from. I think the market cap at the time was like $300 billion, maybe more. But it's also up, I want to say almost 40% in the last month. So basically since earnings. Two days after they posted earnings, they filed a shelf registration to sell up to $10 billion in stock. Not that surprising given how much the stock is up.

They surpassed a trillion dollar market cap. It's a business that compared to all the other trillion dollar market cap businesses looks expensive. My question to you, is this the right thing to do from management's perspective? If you were in their shoes, wouldn't you do this too? And it's kind of an interesting paradox because on the one hand, it's the right thing to do. AI, blah, blah, blah, TAM, plenty of area to invest, you need the capital. But on the flip side, if you're a shareholder, this is in a way management admitting the stock's overvalued. Yeah, yeah.

I think it's a big positive for me for their management team because it shows that they're rational. They're definitely reasonable. They're not just going to be hyping their stock like we saw a bunch of people or investment teams do when their stocks were inflated in the 2020-2021 time period. They should have taken advantage of this. NVIDIA is taking advantage of this. They're not really talking about it much.

they just kind of did it. It's going to be a thing. They're saying that it's overvalued. If you buy today, you're crazy. Yes, probably. But if I was an investor, maybe, and this is a 10-bagger for me, and I bought it, say, five, six years ago, something like that, or even earlier, and it's a 25-bagger for me, I would be applauding this because they're using their stock correctly. They're using financial engineering in a very smart way. And yeah, this is definitely a positive out for me for that management team. So I guess the second question is, can both be true? Can this simultaneously be a good time to buy and them selling stock at this price is the right choice? Can both those things be true?

I don't think so. At least judging on the last three years any situation where the stock has jumped and there's been a shelf offering immediately after i think those have marked bad times to buy yeah it's generally i think maybe the early shelf offerings from tesla sure yeah um but in the long run that ended up being probably a bad time to buy uh well no i guess some of those early ones but i think in the near term it can mean a bad time to buy i can almost say like hey look if you like this a lot i'm so excited about AI, I really want to get on this. I'm very confident in this thesis. Maybe say

there could be an opportunity to buy this at a 50% haircut in 12 months. All right. I think that's going to do it. It's been an hour. It's been one hour. These go live on the YouTube page at 1230 Eastern Thursdays, typically.

Might be a little bit different. You can watch the replays there or listen to the replays wherever you get your podcast. If you like this episode, give us a review on Spotify or Apple Podcasts. We'd really appreciate it and is the best way to promote the show and support us. We are not financial advisors. Anything we say on the show is not formal advice or recommendation. We're general partners at Arch Capital and clients may hold securities discussed in this podcast. Again, thank you

everyone for tuning in. We'll see you next week.