Chit Chat Stocks - JRo Show - Interview with Dan O'Keefe

Episode Date: October 30, 2023

Our good friend John Rotonti interviews Dan O'Keefe. Listen to "The JRo Show" wherever you get your podcasts. 3:00 – Definition of value investing according to Dan 10:00 – Dan’s risk management and portfolio management philosophy 17:00 – when to sell a stock 22:00 – On how he incorporates a macro outlook into fundamental bottom-up stock picking on a global basis 32:00 – Dan describes his team’s equity research process including the reason for nurturing an absolute mindset, not a relative mindset 57:00 – How Dan spends his quiet time. 1:01:00 – How to be a global investor 1:07:00 – Dan thoughts on passively investing in the S&P 500 1:13:00 – the contradictory psychological profile needed to be a good investor. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to the JRO Show. On this podcast, your host, John Rotonti, interviews experts in and outside the world of investing. The JRO Show dives deep into what it takes to achieve mastery and sustain top-level performance. As a quick reminder, this podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. All opinions expressed by John or any of his podcast guests are solely their own and do not constitute formal advice or a recommendation. Now please enjoy this episode. I'm John Rotonti and this is The J-Row Show, a podcast that explores what it takes to achieve

mastery, sustained performance, and longevity. The show hopes to uncover the processes, structures, frameworks, and mindsets that masters put in place to maintain winning performance in their respective fields. Today, I am joined by Dan O'Keefe. Dan is a Managing Director of Artisan Partners and founding partner of the Artisan Partners Global Value Team. He is Lead Portfolio Manager of the Artisan Global Value and Artisan Select Equity Strategies. Dan was awarded Morningstar's International Stock Portfolio Manager of the Year Award twice in 2008 and 2013, and his Artisan Global Value Strategy won a 2023 Investor's Business Daily Award for Best International Stock Portfolio.

I think Dan is one of the very best global stock pickers. He wins all these awards because Dan and his team deliver alpha. Since his portfolio's inception in December of 2007, only several months prior to the global financial crisis, the global value portfolio has outperformed the MSCI All-Country World Index by two full percentage points after fees on an annualized basis and has beaten the MSCI All Country World Value Index by an average of nearly four percentage points per year. That's just incredible. Dan is a friend who has always been willing to share his wisdom and experience with me. I'm grateful for that, and I'm honored to speak with him today. Dan, welcome to The J. Rowe Show. Thank you, John. I'm blushing from that excessively generous

introduction. And I'm very happy to be here. I always enjoy speaking with you. And I've been looking forward to this conversation. Thanks so much, Dan. So tell us, what is your investing philosophy? What kind of investor are you and why? Well, I'm a value investor, of course, right? I mean, that's the name of the team, the global value team and the global value strategy. But I always like to define value specifically, as I see it, because it's a term that has a lot of different meanings. And, you know, when something has so many different meanings, it almost has no meaning unless you're very specific. And so for me, you know, value is, is a judgment, you know, a judgment about what a

business is worth, and an effort to pay a price that affords a return and a margin of safety against permanent loss of capital relative to that worth so you know we try to buy something cheaply relative to intrinsic value cash flow derived value and we try to manage our risk even further by adding what i always call sort of additional insurance policies right we want financial strength we want quality businesses that can grow per share value and we want to partner with management teams who are going to build value over time. So that's different from buying things that are merely statistically cheap or buying things that have a certain absolute PE level, which is one way of practicing value investing, but not our way.

So you just said that you like to have these insurance policies that comes from strength of the business. So what types of businesses do you try to buy stock in? Do you look for certain business qualities to invest in? Are you more attracted to certain business models or certain financial metrics or certain growth metrics that some businesses may have and others don't? Well, I think we're focused on characteristics, characteristics that are evidence of of quality and duration and the ability of a business to to sustain and grow and we're always asking ourselves certain questions you know can it grow is it resilient to competition is it resilient to regulation does it generate cash does it deploy cash in a way that

creates value what is the durability and duration of the earning stream effectively that's that's really the most important question to answer because the the progress of the business ultimately is gonna is gonna determine your for the most part is gonna determine your your experience and your return as an investor and you know there's certainly quantitative markers that you look to for evidence of those characteristics you know so you look look at return on capital you you look at return on equity, you look at free cash flow generation, you look at revenue growth and volume growth, what's the quality of the growth. But you have to be careful because those characteristics never tell you the whole story. So for example, you could look at a

business with a mid-teens or a low-teens return on capital and compare it to a business with a high teens or low double digit return on capital. And the one with the lower return may actually be the better business. And what I mean by that is I would rather own a cash flow stream that can last for decades and be reinvested at 12% than buy a business with low barriers to entry that's got a lot of leverage, but that generates very high returns on capital. So, for example, a railroad will have a lower return on capital than a retailer. The railroad is clearly the better business, even though it has a lower return on capital. So we're always sort of assessing, OK, what are these characteristics?

What are these what are these quantitative statistics tell us? But they have to be they have to be mitigated with with questions of duration and defensibility. So they don't tell you the whole story. That was incredible. Great lessons in there. And some of the questions that you ask will surely go on a lot of investors' checklists. That was just great. Thank you for that.

So what does your typical stock holding look like? What's the typical multiple it trades at? What's the typical margin profile or ROIC profile? Is the company typically buying back a lot of stock? Does it pay a dividend typically? is this thesis based on multiple expansion. So what types of long ideas are you most comfortable with? Well, I mean, we invest in all different types of businesses and we don't look for industries per se. We try to let those characteristics lead us to strong businesses,

So we own Elevance, which is one of the largest HMOs, health insurance businesses in the United States. Phenomenal business. Grows, huge barriers, high teens ROEs, modest leverage. American Express is a credit card network. It grows 25% plus ROE, grows. Marsh Mac, one of the world's largest insurance and reinsurance brokers, one of the best businesses in the world, frankly. grows generates cash great ROEs Compass Group the world's largest contract catering business progressive insurance which most people in this country will know you know those are very different

businesses very different industries but they share those characteristics that I talked about they're highly profitable they have very high barriers to entry they generate good returns In many cases, you know, we've owned some of these companies for, well, I mean, American Express, we've owned since we started the strategy. Alphabet, we've owned since 2007, 2008. Marshmack, we've owned since we started the strategy. Compass, we've owned mostly throughout the entire existence of the global value strategy. Progressive Insurance, we've owned for, I believe we bought that in 2015. So it's the characteristics and they'll lead us to businesses in a lot of different industries.

Now, certainly. We haven't talked about it, but in your question, you touched on a capital allocation and that's that's extremely important. You know, you can have a great business and you can buy a buy a business at an attractive valuation. But if the management team is value neutral at best on capital allocation or value destructive, that can significantly impact your return. So each of the companies that I mentioned, the capital allocation there has been very good. But we're not prescriptive about capital allocation. We don't say, well, you know, it has to pay a dividend of X or Y. It has to buy back a certain amount of stock or or it has to do acquisitions or should never do acquisitions. I mean, every business is different. And what you want is you want capital allocation that's appropriate for that business and for for that industry. So we look at everything very much on a case-by-case basis.

So now that we know some of the questions you ask in your research process, some of the business characteristics you're attracted to, what is your risk management and portfolio management philosophy? For example, how many stocks do you typically own? How do you think about diversification? How do you think about position sizing? what sort of your average core position size, how large will you let a position run? And then maybe is your portfolio typically fully invested or do you maintain some cash? Well, I mean, risk management, first of all, you have to sort of lay the foundation, right? Risk management, risk to us is absolute, right?

It's about losing money. Now, that's not necessarily a given. I mean, many investors will think about risk from a relative standpoint, you know, relative to an index tracking error or something like that. We don't even you know, we don't even really know what that means. We don't generally pay much attention to the index. We're we're interested in protecting protecting principle, not losing money. I'm a large shareholder of the strategies that I manage. And so this is my own money. So for me, risk is about losing money. And, you know, our whole kind of philosophy is underpinned by that.

I mean, just going back to the definition of value investing, that definition is infused with a sense of risk management. You know, we're talking about multiple layers of risk management. Number one, buying a business at a discount. You buy at a discount not only because you see an opportunity for there to be a return from closing the discount, but you're trying to build a margin of safety. And if you buy something cheap relative to what it's worth, presumably there's less downside than if you pay a fair or an overvalued price. And then focusing on financial strength is another layer of risk management. Focusing on the ability of a business to grow is a further layer of risk management. And same with a management team that's allocating capital sensibly and is focused on growing per share value rather than growing an empire, for example.

So risk management is so deeply ingrained into how we operate. Now, sure, we have diversification overlays. We typically own about 30 to 35 stocks. I think that that's an appropriate level of diversification. I think academic studies would would support me on that. But it's also concentrated enough that, you know, when you do the type of intensive, you know, deep fundamental research that we do, you also want to get compensated for that. You know, you're going to do as much work on a one and a half percent position as you're going to do on a five percent position. Now, someone could argue and say, well, that's not appropriate, but and maybe theoretically it's not. but the way that we operate it is. So if we're going to buy something, we spend an incredible

amount of time on it. And so it has to be big enough to have an impact. And of course, we size positions for upside. In theory, we want to have our largest positions have the highest expected return. And just going back to that idea of buying at a discount, if you're buying something at 50 on the dollar. That's a pretty high return, certainly bigger than $0.75 on the dollar. And in theory, you should allocate more capital to the one with the higher expected return. But as a further level of risk management, we kind of know that often the businesses with the highest theoretical return are often businesses with more variability in their outcomes. And so we tend to have the better quality businesses at the top of the portfolio rather than purely

looking at a quantitative expected return. I think that's another, you know, just layer of risk management. But, you know, we tend to start with something kind of like a one and a half percent position. Our biggest positions will be four and a half and five. I've been doing this long enough to know that when you first start buying a stock, it's almost a coin toss as to whether you're going to make money or lose money on it in the near future, particularly when you're buying businesses that are out of favor and trading at a discount. We're generally trafficking in areas where there's a disappointment, there's frustration, it's out of favor. And you buy something, can it go lower? Absolutely. Does it often go lower? Absolutely.

Does that necessarily tell you anything? No. But, you know, you have to be you have to be prepared for that. So we tend to we tend to lean in with kind of a one and a half percent and then, you know, build it up slowly, especially if the share price declines and our sense of value hasn't declined and therefore the discount and therefore the expected return widens. So that's typically the way that we size positions. In terms of cash, it's very much a frictional fallout result of what we do. And we're disciplined about selling in the same way that we're disciplined about buying. And if something reaches or exceeds fair value with with some nuance, and I think we'll probably come back to that in a bit, you know, we will we will we will sell it. And we don't we don't want to have a gun to our head and feel like we have to reinvest it if we don't have something good to reinvest it in. Right. That's that's that's a that's a pressure that I've seen create pain in my career. You know, the reinvestment risk, you know, you sell something that, you know, very well, which you think is at a fair price and you feel pressured to reinvest it in something very often, something you don't know as well.

And you don't really know something until you until you've owned it for a while in this business. And you can learn very quickly that you made a mistake or your estimates are off and you would have been better holding on to the business that you knew better at a fair price than the business that you know far less well at what seemed like an unfair price. But maybe after a few months of ownership turns out to be more of a fair price and you're starting to regret what you did. So you have to be careful with reinvesting. So we'll let the cash build if we're not able to reinvest. If the market has given us a great environment to sell businesses at very attractive prices and not given us an opportunity to reinvest at very attractive prices, the cash will just sort of naturally increase. so let's jump to that question now and dive into when do you sell a stock and um maybe a little bit more about under what circumstances you will hold on to a stock that has reached your estimate

of fair value or maybe even run past your estimate of fair value well let's let's let's answer that by making a few observations. I'm going to simplify. You make money in two ways. You make money from a multiple revaluation, buy something at 10 and it's worth 15, and or you make money from earnings growth. I'm oversimplifying, but I think it's a fair exercise. So you buy something at 15 and it grows at the earnings per share, the value per share grows at 10% a year. Now, the best of all possible outcomes is you buy something at a discounted multiple that grows and you generate two sources of return, a multiple expansion or multiple normalization and the earnings growth. Now, when it comes to a sell discipline, it's been my experience that

it's very good to sell businesses, average or even below average businesses, pretty much immediately when they hit your fair value estimate. So to go back to an example, you bought something at eight times earnings, it goes to 11 times earnings, you've made a really nice return. But because it's not a great business, there's very little earnings growth. And so you ask yourself, well, where am I going to get my return from here? Is my earnings growth going to be much? No. Is my multiple expansion going to be much? No. So if things go wrong, I'm going to get derated on the multiple, which could be significant, could be 20 or 30%. And I'm not going to have much earnings growth to bail me out over time. So it could take me a long time to

recover that. Simplistically, if it's 3% earnings growth and you've derated by 30%, it's going to take you 10 years without multiple expansion. Now, let's take another example. If you own a great business and you bought it at 15, it grows 10 or 15% a year, it re-rates to 20, you've made a good return, and it's now at your, quote, fair price maybe, 20 times earnings, but you're getting a 10% return from your earnings growth. Do you sell it? Well, if it declines by 10%, you've only got one year or less of, you know, around one year of earnings growth to bail you out, plus, you know, time value. So if you lose a little bit of money from here, you're going to recover value in a fairly reasonable amount of time just from the earnings

growth. So it shows you that time is on your side with good businesses and businesses that grow value and time is either neutral or against you in average or below average businesses. So if you get a below average or an average business, you get it to re-rate, you should sell it. If you have a great business and it's re-rated, but you're confident that value is going to continue to grow, you hold on to it. That's been my experience, you know, and we've owned things like American Express, Marsh Mac, Alphabet, Progressive, some of the names that I mentioned earlier, we've owned them for

many years, more than a decade in some cases. And at different times, they have reached or even exceeded their target price. We might trim it some, but we haven't exited because we know that a great business that reaches fair value, if it's compounding value at a double digit rate, you wait a year and it's undervalued by another 10% if the stock price doesn't move. You wait two years, it's undervalued by 20, 25% if the share price doesn't move. And that's the value of compounding and business value growth. And so one should be extremely reluctant to sell those types of businesses and just allow them to compound and don't pay taxes, don't reinvest them into a lower quality business where you're going to have a more volatile,

more volatile outcome. I think that was a masterclass on so many things, on when to sell, on where returns come from, whether it's earnings growth, whether it's multiple expansion or both, and on the math of compounding. So wow, Dan, thank you for that. Do you incorporate a macro view into your stock picking and portfolio management? And if so, what is your current macro outlook well this is you know this is a this is a great question and i think it's probably a little bit more complicated to answer than what one might initially think and i think you have to you have to sort of divide and conquer this concept of macro what what exactly do we mean when we say macro so we could we could take one perspective

And we could define macro as sort of the fundamental characteristics of an economy. So if we sort of take a little tour around the world, I could say, well, let's look at Europe. The macro characteristics of Europe are that population is declining. It's heavily regulated. It's heavily taxed. It's not very business friendly. It's difficult for businesses to grow there. Not impossible, but difficult. difficult uh if you if you then move on to japan you could say many of the same things um it's not an innovative economy the demographics are really bad the econ the the the population is shrinking it's very difficult to to operate a business in japan there's a lot of regulation

uh if you go to china we can make certain characteristics and and i think people who follow china and know something about you know what's been going on there will know that china is now also having some some difficulties and is and is a difficult economy to operate in the united states you know i would say is probably is clearly relative to other economies is clearly the best in in the world relatively you know it's a it's a relatively uh easy place to do business there's flexibility with labor regulation is not as burdensome as it is in europe or japan you have an entrepreneurial culture you can raise capital very easily you have deep capital markets those are very positive relatively now i'd also point out that the united states is probably in

the worst absolute condition it's been for for decades um you know just in terms of you know you know, the deep political divisions we have here, the debt to GDP that we have is now levels we haven't seen since the end of World War II. The deficits that we're running are more appropriate for a country at war than a country at this point in the business cycle. We should be running close to break-even or even a surplus at this point in the business cycle. So the U.S., relatively in the best shape it's probably ever been, given the alternate economies, but in many respects in the worst shape it's been, absolutely. So, you know, when you think about macro through that lens, that clearly has a significant influence on how you allocate capital. You know,

if you're looking at a business which has 100% of its profits in Europe or Japan, you are going to be less likely to value that earning stream at the same multiple that you would value a similar or comparable earning stream for a company that was operating 100% in the U.S. You're not going to get as much growth. You're at greater risk from taxation and regulation. And so you have to take that into account. I mean, you could wake up tomorrow in Italy if you own a bank and the government slaps a special tax on you. That's less likely to happen in the U.S. Yeah. So those are sort of enduring macro features about the different economies in the world that clearly a global capital allocator has to has to has to take into consideration. Now, I think most people don't necessarily, when they ask macro questions, don't necessarily think in that macro sense.

I think they think about macro as sort of the evolution at the margin of an economy or the direction of the economy. So are we going to have a hard landing or a soft landing to sort of bring us to the current moment in the United States? Are rates going to continue to rise or are they going to fall? Is GDP going to grow? So, you know, those are those are questions at the margin about the direction of an economy. And I think this is a much less useful discussion because, honestly, I don't know. And, you know, those are the three words that I think are are probably the most important words in an investor's lexicon. I just don't know. OK, so four words.

And that's, you know, those are words that we encourage everyone around here to speak and to internalize, because having that sort of, you know, humility and understanding how uncertain the world always is, is I think is a fundamental principle of being a proficient investor. Now, let's just say, however, that you did actually have some really good insight about the near term or the direction of the economy. You know, you knew what's going to happen over the next quarter with GDP. Well, if you had that prediction in your pocket, what would you do with it? Would you be able to correctly predict what would happen to certain securities if you had that information? So if you knew that that rates were going to rise in the US the way that they've risen, would you have would you have gone long or short housing stocks? Well, I would have gone short. I mean, you know, mortgage rates going from, you know, a couple percent to seven or eight. That seems like a recipe for disaster in the housing market. Well, that would have been the wrong thing.

Housing stocks did phenomenally well. And the one couple of pieces of data that I've internalized when I think about the macro is similar to what I just went through. If I came to you, you know, I'm your stockbroker. It's December 1941. And on December 6, 1941, I call you up and I say, hey, John, I've got inside information to the government of Japan, and they're going to bomb Pearl Harbor tomorrow. Do you want to go long the market or do you want to liquidate? You probably would liquidate. Yeah, get out. Yeah. Yeah. Well, okay. So the day before Pearl Harbor, the Dow was at 116. One year later is at 119 and two years later is at 135. So macro predictions, I don't feel like number one, you can get them right. And number two, even if you got them right, I don't think you can then get to the second derivative with any precision. And so it's better not to get attached to a macro view. You're probably going to be wrong. Now, you know, the current environment, you know, I look at it and I look at it and I say, you know, I think, yeah, I think the chances of a recession in the near term are

pretty good. I mean, we've got a lot of we've got a lot of headwinds. We've had interest rates go up a lot. There's a lot of leverage in the economy. consumers are increasingly i'm talking about the u.s now consumers are increasingly reliant on on tapping their borrowing to continue to spend rather than tapping their their savings you know we see that in the data we see that in the in the credit card spend volume balance volume versus spend volume through networks so you know do i think there's a very reasonable chance of a

recession? Sure. Do I think that I could be wrong? Absolutely. I know I could be wrong. And what I take comfort in is, again, going back to the principles of risk management, I take comfort around the balance sheets, the business quality. I take comfort in the fact that many of our businesses are trading at multiples that essentially imply a recession with certainty. And I look at a lot of the businesses that we've owned over a long period of time. And like American Express, which I mentioned, I mean, we bought that around the time of the financial crisis. It went through the financial crisis. It's gone through credit cycles. It's gone through competition from the emergence of debit. It's gone through COVID. And earnings

have gone down at certain periods. But the business has been resilient and ultimately return to new highs of earnings. And your best bet is to hold and to buy more when it gets weak. And so the volatility is going to happen. And you have to have a portfolio that can endure different types of environments. It's fascinating. You talk to business people and they will say, good business people and they say, well, I don't know what's going to happen, but I've structured my business and my strategy, my business strategy for a wide variety of different circumstances. And whatever the circumstance comes, we have a playbook so we can adapt. And investing in stocks is the same thing. You should own a portfolio of companies that can adapt and evolve and survive

and thrive no matter what the environment is, because let's be honest, nobody knows what's going to happen. Yep. And earlier in the conversation, you talked about all of the different layers of risk management that you try to put into the portfolio, whether it's quality of the business and strength of the balance sheet, growth of the business, the margin of safety, diversification, all of that stuff. So let's shift because this is a show about processes. So I'd like to dive deep and get specific about your team's research process. If we can, let's start with the role of the analysts on your team. How many analysts do you have? Are they generalists? Are they specialists? And typically, how many stocks

do they cover on average? So we're a six-member team. There's four analysts and two portfolio managers, or there's six analysts, right? Because myself and Mike, my partner, are also analysts. And we are all generalists. We allocate responsibility by geography. And all of this is very intentional. The small team size, the generalist perspective, though that's that's intentional because what we want is we want to we want to develop investors and the way that you develop investors is you you you have to have an absolute mindset not a relative mindset you know you have to learn what is an absolutely good business what is an absolutely good valuation not what is a good relative valuation not what is good

relative risk but what is absolute risk and so if you're if you're an analyst and you're following you know just one industry you're always going to have a relatively attractive stock within that industry but that stock in that one industry may not look very attractive when you when you widen your perspective to include multiple industries you know a cheap car company may be better than a lot of other car companies but it may not be attractive relative to an insurance broker or a credit card network or, or whatever. So our analysts look at all different types of businesses and all industries within their geographic regions of responsibility. And that's, that's designed to, you know, to be, to develop again, this sort of absolute perspective and to grow

investors, not just analysts. And, you know, it is a, it is a small team and that's also by design. You know, we have a intensely collaborative research process and you can't do intensive, you know, deep research that's shared among a team the way ours is if you have, you know, a very large team. and and we because we're looking for very specific characteristics and they're hard to find you know at the same time in other words it's hard to find you know a good business with a good balance sheet and an attractive price we're not trying to to know something about everything that's out there you know we're not trying to skim the surface of of an ocean we're trying to sort of go deep on any one single thing at any point in time that that meets our our criteria uh and we have a you know we have a small we have a small portfolio we don't have a you know a huge

number of names we need we need to find you know three to five to nine depending upon what's going on in the market new ideas a year so if you've got just keep it simple if you've got a 35 stock portfolio and you turn over 10% of the names, you need three to four names in a year or double that if it's a very volatile year or triple that if it's an extremely volatile year and there's a lot of shift inside the market. So that gives you a scope for how we're structured, why we're structured, and what the mandate is from a new idea perspective. But the analysts spend as much time or more on what we own as as they do you know looking looking for new ideas and sort of i call it you know building inventory putting inventory on the shelf you know you want to be

you want to be out in your market you want to be meeting with new companies things that look interesting today or things that look just like great businesses that you want to get to know and and even if the price isn't interesting we do the work and we revisit it that's inventory that we have on the shelf that we can reach for, you know, if the share price, uh, if the share price changes. Sure. Um, six analysts, 35 names. So is it safe to assume each analyst covers about six companies currently in the portfolio? Yeah, that's, you know, that's, that's fair. Yeah. That's fair. And, you know, some people, you know, hear these numbers and, And, and it, and it sounds like, you know, it's not much, you know, you only need three to three

to 10 new names a year with a six person team. And, and I think that, I think that that speaks to the type of in-depth research that we do, but also the constant re-underwriting that we're doing. Yeah. So that talk about that depth of research for a second, how long does an analyst typically research a business before they are comfortable pitching the stock? So assuming the valuation is attractive, are they researching for weeks, months, or even longer? Well, let me take you through the whole process so you can see how it's designed, right? So the way that I think about it is we want to create a funnel, you know and and we're putting companies in at the the top of the funnel and and and down at

the bottom the funnel is is is kicking out you know the distillation of the work which you could you could put into two categories one is something that's actionable immediately and that we might buy or the other component would be something that we like a lot but we just don't like the price and so that's inventory that goes on the shelf and that's extremely valuable so you know how do you fill the funnel? So you fill the funnel from traveling, you know, going out into your markets and meeting with management teams or having management teams come in. We run screens. We have a weekly team meeting where everyone gets together and we have some screens that we run every week on an alternate basis. And we go through those screens. We discuss what has come

up on the screen. Everybody talks about, you know, their work list and what looks interesting, what doesn't, and ideas or leads are generated in those ways. You know, general reading also is a good, you know, source of potential leads. I mean, you know, we all read newspapers, and we're all aware of what's going on in the world. And whenever there's, you know, whenever there's a difficulty or a dislocation, or there's pain, or there's a recession, very often that leads you to a potential investment idea. So once we put something into the funnel, the way that it then sort of works its way through the funnel is the research process. And that research process involves reading the annual reports, reading the quarterly earnings, reading the transcripts,

going through the investor days, studying the industry. There's often industry data and information that we'll pull out. We'll start interviewing management teams of the company and of competitors. We'll study the competitors. We'll build a financial model. And we use all original source documentation. We build our own models. We don't use third-party data providers. We don't use the sell side for information or opinion. We're trying to act as an owner, a potential owner of the business doing due diligence? Do we want to, what do we think about this business? What do we think the future looks like for this business? And the financial model is less about the predictions of the future and it's more about the analysis of the past

to gain insights into the business and the durability of the business and how it might behave in different environments. And we're doing this work as it's going through the funnel and there's an incredible amount of interaction with the analyst you know between myself and mike and the analyst as it goes through the funnel so you know mike and i have one-on-one research meetings with each of the analysts each week in addition to the group meeting and we go through the the progress that's been made over the the prior week on the highest priority name on their work list or if maybe two if there's two and you know it's a Socratic dialogue and you know we're asking questions and we're looking at we're looking at the numbers we're we're we're learning

about the business we we will sit in on the conference calls with with the analysts with management teams and industry experts and competitors and it's this this constant iterative process of moving through the funnel from an idea that's just a lead down to answering the questions, do we like the business? Is the balance sheet appropriate? Who are these people who are running it? What are their incentives? What's their economic alignment? All the work that we do is documented in a notes database. So every bit of work that we do on a company, whether we own it or not, every interaction, there's a note that's written. And there are certain things that a note has to have to be valuable. And that repository of notes is extremely valuable because we go back

to ideas again and again. And so as this iterative process is going through, you're getting closer and closer to the question of, one, do we like the business? Two, do we like the balance sheet? Do we trust the management team? And then finally, which determines whether we buy it or not, what is the price relative to what we think it's worth? And so things come out the bottom of the funnel and they're either, you know, well, they're either rejected, but that's not really going through the bottom of the funnel. They're either purchased because they meet our criteria or it's inventory on the shelf because we like everything but the price. Wow. That was incredible. So it sounds like, I mean, you and your partner, Michael, are

very involved with every step of the research process. You meet with each analyst individually once a week. You meet as a team once a week. It seems like you're aware of what the analysts are working on at all times, which is just great. Question, do you and your partner, Michael, ever assign a company to an analyst? Do you ever say, hey, go research this stock? Yeah, yeah, we do. I mean, ideas, you know, can come from different sources, right?

An analyst can find, can put their fingerprints on the initial idea, you know, from running a screen and come into the research meeting and say, hey, you know, this looks really interesting. And, you know, it goes on the work list Or, you know, Mike or I will come up with an idea and offer it up to someone to work on. You know, we don't really care where the idea comes from.

We're not proprietary in that sense. You know, you don't get more credit if you came up with the idea and we buy it than if you didn't come up with the idea, but you did the work on it and we buy it. We just don't care. Our objective is to make money and, you know, personality and ego, things like that are just are less than helpful. and you know we're we're i think we're very different from a lot of shops in the sense that there's there's not this sort of you know analysts don't work in relative silo and then develop a pitch and put together a packet and then it gets distributed and then we sit down and we we talk about it um we don't operate that way you know we're we're in a constant process iteration on

on an idea and the determination of as to whether we buy it or not becomes very clear you know as we're debating and as we're discussing um now the documentation is still there all the analytic work is there all of the write-up is there with all of the information that's that's that's needed you know to to outline an investment case but it's not like there's you know a lot of work going on behind the scenes and then there's a big bang there's a packet that gets published and we we we read it and then we go have a meeting and talk about it we're talking about it all the time i sort of think of it as sort of like you know renting to own right if you're iterating on something constantly with the portfolio manager and the analyst you're you're you're practicing

the relationship that you have when you own something and it's better to practice and and have that ownership mentality before you own it than after you start buying it. Because as I said, I think earlier in the conversation, you don't really know something until you own it. Yep. So we're kind of trying to own it before we actually own it. You talked about how you have this inventory on the shelf of companies you would love to invest in at the right price and how that's very valuable.

That work is very valuable to your team. Do you ever try to get up to speed on a name that's not on that shelf, that's not on your inventory? Does your team ever try to get up to speed on it, you know, in 12, 15, 24 hours? So, yes, I mean, we frequently look at things that we don't, we haven't done extensive work on before. So, you know, when I when I talk about inventory on the shelf, that's not the sole way that something makes it into the portfolio. It happens that way very often. And look, I mean, I've been doing this since 1997. So there's a fair degree of, you know, inventory. Yeah. Round. You know, I've met with a lot of companies. Mike's met with a lot of companies. Our analysts met with a lot of companies.

And again, every time we we look at something, we we we write a note. But yeah, there are things that we don't know much about, and we sort of have to start from scratch, and that happens very often. And that goes to one of the questions you asked earlier that I didn't answer, how long does it typically take? So if it's something we've spent a lot of time on over the years, it takes less time because we're very familiar with the company. We have analytics that often are up to date or not very much out of date. we know the company we know the industry and so that that takes less time i mean it could take it could take a week or two um if it's something we would know really well it could take you know three four days that would be that would be a little unusual it usually takes a little longer than that but if it's something that we don't know it's going to take a lot longer and my philosophy is you know it just sort of it takes whatever time it takes yeah um

what do you look for specifically in a great stock pitch? What is the structure of that stock pitch from the time the analyst starts speaking during that meeting until the start of the Q&A? What do you hope the analyst communicates in the first three to five minutes of that pitch? Well, I mean, what you're really asking for is what are the most essential elements of an investment thesis and you know whether it's delivered in a you know in a pitch packet or or an iterative process for us you know the best way to answer the that question is is to answer more in the sense of what are the most important questions and so you know we like to start from from an idiot's point of view you know one of the things that that one of the first questions i

frequently ask an analyst is okay explain the business to me like i'm an idiot i want to know what do they make how do they sell it how does it get to market who do they compete with what's their pricing power what's their volume growth you know analyze you know you look at that revenue line in a financial statement, it's a number, but there's an enormity of information that informs that number and drives that number and protects that number or weakens that number. And we want to understand everything that makes up that number. How does it get made? How does that revenue happen? And what we're getting at is what is the durability of that revenue? What's the volatility of that revenue? What's the risk of that revenue to succumb to competition or to

succumb to obsolescence. And then you just kind of go through the business model from there. Okay, we understand the revenue. What are the costs? How fixed are they? How variable are they? What factors could cause the mix to change or to move in one direction or another? Now you're getting down to the operating margin. How flexible is the business to protect the margin? What's happened in the past to the margin? How does that margin compare to the peers? How does the margin compare to other businesses and other industries? and then you get to the capital structure. You analyze the capital structure, you analyze the taxation regime, and then you get down to the earnings number and you analyze the earnings and how it converts into cash. And then what do they do with the cash? What have been the returns on reinvestment? Have they made appropriate decisions about decisions whether to reinvest

or decisions to return cash to shareholders. They're making acquisitions. How have those acquisitions worked out over time? You know, in each one of these layers of the business, there's enormous amount of questions behind that and an enormous amount of information that needs to be dug up. And everything is, again,

trying to get to answer those fundamental questions about the characteristics of the business, its ability to grow and defend itself, its ability to generate cash, the appropriateness of its capital structure. So the format will focus on, our notes will focus on things like the history of the company, how it developed, how the industry developed, what they do, what their competition looks like, what the growth rate has looked like, how do their financials compared to others in the industry? Are they better or worse or the same? The cost structure, the return characteristics, the capital allocation, the balance sheet, historical acquisitions,

you know, and then we obviously discuss in great depth, what do we think it's worth? You know, what type of multiple would you put on this business? And, you know, a better business is going to get a higher multiple. You're not going to put a 15 times earnings multiple on Alphabet, but you're going to put a 15 times earnings on a really good manufacturing business. And so we have those discussions and that's really where a lot of the debate comes down to, is this an attractive price? I mean, this is all entirely subjective, right? So there's enormous us room for debate on the question of valuation. Sticking with valuation for one moment, you said that you build all your models from scratch, sourcing the numbers from the company

filings. How many years out are you trying to estimate future earnings? Well, I'm going to I'm going to discount heavily the value of projections because pretty much every forecast I've ever made has been wrong. You know, it's either been been too optimistic or too pessimistic. Right. And so if you let's let's take some examples. So if you are looking at a business that's fairly stable, you know, a liquor business, for example, or, you know, maybe a brewing business or some or a staples business, something fairly stable. And, you know, it's trading at it's trading at 15 times earnings. And you think it's worth 20. And, you know, long duration, competitively advantaged businesses like that with massive amounts of dollars invested in brand development over decades and distribution over decades, you know, those businesses, in my opinion, are worth 20 times earnings.

That's a reasonable multiple. Do you really need to build a model to project the earnings if it's trading at 15 times current earnings and you think it's worth 20? I mean, you know, now, now a forecast for valuation is much more valuable for a business that is currently under earning. So perhaps a more cyclical business where, let's say, for whatever reason, the sales are depressed this year and the margin is depressed relative to history. and you have made an analytical case that revenue is going to recover and the margin is going to recover and you're going to get through this cycle or this temporary issue that's depressing your financial results. Well, that's going to happen over time. And time is money, literally. And you need to be compensated for the time value of that normalization. So a model,

a discounted cash flow model will clearly be appropriate for that because you need to be compensated for time value so you might normalize the business you know you might you might you might put together projections over three or we don't go we don't go more than five years or five years to normalize and to to reflect the cost of of time is there any you know for many for many businesses you know trying to come up with accurate forecasts for fairly stable businesses it's not particularly valuable yeah no i would agree with that for sure is is there any aspect of your team's process that you think we didn't touch on today i mean we went deep i know yeah i mean we did we did go we did go pretty deep no i

I think I think I think we've covered it. I mean, again, you know, the most important parts are the the absolute mindset, the generalist mindset, the the in-depth nature of the research, the iterative process, the the idea generation and how it and how it goes through the process and ultimately the decision making. So, you know, I think we've I think we've gone through it. Fantastic. Dan, when you were not meeting with clients or doing media interviews or podcasts or traveling for work, how do you spend time working in your office or working at home? Specifically, what administrative duties are you working on or what are you reading? Just basically, how are you spending the quiet time in your office? Well, I mean, you know, I do. I'm a voracious reader. You know, I'm consuming massive amounts of information, you know, newspapers, company filings, earnings reports, industry information. I talk to people, you know, in different businesses. I talk to management teams frequently. um i'm constantly going through information and i'm trying to get to original information

and i prefer to get as close to the original information rather than something that's filtered through an opinion or filtered through a narrative i mean that's i think where where insights are are are made and you know i don't read sell side stuff um although you know i admit there's you You know, there's definitely good sell side analysts out there, but I just I generally just don't I don't care what anybody else thinks for the most part, unless, you know, they're close to the they're close to the ground. They're close to the real economic activity. That's those are the people I want to I want to talk to. And, you know, it often a lot of what I do is just kind of thinking, you know, pushing numbers around, thinking about what we own, thinking about what we could be missing, what we might get wrong. You know, the more you read, the more you study, the more you know what you don't know, and therefore the more questions you have.

And so we are constantly re underwriting and challenging ourselves around here. What what might we have wrong? Is this is this assumption right? And, you know, those types of questions come from just sort of uninterrupted, uninterrupted, you know, just sort of thinking and reading. and and and i think it's i think it's very valuable you know this is a business where it's very different from other businesses in the sense that often what you the way that you measure in other businesses is to look at output you know how many widgets did you stamp out you know whereas here in this business very often the most valuable output is the output that leads to no activity at all. So it looks like you're doing nothing, but choosing to do nothing, not making a mistake is as valuable, more valuable than having output. Most investment decisions are marginal. And so if you're going to do something, you have to be very careful that

what you're going to do makes a lot of sense. So I spent a lot of time doing nothing, I guess, is what I'm saying. Well, I love that. And like you said, you, most investment decisions are marginal and you're only looking for three to six to nine new ideas every year. I mean, there's certainly, you know, there's, there's certainly a lot of non-investment stuff that, that takes up my time. You know, I, I have a lot of interaction with clients. I have, you know, HR related things there are general operational issues around real estate and IT. I try to avoid as much of that as I can because I try to spend as much time as I can on the investment stuff. So you're a global investor. What do global investors need to be aware of and think about

above and beyond what stock pickers only focused on the US have to think about? Well, I mean, you know, you clearly have to have a perspective on the things about each jurisdiction, economic area that are different from the others. You know, you need to understand what's different economically, culturally, politically, regulatorily in Europe versus Japan versus the U.S. versus China. um you need to understand what what types of businesses you know the businesses that you can buy in europe um are in many respects very different from the types of businesses you can buy in the u.s and from japan and in china and so if you're if you're selecting from among those regions you know you need to understand all of the all of the vast differences you know if you So if you just, you know, dropped a value investor who who had never been outside of the U.S. and Japan, they might they might come back from Japan and go, my God, you know, I found all these companies trading that, you know, half a book value.

We should put the whole portfolio in in these businesses. And doing that would probably be the stupidest thing that you could do. So, you know, understanding the why of that is is important. And the only way you get to understand the why of that is by studying these different cultures in these different countries and the differences, spending time on the ground there. That's the way that you learn that. So travel, you would say, is required to be a great global investor? I'm going to answer this in a number of different ways. So I got into this business in 1997, and at that time, the amount of information that was available, particularly for non-U.S. companies, was very, very small, right?

So if you if you wanted to get to know a company in the UK, you you pretty much had to fly there and meet with someone from the company. And you you you had to you had to ask the question, OK, who are you? What's your background? Describe this business for me. Describe the industry. Who's the competition? You needed to have a discussion, a firsthand discussion to really peel apart the layers of the onion to understand what the business is because a lot of that information wasn't available in 1997. You didn't have websites full of company presentations and investor websites. You had annual reports with some had good information, some had very little, and there often wasn't much more than that. Or, you know, you could rely on the sell side. But, you know, we've never we've never done that. So you needed to go and and and meet with these companies to learn about these companies.

And, you know, that that that was necessary. I think. Today, it's less necessary because information, there's so much more information available and you can you can get an incredible amount of information just from websites. And annual reports tend to be better. There tend to be more presentations. Companies do more regular capital markets days. There are now transcripts that are published with all of the quarterly earnings meetings that they hold. So there's just an incredible amount of information. However, as you're building your base of knowledge in this business, you absolutely have to travel because it's the only way that you're going to get four company meetings a day over a week or two, and it's the only way you're going to build your knowledge of all the companies in the world. So it's still important to travel. It's not as important as it used to be. And I think once you've built that base of knowledge, I think it's even less important than it used to be, if that makes sense. Absolutely. Absolutely makes sense. Dan, a bit of a wide open question that you can honestly take wherever you want. What do you think is something the market is getting wrong? Where do you see the most structural inefficiency and mispricing? And you can either point out

something you think the market is missing today, or even something you think the stock market almost perennially gets wrong over time um let me let me answer that maybe in a in a couple ways i mean i think my first point would be i think what is enduring about the stock market what what is true now has always been true and always will be true is that people overreact you know we're we're we're emotional animals and and we overreact to the good and to the bad and so i think that's what you know that's the opportunity that is afforded you know people who are able to bring you know a calm and rational approach to to investing and so that that that endures, I think. The second way I would, you know, answer the question might be to just sort

of talk about maybe some things that I see, you know, today that I think are interesting, maybe their risks and maybe their opportunities. You know, I think one thing that I think is really important to point out as, you know, from a global perspective is just to note, the massive outperformance of the U.S. market over the last 10 plus years, which of course is driven by the IT sector. And if you look at the S&P 500, and many people own the S&P 500 passively, but if you own the S&P 500, quote, passively, it's not really a passive decision. It's a decision that has implications, right? so the S&P is is expensive it's you know 21 times earnings the IT sector is about 130 companies

trades in an average of 29 times earnings and is equal to about 40 45 percent of the index okay there are only 69 companies in the S&P 500 at 10 times earnings or less and they represent only about seven or 8% of the index. So that shows you, you know, what's happened over the last decade plus, you know, value stocks, clearly cheap value stocks have been reduced to almost irrelevance. And the index is dominated by a very expensive group of companies that make up a very large chunk of, of the index. So that that's the starting point if you're buying the index and you know maybe it's a good starting point you know maybe those maybe maybe that 40 45 percent of the index it trades it over 25 times earnings um you know maybe maybe that's a great deal

but it should be noted and and and and and and known that that's a decision that you have to make and so i i think that's that's an important point and you know you can make some similar observations about the global index. You know, the global index has the highest weighting of US companies that it's had in decades, you know, 60% or more right now. Europe has been left for dead and is, I think, the smallest weight it's been in decades. You know, it's gone from, I think, 35 or 40, you know, to 15 now. Wow. You know, just as a point of comparison, the U S is 25% of global GDP. The European union is, is probably about 15. So it's not, that's not a, that's not a data point that necessarily you should do anything with,

but I think it's, but I think it's interesting. Um, but what, what that leads to, I think is a, is an acceptance that, you know, international has sort of been, international companies have sort of been left for dead in many respects. And the U.S. has just massively outperformed and has become expensive and non-U.S. companies are much, much cheaper. Now, we have to also accept that non-U.S. economies, going back to the earlier point that I made, are likely to underperform the U.S. significantly. And I think that's true. But that doesn't mean that the companies listed outside of the United States, which are in many cases comparable in their underlying economic exposures to the U.S. and to other markets, are not more attractive than similarly global

businesses that are listed in the United States. So simplifying that, a multinational company in the U.S., and let's just make something up, the food industry, trades at a meaningful premium to a multinational company, food company listed in Europe. Now, they're both global companies earning their revenues and profits around the world. One's listed in the U.S., one's listed in Europe. The one that's listed in the U.S. is going to be much, much more expensive. So, you know, seeing value in non-U.S. companies is not about a preference for exposure to non-U.S. economies. It's just a preference for accessing global earnings streams at a much lower valuation. And you can really see that if you look at, for example, global exploration and production

companies, oil and gas companies. The ones in Europe traded a massive discount to the ones in the US. So we own Shell and we own Total. And, you know, they trade at single digit PEs, 50% cheaper or so than, you know, Exxon or Chevron, for example. And there's no reason for that. You know, they're not overexposed to Europe per se. They're all global energy businesses with similar economic drivers, similar capital allocation and balance sheet strength. You There's no economic reason for them to trade at such a large discount. They do because they're international companies and all the money has been flooding into the U.S. market because it's outperformed for so long. So you see some of these companies that have been left for dead as opportunities?

Yes, absolutely. Yeah. Dan, last question. You've been investing professionally for 30 years, I think. What are some of the biggest lessons you've learned about what it takes to be a great investor? Well, I certainly don't think of myself as a great investor. This is a constantly humbling endeavor. And, you know, most, most of, most of the time I feel, I feel like a, I feel like a student. Now, I think that's, that's the key point is to be, try to be a great student, you know, always have, always have an insatiable curiosity, always, always be learning, always be asking questions, be terrified of the things that you're missing, know that there is so much you don't

know, know that you are going to make mistakes, and the knowledge that you will make mistakes will have an enormous impact on the types of risks you're willing to take. You know, those are really important. And then I think, you know, to be a good investor, whether you're a good value investor or any type of investor, you know, I think you sort have to have certain personality traits um you know you have to have and i think these these personality traits are very difficult to reside in the same psychology you know you have to have on the one hand a lot of humility because you need to be you need to know when you're wrong uh but on the other hand you need to have stubborn conviction you know enough to dig in your heels

when everyone else tells you you're wrong but you know you're right so that's a that's an uncomfortable psychological profile because you're you're the two sides are at war with the with each other often but i think that's that's this that's a little bit of the balancing act psychologically that you need to be to be a good investor dan thanks so much for coming on the show this was a wonderful lovely conversation well thank you for having me john i always i always enjoy talking to you. And I appreciate how well prepared you are and the good questions that you ask. And it's also really nice to have a relaxed, in-depth conversation. Most of my media stuff is very truncated and we're never really able to go deep on a lot of subjects. And I think we had a

really great, expansive conversation. So it was a lot of fun for me. Thank you for saying that. I really appreciate it. Before we sign off, I'd like to provide a quick reminder. Anything discussed on The J-Rose Show by myself or my guest is solely our own opinions and does not constitute formal advice or a recommendation. The J-Rose Show is for entertainment purposes only, so please do your own research on any securities discussed on this podcast. Thanks for tuning in, and we will see you next time. Thanks for watching!