Chit Chat Stocks - KKR (KKR) with John Rotonti

Episode Date: January 20, 2022

KKR & Co. is a private equity and real estate investment firm. The company was founded in 1976 and is headquartered in New York. Listen as Brett and Ryan ask John questions about the company, its business model, and valuation. Enjoy the show! This episode is sponsored by Quartr, the new way of doing company research. Access conference calls, presentations, transcripts, and more for FREE on your mobile device. Download Quartr on the App Store here: https://apps.apple.com/us/app/quartr-investor-relations/id1552412128  Download Quartr on the Google Play Store here: https://play.google.com/store/apps/details?id=se.quartr.android Subscribe to 7investing with the code "CCM" and get $10 off: https://7investing.com/subscribe/aff/4/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested in more of John's work? Follow him on Twitter here: https://twitter.com/JRogrow?s=20 Contact us: [e-mail]  Timestamps KKR | (4:36) Management | (31:20) 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 Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. Today is our Thursday deep dive episode. And today we have on the show John Rotonti. We had been trying to get him on, or I had been trying to get him on for a while. It's the second time on. And we talked about KKR, which is a business that I was completely unfamiliar with prior to the show. It's pretty fascinating. And then we also have some more broad questions on the back half, which I thought was a really fun conversation. Did you have any highlights from the interview. Yeah. I mean, his overview of KKR was great and he is fantastic at going through the numbers and the expectations, what a business, or excuse me, what a market gap is pricing in or enterprise value or whatever, versus what cash generation you're going to need

to expect over the next few years. He goes through those numbers in an audio format where you can understand, okay, if I'm looking at KKR, I have to either expect the same that he's expecting or whatever to get X amount of returns going forward. He goes through the multiple, why their gap earnings are misleading, all that great stuff. I definitely understood the business after hearing him talk. Yeah. Sometimes it's hard to talk about valuation on a podcast, but he was able to do it in a very digestible way. So I thought that was definitely a highlight. And then hearing him riff on the world of value investors was pretty fun as well. Great anecdotes there. I think the back half, it was semi-serious, but we had some good story time.

All right. Before we get to the interview though, we want to talk about our friends at quarter. So if you are not using quarter, you better get on it because the earning season is coming around. It is an app, basically an investor relations app, very comprehensive. It's got conference calls, conference calls, transcripts, presentations for companies all around the world. I've been using them a lot for our not so deep dive episodes. If I want to get caught up and I'm in the car or something, I'll just throw on a conference call. One of the best places to also read transcripts now, I know those are a lot of places you're going behind a paywall. this is a free place to read transcripts, correct? Yeah. They've got it on iOS. They've

got it on Android. Go ahead and check them out. It's 100% free. So it's quarter with no E at the end. So Q-U-A-R-T-R. They also have a Twitter at quarter underscore app. Yeah. Go ahead and check them out. Download the app. Without further ado, let's get to the interview. Welcome to Chit Chat Money. On this show, hosts 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 a recommendation.

Now, please enjoy this episode. All right. Today we are welcomed by John Rotonti. We've been trying to set this interview up for a while, so I'm glad we were able to get him on the show. I think this is your second time with us now. And today we're going to talk about KKR, which is a company we weren't super familiar with going into it, but then we've got some more, I guess, broad questions on the second half. But before we get into that, you recently launched a new service for The Fool. How's that been? Do you want to talk about it a little bit? Hi, Ryan and Brett. Thanks for having me on the show again. Yes, this is my second time on the

show. Hopefully, there's a third time. Third time's a charm. Yeah, so at The Motley Fool, I'm a senior analyst and the head of investor training and development. And I am leading a team that is launching, we call it showdown. So, it's four portfolios competing against each other. Tom Gardner's leading one portfolio. Emily Flippen is leading one. I'm leading one. And our quant team led by Eyal Kusner is leading one. But we all have great teams with us. And so I've got Tim Byers on my team and Clay Bruning and Malin Quinn and Senmi Deo. So I've got, I mean, I've got a team of, of Stone Cold pros and, uh, it's a five-year competition. And so, uh, we just launched on January 3rd. And so we'll see, we'll see how we do in five years, but it's, it's fun.

And although it's a competition, it's also collaborative, you know, we're at the Motley Fool, we're helping each other, um, even though it's a competition. So we'll see what happens in five years. Yeah. It sounds exciting for sure. Yeah. We're, we're all excited about it. And so we're talking about KKR today. And I think it's a company or maybe just a name that

most people aren't super familiar with. So how did you come across it to begin with? So I love this question because I'm always curious how the investors that I admire come across their highest conviction ideas. And I wish investors would share those stories more frequently. Anyway, I'm pretty familiar with traditional asset managers because in the past, I was a long term shareholder of both T. Rowe Price and BlackRock. And I thought both were very good businesses. But one thing I noticed while owning both those stocks was that in the market downturn, they can suffer from both falling stock prices and redemptions. And so during my ownership of those companies, I think I made the realization several years ago that alternative

asset managers have long lockups. So they aren't as susceptible to redemptions in the same way that traditional asset managers are. So that was a high-level lesson I learned through personal ownership of more traditional asset managers. And KKR specifically has been on my radar for about a year because Scott Miller, the founder and portfolio manager of Greenhaven Road, wrote in his first quarter 2021 letter that, and I quote, if there were one business that I had to hold for five years, no matter what, it would be KKR, end quote. And to me, that's just a very powerful statement coming from one of my favorite investors. So there was just no way I wasn't going to dig into KKR. And so then after reading

that quote from Scott Miller, I looked at the other institutional holders, and I realized that a dream team of investors that I admire deeply all owned stock in KKR. And so, back on May 3rd, 2021, I tweeted that Scott Miller, C.T. Fitzpatrick of Vulcan Value Partners, Acre Capital, Value Act Capital, and Bill Nygren at Oakmark all owned stock in KKR. And so since those first tweets that I sent out in KKR in early May 2021, I've sent a few more tweets. And then in late November or early December 2021, I commenced a deep dive into KKR to see if I wanted to put it in the real money portfolio that I am leading for The Motley Fool that we just talked about. And then we launched that portfolio on January 3rd, 2022, and we did end up recommending and buying KKR for our portfolio. Right. That's a great overview. Now, let's get into what the business actually does from a high level. What does KKR do and what is their business model? Sure. Maybe before I answer that, which I will answer, I promise you, I'd like to share my team's brief investment thesis on KKR because I'm really trying to encourage the investing world to start with the thesis.

And if someone is pitching an idea to me, I ask that they start with the thesis. And if I'm pitching an idea to someone else at The Motley Fool, I'm always going to try to start with the thesis, just in the spirit of leading with our strongest point and capturing the listener's attention from the get-go. And so my team's thesis for KKR is that we think there is a long-term powerful trend of investor capital flowing into alternative asset managers. And KKR is our favorite because it is an exceptional capital allocator with a growth mindset and $111 billion in dry powder waiting to invest at high returns. we think this is a far above average business but trades at a below market multiple and given the discounted multiple we don't think the multiple will contract much if at all so we think total returns will closely track their growth in distributable earnings per share which we think can compound around 15 percent over the next five years so in other words the stock could double in five years, if we're right, plus investors will get a roughly 1%

dividend yield. We've also used a reverse DCF, and we think the expectations for future cash flow growth price into the stock are still too low. And then finally, we think KKR has a natural hedge against inflation. Sorry. So that's the high-level thesis. And then if I dive deeper into one part of that thesis. It's that KKR has a growth mindset because that is what really stands out to us about KKR from the other alternative asset managers. For example, in the depths of the COVID pandemic, KKR took advantage of crashing asset prices by investing more than three large competitors combined. That's during the COVID crash. Additionally, from 2010 through 2014, the capital KKR deployed into their investments grew at an 8% CAGR. But from 2015 to 2020,

the capital KKR deployed into its investments grew at a 31% CAGR. So this is clearly a company that is scaling up and hitting its growth stride. Then finally, one other way investors can see that KKR has a growth mindset is that it pays a much lower dividend yield than the other top publicly traded competitors, Blackstone, Apollo Global, and Carlyle Group. Blackstone and Carlyle's dividend yields are both about 2%. Apollo's dividend yield is about 3%. But KKR's dividend yield is only 0.8%. Rather than pay out a larger percentage of their distributable cash flow, KKR reinvests back into the business and back into their own funds, which helps drive compounding of earnings and cash flow and book value. And then for the dividend growth investors out there,

even though KKR's dividend yield is smaller than its publicly traded competitors, its dividend has grown at a 17% CAGR over the past five years. So as a team, we were really attracted to KKR's growth mindset, and we appreciate how it balances reinvesting back into the business with consistently growing that dividend at a high team's rate and buying back undervalued stock. The last thing I'll say here is from 2015 through to Investor Day in April of 2021, KKR spent $1.5 billion buying back 75 million shares at an average price of $20.36. That compares to a $70 stock price today. To your question, Brett, so KKR was founded in 1976. by Henry Kravis, George Roberts, and Jerome Kohlberg.

Kravis and Roberts are cousins and have been their founders and the co-CEOs until very recently. In October 2021, KKR announced that Joe Bay and Scott Newtall would become co-CEOs, and then Kravis and Roberts would remain involved as executive co-chairmen of the board. Both Joe and Scott have been with KKR for 26 years, and previously they were the co-presidents and co-chief operating officers since 2017. They've also both been on KKR's board since 2017. And we may get into this later, but KKR's growth and profitability really, truly surged during the period from 2017 when Joe and Scott really started running the company as presidents and chief

operating officers. Bay specifically was the architect of KKR's expansion into Asia, which is a major growth platform for the company today. And Nuttall led KKR's public stock listing and was also the architect of the firm's balance sheet strategy, which we absolutely must talk about later, as well as the creation of the firm's capital markets and their insurance businesses. At a very high level, KKR is a leading alternative asset manager, which we can think of as basically investments into asset classes other than publicly traded stocks and bonds. So KKR has traditional private equity funds. They have growth private equity funds. They have credit funds, real estate funds, infrastructure funds, and more.

In addition to these alternative funds, KKR also has a growing capital markets business, and it recently acquired a life insurance and annuity company. So KKR is really a diversified financial services company, and I really think of KKR in those three different buckets, alternatives, capital markets, and then insurance. So where do they get most of their investable capital? Is it from their privately owned businesses? Is it from raising capital through investors for funds, or is it kind of a mix of all of it? Yeah, it mainly comes through funds from large pension funds, other institutional sovereign wealth funds, and stuff like that. And then the way that flows through KKR is the way they make money. KKR basically generates a variety of fees, including management fees, performance fees, and carried interest. Carried interest is just performance fees that are only realized when you exit a holding through a sale or an IPO, for example. Then they also have capital market fees, and then they have float and income from their insurance business, which is called Global Atlantic.

But yeah, so there's this flood of money going into alternative asset classes because pension funds have a 7% to 8% required rate of return, and treasuries are yielding 1.5%. And corporate bonds, you can't get much higher than that, at least not high-quality investment-grade bonds. And so funds are flowing into the alternative asset class at a really, really high rate. Okay. So this isn't the typical business that we analyze here on the show, just in terms of the structure of it. So how are you going about your valuation process with KKR? Is it kind of sum of the parts or is there a earnings metric, I guess? I suppose I could try to do a sum of the parts.

I haven't tried that yet because there are so many parts to this business. Here's how we did it as a team. So the most important thing to realize with valuing KKR is that we started with a theme. So our investment in KKR started with a theme, and that long-term theme was that we wanted to invest behind the trillions of dollars that are flowing into alternative asset classes. And so to put some numbers around this, according to Prequin, assets under management into private equity is expected to grow at a 15% CAGR from 2020 to 2025. Acre Capital Management, an investing firm that I believe to be exceptional, they cited an estimate that as much as $25 trillion could shift into alternative asset classes over the next decade. And so that was in a recent Barron's article.

Why is that? Because the interest rates are so low and pension funds and sovereign wealth funds and other institutional investors have a higher hurdle than you can get in bonds and fixed income. And then, like pension funds, for example, have hurdles of 7% to 8%. But here's the thing. KKR is not just giving you 7% to 8%. So their investing track record is exceptional. Since 1984, KKR's traditional private equity funds have generated 26% annualized returns

compared to the S&P 500, which provided 12% annualized returns. That's going back to 1984, 26% annualized after fees. And so their investing process is delivering incredible results. And so the first part of the valuation comes down to that, the high-level macro theme, which is assets are expected to grow at a 15% CAGR. The second most important thing to realize when valuing KKR is that this is an extremely stable, predictable, recurring business model, which means we can attempt to value it with a narrower range of outcomes. So, what do I mean by that? Forty-five percent of its AUM is perpetual or permanent capital or capital with multi-decade commitments.

So, 45% of AUM is permanent. and 89% of AUM has a commitment of at least eight years, meaning that capital is not subject to redemption for at least eight years. Okay, so now to the numbers. KKR did $3.47 in distributable earnings per share over the trailing 12 months. KKR thinks it can do over $7 in five years. So that's a 15% annualized earnings growth or a five-year double, which is perfectly in line with the 15% estimate from Prequin that we just discussed. I think KKR can double distributable EPS by 15% over the next five years. But if we assume only 13% growth over the next 12 months. Just to be conservative, that results in distributable EPS of $3.92. So at $70

per share, KKR is trading at only 18 times forward earnings compared to the market that's at 21 times forward. So that's a three-point discount to the market. But we think KKR is a far, far above average business. In fact, we think KKR is a great business and think it deserves to trade at a premium to the market. And we would not be surprised to see KKR stock re-rate higher over the next five years. Why do we think KKR could possibly re-rate higher? Because its earnings are extremely predictable and visible. Remember, 89% of AUM is locked up for at least eight years. It generates returns on invested capital much higher than the market, and it's growing economic earnings faster than the market. So, given KKR's overlapping competitive advantages and its earnings growth

and visibility, we think the market should be willing to pay an above-average multiple for investing in a business that we think has a narrow range of outcomes. Nevertheless, to be conservative, we're not going to consume any multiple expansion. we're not assuming any multiple expansion. And to be extra conservative, let's assume distributable earnings grow at 13% to 15% over the next five years. So if we just assume the multiple remains stable, that means total shareholder returns will be driven by distributable earnings per share growth of 13% to 15% plus a roughly 1% dividend yield. So that gives you total shareholder returns over the next five years of roughly 14% to 16%.

Finally, we also did a reverse DCF. So we used new constructs, reverse DCF, and we think the expectations for future growth pricing of the stock are still too low. KKR only needs to grow revenue and cash flow at a 13% CAGR for the next six years. to justify today's stock price of around $70. So our team's variant perception is that we think KKR can grow faster than 13% and surprise to the upside over the next five years. Do those, do their sort of VC type holding,

so I know I was getting into their portfolio a little bit, and I know they have in their portfolio companies, they say Epic Games, ByteDance, companies like that. Do those get included into their distributable earnings per share, or is that just kind of assets for them okay so they do and it's super super complicated um gap accounting and how they how they record their holdings so gap accounting requires that KKR consolidate all of their holdings. So if they hold more than 10% of a company,

they have to consolidate those funds onto their balance sheet and income statement. Now, I don't know if they hold more than 10% of Epic or by dance or whatever, but if they hold more than 10%, 10%, then KKR has to consolidate that onto their GAAP financial statements. But they only own a sliver of the business, but they have to consolidate all of their holdings, assets, liabilities, and then profits and losses. And so when you look at KKR's balance sheet,

Its assets are way overstated. Its liabilities are way overstated. If you look at its gap earnings, they're completely confusing and misleading because not only do they have to consolidate all of this, but they also have to mark to market all of their holdings every quarter. but they're holding these things for 10 years plus. And so when you strip out... And so, for example, if you were to screen, if you go to Yahoo Finance or S&P Cap IQ or anything, you'll see that KKR has negative cash flow from operations. When in real life, when you strip out this mark to market every quarter and you strip out this consolidation that GAAP requires, their cash flows are incredibly strong. The other thing is if you're screening for companies that don't have a lot of debt, you're going to miss KKR because they're consolidating all the debt from their portfolio companies under their balance sheet. When in reality, if you add their cash

and investments, they actually have like $18 per share in cash, in net cash and investments per share. $18 in net cash and investments per share. But if you just do a rough screen, you're going to see $40 billion of debt or $42 billion of debt. Completely misleading. Totally misleading. It's just because GAAP accounting doesn't work great for alternative asset managers. So yes, that all flows through, Ryan. But then they have to strip out mark to market. They strip out the parts of the business they don't own, and they come out with something called distributable cash flow or distributable earnings per share. That's like free cash flow, right? What is free cash flow?

It's what an owner could take out of a business after investing in growth or distribute. That's distributable cash flow, and this company generates a lot of it. According to New Constructs, which is a platform I rely heavily on, they generate – let me see if I can just look at this. So their returns on invested capital have gone from 13% in 2017 to 32% in the trillion 12 months, much, much higher than the market. Their economic earnings per share, in other words, their true core normalized earnings per share is actually higher than their GAAP reported EPS. That's rare.

Most companies that I look at on New Constructs platform, they inflate GAAP EPS. And so you see GAAP EPS higher than the true economic earnings power of the business. KKR, real economic earnings, much, much higher than reported EPS. In the trailing 12 months, economic earnings per share were $20 versus reported EPS of about $9. So you just can't rely on GAAP accounting for KKR. Right. That's a great overview. Now, they have a fantastic track record. But when we're looking at them, we're talking about them, it's kind of vague about what they actually invest in. So do they have any themes? Do they have any focus? I think for any listeners that might be interested in it, or they might be interested in what actually they're investing in. Do they have sector analysis or something like that? Or conversely, do you think it doesn't matter or do they not share that? So they have, I don't even know how many funds they have, but they have tons of funds, 30 or 40 funds, something like that.

And they span the spectrum, right? And so that's what I like about KKR is that they have this diversified business model. And no area of the investing world works all of the time. And so KKR invests across so many asset classes, which helps to smooth out the bumps, right? And so they invest across the growth spectrum. So they have traditional private equity funds that invest in any kind of sort of mature cash flow generating business, more moderate or slower growth, free cash flow, generative legacy type businesses.

They also have investments in credit. They have credit funds. They have real estate funds. They have infrastructure funds. They have emerging market funds. They have growth equity funds, which is what Ryan was talking about. And those growth equity funds invest in everything from two-sided marketplaces to software as a service to cybersecurity to semiconductors to other venture-stage capital investments. They also have an emerging investment bank that generates a nice growing stream of capital markets fees. They're buying music catalogs. I know you all know the music industry. Well, they're buying music catalogs. They've already acquired, for example, the music catalogs of ZZ Top and John Legend and others.

And then outside of investments, they recently acquired Global Atlantic, an insurance company, which provides KKR with $98 billion of permanent capital or float, similar to Berkshire Hathaway's model. And so I'm usually, Brett, skeptical of most large acquisitions, but I think Global Atlantic's acquisition, which closed in – it just closed in February 2021, is transformational in a very positive way. So it provides KKR, like I said, with $28 billion in AUM, permanent capital. It increased KKR's permanent capital by over 5x. And Global Atlantic's float is going to be worth much more in the hands of KKR's exceptional investing team. So Global Atlantic is a life insurance company focused on retirements and annuity products. And I think Global Atlantic would benefit from higher rates.

This is interesting because it has a lot of floating rate investments. That's number one. And number two, higher rates would increase demand for annuities. And so this just shows that alternative asset managers have the capacity to invest in just about anything. And also, another important part when we're talking about their different segments, their various teams, so private equity, real estate, credit, infrastructure, they all share data and knowledge and skills and insights with each other.

So you can imagine that a private equity team doing due diligence on a large acquisition, right? And then they ask the credit team to help them out to analyze the target company's balance sheet and to stress test how much debt that balance sheet can handle. And then the real estate and the infrastructure teams help value the property, plant, and equipment and other physical assets on that target company's balance sheet. And then the international team help to value any foreign assets that company may own, and on and on. And so KKR calls this using the whole brain to source opportunities and to shape their investment views. And so I don't have like a favorite. What I like about KKR is that they can invest across all of these asset classes, and that doing so can help smooth out the bumps. Right. And their track record of returns is nice, too.

yeah i mean it's exceptional you know over 20 annualized so curiosity do you know what they what sort of a multiple uh kkr is willing to pay for music catalogs i have no idea like what the multiples are i i don't but you know john legend is a star and so uh i'm sure he's he's going to demand a pretty penny i i don't know what the multiples they're paying are. Okay, we're going to hit a quick ad break. And then we got more questions on the second half. This episode is brought to you by KPMG. As a business leader, how can you innovate, build trust and move forward in a digital era? KPMG can help by bringing together the right talent and technologies generating insights that spark opportunities. To explore their thinking,

Visit reed.kpmg.us slash opportunities. All right. Welcome back in. A few more questions on KKR. So you talked about management briefly and you said it sounded like there's a new team kind of coming in. That'll be the co-CEOs, I think was their roles. So what are your thoughts on them? And then how important are they to the KKR investment thesis? So the two new CEOs, Joe Bay and Scott Nuttall have only been in that position for a few months. So, honestly, I'm still learning about them. But they've been with the company for 26 years, and they've really been the architect of the company's acceleration and growth that took place while they were co-presidents and co-chief

operating officers. I think that started earlier. So, I stated earlier that from 2010 to 2014, 2015, KKR deployed investments at a rate of 8% CAGR. But from 2015 to 2020, the rate at which KKR deployed investments grew at a 31% CAGR. So that was under the leadership of Joe and Scott. The other important thing to note about management is the link between management and culture. And KKR's culture is unique in the industry. So first, KKR has one global bonus pool at the firm. Everyone is paid based off the success of the firm as a whole and not the success of any one strategy or any one fund. There's a real culture of sharing and collaborating across teams and across funds like we talked

about earlier. This culture is not standard in the industry. Most of the time, investors get carry based on the fund they run and the fund they work for. They get carried interest based on their specific fund they work for. That's not how it's done at KKR. It's a more team-based approach. The other big cultural differentiator for KKR is that KKR invests in its own funds through its balance sheet. This shows great alignment with

KKR's limited partners, and it increases KKR's ability to compound earnings, cash flow, and book value. This is something that really stood out to us about KKR, and it goes back, once again, to that growth mindset because investing into their own funds through their balance sheet, like I said, that compounds growth and earnings and cash flow and book value. And so we think that the balance sheet is the most culturally friendly way to compound economics as an asset manager because one, it's very friendly to the LPs. So you're aligned with your LPs. Two, it shows that you're putting your money where your mouth is. Three, it shows employees that you believe in your own product. This is also not standard. KKR, its balance sheet

strategy and the rate at which it invests in its own balance sheet, it does so at a much higher rate than the rest of the industry. Okay. Yeah, that's a great overview on the culture. You said, don't forget the balance sheet strategy. I don't know if you just explained that, but I want to bring that back up. Do you want to discuss the balance sheet strategy at all? Yeah, just that, that they're investing into their own funds, which sit on their balance sheet. And so they do so much, much more than others in the industry. By the way, that also, not only does it help compound book value and growth of earnings and cash flow, but it helps them attract talent, right? Because they have this unique balance sheet strategy.

and and the other thing that helps them attract talent is the fact that they do have one bonus pool and and it's more of a collaborative environment and they and and and so for one to get to get your bonus the whole fund the whole firm as a whole has to succeed okay last question i think unless ryan has any other follow-ups what is the biggest risk for kkr as an investment you mentioned is interest rates is it that what do you see as any downside that potential here? Yeah, I do think that the market probably thinks the biggest risk is inflation and interest rates shooting up to somewhere much higher than they are now, let's say 4% or something like that. If that happens, it could negatively impact KKR because it will

increase its cost of financing deals and fund flows may slow as some institutional investors move some assets out of alternatives and into bonds. On the other hand, KKR has a massive real estate portfolio, which is potentially good for inflation because when inflation is high, the replacement cost of the real estate assets increases. And so the value of existing real estate goes up. The other reason real estate is good in an inflationary environment is because a lot of real estate has long-term contracts with pricing power built into those contracts. KKR just has a massive, massive real estate portfolio. The other thing is, if interest rates go up, multiples for buyouts would drop. KKR could potentially buy cheap companies and

plant the seeds for future growth if multiples drop. Then finally, we already mentioned this, but another reason why I think KKR could be a hedge in an inflationary interest rate environment is because they do have this insurance company, which would benefit from higher rates because they have floating rate investments and because they sell annuities and demand for annuities would very likely increase in a higher rate environment. So I'm actually not as worried about interest rates over a full cycle over the next five years. I think the biggest risk is that we get one or two years of really poor performance in the stock market. And, you know, other asset values feed off the stock market, I think.

And so if we get one or two years of really poor market performance, KKR would probably decide to hold on to some of its investments longer before they make an exit. And that would lower IRRs. Because, you know, an internal rate of return comes not only from KKR, the capital gain, but also from how long you hold an investment. And so if they're holding these investments longer, they would get lower IRRs and that would also lower their carry fees in the short term. So I think that that's probably the biggest risk over the next couple of years.

Okay. Do you have any more questions about KKR? Okay. Then we have a few questions for you to kind of think about as a portfolio manager. And it's more questions about your investing style. So just curious how you categorize yourself. I know purist investors say there's no such thing as growth or value. It's all value. But do you see yourself as in one camp or the other? You know, I've been doing this for a long time. And for a while, you're right. People would say value and growth are attached to the hip. You can't estimate value without incorporating growth into your model. And that's all true. But when I was growing up in this industry, people were proud to be value investors. And now it's the exact opposite.

Literally, I know people shaming value investors. I'm serious. I just want to come out- All the time. They do, yeah. literally shaming value investors. And I want to come out and say that I'm proud to be a value investor. I mean, proud. I'm a self-proclaimed, self-described value investor. And I don't know if that's going to hurt my career or something like that, but just because of where the sentiment is these days. But there's a spectrum of value investing as well. Even Warren Buffett, we all know the story. He started off as a deep value investor, then Charlie Munger convinced him to pay a fair price for a great business. And so he shifted more towards a quality

value investor, if you want to call it that. I'm even further on the quality spectrum than Buffett, just because I'm only going to invest in growing businesses. And so I love growth. And actually into our investor philosophy statement for the Motley Fool portfolio that I'm running, I stated, we will only buy growing businesses and businesses that we think can grow at attractive rates over the next 5 to 10 years. That's in our philosophy statement. I've committed to that. I'm never going to invest in a business that's not growing. I think you can make money that way if you get it at a good enough price. I definitely think you can. It's just not me. I like growth. I like innovation. I like reinvestment. And so, I look for growing

businesses, but then I'm really patient and I try to only buy them when I think that the expectations for future free cash flow growth price into their stocks are too low. And so I think that's value investing. I do not chase what everyone is talking about on TV or on Twitter or in other financial circles. I don't do that. And maybe my returns will suffer because of that. But yeah, I insist on growth, but I just want to wait for a good price. And I think that's value investing. And I'm proud to be a value investor. Yeah, I totally agree.

It's funny how the term value investor has this negative connotation to it now. And it's almost like, oh, you're stuck in the past. Yeah. You're right. There is some value shaming going on in the investment world. It's almost insane that people think that if you're a value investor, you don't understand growth or you don't at least try to understand growth and innovation and invention. I spend 90% of my time trying to understand innovation and invention. I also, at the end, layer in a value lens.

And so, yeah, it's ridiculous, some of the stuff you see on Twitter. Yeah, yeah. Yeah. Well, we'll get to the next question, but I think, yeah, you got to be comfortable buying something at less than 10 times earnings or 10 times cashflow. And you got to be comfortable buying something north of 40 times cashflow. I mean, it's all unique. It's all individual. And they could both represent good values. It's exactly right. Yeah. All right. Let's move on to another topic. You mentioned this and the importance of an investment thesis. Now, how important is that for you? And I guess maybe for listeners,

What are some ways that you think people can hone their skills of writing an investment thesis or developing one in, say, a rational or thoughtful manner? Excuse me. Yeah, so for your listeners, I tried to lay out our investment thesis in KKR at the beginning of the show. Now, you could disagree with that thesis, but I tried to lay out the thesis. And the thesis is basically how you're going to make money in the stock. I mean, that's a thesis. A thesis is not, you know, a lot of times when you ask someone for a thesis, they'll give you a business description.

That's really important, but it's not a thesis. It's not how you're going to make money in the stock. It's really important. It's just not how you're going to make money in the stock. So a thesis is how you're going to make money. It's, it's what it's, it's, what is your variant perception? What do you think, um, what do you see differently from consensus and where do you think consensus is wrong?

And so using, using, uh, a model, you know, I talked about a reverse CCF, you, you basically look for companies that you think, um, the market is, is not giving enough credit for future growth. You think that the market is, is pricing the stock as if the company is not going to to grow as fast as you think it can. And so you look for companies that can exceed consensus expectations on growth or margins or what have you. If you're a multiples investor, which is fine, there's nothing wrong with multiples as long as you understand the drivers of what's in that multiple, right? PE multiples, justified PE multiples are driven by growth, returns on

invested capital, reinvestment, and cost of capital. It's actually mathematical. And so If you're a multiples investor and you think that a company is undervalued, people throw out the term undervalued all the time. I think the company is undervalued and they don't tell you how. The thesis is how. Why do you think a company is undervalued? If you're a multiples investor and you think a company is undervalued, you think one of three things. You think the numbers are too low, the multiple is too low, or both. That has to be a mathematical certainty if you're a multiples investor. So the thesis is, why do you think the numbers are too low? Or why do you think the multiple should re-rate higher? Or why do you

think both will happen? And so, yeah, that's a thesis. I think that's important if you want to sustainably outperform the market over a long period of time. If you want to read more about this, my favorite investing book, I think it's the best investing book is Expectations Investing by Michael Mobison and Al Rappaport. They talk about this at length and they give you all of the tools you need, including a spreadsheet, to do all of this work in that book. And so, yeah, I think a thesis is really important. As far as how to write them, just practice practice practice and and then looking at businesses and stocks from that angle how is this going to make me money and if you think about it from that angle

and you keep it short you know you'd like elevator pitch short then and then just so we i wrote a thesis for every single company in the portfolio so i have 16 companies in the portfolio right now We're still building it out, but I have a thesis on every single one. And so just doing that is practice. It just takes practice. Okay. I have another question for you. And we've gotten this one occasionally when we're like trying to talk to investors for our fund.

And I absolutely hate the question. So I'm going to push it on to you, which is, do you think you have an investing edge? If so, what is it? I think maybe. And if I have an investing edge, it's that I don't have any FOMO. Zero. I have zero fear of missing out. I almost never trade. I tweeted last year that I made two trades last year, too. I opened my broker account three times, one of which was to get my tax documents and to forward those over to my CPA. I think a lot of investors spend a lot of their time trading or talking about stocks, at least. I spend 90% of my time reading and thinking

and analyzing businesses. And I have zero FOMO. So actually, I've told this story before. I know I told it on Motley Fool Live. I may have told it to you guys, either on the podcast or just when we were talking offline. But the very first week I was on Twitter, the very first week was January 2021. I didn't tweet until February 2021. But the very first week was some week in January of 2021. And it was when Pinterest reported earnings. And there was an orgy of excitement around Pinterest's earnings in January 2021. It's like my first day on Twitter. And I'd never been on Twitter before. And that's the only social media I'm on. I don't even have a LinkedIn account. You can't find me on LinkedIn. And so I get on Twitter for the first day ever

and people are falling over themselves over Pinterest and how they beat earnings and growth impressed and this, that, and the other. And I'm thinking to myself, literally, and I may have told the story the last time, I'm thinking to myself, this cannot end well. Not because Pinterest is not a great business. It probably is a very good business. I haven't done a deep dive on it. But from what I've looked at, it's a good business. But there was literally, there were people just jumping and piling on how awesome Pinterest is. Rocketship emojis. Rocketship gifs. Yeah. Oh, but like all day on Twitter, it's my first day. And I'm like, oh my God,

this is not going to end well. And because my theory is I want to go where no one is looking. I want to find the growth businesses, profitable growth businesses, great run businesses where no one is looking, not where everyone is looking. And so if I have an edge, it's that I don't have any FOMO. And I'm not going to spend much time at all studying a business that's trading at, I don't know where Pinterest was trading. But, you know, before the sell-off in software, there were legitimately companies trading at 30, 40, 50, or 100 times sales. And when you then reverse DCF that, and then you incorporated even a slight rise in interest rates, you see that some of these valuations were pretty out there. And so, yeah, I just wait for them to come back in. And then I buy them.

And so, yeah, if I have an edge, it's just no FOMO. I'm not smarter than anybody else. I'm not working harder than anybody else. Everyone's doing the hard work and everyone's building the models and everyone's trying to network and talk to as many people as they can about their investment ideas. I have an amazing network at The Fool and outside The Fool. So if I have one, Ryan and Brett, it's just that I'm willing to wait.

Yeah, just give some context. the peak sales multiple was around that time so you came on and uh they had a very hot multiple it was around 30 and now it's back down the trailing one's like seven and a half according to coifin that could not that could be well i like hey i like a lot more at seven than i did at 30 exactly if you loved it yeah exactly that's just me yeah all right well i think we probably have time for one more if ryan has another one we may have time to ask too but what i think this is a good wrap up because right now we were talking about before the show and factor investing can be weird, but the small cap growth factor is just totally been underperforming the market over the

past year. It's down like 30% versus the S&P 500. That's kind of the decoupling from the large cap growth stocks and all that stuff. But what do you think investors, individual investors should Keep in mind, moving into 22, I'll just leave it like that. I mean, one thing is look for bargains that have been crushed. Just as a quick side note, and then I'll answer that question. Just because I mentioned the word crushed and that made me think of something. One thing I do look for is when CEOs are buying their stock in large quantities in the open market after the stock has been decimated to the downside. And I'm going to call out DocuSign.

So the CEO of that company has made two separate open market purchases of over $5 million since the stock cratered 40% in a day. Actually, I think he's bought close to $12 million now since the stock cratered. So that's all I'll say about DocuSign right now, but that's one thing that I find very encouraging about that company right now. You're talking about like CEO personal capital, not like a buyback program. Right. The CEO of DocuSign with his own money went into the open market and bought on two separate occasions since the stock got decimated. it. Look, I think that if you're an investor in 2022, you have to have an opinion on where interest rates are going. Not how high, not how fast, but I think you have to have an opinion on

the direction. And I think you have to have stress tested your companies, their balance sheets, and their valuations for how they would react to much higher interest rates, like, let's say, you know, 3% or higher, and how that feeds into the cost of capital. And then when you discount those future cash flows back to the present value, what that does to intrinsic values. So yeah, you know, I think inflation interest rates are going to matter. and um i think some i think some companies have you know mainly non-earning cash burning really fast growing um companies that are earlier in their life cycles that are still trading at high multiples i think that if interest rates go you know higher than three percent they could fall

further some of them and so you just want to stress test your models for that you want to stress test your company's valuations and so that's what i think investors have to keep an eye on interest rates inflation and how that affects portfolio holdings right because that's the big thing if you don't understand why your stock's down 40 then you don't know what to do then you don't know whether to buy more whether to sell whether to panic exactly yep all right that's probably a great way to i'll let you wrap up yeah i think that i think that's all the questions we have um and i know you said you're not on any social medias other than twitter but for anyone that wants to get ahold of you or keep track for you, where's the best place to do that?

Yeah. Twitter. I think it's called my DMs are open. I hear people say it like that. My DMs, you can DM me on Twitter. I don't even know how to use Twitter, honestly. I send out a bunch of tweets. I don't even know how to use it. You can find me on Twitter. I'm the co-host of the morning show on Motley Fool Live. So I'm on Motley Fool Live Monday through Thursday from 9 to 11 a.m. Eastern time. And then on that show, you can ask me questions. There's a Q&A, like we use a Slido app to ask questions to the hosts. All right, perfect. That's going to do it. We want to remind listeners that Brett and I are not financial advisors. Anything we say or discuss here on Chit Chat Money is not formal advice or recommendation. We are, however, general

partners at Arch Capital. So clients may have positions in the securities discussed in this podcast. Thank you all for listening. We'll see you next time.