Good Investing Talks - Dev Kantesaria, what is your formula for quality investing?

Episode Date: October 27, 2022

Dev Kantesaria is one of the two decision-makers at Valley Forge Capital Management. In his portfolio, he is focused on high-quality stocks.

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And today I'm welcoming Dev Countessaria, managing partner of Welliforge Capital. He's here from Miami. Great to have you here. Thank you for having me. It's a pleasure having you. And at the beginning, I wanted to ask you if you can show your hands to us. There you go. Okay, surprise, surprise for me because they aren't tied to the desk. Because as I was going through your holding list, I was a bit surprised that you had so much or so less sell activities in your portfolio. What is your secret source that the hands stay away from the sell button as an investor?

Really, I've studied a lot of playbooks over the years, starting at age eight. And the one that resonated with me, the strongest was the Buffettmonger playbook, which is to focus on business quality. So to stay away from short-term trading, which is a type of speculation and really focus on companies that can compound intrinsic value year after year for many years. It's a much easier way to make money. it's more tax efficient and it's a more predictable way to make money so uh the lack of turnover is really nothing other than a natural outcome of how we think about business quality and

wanting to own a business that has great quality and sustainability for the next 10 years 20 years 30 years so after my bit of a gringy entrance into the conversation we are already fully in the topic of the competitive advantage you've built with your investing business and if you think about the investing industry as an industry you need a certain competitive advantage or a style you can follow to outperform over the long term because otherwise you already said this another interview you could go with ETFs you don't need managed a fund or a partnership so how would you describe the competitive advantage of Valley Forge Capital besides keep keeping your hands away from the sell button?

You know, it's true that 99.9% of the active management industry adds no value. You know, they're separated on a statistical distribution. And in certain years, some investors may look good just based as a statistical phenomenon. So if you look at investors that can add value in alpha reliably, you know, we view our advantage. First, in the form of temperament. We don't get happy when the market goes up. We don't get sad when it goes down. We're not about what we're going to make this quarter, this year, even next year.

We are very much long-term focus. So our time horizon is very important. The fact that we're unemotional, the fact that we're disciplined, you know, that we have this excruciating patience. It's very hard for people like investors to watch their portfolios play out over 10 plus years. You may know about the Oreo test or the marshmallow test that they give young children. And are they patient enough to wait five or 10 minutes for the second marshmallow or the second cookie? You know, most of us aren't that patient.

So you need the right temperament in order to be successful at investing. You need a certain level of intelligence as well as a focus. It is an all-consuming business. You have to think about your portfolio. At least I think about it every minute of the day. It's something that I enjoy and it's all consuming. It's not something that you can stop thinking about at 5 p.m. But, you know, if you look at my background coming from venture capital,

we were dealing with pre-revenue, pre-cash flow companies. So these companies had a large set of risk factors. In some cases, 20 different risk factors that you had to distill into a single pre-money valuation. So it could be patents, it could be management, it could be clinical trial data, it could be competitive landscape, addressable market, et cetera. So I would describe our edge is the ability to assess future risk better than others. And really, it's a form of determining the discount rate. that you want to apply to future free cash flow.

The business school model is you have to use the volatility of the stock as a major input as to risk. Now, volatility, you know, is not always a great measure of risk on a going forward basis. So the fact that Coca-Cola has done well for the last 50 years doesn't necessarily mean that Coca-Cola is going to do well for the next 10 years. So I think it's our ability to look at the entire playing field, looking at the risk factors that will develop in the future. And from there, predicting, you know, a course for these companies that we think have a high probability of playing out. So it's taking risk, but in a very measured way. And we're never willing to trade reliability. We want very predictable companies that have strong organic growth and the ability to compound for many years, but to do it in a very,

reliable way. Maybe let me ask a follow-up question on the unemotional you said in your non-prepared answer. So I think it's more, the more and more I get into investing, it's more about like managing your emotions than being unemotional and being more emotional conscious because it's the superhuman game investing. What does your take on this? You know, a lot of this temperament, I think, is genetic and can't be taught. Now, you can suppress it, but you need to have a good, I think, starting point to have the right

approach to investing. And not everyone has it, and it's good to recognize if you don't have it, because then you can go out and buy an SMP 500 index fund, and that will be a better outcome for you than trying your hand at active investing. So I think there is a genetic component of just how someone is built from day one. I also have noticed a pattern that some of the great investors throughout history come from very frugal environments. You know, seeing your parents be careful buying groceries or buying a car or buying a house brings a certain caution and carefulness to investing in terms of your personality.

So there's no easy way to teach temperament, patience, discipline, the right emotional state. You can provide, you know, young, young people in, in the industry with learning lessons. But you could bring in a thousand of the smartest MBA students in the world, have them spend the whole summer with Warren Buffett, learning everything he has to, and all of his wisdom. And 995 of them would go back the next month to, you know, trading biotech stocks. So it is, it's a rare personality type. and it's really tough to engineer. Yeah, I think it's also investments where I started to become more and more comfortable owning them. I have this state of flow where I also think, okay, there's something bad happening.

I know what this means. I know how I could interpret it is also a factor of work if you're like satisfied with the investment you have. you know so as you look at our portfolio today you know our fishing pond for business quality is only 50 or so companies the entire world and there's thousands and thousands of publicly traded companies to choose from and then from that grouping we're picking eight to 12 of of the best you know companies for the next 10 or 20 years so our bar for business quality is exceedingly high and there's very little turnover to that fishing pond. We may add a couple of names a year. We may take a couple of names off based on a change in business quality. But, you know,

with these companies, we're great historians of what they've done. We are not trying to predict step changes to their business quality. We want a company that's already had great business quality for the last 10, 20, 30, 50 years and still seeing that they can be on the right path on a going forward basis. And so that really removes a lot of the risk that many investors take with a company when they're trying to find the next Microsoft or the next Google.

You know, we want to look at companies that have already shown excellence for many, many years. And we are just extrapolating that on a going forward basis. Let me come back to the point of the competitive advantage And yeah, there your hands also play a role again. You've been a surgeon before. You already mentioned this, I think. You also worked at McKinsey and as venture capitalists.

And then you moved to public equities. What experience did you get from this that helped you to build a certain competitive advantage with Valley Forge Capital? From a young age, I loved thinking about businesses. So everywhere I go, a restaurant, if I'm going out to buy, to buy an ice cream cone, the grocery store, I just have always loved thinking about businesses. I would say the biggest advantage coming from venture capital and transitioning to public equities, you know, in our, in the investment world, people want to compartmentalize

skill sets. You know, venture capital is different than private equity. Private equity is different than public equities, mezzanine investors. You know, we have all of these buckets. I view all of it as a continuum. They're all forms of assessing, assessing business quality. And I would say the most important thing I learned in venture capital. I was a venture capitalist for almost 18 years is studying operational risks in seeing what works and what doesn't work there. So I've been on many boards of directors, seeing how group decisions are made, seeing the weaknesses of those group decisions. I've been involved in hiring and firing many CEOs. I've been, you know, chairman of companies. So a lot of that operational knowledge,

which allows me to assess an important risk factor for the public equities we're investing in today, you know, just by history of other peers, they just don't have that background in operational work. And I think that that is an important component when you try to assess the quality of a business on a going forward basis. So that carryover in seeing just about everything you can imagine on the operational side has been exceedingly helpful in my work today. So if you think about venture investing compared to public equities, how much of a marketing game or what could you learn about marketing and marketing to investors from this game compared to the public equities game? You know, venture capital is a game of hope. You might invest in 12 companies, seven or eight of them may go out of business.

You might get a few with a double or triple, and then you're hoping for a home run. And so in speaking with investors in venture capital, you know, they are in many cases buying a lottery ticket. One of the reasons that I moved from venture capital to public equities is I wanted to have a more reliable way of making money and not leaving so much to hope and chance. With public equity investors, you know, the most important thing that if I were on the other side of the table, that would be important to me is to assess the predictability of the behavior of how we're going to act during different scenarios and the predictability of the return stream going forward. And so you could have situations where, and you see this quite often in the hedge fund world, where someone does really well for three or five or seven years.

And then they do something very silly or they over-extend the risk. And then they're down 80 or 90%. That one year of being down 60, 70, 80, 90% can ruin 10 years of quality performance. So, you know, I love public equities for a few reasons. One, it's a meritocracy. The playing field every morning is open to every single person. You can buy any company in the world. And in venture capital, it was very clubby.

You know, whether you were allowed to get into Google as an early investor in the Series A or Series B round was a function of who you knew. So I love the fairness of the public equity markets. But I also like the challenge of generating returns reliably and compounding over time and not, you know, relying so much on luck or chance. But there are also some advantages you can get in the public equity spaces by maybe access, like having also a good network, being able to talk to the right people? Or is this not the case for you? You know, in my pedigree, I've not been fortunate enough to roll out of Goldman Sachs

or another famous fund. So everything that we have built, we've had to work very hard for and claw our way forward. So we've had no lucky breaks in our 15 years. And so we love talking to investors. We love building our network. But I can't say that that networking effect has kicked in for us yet. Then coming back to your career, you made this big transition from a surgeon to McKinsey, then to venture capital, then to public equities investors.

And you were really good in the roles you had before as a surgeon. I think you graduated with the highest level from your school. how do you manage to keep your like the shift for you personally like with a certain age starting again as a new being a certain industry where did you take the courage from to start new in many different fields yeah i've had a few different careers along the way um i attended harvard medical school which was my dream since i was 16 years old i had a plan on being a surgeon and, you know, I stepped away from that because I didn't enjoy it as much as I had thought. So I was at McKinsey for a couple of years, then made the jump to venture capital.

Our last fund in venture capital was actually quite successful, and that would have been quite easy for me to continue on that path. But I'm someone that is not afraid of new challenges and change. I need to do something that I believe in, and public equities, especially when practice in the right way, just has always resonated with me on a risk-reward basis as the most productive way, an efficient way to grow capital over time versus private investing. So looking back, I'm actually more scared of it than when I was in it at the moment, in the moment. I'm doing, you know, what I love. We started 15 years ago with Valley Fridge Capital with only $300,000 without a specific plan of where it was going to go. So we've been fortunate in very ways to grow it significantly, develop a very strong track record.

And, again, doing what we love. I would say that my personality is to be driven by excellence. So, you know, going back to when I was in the sixth grade, I was the number one. student in my elementary school. And I still have that book here in my office that they gave me as an award. So at every level, I don't rest until, you know, until I can achieve that number one position. And it's hard to measure in public equities, of course. But I go in every day, feeling like I have not accomplished enough. I have a chip on my shoulder, feeling that there's more to do and really striving for that level of excellence and that really has been a strong

motivator and it keeps me, you know, quite energized going into work every day. So is there any risk for investors of you that you might do another career shift at a certain point of time or do you like the infinite game of public equity investing? No, I'm really doing what I love. And again, it's something that I really believe in as well. And so as I think of, whether it's a mom and pop investor or even an endowment or pension fund, the advantages of public equities, if practice in the right way, are so significant relative to every other asset class, cash, bonds, gold, cryptocurrencies, private equity, venture capital. I know that there are fads where some of those other asset classes come into favor. But the liquidity advantage of

equities, the ability to switch out of names into better options, you know, is a real plus for public equities relative to these other asset classes. And I believe that you can end up at the same end point in a more steady fashion. And so you don't need to be out there buying lottery tickets. Coming back to your approach, you love or you like to invest in compounding machines. So what are a compounding machines in your terms? So some of the characteristics that we look for, you know, we're focused on companies that are monopolies or oligopolis in their respective industries. And these are industries that have

strong secular trends in their favor, strong volume growth. Pricing power is the hallmark of a great business. If you can raise your prices above the rate of inflation consistently, you have a phenomenal business model. We like companies that have operating leverage whose margins go up over time. So we own companies that have significant market caps, 50 billion, 100 billion, and they still have the potential to grow margins significantly. We like businesses that are capital light. So we don't like businesses where you have to invest a lot in fixed costs. we avoid companies that have high R&D risk. So if you have to invest a billion dollars to find the next blockbuster drug, that's not

the type of return on investment. That's predictable for us. So there's no rote way to screen for these types of companies. You know, 95% of the time we are intensely reading about industries, about companies, and we find these advantages. Sometimes they're nuanced, sometimes they're obvious, but the market is. not paying attention. There could be a bare case for the company at any given moment because of a regulatory issue, legal threat, some short-term competitive threat about earnings release that gives

us an opportunity to invest in a great business for the long term. So there's no particular shape or size that these companies come in. But those are some of the characteristics that we like to see in a great business. And the final piece is capital allocation. So once you have earned your money as a company, are you going to use it wisely, whether it's raising your dividend, buying back stock. We like offensive acquisitions. Many companies are prone to making defensive acquisitions. And so we penalize the companies, you know, for those acquisitions. We also run our free cash flow models netting out the cost of compensation. So many companies give out excessive amounts of restricted stock and options. And we have to factor that into that compensation into what is ultimately returned

to the shareholders. You haven't always been an investor who invest in compounding machines. What kind of mistakes or learning lessons did you lead to investing in compounding machines and how have them, have they be helpful for you? Well, you always grow wiser with age. It was very helpful for the fund to be running during 2008, 2009. It puts the current down draft into perspective. You know, the philosophy and the approach that we have been running at Valley Forge Capital has remained largely consistent.

We probably have become more conservative. in our old age. I would say the biggest learning lesson from managing the portfolio over the last 15 years has been foreign investments. And even when we buy into our foreign investments at very reasonable evaluations, we're always surprised by a risk that we knew was possible, but it was so outrageous. You know, we put a low probability on it, but it could be a governance risk where, you know, a CEO may self-deal, you know, to some family entity, or it could be the government passing a new legislation on foreign ownership or, you know, suddenly changing the taxes on a company or an industry. These are the types of risk factors that we don't like that are very

difficult to predict. And so our foreign investments have been the most work with the least amount of gain. You know, most of them have still been decent returns for us, but they have really been a hassle. And so as you look at the highest quality business models in the world, fortunately, most of them are here in the U.S. And so we've always been very U.S. centric, and we remain very U.S.-centric today. And we invest outside the U.S. only opportunistically. But I would say the biggest learning lesson for us has been the ability to really factor in all the possibilities when investing in foreign markets. Are there any other lessons you could share with us?

I would say that you're always as an investor kicking yourself when there's, you know, errors of omission. So you have cash, you see an opportunity and you miss it. And that could be for a number of reasons. It could be maybe you incorrectly assessed a risk factor. Maybe, you know, you talked yourself out of, out of an investment for, you know, based on share price, you know, you wanted to buy it at $40 a share and it never fell below $45 a share. So there's a lot of errors of omission that, that, you know, you have regrets about, but those are always in retrospect. You know, should you have bought Google 10 years ago or should you have bought Apple 10 years ago? you know when you're a discipline investor you have to have a specific line in the sand for buying and selling and that may sometimes cause you to miss something and i would much rather have the discipline

around those not around those decisions than to have it free form i think there's much more downside to being casual about those than having um you know some some quantitative parameters that you're you know, lines that you're not going to cross. Maybe you have an answer on this or maybe you don't because there was, in the last two or three years, there was a general hot debate about compounders in the investing scene and everyone was investing in compounders. As you have followed this discourse, maybe what you have sometimes felt like other investors miss on the concept of compounders or when using.

using the idea of compounders and where was a blind spot of this discourse if you have an answer on this? Sure. Yeah. So, you know, a couple of comments I would have on that. You know, I think it's from a marketing perspective, everyone in our industry wants to claim that they are investing in the highest quality companies. I can see the ownership positions of our peers through the regulatory filings and

And, you know, I have a lot of disagreement on whether those are, in fact, high-quality businesses. As I mentioned earlier, you know, our fishing pond for high business quality is about 50 companies in the world. And, you know, it's not hundreds of companies. And we're at our firm, we're even reluctant to invest in our 17th best idea. That's not a risk reward that we find attractive. So the error that I see many people make is to sacrifice business quality for valuation. So if a company is making washing machines and it ends up trading down and trading at a PE of 8, somehow that's viewed as a quality situation because you're buying into it so cheaply. And I think that is the wrong approach to quality investing.

you should never sacrifice business quality. So I think there is always this idea of value versus growth. And so a quality business should be able to have strong organic growth on a going forward basis. They should have strong volume growth and they should also have strong pricing growth. And if they lack either one, they can still be okay investments, but they won't be great investments. Over the last couple of years, high-quality growth names have been out of favor. With the coming out of COVID, the strong economic rebound that we had, really it was the tide-raised-all-boats.

You had many low-quality businesses post-phenomenal earnings and growth, and that catches the attention of speculators and short-term investors. And so the compounders have in their quality that have been shadowed, overshadowed by many other industries and companies that have looked phenomenal coming, you know, as part of the COVID rebound. There will be a judgment day soon. You know, I don't know if it's three months, 12 months, but, you know, GDP growth will revert back to zero to two percent around the world. You know, inflation will, will adjust downward.

And we'll go back to an environment where predictability and strong organic growth will be prized again. We don't worry about these short-term movements and share prices. We remain completely focused on the earnings power of these businesses five years out from now and 10 years out from now. So, you know, the fact that our, you know, quality businesses have been out of favor, that's great for us and for our investors. It allows us to buy into these companies at phenomenal prices for the long term. And it allows our companies, many of them have strong buyback programs, it allows them to significantly reduce their outstanding shares when the companies are out of favor as well. So this has been a highly unusual environment for cyclical companies.

And the cyclical companies have looked great and they still look great. But we know how the story ends. And it will end badly. And the question is, can the speculators, you know, market time, you know, their entries and exits from these businesses. History has shown that that is an impossible task. Moving away a bit from the company level, in your analytical process, what role does politics play in your assessment? Because if you have some financials in your portfolio, Visa and MasterCard, I think the regulation of credit cards in the US and in Europe is a totally different. different game, especially if you think about the long-term risks and invest for the long-term,

the political topics might play a role if they change the playing field through regulation and also what role do the general financial conditions like interest rates and other stuff play in your analytical process. You know, one of the learning lessons that you have if you're a student of the stock market, you know, going back a couple of hundred years, is that compounding machines ultimately take care of themselves, that the share prices of these companies ultimately converge with their earnings power and trying to predict short-term macroeconomic events or geopolitical events. You know, in one of my letters, I talked about buying Coca-Cola before the start of World War II

and why that might have been a bad idea. But actually, it wasn't a bad idea at all. So there's almost never a bad time to buy a compounding machine. And, you know, there is just a lot of conversations and press coverage around who is going to be president, who's going to be prime minister, you know, where interest rates are going to be at the next Fed meeting, what GDP growth is going to be next quarter, what is the inflation report going to look like. You know, they are important factors, and you can have, you know, significant regulatory changes or legislative changes. You know, the Durbin Amendment that was passed to control debit card transaction pricing in the U.S.

Cause the shares of Visa and MasterCard to tank, and that was our entry point into those amazing businesses. So the businesses that we buy are so dominant, they are natural. monopolies or oligopolis. What I mean by that is that they're not forcing the end customers to use their products through twisting arms or contractual arrangements. It's to the net benefit of the end users to use their products and services. So there can be speed bumps along the way for any of our businesses, but we like businesses that have many different levers to pull to achieve their financial targets. And so we don't spend a lot of time worrying about

matters that are unpredictable that we can't control you know we may have a Democrat president for eight years and then we may have a Republican president for eight years but if you look back throughout history it doesn't ultimately matter if you own a very high quality business why do health care companies not really fit into your framework of compounding machines away I could see some of the compounding machines going for your filing but there's no big health care exposure. Yes. So even though I have a background in health care in biotech, there's no pharmaceuticals, biotech, or medical devices in the portfolio. And the reason for that is that they're not predictable

enough for our standards. For those companies, you are marketing a product that can be pulled from the marketplace because of side effect issues. It's very tough to assess new competitors because a lot of the clinical trial data is private. So it's, they, you know, there obviously have been significant businesses that have been, that have been built in those industries, but they just lack the, you know, the reliability and predictability that we need in terms of earnings power over five or 10 years. So although I have a lot of knowledge in the space, it's not something that we have invested in that Valley Forge.

How much time they usually spend to get to know company, before doing an investment? It can be on the order of months if we think that there is a short-term opportunity. But in many cases, we followed companies for seven years, 10 years. Before we bought Fair Isaac, VICO, which is the monopoly business in consumer credit scores here in the U.S. We had followed that company for seven years before deciding to invest. So we read and are historians of many industries and businesses,

but we may follow them for a decade before, you know, we feel like there is a perfect entry point for a business. How does this following look like? Is it maybe if you do a graph of work intensity, is it a huge spike where you learn a lot and then you let it drop and then maybe after two years you learn a lot more? and come back to revisit it or how does it look like the following you do yeah it is it is there is obviously uh when you're getting to know a company or an industry um in depth initially there's

definitely more more work um and then there's a monitoring phase where you're tracking earnings releases regulatory filings analysts days um and so there's a monitoring phase that goes on possibly for many, many years before we pull the trigger. If there's any catalyst, as you say, it could be a regulatory issue, it could be a competitive issue, legislative issue, something that, where there's volatility in this stock, we certainly are doing more intensive work during those periods to see if there's a mispricing of the security that we can take advantage of. But, you know, when you when you follow these businesses, they don't change a lot. And that's a plus for us. We don't like change. And so as you get to know them and follow them over five or 10 years, there isn't

a lot of new, you know, business businesses they've entered into our industries. They generally, the core businesses generally look very similar to what they look like five or 10 years ago. and that's a good thing. You use this role or metaphor of the historian already, the historian of a company. So what do you do to become a good historian of a company? What is your playbook here or your toolset? It really, so it involves intensive reading. There's just a lot of reading.

You have to constantly debate these ideas with yourself. and with your colleagues in terms of risk factors in what is stopping you from investing at this moment versus waiting, you know, for a future entry point. But what I would say is that very much like temperament, the, you know, you could have 100 investors sit through the same analyst stay or listen to an earnings call. and not all of us will walk away with the same points that are meaningful to each of us. I might read a 50 or 100-page document and only gather one or two very interesting points, which many others may not focus on.

And so it's a form of intensive reading, but also getting the right signals that are important to you. And that's an important differentiator between, you know, a great investor, good investor, and a mediocre investor is finding those patterns, finding those nuances that are not obvious to everybody. Do you then also go out and discuss the observations with other investors outside of Valley Forge Capital or do you keep this in the firm, mostly the debates? During the early days of the fund, we used to have more outside conversations. we found them ultimately to be non-productive. And so the debates that we have are really within our firm, with, you know, management of the company itself, we may reach out to experts in a, you know, to address areas of an industry or company that we can't figure out ourselves through regulatory findings. But this is a nice carryover from venture capital where, you know, you had to. look at a lot of data and layer on your own interpretation.

It wasn't as simple as asking somebody whether you thought a drug was going to be approved or not by the FDA because almost always that was a coin toss. So it's really gathering the information and it's making your own decisions independently. And being outside of the noise of New York or some of these other markets where you know fellow investors are talking about how to make the most money this year you know we we like we like being away from that noise so so we actually are very insular but we go to the outside world when we really want to assess something that we're not knowledgeable about or we need to learn more about how do you then control a certain group think

with this setup yeah i've you know we Our firm has really, I've tried to create a culture of intellectual honesty and we're not emotionally attached to any of our investments. We are very cold and calculated as it relates to what we need to do with the portfolio on a going forward basis. But that is always a concern. And I've always believed in a small investment team because I've seen the demerits of having an investment team of 10 people or 15 people. There's a lot of politicking, there's a lot of trading of favors, there's a lot of, you know, intellectual dishonesty, not in a purposeful way, but, you know, if somebody has been working three months on a deal and it's about to be rejected, you know, you may, you may, you know, your comments may be altered by your own biases. So today we have a two-person investment team. It's me and Ben.

We are looking to add an analyst or two in the next couple of years. But it really is modeled off of Buffett and Munger. And Ben and I debate these ideas in a very open way. And we hold ourselves to high standards. So it's hard to know, you know, because we'd be assessing ourselves. But I think we've been pretty good. good about being disciplined and not being emotionally attached to our ideas. In your due diligence process, are there any parts where you put extreme or strong focus on?

I would say pricing power is really a strong focus for us. And all of the parameters that feed into organic growth. We need to see a very strong top line and bottom line. in a growth profile. And so we spend a lot of time assessing pricing power and what that's looked like in the past and how that might develop in the future. But, you know, even a company that has all of the right boxes checked around pricing power, volume growth, capital intensity, margin expansion, you know, there could be one parameter

that is negative that makes the company uninvestable. So capital allocation, just like businesses that grow by acquisition. So we saw how that negatively played out at Valiant in the past. So we could have a business that has a lot of great qualities, but then they've chosen to buy five companies every year. And that's how they're going to grow for the next 10 or 15 years. That's not a playbook that we think ultimately ends well. So there could be only one or two factors that that makes a company uninvestable, even though we like many other things about it.

How do you study pricing power? And is there also like, do you also like then this idea of scale economies shared if you like companies with pricing power? But maybe let's stay with the first question. Most companies that have strong pricing power don't like to publicly disclose that pricing power. So you have to find it in with indirect information. Sometimes it may be published somewhere. Sometimes it may be referred to indirectly at a conference. But you really have to dig and find that type of information.

Again, we're looking for patterns that have played out over a long period of time. We're not looking for situations where suddenly there's a change to pricing power. So we need a lot of. indirect observations and data to often come to the conclusion about how strong that pricing power is. Usually it's obvious. You know that a product of service that they're supplying doesn't have competitors. And therefore, we like services that are cheap and essential. And so even if prices are, you know, go up 10% when inflation is 2%, we want a product of service that is a must have for the end customer, and although they may gripe about it and complain about it,

they ultimately will end up continue using the product because it is so important to them. And now coming back to the idea of scale economy shared is where you lower the price and use it to get more volume and then still have a good profit margin. Maybe Amazon might be one of the companies that place this playbook. Is it something you also look for, or is it more like, that you want to have the classical pricing power that you can increase prices year over year? We, so as we rank order business quality,

we don't, you know, it's the 50 or so companies that we put in our fishing pond, we don't have any in there that are winning the game through size advantage or volume advantage. You know, Amazon has has a great, core business, but that's part of a networking effect for other businesses like advertising, AWS, you know, prime services, video. So, you know, the core e-commerce business at Amazon has very low margins today. It's highly competitive as other businesses in the industry,

you know, are facing death like bedbath and beyond. And it will ultimately, come to companies like Best Buy and maybe even Target, you know, when those companies get desperate and it takes a long year, a long time for companies like Sears, you know, or Kmart to go under, that's a, you know, the e-commerce business on Amazon, although it continues to gain scale and market share, that would not be a business that we would be excited about owning as a standalone business. We like the other, some of the other components of Amazon but but the core business in walmart you know it was a similar story for many years that just would not be we think the straightest path to to compound intrinsic value what role does management

play in your due diligence process you know we we want to own businesses as warren buffett says that your idiot nephew could run i mean you know you want you want competent management and you want thoughtful management. But we don't want to own businesses that requires Steve Jobs to run or a Warren Buffett, who's a great capital allocator. Because that's a business risk that is difficult to account for. So management in terms of execution,

we want businesses that are easier to execute on. Where management becomes quite important is on capital allocation. So it could be related to compensation issues where they're issuing too much compensation. It could be issues of are they using free cash flow in a poor way to make defensive acquisitions or overpay for acquisitions. So, you know, management is an important component. I think management is more important with younger companies. So when you're looking at the startup companies that I used to invest in management was exceedingly important. I think they're less important for the mature businesses that we like to invest in.

So how do you go about building a relationship with management in the companies that are in your circle of the 50 companies or in your portfolio where you own less? Because it's like you're one of us, you're not a small fund, but you're a smaller fund and it's usually a big ship you're investing into. So how do you go about this relationship building? So at our size now, we are able to have conversations with the CFOs and the CEOs of most of these large companies. When we were smaller, that access was difficult. And, you know, ultimately, I didn't think it was necessary. You know, meeting management is a double-edged sword. It can have an effect on you consciously or subconsciously.

if they are sweet talkers, if you get a nice glossy presentation, you might leave that meeting biased on the positive side and, you know, counteracting the cold and rational view that you need to have at all times to assess a business. So although you can go there for fact gathering, and that can sometimes be helpful, especially if there's a part of the business that you need to learn more about. You can also be, I think, you know, influenced incorrectly to think that a business is doing better than it actually is or that the future is brighter than it actually is if you like the management on a personal level. And, you know, by the time you're the CEO or CFO of one of these major companies, by definition, you are well-spoken and you're charming.

and you know so when you meet them you always walk away impressed and that that is not always productive when you're trying to try to assess these companies so how do you ban and you then go about controlling this the sweet talk and bringing it back to the facts it really is just always being disciplined and you know we I've heard everything that's possible, you know, when companies have tried to market me when I was a venture capitalist, even in public equities. So you have to be skeptical. You have to be quantitative. You have to be logical. You have to be logical. There's no perfect way, I think, to prevent some of those biases. But you have to do the best you can. And I think we're, I'd like to think that we've been very, very disciplined about not letting those things influence us.

Any too good to be true stories you want to share you've heard from companies? You know, nothing that we have invested in, but, you know, certainly with the IPO and SPAC, you know, companies that have gone public in the last couple of years. especially SPACs that had lower regulatory standards in terms of what they could promise investors in the future. There were just so many exaggerated and unrealistic expectations that these companies gave to investors. And investors, you know, they're big boys and girls. They, you know, happily listen to the stories and the too good to be true. as you would say, and they bought into it. And whether they really believed it or not, or they wanted to make a quick gain,

you know, there's a price to that speculation. And so you have many of these IPO and SPAC companies down 60 to 80%, some even more. And those companies are not coming back. I think there is this idea that if a company goes down 80%, it has to bounce back. And that's not the case. You'll see most of those businesses. you know, stay where they are and trend even lower from here. So, you know, you have to, as I talked, as I mentioned being a good historian of companies, you also have to be a good historian of

the stock market. You've seen these periods of time repeat themselves over and over and over again. And it's very easy to see, to learn from these past lessons in the stock market. And there's many documentaries and many books that you can read to gather these. lessons. You don't need to make these mistakes for the first time. But this sort of cryptocurrency SPAC IPO period over the last couple of years was just another speculative bubble. And, you know, cryptocurrencies have gone down, but hasn't fully fully burst yet. But it goes to the idea that you need to buy assets that have some sort of intrinsic value, inherent intrinsic value. We know that gold bars can't produce free cash flow and the same thing with

cryptocurrencies. And, you know, when you have money losing SPACs and IPOs that are, you know, they'll claim that they'll become profitable in two or three years, but many of them will never be profitable or they might be profitable seven years out from now. When you run your discounted cash flow model with that many years of losses, you're not getting good value for what you're buying into these companies at. There's so many better options, albeit less exciting. So that's one of the learning lessons is to be a great investor. You have to like boring things.

If you're someone that likes excitement, you like to play blackjack, you like to go to the casino, you like fast cars, you know, that's generally not the right personality type for being a great investor. Which historic lessons are interesting for you now to look into again in this current market phase? Is it 08-09 or are you going back deeper in history? No, 0809 was just an amazing period to learn from. For the people that made the right decisions during that period, it was an opportunity

that comes across maybe once every 30, 40, 50 years. There are many people that had step changes to their net worth in a good way. And, you know, we may be in that period now. This is not as grim as 2008, 2009. Many of the risk factors today are more understandable, but could it devolve into 2008, 2009? The probability of that is growing. It's still low. But how do you react to that? Do you speculate more? Do you get out of the market? Do you market time? Or do you use it as an opportunity to buy phenomenal businesses at, you know, generationally low prices? So, but I, I love, you know, watching documentaries of, of, of, of the stock market, or even of individual, individuals that built great businesses. So it could be Carnegie or Ford or there's for me so many

good learning lessons in there. But there is a documentary that I watch with my two boys, which has been fun to watch. I believe it's called Titans of Wall Street on Curiosity Stream. And it goes back to, it really starts with the House of Morgan, J.P. Morgan. So you're starting the stock market history in the late 1800s. And there's a great discussion about, you know, consolidation within the railroads. You know, most railroads went bankrupt. But if you're, if you were thoughtful about the industry and consolidation, you know, fortunes were made or when the car industry first started and began or aviation, those are boring industries today. But back then, those were the Googles and the Microsofts and the apples of that generation. So I,

I love watching that, and there's always interesting learning lessons that you gather from those stories. You are usually fully invested with the fund, or? We have in our history been at much higher cash positions. Today, we're less than 1% cash. And that is a reflection of the opportunity that we see today on a risk-reward basis. You are catching a falling knife, and you don't need to catch the knife perfectly at the bottom. because when the market turns, it is a vicious turn.

And if you're out of the market for those few days or those few weeks, it could lead to significant underperformance on a going forward basis. So we think prices today and a risk-of-word basis for equities are amazing. And, you know, although interest rates are putting downward pressure on equity multiples, the real focus needs to be on where long-term interest rates are going to be. and not where interest rates are going to be for the next, you know, year or two. So if you do believe that the 10-year U.S. Treasury will be at five to seven percent for the next 10 years, then that's a pretty bearish view for equities.

I don't think that that is close to the likely scenario, but, you know, we do need to make some general assessment of our interest rates will be. I believe that the secular trends really argue for a low interest rates, and GDP growth to remain in a low range. And I think that's an amazing backdrop for equities. So you don't need to market time, you know, your entry into equities. But if you have cash today, it's a phenomenal time to put money to work. If you might see an 08 or 9 scenario with this fully invested portfolio,

without promising that you will do it, what might you do then rotate into even higher quality if you could this, or do you think your portfolio already has such great quality? You know, I think that when there is a lot of market volatility, there could be asymmetry in how the market is reacting to different stocks. So it can be an opportunity to trade out of a lower quality name for a higher quality name. You know, the 10 businesses we own today are the same 10 businesses that we owned in January of 2020, which, you know, I think. think that's a testament to our investment process that the 10 ideas that we thought were the

best on a risk board basis two years ago are still what we think are best today, that they can still compound intrinsic value and still have the growth that we like to see. But if you go through a 2008-2009, the main learning lesson is that sometimes the best thing to do is to do nothing. If you are invested in the right businesses, you should do nothing. And if you have the opportunity to trade out of something for something better, then that is, you know, that's an opportunity to play offense. But for the vast majority of people, if you own an index fund, the best thing that you can do is simply just forget about it, come back a year or two later and look at it then. But the idea of looking at your portfolio day to day week to week

is a very silly notion. It's something that, unfortunately, you know, culture and, you know, just norms require, you know, us to report to investors. You know, if you're a mutual fund, it's daily or ETF, it's daily. Or if you're a fund like ours, it's monthly. But most of those movements upward down are meaningless. They don't tell you much about the long-term business quality, the ownership of the businesses that you own.

So if there's a 2008, 2009, and you're a long-term investor, you should consider it quite a lucky event. The luckiest thing that happened to me in my investment career was actually 2008, 2009. And if I'm lucky enough to get another period like that within 10 years, I would consider that quite a fortunate circumstance. It would not be something that we lament or worry about. we would view it as a very positive development for the long-term investor. Are there any pockets where you especially see value in the current market? I think that with the COVID rebound, that there has been, you know, too much enthusiasm for the cyclical companies out there and many companies that do well during this part of the economic

cycle, quality growth has been largely ignored. And so that would be the place where we would be looking. And we think investors will see the best risk reward ratio. It had quality growth than the names in your portfolio. Yes. So we, you know, if you sent me $50 million today, I'd be very happy because I know exactly where I'd be putting that money to work. So there are, you know, I like to describe it as you're walking along the sidewalk and there's a $100 bill sitting on the ground. and it would be a shame if you can't bend over and pick it up.

We already discussed Amazon a bit. In your portfolio it stood out a bit for me because it has this huge and capital intense TGC business of selling goods at a low margin. And you already explained what you like about it. How does Amazon then fit in your general framework of investing in more like capital high-quality businesses? Yeah, Amazon is an outlier for its capital intensity, and that certainly has been an issue for its earnings for the last couple of years

where they were building out their warehouses, labor, wages, you know, COVID costs. So, you know, the e-commerce business is capital intensive, but it is the platform by which it can add assets that we like far. better. And so, you know, Amazon has been running at essentially break-even for the last 10 years, but there is an inflection point, we think, coming up very shortly, and that's been delayed, I would say, by about 18 months, but there is an inflection point coming up in terms of operating earnings that will come from some of these other much, much higher quality businesses like AWS in advertising. We think of all the large technology companies that Amazon has the most

optionality to go from where it is today to being a $10 trillion company. We think it's much harder to see a $10 trillion market cap for a Google or a Facebook or an Apple. So we love the option value that Amazon has. We like the networking effects that the e-commerce business provides. We love many of their younger businesses in terms of their business quality. But many of them, they're either dominant or will become ultimately dominant and so it is an outlier from the capital intensity but we you know we are out-of-the-box thinkers where we we have to look at each situation individually and on its merits and we felt like the positives there outweighed the negatives so what is then your five or 10-year vision for amazon that drove you to underwrite it

I would say that we are very optimistic about, you know, prime membership fees and the pricing power they're quite optimistic about them continuing to gain advertising market share versus Google, Facebook, TikTok. We think they're EWS. Although we, you know, there might be small market share shifts. We're not underwriting market share shifts. We're more underwriting strong continued volume growth for that entire industry and they're by far the dominant business in that marketplace, you know, third-party seller services and even

the e-commerce business. Once we get back to some more rational costs, one-day delivery is an advantage that they have that, you know, maybe outside of Walmart, no one else in the U.S. has the resources to replicate. So as competitors continue to die in the retail business, on J.C. Penny, Kmart Sears, you know, in the past, you'll have maybe Best Buy or Bedbeth and beyond, you know, in other businesses like that and going forward basis. All of that, all of that mind share will shift, you know, almost entirely to Amazon. And so it's just an amazing platform to then sell people insurance or, you know, prescriptions or, you know, it's really, Amazon has more than any big technology company unlimited potential for how it could get involved in the

customer's life. What roles do the optionalities, in the case of Amazon, you already mentioned optionalities the business has play in your assessment of the business and also how much are you willing to pay for optionalities? Yeah, many of our companies have really interesting positive optionalities, we don't underwrite that in our base case scenario. So as we're, you know, we model free cash flow very conservatively, any optionalities that come, you know, in the future, you know, a new business line that's successful, that is all upside that we have not planned for. So we like to see optionality from a subjective, on a subjective level, but we don't add it to any of our modeling or our expectations. It's nice if it materializes,

but if it doesn't it's not it's not something that we've factored in marginal safety is also important concept for you and in this quality space you're investing in business are usually never really really cheap um so maybe walk me a bit through how you're building your margin of safety and is it like somehow better assessed to this quality place you're investing in Sure. So, you know, win-loss ratio is very important to us. The typical active manager, you know, usually has 60% winners, 40% losers, and they net out to something that hopefully is better than the indices. You know, we want a bat much, have a batting average much higher than that. We want, you know, 90% plus of our ideas to work out. So what that means is that we need to not only be

very careful on the quality in understanding future risk factors, but also to buy in at a price that compensates for things that could go wrong or parts of our thesis that may not play out as strongly as we had hoped. So we're very cognizant of that. And our win loss ratio over 15 years is evidence of our ability to maintain a very large amount of margin of safety with our companies. But it's exceedingly important as part of the investment process to not sacrifice, you know, or to put the portfolio at downside risk in order to achieve upside risk. So we want to have that strong upside return, but to do it in a very, you know, with a calculated amount of risk that we can really have good insight into.

Are there any metrics you take for the marginal safety in a few last one of the other podcast I've heard with you, it was like maybe a free cash flow yield of 8% for some of the businesses, which is a good enough margin of safety. Yeah, there isn't a good way to quantify intrinsic value. Otherwise, the computers would have beaten us a long time ago. You do have, you know, you're doing a discounted cash flow that, you know, you're making assumptions about future risk. And what free cash flow yield, the company deserves for, it's growth and predictability. And so there's many subjective components that come into it.

It's very hard to say, you know, out to one or two decimal points, what free cash full yield a company should be trading at. But it is a rank ordering process. You want to take the hundreds and hundreds of companies that are available to you as an investor and rank order them based on business quality, which is, again, growth and predictability to determine what free cash flow they should deserve. And obviously, that's also a factor of the risk-free rate at any given moment.

So we use the 10-year U.S. Treasury as a proxy for that. But, you know, the opportunity really, the margin of safety is really the gap between what you think that intrinsic value is and relative to the price that it's trading at. And for the types of companies that we invest in, because they have a lot of flexibility with pricing power, Also, they're generally very nimble on costs, that even when there is a downturn like COVID, you know, many of the business segments that we own posted record margins. Or if there's a recession, the companies that we own can still be highly cash flow generative. And so that does place a natural floor on their, you know, on their prices.

Where's the line between like you own currently 10 stocks? where's the line you draw between the 10th to 12th or the 11th stock you have on your list? Where do you put this? Well, even our short list, you know, is tiered by their business quality. You know, the 8 to 12 companies we want to own is just a range. It's not a magic number or a hard number. We have no problem owning 14 companies. you know, if on a risk reward basis, we're excited about those 14 companies. But by the time,

I think you're the high teens, by the time you're looking at your 17th or 18th best idea, you know, there is a fall off in terms of the opportunity with those businesses. Although, you know, it's outrageous to think, you're saying, okay, the 17th, you know, best risk reward idea in the entire world, you know, that should be added to the portfolio. You know, for us, it's not good enough. So, you know, they're, you know, mid-teens is probably as high as you'll ever see the number of names in our portfolio. But when you are running a concentrated portfolio like us, as you pointed out, margin of safety or controlling downside risk or your win-loss ratio is exceedingly important. If you invest in companies that could go down 90% in value, you can't run a concentrated portfolio with that lack of predictability. So I think very few managers run concentrated portfolios because they're unable to underwrite the level of predictability that you need to see in order to have such a small number of names.

Coming back to your research process, when you're working through these different phases of getting to know a company and following it, what makes you say no that you stop work at a certain point or you, you, you, put it on the shelf too hard or work on it later. What are factors if you think about your research process you've gone through that made you say, this is too hard pile or work on it later pile? Sure. Yeah. I mean, as Warren Buffett says, there's many, many pitches that you can swing at. And I think as an investor, we've never had a dearth of opportunity across any market

cycle. And so it really, you know, you have to go with the mentality that even if you've spent months and months intensely researching a company, the ability to walk away or to wait to get more data. But you never have to swing at a at a pitch. And there's there's always more opportunities in the future. And so if you feel like guilty about, you know, wasted work or you feel guilty that, you know, about missing the opportunity because all of your friends are jumping in or, you know, those sorts of, that type of thinking is very dangerous. So we are perfectly happy putting something on the side burner. If, you know, we have some concerns or if it's not easy.

All of the great investments that we've made throughout our funds history have been really easy. I mean, there's a certain happiness that comes from making that buy, you know, pressing that buy button when you're buying into an amazing, amazing business at a good price. The other thing that we often think about is if you're worried about what the next earnings release is going to be because of lack of predictability, then that's probably not a company that you should be owning. So, you know, if you own a beverage company, you know, people pay attention to the Nielsen volume growth and market share reports. And, you know, if you're really worried about those sorts of numbers, then you're really not thinking about as a long-term investment. And that

company doesn't have the level of predictability that you probably should, should, you know, should require. Fortunately for us, very few people think the way we, we do. You know, tens of thousands of the other active investors in the world don't think like us and that's what makes a market and that's what gives us opportunity. For the end of our interview, I want to come back to your hands and the sell button. What are reasons that drive your hands to the sell button and then really let it click to sell a certain security? Hey, tell money here. I'm sure you're curious about the answer to this question.

But this answer is exclusive to the members of my community, Good Investing Plus. Good Investing Plus is a place where we help each other to get better as investor day by day. If you are an ambitious, long-term-oriented investor that likes to share, please apply for Good Investing Plus. Just go to Good minusinvesting.net slash plus. You can also find this link into show notes. I'm waiting for your application. And without further ado, let's go back to the conversation. For the end of our interview, is there anything you would like to add any talking point that's important to you or any message you want to send?

No, I mean, I think this conversation is timely. And we can only look back at 2008 and 2009 and what an opportunity that was to change people's lives, whether you're a pension fund and you have pensioners lives that you're thinking about or or if you're family, for your kids, your grandkids, today is an opportunity that rarely arises in the marketplace. And, you know, speculation is just not an effective way to grow wealth. And so a lot of the media, a lot of the investors have been focused on the wrong things with the last couple of years. And this is a phenomenal time to readjust that thinking and put money to work.

So we are, we're playing offense right now. when others are fearful, and people should not get caught up in where interest rates are going to be next month, what the Fed is going to do, you know, the inflation number tomorrow, you know, who the president is going to be. Those are meaningless in the long term. And so, you know, you will always have something to worry about, whether it's, you know, Greece leaving the EU or a war or an election, you have to get away from that thinking and think of yourself as an owner of a business. And if you own a private business in your hometown, you know, you wouldn't have people coming in every day in offering you quotes on your business. So it's a silly idea to look at the

price this morning and assess whether, you know, people, you know, whether that's the appropriate value for your business. Almost certainly the price this morning that's being quoted is not the right long-term discounted value of your business. So you've got to look through all of the noise and play offense and take advantage when others are fearful. So that's my message to all of the investors of the world. It can be a life-changing moment if you make the right decisions.

Thank you very much for this great closing word, so to say. and now we can get our hands again on the search for great opportunities. Thank you very much for the audience and thank you very much for coming on. Thank you. Yeah, thank you for having me. Bye-bye.

Bye. As in every video, also here is the disclaimer. You can find a link to the disclaimer below in the show notes. The disclaimer says, always do your own work. What we're doing here is no recommendation and no advice. So please always do your own work. Thank you very much.

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