Good Investing Talks - How to generate ideas? A talk with outperforming Value Investor Cliff Sosin

Episode Date: January 25, 2021

Here outperforming investor Cliff Sosin talks about his way to generate ideas and why he declines certain investment ideas.

Hello Cliff, welcome to our YouTube channel. It's nice to meet you here in Westport, Connecticut, on our way to Omaha. Who are you? My name is Cliff Sosen. I'm the founder and manager of the CAS Investment Partners. Since when have you launched your investment partnership? I launched CIS Investment Partners in... I started putting it together in July of 2012, but we actually...

started operating on October 9th of 2012. That's nice. What did you do before that, before your own partnership? Prior to that, I spent five years at UBS, where I worked in something called the Fundamental Investment Group, which was essentially an equity, long, short, investing business within the UBS Investment Bank. During that time, you say in your letters that you did develop your own philosophy, And we want to take this interview as a chance

to do a deep dive in this philosophy. My idea is to start with the process, like from idea generation to buy or sell. So my first question is, where do you get your ideas from? You know, it's funny. I think there's a desire amongst people to have a simply explained regimented process that feels like turning a crank

results in good stock ideas that make a lot of money. My impression is that the way it really works is far more organic than that, especially at sort of the top of the funnel. So the way that I start thinking about a particular idea is essentially random. Organic is a nice word, random is true. As I develop an idea, as I look at MD initially,

what I'm trying to do is draw from, sort of a set, my understanding of the world, which is really you could think of as a set of mental models that explain parts of the world, and apply it to that particular circumstance and see how well it fits. And if it fits well, you start to develop a working hypothesis about something. And so where I'm describing is maybe a process where you start almost randomly at the top of the funnel, and then you become more regimented as you try to apply these mental models. And then you work your way down into, once you have a hypothesis, it really becomes more process of attempting to invalid. your hypothesis, you know, analogous to the scientific method or whatnot. And so that would be a process where you think of, you think you understand the dynamics that are at play

that allow a company to succeed. And then you're thinking about what you should be able to observe in the world, in the ecosystem. That would be consistent with that hypothesis. And you then go into the world or ecosystem. You do diligence and you try to figure out whether or not what you're seeing is actually consistent or inconsistent with your hypothesis. And if it's inconsistent, then you at very least need to change your hypothesis or throw it out all together. If it's consistent, then you aren't sure you're right, but you're incrementally more confident in being right. And if you can develop a theory for why a company is successful based on mental models that are well-founded and unlike and make reasonably reliable, and then you can make a lot of predictions based on that, you start to develop a pretty reasonable chance at correctly.

forecasting the future of a business within a narrow enough margin that you can then make a good bet and so then the last piece really is that you sort of compare what you think might happen based on your understanding with what's implied by the price or what you need to have happen to be have an investment be profitable and that's it I mean it's it sounds so simple but but that's that's just that's what we do but there's the first step we get to her certain name maybe. Yeah, I mean, that's, that's totally random. You know, I, you know, I, you know, I, I've, I have invested in all manner of situations. I've, I've run screens. I wouldn't say running screens

produces any particular better ideas or worse ideas. I've, you know, ended up looking at things for one reason or another and then passing on them and coming back to them years later. I've had ideas that smart friends found and recommended it. The, you know, you know, you know, You know, the key on sort of the ideas front, I mean, I don't have a way to understand whether an idea is a good investment prior to understanding it to any important degree. So in terms of what to look at next, the process is essentially random. There are a few things that I like. You know, we're looking for very few, very extraordinary investments, right?

So you tend not to get very extraordinary investments in situations where, in sort of normal times, in situations where the company. looks like a lot of other companies. You're unlikely, the sunset can't happen. It's just less likely. So a unique business is probably going to be more interesting to me than a not unique business, just another bank versus something else.

But businesses can be unique in subtle ways. I mean, just another bank might seem like just another bank, but it may have some attributes that are actually quite unique. So anyway, something unique is a helpful first step. But really, I would say what really happens is I start looking at it and I start to make progress in that as I start to understand what the business is doing, what the people, you know, what management says and when they describe the business in public or whatever, or the public materials, it starts to indicate to me various mental models that I can apply to the situation. I start to think that, oh, that makes sense. Maybe what's happening is this. I've seen something like this before. And that's where you start to. decide that something might be interesting. Can you maybe name some examples for this mental models? Yeah, well sure.

You mean the mental models or the application. You mean the mental models. Both is fine. Yeah, well, I mean, you know, a simple one that I'll give you kind of two, right? And they're both related to Carvana, which I think we'll talk about later. But, you know, a simple one is that one thing that's really important for Carvana over time. time and that it benefits from is just economy, what I call economies of trust. And this is something everyone sort of knows, but the idea being that if you can become

a trusted counterpart in a system, there's just an enormous amount of value that's unlocked for everybody. And Carvana, they're competing with car dealerships that are, by and large, not trusted. And they are earning people's trust in this industry. And that produces two big benefits. The first is it makes it easier people to do business with you, so they do more business with you. And the other is it's a huge competitive advantage because people, why would anyone do business

with someone they don't trust when they can do business with someone they do trust? And it takes, it's very hard to duplicate because trust is earned over a long period of time. And so, you know, that would be a simple one. A more nuanced, complicated, mathematical one, you know, is that if you look at industries where people sell different goods, you know. goods, and there's a small number of competitors. There's some game theory that describes how the competitors will price those goods. And what I'm referring to here is what would be called in microeconomics, a single-stage

hoteling game. So here, I mean, the classic example of a hoteling game is you have two ice cream vendors on a boardwalk, and people pick ice cream vendors. you know based on the price that they charge and the question is what price should an ice cream vendor charge given where the other ice cream vendor is and it turns out that you know there's you don't actually just charge in a perfectly competitive market you would just charge marginal cost there'd be no profits but if you imagine two vendors one at 33 the other at 66 on a hundred you know unit long boardwalk

you know the vendor that's at 33 or 66 has a incentive is willing, if they both charge marginal costs, they split the market equally, but neither makes any money. So both vendors have an incentive to raise their price somewhat, and they'll give up some market share if the other guy doesn't raise price, but they'll make more on the market share they get. And so they'll make more money doing that, independent of the other person's decision. And since they both actually make that decision at the same time, what happens is they both raise price a bit, and they actually sort of redivide the market share more evenly, and then you keep doing this. And you end up getting to an equilibrium,

where there are economic profits, you know, for the competitors. That's the single-stage game. And you see that all over the place. That's geographic space, but if you think about brand space, you have two types of pizza that are different, that have different preferences. Or in the case of used cars, I have a unique used car. It happens to be a particular color and style and trim and everything else.

And you have a unique used car, but they're different. And there are different, there are consumers who would be willing, at the same price, who would prefer mine over yours. As I change, increase the price differential between the two, there's an elasticity of demand effect. But that means you're playing a hoteling game. By the way, the multi-stage hoteling game is if you could locate your ice cream vendor,

where would you put it? And the funny outcome there is that both of them end up putting it right in the middle, and they make no money. So that's why if you're Ford, you make a car that's just like Toyota, and you try to make them as similar as possible. So the second mental model, though, in the case that I'm pointing out, is that you also applicable to carbana, because it deals with the possibility that there is a competitor.

Right now, I think there's a reasonable chance there won't be a big viable competitor. But if there is, they're not, even if they're competing in a non-cooperative way, the non-cooperative equilibrium should be one where both of them make a lot of money per unit. And it's a very big market. And so that's why, that's another good reason

that I like the business. So two very different mental models, right? One really drawn that you would sort of, you could find in like a microeconomics textbook that has like math and like we could keep going. Another that's, you know, squishier that you would read about in like a Buffett letter or something where it's like, look,

if people trust each other, a lot of good things happen and being part of a nexus of trust or better you're controlling a nexus of trust is really valuable. And, you know, that isn't, I don't think you find that, you know, that often in microeconomics seminars. But it's, they're both true.

So I try to draw them all and then apply them to these situations, understand it. What makes you pass an idea? You said it before that you sometimes pass to an idea and come back years later. Well, I mean, there's lots of reasons that I pass on a year. You know, the most common reason is that it's a reasonably comprehensible business and it's priced about right. You know, the world's competitive and that obviously happens most of the time. Another reason is that I either don't have the mental models to make good predictions about the business over time,

or I do, and those predictions are that, it's actually very hard to predict. So I think of fashion as sort of intrinsically unstable, because when people, it's not necessarily always the case, but you can think about there are certain elements of fashion where it is important to me to wear something different. People buy fashionable items to signal that they have money and taste.

And it's the taste element that's complicated. It complicates things because it quite, it can be, It can be the case that buying something different than everybody else shows that you have taste. And in that sense, the thing that used to be a way to signal having taste can actually become a way of signaling that you don't have taste anymore because you're not buying the new thing. And this isn't clearly true in every fashion category, and I don't actually know all the answers there, but it's one of those things where you can look at businesses where there's

a lot of trend risk. And I find them to be fairly difficult to predict. And maybe I just don't have the tools. Maybe there's someone else has a mental model to understand it and I don't have it. Or maybe it can be developed. Or maybe it's one of these things, you know, think about quantum mechanics. There are some things that are just not knowable. And so, you know, that's one.

There's a book I read that described an experiment someone did, which I thought was great. It was before the days of downloading music. And these researchers, what they did was they got a hundred unique pieces of music by artists. And they then got teenagers, and they created a website. This is a novel at the time. They created a website. And they allowed the teenagers to download the music and listen to the website and also

to comment on the website about the music and to rank the music. And they then had the teenagers, you know, engage in this. And what happened over time was there was a ranking of popularity of the music in terms of frequency of download and review and whatever else. What they didn't tell the teenagers was that they actually divided them into a separate, distinct sets of worlds. So you would be originally randomly assigned to one world or the other or the other, the other, and they all started with the exact same set of music.

But what happened was, as those worlds evolved, the music that rose to the top and the music that fell to the bottom became, were actually totally different. And there was a very weak correlation. Like if you were the best in one universe, so to speak, you were probably slightly higher ranked on average in the other universes, but it was a very weak effect. And the dominant effect was chance. And so if you think about how certain works of art have become, why the Mona Lisa is the Mona Lisa and other works of art are, you know, just works of art, there is it probably

a meaningful kind of self-reinforcing chance-based phenomenon that's happening. And my point on that is that there are just some things that are intrinsically unpredictable. And so sometimes you either know something's intrinsic and predictable or you just don't know how to think about it and, or frankly, it's just priced about right. You already mentioned two criteria like you like on businesses like predictability. and price? What are other criteria that make you like a business? Ha! You know, I mean, I'm looking for businesses that are going to do very well over a very long time

that I can get at a price that doesn't reflect that that are run by sensible people. You know, I... Yeah, I don't think there's anything more to it than that. Predictability is an interesting term, you know... It depends on what you mean by predictability, right? The ability to predict the performance of a business every day, every week, every month, every year can be nice, it can simplify your life if you're analyzing a company. But there are plenty of businesses that can be great businesses that maybe are predictable

over, on average, over 10 years, but maybe not predictable every day. maybe they serve a volatile end market. And, you know, think of someone who's trying to value like a company that sells parts into the new car space. It may very well be that like you, for some reason, technological, manufacturing scale, whatever it is, are very likely to make, you know, $10 a car, you know, no matter what, for as long as cars exist. But every year the number of cars made might vary substantially. So it might be very hard to predict how much money they can make every year, but a sensible guess that the number of cars made over the next 10 years is easy enough to do. And so, you know, the predictability, I don't

know, you can take predictability too far, but predictable, but what would be key there would be the predictability of the $10 per car, right? That would be the bit that you'd be focused on. So it depends on what you're trying to think about. You mentioned the sensible people. Uh-huh. Like, what importance does management play for you? This has been an area I've evolved a lot over time. When I started, I probably would have told you, look, I generally tend to screen for crooks. But my general sense is that management's on average, roughly average, and I can find good businesses at cheap prices, and with average management, you know, it'll be fine.

Over time, I have started to develop some real perspective on that. It'll be interesting to see whether or not this is right. But in general, there's a lot of ways to think about this, but the way I've tried to put it is I want management teams who provide well-reasoned and sensible business answers to business questions. And what does it mean? Why did you decide to invest in this market versus this market? Why did you decide to buy this supplier?

Why did you do, ask why they made their decisions? And then listen to the answers. And if the why is a reason that makes a lot of sense from the perspective of someone who is going to own this business for 100 years and is trying to make it maximize its profits, then it's well reasoned and they're thinking from kind of the right principles, then And that's probably indicative of someone making good decisions running the company. If the why is sort of poorly thought out or not thought out or driven by factors that aren't consistent with what you want, then, you know, that's a problem.

Like, why? Well, I thought shareholders would value a higher, growth, lower cap-x company. Like, really? That's a terrible reason. You know, or, you know, whereas, and it's important to not judge by outcome, right? So why did you make that terrible decision that ripped up a lot of money? Well, you know, here was how I was thinking about it. Here was what I thought was a reasonable set of outcomes.

Here's why I thought these were going to be the better outcomes. And then we did it and we learned this and it was a disaster. You know, that can be a great answer and that can be indicative of a great management team. So I'd say that's one piece, well-reasoned, sensible to business decisions, you know, and it's also kind of a measure of intelligence. I mean, they're not, if they're just making dumb decisions, right, that'll come through. And then, you know, there's an element, I think, you know, management teams are a product of the culture they're brought up and, or brought to or whatever.

They're not totally, it's not as though someone sits on top of the company and, like, makes the company what it is. It's much more organic than that. Companies are sort of living things with a lot of relationships between people. Companies shape, management, management-shaped company. That's right. There's a relationship between them, that's right. And, you know, for a couple of observations that, one, the right management depends on the situation.

All companies, if you think about companies as little societies, they all have different norms and values and expectations. And, you know, the way you signal importance and relevance at Google versus the way you signal importance and relevance at Procter & Gamble is probably very different. And so the types of people and the behaviors are going to undertake in order to be successful vary a lot. And so the type of leadership that they're going to want and need will, what will be able to undertake? will vary a lot. But in general, I think you can try to sort of just ask yourself simply whether or not you want to work for this person and whether this person would inspire you to do your best. And whether you get a sense that people there, the term I've sort of come around to is you want to invest in firms where the people feel energized.

You know, I think energized is like when you look at organizations that really accomplish a lot. lot. If you look at Apple under jobs or Pixar during its heyday or, you know, the Apollo moon landing or whatever, you know, the word that comes to mind is energized. And so if you can create a place where people feel energized, and you won't get that talking to the management team so much. You'll have to, first of all, you can almost just feel it. If you walk into the office, you can almost just feel it. But then you can talk to former employees or talk to, you know, current employees. And you'll just get a sense that people are really excited to be a part of this team and anxious to help each other and equally importantly anxious to ask

for help. On the asking for help thing, it's totally unintuitive that, you know, there was a great... What you want in an organization is a great deal of free-wheeling intermingling of ideas. If you want them to be kind of creative and productive and whatnot. free-willing and intermingling of ideas and of information. And in order to achieve that, people need to trust each other. They need to be able to look foolish. They need to be able to just generally, they need to ask for help when they need it.

They need to offer help, you know, when it's asked for. And they need to do that necessarily reciprocity. So like it can't be that Bob helps, you know, Janet and Janet helps Bob. to be that Bob helps anybody and Janet helps anybody and help, and so you get more transmission of help through the system. One way to think about it is that, you know, reciproc, like there's a, in the economy we solve the transaction for goods and services with money, right? But in an organization, you can't transact for like, will you come help me with my Excel project for, you know, I'll pay $3. And so what you do instead, but so people transact, the

The problem is that you're kind of left at barter if people, if you don't have a culture where people just help everybody, you're left at barter, so you get a whole lot less transactions. And so you can make the economy, so to speak, much better if you can add, infuse it with a sense where people just sort of are, there's no us and, no I and team, and I'm here to help, and like, anyone who needs help. And the hardest part about that in some sense is people asking for help, because you need to look vulnerable and stupid, like, I don't know, I didn't understand what we were

talking about, like, can you explain this to me? There's this reading on this dial that makes no sense to me, like, I've never seen it there before, like, but I forget, like, can you help me? If you do things like that, then, like, you know, good things happen. And one of the, there's two pieces that things I read that really inspired my thinking along these lines, but give and take by Adam Grant is a book kind of about this. I'm actually reading a book now called The Rainforest, which is sort of describing, using those same ways of thinking to describe why Silicon Valley is so productive. And then also there's a great Harvard business case about Shell, I think it was Shell,

one of the big energy companies, and how they basically had all these really tough, roughnecks engage in trust-building exercises. And what they found was that by doing that, they radically reduced the frequency of accidents. And the theory that they had was that it was this idea that, you know, if people feel that they can be more vulnerable, they're more likely to ask for help. when they ask for help. Information, like, I don't know what that dial means, but it seems to be at a level I haven't seen before, that information transmits to the organization and kind of gets

a response versus someone instead of saying, oh, gosh, that's a problem, I need to prove everyone I'm smart, let me go down to my room and like read the manual, which could, you know, lead to the whole thing blowing up. So long answer, but you want an organization that, you know, where the people, the organization itself seems to have the right norms and values, seems to be energized, seems to be a place where people are collaborating well, where everyone's kind of pulling, you know, well-aligned. And then the leadership needs to kind of be the sort of people who foster that. Not domineering, you know, someone you'd want to work for.

I mean, a simple test is, would you want to work for that person? Would that person inspire the best out of you? And if the answer is no, you know, then you just to factor that into your range of expected outcomes. Thank you very much for the first part of our interview. We continue the discussion in the second part. Excellent.