Invest Like the Best with Patrick O'Shaughnessy - Dan Rasmussen - Private Equity Returns in Public Markets - [Invest Like the Best, EP.78]

Episode Date: February 27, 2018

It has been a while since we discussed private equity on the show, so I was excited for this week’s conversation. My guest is Dan Rasmussen, the founder of Verdad advisers. Dan worked in private equity and has spent years studying the entire field. Dan identified several key drivers of private equity’s outsized returns: size, value, and leverage. His firm uses these factors as a starting point to build a portfolio of public equities that behave like their private brethren. We cover a ton of ground, discussing the prospective returns for equities, forecasting, and tons of investing strategies. Please enjoy this conversation with Dan Rasmussen.   For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag   Links Referenced Subscribe to Dan The Gospel According to Michael Porter Tobias Carlisle Steven Pinker E.O. Wilson   Books Referenced What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time Quantitative Value, + Web Site: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors Expert Political Judgment: How Good Is It? How Can We Know? Superforecasting: The Art and Science of Prediction   Show Notes 2:03 – (First Question) – The current state of private equity investing        4:09 – The three myths of private equity  6:51 – Taking a deeper dive into the myth of growth through operational improvements 9:29 – What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time  11:25 – Valuations for private market investment and where they’re going  14:03 – Private equity companies that have a higher chance of delivering results that exceed expectation  16:39 – Other observations on the private equity space that would be interesting to investors considering the asset class  19:33 – Importance of being very purposeful in picking your reference classes 19:42 – Subscribe to Dan  22:03 – How do the lessons Dan has learned in private equity translate to his investment strategies  25:21 – How do you apply purely technical, systematic thinking into public market investing  29:23 – Analyzing leveraged stocks and the value they could create  30:06 – How Dan thinks about the direction of debt vs just the level  33:11 – Predicting a firms ability to deleverage  35:20 – How Dan’s company whittle down a company and are able to see value beyond their quantitative screens  41:29 – How does Dan think about the global vs US opportunity set  44:22 – What originally drew Dan to the Japan market  47:03 – How do rising rates impact Dan’s strategy in investing in highly leveraged companies 55:03 – Porter’s five forces 55:25 - The Gospel According to Michael Porter 1:00:51 – How Dan thinks about competitive advantage 1:04:41 – Exploring Dan’s personal process in pursuit of his ideal strategy 1:05:19 – Quantitative Value, + Web Site: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors 1:05:20 – Tobias Carlisle 1:06:27 – Steven Pinker 1:06:28 – E.O. Wilson 1:07:11 – What other markets pique Dan’s interest 1:09:39 – Why there is such a focus on small for Dan 1:11:24 – Expert Political Judgment: How Good Is It? How Can We Know? 1:11:28– Superforecasting: The Art and Science of Prediction 1:12:54– What was it like writing the book 1:17:19 – If Dan was going to write another book today, what would it be about 1:19:08– Kindest thing anyone has done for Dan   Learn More For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

This podcast is sponsored by CFA Institute, the Global Association of Investment Professionals whose mission is to lead the investment profession by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society. CFA Institute serves a global community of investment professionals, working to build an investment industry where investors' interests come first, financial markets function at their best, and economies grow. The chartered financial analyst credential is the most respected and recognized investment management designation in the world.

The views expressed in this podcast do not necessarily represent the views of CFA Institute. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaughnessy is the CEO of O'Shaunasy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunsi asset management.

This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy asset management may maintain positions and the securities discussed in this podcast. It's been a while since we discussed private equity on the show, so I was excited for this week's conversation. My guest is Dan Rasmussen, the founder of Verdad Advisors. Dan worked in private equity, but has also spent years studying the entire field. Dan identified several key drivers of private equity's outsized returns, size, value, and leverage. His firm uses these factors as a starting point to build a portfolio of public equities that behave like their private brethren.

We cover a ton of ground, discussing the prospective returns for all equities, forecasting, and tons of different investment strategies. Please enjoy this wide-ranging conversation with Dan Rasmussen. Private equity is a really fascinating. world, and I think it's an asset class that very few people understand. From 1980 till 2010, it was probably the best place you could possibly invest. Returns, you know, net of fees for about 6% in access to the public market. And private equity, you know, this is all the more remarkable because we know so much about how difficult active management is and how high fees can drag on returns.

And here you had a very complex, clearly very active, you know, they're taking control of every company and very high fee asset class dramatically outperforming. And the question is, why was that? Why did it work? And then even more interesting, perhaps, is that it hasn't worked since 2010. So if you look at the Cambridge Associates benchmarks, private equity is actually underperformed since 2010. And so the key question is, what's changed? And I think that if you look at what's changed, probably the biggest thing is that, and you see this all the time in investing, where where something that really works well and is a very good idea gets adopted by everybody, money pours in, and the returns go down. And that's what you see happening now in private equity,

where every institutional allocator believes that the ongoing forward returns of private equity are going to look like that 1980s, 90s, 2000s history. And so they're saying, well, we should have a 20% allocation to private equity, and we only have 12% today. So let's deploy a ton of capital into this asset class. And as that money has rushed in, private private equity firms have sprouted up. They've raised huge amounts of money. And they're all competing for the same limited set of opportunities. The number of businesses going up for auction has not changed. What has changed is the number of competitors in the auction. And if you think about that from sort of public equity market perspective, you know, these are tiny little businesses, you know, 15, 20, 30, 100 million of EBITDA.

And they're selling for absolutely insane prices, you know, 11, 12 times EBTA, you know, six to seven times, a net debt to EBITDA, yeah, of debt financing. And it's just a crazily competitive market. And it's almost to some extent like a gold rush, Patrick. Can you talk about the three levers, which you explore in the piece describing kind of how private equity firms profess to have earned such impressive results and why maybe those things aren't necessarily even true or at the very least maybe very different looking forward? Yeah, you know, I think the three sort of persistent myths of private equity are first that private equity makes money through operational improvements. This is actually the whole rebranding, right?

It used to be the leverage buyout industry. Now it's the private equity industry. And they're even trying to rebrand it as growth equity now, which is I find amusing. But the first myth of private equity is that private equity creates value through operational change, that you have these brilliant managers that went to Harvard Business School that can come in and turn around a business. The second myth is that private equity is lower risk and less volatile. than the public markets. And that's a myth because private equity firms mark their portfolios quarterly,

their private companies. And so they decide every quarter, you know, what is this worth? And generally, they look at it and they say, well, EBIT does up a percent or down a percent. So, you know, I guess we'll say that it's, you know, flat. It's, you know, we'll market at one. Now, Patrick, if you and I could do that with our public market portfolio, we'd say, well, nothing's changed about this business. There's no new information since we bought it. You know, there's no new catalyst. So it's, you know, it's flat. But of course, you know, that's not how markets work, markets are dramatically volatile. They go up and they go down for sometimes for a reason and sometimes like they did in early February for seemingly no reason at all. And the private markets don't

experience that because it's just based on the judgment of an accountant or the private equity firm itself. And so as a result, private equity looks less volatile. But in reality, what they're doing, which is buying small companies using a ton of debt, is actually, if it were a public market equivalent, would be much more volatile than the public markets. So there's this aspect of misunderstanding the risk. And then third and finally, I think that although every disclaimer in every fund presentation says past returns are not a predictor of future returns, everybody looks at private equity and says, in this case, past returns are a predictor of future returns because they don't necessarily have another way of thinking through, you know, what are the factors that drive returns that

would change the expected return? And because they think that the source of return is operational change, then all they need to do is find a great operational change agent, and they should get the same returns because, you know, factors in their minds purchase price or leverage levels are not the core driver of the outcomes. And so just because those things change, you know, doesn't, to them signal a change in the asset class as potential for our performance. And those are, I think, the three myths of private equity. And I'm happy to dive into each of them individually or whichever one you'd want to start with. Well, let's start with the operating one because you did some good empirical work, which obviously is in the spirit of how we try to look at things as well,

not just to theorize about what might be or could be, but what actually has been in the actual data. So talk about the data that you collected at your firm to assess whether or not this kind of operational improvement narrative was in fact true. Yeah, and before we get into this specifically, I think there's sort of this analogy, which I keep coming back to, which is that in private equity, they keep saying we make operational improvements or we do X, Y, or C, we do. We do deep diligence, right, et cetera, et cetera, et cetera. But they say that, but they never offer any evidence. They never offer any proof.

And making money in the market is so hard. Five to 10 percent of managers are creating really significant alpha and everybody else is losing to the index. And so in some sense, it's almost like someone came to and said, well, I can run an Olympic level 100 meter sprint. And you say, really, well, that's impressive. You know, what was your last time? And they said, well, you know, I don't keep track of time, but I guarantee that I can run it.

And the fact that they never offer. any evidence for their operational improvements other than anecdotes, that they never ever have any evidence that their diligence results in superior forecasts. It's as equally as absurd that someone who does not keep track of their operational improvements or who does not keep track of the accuracy of their forecasts could be doing the equivalent of an Olympic-level sprinter is absurd. But let's dive into the operational improvements. And I'm going to speak in aggregates and averages, right? This is not to say that no private equity firms add value. There are certainly ones that can and do. But again, those are the top five or 10% of firms. For the bulk of firms, it's not the case. So to test this,

what we did is we said, let's look at every private equity deal that issued public debt as part of their financing. And the advantage of the reason that we wanted to look at that was because if they issued public debt, that meant that they had to give gap financials prior to the acquisition, usually two or three years prior to the acquisition, which is what they used for the financing. and then also to report afterwards, you know, how the financials of the business did. And so we look back and we found about 390 private equity deals that issued public debt. And what we looked is, let's look at the three years pre-acquisition and the three years post-acquisition, what changes about the financials and what's statistically significant about that.

And what we observed is that revenue growth and EBITDA growth slowed. And if you think about why that would be the case, every private equity firm in their under writing is selecting for high-growth firms that they can then input into their models having high growth into the future. And of course, if you read what works on Wall Street, for example, you'll quickly see that things like growth rates are mean-reverting. And so it should be no surprise that private equity firms choose things that have grown in the past and that growth rates mean revert a post-acquisition. And second, you know, private equity talks a lot about cost-cutting, efficiency, margin improvements. We found almost no improvement in margins.

at least nothing particularly noticeable, maybe a few basis points. Now, what did change? In 70% of cases, a massive increase in debt, right? So, you know, typically from about two times debt to EBITDA to four or even five times debt to EBITDA. I mean, as a result of that, obviously, massive increase in interest payments. And then what we also observe is a decrease in capital expenditures, which makes sense. If you just took out a lot of debt, you're probably not going to want to invest in capital

expenditures. What instead you're going to do is shift that money to interest debt service and debt repayment. And so I think if you back up and say, okay, what does that tell us about the asset class? Is that in the vast majority of cases, private equity firms are buying the whole company, right? They're taking control in order to an effect of change in capital structure. That is the goal of the private equity transaction is to lever the firm up and through that leverage, enhance equity returns. I mean, everything afterwards about operational improvements. is to some extent window dressing. It's sort of like, well, if you own the firm,

surely you're going to want to talk about the things that you did what you served on the board or the wise counsel you gave to the CEO. But the idea that having a private equity manager on the board or even having the advantage of their considered judgment would somehow dramatically improve every operational metric for a company, it's just not the case, at least in aggregate. And what you see in aggregate makes a lot more sense, which is they just buy things that are growing fast,

So those growth rates slow down. They lever them up a lot and they, you know, take all the cash and use to pay down debt and service interest. I'd love to explore the price component in all of this. There's a great chart in the piece that you wrote, which compares the median EV to EBITDA multiples for both the private equity kind of pool and the S&P 500. And you see kind of going back to the late 90s, this massive discount that was available in private markets paying, you know, eight times EBDA versus 14 or 15 for public markets.

And then really kind of into the financial crisis. and then since those two lines have have converged and they basically look exactly the same. So you would think that you would get some sort of discount for the illiquidity that you're taking on as a private investor, but that doesn't really look like the case. And I think your research suggests that probably the most predictive variable, and certainly we'll talk about this in public markets too, of future performance is the price paid at the beginning when you're talking about averages. Of course, there's always outliers that, you know, you buy it an expensive price and it was

still a great buy. But on average, price matters. So maybe talk about how you think about private. market valuations, what's driving them and how important they are on the outcomes for investors. Yeah, and this is probably one of those things that's the most misunderstood about private equity from the outside and the most clearly well understood by people that actually do the transactions. And that's the importance of valuation. I would say that private equity valuations are even more important than public equity valuations. And the reason for that is that every private

equity transaction, or at least the vast majority or in aggregate, are debt financed, usually about 65% net debt to enterprise value. And so as you increase purchase price, you're increasing debt levels and you're increasing interest payments. And that has an effect, you know, if you think of free cash flow yield as being, at least theoretically, right, should be, you know, the driver of equity returns. If you increase the purchase price, you're not only decreasing the size of the denominator in that free cash flow equation, right, because you're, you're, increasing the amount you pay, you're increasing the market cap or the equity value, but you're also decreasing the numerator because you're adding interest costs. And so any increase in valuation

actually has almost an exponentially negative effect on free cash flow yield. And conversely, as you get cheap, the cheap levered equities, right? The 1980s, 1980s, LBO is done at six, seven times EBITDA. In those cases, you had the increase in leverage far outweighing the increase in interest payments. but there's essentially this exponential curve as you increase valuation. And so that's what makes private equity much more price sensitive, is that the expensive companies are at a high risk for bankruptcy, their interest payments are substantial relative to their free cash flow. And that means that you have a lot more downside in those expensive LBOs than you might in an expensive public equity that's not levered. How do you think about, as a quick aside, thinking about some of the famous private equity firms,

you mentioned a few of them in the piece. One that comes up all the time is 3G, less because of their results, which have been impressive, but more because of this sort of philosophy behind the operational improvement behind zero-cost budgeting and these really interesting theoretical ways of potentially improving a business. I'd be curious what your take is on a company like that in particular and whether you think it's possible to identify a subset of private equity firms that looking forward, because obviously that's all that really matters for people making decisions today, that looking forward might have some higher chance or higher average percentage chance of delivering on this kind of excess return over public markets through unique

operating means. Patrick, I think I'm an empiricist, right? I think that let's just take the data and look. So take every LBO that the firm is done. Look at the financials, three years pre-acquisition and three years post-acquisition. And if something jumps out at you and you say, oh, gee, in every single case, EBITDA margins double, then probably that firm is good at cost cutting. If revenue, growth is 8% for everything historically and 16% afterwards. And they say they're a growth equity firm. Then I'd say, well, gee, you seem over dozens of examples to actually achieve what you're selling me on. And so, you know, I think that's a good way to test it. And it's simple. And if you look at 3G, for example, and there are other examples of this vista equity, for example, in San Francisco,

cost cutting is something that works. Every business has fat to cut. And especially a lot of these software businesses and consumer package good software companies where the product is sort of selling itself and you don't need to service it necessarily. And those firms, if you look at pre and post acquisition for 3G's buyouts, EBITDA margins often double after their acquisition. And so I think it's pretty clear that 3G has a real skill at cost cutting that I think investors could underwrite. Now, perhaps unsurprisingly, 3G uses their own money to do the deal. So you know, you can't necessarily access those returns because they're not taking outside capital. But I think the point holds that there are firms that can operationally change businesses. And I think it's easy to just

ask for proof. And that's not an anecdote, like when was the last time you improved a company, but rather, you know, systematic across the portfolio level data. And I think for those that look at that data, you know what they'd see is the vast majority again, don't do anything. They just lever the firms up. And where firms are successful, and so far as I've seen it, the most successful strategy tends to be cost cutting. It's very hard to systematically improve growth rates. But cut in cost is, I think, a doable and achievable, systematic thing and something where you can develop a real expertise. We're going to talk a lot about a new method for forecasting that you are a subscriber to and just forecasting in general. And it's how difficult it is,

how it can be useful, how it's misused in finance. So I'm not going to ask you to make a forecast about the future of private equity. But instead, just to ask if there are any other observations of the landscape. As you look at it today, you mentioned this kind of massive amount, I think it was $700 billion or something of committed capital, meaning investors have committed capital to private equity firms that has yet to be deployed. You've got sort of this interesting recent rise in rates, so you need to think about the cost of debt financing. As you look at the landscape today, is there anything that jumps out at you that could be interesting to investors considering the asset class? Yeah, I mean, I think the biggest developments, I mean, I think you're going to

see these large institutional investors, you know, the Dubai pension funds, the Abu Tabi Investment Corps, the world, taking up, they're increasing their allocations to private equity. And so I think you're going to see massive increased flows into the asset class for years to come. And that's going to continue to drive purchase prices higher. And so I think any firm where you're seeing the aggregate or average buyout multiple for their deals north of 10 times EBITDA, you shouldn't expect those funds to return higher than the public equity markets. It's just not likely, at least in aggregate. Now, because these portfolies are so small, right, if they do 10 or 15 deals per fund, they could just have one or obviously everything's a probability distribution, right? Some of the

funds that do really expensive deals are going to work. But I think in aggregate, they're not going to. And a lot of those deals are going to end in bankruptcy or restructuring or they'll just hold them for seven or eight years or nine years before you ever get your money back. And so I think the biggest advice to investors, I think, is to say, be really, really careful because it's unlikely that those expensive investments are going to perform to the extent that you think that they are. And it's shocking to me, but the consensus among institutional investors about private equity outperformance is so firmly held. I mean, I think it's something like 50% of institutional investors believe private equity will outperform the market by 4% per year.

And I think there's maybe less than 10% who think it'll even be even. And I'm just saying, I'm not, I'm not a radical or an extremist. I'm just saying, look, you know, over 10, times EBITDA, even Cambridge associate's data suggests this underperforms the public equity market. And so my view is if they're doing deals at 11, 12 times EBITDA, which is where prices are this year, it's just not going to work. It's going to lag the public market. It's a huge fee load. You're locking up your capital for seven or eight years, maybe more. Be careful. And if you are going to allocate to private equity, allocate to the firms that are buying companies cheaply, those still exist, and allocate to firms that can actually prove to you that they can

create value across their portfolio and in aggregate, rather than just being seduced by anecdotes. One of my favorite parts of all the various stuff you sent me to read ahead of this conversation, which was great fun. Everyone should definitely subscribe to the thing you send out every week. There's some really, really great stuff in there. Was this idea that many of the most successful investors in history, sort of the Mount Rushmore type names, the names that we revere and hold that as examples all the time, maybe successful largely because of the sort of reference class or area that they chose.

was to invest in. So you mentioned, you know, Mitt Romney, his success was likely not because he was some amazing equivalent of a stock picker in the private markets, but just that he was operating in a very cheap, kind of levered, small cap, private business space. So maybe talk a little bit about that idea of where you choose to hunt, and that will be a good transition into how you've decided to invest your own money and choosing a reference class like that accordingly. So, you know, I went back and read all Mitt Romney's early letters when he was investing. And I found one from, you know, about 10 years into his career. And he said, you know, prices this year are getting more expensive.

We used to buy things at four to six times ebit, but we're having trouble finding things at those valuations, which worries us about our ability to generate alpha at higher valuations. And, you know, we're seeing some of our competitors get involved in auctions, which just seems, you know, crazy to us. And I'm paraphrasing, but you look back and say four to six times ebit, right? You were buying things at four to six times ebit? Of course that worked, you know? And I think that your idea that of reference classes is exactly right, right? It's, did Buffett succeed

because he was a genius or because he realized the value of, you know, using insurance float as a form permanent capital? Did Mitt Romney and Cravis and Roberts and all these guys? Did they succeed because they were the best stock pickers in the world? Or because they found a corner of the market that was deeply undervalued? And I think that when you then think about these reference classes of these great investors, they were finding places that were. are undervalued, where other people weren't doing this. Ah, you know, I don't know. It seems crazy to go out of the public equity market and buy small private companies with

debt. I don't know. That sounds really risky to me. Or, gee, putting insurance money into common equity, I don't know. That's, you know, that sounds really, really risky. And I think, you know, I think it's Peter Thiel who says that good ideas are sort of the intersection of something that could be a good idea, but sounds like a bad idea. So it scares enough other people away.

I mean, I think anything where there's consensus is unlikely to provide a good investment opportunities are almost always found in non-consensus contrarian places. So if reference class is critically important, talk about what then you've done with the lessons that you've learned from your experience personally in private equity, studying the business. How does that then translate into what you do on the investment side? Yeah. So I think ultimately investing is about making good forecasts. And I think too many investors subscribe to this sort of clinical or expert-based judgment that

Right? If I know a lot about something, I should be able to make good forecasts. And there's a huge amount of academic literature, which you know well, that really started with Paul Meal and Daniel Kahneman and Philip Tetlock at Wharton has really run with this. But figuring out, and Tetlock does this amazing study where he surveys thousands of experts for, I think, a 10-year period. They do some 30,000 forecasts. And he finds that expertise in a given field does not improve forecast accuracy. All it does is increase your confidence in the accuracy of your forecast. And if you think about investing, right, there's nothing more dangerous than increasing your confidence without increasing your accuracy, right?

I mean, that's a massive calibration error. And so the fact that the vast majority of fundamental investors are using discounted cash flow models and they're trying to understand these asset classes, start to understand these individual investment opportunities by studying them in great depth. It's just not going to work, right? it's not the right way to make forecasts. And what Tetlock and Kahneman found is you have to use base rates. And a base rate is saying, you know, the classic example they use is sort of Jenny is studied

English literature at Amherst and she wears glasses and she loves to read Trollope's novels. Is it more likely that Jenny is a nurse or a librarian? And most of the expert clinical, everything is telling you, well, she must be a librarian because they're all these signals that, you know, she likes reading. she wears glasses. She must be a librarian. But actually, nurses are, I think there are, you know, 999 nurses for every one librarian. And so, of course, the answer should be nurse. She's much more likely to be a nurse. And that's a base rate, right? You just say, what is the probability distribution of outcomes given a certain, of historical probabilities, essentially? And so if you wanted to

say, well, how are these buyouts going to perform? You'd say, well, what are the statistically significant predictors of a buyout? It's performing. You might say, okay, size, value, leverage, maybe what industry it's in. Who knows? I think probably the first three would be the ones that I would pick, size value and leverage. And then you might say, okay, well, how did comparable private equity deals done at a similar size, a similar value, a similar level of leverage perform? And I think if you look, you'd say, well, the deal's done it less than seven times

evita do really, really well. You know, you look at the vintage years that were done at those valuations. They dramatically outperform the public equity market. and they were small, cheap, highly levered, right, that worked. But if you look at the vintage years or the individual deals, done it greater than 10 times Ibetah, they don't appear to put the market. And so, you know, you should use that reference class judgment rather than saying, well, you know, Seth has been doing private equity for 30 years and look at his track record.

And Seth thinks this company is a really good investment today. I mean, he wants me to give him money to do the deal. That's a way of thinking. It's just not a way of thinking that's going to lead to accurate forecasts. I always love that Bezos idea of Amazon betting on things that won't change, meaning they're not trying to forecast technological change. All they know is that the customer is going to want certain things in 10 years just the same as they do today. And I always try to think about that in terms of investing. Like, what am I pretty confident will not change?

And everything you just said really makes me think of a couple of things. One is this, we just so crave a narrative, agency, the fact that there are people that are more or less skilled than others. and somehow we can find them. It just feels to me like that is something that is never going to change and therefore might represent a persistent advantage for us quantitative, more systematic, base rate-driven forecasters, I guess you could say. I'm curious then how you take that philosophy, assuming you agree, and translate it into a live investment strategy in public markets.

Probably one of my most formative experiences was I spent a summer at Bridgewater Associates and you don't need to spend long at Bridgewater to get infected with their way of thinking. and Ray Dalio's influence, and it really shaped a lot of how I approach investing today. And Ray's approach investing. He said, first, come up with the logical principle. It's something that makes sense. It's simple. Second, since most good ideas don't work, test that logical, simple principle across as much, you know, as many market cycles, as many regions or geographies, as long as the time period as possible, and see whether your logical intuition matches the empirical evidence.

And then third, if both of those two things work, try it out in live trading. and see if it works out-of-sample, you know, the great out-of-sample market, which is the future. And I think that's how I approach investing. And so I think my logic is very simple, which is that private equity dramatically outperform the market from 1980 to 2010. The way they did that, if you look quantitatively, what they did is they bought companies at less than seven times evita. They levered them up 65 percent.

And they generally bought small companies, that $200 million of market cap. And so my logic was simple is that buying small, cheap, highly levered, companies should be a good investment strategy based on the historical evidence from private equity. And I think if you think logically, again, what small, cheap and really what cheap and levered together do is jack up free cash flow yields. And so if you're buying something at six, seven times, even to about 50, 60 percent leverage, your free cash flow yield should be around 20 percent. So it should be unsurprising to you if you buy things to the 20 percent yield that they return 20 percent. And so that's sort of the logic. And I think the empirical evidence is to go and test that.

broadly does buying small, cheap, highly levered things work across markets, across geographies, across market cycles, to which the answer is broadly, yes. And then finally, third is to do it in live testing, right, to bet your money where your mouth is, to bet on the results being right, which would I do on a day-to-day basis. And I think the biggest lesson I've had since starting my fund, instance, doing this in live trading is to say, is to almost think like blue team, red team, right? If blue team is buy cheap, highly levered things with really big free cash flow yields, your red team is, but gee, these things are levered and they might be cheap for a reason. And so you've got to do everything you can to ensure that you're not buying things that are going to go bankrupt.

And you're not buying that sub-subsegment of firms that are cheap because they're really having deteriorating operating performance. And so I think of my process is basically a balance between the red team and the blue team. And I think the red team is relatively simple, right, small, cheap, highly levered thing. On the blue team side, I think there's some key quantitative rules that you can use to helpfully, eliminate bankruptcy risk, or not eliminate, but reduce. You know, you can eliminate all firms that have a C credit rating. You can eliminate all firms that have really high short interest. You can eliminate firms that score low on the relevant Petroski F score factors. You can use all the sort of literature from, you know, the quality literature from that, you know, that you've put out,

that Petrosky has put out, that Cliff Asniss has put out, you know, take all those quality factors. And those are going to be doubly important to some extent in levered equity. is because bankruptcy is always a possibility if you have debt. So the small and the value pieces of the kind of three-part beginning point that you've laid out here are obviously very familiar to quantitative investors around the globe that many of whom have found, we would question maybe the small one a little bit, but certainly the value one is pretty impossible to argue with. What really stands out in is unique is this notion of higher leverage.

And so I'd love to dive into the thinking there, how you have found in the empirical evidence, the difference between, let's just say, the reference class of all cheap small stocks versus small cheap and levered stocks? Like what sort of the differences in returns or risk-adjusted returns you observe there? And then talk about how you then dive into these companies, as you mentioned, to alleviate concerns around bankruptcy risk and the like. So if you compare small cheap levered firms to small cheap firms that are unlevered, if you look on sort of a EV to EBITDA basis, the levered ones will outperform than with higher volatility. But if you look on a free cash flow yield basis, roughly, they're going to have a similar profile. What leverage does is it just jacks up free cash flow

so if you buy something for 10 times cash flow, if you're unlevered, you know, you have a 10% cash flow yield. Well, if you lever that thing up 50%, now you have something that has 20% minus whatever the interest costs are. So, but let's say roughly 20% free cash flow yield. And so a 20% free cash flow yield firm is comparable to another 20% free cash flow yield firm, but leverage is just one way to increase the free cash flow yield to equity. And so I think broadly, that's how I would say they compare, is that by using leverage, you can create a broader sample of high free cash flow yield opportunities. And I think, you know, secondarily, I think in a time, I think there are so many people chasing small value that at least over the past few years, small value, and hasn't seemed

to work as much. But I think the advantage of investing in levered firms, which has worked over the past few years, is that leverage creates its own catalyst, because as you repay the debt, the firm gets less levered and thus more attractive to a broader selection of investors who like cheap firms, but not cheap levered firms. And I think if you think about most value investors say, never touch a levered firm, don't invest in levered firms, right? Fortress balance sheet, et cetera, et cetera. there is an opportunity in the levered universe to go to a place where other people dismiss the entire cross-section of equities without seeing that for some portion of those equities, the returns are actually extremely attractive. And the returns are going to come from the de-leveraging process.

One of the things that we found in the empirical work that we've done is that it's not just the level of the leverage, but the direction as well. And that if anything, maybe a Goldilocks scenario would be something that is a company that is relative to its, say, industry or sector peers, paying down debt to get closer to sort of like the standpoint of the distribution of capital structures within that space. So how do you think about the direction versus just the raw level of debt? That's exactly right, Patrick. It's the most important thing you have to know about investing in levered equities is that it's the direction of leverage. You've got to be de-levering. And that's also, you know, free cash flow yield. That's how I calculate free cash flow. It's how much debt

did they pay off in the last year? Let's divide that by a market cap. And what I'm looking at, you can call that almost de-leveraging yield. I mean, if you buy these high de-leveraging yield companies, you get a bonus because you don't just get the yield like you would with a dividend, but as they pay off that debt and they get closer to the median leverage for that industry or for that subset of companies, you know, you get multiple expansion because a lot more people grow comfortable with the firm. And so understanding the dynamics of debt pay down and what causes a company to pay down debt. Why do some companies pay down debt and others don't? That is to some extent the key, I think, to unlocking value among leveraged companies. Is that something that you actively try to predict?

So one way to do it is just to look at the recent past and say, you know, firm XYZ has had a recent trend of consistently paying down debt. And so we think that's going to be a predictor of a propensity to continue to pay down debt. Or is it more complicated and nuanced than that? To go back to forecasting, I think that investors have to multiply importance by no ability. So something like, how fast is the company going to grow over the next five years? Very important to your outcome. How knowable is it? According to most academic literature, not knowable at all.

A company that has grown above the median for the past three years has about a 50% chance of growing above the median next year. It's just pure chance. Now, de-leveraging is not only very important because if you can pay down debt, obviously, it's going to accrue to equity, but it's also knowable. So if you just said, let's look at all. firms that paid down debt last year, what percent of them will pay down debt next year? The answer is 60 percent. That's a lot better than 50 percent. I mean, that's a great number.

So it is a very persistent phenomenon. So just looking at firms that have paid down debt in the past gets you a long ways towards predicting next year. Now, we actually use just a simple Bayesian boosted tree algorithm where we took all the U.S. data back to 64 and said all the statistically significant factors that you would look at, or I would look at, right, asset turnover, net debt to enterprise value, market cap, price momentum, et cetera, plug that into a machine learning algorithm and said, hey, show us whether you can improve on that 60% accuracy rate. And we see in our tests, and we've done this out of sample, and we've also

done it in live trading, we can hit probably about 70% accuracy by going more complex than just looking at historical debt paydown. There are other predictors that help shade that, you know, how much absolute debt, for example, firms that have had sharp drops and share price tend to be more likely to repay debt, et cetera. I think about the process that you've laid out very transparently in the work that you've put out there as kind of a couple simple stages. One of them is just the window. Obviously, you needed to arrive at these variables that you felt were important.

We've talked about those. You use those variables to get to sort of a small subset of global equities that seem to exhibit these characteristics that mimic sort of what used to make private equity so successful. But then from that point, you are winnowing the portfolio down more. And one of the things that I thought was most interesting was this grid that you showed, basically explaining how often you and your team have added value on top of just the purely quantitative screen. So talk a little bit more about how you do that, how you're diving into these companies, how you think about forecasting within there, and whether or not you've added any value through that additional layer.

And this is something we track really closely because after we do all of our process, our quantitative process, we don't just take the top 40 ranked things from our quantitative work and invest in them equal weighted. We actually go and say, okay, let's go, I know that all the quantitative work we've done says this is a good opportunity. Let's just go read the financial statements. Let's check it over. Let's make sure we understand it. Let's read some of the earnings called transcripts and see if there are any red flags that would really change our perspectives on this business in a big way relative to what we know about the company from our quantitative work. And then second, I think in addition, we're also saying we don't necessarily want to equal weight everything

because in deep value, you know, I think that you really want to average in and average out. You want to move slowly because oftentimes big price movements, which drive valuations are also signals of future fundamentals. And so if you see a stock that's dropped 50 percent, most likely next quarter's earnings are not going to be too hot. And so you really want to wait a quarter or two quarters or even three quarters to get a full position in to make sure that you're not buying, on sort of a bad signal, which is, you know, LTM financials relative to market cap today. And so I think between those two things, we then track, you know, if we just had bought the top 40 equal weighted, would we have done better? And our hypothesis is, you know, we're going to try

to do better than the top 40 equal weighted through those two methodologies. But I think a lot of evidence from Paul Meal, from others, suggests that it's really hard to add value relative to a simple algorithm. And so are we able to do that or not? And we've been tracking it for the past three years. And we found that, you know, about 70% of the time, we're right. We can add value relative to our simple screen. And I think part of that is the waiting and timing and how we buy and sell things. And I think another component is just, I think, pairing a fundamental logic, right? We know what we're looking for. We're looking for small, cheap, highly levered firms going to pay down debt and that are not falling off a cliff or going to go bankrupt next quarter.

And actually, when you look at some of the things that score most highly, right, the smallest, cheapest, most highly levered businesses, if you looked at the global, our global screen today, you know, the number one thing would be a small cap Canadian mining company that trades at 1.2 times EBITDA. And it does not take long to dig into that thing to find out that you do not want to touch it with a 10-foot pole for about half a dozen reasons. And so I largely think of what we're doing is sort of sanity checking the quantitative work. And it's more algorithmic in some sense than it is.

We're certainly not doing DCF models or other crazy stuff like that. We're sort of saying, well, we met with the management team and we looked in his eyes and we saw a hunger for making money that we just knew we had to back him. You know, some of the other stuff that seems insane, but a large number of fundamental investors actually think works for some reason. With respect to the Canadian mining example, I think it's funny and interesting that you have been able to add value. I used to go through this exercise where for new names that would come into our screens,

I'd go read, you know, as much time as I could allocate, which often probably wasn't enough for this to be a super serious exercise. But I would read the, you know, historical 10Ks for companies and try to just give like a for fun, subjective guess as to whether or not this company was going to be one of our better performers. And I was virtually always wrong. And I think it says something about the, that was largely based on my read of the 10K and sort of the language, et cetera. and that this value factor is so often predicated on like the pessimistic outlook being wrong or the overly pessimistic outlook being wrong. And it makes me even wonder about the Canadian mining stock. Like, yeah, it seems like a disaster. But when we look back every year or every quarter at our attribution, oftentimes it's the stocks that seem like the greatest disasters that deliver the most incredible results.

So I just think that's such an interesting exercise to go through. Yeah. And I think in our case, we look at another way we looked at it is we looked back, every quarter. for the past three years. What we've done is we've for strength our portfolio. What do we think subjectively is the most attractive opportunity? And what do we think was the worst? And we found actually very little ability to distinguish between, say, number one and number 30. But at the bottom end, the stuff that we really didn't like actually did slightly underperform the rest of the portfolio. And so I think really what we're doing is we're saying, hey, I don't think what we're doing is

trying to say, oh, I know this is people are really pessimistic about this company because they think that pulp prices are declining and capacities coming on in China or some really complex thing. We're just trying to say, hey, is there anything, you know, you read the 10K and you say, oh, I didn't realize that, I didn't realize they'd already breach their covenants. Or, oh, holy smokes, all their maturities are due in a year and anyone who could have refinanced would have. Or, gee, I didn't see that they actually lost their biggest customer. And that's a 20% hit to EBITDA.

So it's actually not as cheap on a prospective basis as it is on an LTI. basis. It's sort of much more simple things like that rather than, I think, if you train your mind, I think, to say, we're not trying to second get. We are fully in line with what the screen is looking for, right? We have a clear view that we want to buy things that are not going to go bankrupt. And if we can identify those things that are going to go bankrupt through whatever means necessary, we're going to do it. And we think there's some ability of humans to look at a company and say, gee, that thing is on a path to bankruptcy. I think one of the most interesting questions, prospectively for investors is geography. And now I'm talking specifically about public markets,

but I suppose a lot of this logic could be applied to private markets as well, which is looking forward, how would expanding our universe to a global or international opportunity set versus the U.S. opportunity set where I think we have our home bias where the returns have been best, you know, since the financial crisis with the S&P crushing everything? How do you think about the global versus domestic opportunity set. What things do you think are good about it? What risks concern you? I'm fascinated by this question as we think about returns going forward. Yeah. So, you know, and I run a global fund and a Japan fund. So, you know, I don't run a purely domestic U.S. strategy. And I think to me, it always seemed if you could look at 15,000 equities and you can buy them

on your brokerage account, why would you limit yourself to the 3,000 that happened to be in your a country that you happen to invest in, unless there's a very solid reason why a company being headquartered in the U.S. should be predictive of future returns. And I didn't really see a reason why there should be. So I figured, you know, let's just go wherever the opportunities are globally. And I think broadly today, today personally, you know, our fund, our global funds about 40% in the US. We still see a lot of opportunities in the U.S. and about 35% in Japan, which is a really interesting market for what we do. And then the remainder in emerging markets and in Europe. And I think Europe is a little bit of a harder place today for us to find opportunities, both because the absolute

number of companies in Europe, the opportunity set is more limited and fewer of them are levered. And high yield spreads in Europe are so tight that, you know, it's just hard to find great value opportunities in mainland Europe. There are a bunch of good ones in the UK. But, you know, France, Germany, we almost have no exposure to. And then I think in terms of which geographies really do generate, you know, maybe surprise results or where the country of geography actually does predict outcomes. You know, one of the most interesting things we found is that if you look at Japan and specifically

the Japanese Koretsu system, the bank government company, cabal, whatever you want to call it, the way that their financial system works, essentially they will not let public companies go bankrupt. And so for a strategy like ours of buying small cheap, highly levered things and then trying to avoid the ones that do bankrupt, we can basically buy anything in Japan because nothing's going to go bankrupt. except for maybe one out of 3,500 companies a year or something. And so for us, we love Japan because it's a much lower risk way to execute our strategy. And it's a place where valuations are still very low.

And there's a large, large opportunity set. There are 3,500 publicly listed companies in Japan. So you have almost as many companies to choose from in Japan as you do in the U.S., which is just great from a quantitative perspective in terms of being able to find the things that meet, you know, for us, a very specific set of criteria. It seems like one of the most interesting markets in the world, not only in terms of maybe the opportunity set today for the reasons you just laid out, but also for its history. It's just such a different, you know, you mentioned Karetsu and like the, I think it's Zibatsu is the other term, where you've got this kind of interesting emphasis on market share versus profitability and kind of the interrelated nature

of the businesses, the conglomerates. What was it that originally drew you to Japan as an interesting source that led you to launch a standalone strategy there? Initially, Patrick, and the way my mind works. I just saw a bunch of cheap stuff there. I said, well, you know, there's so many cheap companies in Japan. It seems like a place I should look into. And so when we done our sort of US back test of our strategy, I said, well, gee, you know, I'm curious as to whether this works in Japan. I mean, there's so many cheap opportunities there. Why don't we test it? And so ran the whole back test. And, you know, I got the results back. And I actually sent it to a friend. I'd worked with a Bridgewater. And he wrote back, said, Dan, look, you know, great. You've replicated this

out of sample, but you messed it up. The data is totally BS. And I said, well, how How did I mess it up? I'm missing. I thought, you know, I can't see any problems. So he said, well, I don't know, but like look at 08. The volatility on this thing is like half that of the NECA. And that's just impossible. How could, you know, leverage small value be less volatile than the broader large cap index? It just doesn't make any sense. And, you know, how could the volatility be, you know, 17% standard deviation, which I think what we found. And as we dug in, what we realized is it was all about these bankruptcy dynamics, right? Without bankruptcy, why? would a small levered company be more risky than a large public company? When you have sort of explicit support from the banks and the government to promote stability and to promote small business, you essentially have this backstop, which the large exporters don't necessarily. They have big capital inflows in, big capital outflows out, flows out.

They're heavily dependent on external business cycles. And they're way too big for a small Japanese bank to sort of buy a few shares to prop up the stock price. But, you know, you go into small cap land and you go into the firms that are levered, you know, it's a really different world over in Japan. And so for us, we also thought, I think the problem, you know, there are problems with investing in leverage small value and small value generally is that it's really volatile.

And if you look at, you know, your philosophy and mine is that in order, you know, you've got to help people really understand what they're doing and really understand how that volatility works in order for them to make money in a strategy that exploits small value or exploits, you know, leverage small value in particular. And so, you know, in the U.S., right, you're just going to see a. huge amount of volatility, and that's just not right for everybody. And I think being able to say, well, if you like small value, you like leveraged small value, but you don't like drawdowns and you don't like volatility, do it in Japan where you'll have a much more cushy, you know,

cushioned experience on the downside. You mentioned earlier this interesting observation that it was very hard for you to force rank numbers one through 30 out of 40, but you could kind of maybe find some information in the absolute worst 10. We found something similar in the just purely quantitative way that we do things that, and everyone talks about quality, it's such a nice word. We're going to get to Porta's Five Forces here in a minute, which is going to be a fun conversation

that's a little bit different. But the general consensus seems to be that quality is a good thing, right? You want to own better businesses for the long term. And what we found is that, nah, like, it's maybe a little bit true. Like, like, not really. Like, what you really want to do is avoid the absolute worst quality stuff.

And that there is some really useful information in that left part of the distribution, but that like really high quality stuff doesn't matter all that much. But one of the interesting things that we found in kind of this recent period is if we could go back in a time machine and take off the some of the factors that we use to strip out what we view as like super irresponsibly levered companies. So this would include companies that have a lot of leverage but that are in the process of adding a lot more, that if we could just turn that off for this cycle, we actually would have done a lot better. And that companies that have judiciously used debt and levered up have done really, really well. And I'm curious how you think about that in the context of the future, specifically with interest rates. So we've had this, you know, most of the period that all of us quants used to study equities is a secular declining interest rate environment.

There are, of course, pockets of rising rates. There's the 70s. You know, it's not just one direction. But I'm curious how you think about prevailing interest rates, whether it's something you use as an input or something that concerns you looking out for the next 10 years, let's say, of your strategy. Yeah, so we went back and we looked back to 1964. And we did a few different things. We looked at the correlation between, you know, one-year returns and every different interest rates. So Fed funds rate, one-year treasury yield, five-year treasury yield, 10-year treasury yield. And we also looked at, I'm not sure the exact number,

I'd have to look, but maybe a dozen or 18 or so periods where interest rates rise over 1% over a year or two. And so if you look, you know, at both of those, you know, types of environments and you say, okay, well, you know, how did that correlate with equity returns? How did that correlate with a small value premium, you know, how did that affect levered small value in particular? And what we saw is that there's no correlation really between interest rates and equity returns. And actually, small value appears to do quite well in rising rate environments. And leverage small value does not appear to be penalized in rising rate environments. And I think that's just interest rates as they rise or fall.

They often rise or fall. They rise in correlation with other good things, you know, with good things happening like rising growth or for equity's rising inflation. and they fall obviously when things get bad. And so if you layer those two things in together, you know, it's really hard to find any sort of useful signal from interest rates. I think that's said. What we find is that obviously the borrow cost and the refinancing risk of companies is cyclical.

And it's cyclical. And the much more volatile time series other than interest rates is actually, you know, high yield rates and the spread between high yield and the prevailing interest rates. And what we find is that any time that high yield. yield risk spikes when you, you know, you go from sort of historical average of, you know, three or four percent high yield premium. And all of a sudden, in a year, rates go from, the high yield spread goes from three percent to nine percent. That's going to be a really bad time, a really painful time for levered public equities. And so for us, we are just cognizant that

any time that the high yield market panics, levered equities are going to panic even more. And so we just have to design our strategy in the U.S. and Europe to be full cycle to make sure that investors are not going to sell at that one year out of five when the high yield market panics and that they live, because the rebounds from that are very quick, right? It's just a liquidity-driven thing. These are liquidity-driven panics where people say, oh, my gosh, nobody's going to lend to a company ever again. And, of course, 12 months later, they're lending to companies again. These things are always short-lived. But dealing with that volatility is one of our core business issues. And then I think if you go over to a place like Japan, you know, where there is no high yield cycle and interest rates have been, you know, zero for 30 years, you don't see that risk or that volatility.

But in the U.S. and Europe, you really do. How do you manage that on the business side? Do you lock people up? Yeah, we only accept locked up capital. It forces a very productive discussion. You know, if people are willing to lock up for three years, we generally think they're aligned with us on understanding that this is a long-term thing and it's going to be volatile. And if they say, oh, gee, well, why do you have that lockup? but, you know, aren't these underlying firms quite liquid? And we said, well, it's not, it's not that the firms aren't liquid. It's that, you know, we want to make sure, you know, we're aligned behaviorally to make sure that we can make money across a full cycle.

You know, I sort of, I think that the Hippocratic oath of investing to some extent is, you know, don't lose people money. And the easiest way to help people not lose money in equity markets is to extend their timeframe, right? I mean, if you, if you just run bootstrap simulations on U.S. equities or small value equities or levered small value equities doesn't take that many years to dramatically improve the probability distribution of outcomes. But people think in such short term, right?

They think in quarters or years. And if you think that way, it's going to be really hard to make money in some of these more factor-based strategies. It's remarkable how uncreative the industry has been with fees and how we've learned, certainly, in the behavior gaps that exist in public markets where just every single. single study you look at shows people just make dumb timing decisions that hurt their returns, selling out at the worst time and buying when stuff's expensive. I wonder why that's not a more common thing. It sort of sounds like when you were describing Buffett's strategy of,

you know, investing in common equities with insurance flow, that sure sounds risky. It seems like maybe we might look back in 20 years and say, how dumb was it that we didn't force some investors to lock up their capital, especially those that can afford to do so with perpetual time horizons. It seems like a really interesting way of aligning, aligning incentives, all of it. Yeah. And I think it's also funny, you know, just to get back to the beginning, where this discussion started, which is private equity. I mean, if you talk to institutional allocators, you say, well, you know, what do you like about private equity? And so they're really long-term thinkers. It's long-term holds. You know, our money's locked up for 10 years and it's just great.

And we think it's worth paying 2 and 20 for the privilege of having our money locked up for 10 years. He said, well, what about like locking your money up in a really smart, you know, factor-based small value strategy? Would you ever do that? And so, oh, no, no, no, I never, you know, we would never do that. We would never do that. I mean, why would we want to lock up our money? We hate lockups. You said, but I just thought you said, you wanted to pay higher fees for the privilege of locking up your capital in private markets. You know, why walk me through, you know, why you wouldn't want to do that in public markets. And then you say, well, public markets are so short-term oriented and the private guys are long-term oriented. So, well, you gave them 10-year capital, right? Of course, in some sense, they're a long-term oriented. And I think it's funny, you know, you just think of the incentive effects, you know, and how that changes. Private equity in some sense has the perfect wrapper for an equity product. You know, and that wrapper is a 10-year lock-up with quarterly valuations that are subjective and based on the manager's opinion of what the portfolio's worked. I mean, that's just perfectly, perfectly designed to behaviorally adjust for the problems that most investors face, which is buying and selling the hot, you know, selling the bad

things, buying the things that have gone up, switching your money around too much, et cetera. And in some sense, you know, the sort of straight check in a private equity is very good for these institutions. And the lack of transparency on interim valuations is also historically been very good. But I think where that becomes worrisome is if they start to do bad things, the results of those bad things won't be seen for five or 10 years. And so investors can fly blind. into a very risky environment where they're not getting the sort of constant feedback that you'd get in public equity markets. So one of the things that I'm sure you've thought a lot about, and certainly we do here as business owners and managers, is the idea of competitive advantage and something

that we can do uniquely well relative to the peer set and sustain that through time to have a real successful business, which brings us to Porter and what you call the modern parable of five forces. You wrote a long piece in institutional investor talking about the lack, this has been the theme of our conversation, the lack of empirical evidence for the Five Forces framework and some of its predecessors. So maybe you could start by giving an overview of kind of your view on this widely accepted paradigm for thinking about industries and businesses and competitive advantage. And then we can talk about maybe some alternatives. Yeah, you know, so it's interesting, to the story of how Worlders Five Forces came about was that in the 60s and 70s, there's a prevailing

school. It's called Industrial Organization. It was a subfield that looked at how does the structure of different industries affect the performance of firms. And broadly, the theory was that industry really mattered, right? That different industries had these structures, and the structures of those industries affected how firms performed. And within that, essentially the higher the market share of a firm within its industry, that the higher their profit margins would be, the more market power they would have in that industry to dictate prices, to do bad things like keep competitors out, et cetera. And that was called the structure conduct performance theory. It was actually the basis for most of the antitrust legislation in

the 50s and 60s, which said, you know, gee, we got to stop monopolies because, gee, if a company gets, you know, if they, you know, take a 30 percent market share company, they buy and other 30% market share company, they'll have 60% market share, and they'll use that market power to screw over customers or suppliers or whatever it might be. And that was really the fear. And Porter emerged from that world. And he studied under a few of the sort of foremost thinkers in that structure conduct performance field. And he comes to Harvard Business School at a time when Harvard Business School's strategy curriculum was SWAT analysis, right? Strengths, weaknesses, opportunities, threats, right? You draw this like four squares and you'd say, oh, well,

this company has strength and this and a weakness in that. And that was how they, you know, define strategy. And Porter sort of looked at this and said, gee, that doesn't sound very rigorous, right? I mean, that sounds a little bit like silly. You know, how could you possibly get any sort of useful insight from doing a SWAT analysis? And so he said, well, why don't we take structure conduct performance and have students study industry structure and study how industry structure and how market power can shape a company's profitability. And that's much more rigorous. And so, you know, he came up with this theory of the five forces, which is really saying

the power a company has over suppliers, over customers, competitors, barriers to entry, etc. In each one of those cases, the power you have over a supplier, in essence is your market share. How much market share do you have is going to dictate, you know, how much power you have over your supplier and the same versus your customers. And so in effect, it's just a reframing of the simple idea that higher market share is going to lead to market power, which is to allow firms to bully suppliers or customers or competitors and thus earn higher profit margins. And I think all this sounds really plausible, right? I mean, I think we all sort of

intuitively would agree with that. I mean, if you control the market for X, you know, you should be able to drive prices higher or something. And certainly a company that's the only company that can produce something should earn some higher margin or something. I mean, it makes perfect sense. But what happened is basically a bunch of the Chicago school economists, some of these really famous guys, you know, Bork and Posner and others, started saying, well, she, you know, is this really true? You know, does industry structure actually dictate performance? Does higher market share actually translate to higher profitability? You know, or any of these nice stories actually empirically true. And they started running all these price, industry concentration, profit margin studies. And they found that it's not true. It's not true at all. There's no relationship. An industry as a factor does not predict almost anything. A company's market share in its industry doesn't predict almost anything. There's just no correlation. And so, you know, starting in the 70s, basically the antitrust court started to say, well, gee, we can't use this, right? We can't just say because a company has high market share, it's going to be bad because there's actually no evidence for that. So we're going to have to start. So we're going to have to start.

using a different methodology which to actually look at the impact on customers. And actually the field of industrial organization too said, well, gee, based on the studies, right, it's clear that industry is not dictate structure. Industry structure is not dictate conduct or performance of firms. So we're going to actually stop doing these industry studies. And all of that was happening, right, this huge erode, you know, basically a huge intellectual demolition of this whole bad theory was happening. At the same time, Porter was making this the heart of the Harvard Business School curriculum

in the early 80s. And what's sort of shocking is that for 30 years, maybe longer, right, this is the centerpiece of the strategy curriculum. People are learning market shares, market power, drives conduct, drives margins. And it's just been wrong. It's been empirically wrong since the 70s. And I think for investors, it's even more worrisome. Because I think as we talked about earlier, anything that increases your confidence without increasing your accuracy is the most dangerous thing in investing. And a theory like Porter's Five Forces, which says, buy the winners, buy the companies that are really great businesses, and you're going to do well because they have power. It's going to lead you to come up with elaborate intellectual

justifications for buying large-cap glamour stocks. And by and large, that is not a strategy that works. It's so funny when you look at things like net margin as just simple factors, which again, I think you said earlier, there's a lot of things that seem logical and very few of them actually mean anything. And net margin is one of my favorite examples. You know, something we get asked a lot about as like a quality factor or something else. And sure enough, like you look at the data and it just, it's almost irrelevant. Like it doesn't seem useful in virtually any way at all, but it's something that people talk and think a lot about. It's remarkable how long some of these things can last. I wonder if you think that it's, if there's any,

anything redeeming about the Five Forces framework, maybe not for investors, but for for managers. Do you think that the framework is a smart or interesting way, like let's say you for your business? are these things that you are thinking about, that your behavior might be different because you're thinking about them? Or do you think about competitive advantage in a totally different way? And if so, how do you think about it? Yeah, well, I think it comes back to this idea of forecasting, which is that, you know, I think that predicting the future is really, really difficult. And so I think most efforts to plan things are bad because there's not going to come true. Other things are going to happen. And so the more time you invest in planning and sort of saying,

well, gee, let's use this strategic model to dictate. what we do, you know, it's just a really bad way to make decisions. I mean, I think there are much better ways to make decisions. I have a very simple idea, which if I can produce beautiful, excellent strategies that beat the market, I'm going to have a great business. And by the way, it's a heck of a lot of fun to go look into the market and try to figure out which, you know, how do you build these strategies to design them, to do the research, to prove that they work, to tell people about them, right? I mean, it's a huge amount of fun. And I love doing it. And I think that when you love what you do and you do it really well, maybe you make beautiful chairs. And what

you derive meaning from in life is that you make the most beautiful chairs and people love the chairs and they buy them. And maybe there's no great strategic plan. And there are a ton of other companies that make chairs. And so you might not have a high market share or high competitive advantage or anything like that. But if you love what you do and you do it well and you make your customers happy, I think that's sort of much more satisfying than sort of these elaborate plans as though you're sitting in a war room in World War II, you know, plotting out tank movements two years in advance. I mean, it's just, I just don't think it's the right way to act or to make decisions. And I think from some of the critiques of Porter's Five Forces and these, you know, strategic planning curriculums, I think,

are so good. It's just that, it's that, you know, there's this, the rise of this sort of managerial thinking that's so sort of distanced from the actual thing or art or profession or methas, The actual thing that you're supposed to be loving, doing and doing well and doing for the customer. And instead, you're doing it because your PowerPoint presentation, you know, Bainting company came in and gave you a 50 PowerPoint slide presentation about how you need to segment your market differently and act to increase your score on one part of your Gant chart or something. I mean, who wants to live their lives that way or run their businesses? That way it just sounds so dull and unsatisfying.

My guess is that you're not a fan of the interview question. Where do you see yourself in five years? No, I mean, it's funny because I'm going back to lecture at Stanford to Charles Lee's class and talk to the students there and point out the sort of craziness of the things like the DCF model. You know, you've just built this model, which forecasts cash balances, income, profit for five years in the future. Like, does any single one of you want to offer a two-decimal point figure for how much in revenue they're going to make in 2023, what their net income on their tax return is going to be in 2020? and how much money they're going to have in their bank account in 2023, even what industry they're going to be working in 2020, 23. And you are the world's leading expert in you.

And if you can't forecast that, what in heaven's name makes you think that you can forecast that for like a complex business like Microsoft? I mean, it's just the height of idiocy and hubris. I always thought that the far more interesting and eye-opening interview question would be to ask people, what are the things that they do every day or every week? Another way of asking, like, what is your personal process? So I'm curious what yours is. What are some of the things that in pursuit of interesting investment strategies and the sort of

analysis that you clearly love to do, what are the things that you do, you know, either daily or weekly? Yeah. I mean, I think the first and foremost thing I do is just read a lot. I mean, I think we are so blessed with things like Google Scholar and Amazon, right? I mean, I have all these books on my shelf, right? I mean, I can reference, I've got what works on Wall Street. I've got West Gray's book, Quantitative Value.

I've got Tobias Carlyle's books. I have all these books that I can read and learn what the great minds of investing are thinking what all this empirical research is showing. And then, you know, you can come up with questions as a result. You can think, well, gee, I really wonder, you know, does market share drive profits? You go to Google Scholar and you say market share profits, relationship, enter, you know, or meta analysis, profitability returns and enter. And the whole world of knowledge is, you know, open to you.

And I think if you just bother to spend time reading these things and studying what other people putting out, you can accelerate your learn it, your personal learning so dramatically. And I just think that ultimately, if you read even 50 pages a week over a year and then over 10 years, the exponential amount you'll have learned relative to what people who don't read or don't bother to study stuff is just massive. And I think not just reading within investing, I think there's obviously a lot of great stuff in investing, but I think a huge amount of interesting research is being done in behavioral psychology, the Connman, Tetlock, world. All that research is fascinating.

I think reading stuff also, I've been reading a lot in evolutionary biology recently. I mean, Stephen Pinker, E.O. Wilson. I mean, some of these guys have just incredible data-driven insights that I think are so valuable. And so I think reading a lot and then, you know, I spent a lot of time just walking and thinking. And I think being a more quantitative person, right, it frees you up because you're not doing all these things that waste most people's time, like creating PowerPoint decks about competitive advantage. so you have time and I think taking a nice walk and just thinking about things and are there any ideas that I might have as I sort of reflect on the stuff I've read. And I think that largely it's nice because

those two things are also pleasant to do. I enjoy reading and I enjoy going for walks and I enjoy making bats about companies. And I enjoy doing a lot of empirical research. So it's sort of an ideal life from my perspective. One of the mantras we have around here is to never confuse activity with effectiveness. We couldn't agree more on reading and walking. I think they're probably that combination is an incredibly potent and powerful thing that seems to people like you might not be working as hard, but in fact is a far smarter way to work. I'm curious looking at when you look at the markets, we've talked a ton about private equity, its prospects, levered small value public equities. Are there other areas, other be asset classes, corners of these two markets we've talked

about that have piqued your interest recently? I'm curious as you look out and are thinking about the world and where opportunities may be back to that picking the right reference class. If there are other areas of deep interest for you right now? Yeah, you know, it's funny. I've almost thought about writing an article that said why most good ideas don't work or something, you know, but I feel like I've spent a lot of time diving into things mostly just to sort of reject them or say, well, you know, I don't know. And, you know, one that's caught my eye recently is if you look in the public equity markets, and I think a lot, you know, because I'm thinking a lot about a lot of the companies in my portfolio that I think we do do a good job of sort of picking the ones that are, you know,

eliminating the ones that have low expected returns and that aren't, you know, are sort of false positives. And, you know, I spent some time looking at companies, I just running screens of companies that look like to me, they're going to go bankrupt. And then from there went down the pathway of looking at stocks that seem likely to be fraudulent. And if you look at today's market, there's so much fraud, and especially in some of the U.S. small cap, biotech and tech in particular, there are a lot of things that look like frauds. And they've got these huge market caps and no revenue, no profits, and they're promising to, like, use a spray gun to cure cancer with gene editing or something. And you just, like, this is not sad as a $700 million market cap. But, you know,

what's interesting is even though I've sort of made those observations, right, that I can run a lot of these screens and see things that obviously don't look attractive. Anytime I run a quantitative screen on this or a back test on any of the rules I've come up with, even though it generates it's alpha relative to a negative market index, they all lose money, which I think is sort of interesting because, you know, I like making money and so losing less money than another hypothetical alternative is not overly attractive to me. But it's been fun looking into it, but even though I probably am not going to do anything with this information, it has been fascinating to look out there at all the things that predict bad outcomes. And yet even with all

the things that can predict bad outcomes, it's still really hard to make money shorting things for any number of reasons. I forgot to ask earlier when we were talking about the key variables about small cap in particular. One of the things that we always think about is capacity of strategies and having this philosophy that we should always forsake higher capacity for the sake of higher alpha. We just always want alpha instead of assets. I'm curious how you think about that because my guess would be that the test of an unconstrained version of this that's not just small cap, but would be allowed to go up into medium and large cap stocks, would also do extremely well. And so I'm curious about the strength of your conviction in that part of the three-part stool.

I think value in levered are, you know, we've talked a lot about those. But what about that idea of small and why not go upmarket? Yeah, I'm with you, Patrick. I think size, at least in our research, especially in Japan and outside the U.S. And more recently in the U.S. does not seem to be overly predictive. And we don't wait it very much. But we do say we do levered small value because most of the levered value opportunities are small. So it's a good descriptor of what.

what we do, even though it's not a driver of our decision-maker, decision-making, you know, we don't necessarily think a 200 million market cap company is just automatically going to outperform an $800 million market cap company. And so I think when you go up, I love running, you know, these beautiful niche capacity-constrained, tiny little strategies, because I know that there's a huge amount of alpha to be made in them. And I think my view is that, hey, once we fill up the capacity of these strategies, we can't run, you know, levered small value, would there be an opportunity to run levered midcap value. I think, you know, there might be in the future, but, you know, I think we have a while to go before we'd do that. What have been some of the most, you mentioned this idea of Google Scholar

and reading. I'm curious if there was a person or a source that you've learned the most from that might be surprising to people recently. The single most influential thinker to me is Philip Tetlock. I mean, I think his book, expert political judgment, and then more recently super forecasting. And he's one of Daniel Kahneman students. And I think that investors, we, are forecasters. That is our job. And we have to be reading the forecasting literature. And Tetlock in particular has done so much good work on how to make better forecasts, what bad forecasts look like, how to make good decisions about the future. What are the, even he does things like, you know, what's the duration of a forecast, right?

Like how accurate, how far into the future can we our forecast see? And I think I have just learned so much from studying his stuff and then comparing it to every part of my own process and saying, well, gee, if Tetlock says it's nearly impossible to predict outside of a one-year horizon, certainly we should be only thinking, and why would we ever think in two or three-year, or, or, gee, you know, just focusing on the use of base rates. And even Tetlock says, you know, interestingly enough, in his super forecaster study, he actually does not just stop, his super forecasters don't tend to just stop at the base rates. They actually do make individual more qualitative adjustments at the end after they've finished doing a base rate assessment. And

he's found that that does work. And so I think, you know, that is probably the field that I've learned the most from. And I think it's the most contrarian, too. I mean, I think, you know, so few people are familiar with the forecasting literature. And so much of our industry is tied up in forecasting, sometimes unwittingly that it's probably the single most impactful thing I think any investor can read. What was it like writing your book? This is something you're probably, that's totally outside of the field of investing. Maybe describe what the book was, what got you started and whether or not you enjoyed that process. Yeah, so I wrote a book. It was my senior thesis. I studied the history and literature of the 19th century American South with a focus on slavery in college. And I wrote my senior thesis about

a slave revolt in New Orleans that was actually the largest slave revolt in American history. And I think what interested me about it was this sort of, I think when you look at American history, first and foremost, America is an absolutely amazing country, one of the most amazing enlightenment, reason, the rise of capitalism, free market, democracy, right? I mean, those forces have driven such a huge amount of human progress. These are some of the best ideas humans have ever had. I think it's very easy to look at American history, therefore, and write this narrative of tremendous progress and to do so accurately. But I think some of the most interesting literature, the most interesting things from a moral or philosophical perspective are to look at those places

where in the service of that progress, moral compromises or great sins were made. And I think if you look at the American South in particular, you see that in the greatest relief where tremendous economic progress is coming at the cost of, you know, literal enslavement of people, of a lot of brutality. And then to see those enslaved people rising up and trying to overthrow that system, but doing so in a way that was, you know, incredibly violent, that's the only way to do it, but destructive. And to think about those tensions between good and evil economic progress and slavery

between a violent, destructive uprising, but then also the concomitant brutal violence of slavery. And I think it's just such a fascinating place to study, you know, the human condition and what drives people and the tradeoffs that this country is made and that, you know, we all make. And I forget who said it, but, you know, that the line between good and evil, Vol passes through every human heart. And I think there's no better way to look at that than in some of these more graphic and interesting episodes. And I think this Slaver Vault, New Orleans, was one such. What, I'm curious what details looking back on that research most stand out.

Yeah, so it's sort of funny. I mean, I sort of approached the study in a very similar way to who the way I invest. So, you know, if you look at the history of the Slaver Vault, what's interesting is that there's no, none of the slaves ever wrote down anything that they did, right? There are no letters, no diaries, they were illiterate. So we actually have no way to know what they were thinking or doing. And so constructing the narrative of what happened in the revolt was actually quite difficult because most of the records we had were actually wills and testaments, land records that sort of said, well, I had 80 slaves five years ago. And now I have 20 court cases, which were basically these lists where they said, Kuq was a 23-year-old slave purchased for

$800 who used a machete in the cane fields, and he was executed on X date for insurrection. And so what I did to sort of decipher this is took all this data, put it into Excel, into this big database where each, I had a line for each of the individual participants in their vault, where they came from, what we knew about them, where they came from, from those property records and legal records, and then took those, and then I got old landmaps, and then from the time, and I shaded in, if they were, 10 slaves or more, red, 5 to 10, orange, you know, less than 5, you know, et cetera. So you could actually see visually mapped where they came from and then marked each event

where we knew where it had happened on the old landmaps and then used Google maps to say, okay, well, how long would it have taken to walk from point A to point B, et cetera. So we know that if this happened at 10 a.m., this other event, which we know from the legal records happened here must have happened at 5 a.m. And so it was this huge process of sort of detective work and using sort of empirical tools or quantitative tools in some sense to unpack history. And then once I'd had the sort of bones of the story, the architecture of it done, to then go back and say, you know, what would it have looked like, felt like, smelled like, you know, how would they have felt, you know, what were

their emotions have been? And to paint that by using other contemporary sources. So, you know, really the process was, you know, although, you know, writing about history, probably a process or a thought process that is not dissimilar from the way I approach investing. If you were forced to write, that's a fascinating process, first of all. What a neat story. If you were forced to write another book today, what would you write about? I've been thinking about it. Is there sort of a theme to the pieces I've been writing about quarters five forces or modern finance theory? And I'm working on a few others. But I think if there's one theme to them, it's, I think, or two themes. One is that, you know, most good ideas don't work.

And I think the second would be that experts who are often purveyors of good ideas that don't work. are often, you know, no better or worse because they're more confident than laymen armed with common sense and logic. And so I think it would be fun to write a book, you know, maybe not to bonfire the vanities, but maybe bonfire the bad ideas or something and just talk about because I think many, there's a great study. I forget if you posted it on Twitter or someone did that basically they looked at financial advisors and many financial advisors make horrible decisions, but they then looked at what do the financial advisors do with their own portfolios, and they actually made the same bad decisions that they made for their clients.

So it wasn't that the financial advisor were about to screw their clients. Far from it, they were doing the things they thought were best. They were just making bad decisions because they had bad ideas. And I think that's sort of a better picture of a lot of the parts of Wall Street. It's not that these people are bad people. They're trying to screw people. It's just that they are operating from frameworks that don't work, informed by ideas that don't work, believing theories and philosophy.

philosophies that don't work. And I think it would be fun to sort of continue to expose some of them and then to offer alternatives that are based on reason and logic and empiricism and the scientific method, which are things that anyone can access. Anyone can say, hey, what's the evidence for that? Let me weigh that evidence and see whether it makes sense. And it doesn't require you to have spent 400 hours studying the vacuum cleaner industry. Well, my closing question for everybody, which you probably know ahead of time, is to ask for the kindest thing that anyone's ever done for you. It's such a wonderful question. And, And, you know, I think for me, my mother from the age, probably when I was little, barely able to talk until, you know, I could read on my own, would probably spend an hour to a day reading to me. And I think that instilled a lifelong love of learning in me. And I'm sure it was boring for my mother to read book after book after book. But her self-sacrifice and time she spent reading to me, I think really inspired in me a love for reading, which has shaped, you know, my entire life and career. And I think that that was probably the greatest kindness and it was done, I think, sheer surely out of love and self-sacrifice. It's a wonderful, wonderful answer, one that's unique. I haven't heard that particular.

You know, I've heard obviously a lot of parents over the 75 answers I've gotten. But I love that answer. And I can so attest to it as a parent myself where it's so easy to, you know, turn on a TV or a device of some sort to occupy your kid. And it definitely is boring at times to read to them. But it's so clearly impactful. So what an awesome, awesome answer and great place to end. This has been a really fun conversation as I know it would be. Thank you so much for your time.

Thank you, Patrick. Hey, everyone. Patrick here again. To find more episodes of InvestorFieldguide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com Forward slash book club. After you sign up, you'll receive a full investor curriculum right away and then three to four suggestions of new books every month.

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