Invest Like the Best with Patrick O'Shaughnessy - Modest Proposal – Value is Dead, Long Live Value - [Invest Like the Best, EP.95]

Episode Date: July 17, 2018

A very short introduction today because my guest is anonymous. Suffice it to say he manages a large pool of private capital. He goes by the pseudonym “modest proposal” and his twitter presence is one of the reasons I first got on and now stay on the platform. He is level headed, smart, and skeptical by nature, all of which made for a great conversation. We discuss how difficult the market has become for active investors, thematic investment opportunities, and the potential sources of market mispricings. Please enjoy our conversation, and let me know which other anonymous accounts you’d like to hear from. 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 Factors from Scratch: A look back, and forward, at how, when, and why factors work Josh Wolf Podcast Episode Mike Zapata Podcast Episode Michael Mauboussin Podcast Episode   Show Notes 1:55 - (First Question) - How value investing has changed 5:45 – How does he apply the lens of market over-reaction to the current market today             5:47 – Factors from Scratch: A look back, and forward, at how, when, and why factors work             7:06 – Josh Wolf Podcast Episode 8:35 – Areas where he prepares most             8:36 – Mike Zapata Podcast Episode 12:18 – Where markets may be over reacting in media 20:10 – How does he invest on this thinking             20:44 – Michael Mauboussin Podcast Episode 22:35 – Other parts of media that he finds interesting 27:35 – Aggregation theory and how it plays into his investment philosophy 31:06 – Structuring a long-short portfolio in today’s media market 35:59 – Customer acquisition costs and how it’s impacting retailers 40:51 – The role of physical locations in a world that was upended by virtual retailers 49:41 – Consumer Internet Story thesis and what he’s seen during his career 58:11 – Why the FANG stocks can’t win in the niches 1:02:25 – The distrusted 50 1:05:00 – How he thinks about Capital Allocation and buybacks 1:11:08 – His view on international equity markets 1:13:58 – His take on the asset management business 1:19:38 – Allocation of a portfolio in between periods of conviction 1:21:08 – People that he has learned the most from 1:23:54 – How do you identify people who are capable of evolving after a rough spot 1:26:53 - How does he force himself to adapt to new conditions and evolve 1:30:31 - Thoughts in investing in cannabis industry 1:32:31 – Conditions where he would get interested in crypto currency 1:36:20 – Kindest thing anyone has done for him   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

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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'Shaunicee 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. A very short introduction today because my guest is anonymous. Suffice to say he manages a large pool of private capital. He goes by the pseudonym modest proposal and his Twitter presence is one of the reasons I first got on and now stay on that platform. He's level-headed, smart, and skeptical by nature, all of which made for a great conversation. We discussed how difficult the market has become for active investors, thematic investment opportunities, and the potential sources of market

mispricings. Please enjoy our conversation and let me know what other anonymous accounts you'd like to hear from. So the framing of this conversation is going to be value investing, weird overreactions, mispricings in what has become a very competitive and difficult market. Maybe just start by giving your impression of how value investing specifically has changed, maybe what you view as the drivers of the historical outperformance of value, and whether or not those same conditions or that same opportunity set exists at all today. Yeah, I mean, it's something that I've thought a ton about. I came into the business working with a guy who was a traditional deep value, loved net nets and discounted to cash. And so sort of steeped in that mindset and spent probably far too long studying

the early days of value and all that. So I come to this sort of point where I look back over the last 10, 15 years and say, what happened? Why are we at a point today where people are questioning it? Does it still work? And obviously, if you're doing that, there's the chance that right now is the moment to get in, but people have been saying that for five years. And so what I look at is, I love how Jeremy Grantham talked about. There was career risk to owning value stocks, particularly if you're a discretionary manager, right? If you're in the 70s and 80s telling people you were buying, whatever it was you were buying at the time that was out of favor, there was real career risk and Buffett's talked about this forever. And I think the seminal moment was 98 to 02. And if you go to that period of time, you have value managers being called the dinosaurs left out. They don't get the new economy. And so for two years, most of them dramatically underperform. And that's when, you know, the comments, I'd rather lose half my shareholders than half my shareholders' money and all that famous soundbites came to be. And then what happened is, obviously, growth imploded.

The S&P was down 0-0-0-1-2 and value miners flourished. And so, in a sense, not only did the career risk of owning value go away, but it was almost like value became lionized. And henceforth, everyone says they're a value investor. You never hear anyone anymore say, I like to buy really expensive stocks that are going to go up a lot more. There's more career risk today, I think, in saying I'm a momentum investor or I like to buy really expensive good companies than there is to say I'm a value investor. So you had that sort of career risk angle change. And simultaneously, you had a ton of academic research throughout the 80s and 90s that really showed there was a value premium and it worked. So then folks like your father and other smart people said, we can systematize this.

And so on the one hand, you had discretionary managers say, hey, this worked. I can buy it. These people came through the crisis unscathed, the vote O to O2. Let's do that. You also had lots of capital pouring into the quantitative side saying, well, if we build screens that scream for value, that will work. So I don't think it's a coincidence that that period of time from there on growth has basically outperformed.

There's some small episodic periods. And historically, that's how it is. Its value has these short bursts. But they've become short and they've become shallow. And I do think that there is something to the idea that what did work, the idea of buying discount to the present value of future cash flows, that still works. Value investing, though, as defined in either the Graham and Dodd tradition or even sort of, you know, how it migrated over time with Buffett in the 80s and 90s, I think has become a lot harder, a lot more efficient. I don't want to say it doesn't work.

But I think as a overall just mindlessly buying the ETF, I think it's going to be a lot harder. We just, or I guess depending on when this airs, we'll have just published a big like 50-page report on value factor investing. and maybe the most important finding, which may seem obvious, but we really show it in some detail, is it works because people overreact. And they see recent bad results in earnings and cash flows. And then those tend to continue through a holding period of a year or year plus. But ultimately, there's a stabilization and recovery of fundamentals. And all of value investing is just multiple expansion. And to expand multiples, you need recovery and fundamentals, which means people overreacted.

You said, you know, price of discount and cash is always going to work, obviously. If you buy something that's cheaper than it should be, it's going to produce good results. How do you apply that lens to the market today? So if you came up in that tradition, and I think you believe in overreaction as a source of opportunity, what does that mean today? So, I mean, I'd love to read your paper because that's a perfect setup for how I look at the world, which is, to me, the last sort of remaining anomaly is human behavior. Every other anomaly gets exposed and arbed away. I say, as long as humans are participating in markets, there will be roles for active management. It will just become probably fewer and far between and waiting for those episodes.

Josh Wolf was on and he had that 100%, 0%, 100%. Like I sort of say, I'm 100% sure people will overreact. I have 0% idea when or why. And I'm 50% confident I might be able to exploit them. But what's interesting about the overreactions and why, as we'll talk about some of the sectors that I pay more attention to, is if you look at some more prosaic old line industries, a general overreaction might be like a 3% sell-off on earnings. In small-cap consumer internet, if someone misses earnings, they might be down 25%.

Right. And so the idea is, and it's exactly what you said, is people linear. extrapolate the recent result. And I think Seth Clarman in his end of your letter this year said, you know, overreaction sort of emanate from an initial right idea, but then get taken too far, because whether it's humans and then Algo's jumping on that or something to that extent. Today, I find that the biggest sources of opportunity are sitting on your hands most of the time because day to day, the market is just super efficient. And believing that you can go into the market today and just point to a stock and say that's mispriced without some sort of either

big narrative overhang or some, whether it's earnings or M&A or something that's causing a specific dislocation, I think to systematically outperform that way is extraordinarily difficult. A guy I just said on the podcast by the name of Mike Zapata, who was a Navy SEAL for a long time, has this fascinating analogy he uses from that life and what he does now, which is value investing, which is that the key thing is tons of preparation to understand either an individual company, an industry, a trend, whether it be, you know, retail that's online versus physical, which we'll talk about, and just waiting, right? Like just sitting around and waiting for the perfect opportune time when people have screwed it up, and you recognize that because of your

preparation. So maybe talk about the areas in which you prepare most, the trends that you are most interested in today, that you kind of sit around waiting to see overreactions with a lot of preparation. I wish I was smart enough five, seven years ago to have known what to prepare for. The preparation has almost come by virtue of where I've gotten involved and then continuing to pay attention and learn more and more and more. And there's a huge value to that because when something happens, there are instances where a stock, like I said, can be down 25%. You may have a week. You may have three days to jump on that. Other times you might have months. So there's a huge advantage to having that sort of database and knowledge of all the companies or the general.

issues going on. The areas that I find today are most interesting are clearly at the intersection of technology and older line industries, specifically, you know, what's going on in media and video distribution, commerce, e-commerce, retail. And essentially, I remember a quote Mark Andreessen had where he said, I study value investors to learn from them. And I study VCs to learn from them. And he was essentially saying, you know, we're betting on the future. They're betting on the past. And what I like to do is kind of say, I'm betting that the future may come a little slower than everyone else. And what I've learned is the technologists are almost always right about the end state. But the frictions between here and there are often way greater. And so if you can figure

out reverse engineer sort of what the expectations are that are embedded in some of these change situations and say, wow, maybe they're right. Maybe everyone will watch TV on a one-to-one stream directly pulled down what content you want, where you want it. That might be the end state. But it might also take a lot longer to get there. And this specific instance might be overpricing that reality. And so it's essentially having to understand and study the future.

But because I can't predict the future, all I can do is take what the technologists are saying and writing and investing in and study that and then say, okay, what are the chances that that disrupts this business tomorrow or five years or seven years? And what is the market today pricing in for the cash flows of the legacy business? And then a sort of second instance is within, this is more consumer internet is oftentimes because these verticals end up being winner, or take all or take most. If you can find an instance where the number two may still prosper, they can be priced extraordinarily cheap.

Now, the right thing to do is probably just to go buy the number one and hold on, but that would be too easy. So instead, you find these instances where maybe the profit pools large enough that it can support two players or three players like online travel or, you know, an online real estate, some of these huge end markets that support multiple players as opposed to a single dominant player. There you can also say, okay, this is trading at eight times cash flow. And I think the market's large enough to support, you know, huge opportunity.

It seems like everyone forgets about the key price component in all this, that these technology narratives, I'll use that word narrative deliberately, are so powerful. And the end state often is correct. The opening anecdote in the paper we published was asking whether or not people would prefer to buy like a basket of New York City taxi medallions or Uber stock today. And when I asked this question, I've started asking this question, like big investing audiences when I give presentations,

and it's like 95% Uber because no one thinks about price and stabilization of cash flows, which I came across this idea because of a really bright investor who we mentioned the paper name Andrew Milgram here in New York, and they've stabilized, right? Like it's a classic sort of value versus growth story. Let's use that lens to go through each of those stacks. So maybe we'll start with media. Maybe you pick the company that's a jump off point, maybe it's Disney or something like this. but talk about like the relevant players and the key trends that you look at and where markets may be overreacting in your estimation.

Sure. So I think it's important to go back a little bit and just frame that ecosystem, which is historically there's this tug of war between content and distribution and people are always saying who's going to win and who's got the upper hand. And essentially what you have is you have five or six big media companies that sell a package of networks to video distributors. And those video distributors market it up 50% and they sell it to us. One of the world's great all-time business models is you got paid a monthly subscription fee from 100 million households who may or may not watch, most likely did not watch your networks. And then you got advertising revenue on top of that. And that was phenomenal. Cord cutting became an issue in the investment world starting in the mid-2000s.

People were already talking about this. So this is really the third go-round with. fears of cord cutting and what if people start watching over the internet, then it was YouTube and ABC was putting free content on iTunes because Steve Jobs convinced Bob Iger that was a good idea. Today, though, the reality is it's happening. So you have to be a lot more careful. And so I think you need to split the world this way. There are media companies that are inexorably tied to what we will call the linear TV bundle. Those companies have a very challenging future. If they are pure aggregators, meaning they're doing syndicated reruns, that's a terrible place to be.

If you are doing your own original content, a discovery or scripts, they own all their content, they do original programming. It's possible that that content resonates in the next world. But the problem for anyone trying to make the leap from linear to a direct-to-consumer model is the economics are inferior. That's because, again, you had 100 million people paying you, and maybe in the next world, you'll have 15 million people paying you. And if you just think about it, you're getting three bucks. Now you need to get, you know, 15 bucks. And you have all the costs. So it's a difficult challenge.

The second bucket then is sports news, essentially live, the kind of content that needs to be consumed live. And for now, that's a handful of big companies, Fox. Comcast, MC, Disney, ABC. I think there's real questions about what the ultimate sports endgame looks like. Is there a single sports aggregator of rights? Are there a handful just because the expense is so high? But whomever controls sports rights going forward will probably have a pretty prosperous future just because it's the only way you can aggregate 25 million people at the time anymore.

And so advertisers will want to be there. So that's sort of the framing. What you asked about Disney, and Disney is a funny one because from the time I joined Twitter years ago, which was how we met, I sort of had this notion that Disney was completely misunderstood. And everybody said, oh, they're uniquely positioned for the direct-to-consumer world. And I said, that's absolutely ludicrous. They're getting paid $7 a month for ESPN by 100 million households.

There's absolutely zero chance they could replicate those economics in the next world. And it was just sort of taken for granted, and Disney was, you know, the favored media stock for a long, long time. And then August of 2015 was just a seminal event for the pay TV world, which was Bob Eiger announced that ESPN was losing subs. And surely anyone who had paid attention to the media world should have known that cable companies are losing subs and satellite companies are losing subs. The whole pay TV ecosystem is losing subs. Why wouldn't ESPN be losing subs? The entire media world got just rocked and has never really recovered from that. But what's also interesting is if you look at 2015, that was the year that the cable networks

business of Disney peaked or recently peaked as a percent of operating income. Going back a few years, that number might as been a high as 65 percent of the companies. And so you said, wow, this company is a pay TV, linear TV company. And so I had been negative on them for a long time, but, But then that sort of played out because the multiple compressed and their earnings were sort of flattish and the other IP part of the business did whatever. And then late last year, they made this really interesting announcement, which is they're going direct a consumer with a Disney branded product.

Disney Flicks, Disney Now, whatever it will be. And I got interested, oh, I pay attention to this because I pay attention to the whole ecosystem. But what's so fascinated to me is the framing is, wow, this is Disney's attempt to migrate their linear TV business to the online world. I said, no, that's horribly incorrect. Disney's linear TV business is ESPN and then some smaller, you know, Disney Channel is really the only Disney IP cable network. They're not taking that business with it.

That business has to do its own thing and that's what ESPN Plus is. And who knows, someday, like I said, there will be some one or two aggregators of sports writes, maybe ESPN has a role in that. Maybe they don't. They probably do just because they're there and inertia is a big thing. But what Disney was doing was saying, we're going to take our owned IP, which even as I was skeptical of Disney for many, many years, I would have to admit, they have the best owned IP in the world. I have a young child. And me too. We put on, he wasn't old enough to watch it. We just put on like the Pandora station with Disney sing-along and he shut up in the car. But I turned to my wife of like, we're subscribing to this product.

You know, now up and down the stack age-wise with Lucas and Marvel and all that. So I don't think there's an argument that they have some of the best IP, if not the best IP. And what they're doing is they're taking that IP, which plays off of the studio and the parks and the consumer products. And they're taking that direct-to-consumer. And that is actually super interesting because, as we'll talk about, customer acquisition costs kill you in any online business. well, A, you start out with the brand awareness. B, you have multiple touch points with consumers. C, you can leverage them into bundles, which is another huge topic of interest.

So I'm actually really interested in how that evolution is going to go because going back to sort of overreactions and narratives, the narrative today is you can't read a story about Disney without reading about the death of ESPN and all that. And I'm like, no, no, that played out. they're now down to probably 20% of segment OI. So yes, that's happened. Now the question you have to ask, and I don't know yet, but it's what I'm paying attention to is, wow, can they leverage these assets online in a really powerful way? And if so, that could be really interesting. How do you think about structuring this or expressing this via investments?

So as a deep discretionary guy is kind of how I would categorize your thinking. you've got this insight or a set of insights. We've just talked about one company, but there's a whole bunch of companies that are part of this ecosystem. How do you think, without giving the actual positions, how do you think about structuring this and expressing this? It's really opportunistic and episodic is I can only judge what I see

and what I think will happen and compare that to the market pricing today and what I think is embedded. So Mike Mubeson, who you had on, he does this expectations investing. and over time, the way I've migrated away from traditional value investing is traditional value investing, you sort of say trades at 12 times PE, I think maybe it can reread if some good news happens. And so that's sort of the what, the what evaluation is it's 12 times earnings or it's 8 times EBITDA. And for me, the more important question is the why. And I need to be able to understand

why is XYZ trading at 12 times or eight times. Then you compare that why. to the future and say, look, 99% of the time the market's right. If you look at an earnings overreaction or an earnings reaction, a lot of the time, the future earnings power might have been impaired. The slope might be lower. Something real might have happened and the market gets it right and you move on. So what I'm looking for is trying to reverse engineer the embedded expectations and compare that to what I think is a reasonable base case of what might happen and say, okay, that's now interesting. If you do that at a low starting multiple, even a reasonable multiple, and you have this

sort of embedded expectations that you think are wrong, you said, you know, it's basically multiple expansion. Well, the multiple expansion comes from the fundamentals coming through, but also the reversal of this sort of overhang or incorrect analysis. And so on the downside, you sort of have a belt and suspect. of low expectations and a reasonable price. And on the upside, you have fundamentals improving or outperforming relative to expectations and then the psychological shift.

And that's how you make big money in these situations is when, you know, the multiple goes beyond where you ever imagine. I've probably sold too soon. But that's what you're hoping. Are there other parts of the media specifically and kind of video distribution ecosystem that you find particularly interesting to that? Yeah. I think so for much of the middle 2010s, I was completely out of media because I think, and I'll say here that the distributors as well, the cable company, satellite companies and telcos to some extent, just because I think it was pretty well internalized what was happening and the market was kind of right.

Right now, because of the acceleration and cord cutting, and we can specifically talk about sort of what AT&T is doing with DirecTV now and some of these other entrants, the pace of traditional household. subscription decline has accelerated. That's undeniable. And so what's happened with that is that companies that I thought the market had sort of properly assessed as broadband distributors first, and then also happen to sell pay TV, which are cable companies, have gotten caught up in this cord-cutting maelstrom. And so these aren't unique insights. Anyone who covers the TMT space sort of knows this. But in general, a cable company is actually, first and foremost, they sell broadband. And if you look at their revenue, if you look at their gross profits and you look at their EBITDA, these are broadband first businesses.

And they do happen to sell pay TV because that's their heritage and they, some of them make some money on it. But the idea that if all the pay TV business in the world went away tomorrow, which is not going to happen again for the inertial reasons we've talked about, these businesses would actually still be okay, if not better in some regards. They'd have higher returns on invested capital because they've had lower cap-x. Their margins would be higher. They'd be very attractive businesses.

The problem is a lot of people don't want to really stay to find out what the world looks like for a cable company without a video business. Is that just low, single-digit grower, where you're wholly relying on pricing power in a business that Congress at any time could sort of take? take a skeptical view of. So there's a lot of reasons to be skeptical of them today. But that is one particular piece of the ecosystem. So if I step back and I look at the various players,

we already talked about the people who have content that is inexorably tied to the linear TV ecosystem challenged. You have folks like Disney where you're being painted with a brush of your linear TV, but the reality is now, you know, 50% plus of your operating. income and a very bright future is divorced from it. Then you have distributors, satellite. Satellite is a dying asset.

And those businesses have no real future. I mean, they're harvesting cash flows today, but the terminal value of satellite TV is zero in my estimation. And then you have these other distributors of pay TV who actually are broadband providers, but are caught up in it. So if you look at those four different subsets, of them are interesting because, yes, they are currently getting hurt by cord cutting and the decline of the linear TV system.

But the future, there is a real future besides that. And so that's where the type of opportunity is today. You know, there's a lot of deal action going on right now, and that's sort of clouding the investment case. But I think if you step back and you look over three, four years, it's not perfectly analogous, but there have been other examples in the past where people have overreacted in this specific space. And I think there is an opportunity there for patient people to try to sort amongst the various players and say there are some survivors. There are probably some winners.

And then there are definitely some losers who, I don't want to specifically name names, but there are some smaller free radicals they've been called that their challenges, if they merge together to create scale. And the idea is we get bigger so we can fight back against the big distributors. Well, the problem is now you have 15 networks you're going to that MSO with and they're like, no, we want your five good networks. So the bigger you get, the bulkier your package gets. And the more likely distributors today are to push back. If you stay small, though, what's your relevance in the next world? Then how do you participate? So they're kind of in this very difficult position. And some of these folks have launched, I think it's called Philo.

It's like a $15 bundle of, you know, people have called it The Losers Bundle. But maybe it will get traction. Maybe it won't. But it's a very difficult hand for them to play where, you know, some of the bigger guys who own sports, who have news or who have the branded IP that really resonates regardless of the distribution mechanism, I think those guys are positioned to prosper. Talk about this massive trend. We've talked about Ben Thompson's aggregation theory before, which I'm fascinated by. Mostly I'm fascinated by how the market prices this idea and whether or not the market has properly reacted to attention aggregators in this cycle. So, like, if you look back at Facebook's history, for example, and you compare historical price to today's earnings, if you look at like it's PE to today's earnings in the first three or four years, it's like five, six, seven.

I mean, it was remarkably cheap as they were sort of aggregating an audience. Talk about aggregation theory and kind of how you think that interplays with how you think about the investment opportunity and all this stuff. It's a great question because I tweeted this one time and I was having a conversation with someone the other day about it, which is maybe the idea of eyeballs wasn't wrong. And it's one of the most besmirched ideas coming out of the tech bubble was, oh, price to eyeballs. And oh, those people were idiots. Hmm. Turns out, maybe it's not eyeballs, but it's attention. And that was right.

And what I think is different is back then you didn't have the monetization engines to properly capitalize on it. And you didn't have scale of mobile. The mobile scale is something that I think people just, you know, it's now internalized. I think people understand, which is why these companies are five to 800 billion. But, you know, Facebook has over two billion users. Ten years ago, you would have looked at Verizon and AT&T and said, wow, these guys have. 70, 80 million wireless subscribers. Today, they have 100 million wireless subscribers. That's huge. Wow, Comcast has 22 million video subscribers or 25 million broadband subscribers. That's huge.

These are monopolies. We need to regulate them. Facebook has two billion. Google has six products, seven products with a billion. Instagram's about to cross a billion. This is scale that we've just never seen before. So, yeah, clearly people were slow to pick up on the fact that there would be hyper scale by virtue of mobile, that that hyper scale by aggregating an audience of that size would be able to monetize dramatically and that that would squeeze out a lot of other media types. So today, if you're trying to sell programmatic display on your site that gets 10 million uniques a month, great. Good luck. Have fun. That's a very, very difficult business because what scale means today is so much bigger. And look at Netflix. I mean, you know, it's, it's hard to have a

conversation in media without talking about Netflix. But Netflix is on its way to, you know, the market is pricing in 250, 300, 350 million worldwide subscribers. So it's nice that once there was 100 million pay TV households, but that's, you know, it's going to be a rounding error in the next world. And so you look at, you know, what's Google going to do with YouTube? What is Facebook going to evolve, Facebook Live? I mean, these platforms have so many users that they certainly are positioned to capture more and more audience. You know, with Facebook, I question, is that the use case of the Facebook feed or of the Facebook app is blasting that up on your TV and spending three hours? Whereas with YouTube, you can look at it and say, the use case of

YouTube is consuming video. It shouldn't be that much harder for them to then pivot that product into sort of a much more all-encompassing hold on your attention. We talked about overreaction, which said differently is over-extrapulation. And the things that people are worse at extrapolating is non-linear trends. And I'm curious if forced to under your head, you had to structure a long short portfolio, like a market neutral portfolio, and the whole time was five or seven years, you know, something pretty long dated. Is the play that, then in your mind long Netflix and like short everything else because it's got the kind of weird nonlinear potential or is the market already figured that out you know you said it's pricing in an insane amount of

subscribers i look at netflix and i say to me there's only one question i think for Netflix beyond it's clear it's pricing in 250 million plus is what is the ceiling on content spent and the the hope there is obviously that they you know if it's 15 billion 20 billion 22 billion that they don't need to spend above that and almost physically can't. And if that's the case, then you get nice margin expansion and all that. But I think the back of the envelope math I did was, you know, 500 million subs and they get to a 30% margin and Arpoo goes up, which doesn't make any sense because the next 100 million subs are coming from India at three bucks. I think you got like an 11% IRA from here. And so the nonlinear outcome has probably happened there. I actually think it's

a no coiner. I'm a no fanger. So if I look at Fang, I could actually be kind of dispassionate about evaluating them. I have the hardest time penciling out, you know, a really exciting IRA there. You know, in Amazon, you still have the non-linearity of AWS. It might still be early days there. Facebook, Instagram is about to cross a billion users. That seems like a unique property. Google, you know, you can make the bare case, but it's the world's most efficient marketing machine.

And more and more dollars are going there. So I don't have a strong view on each of those valuations. I think the Facebook, it's pretty clear what the risk there is is that young people stop using it and they have a hedge and that everyone goes to Instagram. But, yeah, that's a real risk. Google, the risk is that AI or something like that actually answers the questions you want without having to click on an ad. You know, Benedict Evans says the great irony of Google's business is that search doesn't actually give you what you want. You're clicking on ads instead. Like maybe someone actually figures out how to give you what.

what you want. And then Amazon, you know, which is sort of my obsession because of the e-commerce stuff is you have to separate AWS because that's sort of in a different world. But on the retail side, I am curious and I spend a lot of time thinking about over 10, 15, 20 years, how can that bundle that they've created be then unbundled again? And the bundling, unbundling bundling cycle in tech is just so fascinating because right now you're seeing it apply to so many old line industries. You know, CPG is just being radically unbundled. And you're seeing it in media where these groups of eight networks are finding out that maybe two matter in the next world. And maybe even networks don't matter. Maybe shows matter. And so then shows migrate to Netflix

because they package them all together. So with Amazon, Amazon's a curious one if you leave aside AWS of they look infallible. I do wonder if, okay, shipping does AVs, does automated vehicles somehow bring two day, one day, same day shipping capabilities to everyone neutering that? Amazon's not the cheapest already. So there are folks selling cheaper than them. Does someone figure out how to aggregate as much supply? Does Walmart decide, hey, maybe we need a much bigger third-party marketplace, and we can marry that to our logistics and then eventually add on autonomous delivery. It's such a fascinating question to me because it's clearly, you know, today the best run company in the world, the most interesting, most exciting

company. And so as a contrarian and a crank, why not spend all your time instead of owning it, figuring out how to deconstruct it and what does that mean for other players? You joke, but you talk about, you know, where to overreactions come. reactions come from wherever Amazon gazes. And there are times where a significant portion of what I'm doing is essentially saying, is Amazon really going to kill this in the next five years? And I actually say, you know, it's possible Amazon kills every company in every vertical that they look to. But I don't think they'll do it simultaneously. So if you can find the areas where they're less able to leverage their existing infrastructure and their existing capabilities, but the players

are getting penalized as though they're going to. That's really interesting. And yeah, I mean, that's been a source of real opportunity for the last two, three years. It's a perfect segue to a line you said earlier, which is the idea of customer acquisition costs just killing internet businesses. Let's talk about CPG, retail, physical retail versus online. And you're thinking on this on this kind of interesting part of the market. Well, if I can go back to start, the first internet company I ever invested in was Expedia. And this was in 2011.

And it had blown up for one of its many times where people overreacted, their earnings. And so I started doing work on it. And the online travel space is actually a great intro to the consumer internet because it's an enormous end market, trillion dollars plus. So it supports multiple players.

You have suppliers on one, side desperate to fill up their incremental room night, incremental seat on an airplane. So really value finding customers. On the other side, consumers hated picking up the phone and making a phone call to a travel agent or to a hotel. So online travel solved a real problem. It aggregated audience on one side, supply on the other, and it's been a home run. But at the time, you're studying it, looking at it. Like, wow, these companies spend 40 to 50 percent of their revenue on customer acquisition costs. And there are seven players in the market. That's probably not sustainable because price line, which is now booking.com, as they grow faster and faster,

they're going to have more marketing dollars to spend. Expedia, as they grow faster and faster, they're going to have more marketing dollars to spend. What about orbits? What about Travelocity? These guys can't hang. And so what I learned from that experience was, wow, there's a massive advantage if you can outspend your competitors, acquire all the customers. But then the realization was, not every end market is this big. And if I have to spend like that and I can't access a profit pool that that's big, wow, I'm really screwed. And so if you apply that to the e-commerce framework, the problem is in e-commerce, for the most part, you're selling fungible goods, meaning they're found on multiple sites at low gross margins, most of the time in the 30s.

And now you have to acquire customers. And so there's a reason there are almost no standalone profitable e-commerce companies is because you either dedicate yourself to a niche and you stay subscale. You just enjoy the fruits of that small niche. But nobody wants to do that. You want to grow. And once you take on the institutional imperative to grow, the way you grow is you go and you acquire customers. And once you do that, you go to Google search, you go to Instagram.

you run TV ads, you do whatever you can. And all of a sudden, I call it sort of this, you know, law of diminishing returns in customer acquisition, which is your first cohort is your most profitable. And cheapest to acquire. Yeah, because you had a product. You hit product market fit. Everybody loved it.

This small group of early adopters. They told their friends, great. You get to 50, 100, 150 million dollars. So now you've raised a bunch of money. You're worth a billion dollars on paper, but you got to grow. So what do you do? Oh, well, we'll go out and we'll buy some Google search words. Okay, look, the ROI is okay. Or maybe the ROI is not okay, but we say we'll spend to a zero dollar profit on our first purchase with them, but they'll come back. And so now you start, you know, fudging the LTVs. And the other problem is your cost to acquire is increasing because other people are doing this too.

And so you can look across the landscape. Marketplaces are different. So, e. Bay has very high margins, very different, but first party seller of goods, this idea that by getting rid of stores and getting rid of the fixed cost infrastructure, all of a sudden you were going to have this wildly profitable business has just not borne out at all. And it's actually interesting. Even Amazon has migrated to a third party selling model where the vast bulk of whatever profits they have in their retail business come from the marketplace business. So I think it's just, It's shown that online customer acquisition is a very challenging way to scale, whether it's just a niche brand, which you're seeing a lot of, or a broader store idea.

So people have hit the wall. They've tried to sell themselves. The ones that haven't basically gone out of business. And, you know, I talked about this looking at, Andy Dunn had this old post about various ways to fight Amazon. And if you look through the various ways to fight Amazon or avoid Amazon, almost none of them have worked. At the end of the day, you know, whether it was flash or, you know, daily deals or subscription boxes, you get some adoption and then you hit that wall where you just cannot acquire

your next customer profitably and you're kind of done. When we first got together, we were talking about physical like malls and retail and things like this. So talk a bit about that idea. And this funny thing that like the unbundling bundling cycle, everything's coming full circle and the Warby Parkers of the world are opening stores. So talk about physical as, you know, customer acquisition costs. This sort of speaks to the opportunities and how I look at the world. In November of 2016, something happened in the United States that caused consumers, for whatever reason, to pause their spending for a little bit.

They also, for whatever reason in February of 2017, didn't spend as much as expected either. Some people think it's delayed tax refunds. And so the numbers that retailers, physical retailers reported, were horrific, just eye-wateringly bad. And also as a result of that, a bunch of them filed bankruptcy. Now, you can say many of them had improper balance sheets because they were owned by private equity who had levered them up and not expecting perhaps the election to cause distress. But for whatever reason, a huge swath of retail filed bankruptcy and closed a bunch of stores. And so you started seeing stories about retail apocalypse and death of the mall and all this. And so my spidey sense goes up and, you know, again, Amazon's killing them all.

So first response is, wow, I got to go look at this if Amazon's responsible. And see, you know, maybe there's an overreaction. The problem is if you build the worst business from scratch, if you just whiteboard, what does the worst business look like? And when you're done tallying it up, you've built a retailer. So I had no interest in actually exploring retail because the ones that had prosperous business models, T.J. Max, Costco, they hadn't been impacted. They were still, you know, trading as though they were great businesses because they are great businesses. The ones that were trading as though they were crap businesses are crap businesses. And so maybe I could catch an apparel cycle or something like that that I have no expertise in.

So I said, no, can't do retail. Real quick, before we go on, just enumerate. what makes, say, a Costco a good business and a traditional retailer is such a bad business if you're whiteboarding it. Just not to take that for granted. Sure. Well, I am not an expert on Costco, but they have a model that's a subscription model in the physical world where essentially their operating income is subscription revenue. And then they provide an enormous amount of customer surplus. Their customers love them. They sell it a, I think it's a 10 or 15 percent markup. They have nailed the rollout of stores. They know where to go. They know how to do it. They know how to merchandise a limited assortment. Their suppliers want to be there, work with them. So

unique. Walmart for years and years one on their supply chain, T.J. Max wins on the buying, meaning their buyers, their open to buy is out there able to source goods and their customers have a treasure hunt experience that can't be replicated online. So there are various players that have figured out models that work. The generic retailer has high fixed costs, high working capital intensity, low differentiation. They take fashion risk. They need to acquire customers.

Essentially, you're selling at a 40% margin with high fixed costs underlying that. You have SG&A. You need to comp 2 to 3% a year to not de-leverage your fixed costs. You have inventory risk that if it rains in May all of a sudden you're on the conference call saying, well, you know, we didn't move through our spring t-shirt line. So it's just, it's a horrible business. It's why there are very few persistent

overtime performers. You'll have someone come, you know, five, 10, 15 years. They over-expand. They become stale. And now they're stuck with an aging store base. So that's, that's on why I had no interest in retail. So as I looked around, I was reading about the death of the mall. And at the time there was a paper circulating that was the next big short was was mall CmbS and I read it. And it was actually very interesting. And there's some embedded correlation risk in the CNBS product that made it. I could see why people would want to do it. But that's a great headline to have, right?

The next, you know, big short is out there. And so I started looking and said, okay, there are 1,200 malls. That sounds like a lot. Wait, about 900 of them make up maybe, you know, 10% of the value in the same. sector. So yeah, those are probably going to die. But what if you don't own those? And so you sort of said, okay, there are 300 malls. They make up 90% of the industry value. They're owned by five public companies. Let's start taking a look at that. Some of them have assets overseas. So that made it less interesting to me because I don't particularly have a strong view on what's happening in the

rest of the world's retail. And you can sort of narrow it down and come to the idea that some of these might be really interesting because, A, you had this overhang of retail apocalypse, mall apocalypse. B, you had what I thought would then be an improving retail environment because, again, I think that late 16, early 17 was sort of an anomaly in, yes, the trends in retail are bad, but they're not that bad. So I thought you would get some improvement there. And then, you know, if you really get into the nitty, gritty details, the A mall

properties in general did not suffer negative NOI in 09. And their occupancy in the 2000s was call it 92, 93%. Their occupancy today is 94 to 95 percent, but it's down from 96. So if you think about extrapolation, 14 and 15, 2014 and 2015, the best malls in the country were operating north of 96% occupancy, which is kind of crazy if you just think about the general churn in and out. It's very difficult to run an entire portfolio at 99. So maybe 96 is the upper limit. And so that had come down to 94. And so Wall Street linearly extrapolating is like, well, the next stop is 92 and then probably 90.

And so what, again, reverse engineering, you could sort of look at it and say, wow, it looks to me like we're assuming net operating income, which is, you know, the key metric here. was going to go negative, kind of in perpetuity. Because otherwise, if you just thought that NOI would be flat or up, these were fairly attractive. So then you say, okay, what has to happen for NOI to go negative? You say, okay, well, it didn't happen in 09, so we need consecutive 09s. And you can start to say, maybe this is interesting. So it really started to do a lot of work there.

But it ties in nicely with, like you said, Warby Parker, which is Warby Parker is not going to open a thousand stores. Gap today has, you know, 1,200 old navies, a thousand Gap. That model is dead in my estimation. But what you will probably have is folks who launched online, built that initial fan base, decided, we have a big enough business today that we can start to scale this. We know, and this is really powerful, that when we put a store somewhere, our online sales go up. Our stores, we can operate them profitably because we don't need a 10,000 square foot store like they used to have. We can have a 1,500 square foot store. We can operate it profitably and it's a source of customer acquisition. And it benefits our online business. Okay, where do we-

Brands just in general. It builds a brand. It's kind of like Madison Avenue, high street retail. That business is challenged today because everybody was running those at a loss, but they needed it for brand building. Well, what if you can build your brand profitably by not putting it on Madison Avenue, but putting it in a really high traffic urban mall. So I think the future looks like a lot less malls and retailers that are not e-commerce or physical, but they're just retailers. They're people selling you stuff and their brands selling you stuff. And they probably want to have locations in San Francisco, New York City, Miami, Washington, D.C., Los Angeles.

You know, there are however many urban locations that you're going to pick, and whether that's 200 or 300 or 350, you know, you can go through the demographics of all that. But that seems like a model that's going to work because online only is not working and offline only is not working. So some hybrid clearly makes sense. And who figures it out how it works is definitely an open question. But my guess is whoever it is is going to want to be in these specific locations. So I'd like to go back a little bit and tell in some more detail this consumer internet story. It's a thesis that's a couple years old now and has in many ways played out. But it's a good example of our overall conversation, which is over extrapolations, overreactions.

So maybe go back a few years and describe what you saw there, what you were thinking about as it pertains to those businesses and why there may be an opportunity that's been mispriced by the market. From there, we'll also go deeper into this no-fanger idea about why and how, maybe. maybe these businesses won't disrupt as much as everyone is talking about. But we'll start with this idea around consumer internet companies. Sure. And I was not unique in the insight that the consumer internet's going to be great. But I think at given points in time, particularly in the small and midcap space, there's been tremendous opportunity either because one of the big guys was allegedly pointing their traffic

gun at that area or just general competition was increasing. So there have been episodic opportunities to look at some of the businesses. But I think if you go back to the late 90s, you had sort of this Web 1.0. And then starting in the mid-2000s, you had this next gen, which were more technologically savvy, much better able to pivot to sort of the mobile world. And there I'm thinking of the Zillow and Trulia is in real estate. Seameless was started early on, but they sort of dominated their category. And as you started to look through each of these verticals, you had a couple billion dollar companies that were steadily accumulating the type of aggregation that we talked about earlier, but within a niche.

That niche could be huge. Zillow has the vast majority of real estate browsers in the U.S. are going to go there and they accumulated that via putting this estimate out, building traffic, and then subsequently becoming essentially the de facto. Seamless and Grubhub came out at the same way. They just steadily built supply, aggregated, both sides of the marketplace. But what I think was underappreciated was similar to folks not appreciating, wow, Facebook has two billion users. They're probably going to make a lot of money off that was that there was an opportunity within these verticals for each leader to extract real economics. And the reason was the CEO of Groupon once said something that's blindingly obvious, but has stuck with me is that the folks who have won in the internet have made the experience better.

So if you look at online travel, calling an airline was horrible. Calling a travel agent was annoying. Booking your travel online is just better. And so all these various winners calling a restaurant to get your delivery each night is an inferior experience to going online, hitting, I want dumplings and, you know, whatever, and getting it delivered. So these businesses took friction out, made for a better user experience, aggregated the customer side, went out, built the supply side that wanted to access that, and did essentially what we talked about with the big platforms, but for specific use cases. So at various times from 2011 on, you had opportunities to pick up some of these companies at extremely attractive prices. And one particular, you know, in late 15 and 16, much of, and early 16, much of the stock market was on sale. But there was just a unique opportunity where, you know, you look at Grubhub.

They were getting competitive Amazon announced. They were coming in with their restaurant delivery. Uber Eats was getting press. And a friend of mine says, small focused always wins. Because every day they wake up and it's life or death for them. And for Amazon, signing up a restaurant. and figuring out how to deliver food to customers is nice, and maybe there's some tangential association to prime. But for Grubhub, every day, the most important thing, the only thing that

matters is making sure that consumers get the food they want when they ordered it. And so whether it was Match had just come public and that stock got down to eight times EBITDA. And today, if you look at match, it trades it closer to eight times sales. So people have figured out that, hey, internet dating is probably a real business. But there was a good four or five months stretch there where you name it in small and midcap. Most of the leaders were being treated skeptically. And, you know, I think they're up to 250 percent, 200 percent, something like that from the bottom. But I think the more interesting case is when an Amazon does announce they're going, after someone or Facebook does announce or it actually used to be with Apple at

WWDC you'd see they'd make some announcement of hey we're pulling in this service into our OS and the stocks would be down 20% now it tends to be more Amazon or a couple weeks ago Facebook announced right they're getting into dating and so the knee-jerk reaction is well everyone screwed right they have 250 million literally right they have 250 million single profiles, people spend 40 minutes a day on the platform, why isn't this obvious? And who knows, they haven't launched the product yet. We need to see how it evolves, how they iterate it. But again, Match has multiple brands who wake up every day with one goal in mind to make the user experience better to connect daters. Facebook, to me, if you were to say, given what's going

on with privacy and all that, would this be the right time headline-wise to launch a dating product? You'd probably say no. So you sort of ask yourself, okay, why are they doing this? And I have no idea if this is causal. But if you look at the last 15 to 24-month data, the sort of 18 to 30-year-old cohort's time spent on Facebook by third parties is said to be declining at 25 to 30 percent. if you wanted to reengage that cohort on your platform, an interesting way to do it might be to try to launch a dating product. So I always take sort of from first principles not can Facebook get into dating. Of course they can. They have billions of dollars and they generate billions of dollars. They can do it. But why are they doing it? To what end? Is this a consumer proposition?

Or is it to solve a need of Facebook? And so in this instance, it looks to me like they're trying to solve their end of declining engagement amongst a certain age group that might be invigorated by dating, as opposed to solving a customer problem, which is, I want to meet someone, I want to have a good experience. That, you know, I think match was down 25%. I see who owns 80% of it was down 22%. And we'll see. I mean, they got to play their hand.

But you see that time and again where if you know these companies to, I think it was two and a half years ago, Amazon announced that they were going to get into a business of a small little company called Shutterfly. If you have kids, you know Shutterfly because you probably make photo books for grandma and grandpa. You know, you put their faces on mugs. Amazon said, we're getting into this business. And look, the first reaction is, oh, crap. Like, this is the big behemoth. They have 60 million prime households, same exact demo of moms buying stuff. But then when you see actually how they launched the product, if you've ever. gone to Amazon's homepage, you know, it's nearly indecipherable to find anything. So the click flow

to actually get to the site. Then when you got to the site, it kicked you to a third party because they were white labeling, basically an outside provider. You saw that essentially the only thing they had going for them was they were charging a lower price because it's Amazon and that they had a large user base that they could potentially tie to. But the experience was inferior. It was not anything that they really cared about. And so the stock has more than double. since that announcement. Going back to these overreactions, if you know these businesses well, because they do dominate their category and take the lion's share of the profit, if Fang decides, hey, we

want to go do this, you think hard and you get scared and you go, oh, crap, they're coming. But then you sort of analyze the situation and say, maybe not. We were talking before we started about, I'm going to mispronounce his last name, but one of the original PayPal Mafia guys, Keith Roboy or however you say his name, had an interesting point on Twitter about post-95, any company, especially in niches, that has any sort of traction, really hasn't been killed by one of the big incumbents. And that's very counter the narrative out there, which is that the fang stocks, basically, as you've just described, could go after anybody and wipe them out. But that really that hasn't

happened. The underlying question is, so why isn't Amazon or Facebook or whomever? Why isn't Facebook going to win in these niches when I think it could grow their business? businesses tremendously. Is it a lack of focus? Is it an investing truth that focus and niches are just going to work better than do everything platforms? How do you think about that looking forward? Again, I don't think the question ever should be asked. Can big tech get into something that a portfolio company of yours or someone you work for? Can they get into it? Yes, they can. The no barriers to entry on the internet is true but uninteresting because it definitely is. So the way I think about it I try to say, okay, what are they trying to do?

It's unlikely that they're just saying, we're going to set up a Me Too service and try to grab some of that profit pool. Usually it's to further some core mission of theirs. So with Amazon, if you think about it, from the consumer side, Prime is the center. Prime is the universe. So if there's something that can be added on to Prime as a service, you should think long and hard about that because they can integrate it, They can give it away now as part of this subscription. It's 60 plus million households. So you kind of need to start from first principles of not can they do this, but why would they do this?

Facebook is an interesting example because if you were to go back 18 months and you were to say, has Facebook ever made an incursion into another category and won? Everybody would laugh and say, no, of course not. You know, everything they've launched and tried to do has failed. But then they took on Snap in stories with Insta and had lots of success there. And so recency bias now everyone says, oh, crap, if Facebook comes for you, you're screwed because they're going to leverage their 2 billion user base. But I think to answer the question, it's one, usually they have an ulterior motive other than just winning the category. Two is, again, these niche companies, even though they can be $10, $15, $20 billion companies,

they wake up each day with one purpose. And that's to serve their customer for whatever specific services it is they're providing. They work on the U.S. of that. They're building the supplier base on one side. They're just constantly iterating that. If you're a global platform or aggregator, you have lots of goals. You're doing lots of things all over the place. And so you dedicate an engineering team and maybe one.

One day you use your homepage or your ability to drive traffic to it. But then the next day, you're on to something new. Google has Google Photos, which is, you know, by far the best photo repository site. And they do that because they have phenomenal machine learning algorithms. And it helps them to really develop internal talent and expertise. One day for no apparent reason, they decided to offer photo books on their front page. And so again, people go, oh, shit, Google's making photo books. And you know, you don't like to see that, but you sort of say, okay, are they going to build out printing functionality?

Are they going to build a good user experience? Or are they doing this to prove that their machine learning algorithms are really good at picking out seven photos of your baby over a month at a time? And that's probably the goal that they're aspiring to. So I think you have to look at when a small focused organization with one mission in mind is fighting a. very large organization with unlimited resources, but not focus, I think Keith's point is that you should probably bet on the guy who this is all they're doing all day. And that's, it's been a huge opportunity to make money because, again, from time to time, one of these platforms is going to say, oh, I like that. Let's go do that. You mentioned this idea of the distrusted 50. I'd love

you to describe this list, kind of its derivation and why you find it interesting because it fits nicely and with this kind of general idea. Well, yeah, there's a research shop, empirical research, and they do wonderful, fundamental, quantitative research. So it probably mirrors a little bit of your investing style. And, you know, I'm not a quantum, just a general fundamental guy. And their research nicely lines up with a lot of what I see. And this notion of the distrusted 50 essentially is that free cash flow tends to be undervalued.

and that there are groups of companies that generate, that have great businesses, generate relatively high free cash flow margins and free cash flow yields, and the market sort of systematically under prices that either because they think that the capital is going to be squandered or that it's unsustainable. And so in the paper that you talked about putting out this idea that value is essentially multiple expansion. And in these cases, basically you're getting. a nice yield. Maybe you go in with a five, six percent free cash flow yield, maybe higher. And so you

essentially clip that coupon. But what you're really hoping is that at some point, it goes from distrusted to trusted, and you get the re-rating. And a lot of what we've talked about is, so I have these ideas of the future and all that. But in reality, I'm not predicting the future. I'm reading the VC blogs, just like everyone else. I'm listening to your podcast with them. what I'm trying to do is find a view of the future that differs from the markets today. And then my belief is that over time, the market's belief will accrete to my view. That view doesn't actually have to come true. I just need the market to come to believe that.

So a little bit of these distrusted 50s and the general notion of buying sustainable free cash flow is that if you go in with a high yield, again, we're not talking double digits here. but call it 5 to 8%. That is pretty good protection because each year that's accruiting to the entity. And then what you're hoping is at some point, and you want to have a view of what that point might be, but at some point that the market then, whether it's they don't destroy capital by doing M&A or doing something stupid, or that durability of the franchise is proven out, that you re-rate that down to a four or five percent yield. And now you've made a lot of money and you go find the next one that's distrusted.

So part of that distrust is, you know, whether or not the managers of that business are going to do a good job with their capital. I'd love to talk a little bit about how you think about capital allocation and maybe even some specific hot button issues within that topic. So let's maybe start with buybacks. So this has become like the whipping boy in the media and it's a hot topic. There was a story yesterday in the Wall Street Journal about how the instances of insider selling, there's an abnormal rise of that. following buyback announcements, which tends to lead to a pop in price or has tended to lead to a pop in price, how do you think about something like buybacks as a starter when it comes to capital allocation?

Sure. The great luxury of today is that many of these businesses we've talked about generate enormous excess capital. And that is a blessing and a curse because, you know, Buffett pointed this out many, many years ago, as you spend your whole life working really hard to become CEO or in these tech companies case, you founded it, you know, in your dorm room. and then one day you wake up and now you're responsible for allocating $6 billion in excess capital and you have no experience in that.

So, yeah, this is one of the key issues for many, particularly in the tech and media world, that generate just enormous excess cashes. What do you do with it? To buyback specifically, I think it's pretty simple. If your stock is reasonably discounted to what you think you or a private market buyer would pay for it, buy it back. Buy it back. If it's not, don't.

The single worst thing, and when I talk to a management team, I say up front, I go, I'm going to put this out here. This drives me more insane than anything else. If you say we buy back stock to offset dilution, I will go bonkers. Because if you think about that, there are two entirely separate decisions. We issue stock to pay our people because in some industries, that's how people choose to get paid. Don't make the second offsetting decision for no other reason than you want to buy that stock back. If the stock's not cheap, don't buy it back. That's just like issuing stock.

If you have a very expensive stock and you issue it to do an acquisition, great. That's smart. If your stock trades it 25 times EBITDA and you're issuing stock to your employees, you're acquiring them cheap. But if your stock's cheap and you pay out SPC, fine, that's fine. But go buy back your stock because you're increasing the per share value of my stock. And so much of this gets back to is the goal to grow the size of the size of the enterprise, where's the goal to create value per share? And that is often lost on people because

folks are empire builders, folks are, you know, have delusions of grandeur. But per share value is what we're trying to maximize. And again, the calculation is simple. If your stocks, cheap, buy it. If it's not, don't. But I don't think that for most management teams, this is sort of the thought process. Now, there's a separate big buyback debate that I've engaged in on Twitter for four or five years, which is, does buybacks come at the expense of, whether it's corporate investment, R&D, any of this. And there, I just think the evidence is very poor that buybacks have come at the expense of something else. Because if you think of the uses of capital, right, there's internal reinvestment. And we know that R&D is rising and has that, that is not a problem.

So then the other uses of capital are going to be capital. are going to be buybacks, dividends, and MNA. The metric most people point to is free cash flows, use, dividends, buybacks. And I'm like, but that's already net of R&D and KAPX. So the real remaining criticism then is that KAPX has been underinvested in. Well, I think the argument for that is that global demand growth has been slow. there was a lot of excess supply coming out of the great financial crisis, and we've had to work through a lot of that. In certain industries, take tech. There's massive KAPX going on. The problem is when you look at the ratios of KAPX to say sales or anything, these companies are growing so fast and are so big that, you know, Amazon spending $25 billion in KAPX looks like a drop in the bucket relative to their P&L. So I think that there's a societal question of our buybacks bad.

And there I would say no. I think that actually they're completely legitimate. They have not come at the expense of other things. Then there's the financial question of are most of these buybacks being done, value accretive? And they're at situational. And you have to look at that. I wrote something a few years ago where I said this idea that we want tech companies to just be throwing all their money into, you know, whether it's M&A or R&D, is crazy because you want the experts doing that. And a lot of tech companies have built a product in a certain cycle, earned enormous cash flows off it.

And now the expectation is go throw that capital in and build the next thing. Do it again. Right. And the base rate of success of that is extraordinarily low. And so if you're a shareholder or even if you're just stepping back, somewhat observing society, you would much rather that capital go back to its owners. And then that capital deployed elsewhere into the next guy who has a better chance, of building that next new thing.

It sounds so funny. It's so funny to me because it's almost like people are saying that somehow these CEOs or whatever can allocate capital better than markets can, which just makes no sense. Right. And some investors are presumptuous enough to try to tell management teams how to do their job. I generally don't think I'm smart enough because I've never worked for a big company or even a small company to tell them how to do their job. I have ideas.

They laugh. We go on the next topic. But on capital allocation, if you're an investor, this is literally what you do. And so there, I do think that an informed conversation with management is warranted because you are constantly dynamically allocating capital to its highest and best use. And that's what companies should be doing. But for various reasons, oftentimes they either don't think of it properly or they just aren't doing that. Talk a little bit about international equity markets from your seat. So a popular topic has become China largely because there's many now recognizable huge names.

in the tech world specifically. But how often does your opportunity set creep outside of the U.S.? Is it something that you care about or think about all that often? Are you kind of agnostic to, you know, where a company is domiciled or headquarters? And do you see any differences, I guess, in international markets relative to the U.S. that makes opportunities to earn Alpha more or less attractive? I would say in general, I mostly do U.S. listed equities. There have been times where some of these quirky overreactions a few years back, ABI, which is a European listed. company, but has the majority of their earnings from the U.S. and Latin America, was getting sold off on the European crisis. And I think they had like 8% of their sales at the time in Western Europe.

So I situationally look for episodes like that. In general, find the lack of access to management. The financial statements sometimes are in different languages or using different accounting standards to be difficult. But sure, always looking. We started out talking about value investing. I think every value investor worth their weight has at some point paid their dues in Korean Preferreds and Japanese discount to NAV. Those are always on the common. They're going to work next year. But so you, you know, you look for those. But I think in general, it's been possible to get really nice international exposure via U.S. listed companies. With the Chinese companies, you know, you asked me about them and tech. I think it's interesting because they've,

gotten to this massive scale and they're clearly so successful in their home markets. So there's a notion that they should be able to expand out. And I don't have any great insight into them. But I do wonder, once you enter a fully competitive market without the backing of the home team and you're up against both the local incumbent and then the U.S. platforms, that's just a different competitive operating environment. They bring a lot of advantages, which is massive scale, massive balance sheets. Some have tried. Alibaba had a U.S. site that they were trying to build up e-commerce-wise.

I don't think they had great success there. There's notions sometimes that they may buy their way into the U.S. They have a staking coupon. They may someday link up with eBay. Someone people have talked about, 10 cent, you know, their global via their games business, things like that. But I think it's a different competitive environment when you have to go head to head, out the finger on the scale and you're not a name brand. So whether the assets you're bringing to

bear are enough to sort of overcome some of the structural frictions and reasons that category winners win, I don't have a good view on that. I'd love to talk a bit about the industry itself, the asset management business, the investment business, and your take on it given a fairly unique seat. And having watched it for a long time, just like I have with a lot of interest, I think. One of the themes of our conversation is the episodic nature of big opportunities. We talked about three examples in consumer internet, sort of the cord cutting overreaction maybe to cord cutting, things like real estate and malls. Obviously, those are discrete sets of opportunities which may play out over some period of time. One of the things I've been thinking a lot about, especially

for fundamental active managers, is that by giving money to a fundamental active manager, you're sort of implicitly assuming that the opportunities are fairly evenly spread. through time, but that doesn't actually seem to be the case. How do you think about that? What do you think the kind of future of what's your assessment of active management, generally speaking, and any thoughts on where you think we might be going would be fascinating? I think if you're a dispassionate analyst in our business and you step back and you analyze the nature of the money management business, you would probably say, wow, this is not a place I want to put my capital. And likewise, maybe I don't want my kids going into it. I think you're at a point where you have a

have some of the smartest, hardest, hardest working, most driven folks, all competing in, I don't want to call it zero sum because some markets have positive some, but in very competitive situation. And you can look at any number of ways of slicing and dicing the data, but it's clear that the excess performance generated by even superstars has been diminishing and reducing in persistence. So the amplitude of outperformance has come down and the persistence of it has basically disappeared. So I do think that there are a handful of folks who have demonstrated over many, many, many years that they are truly elite like you would in any other profession. But I think, you know, Michael Modison talks about the paradox of skill and our profession is now cursed by the fact that there are a lot of really good people doing.

it and that luck probably plays a larger and larger role in outcomes, and that generally isn't a persistent characteristic. So I think the notion of these episodes, why that appeals to me is because as I've done this longer and longer, market efficiency is something I originally came into the industry scoffing at. And today, I think, they're mostly right. And, you know, most people sort have used an example of us. Stock goes down 25% on some news and everyone goes, ha, ha, ha, EMH. And you're like, no, EMH says you can't systematically take advantage of those mispricings to outperform. And we know that's definitely true because very few people are doing it. So I think the idea you can go in day in and day out and find wildly mispriced securities and systematically outperform.

That is crazy, is your word. So there are folks doing it. And so I don't want to knock. them and, you know, I'm not an expert on every strategy. Maybe we'll go back later and say, picking who might be able to do that is crazy. Yeah. It's very difficult ex ante to identify the persistent outperformer. But it is clear that from time to time, whether it's a thematic narrative, there's a macro overhang. Look, it's easy to say in retrospect that the fall of 15 and early 16 were great buying periods. But if you bought a lot then, that worked. And that generated out performance for a few years. So I think the way that performance is evolving is it's who can sit on their hands, be patient, and wait. And that's always kind of been the case. But I think the waiting's

getting, it's getting harder. You're inundated daily with data. You think it matters. You see your competitors, performance numbers. There's so much news flow. There's the urge to action. And it's almost made it harder and harder to sit and wait and say, what are these fat pitches? When should I put significant capital to work. And then as far as a business, if that's the right way to invest, I have no idea how you structure that as a business. Folks in distressed debt have managed to figure out how to pull down opportunity funds. And that has worked for them. They know when the time is right to deploy that capital. Certain folks have earned the right to go to their investors and say, we see something or we will see something. But I think for the investing is a game of

of multiple sigmas out. No one's really interested if you're operating at the 95th percentile because there's a lot of people then to your right. It's how do you structure your business to sustainably generate outperformance? I think you need to have this patience, this mentality and this capital all align so you can do it. On the other hand, I will say I look at a lot of pitch books and this idea of time arbitrage has kind of been universally gravitated towards as why active manager should exist. So I think you have to be careful not to just say, we're arbitraging time. It's the last available source of the balfa because guess what? Everyone's pitchbook says that. So I think you need to be careful in not just saying the tried and truism. You need to actually

mean it that, look, I do nothing for 18 months at a time. And then opportunity presents itself and I pounce. And I think behaviorally it's really difficult. Business-wise, it's really difficult. So I'm not sure that folks can actually do that. But that is, in my estimation, I think, again, the idea you can just go into the marketplace and beat people day to day is not for the traditional fundamental investor. The combination of patience and conviction, the kind of classic Buffettmonger thing, is popular. How do you think about the allocation of a portfolio in between periods of conviction? So in between the opportunities to do something that seems like a broad mispricing that's

happened, you know, cord cutting, for example. How do you think about positioning the portfolio when there's nothing to do? Are you just long? Are you an SPY? Like, you know, markets are mostly efficient most of the time. I'm going to differ from what I actually do it by a day job and from what theoretically might be, I've spent a lot of time thinking with friends about this is what if the right thing to do is just put it in low-cost index fund, not charge money on the capital in the index fund, just charge on the actively managed assets. And when the opportunity presents itself, you divest SPY and you go buy out. Look, I can't speak for allocators. I don't know how they view the world. I think that would probably be very difficult pitch to make to a lot of people that, wait, so we have this guy, he's 80% in the SPY right now. And at some point in the future, you know, even though that's probably a smarter thing to do than leave it in cash and wait until an opportunity fund draws it down because most of the time

the market goes up from human behavior, my guess is that wouldn't work. I think your question is, though, you know, on a day-to-day basis, what does an active manager do when there's not a lot to do. And, you know, I think that's where a lot of mistakes are made as people try to reach. And I think that's where discipline and respect for the market is really important. What are some other investors that you've, I was going to use the word respect, but I'll change that a little bit and say, not just investors, there's other thinkers that you've learned the most from that have most impacted the way you think about markets. Look, I think it's cliche, but anybody who says they haven't learned a bunch from Warren Buffett as a fool.

His shareholder letters over the years, still to this day, if you go back and read, you know, I once posted on sort of franchises versus businesses, and it started a multi-month conversation around this idea of what's a franchise and what's a business, and a franchise is truly special. He talked about in the early 90s, essentially the death of media, that you owned a local newspaper or you owned a local TV, station, you were king because you had a local monopoly. He said the future might be bright. And look, it was for the next 15 years. But he saw the writing on the wall then. So I think set aside your views of how he's earned his money lately or if you don't like what he does with banks, any of that. If you just look at the 50 years of writing, you have to have learned from him. Mike Mobeson has put out some of the most fascinating work on actually the mechanics of investing. And I think he's really helped folks think about adapting.

And this idea of expectations investing, which is you don't go to the track and you bet on the favorite. You go to the track and you bet on the mispriced horse, right? And investing is the same. You know, a lot of people feel comfortable owning the best businesses. Well, that's fine because it is nice to sleep well at night knowing that your company is great and a leader and all that. But is that the right way to outperform? unclear. At certain points in time it is and at other points in time it isn't. So this idea of understanding and becoming sort of a market psychologist, I think, is very underrated. Who else?

You know, there are so many folks out there, but those are two that I would definitely point to. And then the ones that I would love to have access to their brains are active managers who have thrived over the last 20 years by evolving. And how have they gone from being just high-yield bonds to running a multi-platform or a multi-asset class business. Because that sort of mental dexterity is truly, I think, what has separated that elite. 0.0001% from a lot of the people who maybe for a 5, 10, 12-year window were in their cycle where their style of investing prospered.

But when the cycle changes, the persistence goes away. And then there are a handful of managers that I don't want to name them, but that I personally look at. at an awe from the outside because you see that they've managed to rotate capital into strategies that are working at the right time and therefore prosper over multiple decades. It's amazing looking back. You talked earlier about the 98 to 2002 period being so important for our business. And the lifespan that a lot of value managers were able to survive despite bad performance because of how well they did in one specific period, but then maybe haven't

evolved. And I just think that highlights, look, from an allocator standpoint, it's so hard. How do you, how the heck are ahead of time are you going to identify the ones that can and will evolve? So I think I will name one person because I'm fascinated by his performance. He puts out great letters. He's given speeches on this is Bill Nygren at Oakmark. And if you were to go back to 0405 and look at the cohort of value mutual fund managers that were sort of revered for their ability to come through, you know, the 98 to O2 time period. He was definitely listed amongst them. If you look to today, he is one of the very, very few who has not only survived, but generate a significant outperformance. And so the question is why. And it's, well, he bought Amazon in 2014 at 200 bucks. And he owns Google. And he said,

I know what we were supposed to do. When I came into this business, I looked at the, list of statistically cheap stocks. I picked amongst them. I don't like that balance sheet. I do like this one. Let's buy them. But in recent interviews, he said, look, that doesn't work anymore. And today, you know, I remember when he made his case for Amazon and he essentially said, look, if you look at their price to gross profits, it's as cheap as it's been, I get that they're not earning any money right now. But, you know, they're about to inflect and we think it's being underpriced. And he was right. So I think he's done a really good job. job of adapting the value investing style. And again, value investing is simply buying future cash flow

at a discount, right? But value investing, as many people learned it, was buying statistically cheap stocks. And he adapted. Others maybe haven't. And you mentioned from the allocator's perspective, it's really difficult to say, is that person adapting or is that style drift? And if someone goes through a period of underperformance. Is that person dogmatically sticking to a failed or a, you know, historical process? Or are they sticking to their process and on the verge of performing again? Because we know it for outperformers, generally you underperform 30 to 40 percent of the time. So I think one of the constant tensions in money management is markets evolve, markets

adapt, investors need to as well. But how much is it adaptation? and then when do you go too far into style drift? And late in a cycle, everybody wants to own momentum-driven growth companies. So you see people pile into that, which is typically a late cycle behavior. Or is it just people saying, you know what? These businesses are still undervalued. The market's getting it wrong.

I'm going to buy them. And that's the tension that you have to weigh. This adaptability idea is becoming, I don't know, maybe the thing I think about more than anything else because that tension is fascinating to me as a moment. an investor to looking at thinking about companies like, you know, Jeff Bezos or whatever brilliant manager's ability to adapt to evolving conditions, they're investors too, right? Like, they're allocating capital too. And those will be the winners, right? The right balance of sticking to some set of core principles, you know, you use the term style drift. Like, I think you probably

need some, whether it's customer centricity for Amazon, you need some true north to orient yourself, but then constant adaptability is really important for business managers and investors. How do you think about that personally for you. What are the ways that you try to force yourself to adapt to new conditions beyond obviously just, you know, thinking a lot and reading a lot? Are the things that you're deliberate about to make sure that you don't get caught in that snare or that trap? Yeah. If you go back to my history, starting out buying $400 million companies that had $200 million in real estate that wasn't on the books and $150 million in cash and maybe had lousy management, but you would put up with it because one day they might sell the real estate and

buy back a bunch of stock to today where I look at some high-growth internet companies when they're going through challenges. So there's clearly been an evolution. And here, I'll actually put in a pitch for Twitter. Twitter exposed me to a broad range of investing styles that I never would have encountered. If you are one of those crusty old deep value investors, you tend to talk to other cranky, crusty old value investors. And you try to find the least bad in a really crappy industry. You go out and, you know, you look at the real estate that's not on the books and get really excited. By seeing that technical analysis worked, by reading the thoughts of VCs betting on moonshots, by seeing growth investors talking about, look, I don't care if I'm paying 25 times earnings.

The RIC is, you know, 30 and they're reinvesting at a super high rate. In 10 years, they're going to be earning, you know, five times more than they are today. So seeing that all these other styles worked, necessarily just made you question. There's no one true way. And I do think that folks can sometimes, people can sometimes fixate on this fact that like, my way is right. Well, value works or did work and momentum works. We know they both work. And that's a pretty funny conclusion is that people doing the exact opposite thing could both outperform, you know, the market. And so I've, I've forced myself to do a lot more reading about high tech, what VCs are investing in.

You know, I subscribe to a bunch of newsletters on that stuff. I've tried to expand my circle of competence always. I think this idea of expanding that circle, not getting content to say, I know three, four industries and that's it. There's something fun and exhilarating about a new industry, but you also have to be careful because when you wait in, there are people who know that industry really well. and you just got to be careful that your ability to understand the market psychology in a new sector as you're getting up to speed is going to be worse.

And so you may think you've discovered something. Wow, this is really novel. Look at this. But what you find out is that the industry thinks of it differently or has internalized it in a certain way, already knows there is already priced in. And so I think you have to be careful of that. But you can't be stagnant because the market's constantly moving. You know, capitalism is dynamic. Markets are dynamic.

And if you just say, all I do is X, the market moves away from that. Now you're left with an old bag of tricks. I'm going to close with a couple of just fun ones. Just purely for fun, you probably haven't done deep dives on these, but just fun to giving your mindset to get your reaction to these. So the first would be the impending investment and interest in the cannabis industry. I think my biggest challenge with it is it is a Schedule 1 drug and it is the federal government still rules it essentially illegal in all shapes and forms.

Is there going to be a huge opportunity there? And is there one today? Yes, sure. I think it's very difficult as a fiduciary to put capital to play when with the change of an administration, you could just have the DEA kicking indoors. Longer term, it strikes me, it will probably be legalized. I think you don't really know the name of the richest lettuce grower. And I think that, you know, this will just be a scale business. It's farming. So I think you'll probably have an early gold rush once it is fully legalized where everybody consolidates. But this is a very old world industry that will sort of evolve in the way that classic real world businesses evolve where a few players come to be the main suppliers. There are a few big brands probably. Someone's selling all the

equipment to them. But it should become industrialized. In the interim, if you can find, businesses and ways to play it legally, then you're going to earn the excess rent that a market that's not fully legalized and that capital isn't fully deployed to. So hats off to the people. I know people who have played real estate in it. I know people who have gotten licenses for the dispensaries and all that. But even today, on the ground, it can be a hard business. If there are 10 people with licenses to a dispensary, you're running a retail store and you're out there marketing. So I think it's a, you know, very interesting opportunity, but I think it's difficult with the overhang of the federal government to put a lot of resources into it. You mentioned you're

a no fanger. I'm curious if you're also a no coiner. And if so, are there any conditions? And I really only ask this one because the crypto world is in the midst of a pretty massive drawdown now from its highs, albeit very short-lived ties. Are there conditions under which you would get interested in that world? Yeah. I'm waiting for the first coin that generally. rates a bunch of cash flow and is thoroughly out of favor to then buy. I think crypto is fascinating for two reasons. Behaviorally, it was the most perfect thing I've ever seen. I grew up watching the internet bubble. Actually, even before that was baseball cards. And baseball cards was just this wild bubble with the Honest Wagner card and things like that in my youth. Then I saw the tech bubble.

and to this day, it's one of the craziest things I've ever seen was, you know, the globe.com's IPO, VA Linux. I remember seeing it scroll across the screen like plus 220 on its IPO day. But crypto was just so perfect that the stretch from, I don't know, last, the spring of 2017 to the end of December was unlike anything I've ever seen behaviorally in my life. And I think I once said, if this doesn't break, then it goes against everything I hold true about human behavior and how markets work. And fortunately, it's somewhat broken, even though I think it's still up like 2x from when I said that. So behaviorally, it's been wonderful to watch. Investing-wise, through your efforts and others, I've actually tried to learn a bunch about the technology.

And I'm fascinated by it as anyone should. And one of the things that got me to do was I went and I bought a book called Eft Companies. And if any of you out there listening, remember, at the end of the, towards the end of the bubble, there was fuckt companies.com. And it was a website essentially tracking just companies that were goofy ideas that died. And the guy wrote a book, God bless him to further monetize it. So I bought this. If you look through like the first 10 pages of F companies, probably seven of them have been reincarnated in new businesses now worth like three plus billion dollars. So the ideas seemed dumb at the time.

And yes, they were fucked and they went to zero. But they weren't bad ideas in many senses. And so I did this because I wanted to, you talked about sort of adapting as it, I wanted to force myself to say, yes, 99% of ICOs right now are frauds and scams. It's morally repugnant to everything I believe in about markets and honesty and all that. But there's probably something here. There is something that will probably change the future indelibly. And you should pay attention. Don't be the asshole in 2002 and three saying this internet is never going to take off.

Why would anyone use it? And by the way, all the winners have already been established. So I'm open-minded on it. You know, Bitcoin as a store of value clearly has a special use case. And I can see why people who used to like to own gold would like to own this. Ethereum and some of the newer building blocks. Yeah, that I'm going to watch and learn about because that seems where a lot of the action is. I know there's a lot of excitement around tokenizing securities. And I just think it's really early days. The world moves very fast there, though. You know, they're recreating the existing financial system at light speed with all the pitfalls

and perils there. So I think it's worth watching. I don't believe I have a particular insight enough to go say, okay, Bitcoin 6500, now it's time. Could I see it at 50,000? 100%. Could I see it at 1,000? also 100%. And I do pretty well in my own investing, and so I'm going to stick to what I know.

Well, this has been an awesome exploration of many different industries and ideas. My closing question for everybody is to ask what the kindest thing that anyone's ever done for you is. I think it's got to be on the personal side. There are people who have helped me professionally. But on the personal side, my parents divorced when I was about six months old. And so my mom had two kids under the age of four. And we moved back. We moved three, thousand miles across the country. And she was a single mom, two kids, no job. And she started dating a guy who ultimately became my stepfather. And I always appreciated how incredibly generous and amazing he was to support us when we weren't his kids and, you know, to take us on at that age when he was a grad student

and, you know, didn't have full-time income yet. As I've gotten older and sort of experienced the responsibilities of having a family and having kids, you know, I think it resonates even more that, wow, I don't know if when I was in my early 30s, I started dating a woman who had two kids. That is a big order. And for him to have done it and provide me and, you know, my siblings with the opportunity that we got, you know, in retro, as much as I was appreciative at the time, I think in retrospect, it's just the magnitude of that is even greater where I say, well, who knows where I'd be, but I probably wouldn't be here without that set of kindness. Fantastic.

So hopefully in a year when markets have evolved a little bit more, we'll get together and do this again. Thanks for all the time. Hey, everyone. Patrick here again. To find more episodes of Investors like the best, go to 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, we'll receive a full investor curriculum right away and then three to four

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