Invest Like the Best with Patrick O'Shaughnessy - [REPLAY] Deep Basin – Earning Alpha in Energy - [Invest Like the Best, EP.81]

Episode Date: September 11, 2019

My guest this week are Matt Smith and Ian singer of Deep Basin Capital, a hedge fund specializing in the energy sector. I first met Matt almost 10 years and, in that time, I’ve grown to respect him as much as any investor that I’ve ever met. Now having spent time with Ian, who specializes in oil and gas field exploration companies and the rest of the Deep Basin team, I have similar respect and admiration for all of them. Deep Basin does almost the exact opposite of what us quants do. In fact, their entire goal is to build a portfolio of mostly idiosyncratic or stock specific risk, the very thing us quants mostly remove from portfolios. Deep Basin positions the portfolio to make a series of carefully constructed bets, long and short, without taking market risk, style-factor risk, or even commodity risk. They use a hybrid fundamental and quantitative process which we explore in detail.  This is definitely another good example of who we are all up against in public markets. What makes this story unique is that we are investors in Deep Basin’s management company and so have a clear interest in their ongoing success. Listeners know that I want to be as transparent as possible on this podcast so we event spend a little time telling the story about how it all came together a few years ago. I have learned a ton about investing from my countless hours with this team and hope that this conversation gives you a glimpse into what is happening at the cutting edge of investing in the world of hedge funds. Please enjoy my conversation with Deep Basin 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   Books Referenced Expectations Investing: Reading Stock Prices for Better Returns   Show Notes 2:47 – (First Question) –  Looking at the universe of the energy space that they are focusing on 7:48 – Breaking down the important components and their labels in this space 10:27 – What makes energy companies distinct from the broader market. 12:52 – How the isolate unique value creation 14:58 – Ian’s take on the upstream part of the business where he has spent a lot of time 18:35 – How does Deep Basin use data and what edge do they derive from it. 21:31 – What insight are they looking for from updated well data 23:59 – How do they use combine the business value that they measure with the market price that is being forecasted             24:40 – Expectations Investing: Reading Stock Prices for Better Returns 29:34 – How do they build an actual portfolio 31:51 – Their systematic approach to energy investing 37:53 – What are their thoughts about using leverage when making investments in the energy space 40:53 – A look at the changes to the hedge fund industry over the entirety of their careers 45:46 – Defining the culture of Deep Basin 49:15 – The story of how OSAM and the O’Shaughnessy’s came to be investors in the Deep Basin 54:13 – Kindest thing anyone has done for each of them   Learn More For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

This week, we are excited to re-release episode 81, Patrick's Conversation with Deep Basin Capital. 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'Shaunacy 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.

My guest this week are Matt Smith and Ian Singer of Deep Basin Capital, a hedge fund specializing in the energy sector. I first met Matt almost 10 years ago and in that time I've grown to respect him as. much as any investor that I've ever met. Now, having spent time with Ian, who specializes in oil and gas exploration companies and the rest of the Deep Basin team, I have similar respect and admiration for all of them. Deep Basin does almost the exact opposite of what Usquant's do. In fact, their entire goal is to build a portfolio of mostly idiosyncratic or stock-specific risk, the very thing Usquant's mostly removed from portfolios.

Deep Basin positions the portfolio to make a series of carefully constructed bets long and short without taking market risk, style factor risk, or even commodity risk. They use a hybrid, fundamental, and quantitative process which we explore in detail. This is definitely another good example of who we are all up against in public markets. What makes this story unique is that we are investors in Deep Basin's management company, and so have a clear interest in their ongoing success. Listeners know that I want to be as transparent as possible on this podcast, so we even spend a little time telling the story about how it all came together a few years ago.

I have learned a ton about investing from my countless hours with this team and hope that this conversation gives you a glimpse into what is happening at the cutting edge of investing in the world of hedge funds. Please enjoy this conversation. So as you think about the energy space specifically, talk about the features of the universe that you're starting with, maybe define what that is, how many companies is it, and what makes that an interesting playground, if you will, for assessing long, short opportunities. If you think about as an analyst, what you're going to do.

you strive to do is find a place where you can add value, where you can do something that is repeatable, you can do something that is differentiated, and where you can find yourself more repeatedly on the right side of an investment than on the wrong side and tilt the odds in your favor. Having spent some time in media and telecom and then industrial's materials, and then for eight or nine years energy, I've just found that not only was it a sector where I'm passionate about all of the intricacies of the business and the complexities of the global energy chain. But it happens to be a sector where the complexity scares people. And if you dig in and you construct a portfolio to remove some of that complexity, what's left over can be

very long-term structural idiosyncratic investments on the long side and short investments in structurally advantaged businesses on the long side and structurally disadvantaged businesses. And you can do it. And we certainly try to hear in a way that's free and clear of oil and gas prices, free and clear of interest rates. And part of our education in Soto was building a high idiosyncratic risk portfolio. You know, I read the Buffett letter when it came out. And, you know, I think he still spends some time on alpha and beta. And I would, I would say, I care a lot about the attribution, the nature of the returns that our process, that my process as an analyst generated. And in energy, like no other sector, I've been a part of, understanding these

businesses at a very atomic level allows you to build informed views and very low variance models of what the future prospects for the business look like. And that allows us to have insights that we think are valuable and alpha generating. And the beta piece, is the removal of all those things like oil, gas, interest rates, systematic risk. In many cases, we purposely tried to get rid of style factor risk in the portfolio. And what's left are these repeatable, we think, asset-driven insights of these businesses. And unlike any other sector, we have 70 businesses that make the same product in upstream in the U.S. or liquid.

Canada, you know, another 15. You can build a very elegant portfolio and really isolate specific nuances that you're trying to achieve in a portfolio. And we can stay in energy investments far longer than most investors can, because we can take out lots of the bad things that can happen in the energy sector. For me, one of the interesting things about energy is an investment space is that everything is always changing all the time. And there's lots of places where that's true. But the assets change under these companies over the matter of, you know, three months, maybe six months. Technology changes every sector, and that's true in energy. Unlike other sectors, a lot of the data that shows how and

why those things are changing are available. And to the extent that you can stitch that data across a lot of different sources together into a coherent sort of analytical space, you can really get a deep understanding for how and why those assets are changing and what the prospects for each of your companies are. And just like any other sector where data work is being done, it's easy to draw lots of different conclusions from similar sets of data. And so part of what we do is paint that coherent picture across a lot of inputs and continually calibrate those inputs into what companies are talking about. And that calibration effort takes a lot of time, a lot of focus, a lot of systematic sort of pieces in place to capture all of those things.

And the result is you continue to have a more informed, better dialed in version of what the company's prospects are. And that allows you to be on the right side of how those stocks move a lot more times than not. And the ability to integrate a lot of disciplines together to give a really robust picture of what each of those narratives are, but ultimately informed by what the ground level data pieces are painting is a unique thing to energy. And we've spent a lot of time putting all of those pieces together and throw in what the energy sector volatility looks like on top of that. And you have a pretty robust space for alpha generation. One of the things that's fascinated me just talking to Matt over many years is like you said,

global complexity of this, especially where you've got one player that's incredibly opaque. You may not necessarily know what's happening in the region and has a huge impact on commodity prices, et cetera, at the risk of getting overly simplistic, but I just think it's useful since we're going to talk about how to attack a sector and construct a portfolio around a sector. Maybe we could just spend a few minutes on what the parts of the ecosystem are. So I don't want to take for granted that people know the key difference between upstream, midstream, downstream, service companies, et cetera. So I'll leave it to you. to decide what those categories are, but maybe just a couple minutes on like the taxonomy of the

space, just so that if we use these terms later on in the conversation, we'll have sort of a record of what the map looks like. The chain really is dominated by, in terms of market capitalization, but also in terms of where the economic rent lies. Upstream oil and gas, the producers, they go out and explore for, acquire oil and gas resources in the ground, and they hire services companies like Slumberger, Haliburton, et cetera, to exploit those. Service companies are, there are many service companies, and they've largely, a bit like De Basin, become more focused on leveraging technology than traditional service companies that were just iron. And, you know, Slumberger in that regard is certainly about as much of a technology leader

as there is. From services where you, they help you exploit the rock and produce oil and gas molecules. Midstream companies are next. The, you know, natural gas needs to flow through pipelines. Much of it has to flow through processing plants that separate the methane, which is the actual natural gas stream from ethane, propane, butane, isobutene, all the natural gas liquids, many of which go into different processes like chemical raw materials or the refining process. And so there are multiple layers of separation with processing. And these gas molecules flow through pipelines into power plants, home heating needs, your stoves, you know, and they flow into industrial plants, et cetera. Oil can really move via truck, train, or pipeline. And once they get

to the market, obviously, they're going to refineries. It's going on ships, tankers. It's being used for ultimately converted into gasoline, distillate, jet fuel, asphalt, et cetera. So upstream, services, midstream, downstream, which includes refining, chemicals, and all the way through to power plants where gas powers turbines and utilities where, whether it's a local distribution company that delivers gas to you or whether it's a utility that delivers electricity to you, all of it starts with really natural gas, coal, nuclear, et cetera. You mentioned you love tearing apart businesses, kind of the engineering idea, the stats background, technical background, et cetera. As you think about energy, the businesses themselves,

what is unique or interesting about them? We've joked that it's like maybe structurally some of the worst businesses in the world, maybe describe why that's the case and any other relevant features that make energy companies distinct from the broader market. All of the traditional investment principles I came up learning, you know, sustainable competitive advantage, the five forces, the importance of management's ability to build a team in process and allocate capital to their resources to generate earnings, free cash flow, dividends, returns of capital, etc. If you look at the upstream business, and it's changing a little bit, but if you look at the upstream business, largely they're awful businesses.

They are depleting assets, price takers, none of the U.S. EMPs, for instance, set the prices for their products, period, and that will never change. They really control how they allocate capital to exploiting rock. They control the frequency or cadence at which they drill wells and turn wells into cash flow and ultimately recycle it in the ground. But these businesses are not ever going to be anything but depleting deep cyclicals. And they have to be treated as such. It's been treated with great care.

I think we could go on and on about why somebody would lend an upstream company the fifth turn of leverage on the underlying EBITDA when it's very hard to, when you move forward 10 years, cover the debt unless they go out and acquire or find new resource, which you currently can't underwrite when you lend the money 10 years. There's an interesting conversation we had about the high yield markets for energy. But the important takeaway, though, is long-only setting or credit setting or private equity setting, and we certainly have great respect for lots of smart investors in the space. But what we try to do specifically is in a high idiosyncratic risk or beta neutral portfolio where you care about the oil risk and the natural gas risk that your portfolio exhibits. And in this case, we purposely try to make sure it's roughly zero. You can actually

get rid of a lot of the bad stuff about these businesses. And what's left over are some very interesting value creation companies. Can you say more about that idea of isolating unique value creation post neutralization of commodity risk? I'm just curious, like, what exactly you mean by that? I may overuse this. We've been on the road a bit here recently, seen lots of companies so not as of late. But if you think about modeling financial institutions, and as long as you have good command of their assets and liabilities, you can generally have a good understanding of their sensitivity to a given change in the treasury curve to their cost of capital and understand how that impacts

their earnings. And in the context of a portfolio, if you do that enough times with financial institutions, you can actually build a portfolio of financial institutions where you can really tweak your exposure to the treasury curve. Building a portfolio of energy businesses is very similar, particularly with upstream. And we're fairly upstream heavy with what we're doing so far. Each of these businesses has a fundamental sensitivity, which we call elasticity, like a convexity measure, to a given change in oil prices or natural gas prices. That is to say, at $60 crude, EOG resources generates. a couple billion dollars of free cash flow. With that, it can reinvest in the ground and generate

future wells that produce and grow production, and ultimately they can return cash to shareholders. But there's a measurement. There's an objective measurement modeling exercise that you can do and understand the value in cash flow of these businesses at the strip using the prevailing oil and gas deck. You can sensitize that, which we do for every one of the business models, to understand exactly how value changes for a given change in crude oil or gas prices. similar to the idea of understanding of financial institution's sensitivity to interest rates. And if you care enough to take the added step after you, you find investments that you like on the long side and investments that you like on the short side with very little tweaking,

you can actually achieve a portfolio where, you know, if there's a shock in oil or a shock and gas, you can be fairly agnostic to it. And that seems to be increasingly to us a value-added way of isolating the company-specific investment that we're trying to make. Ian, I know you have spent a ton of time upstream specifically. I'd be curious for your take on that part of the ecosystem and sort of the levers that you think, one, most interest to you. Like, why are you fascinated by these businesses? And two, from an investment perspective, the sorts of things that you like to spend your time on. So as you mentioned, it's constantly changing, which is probably a good thing, right? Like, if you're in a competitive landscape,

you want it to constantly change because then your skill can shine. So I'm curious how you think, about it, the things that you think are most important to focus on. And as we think about Alpha, alpha always requires that the broad market has got it wrong. So maybe structural ways or structural mistakes that markets tend to make specifically in that space. At a core level, what is interesting along the lines of assets are changing all the time and companies are changing the way they do things all the time. And I mentioned this before. We have information well-level data across the United States and Canada and even other countries where we can look to see how those things are changing and more interestingly and more importantly why they're changing. And so I spend an inordinate

amount of time going through data to understand all those things and more or less rebuild all of the companies that we have in our investment universe from the well level up and And whether it's a $200 million market cap company that has 100 locations or it's ExxonMobil, that's the approach. And every company is interesting in that regard and how they're exploiting their resource and how they're developing their longer term development programs beside that resource is really interesting. Something that markets have a bias on for really any sector is taking a base case and extrapolating

that base case too far into the future. And we've found that is a commonly repeated mistake in energy. And if you think about a depleting asset base, which we talked about as part of why they're structurally not great businesses, the genesis of that is a decline curve for every single well. So the asset base is made up of a bunch of individual assets that are declining at some pace, which means that when you add all those things together, you have a large decline rate for every upstream oil and gas company that they are fighting by investing more capital into other declining assets. Base case is very, very important because your decline rate is your base case.

And as wells change over time, not just at the beginning of their life, but forever, there are always times where people don't understand what the base of the company is. company is. And, you know, we spend a lot of time understanding those deep points where activities that companies have done years ago are affecting what their prospects are today. And, you know, that takes dedication. It takes a lot of carefully controlled modeling so that you can isolate all of those things across all your companies all at the same time. And it's interesting work and it's nuanced work and the data sets are rich. And so for an analyst with the technical background, you know, it's a playground sort of every day to find something interesting to think about or talk

about. And, you know, with lots of companies, with lots of assets, there's always sort of some new idea percolating to the top of the list. It's a great excuse to talk about data and the quantitative side of all of this and the importance of it. It's an extremely hot topic in all sorts of investment circles today. I think that almost every successful long-term asset manager is thinking about how to incorporate systematic tools, quantitative methods, data itself into their process to make it better. And energy is an especially interesting area for this particular idea. So maybe you could describe, we'll actually get into how you think about building a portfolio now and evaluating businesses with this, I'll call it man plus machine model. It's just a term that people have kind of glommed

down to, which is you mentioned the legacy from Citadel of very systematic thinking, structured thinking around fundamental work. Now you've got this incredibly rich sets of data within energy, but from all over the place, from my perspective, extremely complicated and probably requiring some deep contextual knowledge to actually do anything with. One of the questions we get all the time is like, well, anyone can access this data, whether it's a purely quantitative strategy or in a kind of hybrid like yours, how are you going to have any edge in something that's just free for anyone to access or even if it's not free and you need to pay for it? It's not overly expensive. How do you answer that question about the use of data and the edge that you derive

from in the process? Going back to this concept of being students of our businesses and whatever sector does you follow, the goal is to have an informed low variance model. of what exactly is transpiring in the operations and financial results of your businesses. And if you imagine owning a company completely outright 100% of it, you know exactly what's going on in the business from day to day. You have a good sense of the prospects for the business looking forward. Hopefully it's in a business where you have more control over the product prices that you're selling and you have a competitive advantage. But in this case, energy, the sector happens to be a sector, again endowed with this incredible access to the data.

The data represents access to the building blocks of our businesses. Ian mentioned, and certainly oil and gas wells, are readily available, but because they're readily available, it doesn't make them easy to wield. Having a pure data set, and the bigger the data set, obviously, the harder it is to wield, but having a set of data, in and of itself is not a solution, is not useful in investment process. You have to be able to distill the data down into its normalized component. parts and be able to take that and turn it into a cohesive model for the business by wrapping financial statements around the data or put in simple terms. If these companies were factories,

if they were manufacturing companies, understanding exactly how many widgets can be produced, the cost to produce the widgets, the number of people required the length of the manufacturing line, cost of distribution, et cetera, to get to the end market. In the case of energy, we have most of what we need to build very informed models. and it starts with this oil and gas well data. So what insight are you trying to glean as the well data gets updated? So I certainly understand, okay, these companies are predicated on successfully finding and extracting minerals from the ground.

It's pretty straightforward. And the uses are pretty straightforward. So what are you learning through those data updates that's interesting and compelling? Are you building some sort of web of understanding of the viability of a certain set of acreages or regions? What is the insight that's different than just getting sort of an updated, proven resources or updated asset value or something like that? It's sort of a lot of what you just described.

But really, when data are updated for all of the wells across all the U.S., we get a couple things. One, we get a more current understanding of what the production of the company is, just the aggregation level of analysis, how much are they producing? And, you know, there's some context and value that can be discerned from no. what that level is. But more importantly, we can understand how different time periods of wells are changing. And if you understand how a resource base or the productivity of our resource base is changing over time, you start to uncover bits about the second derivative of the prospects of a company. And really, that's a really important thing because the second derivative is what makes deltas in cash flow for the business. If the well is going to cost the same, but

produce less. Their cash flows will be lower. Their economic return will be lower. The ultimate valuation will be lower. And conversely, if they spend the same and the well produces more than you expect. But then it also gives you insight into how a company is developing in their asset. You know, on a single acre or a unit of acres where a company is drilling, they don't just drill one well. They drill a number of wells in a defined system. How they drill those wells at what depths at what horizontal lateral spacing informs how that productive system will produce hydrocarbons. And when you can evaluate how they've done that, the type of technology that they've used in the wells to actually get their production and you can see what those changes in productivity are,

you really start to paint a very rich picture of what is happening, why it's happening, and how to take those things to forecast what will happen in the future. So the second key component of this, we've really focused on your assessment of the value of the assets of an upstream business or the value of a business more generally speaking. The second key component here is market price. So the opportunity is going to be the gap between your assessment and the market's assessment. So we have price. But how do you take price and sort of back into what that means the market is estimating about the business as well, is about their assets? etc.

So that you can gauge the width and maybe duration of that mismatch, of that gap between your expectations and the markets. You asked about Malbison, basically. One of my favorite investing books is by Michael Malbison called Expectations Investing. And it is quickly summarized. He writes about using security prices to understand the embedded or price implied expectations. And in any industry or any sector that I followed, if you build or care to build a strong model that captures the operating assets and financial performance of the company.

You have the jumping off point for iterating to understand what the market must believe today at reasonable assumptions, holding all else constant, what the market must believe today about, for instance, production growth, or what the market must believe today, if we know production growth, costs and cap-ex, what the market must believe about oil price embedded therein or costs or capital expenditures, et cetera. And, you know, Malbison is helpful because that iterative process is required with this living, breathing set of companies. As these assets change, you're going to go mad if you don't try to slow it down and understand as things change, what it means for the change in the value of the business, but also what the market's understanding is

and you're constantly trying to recalibrate and find these big disconnects where the market doesn't see the assets quite how you see them yet. So we're entering an important topic, which is the idea of investment. the energy businesses, is it value, is it growth, what's important, all the different factors. The problem with these businesses, most of them, not the more structural technology companies like slummergy, but the problem with upstream companies is that the intrinsic value of the businesses falls when the commodities fall. There is no margin of safety when the commodities fall, which is what we've really seen play out over the last four or five years. So when you go through a valuation exercise and distill all of these well data and turn them,

into quarterly operating in financial models. When you're building a model for EOG, again, to carry that example forward, you're modeling the next 50 years by quarter. You're taking all of the known components of the assumptions, the well data, the cost, capital expenditures, et cetera, and you're turning it into a practical version of what you think the operating and financial results will be for that business. And if there's one endeavor that we have here, one pursuit, it's we try to do that with as low variance as possible. and what you get, and it is largely an objective exercise. And so that's a major, I think it's an important takeaway, which is that modeling an energy business, modeling an upstream company is largely an objective exercise.

If you care to use the data available to you to do it, oftentimes people screw it up by injecting speculation on the commodities. But in reality, most of what you need to know is out there and available to you. So if you go through the, take the care to wrap financial statements around the data and you have a good picture of what the company's producing and generating for cash flow on the prevailing strip. Putified strip. The strip prices are the forward commodity futures prices where all the participants in the market are voting each day and they come up with a price for crude oil in both physical and financial terms. Same with natural gas. If you use that prevailing strip, which is frankly if you owned 100% of one of these companies, it's where you would go out and hedge the cash flow of the business, which is why we use the strip. If you model a business in this way, the next 50 years by quarter, obviously things can change, and there's a margin for error the farther you go out.

But you can start to build an understanding of how differentiated, using objective assumptions, make your appraisal versus the current market price of the stock. And that's where it gets exciting for us is building an appraisal of net asset value. That is what we find we're wildly different. Now, we don't just show up each day and buy cheap navs and sell expensive ones. The key is then finding where revisions to market expectations, when the revisions are so extreme that they will force the market around our point of view on the asset value. Just one thing to add absolute price, absolute valuation is, as you can tell from Matt's description, it's pretty difficult in a market that's as fluid as energy where, you know, know, there's geopolitical factors and influencing price of the commodities. There's, you know, actual supply demand factors and all sorts of other things.

In a long, short approach, the ability to take valuation and use it in a little bit of a relative space is important. And being able to take the commodity component out of valuation via the way that we structure our portfolio is a key thing to do. do when we just want to isolate undervalued or overvalued operating performance. And when we look at, as Matt said, when we look at overvalued and undervalued companies based on how we appraise those assets, that's really what we're doing. Maybe talk about how you then are building an actual portfolio. We've talked about what it's neutral to, which is beta for the most part, commodities, interest rates, etc. style factors. But how are you then actually taking your working knowledge, your company models,

all the work you guys do constantly and relentlessly and turning it into an actual portfolio. If you can readily force rank these businesses each day in terms of the markets price versus your appraisal, it's the jumping off point for starting to think about portfolio construction. We tend to think a lot about quality. We tend to think a lot about the idea of longevity of a business. A lot of these businesses, again, because they're depleting how many future wells they have to drill to generate returns that are as good or better than their current return on investor capital is an important feature of how we think about the sustainability of each of our businesses,

and their ability to grow and do so within the context of their balance sheet and covenants. If you think about the world, though, where you need to be mindful of the portfolio's sensitivity to crude natural gas and remove those, you can't just buy quality and short, bad companies. You can't just buy good companies, short bad companies. And you certainly can't just by management teams that you like and short bad management teams. What we try to do is balance out and be style agnostic and find truly disconnected undervalued businesses on the long side and overvalued business on the short side, but where it could be in the realm of expensive companies, where, you know, something that may look expensive on near term EV to EBITDA is growing

so quickly its cash flow stream that in three years, it's multiple compresses substantially and it looks inexpensive. That juxtaposed with a company that looks incredibly low multiple today, but has no prospects to grow production and it's a depleting set of assets. So three years from now, its cash flow is less. There are multiple cases of this where what looks like a value proposition today in several years in the upstream business can actually look like a catastrophic destruction of value and vice versa.

Oftentimes expensive companies look more interesting from a multiple perspective than cheap companies because of this idea of longevity and sustainability. Let me ask a clarifying question there. So one of the things that I've always fascinated with is understanding why the value factor as an example works. And when you dig into it, there's a lot of competing explanations for this. One is that they're riskier companies, so you're compensated for that risk structurally. One is a behavioral explanation.

So people get overly pessimistic about the prospects of, say, a low PE stock. But ultimately, like you're buying future fundamentals when you buy the stock today. and one of the interesting things about, say, buying low P.E. stocks is that fundamentals tend to mean revert at the market level. So if you've got really bad recent trends, odds are that it'll be a little bit better than average in the future. And that's just a very broad generalization. But when you pair a low price pay today with the tendency of bad recent fundamentals, which is what value stocks tend to to have to mean revert, it ends up being this great deal. And you end up earning 4% annualized excess return over a really long sample, even when everyone knows about this. So it's an open secret

that value investing works. But what you said is quite a bit different than that, which is that in many cases you might find companies, let's say it's one that looks expensive on EV to EBDA today, but has much better prospects of the opposite of mean reverting fundamentals. So maybe you could unpack that a little bit more as to how you might go about identifying that kind of company relative to the more mean, like broad sample of mean reverting companies. The interesting thing about low multiple stocks and especially the upstream universe, you know, we talked a lot about assets can change all the time. There is an element of upstream oil and gas where companies sometimes have assets in a geological section that there is no promise to the

upside. You know, the probability of the prospects of that resource improving have been statistically rendered to be very low. And so a low multiple stock that has underperformed because it's assets don't working don't necessarily have a fundamental reason for mean reversion because their prospects are not in a mean reverting type of area. It's not, you know, a consumer stock that is gaining and losing market share over time. It's a company with a physical asset that potentially doesn't work. And so as they continue to spend money on that asset and it renders sub-economic results, its multiple will actually inflate over time. And you know, you're sort of doing something that's counterproductive to what real value investing is. And so part of what we do

is try to discern when a company with a low multiple is for a physically, geologically, structural reason, or if it's just the market doing something silly with a stock. And so, you know, we're not factor investors, but we're very aware of factors. We recognize that value can be an extremely positive tailwind to investing. But figuring out whether it's structural that it's a value, quote unquote value stock, or if it's just market perception is where we can come in and really add value with our analysis. And there is a, Matt was talking a little bit about portfolio construction and how it's not just about buying good companies and selling bad companies, but finding pockets of dispersion in all of those areas. A good company that has better prospects and a good

company that has declining prospects, that's two highly valued companies that can be on different sides of a trade or two low valued companies that have separate operating prospects can be on different sides of a trade and you're not making a factor bet. That is true alpha. And that is what our process and our whole systematic approach to this business is set up to do. We certainly appreciate some of the long-term tailwinds like Ian described that low multiple stocks have had. I think in energy there's a bit of a wrinkle and that is the price you're paying for a cash flow or earning stream today has very little to do with the earnings possibilities for the

business five years from now or 10 years from now. And when we stress this idea of building a 50-year model for each company, granted the margin of potential outcomes is very wide, understanding the prospects of EOG or Pioneer or Diamondback Energy or QEP resources, which is quite topical, what their ability will be to reinvest their cash flow today to generate earnings next year, five years from now, 10 years from now is of critical importance. The longevity of the assets relate back to the multiple. you should be willing to pay on any metric for one of these businesses. And so what's hard about just thinking about pure low multiple PE or low multiple EBITDA investing is, you know, it's a moderately efficient market. We know we can argue either side of that, but the market's trying to price and understand the EBITDA cash for growth of the earnings growth of these businesses all the time, the amount of capital they may need to fuel that growth. looking at these businesses today, a low multiple business, again, may have limited business prospects at a four times company. If they only have three years of wells to drill to generate returns,

and then they have to go out and make an acquisition of more acreage or of a company to backfill their depleting production, it doesn't matter if you're buying a low multiple company because they're probably going to have to do an accretive deal when the time comes. And so I think we we try to think about the long-term earnings in cash flow potential these businesses. We try to pay as low a multiple as we can for our lungs today and as high a multiple as we can for our shorts today. But each of the companies is so different in terms of their resource and rock and their locations in those and quality of those and the prospects for those that the comparability is something

you have to be very careful with of PEs or of EVV to EBIT or of cash flow multiples. Let's talk a little bit about leverage at the portfolio level, not at the company level. So back to the way that traditionally speaking hedge fund portfolio should be constructed, which is neutral to a ton of stuff. So if you were unlevered, you would basically earn a return. That's the return spread between your longs and your shorts, hopefully favorably in your direction. Obviously, it's very common then to apply leverage to that unlevered return stream of the difference between longs and shorts. How do you think about that exposure?

How systematic is that thinking? How much does it change through time? what's like a rough range. This is a topic that we definitely haven't covered before. So I'd be interested to hear your perspective. I think there are two parts to this and then Ian can add anything. But the first part is the amount of gross leverage that you apply to your underlying equity AUM should be a function of the breadth of ideas and the conviction you have in those, in our case, in an idiosyncratic way. So the number of names, the more names, the more conviction, the more timeliness of the ideas. Ideally, you invest a portfolio today. And,

tomorrow the market comes around to your point of view on every investment. That's obviously never how it happens. So think about it like a life insurance portfolio where you have duration matched longs with duration matched shorts, hopefully. Building a portfolio where you have lots of ideas is the first driver of how we think about leverage. The fewer ideas, if ideas are scarce, we do not want to lever the returns of our investments on the underlying equity. The second layer, I would say is been quite important recently as we've gotten into a less stable, higher risk, higher cost, capital regime, particularly late January and February, how much you lever the portfolio, assuming you have a breadth of ideas, should be lower in times of extreme regime uncertainty,

which we have every bit of that today. Yeah, there's sort of the two sides. There's a statistical approach, you know, a mathematical approach. a mathematical approach to risk and leverage. And there's a fundamental approach. And Matt talked a lot about the fundamentals, having a breadth of ideas, having conviction in them, having some fundamental stability in the broader macro landscape. And then alluded to the statistical side, we are always looking to provide a target risk. And from there, we can back into what the portfolio needs to do against our risk management calculations and leverage a lot of times holding the fundamental

pieces of this constant falls out what that volatility target is. If you can highlight the dollars of volatility that you need to generate with your portfolio and then use a statistical risk management model to estimate what that portfolio volatility is. How would you assess the changes like in your relative careers in the kind of hedge fund industry. What are maybe the positive and negative changes that you've observed? Maybe Matt, you first, over the entirety of your career now. Feels like it's gotten harder every year. Using data in 2005 when I started professionally investing in the by-side meant SEC Edgar website. You could go electronically pull financial statements and then you get on a plane to go see management teams. Now, today we still go spend a tremendous

amount of time in the field with public and private companies to understand what's happening in the energy ecosystem. But the major change that's allowed Deep Basin to exist has been this incredible programmatic access to these building blocks of our businesses via data. And certainly you've seen statistics where the availability of data has grown exponentially and will continue to. We've seen that with energy datasets, with the data sets necessary. And frankly, it's why small operations, small, single person,

or two-person teams have a hard time wielding energy data in a way that's systematic. It takes a fair amount of team and process to do it. So the major change has been the availability of facts about our businesses to allow us to exist on this island. I think the rule of 80-20 is sort of leaving in some cases in the investment universe. You have so many people that are specializing in sectors and going to pretty significant lengths to derive an edge that getting the last 20% right is the edge itself. And the first 80% isn't really worth. Just table stakes.

It's not, yeah, exactly. And so I think from a positive side when you work in the asset management field broadly, but particularly for hedge funds that are doing an extraordinary amount of work and trying to find some edge, you're working with a lot of really smart people and the number of smart people and their smartness seems to be increasing. And so, you know, from my seat, that's a good thing. And it really makes you constantly fight complacency and it's a good driver. The negative side changes over the last call it five years. I don't know, maybe maybe the only thing I would say is that, you know, there's there's a lot of aggregation that's happening where independent fund managers

are going to, you know, large platforms and platforms are great places. They're smart people. They've got great resources. They've, you know, they're built by really smart, really thoughtful people. They have good returns. But it's changing the way that the market works in some cases. and how liquidity profiles are transpiring. And that's an advantage and a disadvantage in some ways. It creates a different profile of volatility. But in some ways, it's better for markets to have some fragmentation to them. And, you know, that's a change that I think is not necessarily a great one.

One very clear change is the role that passive flows are playing and, you know, increasingly in driving securities prices. Some of it can be just paying very low fees for, in our case, the XLE, the S&P Energy Sector Spider, or the OIH, the services ETF, when there is material buying and selling of those indices, we see the correlations of the stocks contained they're in as picking up and driving and overwhelming really most of what's going on fundamentally in the short run. We've obviously spent all the time trying to build a portfolio that where we pay attention to our exposure to specific passive indices, et cetera, to try to mitigate that when it

happens. But we frankly like that in January specifically there were tremendous reflationary forces that the market started to bet on and were buying aggressively buying passive energy exposed indices. Now that's not worked out very well in the recent pass in late January and February, but it caused tremendous distortions in the pricing of some of the securities embedded in those indices. And subsequently, these companies had to report earnings, provided forward-looking outlooks. And in many cases, you know, any benefit they saw from the passive index inflows was turned into, you know, serious downside stock price moves when the company's reported earnings, for instance, in February. So we try to use and surveil and understand what's going on in

factors, what's going on in passive fund flows. And we try to use, you know, use those to our advantage when because they, they tend to cause distortions and mispricings today more than, more than I can recall at any point in my career. So we'll close to the couple questions on the firm. Culture is something that fascinates me. And then I've got a closing question. And I ask everybody,

we'll close with that. So maybe first a question on culture. So I think it's probably something that it's, it's a little bit fuzzy and very qualitative if you're trying as an allocator, let's say, to assess the culture of an asset management business. But there's just no doubt that a strong culture is something that can help firm's weather storms can give them even a greater boost in good times. So as you think about

being just, you know, a year or two years old with the basin, what are like the core cultural elements? Like if I went out and asked the rest of the team, if you had to describe the firm's culture in a couple words, like what kind of words would they use? The first one that comes to mind is intellectual honesty and sort of honest holding of everybody to that standard and, you know, the byproduct of having that be a real pillar of what we do is people aren't afraid to be wrong. There's no love lost or egos hurt when, you know, opinions change based on the presentation of new information. And, you know, so that type of environment really helps foster intellectual curiosity and removes the negatives of emotion from what is an intellectual pursuit. And that's a great thing

to have. And, you know, I think we have that in spades. And Matt can talk about some of the personal attributes. But, you know, from my perspective, the fact that we've, we've all worked together before. And, you know, we have a side from just being intellectually honest, you know, hungry professionals, we all strive to be good human beings. And that means holding yourself accountable and being honest and being, you know, forgiving and understanding. And I think everybody at this firm has all of those things that allows intellectual honesty to really be a core component of our success. I would probably add just a couple of traits. One is, and this is really informed by our past experiences that we reflected on,

but we are obsessive about process adherence. If there's one thing that really gets an energy portfolio down, it's when it would be if I were to decide to take a big swing at what OPEC's going to do in this spring, or when Russia is going to give in on, you know, take back or renege on the cuts. Extreme process adherence we have found is the most important pillar of sustainably repeatable investments in this sector. There are certainly temptations to have commodity views. We talk about commodity views all the time. Now, we use it to get it out of the portfolio, but we see that temptation. And thankfully, it's now totally institutionalized.

And it certainly was from the very beginning. But this obsession with process is something that happens daily. The second piece that I think is important is there's meaningful passion about the subject matter. I've been a student of statistical companies since I started my career. And over a long period of time, it's really been focused on energy. And that may make me very narrow in my focus, but it's something that I've come to be very passionate about Ian, Graham, Kobe. Everyone is mostly devoted their careers to this discipline and this sector at this point. And for good or for bad, we love talking about digging in on

trying to get it right and investing in these energy businesses in this idiosyncratic way. I find it incredibly important to be as transparent as humanly possible on this podcast. And so there's an important feature that we haven't talked about, which is that both our family and our business are direct investors in your business. And so I thought a fun way to handle that rather than me just, you know, disclaiming it in the introduction or something like that, which I'll also do, is for you to maybe just tell from your side that story very quickly because it's a neat story, one that's been incredibly interesting, an amazing way to learn for me and for our business as well.

So maybe you could just end a few minutes on that as something fun, but also in the sake of transparency. From the beginning of my career through early 17 or even early 6. my long-term goal was always to build a sustainable investment firm where I can be a key determinant of the culture, of this process adherence that I described, and of the type of people who I'm surrounded by each day. And that is something that in the case of Deep Basin, I wanted to capitalize like a technology company. When I left my prior firm in early 16 and sat out a year on a non-compete, I thought about who I wanted to be when I grew up.

And a critical piece was I wanted to surround myself by people who challenge me and make me feel stupid each day. And, you know, I knew where to find some of them. But I was grateful to be introduced in early 17 to Kobe Platt on our team, Garrick and Travis and the members of our operating team. And in order to pursue and build the business that I really wanted to build, we had some options on some, you know, LP-type. Seeds, traditional seeds, and we were thankful when we sat down and put our heads together with the Oshanesee, with you and you and your dad, that you saw the vision that I had, that we had for the firm. And frankly, it needed to be capitalized like a technology business. And like no other seed that we evaluated, having a very long-term permanent capital partner that is like no seed that,

I saw when I started thinking about doing this. And certainly the fabric of the people were in business with is important to me. And it was important when we started to build this team in culture. We believe in order to build a sustainable investment franchise to invest in these businesses that were so passionate about, we needed to build a team and process and sufficient mode around a business, which required a significant technology investment. That's why I describe it as effectively capitalizing like a tech company. But we spent almost a year building significant technology that allows us to to today, you know, keep our eye on the horizon and have the headspace to take risk. And for that, we've been very grateful. Well, I appreciate the story. I mean,

obviously, I want to be transparent given that we have a vested interest in your success. And our view is that the future of this business is far more collaborative, maybe than it's been in the past. We're a long-only business, so we're not directly competitive. But we're we found just tremendous value in being open to experimental and new ways of collaborating with other investors. You end up learning so much more than if you try to just view everyone as a competitor. So it's been a remarkable experience. The last question that I ask everyone, so I'll ask each separately is for the kindest thing

that anyone's ever done for you. I'll go first. I think it was the second date that I went on with my now wife. and we decided to meet at Grand Central for oysters at the oyster bar there. And we were going through our meal and, you know, we had a few drinks and we were having a great time. And we went to leave. And the waitress came up to us and said, you know, you guys are all good. And we said, what do you mean?

We just had like two dozen oysters. Like, we're definitely not good. And she said, no, there was a gentleman across the table from you that said he reminded you of him and his wife when they were young and he paid for your tab. You know, as I sit here today, my wife is pregnant with our third. And as I think about, you know, the 14 months or 13 months since we started the build Deep Basin, you know, the kindest thing by far that's ever been done for me is my wife enabling and encouraging me to pursue my dream, which has been building a team and process and culture where everyone can come and be passionate about this very, in many cases, people, may think very myopic pursuit, which is systematic fundamental investing in these energy businesses in a repeatable way. My wife, I'm lucky, very simple things make her happy. She loves family. She loves to read. She loves to cook. And I'm thankful that she has not encouraged me to go out and do this, but she married me. And that I consider the kindest thing that anyone's ever done for me.

Well, this has been really fun, as I knew it would be an awesome, awesome. deep dive into a very particular kind of investing. So thanks for your time, guys. Thank you. Thank you, Patrick. Hey, everyone. Patrick here again. To find more episodes of InvestorFieldguide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com forward slash book club. After you sign up, we'll receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also find out of Follow me on Twitter at Patrick underscore Oshag, OSHAG.

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