We Study Billionaires - The Investor’s Podcast Network - TIP177: Mastermind Discussion 1Q 2018 (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. So after the first month in 2018, the market sure looked like it was unstoppable and the price was going parabolic. And before we saw this 10% correction, we saw more call options compared to puts by two standard deviations. In addition to that, we saw the price at three standard deviations above the 200-day moving average. To put things simply, the stock market hasn't been priced at the levels we're seeing it today since 1929 and the year 2000. So with all of that said, we've assembled the mastermind group to talk about any opportunities that still might exist in the market that could potentially outperform the S&P 500 index.

Starting point is 00:00:42 So on today's show, Toby, Hari, and Stig, they talk about individual companies, but my selection was a little bit different than theirs. Instead, I talked about the first deep learning artificial intelligence ETF that's completely autonomous in its stock selections that was just recently rolled out in the last two months. So hopefully some of our ideas and our conversations help you think through the picks in your own portfolio and help you navigate the interesting times that we're currently seeing in the markets. So if you're ready, let's go ahead and get started.

Starting point is 00:01:13 You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. All right, guys, we got the mastermind assembled again here for the first quarter of 2018. So let's talk about the format that we're using for our masterminds for people that are joining us for the first time is each person brings a topic or a pick to the discussion. And then the group kind of goes around and kicks it around and tries to play devil's advocate of why it might not be a good pick. and then the person who's presenting, it provides basically all the pro points on why it might be a good pick. So anyone want to go first?

Starting point is 00:02:06 I think Toby told me he wanted to go first before we started the show. Was that right, Toby? I don't mind going first. I think I went first last time, but I'm happy to let you guys eat my dust. Give it to you. All right. Well, you do have a very strong background to say that after the last mastermind because Toby recommended Gilead. And I think that's up, what, 20% since you recommended it on the last show?

Starting point is 00:02:28 It's something like that, but I think in the interest of full disclosure, we also have to mention a short guarantee, which has had a bit of a stuffing kicked out of it. I still really like a short guarantee, but it's down. Puerto Rico, it looks like it's a little bit of a disaster. I think that AGO, assured guarantee is going to be okay. So I like it where it is at the moment. I think it's still really cheap and it's still in my screens where it is. But just in the interest of full disclosure, I'm going to own up to that one too. There you go. Okay. Well, let's hear what you got for us today. So, Pick Today is a funny one. It's Micron Technology. The ticker is M-U. It's one that I have recommended on the Acquire as Multiple. So I recommended this on the Acquireers Multiple on October 1, 2015. And at that time, it was trading at $14.56.

Starting point is 00:03:20 Right now, it's trading a good deal higher than that. It's at $42.49. So it's up almost three times. and I'm about to recommend it again, which might sound crazy, but I'll tell you why I really like it. Market cap $49 billion. Enterprise value is about $53 billion, so it's got about $3 billion in excess of debt over its cash. Trades on a very low PE, just under seven times, trades on a very cheap acquirers multiple. the problem with this stock is that it tends to be pretty cyclical. So the earnings are up and down a fair bit.

Starting point is 00:04:02 So when I recommended it at $14, I think it was trading on roughly the same acquires multiple. It was trading on 5.7 acquires multiple. And so it's up three times on the same acquires multiple, which tells you what the operating income has done over the last two years and a quarter. It's up three times. So that's what happens with the stock.

Starting point is 00:04:24 The operating income is up and down, and it's as close to as expensive as it has ever been. So the reason that I like Micron so much, there are two reasons. David Einhorn has a big shareholding in it, and Einhorn's a super smart investor. He's had that shareholding in it since I recommended it in 2015. So, you know, it's not something that he's necessarily buying now. It's something that he was buying when it was one-third as cheap as it is now. But it's still as cheap on a valuation basis as it was. then. So I don't mind it. It's in a semiconductor sector, which is very boom-bust. And it's booming,

Starting point is 00:04:58 but it remains as cheap as it has been. So I think it's an interesting stock. You know, I don't like really buying things at the very peak of a stock market run-up. And I don't really like buying something necessarily three times higher than I've bought it in the past. But if I look in that screen, in a market that's pretty tough to find things, I think Micron is interesting. So Toby, the thing that catches my eye when I look at this, just at the numbers. I'm looking at the top line, the revenue on it. And it seems like the revenue is really all over the place. What's driving these cycles for the semiconductor industry? That's the nature of the industry. It's a little bit bum bust. It's the very end of the

Starting point is 00:05:37 the consumer end of the industry is always pretty stable. But by the time you get through to the manufacturers, to the OEMs, it gets very volatile. And that's where these guys are. It is very subject to those cyclical moves. And so it's a stock that does look cheap when it's actually expensive. And so that's the main concern of something like this. But, you know, if you do a rough DCF on it, and these things are pretty tough to do discounted cash flow analysis on, which I don't typically love because they're always very, the DCF moves around a lot depending on the inputs that you use. But I think if you look at sort of the last five or 10 years of growth and you punch those statistics in, I think you get fair value for me in something like this is around

Starting point is 00:06:19 $70 to $90. So I think at $42, it's worth putting a small part of the portfolio in, understanding that it's a very cyclical stock. What discount rate are you putting in to get that price that you just quoted? I'm using a discount rate of 12%. Hmm. So going back to the revenues, like the thing I guess I don't understand is I understand cyclicals, but when I'm looking at the revenues on this, you go to 2014. in 2015, you were looking at $16 billion for their revenues.

Starting point is 00:06:54 But then 2016, just one year later, it dropped clear down to $12 billion. And then we saw a jump clear back up to $20 billion here in 2017. So like the revenues practically doubled. And I guess for a company that size, that just really surprises me. So I guess my concern moving forward is if we buy now at the highest revenue we've seen, what does this look like if that would drop back down to call it 60% of what we just saw in revenue for the coming year? Yeah, it's going to look a lot more expensive. But here's the thing.

Starting point is 00:07:29 The revenue has been growing pretty consistently. I mean, the nice thing about Micron is it's got a track record that goes back 30 years, something like that. Yeah. You can look at it. In the 1990s, it was earning a dollar a share. Now it's earning $18. This is in a revenue sense. It's earning close to $18 a share.

Starting point is 00:07:46 You know, it's cyclical, but it has grown. over that period of time. It's not my most favorite stock pick I've ever had on the show because it's just the market is getting tough to find stuff out there that is cheap. You know, what I typically like is trough earnings, trough revenue, and cheap on that trough. It's definitely not that. It's cheap on what looked like pick reps, pick operating income.

Starting point is 00:08:09 So it's not something that I'm going to go to the stake to defend, but it's in a tough market. I think it's not a bad option. Toby, this is definitely an interesting one. And for me, because I pass through Micron Technologies headquarters every day on Highway 237. And it's something familiar to me because it produces two important components in most servers, DRAM and NAND, which is the storage flash drives. What concerns me, and I think Preston kind of pointed it out, their revenues can be quite cyclical or varying, year over year. And the reason being, correct me if I'm wrong, Toby, 64% of their revenue roughly is from DRAM,

Starting point is 00:08:54 which is basically an OEM product that they sell to folks like Intel. And that's where I think the buyer power is huge, like Intel or there are only few. And for me, To be, I think in the near term and long term, I don't know how to see this talk. I think you are looking at from a valuation perspective in the current market, the risk I see is it is yet to be seen whether they'll be able to capture meaningful market share in the inland storage market. So that's a bet that they're making because their DRAM is a commodity business. And recently Intel announced a $5.5 billion investment in building their own facility for memory chips. And that's the risk they have is they're dependent on.

Starting point is 00:09:42 on these big guys for a majority of their revenue. Any thoughts on that, Toby? I think that's all dead right. And I agree with you 100%. And I think if this was something that was trading close to fair value and I had to take a view on the business, then I'd probably pass. But I do think that a lot of that is already discounted in the valuation. So I think you're sort of getting paid at this point, you know, you get a pretty strong balance sheet. It's got lots of free cash flow. You're not paying very much for it. It's at a cyclical peak and at some stage there's going to be a retrenchment in the valuations and there's going to be a retrenchment in the business that's getting done and that's a real risk. But I've been saying that for close to six years now and I haven't seen any of that.

Starting point is 00:10:27 If you're continuing the hold, what would it take for you to change your mind? Would it be a specific price action that passes through a certain level or I'm just kind of curious how you'd think through that. I mean, as a general statement, I always look at my opportunity set and where a particular stock is in my opportunity set. So Micron is one of those stocks that is often in the screen just because it tends to trade it about the same multiple regardless of what the earnings are doing. But it did disappear. Like the last 12 months, it's sort of disappeared and it's come back into the screening. And so I know it pretty well. I've seen it regularly over the last sort of 10 years. And it's worked for me when it's been cheap on this multiple and I bought it and then sort of just rolled out of it

Starting point is 00:11:09 12 months later as the long-term capital gains tax has become available. So I bought it October 2015 and then would have sold at late 2016 or maybe early 2017 to push the tax. And it's back again. So it's a different proposition when it was trading at $15 at sort of three times as much, it's a much more difficult stock to own. But it's not an easy market to find opportunities. So Toby, I'll try to make this question slightly more generic, so we don't all just beat you up on this topic. Whenever I look at, you know, over the past 10 years, and I can see in, say, for instance, 2008, 2009, it was like two very rough years. Then you have two years. Then you have a lot better, followed by 2012, 2013. There was then again bad. 14, 15, good again, 16 bad. And now it looks like it's in a good cycle. As you also. said before. So I guess in continuation of the debate that we had with the group here, more just in general, how do you work with cyclical stocks? And not just in terms of pricing and finding the fair value, I would assume that you can push the capital gains tax to get a lower rate for most

Starting point is 00:12:23 stocks, because after all the cycles are at least a few years. So which indicators do you look for, I guess, to figure out where you are in the cycle and when to exit and enter, and perhaps not just about what's the operating margin. Do you have other indicators that might be more industry specific? Yeah, I think so. That's a really good question. Very, very hard to do. I think if you look at any stage over the last,

Starting point is 00:12:49 so after the 2009 bottom in the first quarter of 2009, at any stage over the last eight years or so, eight or nine years, you would have thought, looking at Micron, that it was probably overdue for that down swing in the cycle. And it's had a few bumps, but it's never had that really low swing. And I think that that's why it's continued to trade at a fairly low multiple because there has been that expectation that it's going to pull back

Starting point is 00:13:17 and it hasn't happened so far. Like I said, it's not my favorite pick. And I do feel like it's 3 a.m. in the casino and someone should drag me away from the crowd table. What an analogy. Sorry, you're beating up so much, Toby, that you had to almost go back on your stock pick. I'm not going back on it, but I will say this. This is no, this is no, I like, I still like AGO and I still like Gilead. And if this works out, then I'm going to pretend like I knew it was always going to work out. If it doesn't, then I'm going to say, I hedged it pretty well on that call, didn't I give you the verbal hedge. All right, Hari, let's go ahead and hear your pick. My pick is Fairfax, India, which is,

Starting point is 00:14:01 It's not Fairfax Financial, the mother company based out of Toronto. However, Framewetsa recently started a couple of years back. He created a new subsidiary called Fairfax India. India, as you know, is growing at a rate of 6 or 7%, even if the government doesn't do anything. It also has huge runways. Like a couple of numbers I will throw out. Of course, we all know about India's population of 1.2 billion, huge, population of people below 30.

Starting point is 00:14:33 And also in terms of penetration. So a couple of figures to keep in mind, the mortgage penetration in India is 7 to 8% of GDP, which is one of the lowest. It's even lower than Ukraine. And insurance is 3.2% penetration. All this kind of screams opportunity as the current government led by Narendra Modi is pro-business and progressive and is bringing into effect a lot of laws that are bringing India closer to many of the developed economies. For example, we all have heard about demonetization and GST, which is a

Starting point is 00:15:16 global service act that made India's taxation simple. But what we have not heard about is bankruptcy protection law, which was not there in India for a very long time. They're also working on clearing up debts in the banks. And they have a huge focus on infrastructure. They have a ministry focused on infrastructure now. All this gives Fairfax, India, ample opportunity to invest. And it turned very well in the past couple of years of their operation. Some of the numbers I was looking at, they started in 2015 with the net total asset of close to $1 billion.

Starting point is 00:15:56 and that's the capital they raised initially. And they had to go and issue some bonds as well as raise additional funds to equity issuance because they had so many opportunities. And today their total net assets stands at $2.5 billion. Their income or revenue grew by 96% in 2016 and then 272% in 2017. So from 65 million today is around $480 million. And their net earnings also grew between 150 to 250%. So they started with the 40 million of net earnings.

Starting point is 00:16:34 Today they have 364 million in net earnings. One of the interesting things for folks in the U.S. and who are not Indian citizens is it's really hard to invest in Indian market. There are some restrictions for non-citizens investing in India. and Fairfax is a great opportunity, even for those for Indian citizens, because not only do they buy public companies in India, it's a holding company, but they're able to buy private companies in India. It's really hard to gauge their book value, but it is fair to say that their book value is much higher than $10,11 that we see today because of this issue of their private investments. However, a few interesting facts about the Bangalore International Airport is that they took a 38% stake initially for $385 million in early 2017, but then they went ahead and bought 10% extra stake and paid $125 for that in the next round. And that shows the increase in the value.

Starting point is 00:17:47 And that's typical in India where land prices are increasing at a healthy rate, especially. Especially the Bangalore International Airport is an interesting investment because it's pretty much a monopoly. One of the fastest growing airports in terms of traffic and it's the third busiest airport in India after Bombay and Delhi. Similarly, they have made investments in other companies which are either into specialty chemicals or into financial services. and I suspect that they might make some investments in insurance as well because that's a growing industry. And I know that even Berkshire Hathaway, Ajit Chang with Berkshire Hathaway insurance, is also very active in India. I don't know whether they have made significant investments, but I do know that they're interested in India as it's a growth market. So all this makes me interested in Fairfax in terms of long-term holding.

Starting point is 00:18:44 Today, it's selling it around $17. The stock prices are around $17.67P and its book value on the balance sheet is $10 to $11, which I suspect is less than the actual book value because of their private holdings. I just want to quickly say that the ticker here in the U.S. for buying this is FFXDF, if anyone wants to know. And this is an over-the-counter traded equity position. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord.

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Starting point is 00:23:25 And something else that I wanted to point out, Hari, is it seems like they got a decent letter to shareholders here, a PDF. We'll have a link to that in the show notes for people to go through because I think this is a really interesting pick. And this is much different than something that we typically talk about on the show. My immediate thought when you started talking about this, I was really interested in more the managers, the people that are running this company. What's the story on them? Do you know anything about them? Good point. Actually, there is one negative, however, not negative, but something that we should keep in mind when we are interesting is.

Starting point is 00:23:59 Prey Watsaw obviously is involved. However, the management team running in India, the main guy is Harsha, Raghavan. He has a very good track record in India. However, there is a management fee here. So that's an interesting twist to this company. So there is a management fee of 20% above 5% hurdle rate that goes back to the parent company, which is Fairfax Financial. So what do they get back, Harry?

Starting point is 00:24:26 And I know it's owned by Fairfax Financial Holdings, but are the facility in anything in terms of finance, operational, or is there any kind of value that's flowing back to the subsidiary? And how does this influence me as a shareholder? It will influence me as a shareholder in terms of my net earnings because part of the earnings is actually going to Fairfax financial. Yes, so in this situation, whenever I look at the latest interim report, there's a performance fee for the first nine months of 2017 of $84 million.

Starting point is 00:24:58 that basically comes from them or perform the market and then sending a transfer back to the parent company. Is that correct? Yes, that's correct. Okay. It's really interesting because it's almost like it's a private equity relationship with like general partners and limited partners, but yet it's kind of confusing to me, to be honest with you, the way that everything's structured. Toby, are you understanding all of it? Because it seems really confusing to me. When I look at investment companies, usually what I like to do is to buy investment companies at a discount.

Starting point is 00:25:28 to tangible book. So Fairfax, tangible book is $13.50. And the stock closed today at $17.86. And the reason that you want to buy them at a discount to the tangible book in the ordinary course is because you have to pay that fee. You know, you're paying some fee for the management of the fund. And it's reasonably fat in this case, 20% over a 5% hurdle. The reason that you might want to pay a premium, and so that, the premium here is about 30% something like that is because you really love the manager and there's no other way to get in with the manager. And the manager that you would love in this instance is Prem Watson, who I think Prem Watson is one of the best investors out there. I love what he does. And I think he's been one of the guys who's correctly hedged into the 2008 drawdown. So he made a lot of money then and he's been very careful through this whole process. For me personally, if I was going to invest in something like this, I would want to be closer to Prem than the other investors. So I would want to be in the Fairfax parent company.

Starting point is 00:26:31 So you're getting India exposure one step removed from prem at a 30% premium to tangible book where there's going to be that carry going back. So you're really betting on prem getting it right and making a lot of money consistently over the long term, which he has been able to do. But I kind of think that the bet here is it's not asymmetric, which is what I kind of look for. So I think that this is definitely something that I would invest in at a discount to the tangible book. So I'm going to stick it in my watch screen and if it goes below $13.50, I'll take a swing at it. But you would never get access to this guy on a GP level, right?

Starting point is 00:27:10 Well, you can invest in Fairfax. Fairfax, the holding company, you can invest in that. And you can invest in that. You're paying a premium right now too. But you can get it without the carry. Yeah. Harry, whenever I saw this pig, I was really impressed and I read through the shareholder later. And for me, that just speaks the world about the company. And it's one of those where you just, even though if you just skim through it, you can really like get a feel of whether or not they understand what they're talking about. And you might be like, well, sure, I mean, they're the management. Why wouldn't understand what they're talking about capital allocation? Just the way to talk about capital allocation, I think most people would be surprised how capital allocators sometime, at least on paper, talk about allocating the capital. And whenever you see the outline that they have, I was very much convinced.

Starting point is 00:27:54 There are a few things that I don't like. I definitely don't like the performance fee. And for instance, whenever I look here at the consolidated statement of earnings, and I talked about the $84 million before for the first nine months of 2017, so the net earnings for income taxes after this is deducted would be $361 million. So, I mean, it's definitely significant. And once you keep in mind that whenever you're looking at something like this, you have your net realized gains in investments that would wildly fluctuate,

Starting point is 00:28:22 It's just another comment also what you talked about before. Hari, it really depends on when they're selling. A company can look a lot more profitable whenever they sell an investment has gone well. And so take it for what it does whenever I bring these numbers up. But it seems to be a very high tax that is almost sure to be paid. I know even though it's above a 5% threshold for the access to private companies in India. Yeah. I mean, their cost structure reminds me of Buffett's partnership.

Starting point is 00:28:51 And I think Kristen kind of pointed it to this as well as you can look at it as a GPA general partnership that you're getting access to. For me, the selling points here is access to India. And as Toby mentioned, access to the frame in a way. And the fact that frame has a lot of connections and context in India, he really knows what he's doing. And the fact that in India, average mutual fund grows anywhere between 14-20. to 16%. That's kind of an average mutual fund. And some of the good mutual funds are growing close to 19, 20, 22%. So that shows the growth potential in India. So I expect that even after fees, the management fees, this stock would do well in the long run, assuming that it has a same kind

Starting point is 00:29:44 of culture and DNA that frame WhatsApp rings in and Fairfax financial. But I also get Toby's point about being careful about buying it at the right price closer to the book value. So, Hari, I think this is just a related question in terms of the private companies that you talk about and that's very interesting because if you look at how the public companies are priced right now, I mean, India is pretty expensive if you just look like across the board. Do you have any other vehicles if you want to find the right managers to invest in private companies? It's really hard to say. Investing in private companies, at least I'm not sure if there are too many of them. There might be some. And I'm sure there will be more coming up. There are a lot of investors in the U.S. or holding companies in the U.S., including Berkshire Hathaway, who are interested in India. So, yes, opportunities might be available through other vehicles as well. But this is one of those direct vehicles, which is focused on India. There you go.

Starting point is 00:30:47 So go ahead and fire away your pick. All right, guys. So my pick is Air Cap Holdings and the stock ticker is AER. And Air Cap Holdings, the business is to buy lots commercial airplanes and lease them out to airlines. Right now they have a very diversified portfolio, more than 200 customers in 80 countries, a lot of exposure in emerging markets too. And it's one of the world's largest aircraft leasing companies.

Starting point is 00:31:13 It is actually the largest independent one. they owe more than 1,000 aircraft. Full is closer already bought the stock. It was a very significant position. Whenever I look at the industry and the business model, it's more or less a spread business. So they ensure financing. And so they would actually go ahead and buy the airplane.

Starting point is 00:31:35 They would typically borrow at rates around 3 to 4%, depending on the maturity. And then they will lease it out. And right now they have a healthy spread around 9%, which I found very attractive. So they have these buy in bulk deals with boring in Airbus, which is also one of the reasons why they can get a discount, but it's more the financing really more than anything.

Starting point is 00:31:58 This is also a good deal for the airlines. The leasing is responsible for the maintenance and service of the plane. Air can obviously get the yield, but they also take the risk of the residual value of the plane. The company is very efficient in keeping its fleet leased. basically it won't go ahead and buy an airplane before they already know that they can lease it out. It's Everest at 99.4 in the latest quarter. And if you look at the competitors, the largest one would be GE Capital Aviation Services.

Starting point is 00:32:29 It's approximately twice as big, but it's not an independent company. Most of the competitors are trading at a higher PE ratio. I think the valuation that we'll get to later would be very interesting for this company. So whenever I look at how the company has issued shares and bought back shares, it kind of looks like it's been all over the place. I would definitely encourage everyone to read through some of the statements where the CEO talks about how he is evaluating whether or not he should buy more planes, if he should buy back stock and devalue his stock. And that's, I think, just that you have a CEO talking about the value of his stock, like a capital alicator at a solution. lot of value too. Now, if you look at the free cash flow, it looks absolutely horrible. First of all, it looks like it's all over the place, and it looks like the earnings that you see. It doesn't come out

Starting point is 00:33:25 in terms of cash flow to the investors. Now, this is really an accounting thing. The way that you very often see this calculate is that you have the operating cash flow, which is basically the cash flow that you make from the company's core business, and then you take out the CAPEX. Now, for a company like Air Cap, that would typically mean that you have a negative cash flow because you will be buying a lot of airplanes. Whereas for you selling those airplanes back whenever it's further appreciated, that won't be included in that number. So if you actually do the math on that, you are closer to a free cash flow of around $1 billion. If I look at the valuations, just in terms of putting in the numbers, I assume throughout $800 million free cash flow,

Starting point is 00:34:12 which is, I don't think it's on the generous side, and a 3% growth, most likely, and I have an upper band of 6% and a flat as a lower band for 25% and 25% respectively. I end up around 9.5% at the current price. Sorry for the lengthy pitch. Please feel free to shoot. So Stig, my biggest concern whenever I saw this was exactly your last point there was the free cash flow, the CAPEX on this. So whenever I look at the company and you're looking at the revenue has just been going wild for the last 10 years. It's just been going straight up. But what I found really interesting was just in the last year, you actually saw the revenue contract by $100 million, is somewhere around there. So it's flat.

Starting point is 00:35:00 It's been flat. And when you look at the last year, the TTM on this, it's still flat. So I guess my concern at this point, it seems like they have stopped buying new aircraft. And I haven't dug into this nearly at the level that you have. But it seems like they've stopped buying new aircraft back in 2015. Their CAPEX continues to press higher and higher. And whenever I think airplane business, I think a lot of CAPEX and the sustainment of that fleet that they're doing, this is very expensive stuff that they're managing here.

Starting point is 00:35:32 So I would expect the CAPEX to be, continue to be pretty high. And I think that that's where when we're looking at all the CAPEX that they spend over the last 10 years, it makes sense to see their revenue keep going like it was because they're just buying so many new aircraft. Then it's just adding to the fleet and their revenue is going up. What does that CAPX look like moving into the next 10 years, assuming that the fleet stays flat and they're not adding to the fleet and they're going to make their revenue fairly flat? assuming they're not going to continue to add to the fleet. When we do that, what does the free cash flow look like? You said you think it's $800 million? Is that what you said? You think the free cash flow comes to?

Starting point is 00:36:09 Yeah, and that might even be like on the more conservative side. I don't know. I mean, if you look at the past three years and you also include the proceeds from sales and disposal of assets, you know, you get $2 billion, $1.6 billion, $1.5 billion. And if you look at the trailing 12 months, if you just go into any service, it would say it, negative more than a billion dollars. So it's really important to agree through the cash flow statements. And I really think it's interesting what you said about the revenue and how they look at the capex. So one of the thing is that they would buy the aircraft and that would be reflected as, you know, a capex. The maintenance, whenever they lease it out, they will go to the leasing. So they won't carry that. And the other thing is whenever you read through the latest earnings call is that the CEO would say that right now he's not looking to buy more aircrafts because it's been more competitive. So at least he won't be as aggressive. Partly it's because it took on some debt, both to

Starting point is 00:37:10 shareholders if you like by issuing more stock, but also that in general after the huge acquisition a few years back. So they're going to spend some time paying some of that debt back. And also he finds that the stock price is very interesting right now in terms of repurchasing stock. And tracking what has happened over the past few years, he's definitely been true to his word, close to a 10% buyback yield despite the investments he made. So when I'm looking at the cash flow statement, I'm looking at the depreciation. To me, it seems like maybe their depreciation is about $2 billion a year on the fleet. Would you say that that's an accurate number just so we can kind of then look at whatever

Starting point is 00:37:45 their operating income is and then subtract that out? That's probably true. I'm looking here at, I think it's the latest 10K I'm looking at here. Are you looking at Morningstar? Yeah, I mean, I'm ballparking the numbers here, but I think that your 500 to 800 million and free cash flow estimate moving forward would probably be pretty accurate.

Starting point is 00:38:04 I definitely did not dig into this at the level that you did. I'm curious, Toby, would you agree with that conversation we just had? Are you kind of looking at the CAPEX kind of being the main concern and what that steady state looks like moving forward? I'll tell you what my main concern with these sort of businesses is, these things that carry enormous amounts of leverage on not a great deal of equity. And then you have it in an industry that's pretty cyclical too. So Stig had the baseball bat out on me before on my cyclical industry.

Starting point is 00:38:38 But my cyclical industry, I think, is less cyclical than this industry. And it doesn't have the leverage in it. So this is one of those things. Have you looked at this through a period like a recession like 2000, 7,89, and seeing what does the free cash flow look like? What are the customers doing through that period? Are they able to keep on making the payments on the leases? Do they fold the tent? Does it survive through that period? Yeah. So, for instance, if you look back in 2008, like the worst year they had, it was 97.7. It was still a profitable year. And I have like one thing I would like to add to all

Starting point is 00:39:14 the betting that we did before, Toby. This is a huge position in David Einhorn's portfolio. is this 10%, which is also one of the reasons why it came on my radar. And more recently, Monish Paprai has bought a lot of this company over the past few quarters. Right now, it's Monipaprii's third biggest holding in the U.S. So, you know he might be rather be invested in India, as you talked with Howard about before. I think it's definitely a stock worth paying attention to. I really like Toby's concern here. When we go back and let's look at 2007, 2008, they were doing about $1.1.1.2 billion for their top line.

Starting point is 00:39:55 And as soon as the recession hit, that got cut in half. So their top line went 50% of what it was whenever they went into a recession. If that would happen today, as I think through this company back then, they were one-fifth the size of the fleet that they've got today. And so now that they're five times bigger, how much more is that going to impact a larger company that's leasing? aircraft. Is it going to be 50%? Is it going to be greater? Is it going to be less? I don't know what that is, but I think that that's a really important concern because if we take that revenue down from five, let's just say it's 50% like it was during the last recession. And you go from $5 billion down to $2.5 billion. And we already said that we think that their depreciation alone is going to be

Starting point is 00:40:37 $2 billion before operating expenses and things like that. I think you really get into an interesting dynamic where this thing could be, I mean, what company wouldn't be, impacted with the recession. But I don't know about this one. I guess I'm not as excited about it as you are. Yeah, I think you and Toby bring up some great concerns. And I mean, if I look at how the revenue has been developing, you know, you're right. I mean, it's, it's a rough drop. It's not so that if we have that revenue that you would just have the same expenses and just, you just be flat. So if you look at the worst year in terms of efficiency, it was 97.7%. That was back in 2008 when it dropped. And of course, like, since these are lease agreements, if they should

Starting point is 00:41:24 default on the payments, they will get the plane back and that can be sold off, which is a natural part of the business. But you're right. I mean, in terms of recession, the price won't be as attractive as it would be today. I was just going to say, in support of you, if the company can maintain its current growth rate and it can keep on doing what it's been doing, I do think it's very, very cheap on a discounted cash flow basis. I do think you're getting enough of a discount that it is well worth taking a swing at with a small position. So I think, you know, if it keeps on doing what it's been doing, it's worth like $120 to $150 and it's trading at $53. So that's enough of a discount that I would be prepared to take a swing at something like this,

Starting point is 00:42:06 even having said a lot of other stuff. But I do think that your risk in something like this is close to zero. So you need to size it like it's money that you can lose. But it's not growing, Toby. I mean, up until 2015 it was, but since 2015, it's not growing. It's going to slide around, though. It's not going to be every year. It's going to cycle. You know, a few years ago, my screens all filled up with the airlines, and I was worried at that stage that airlines are one of those cyclical stocks that you look at the peak of the cycle,

Starting point is 00:42:35 and they look cheaper at the peak than they do at the trough. And I've got Warren Buffett's words ringing in my mind that he's always nervous about airlines. Now, this is an airline. This is a leasing company. So it's one step further removed. It's much closer to the whip end of the tail because it's selling to the airlines. But I do think that it's enough of a discount on a DCF basis that it is worth taking a really close look at. It's interesting.

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Starting point is 00:46:17 slash income. This is a paid advertisement. All right. Back to the show. All right, guys, so that was all I had for AER. Preston, you know, of all the stock picks that we had here in the group, I think I look forward to yours the most. it was definitely the one that was most out there. And I'm saying this as I'm smiling. I don't necessarily

Starting point is 00:46:38 saying it's a bad stock pick. I just, I really did not expect that, especially not from you. And I guess not from anyone here in the group. So please let us know what is your pick? What do you want to talk about today? All right. So let me start off by saying I do not own this. But I find it really just an interesting discussion. And I look forward to seeing more of this in the future. So the stock ticker for the one that I've got is AIEQ. And this is an AI artificial intelligence powered ETF. And this is a Silicon Valley company that has made this. If you just type in AIEQ into Google, it'll be the first thing. We'll have it in the show notes if you guys want to go to the homepage for the people that created this thing. But every stock pick in this portfolio is being picked

Starting point is 00:47:30 by a deep mind neural network machine learning algorithm. And they used Watson for the programming on this. And they just, you know, set it loose. And this thing started trading on the 18th of October. And since its inception in the October timeframe, it's done 9% since its inception. And to give people just an idea of where that's at in the grand scheme of things, The S&P 500 is done 10% since that point in time. So it's trailing the S&P 500 by 1%.

Starting point is 00:48:08 So it's in the red as far as I'm concerned, underperforming the S&P 500 so far. But let me just say that basically the first three weeks that this thing went on the market, it got punished, absolutely punished. Like it just underperformed the S&P 500 every single day almost for the first three weeks. and then it was like out of nowhere this thing started taking off. So if you look at it after that first three week period, it has done 14.6% when the S&P 500 has done 11%. So it's outperforming after that punishment period. And when you look at the price chart on this for that first three weeks, I mean,

Starting point is 00:48:48 it was just like straight down, like a straight line down. And then out of nowhere, it just started taking off, which is kind of interesting as far as I'm concerned. So what I really like about this is when you go to the page that company has for the information about it, every day they publish the holdings that the algorithm, the AI bought, is picking. And it's only equities, long equities. From what I understand, it doesn't go short. So it's only buying long equities. And it's buying anything that it can find in the U.S. stock market. And it has a cap of it can only hold 70 picks maximum. And I think on the minimum side, I might be saying this wrong, but I want to say it was 30 or 40 picks on the minimum side.

Starting point is 00:49:34 So this is what's awesome. So you can peek in there and you can see exactly what this thing is holding on any given day. And you can pump it out actually into an Excel document right off of their web page. And what I found fascinating about this is the number one pick out of every stock that this thing could pick in the U.S., its number one top holding is Amazon at 4.11%. The number two pick that this algorithm, this computer has picked, is Google at 3.65%. When you go through and you look at some of the other picks, the thing that I was, so like whenever I saw that, I was like, okay, so those are like strong momentum picks. So I was like, maybe this thing is just doing straight momentum. But then whenever I scroll down and I looked at some of the other picks inside of the portfolio,

Starting point is 00:50:23 believe it or not, it owned GameStop as one of its top 70 holdings. And right now it has 70 holdings in it. So this thing is purchased GameStop, which we all know is definitely not a momentum pick. If anything, that's an anti-m momentum pick because that thing just keeps going down. It's coming up in this filter once again with this AI bought, which I just found fascinating. Now, let me just say, when I first, started looking at this probably a week or two weeks ago. GameStop was much higher in its

Starting point is 00:50:56 holdings. I think it was holding about a percent of GameStop. And now a week or two later, GameStop is now in its 69th holding position at 0.25%. So it's been selling its GameStop position because I think it found out that it was catching a falling knife like everyone else who's purchased GameStop in the last year. But I found that interesting. So, What's really cool about this is I don't think it has a preference to a momentum or a value, but I see some of the picks in here kind of resemble both strategies, which is fascinating. So the reason I bring this up isn't necessarily because I'm telling people to buy this, because this thing has a track record of about two seconds.

Starting point is 00:51:41 But I think it's kind of a neat tool to just peek in there and see what the heck it's holding and maybe why it's holding what it's got. One other highlight before I throw it out to the group to kind of hear your thoughts on this is when I scroll through some of the holdings, I see some various financial companies in here as well. And when you think about holding financial companies right now with interest rates going up, that would be a smart decision. So I have no idea. When you read some of the information on the site, I guess it's even taking social media accounts and as data points. there is so many things. It's reading all the 10Ks, the 10 Qs, it's looking at all the financial data, it's taking in news stories, it's taking in social media feeds. I mean, this is crazy.

Starting point is 00:52:28 It says here that every day process is more than one million filings, news articles, and social media posts. I mean, obviously, they're not telling us how they're processing it. Obviously, that would be their IP, but I think it's very, very interesting. How much have the turnover been Preston. Like how many times that they're just replacing holdings? You know, I haven't tracked that, but I've peaked in at a couple different companies, and I haven't seen those companies fall out of the mix in the two, three weeks that I've been looking at this. Now, I mentioned Amazon and Alphabet being their top two holdings. Number 15 is Facebook. They have 2.38% of the portfolio is Facebook.

Starting point is 00:53:07 Now, the one that I found fascinating that's not on here is Apple. It's not holding Apple. So isn't that, like, for me, like, I'm just like, wow, that's pretty interesting, especially with all the news that came out that the iPhone 10 sales have been lackluster and everything else. This thing has not, it's not holding Apple, but it's holding the other three big companies, Facebook, Amazon, and Google. And GameStop. And GameStop.

Starting point is 00:53:36 Man, it's It's got a bloody hand. It's like a right of passage for every value investor. You come in and you buy a little bit of GameStop and you lose some money on it and you get a little bit smarter. So I'd just say welcome to the market, buddy.

Starting point is 00:53:53 So, Hari, I'm curious to hear your thoughts. Is this something that you've heard about out there in the Valley? Because this is from Silicon Valley. Yeah, I've heard a lot about that talk about this and other AI approaches. A couple of things that I want to just throughout it is like its expense ratio is 0.75% so it's not cheap. Yeah. And the other thing is

Starting point is 00:54:13 it would be interesting to see how different it's holding like the top 70 compared to a index fund. What's the difference? And finally I'm asking you both like if I had to put your money between Toby and this, which one would you choose and which one would you sleep at night peacefully? Considering Toby hedges, my money's on Toby. Exactly. What I like about it is the holding, as you said, to understand what's the algorithm behind, you can kind of try to reverse engineer the algorithm,

Starting point is 00:54:47 maybe if you monitor how they are placing their rights. I was just going to say, I love the idea of a quantitative machine learning approach to the market. This thing's probably been trained on both value and momentum data, which is why you're going to see those value and momentum picks, because those are traditionally the two best risk-adjusted methods, most robust over the very long term. And doing those two things together is going to give it a very interesting return profile. I was totally kidding before about the GME, the GameStop line.

Starting point is 00:55:21 I'm being rude there that somebody is going to get GameStop right and buy that at the right time and make some money out of it. And I say that because I've done that in lots of different stocks where, and I had to buy them, you know, over sort of three or five years before they actually found. the bottom, but they did eventually get there, and I probably lost money on balance over them, over the whole period. But that's what, as a value investor, you kind of have to buy those off-the-run, ugly things where everybody says you're an idiot when you buy them, and then they go down and you're proven to be an idiot because enough of the time you buy them and everybody says you're an idiot and they go up so much that then you get to turn around and say, you're wrong, and that one made money. And on balance, that's basically how value works.

Starting point is 00:56:01 You get to buy these things, even though they are falling knives. You know, the fact that Watson is there for me that says that that's, that's pretty much a marketing gimmick. And the ticker A, I, EQ, that's a marketing gimmick too. But that's okay. That's part of what this business is, is marketing. But I do think it'll probably work.

Starting point is 00:56:19 The track record's far too short to say one way or another. If I look at my value and momentum screen and I look at the way that it performed, it's roughly done about the same thing. It's up about the same amount and it was down about the same amount through that period. So that's what I would guess they're doing value and momentum at a 75 BIPV, pretty good belly. So, Preston, whenever I did my research, I couldn't see any kind of backtesting. Have they talked about the performance of this algorithm in the past? I know it's always improving, but have they provided any kind of stats like if you invested this to the A bit or whatever that

Starting point is 00:56:53 would be? So, you know, my dad and I gotten a little bit of a discussion about that exact comment. And, you know, I told him, I said, I'm sure that they loaded up all the historical data. going back 100 years whenever they were developing the base algorithm for this thing. And my dad said, no, I think it's just the last 10 years. And I said, there's no way that somebody out of the valley would just use the last 10 years. Well, I went in and I read the prospectus on this. And in the prospectus, it says that the information or basically the way that it's making decisions is only using data off of the last 10 years.

Starting point is 00:57:30 my opinion is that they did a bunch of backtesting basically loaded the algorithm in there based off of 100 years of back testing information and data and everything else that they would have fed it. But then once they let it loose here on the 18th of October, I think that it's only pulling information for the last 10 years for the picks that it's assessing today based on what I read in the prospectus. One thing I would say about this, the good point in time back testing data goes back to 1963. every single quantitative system in the world is trained on the same data. There's a group called Euclidean who did the back testing for my most recent book, The Acquire is Multiple. And they have written this great paper, which I'll give you the link to it so you can stick it in the show notes, where they looked at using AI trained on that same data to see what it would come up with.

Starting point is 00:58:21 Basically, what they found was that humans have haze this data so much. There's so much data mining going on already that AI can't really find anything new that's not already in the data. And I've spoken to guys like Pat O'Shaun, I see I know you've had on the show before. You know, they're one of the original Quant shops. They've been doing it for a long time. They've got a couple hundred super smart PhDs in there who are grinding on this data all the time. There's not much left that anybody else can kind of dig out of this stuff. It is possible that AI is going to do something.

Starting point is 00:58:50 Like if you've seen that documentary on Go, the AI kind of comes up with this. you know, this move that causes the guys who are experts in this to say, you know, humans have been playing this game for a thousand years and it turns out we didn't really even know how to play the game because the AI is doing something completely different. It is entirely possible that that happens and this thing does figure something out. But so far, humans have gone over the data with such a fine tooth comb that I don't think that they've found anything new, but it's a very, very short time period. We won't really know for probably 10 or 20 years who's doing better.

Starting point is 00:59:24 You know, my frustration with this specific ETF, and I'm looking to see if they have other opportunities out there that do hedging. And I'm just kind of surprised that the first thing that they launched is just a straight long. Maybe that's a marketing thing so that they can get this out there, maybe not have too many products, funnel everybody into this. And if it outperforms the S&P in the first year, then they can roll out other products that are completely hedged. Would you think that that's probably why they went about this the way that they did and it's only a long strategy, Toby? Hard to say why they would do that. I personally would not launch a long only strategy into this market. You want to launch a long only strategy in 2009 or 10 and not in 2017. Yeah, you know, whenever Preston sent this and I looked it up and as Howard said, their expense ratio was three quarter percent, I thought this is a pretty smart move because this is AI. So they really don't have to tell anyone or convince investors what they do because they can just say it's AI. And we all look at. love that and they don't need to disclose it. And then you will just like administrate a lot of money

Starting point is 01:00:29 and get a lot of fees. That would make a lot of sense. I think one of the things I would really like to see for any ETF or any kind of quant strategy is really to say these are the historical results, obviously the my chance. These are the arguments why we think you will continue working. I think it sounds amazing whenever I read that they had a million pieces of information in terms of every day and filings and social media posts and whatnot. I think we can all see why that would move the markets. If not social media posts, then, you know, filings. But if that's the argument, if you can't be more detail than that, I guess I'm more skeptical.

Starting point is 01:01:07 I think, Steve, you're on to something because as Buffett says, if data or information is what made money, then all librarians would be billionaires. So I think the problem with this fund is they don't talk about their investing philosophy how they allocate their portfolio, but it's all about like we gather tons of data. So one other thing I want to just say is if they wanted to make it even more appealing to the market, especially its folks in Silicon Valley,

Starting point is 01:01:34 they should have said this is AI-based ETF that works on blockchain technology. You're right, they did miss an angle there. Hey, you know, Hari, I disagree with you on your other point, Not the blockchain point. I think you're exactly on par there with that. Maybe not today, but about a month ago, that would have worked really well. But I don't know.

Starting point is 01:01:57 I disagree with you. I think that this thing's ability to look at all the data points and then come up with the correlations of all those various data points is something we have never seen before in history. And I think, on my personal opinion is that Buffett's quote about the librarian thing is actually going to go up and smoke. And I think people are actually going to see that in the coming 10 years. I think that there's a lot of power coming with some of this stuff.

Starting point is 01:02:23 And I think that this is just the tip of the iceberg of what we're going to be seeing moving into the next credit cycle. The reason why Quant works is it doesn't panic at the bottom. Well, and this is the other thing. Like, if you were going to say that the data points are, you know, everyone would be a librarian kind of argument, and then you go back to Toby's point of the game of go, it doesn't hold up. It just doesn't hold up. I mean, watching that video, and we're going to put this. in the show notes. If you guys don't know what we're talking about here with this game of go in artificial intelligence, you got to watch this. This is mind-blowing, in my opinion.

Starting point is 01:02:56 And my expectation, honestly, is that I think in a year from now, if we looked at this ETF, I think it's going to outperform the S&P 500. I really do. A years too short a period of time, value and momentum can underperform for long periods of time. I would say you need to give it probably three, five, ten years to really work out what's going on. But I'm with you. I agree. You agree with me, Toby. Yes. Well, let's go around the table. So Stig, what do you think?

Starting point is 01:03:23 And Hari, what do you think? What's your gut tell you? Please go first, Harry. Undecided. Hari doesn't seem convinced. Yes, especially about the game of go. I think when we are talking about AI, we have to keep in mind that in machine learning,

Starting point is 01:03:39 whether it's game of go or chess, what happened between chess and game of go is that the number of patterns are possible moves in increased, but it is, as George Soros says, markets have what he calls a theory of reflexivity. The observer is the observer. And in case of chess or any other skill, where you don't have the observerie interacting and doing something back, it's not a complex system. So, yeah, it works very well in those scenarios. But when it comes to complex system like market, it's different.

Starting point is 01:04:18 There are humans involved. Economy is a complex system. Stock markets are a complex system. That's where I'm not totally convinced about the argument that you just feed data into the system and you're sure that this will outperform the market. And as Toby said, I think we have to wait and watch. I'm not saying that they will not do well. But I feel we should hold back our judgment.

Starting point is 01:04:42 Harry's the guy in Silicon Valley looking at all the baling wire and sticky tape holding together all the computers from the back end. He knows how ugly it really is. No, and I think that that's what's so surprising for me is Harry is the guy who's saying that it's not. I mean, he's closest to this stuff way closer than any of us. So that's really surprising to me. Stig? Toby, I've got a question for you on this. When we look at the way that this opened up on the 18th of October, there was a huge,

Starting point is 01:05:12 spike. The reason I'm asking you is because I know you've launched ETFs, so you understand the mechanics of how these work. There was a huge spike in the price where it jumped 3% in the first three days. And it just looks like because it was getting so much publicity on CNBC or whatever, these guys were all in the news and everything. Everyone's buying this thing. And then you saw like a really strong correction for the coming two weeks or whatever, two and a half weeks. Is that a function of basically the bot receiving all of this money and having to make a position as it's receiving all these funds early on, that it basically had to take a position. It was like it had a gun to its head to take a position in a very short amount of time,

Starting point is 01:05:55 which wasn't necessarily advantageous for it. And then it had to recalculate and basically reboot the weeks after that. Would you think that that is maybe why it did so bad out of the gate? No, I don't think there's enough. It's not big enough to impact the market in these stocks. that's not where I'm going with it. I'm saying, think of it like this. Like if I gave you a million bucks today, there's positions that you are eyeing that are at the right timing for you to kind of step into it. And then there's other ones that you'd wait to maybe take a position. You wouldn't do

Starting point is 01:06:26 it all on the very first day. But it seems like this thing was forced to take 40 positions on the very first day. Do you think that that could have impacted the way that it performed? No, these things are built to always be able to buy a portfolio. I can buy a portfolio. I can buy a portfolio tomorrow morning. I can buy one at midday. I can buy one at the close. You know, the systems are built to buy portfolios all the time and to manage the portfolio. So it's just, that's just random chance. But it comes in sometimes, sometimes the market is volatile. Just while I've got the market, just to go back very quickly to something that Harry was saying before, it's interesting. You know, you say chess and go are closed systems and the market is an

Starting point is 01:07:05 open complex system. When you look at the back testing, which these things are fed, I think that the market actually looks like a closed system to these things. And that's why I say, everybody in the world tests the same data from Compustad to 1963 in the US. That's an idiosyncratic market. Everybody's getting the same results, value and momentum. It's possible that Go and chess have more positions available to them than these things looking at those limited data sets. So, you know, that's a concern of mine. That's like an existential question that I'm always worried about, does the data set that I'm looking at training my systems on reflect what we're going to confront in the future?

Starting point is 01:07:45 And the answer is probably not. And that's a real concern for me. But the only advantage I think that I have is that when I look at my systems have been going back to 1963 because they've got that data back to 1963, if you're just a stock picker and you're in the market, your experience is limited to the period of time that you are personally in the market. You can only learn over, if you're my age, you might have started in the early 2000s, late 1990s, and that's an idiosyncratic period in the market. Would you be better off having trained it back to 1963?

Starting point is 01:08:18 Or is the artificial intelligence less useful because it's got that long history than a human who has a much shorter history and they can make decisions based on anything? You know, when you think about their prospectus, only going back 10 years to make the decisions that it's making today, do you think that maybe that's one of the reasons why they did it that way? so they're not so polarized by the way that everyone else in the market's making decisions. It might be just the data. They're looking at data averages over 10 years. I'd be surprised if they're only going back 10 years. I was blown away by that. But when I read it in the prospectus, I was, I don't know.

Starting point is 01:08:54 I was just surprised. I was like you. I didn't believe it. All right, guys. I think that concludes our first mastermind group meeting here in 2018. But before we let you guys go, we would really like to give you guys. a handoff to the audience where they can learn more about you. Harry, would you go first? Same blog, bit's business.com. All right. We'll have a link for that in the show notes.

Starting point is 01:09:16 How about you, Toby? Where can people find out more about you? Acquireasmultable.com on Twitter at Greenback, which has a funny spelling. I know you'll put it in the show notes. Yep. We'll definitely do that, Toby. And you are way too modest. You authored quite a few amazing books. So we've got to put a direct link to them in the show notes as well. But guys, That was all that Preston and I had for this week's episode of The Investors Podcast. We see you till again next week. Thanks for listening to TIP. To access the show notes, courses or forums, go to theinvestorspodcast.com.

Starting point is 01:09:49 To get your questions played on the show, go to Asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP177: Mastermind Discussion 1Q 2018 (Business Podcast)

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