We Study Billionaires - The Investor’s Podcast Network - TIP275: Mastermind Discussion 4Q 2019 (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. On today's show, we've reassembled the mastermind group to talk about four stock picks that might outperform the S&P 500. Each member of our group makes a pitch, and the rest of the group provides important insights to think about and consider so the risk can be managed and the proper intrinsic value assessment can be made. So without further delay, here's our mastermind discussion for the fourth quarter of 2019. You are listening to The Investors Podcast, where we study the financial markets and

Starting point is 00:00:32 the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Hey everyone, welcome to the Investors podcast. I'm your host, Preston Pishon. As always, I'm accompanied by my co-host, Stig Broderson, and we've got Hari Ramachandra, Toby Carlow here. Guys, welcome back. We're thrilled to have you. So during this discussion, we ran into a little bit of audio issues for the first like two or three minutes of this discussion. You're going to find that Toby's audio is a little bit off, but I promise you it gets a little bit better as we go through the rest of the interview. So with that, we'll get started. Okay, Toby, please go ahead with your peg.

Starting point is 00:01:19 Last time I was on, I had Vonage, which has fallen pretty significantly over the quarter, which was a short of mine. So I think the time before then, I had Netflix. So I have this theme of shorts that I'm going to continue with today. My short is I3 verticals, probably not a company that a lot of people have heard of. The ticker is I-I-I-V. It's a payment processor. What it does is it takes various different payment options and turns them into cash for different companies.

Starting point is 00:01:51 It does it across three lines, education, public sector, and non-profit. It's not a huge company. So it's a $780 million market cap. The enterprise value is closer to a billion, so it's about $2. $200 million in net debt sitting on the balance sheet. Really expensive.

Starting point is 00:02:13 It's close to 10 times. Book value. E.E.E.B. My favorite metric, 153 times. By any measure, it's got these huge multiples because it's a software as a service business and anything that software as a service is now worth an infinite amount of money according to the public markets because they have an infinite total addressable market and they can scale there at zero cost.

Starting point is 00:02:36 That's not actually true. That's not the case, but that's the perception of every software as a service business. I think they've got a little cash squeeze coming. So their cash to debt ratio is 0.1 at the moment. So it's possible that they need to do something in the not too distant future. They've got narrow kind of interest coverage debt to EBITDA is 5.5 times, which is what you would expect to see in a leverage buyout straight after the acquisition, and they would be trying to pay that down like their hair was on fire.

Starting point is 00:03:05 So the way that I put my shorts on is I have them on for about a quarter and then I reassess. So this one is a newish one for us. So I'd be short this for about a quarter and I would look at it again in the end of March, April. I'm looking at this and in the last 71 days, this thing has gone up 50%. So I'm kind of curious what was driving that factor for it to explode up in price? Because, I mean, fundamentally, this thing looks like a disaster. But the price action is kind of scary, taking it short and seeing it go up 50% in the last 70 days. If you have a, if you cast your eye back to about the 70 days before that, too, you'll see it takes a dip of about half.

Starting point is 00:03:51 Yeah. Oh, yeah, no. Let me measure that real fast, just so I can tell the audience what's talking about. So, yeah, 70 days prior to that, it dropped 40%. So, I mean, it's extremely volatile. I guess what I'm saying is, so how do we know this time it's going to drop back down like it did 140 days ago? I think it's got some near-term liquidity issues that are going to need. I think that that's a rant because they need to raise a little bit of capital.

Starting point is 00:04:19 So they're planning on they're going to do a capital raise. And I think that that'll be the thing that waters the stock. So just another thing. I always short these things very small in the portfolio. these are shorter to less than 1% for the most part. So, you know, whenever I'm looking at this pick here, Toby, you know, this is a rapidly growing company. Back in 2016, revenue 200,000, 16, 263, then the year after, 324, and now around 370s.

Starting point is 00:04:50 So this is a company that's growing pretty fast. It is also growing fueled by debt. So the debt to EBITDAIS 3.25 and I read through the documents of the company and currently they put a restraint of themselves not going more than four times that. So you might be right in terms of there might be a liquidity squeeze. Baring interest rates 5.5% at the moment, obviously that would likely go up if they continue to make acquisitions. And I kind of want to talk about that. If we look here in the fiscal 2019, they completed nine acquisitions. And this is a strategic focus for them that, you know, they want to pick up new business

Starting point is 00:05:31 with new payment systems. I think one of the most noticeable was the utility payment system that just picked up. And so whenever I'm looking at this, it's not necessarily that I disagree with you that it looks expensive. But it's really hard to make conventional valuation based on this in the first place, which I sort of don't really like, because this looks like a company that's on a buying spree, it keeps on reporting high growth rates, you know, by definition almost. And as you said before, you know, the market just continues to value that really, really well. So I'm thinking,

Starting point is 00:06:08 yes, we can say that the market might be overestimating the impact and the revenue potential or the net income potential. But as long as a company like that can continue to fuel that growth with close to, well, I wouldn't call it zero cost, but like money is very, very, very, you know, very cheap right now and being rewarded. I guess for me, it seems to be if I'm going to put a short on, I probably would like to buy that put and then just pay the premium. Definitely don't want to write a put. I guess that's some of the concerns that I have. I guess to me it doesn't look like the obvious short. So Toby, I completely agree with Stig on this. I don't understand why it's a high probability short. I mean, I wouldn't be surprised if it went down by 50% in the coming

Starting point is 00:06:53 quarter, but what assurance or key metric do we have that makes us think the market is going to start pricing that abrupt change into the price? I have a bias against that kind of manufactured growth from roll-ups, so that's part of my dislike for something like this. Hmm. That's interesting. I've never thought of using something like that as a metric, so that's pretty interesting. All right, so if you guys don't have anything else, I'm going to go ahead and pitch mine.

Starting point is 00:07:23 I was going through our intrinsic value, our TIP value filter, and as I'm going through it, there's just so many financial companies that are coming up in the screener. And I personally believe that we've got a major issue with fiat currencies. I think we have a major issue with bond markets globally. And based on that global macro opinion that I have, I'm very hesitant to invest in financial companies at this point. So in the filter I was going through and I was trying to find companies that were, you know, great value picks but not part of the financial services industry. And I came up with a company called Biogen and the ticker is B-I-I-B. This company has a ton of intellectual

Starting point is 00:08:16 property. Their annual top line is around 13.4 billion and that was for the 20,000.1,000.000. And that was for the 18 number. They're flush with cash. They have a very large profit margin. So, for instance, their bottom line was $4.4 billion. And so when you compare that to a top line of 13.4, you can see that they are, they're really kicking off some high margin business. And that's after tax, 4.4 billion. Not highly leveraged at all, which I really like. When I crunched the numbers on this and I'm trying to figure out the intrinsic value. I do it through an IRR calculation. And so the IRR that I got for for Biogen was around 10%. What I really like about the company is that they have a great track record of mergers and onboarding their acquisitions through

Starting point is 00:09:12 the years. What I find a lot of the time with companies is you have management that are making acquisitions and sometimes those acquisitions are more based on ego because they're just trying to grow the top line and to make the company bigger. But they're doing it at the expense of the shareholders because they're not bringing on margin whenever they're doing those mergers and expansion. This company, I think, has demonstrated for multiple decades that that's not necessarily the case. They're very strategic in the way that they are bringing companies on or they're acquiring assets, they're acquiring intellectual property that is very strategic and advantageous as they combine it with their other product lines. And that's something that I really like,

Starting point is 00:09:57 based on the numbers that I'm seeing. The company was founded back in 1978 by some PhDs, very smart individuals. They do a lot of research in neuroscience. They do a lot of drugs. They're working on one right now for Alzheimer's. In fact, back in March, of 2019, they were going to launch a new drug specifically for Alzheimer's. And here there was an issue with the launch. Once this became public knowledge, the stock price got crushed back in the March time frame. But then in October, they got some type of amendment and it looks like the drug is now going to market. So I think that that's a very good sign for that new asset that's one of many in their list of assets that bring in all the bottom line margin

Starting point is 00:10:49 and profit that we're seeing in the numbers. In general, I'm really, I'm very comfortable with the cash flow that the company's kicking off. I think that those are going to continue to persist into the future. I think based on where we're at in the credit cycle and the craziness that we're seeing with central banking action, I think that's. this is a company that's going to outperform the S&P 500, and so that's why I'm making it as my recommendation today. So with that, I'm kind of curious what you guys all think.

Starting point is 00:11:21 I hold it in the Acquire as fun ticket, ZIG, and I like the position. Yeah, I like the position also. I think whenever I looked at the numbers, it looked really good. It has a lot of the characteristics that we really like. The growing top line, you know, it doesn't really have any Kappex, great margins. we see with pharmaceutical stock. So it looks good. And then I obviously had to ask myself, you know, why is the market pricing this so attractively,

Starting point is 00:11:51 I guess, in comparison to so many other things out there right now? And I think you brought up like a very interesting point there before, Preston, in terms of how the stock price is fluctuating. It's very interesting looking at these companies whenever you look at the stock price. You know, they have these steep climbs and these steep drops, which is just, you know, 100% correlated. to announcements of late States products, which is just always interesting. It's a very difficult game to play. I pitched the stock before United Therapeutics here on the show, and Toby

Starting point is 00:12:23 pitched Gilliette before. Some of the numbers looks really, really good. It's just, I guess for me, I'm not smart with picks like this. It's kind of, it's hard for me to grasp everything that's going on with patents and the value of these various patents. So let me just give you one example of something I am concerned about whenever we look at the, that stable, nice revenue growth, the blockbuster drug that they've been making so much of the revenue on. So last year, 42% came from Tick Federa, which is a drug also for Alzheimer's. And it can be challenged now. So, you know, no surprise, whenever a patent can be challenged. You know, they see the client margins and they don't see as much revenue from that. So that's something that. That's something that

Starting point is 00:13:10 I guess I'm a bit concerned about for a company. And this is, I just want to say for the record, I like the numbers. This is also two fine there in the soup, but say that the buy back yield is what, four, six percent, like very, very nice also because of the current valuation. Don't really give any dividend. I don't think they have a history of giving dividend, which is something for a lot of stocks I would like to see right now, given the macro picture that Preston talked about before. And all of that money, the remaining money is really plowed back into acquiring and developing new drugs. So I think that you can't get decent returns, high single GJETs, probably, even though it's probably going to be a sort of a bumpy ride

Starting point is 00:13:53 as it is with these companies. So I think holding it like Toby is doing, like in a portfolio with so many other stocks, more based on the metrics itself, more than necessarily, this is the winner. You know, it's the winner in the industry. I think a portfolio size more than 1, 2% is probably a bit too aggressive for me. Yeah, I pretty much agree with everything you just said. Hari, I'm curious what you think. Yeah, I just had a question. I was reading up about their company and I found that they're under investigation

Starting point is 00:14:26 for their treatment of dementia and Alzheimer's disease. Are you aware of this investigation and how critical is it for them? I'd tell you how I would go up. about it as I would go and I would look at how much the settlement is for. I'd look at the probability for past settlements for this industry and like how much of that gets adjudicated. And then I would just compare that to the bottom line and what kind of impact that might have for future revenues or impairment of the intangible asset. That's how I would go about doing it. Yeah, I would just say for something like this. So optically it's really cheap and everybody

Starting point is 00:15:00 would say, well, why is it really cheap? The thing is that the stock is down, hasn't gone anywhere for five years. And the reason for that is very simple. Five years ago, it was a very, very expensive company. It was trading on, say, 40 times enterprise value and free cash flow. Now you look at it, it's trading on something like eight and a half times enterprise value to free cash flow. So what it's done is it's grown pretty consistently for the last five years. But the stock hasn't gone anywhere because it's been working off this massive overvaluation. Now when the stock's cheap, it's easy to find all the problems with it. things don't get cheap without a reason. But my view is that many of these things just turn out to be

Starting point is 00:15:39 temporary, that the investigation's temporary. I just think a little bit of this in the portfolio, these sort of positions tend to work themselves out. I feel pretty good about something like this. You know, it's funny you say that, Toby, because I'm looking back at the price and it peaked in 2015, like right at the start of 2015. And this thing has gone sideways and kind of down in price ever since, but when you look at the fundamentals, they just kept on getting stronger throughout that whole period of time. Something else that I really like about this on our momentum tool, the annual volatility on this thing is around 21% annually. It just broke out and turned green on our momentum tool, which I also think is a great indicator. So not only do we have

Starting point is 00:16:23 fundamentals, we also have the price of the momentum changing outside of its statistical volatility range for a long-term annual position. In general, I like it. But I'm with Stig. I think the valuation from an IRR standpoint, if you think you're going to get more than like 9 or 10%, you're probably overestimating future cash flows, in my personal opinion. But I think that that's probably where this would lie for me as far as valuation. Can I ask you, Toby, because you know, you hold this in CIG. So how many positions do hold? I'd assume you have some sort of mechanical way of determining the position size or something like that. But could you please elaborate a bit more on that? We hold 30 positions long, 30 positions short. The longs 4.3 times the size of the shorts.

Starting point is 00:17:08 So the longs tend to be around 4.3 percent. The shorts are 1% at inception. I don't spend too much time trying to work out which opportunity is better than the other because our universe is 1,500 large. We're taking 30 positions, which is 1 5th of a decile. So we're already very concentrated and then I think it's hard to sort of differentiate between opportunities in there. What we're trying to do is capture that deep value movement of the market, which anybody who's been following along closely, that got out to historic wits bottomed on August 27 and it's been outperforming the market since then. So that value, however you measure value, has been doing better through September, October, November and into September. So I feel really good about value at

Starting point is 00:17:50 the moment. So I like these kind of positions that are cash rich, generating cash flow, trading on very low multiples. And the idea is that you buy it with the possibility that the Alzheimer's drug gets approved or something happens and then you'll get this massive pop to the upside. But in the interim, it's unlikely to lose much money. 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, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th

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Starting point is 00:22:19 So does it mean that whenever you rebalance, it's equal weight rebalancing? We rebalance back to equal weight. This stocks run pretty well. So we've been in it for a little while. So I think this is one of our bigger positions at the moment. We are just about to rebalance. I'd say that by the time this comes out, we'll have rebalanced, but it's 4.86% as at December 15 when we're recording.

Starting point is 00:22:41 Anyone else have any comments for Preston's pick? Seems like everybody liked it. That's the kiss of death. That's the kiss of death. Okay, I can go next, guys, if you don't mind. My pick is Allstate. I guess a lot of you guys are familiar with Allstate. It owns and operates 19 companies around the United States, United Kingdom, Canada, and India,

Starting point is 00:23:05 revenue of $40 billion. So it's one of the hundred biggest companies in the U.S. based on revenue. So this is not your odd value pick. It's not your exciting 10-bagger, anything like that. It's a stable stock. It's a stable compounder in these times with a relative low yield. And there's basically two reasons why it first came on my radar. So we have our own filter where you have something called the TIP multiple, which looks at the EBIT to enterprise value, and we weighed that primarily towards the last three years. And it has just had a very, the multiple is 10.1, which is for a large cap stock is relatively though.

Starting point is 00:23:47 And Preston talked about the momentum before. We also have a green momentum. And even so, we have a little insight of buying too. On the surface, it looked pretty well. So if we dig a little deeper, if we look at some of the performance over the past five years, you know, it's gone from 68, 69, and today's training around 110, near a 52-week high. And it's similar to what the S&P 500 has been doing. So my take is that there's still value to gain, even here at a 52 high.

Starting point is 00:24:18 It sounds so much unlike me. I'm usually looking at these odd stocks as a 52-week low. So I'm trying the other way around here. Also, it is the largest public or traded property cash cash insurance company in the U.S. So they have insurance products, they have wealth transfer in financial products, but 85% of revenue comes from property liability insurance, and 50% of total revenue is from auto insurance alone, which might be sort of a negative, but we can talk more about that later. Insurance is a very simple business.

Starting point is 00:24:52 the company underwrites insurance and basically what they do is that they make money on expectantly paying less back to the policy holders than the charge, then they take that cash and they hold it for the customers and then they invest it in different assets. So it's not too unlike, you know, Brooks Hathaway that we talked so much about here in the show before. So, you know, they would both have an underwriting income, but they will also have a net investment income. And if we look at how they are positioned, generally, in terms, Insurance is a very fragmented industry. You don't have a lot of big players. You have, you state farm is the biggest. They have like 9.6%. All state is number five in the states, having

Starting point is 00:25:34 little less than 5% marginia. So it's not like you have these duopoly or anything close to that. Because it is a no-mode type of business. There's very few people who are, who just wants this insurance company because it's so much better than all the others. You know, price is very, very important here. So if we look at some of the negatives for Allstate, and I think it just might just put it out there, we might be at the top of the market cycle. And you know, the reason why I'm saying this is that, as mentioned before, 50% of the revenue underwriting revenue comes from auto insurance. If I had to say, if you ask me, I would say that we're probably at the top of the cycle right now, which might not be as attractive. But all of that being said, it's a business

Starting point is 00:26:19 that I really like, not a lot of CAPEX, generates lots of free cash flow, buybacks are high, 6.7% trading 12 months, nice yield almost 2%. Let's talk about some of the assumption going into the valuation I'll go to here. So as you guys know, Preston I usually like to look at stocks with in three different scenarios, like a positive base scenario and the negative scenario. And what it did was, I said there was a 25% probability of a 5% growth. 50% that's my base case of minus 2 primarily because of the exposure to the order insurance and then 25% for a minus 10 growth in future cash flow and I come up with a return of 10.2 so that's my pick guys and since I've been so nasty with you all the guys' picks

Starting point is 00:27:09 please bring the bats and let me tell me why I'm wrong guys. Toby you want to beat them first you want me to beat them? The thing is it's it's a it's a It's another one that I hold in the fund. So I like it. I've held it for a little while now. It's worked really well. I like it for all of the reasons that Stig has identified. It's one of those things that, you know, I get nervous when they work as easily as this one has worked. It's still pretty cheap, though. It's free cash flow yield. It's sort of, it's on an eight-times multiple of free cash flow yield. It's getting, you know, on my preferred metric acquires multiple, it's about 11, but I bought it a little bit cheaper. It's just, I hate to sell them when they're cheap like this. It's been as high as 13 just over the last.

Starting point is 00:27:48 couple of years, so I don't think it's expensive. It's still performing. I think it's a really good pick. Nice work, Stig. Wow. Oh, Toby, you're, oh, after all the bashing gave your peck. Come on. I expected so much more from you, Toby. Nobody likes the short, guys. Nobody likes the shorts. I have a question on this one. And specifically for insurance companies, not just for all state. In the low and negative interest rate environment we are in, and looks like we are going to be in this for a long time. How does it impact insurance companies' earning power and in general their health? That's number one.

Starting point is 00:28:28 Number two, given a choice between Berkshire and Allstate, which would you own? Okay, so two great questions. The first one, how does influence the earnings power whenever you have a very low-yield environment? If we look specifically at Allstate, you know, 68% isn't fixed income, which is not that interesting. And it has to be, you know, there is something that's called matching because they need to be able to prove to the authorities that they actually can repay that to the policyholders if something goes wrong. A lot of that would have to be in a fixed income. So you can't really get away with that. It's not that interesting. Just last year, 3012 months, they have an investment portfolio

Starting point is 00:29:10 $81 billion. The return on that portfolio was 0.8%, which is not uncommon. For instance, Mackell, you specifically mentioned Berkshire, but if you look at Markelle, who is very often top of the class, they were negative last year. So it is tricky. The other part or the other side of the coin, whenever you have something like very low yield, is that you typically have a higher underrating income. So it goes in these cycles. So whenever you can't expect to make any return on the money you're holding for the policyholders, you need to make the money on something else. And what you do is you underwrite insurance in a different way. So you would have what is referred to as a combined ratio. That would be relatively lower. So if you have a combined ratio of 92%, that means for every

Starting point is 00:29:56 $100 that comes into a company, you would expect to pay 92% out. That's the other side of it. So if we imagine that you would have a very high yield environment, imagine that you would have, you know, 6% risk-free rate. So the 10-year treasury, that's why I'm referring to whenever I say risk-free rate, you would be a lot more aggressive in terms of riding the policies because then you know you can make those 6%. And what I would recommend for everyone to do if they want to understand this even more, I don't know if I give the best explanation to this, is to read the Berksa Hathaway's or Warren Buffett's letters to his shareholders.

Starting point is 00:30:33 Max Olsen did a great write-up and it's been updated and you can find it on Amazon. It's not too expensive unless you buy the entire book, which is a lot of pages. And he explains that Warren Buffett also makes that comparison of these cycles. whenever you had a high guaranteed rate and a low guaranteed rate is what you're seeing right now and what that has done to the combined ratio. That's kind of like your first question. You want to make that recommendation. Then you're asking which company would I prefer to own Berkshire Hallaway Allstate?

Starting point is 00:31:02 So the way I want to respond to this is in a very value investing type of way. It depends. What's the valuation right now? If you ask me, how is Berksia Hellerway price? I think the BCS are priced around 220, 225 right now. It's probably priced relatively fair. Can it be expected? Can Berksa Hellerwey expected to upperform the market?

Starting point is 00:31:24 Probably, probably a little. I would imagine even this price level. Then we look at something like Allstate. Can they expect to upperform the market? Yes, I think they're priced relatively more attractively, but I don't expect it to be more than, I don't know, 10%. And if you asked me, what kind of return would I expect if I bought Berkshire? at this share price. So not necessarily a share price that I entered, but at this share price,

Starting point is 00:31:49 probably say 8%, 9%, whenever you ask me and I would say 8, 9% for Berkshire, and I was like, oh, my Excel sheets says 10% for Allstate, you know, that's the same. You know, it's not that much of a difference. This is approximately the same. The reason I was asking about Berkshire at this current price and Allstate is, last time in 2008 during the Great Recession, Allstate's earning dropped by almost 80% from peak to drop. And it took them quite a bit of time to really reach profitability. And whereas Berkshire, you get the downside protection in terms of they being conservative, solid balance share, diversified businesses and buffet. At this point of the cycle is what I am asking. Because how protected is the downside with the state? If I have it in my

Starting point is 00:32:42 sizeable position in my portfolio versus just having Berkshire, which gives me the insurance exposure anyway. Earnings are a little trick, and you can say the same thing for the free cash flow. Whenever you do value insurance companies, they don't follow the same accountant standards as Coca-Cola or Johnson & Johnson. There's also a lot to be said about the investment income. It's just like taking a beating. That is the very nature of insurance companies because that's how they deploy their money.

Starting point is 00:33:11 So I think you have a good point, Harry. I think you have a really good point in terms of the downside protection. Because Berkshire has a different structure than Allstate, they are an insurance company, but there are so many other things. So you might say the downside is lower. I would also argue that at least at this price level, the upside is also lower for a company like Berkshire-Hathaway. And I just want to say for the record that I both own stock in Berkshire and Mackell and

Starting point is 00:33:36 not in Allstate at the time of recording. My only comment on this one, I completely agree with everything that's been said. I liked Hari's highlight there with comparing downside risk being probably a lot different than the downside on this one if we would go into a credit contracting type event. The thing that I would probably be paying very close attention for ownership on this is I'm using our momentum tool. So it's coming up with a 17% annual volatility based on the current price of $1,000,000, $10 a share, it's saying that the stop would be set at $93 is when you'd be getting out of that

Starting point is 00:34:14 volatility, that the normal volatility range of the price action. So as I would own this, my expectation moving forward is that it's going to continue to make money. It's going to continue to do pretty well. But for me, I would keep adjusting that stop because historically, as I look at this over the last 10 years, this thing's been green on our momentum pool for almost all of that period of time. There's been a few instances where it stepped out of it. So I'd be watching the momentum when the volatility steps out of that 17% range to the downside is whenever I'd probably liquidate position to try to minimize that downside risk that Hari's talking about. Very interesting point you bring up, and I also want to say in terms of position size,

Starting point is 00:34:55 you would probably do something similar to what Toby is doing, like have them like a minor position in a lot's portfolio. And I would be happy to do that with a company like all state, it's not the best insurance company. I think it's priced well, but it's not the best. I think they're doing a good job with capital allocations, but it's more an insurance company than there are a capital allocation company. And the reason I say this is if you look at their total asset on the management, nine percent of that is inequities right now. If you look at a company like Macal, also very often referred to to baby Berkshire, you know, You have 29%, which is more or less all that a company like Mackell is allowed to put into

Starting point is 00:35:41 equities. And no surprise, you have Tom Gaynor, you know, who's such a smuggler who's handling that, who is allocating into Mackell Ventures, who is like reinvesting into stocks. And he has a very good approach with sort of like a podcast series itself, how he's doing that. So it's more like it's not the top of the class, but what is the valuation you're getting right now? And for that reason, I wouldn't put it like is much more than 2 or 3% in my portfolio.

Starting point is 00:36:09 All right, Hari. Let's hear it, man. Okay, I'm ready. So this time my pick is GraphTech. The reason this caught my attention was due to Pabri. Graphic is a manufacturer for graphite electrodes, which are essentially a key ingredient in electric arc furnaces for manufacturing steel. This company was originally founded back in 1886.

Starting point is 00:36:37 The name was National Carbon Company, and they were acquired by Union Carbide in 1917. Then in 1995, they were again brought out as public company. And back in 2015, I believe, Brooksville took private. And then lately in 2018, April 2018, Brooksville spun it off as a IPO, a public offering, and Brooksville still holds 80% stake, I believe, in the company. A couple of things to kind of keep in mind is this company has a history of innovation, especially in this manufacturing skill, and they were the first to come up

Starting point is 00:37:20 with the UHP type of graphite electrodes. They were the first to come up with that. And they also are well known for high-quality graphite electrodes in the industry. And in fact, they are the leading manufacturers of graphite electrodes. They also, in 2010, acquired Sand Rift, which is a top manufacturer of needlecoke, which is a raw material or key ingredient for making graphite electrodes. Needlecook is absolutely essential. And there are only few companies at the scale of sandrift. The other one is Phillips 66. So needle cloak is either number two or number three. The rest are either in China or Japan in terms of manufacturing capacity. So the reason Brooksville took them private was that they were struggling, not efficient. So obviously

Starting point is 00:38:12 Brookfield management, if you know them, they basically have a good tracker record of acquiring esoteric businesses like this, including a nuclear power plant that they're operating today. In two and a half years, they basically successfully restructured and reposition graphitech by selling of non-core assets like NeoGraph Division, and then they started focusing more on the core electrode businesses. And they achieved quite a good increase in their productivity by saving almost $100 million in cost per year. So when they acquired Graph Tech back in 2015, it was generating around 45 million of EBIDDA and a revenue of 530 million. But now in 2018, when they took it public, it was generating a EBIDA of $1.2 billion

Starting point is 00:39:05 and a revenue of $1.9 billion. So that's what, and in fact, Brooksville was awarded for this in the private equity international trade group. So that's kind of the background. I'll go into why the stock currently is trading low. but before that, let me talk about some of the positives of GraphTech. Number one is that it's a leading producer of high-quality graphite electrodes. It's in fact in the top three.

Starting point is 00:39:33 The second is it has established itself as a reliable high-quality producer with its vendors and has good pricing power because total cost of producing steel through electric arc furnace of which graphite electrode constitutes only 1 to 5% of that cost. So they do have pricing power from that perspective. And the other part is that after acquiring sandraifts, one of the major problem for graphite electrode manufacturers is the stable, reliable, and low-cost supply of needlecook, which is the key ingredient. And needlecook is actually made of what is known as decant oil, but because of sandrifts capability to supply almost 70% of their product line and sandrifts supplies 100% of its products to Graft-Tec, because they're 100% subsidiary,

Starting point is 00:40:34 Graftek has a stable source of needlecook and also at low cost. So 70% of their product line can be sourced through low cost. That protects them from fluctuation in the price of needlecroke, which is a big factor in this industry. And the other source of volatility in this industry is the price of graphite electrodes themselves. If you look at the variation in the price back in 2016, it hit a low as low as $2,000, $1,500 to $2,000 per ton of graphite electrode to a high of around $13 to $15,000 in 2018. After Brookfield acquired Grafax, one of the ingenious thing they have done is to sign this three to five year contract of take or pay agreements with their major vendors. In fact, 65% of their production capacity is now covered under take

Starting point is 00:41:32 or pay through 2022, which gives them at a fixed price of around 9,700 per metric ton, which is higher than what's the Boeing price today for graph rate electrodes. And, And because of that, that gives them price stability and input side. So input side is needlecook, but because of sandrift, they have stabilized that. And because of this take or pay, they have stabilized the output price. And people are not aware of this take or pay contract. It's basically customers sign a contract where they will say that they will buy a fixed amount of graphite electrodes from graft tech through 2022. but if they don't any year, they're going to pay 100% of what they would have paid anyways

Starting point is 00:42:20 without taking the delivery and some percentage, 60 or more percentage for the next period till 2022. So that gives Graftek a reliable source of revenue. And then Brooksville still holds 80% stakes. So that gives some stability. You have a rational investor who's with you. So that's the positives. And the risks, I think like anything else, in the manufacturing sector, the risk is China. And that's one of the reasons market is a bit spooked about this company because the Chinese had a crackdown on their graphite electrode manufacturing because of pollution concerns. However, China is embracing electric arc furnace rapidly. So there is a concern that China can ramp up their production. Chinese companies are in the top

Starting point is 00:43:08 five and they can undersell everybody else. So that's number one. Number two, the reason Graphite electrode companies were suffering, many of them, the competitors of Graph Tech, is that needlecook supply was quite constrained because of the recent adoption of needlecoke in lithium-ion battery. And that gave an advantage to graphite electrode in the past couple of years. However, whenever the price of needlecook goes higher, both companies tend to shift to alternatives like natural graphite or graphene, which will again stabilize the needlecook prices and bring it down. Then again, the other risk is its fate is tied to the steel manufacturers.

Starting point is 00:43:53 It all depends on the demand from the steel manufacturers. And in fact, right now the reason the stock is done is it's going through that cycle. The graphite electrode prices hit a high in late 2017 and early 2018. now it's trending lower. It's not yet hit the 2016 lows, but it's going there. So those are the concerns, and that's one of the reason why the stock is down. But I believe, like, you know, Prabra, when he took a stake, there were some catalysts that might cause this investment to do good.

Starting point is 00:44:27 And that's number one is the thesis that the China will disrupt this industry and disrupt graphite tech specifically might not be well formed because if you look into the details of the Chinese manufacturing sector, they are not into high-quality electrodes yet. And it will take them some time to really manufacture high-quality graphite electrodes. That means it has to be less than 600 m m in diameter. They are not there yet. So that's number one. Number two, the rising production of steel and iron and aluminum, which all needs graphite electrodes in China, it's growing at a very fast pace. In the last 10 years, it has been growing at a tail. a cagger of almost 7% same in India.

Starting point is 00:45:11 So their internal demand is sufficient for their production. So it's probably not going to interfere GrafTech's customer demand. And finally, Grafax already has protected majority of its revenue stream with the take or pay contract. So at least for the next couple of years until 22, the downside is somewhat protected because stock today is paying a dividend of 2.7%. So that's the kicker on top of this. Their balance sheet is not that bad. When I was looking into this, I was remembering Burbrice's stake in Horshead, which didn't go really well. So I was a little skeptical when I saw he took a stake in this. But this seems to be a different story. And Brooksfield being an 80% owner in this company gives me another level of

Starting point is 00:46:05 confidence because they're a very mature, astute investors. And at the same time, they will also sell their stake over a period of time. So there will be dilution, but I'm assuming and hoping that they'll be rational about it and the way they sell off their stake. So in terms of valuation, I think I would want to hear from you what do you guys think about the valuation and its prospects. Thanks. Let's take a quick break and hear from today's sponsors. No, it's not your imagination, risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform.

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Starting point is 00:49:53 So, Hari, my first problem with this, and it might be just the data source that I'm looking at, is it seems like the numbers are kind of all over the place. Fundamentally, the numbers are all over the place. Like, I'm seeing large growth and then the balance sheet. It's kind of hard for me to even find some of the balance sheet numbers that are reliable, because as I'm going from one source of data analytics to the other, I'm getting different numbers, which is kind of strange for me. When I'm looking just purely at the price, this thing's volatility on an annual basis is 60%. Right? So that's like, that's like cryptocurrency type size volatility. I'm having a hard time with it because, you know, I think one of the most important things about Buffett's style of investing,

Starting point is 00:50:44 if we're using him as kind of a benchmark on valuation, is he likes numbers that have a very trend-like look to them. like the top line is growing and there's not a lot of variance in those fundamental numbers. When you're looking at the cash flows, they're really predictable and they're trending in a certain direction. But maybe there was just bad news that came out and the market is super emotional and they give you that big opportunity to step in and take a position and it'll give you that 10% return or whatever, right?

Starting point is 00:51:15 With this, I mean, the numbers are so lumpy. You go from one year of not even having free cash flow to having like this total way. wave of free cash flow. And then there's just nothing that I can kind of wrap my hands on. If this was a bond, then I was trying to figure out my coupon payments so that I could figure out the valuation, it would be like, you know, just a total swag as to what those coupon payments are going to be. You have no idea from one half of the year to the next half of the year what you're going to receive in the mail for your coupon. So for that reason alone, because it lacks the stability characteristic. I just can't even come up with evaluation, let alone go any further

Starting point is 00:51:56 to try to understand anything about it. When I would look at this, I would not even attempt to go any further just because the numbers are so lumpy and so unreliable for me to even spend time qualitatively trying to understand it. If you look into their history, you will know why. The reason being Brookfield acquired them two and a half years back. So I think we should look at it is that it's more like a new IPO rather than a company that has been operating for a while. Because what Brookfield did is they had a lot of diversified product portfolio and they had almost six, I think, manufacturing setups. In the last two and a half years, they reduced it from six to three and they made a lot of good productivity gains. but more importantly, they improved their relationship with the customers in terms of the contracts.

Starting point is 00:52:49 So it's really hard to look at them like a company that's operating for many years. It's basically like a IPO new company that IPOed in 2018. So yes, there is not much history into that. I think Toby, you had something to say. It's one of the stocks that comes into the acquires multiple screens. It's been there for a little while. I think that Pabrii secretly uses my screens to it. No, I don't really.

Starting point is 00:53:15 I'm joking about that. But we have a lot of overlap. There's a lot of the stocks in my screen that end up in his portfolio, just for a coincidence, I'm sure. Probably it's a similar investment style. He doesn't mind a little bit of volatility. Look, it's as cheap as it's ever been. It's trading it like a five times multiple.

Starting point is 00:53:30 That's a gigantic yield. Revenues have been pretty good. They're buying back stock. I like a lot of things about this company. I think that the volatility doesn't really bother me, but it's one of those things that could be volatile to the upside too. I don't think you can lose much on it, and I think it's that nice asymmetric position. It's been around in my screens for a little while. It's the only thing I'd say, it's sort of been bumping around four or five times on an acquires

Starting point is 00:53:53 multiple basis, which is cheap, but that might be appropriate for a commodity stock, but when these things catch fire, they run, so I like it. I have a confession to make. Let me start by saying that earlier this year, I took a significant position in Kraftag. I actually put around the 8% of my portfolio into the company. So I should have something to say about this. I really like the company and it's sort of like a tricky thing. I think it's important. And Prest and I have been very upfront with that here on the podcast. And you could say the same thing for Toby O'Hari. Like we also want to eat at home cooking. And then you have on like the flip side, you know, for some stock picks, you, this is something that whenever I first started listening to, you know,

Starting point is 00:54:36 Guy Spear and reading his book and then when it's pop right, they talk about this bias. of going on record for things because then you can't, then you feel like you can't change your mind, which is sort of like can be a tricky thing. And I kind of, in all fairness, it was not because Hari sent an email before I actually sent that to the group what I was pitching. I just felt I liked this pick so much

Starting point is 00:54:59 that I don't want to anchor myself too much before, I guess, I know this sort of sounds weird. Before I know I learn more about the company. So there's this weird thing whenever you do investing, and guys, I will come to Graf tickets some part in time. But there's this weird thing that obviously you do a lot of research before you invest in a company, but in a way you don't really learn about the company before you own it. I know that sounds sort of silly, especially if you take a significant position in it.

Starting point is 00:55:25 And I'm sure that a lot of investors would know what I mean. You definitely spend countless hours before. That being said, you learn in a different way whenever you have money in that business. I like the stock for the same reasons as Harry. What I like is that to me, I know this might sound odd whenever you look at 10-year key ratios or whatnot. Keep in mind what Harry said before about, this is sort of a new company in many ways. There's actually a lot of stability to this company, which might sound super odd,

Starting point is 00:56:00 whenever you see the volatility and when you see everything that's been going on. And what I mean by that is not only what Harry already talked about in terms of how much that's been locked in until 2022. It's also that it's being locked in with a 70% gross margin, which in itself is interesting. It's very difficult to add supply into this. It takes around seven years to build supply. And right now there is no added supply added into this industry, whereas, as Harry said before, Grashev is one of the key players.

Starting point is 00:56:34 So you have a demand, we could talk more about the demand later. You have a rising demand that is already secured, 65%. I think there was a number you brought up, 65 or plus percent, has already been locked in at really, really nice margins. And then you don't have any supply coming in anytime soon. Now, so for me, there is a big difference between uncertainty and risk. And you're definitely right, Harry, that there are some uncertainties. China being one of them. You all right, it would take a long time for them to have that high quality, but it is like risk, how much capacity are they going to throw into it eventually? But you don't have a lot of risk because for the near future, that won't change. They just can't happen.

Starting point is 00:57:19 So it's one of those things where I'm like, heads I went and tails I don't lose much, as Monis Paparise would say, because I probably would just get my money back. You know, if everything goes south and, you know, China calls in tomorrow and says that they're going to ramp everything up. And I'm like, I probably just get my money back, but I think that the upside is really huge. So I'm not just talking about, you know, for instance, in terms of steel, and we're talking about security of that. But you see a huge influx right now because the demand will in the future also be driven by electric vehicles.

Starting point is 00:57:52 Projections is probably that the demand for needlecoke will be almost double of what it is right now in 2025. And it might be even more than that. If we say that in 2025, the sales of electric cars would be 10, 11%, 10 times what the demand will be today. So I whenever I say that, I'm talking about what's demand for that specific part used for electric cars, and then whenever I say double, I mean, what is the needlecoke demand now, which will be double in 2025.

Starting point is 00:58:24 So there's two different numbers. So I never say 10 times double. It's not the same. It's 10 times for something that's very low, but it's expected to go up in the future. And I think steel aside, and we can talk more about that, I think we can all agree that the demand for electric cars is probably bound to go up. It's a key ingredient in the lithium batteries. So I'm pretty bull. You can expect to see a lot more buybacks also. The return to shareholders probably going to be like 50% or 60%, at least that is what the management targets.

Starting point is 00:58:57 Sorry for the long spill, guys, but that is sort of some of the reasons why I am so bull on the stocks. There was the confession for the day, I guess. I'm glad you came out of the closet. It's funny how owning a stock changes your view of that stock, doesn't it? You've got to get a reputation for just changing your mind all the time. That's what I'm trying to develop. Someone says, when are you like pitching that stock like a week ago?

Starting point is 00:59:22 Yeah, I changed my mind. That's a good point. You know, it is sort of like tricky thing, right, going on record and saying, this is the most amazing stock. And then you kind of feel guilty if you end up. selling it afterwards, you kind of feel like a fraud, because then you set that to someone, I really like this. So it is just one of those situations. But now that since Harry brought it up, I don't think I can stay in the closet, as you would say any longer.

Starting point is 00:59:47 The question I had for you guys is, the way I see this one is this is like a three to five year play at max. This is not a stock that I would hold for a long time. Because there is a catalyst, but eventually there are some uncertainties if it plays out like the China production, if they get onto the value chain higher up, it might disrupt graphite at some point because graphite is like a single trick pony. There is no other product. So I wanted to get your opinion. Toby, how are you planning to manage this in your portfolio?

Starting point is 01:00:21 Is it like a medium-term hold? I don't hold graph tech. It's just in my screens. Sorry, if I wasn't clear about that. it's of the three that we've discussed, it's when I don't have a position. I actually really like it though. I want to take a closer look at it, but it's just in my screener. It's on the AcquirisMultible.com website.

Starting point is 01:00:43 I would use, Dick. Thanks. Yeah, I agree with you. I mean, it's one of those where, not to repeat myself too much, I feel that if we see a lot of supply coming in, which, you know, for commoditized business we don't want to see, If we see a lot of supply coming in, I'd probably be very. For said reasons, that probably won't happen anytime soon. Anything else for Graph Tech, guys?

Starting point is 01:01:06 So before we wrap up, Harry, last time we talked about Berkshire Hathaway. And Toby, you are going to the Berkshire Hathaway event. Preston and I will, of course, be there. Harry, you said 90% last time. Where are we now? Arts has increased. In fact, I'm planning to get my son to. This will be his first visit.

Starting point is 01:01:26 Okay, guys, so if anyone else is interested in joining the Mastermind group, we will make sure to link in the show notes. We already have an itinerary or what we plan to do. We're going to have some casual events. All of that will, of course, be completely free. And if everyone wants to join us, they can join us by signing up to contact at themasterspodcast. com and you speak to a member of our team and she will set you up with the WhatsApp group that we have for people going.

Starting point is 01:01:52 Guys, thank you so much for taking the time to come on the show. Toby, Hari, could you please give a handoff for the audience where you can learn more about you guys? Okay, I'll go first. Thanks, TIG. You can always reach me at my blog, this business.com, or my Twitter handle at Hari Rama. I have some free screeners up on Acquirersmultable.com and run a firm Acquireus Funds.com. You can find my fund, the Acquireus Fund. that's an ETF ticker ZIG.

Starting point is 01:02:23 It has all the holdings up on the site. You can see performance data is probably best going to Morningstar, but it's been a good time for value, so it's worth taking a look at it. Thank you, Toby, and thank you, Harry. We already look forward to the next mastermind meeting next quarter. One thing I'd like to talk about is that if you do enjoy these mastermind group meetings that we unfortunately only do once a quarter,

Starting point is 01:02:46 Preston and I also do a monthly write-up of a stock that we find interesting. and everyone can get free access to that, simply go to tipemail.com, that is tipemail.com, and we'll make sure to send you a write-up of both a stock that we find interesting, but also the current mind conditions. All right, so for this next segment of the show, we'll answer a question from your audience, and this question comes from Couty. Hi, Preston and Stick. This is Couti from Finland. I have really enjoyed your show. Keep up the good work. My question is about the future projections about the company's growth.

Starting point is 01:03:24 When deciding percentage to a future scenario, how do you decide the likelihood? Are there any tricks to make better projections, or is it just your best question? That's a great and also a really hard question. It really makes me think of the quote. It's hard to make predictions, especially about the future. And that is also true whenever it comes to predicting growth rates. So before I talk about how you can estimate potential growth, I would like to highlight the word estimation here.

Starting point is 01:03:58 We have different rule of thumbs in terms of doing that, but more than anything else, is more odd than science. There's no really best practice of how to have an accurate prediction of a growth rate, because in essence, you're predicting. So a few different things that you can do. The first one is you can listen to the management on the earnings call. You also really need to understand that earnings calls are typically very biased in favor of the company. I would pay very close attention to the track record of the management's earlier predictions

Starting point is 01:04:29 about growth rates before I would potentially use that. Then I would say that you also need to understand the business units and you also need to read reports from third parties. So, for instance, Google is making most of the money from online advertising. And it's an industry that I expected to grow 15% the next year. This is a number that I have from industry report. So if we assume that this is approximately correct, it's really up to you to determine how much would be captured by Google,

Starting point is 01:04:59 how much would be captured by Facebook, and other competitors like Amazon. Very often, these industry reports will also have some of those estimates, but of course it's also up to you to determine, hmm, are there too favorable, you know, Google's favor or not, if that is the company in question. Now, keep also in mind that most listed businesses, especially large-cap stocks, have multiple business units. It's important to understand where revenue and profit is coming from.

Starting point is 01:05:26 For instance, we can't really use the growth rates of Disney's Marvel movies, even if we have the data, because to predict the growth rates of Disney, we need to understand that the Marvel movies is just one piece of the puzzle to determine the total revenue. And even if you could, you also need to understand how profitable that business unit is. All that being said, there's really no reason to make more complicated than it is. Now, what does your common sense tell you about this?

Starting point is 01:05:56 One thing is what the management says, or what you can find in a report about the industry, or what you can learn in the 10Ks. But what do you think in as an investor? You invested in the stock in the first place because you understood the industry and the business. And based on what you know about the company, make sure to filter out the noise and then come up with your own growth predictions. And of course, I have to say this here at the very end of my response. Regardless of which growth rate you come up with, make sure to be very conservative. I mean, growth is fantastic, but too many stocks have turned into unprofitable investments

Starting point is 01:06:33 because the investors were just too optimistic about the future. So I really like this question and it reminds me of my days back in business school because I would make a bunch of professors really angry whenever they would bring up this idea of calculating a value with a beta and looking at the historical price volatility as being your quote unquote risk. And I would always raise my hand and ask the professor if they thought that maybe the underlying assets of the business and how they are able to sustain their competitive advantage moving into the future with all the other competitors in the marketplace was the actual risk

Starting point is 01:07:17 to the business. And I guess this was my way of kind of torquing the whole debate as to how you calculate the intrinsic value of a business. What's important that you're actually looking at? And it goes right at the heart of what you're asking, which is how can I make a projection with any type of confidence that I'm just making it up or that it's, you know, just a total swag. And so what I would tell you is really dig into the assets and the liabilities of the business,

Starting point is 01:07:50 understand what their competition is, understand how stable those future cash flows are going to be based on the asset lines that they have on their balance sheet. So let's say you have a company. That company has one product and it's the total breadwinner of the company. And that product has been very stable for years on end and they don't have many competitors in the marketplace. Typically, that's a good sign that they're probably going to have competitors in the marketplace moving forward.

Starting point is 01:08:22 But that's where your research comes into play. And if you suspect that that environment's going to change or if you suspect that that environment's going to stay steady, well, now you have a better idea as to how much variance and how wide those angles of your cash flow projections need to be. I always use the example of a hurricane and whenever they're trying to project where the hurricane's going to hit seven days in advance, they have a cone of probability as to where the storm's going to hit. There's a most likely course. There's a left and a right limit. I look at future cash flow is the exact same way. I kind of have, I look at where the storm, the quote unquote storm has gone, right? Where did the

Starting point is 01:09:06 cash flows come from? What did they look like over the last 10 years? And then my projection is, is kind of interpolating off of that path moving into the future. But if you're going to really put a lot of money into a position, you got to think through what are those underlying assets, what are the liabilities of the company, what's their competitive position, especially for their breadwinning product lines and service lines within that business. And then you've got to base those estimates on those variables, in my humble opinion. All right, Colty, for asking such a great question. We're going to give you free access to our intrinsic value course for anyone wanting to check out the course. Go to tip intrinsic value.com. That's tip intrinsic value.com.

Starting point is 01:09:54 The course also comes with access to our TIP finance tool, which helps you find. and filter undervalued stock picks. If anyone else wants to get a question played on the show, go to AsktheInvesters.com, and you can record your question there. If it gets played on the show, you get a bunch of free and valuable stuff. But guys, that was all that Preston and I had for this week's episode of The Investors Podcast. We see each other again next week. Thank you for listening to TIP.

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