We Study Billionaires - The Investor’s Podcast Network - TIP622: Finding Certainty in an Uncertain World w/ Joseph Shaposhnik

Starting point is 00:00:00 You're listening to TIP. On today's episode, I sit down with Joseph Sheposhenik. Joseph is the portfolio manager of TCW New America Premier Equities. Since its inception in 2015, the fund is compounded at 15.8% per year net of fees versus the benchmark of just 12%. I admire not only how brilliant of an investor Joseph is, but also his humility and his commitment to continuous improvement. In his Q4-2020 shareholder letter, he wrote, I quote,

Starting point is 00:00:31 Since our strategy's inception on July 31st, 2015, TCW New America has outperformed 99% of its peers, according to NASDAQE investment. While we take pride in our outperformance, we never declare victory. We strive to continuously improve upon it, end quote. Getting to the top is extraordinarily difficult, but staying there is also difficult, and I believe that this level of humility will take Joseph far. Joseph puts an intense focus on only investing in superior businesses that have long runways for growth coupled with a patient approach to sitting on these companies for many years.

Starting point is 00:01:07 For example, Joseph's top-holding Constellation Software is now over 19% of his fund as he took to heart Peter Lynch's approach of not cutting the flowers to water the weeds. He recognizes that just a single investment held for a long period of time can contribute tremendously to generating exceptional long-term returns. During this chat, Joseph and I cover why certainty is an essential part of a quality investing framework, the two types of recurring revenue, how Joseph thinks about portfolio allocation by industry, given that so many quality businesses are in the software industry, how understanding incentives can help make us better investors, value accretive versus value destructive capital

Starting point is 00:01:45 allocation decisions, why we should ignore Buffett's advice of buying businesses so great that an idiot can run them, how Joseph developed his own investment approach after working working under two investment legends at Fidelity, Will Danoff, and Joel Tillinghaus, why growth and free cash flow per share is Joseph's North Star as an investor, an update on a few of Joseph's portfolio holdings, including Constellation Software, Broadcom, and Roper Technologies, and much more. It was such a pleasure having Joseph on the show, and I know you're going to get a lot out of this conversation. Joseph was also kind enough to join our TIP Mastermind community for a Q&A That is scheduled for the afternoon of April 18th, so if you'd like to have the opportunity

Starting point is 00:02:26 to ask Joseph questions about his holdings or investment approach, you can check out our TIP Mastermind community by clicking the link in the description or simply sending me an email at Clay at the Investorspodcast.com. With that, I bring you today's episode with Joseph Sheposhenik. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Clay Fink. Welcome to the Investors Podcast. I'm your host, Clay Fink, and today I'm so excited to welcome back my friend Joseph Sheposhnik to the show,

Starting point is 00:03:21 Joseph, welcome back. Great to be with you, Clay. As you know, Joseph, we've talked a lot about quality investing on the show and you have one of the best track records. I've seen applying this type of approach. For those not familiar with Joseph yet, he manages this TCW New America Premier Equities Fund, which over the past nine years has compounded at 15.8% net of fees. And that's versus his benchmark of the Russell 1000, which compounded at 12% over that same time period. Joseph, you think about quality investing a little bit differently than others. And I really wanted to bring you back on the show to discuss this concept.

Starting point is 00:04:00 So how about we start with how you came to this view that you have of quality investing and how it might be a little bit different than others might view it? Everybody comes at investing in a different way. I started my career at Fidelity where I covered the semi-electory industry, which was incredibly volatile. And then I transitioned research coverage later in my career to industrial and chemical businesses, which are also incredibly volatile and relatively low quality. And so as you go through that process, you learn what you can do to find some quality in those businesses. So we're all a product of our experience and of course from learning from the great fund managers that we've worked with. But from my perspective, Warren Buffett laid out the formula for quality investing in the 1996 Berkshire Hathaway Annual Letter. And if you look at it,

Starting point is 00:04:50 he lays out a four-point criteria. And let's just go through it really quickly here. The first point is, he says, the certainty with which the long-term economics of a business can be evaluated. The second point he cites is the certainty with which management can be evaluated both to its ability to realize the full potential of the business and to wisely employ its cash flows. The third point is the certainty with which management can be counted on to channel the rewards of the business to the shareholders rather than to itself. And the fourth is the purchase price of the business. So I think what's important to take away here is Buffett's emphasis on certainty. He cites certainty three out of four times or three out of four points here. And from my perspective, it indicates that circle of competence isn't enough. It's circle of predictability and certainty is just as important as competence, valuation, or all of the other characteristics that we talk about. So, you know, if you can't predict the cash flows of a business a year or two years out,

Starting point is 00:05:57 you certainly can't predict them four or five years out. And it's really hard to value a business and come to a reasonable conclusion on a business if you can't predict it. So we spend a lot of time focused on just finding businesses where certainty is reasonably predictable and you can actually make an assessment on a business. We think that most businesses you really can't predict and you really shouldn't be spending time on businesses that you can't predict. I think that it would be incredibly interesting to go through two examples which kind of compare

Starting point is 00:06:30 and contrast certainty versus uncertainty in the businesses that we evaluate. So the first business that we'll talk about is meta, the old Facebook. And let's just spend a minute rewining the clock to 2021 and look at where meta was and then what's transpired over the last couple of years. and then compare that to Roper, which is a holding that we've owned for a long period of time. So everybody knows what meta does, so I won't spend much time on what they do. But let's just spend a minute talking about their position in 2021 and how investors evaluated the business back then.

Starting point is 00:07:05 So if you looked at meta back then, it was a business with a huge market position, but losing some market share, recurring revenue was relatively transactional. so not particularly recurring, tied very much to the ad market. Organic growth was very strong. They were growing in the 30s, 30% range, but down from the 50% growth that they had done in prior years. Margins were in the low 40s. They'd come down from the 50s.

Starting point is 00:07:33 Free cash flow growth was slowing, but returns were incredibly solid. But then a lot of things happened. The Apple privacy requirements stepped up significantly so their ability to target customers declined significantly, at least for a short-term period of time, they stepped up investments in the Metaverse or initiated them, and that became incredibly expensive to the P&L, and the ad-spending environment worsened, and that can happen in a cyclical business like Meta.

Starting point is 00:08:01 So that really resulted in margins going down from the 40s to the high 30s, or from the high 40s to the high 30s, cap-x going from 15% of sales to nearly 30% of sales. returns going down, free cash flow going down, earning slowing. And I think what was incredibly interesting is analysts consensus estimates for free cash flow for 2023 began in 2021 at roughly $50 billion. And in the middle of 23, after all of this news was baked into the numbers, free cash flow estimates for 23 fell from $50 billion down to $10. Wow. So, So there was all of this uncertainty. Of course, the stock felt that significantly we'll get there in a minute. But, you know, analysts had, you know, they didn't see this. Analysts, buy recommendations

Starting point is 00:08:59 as a percentage of ratings, stayed very steady at 80% the entire time. All of this craziness was going on in the stock and in the business. So the analysts couldn't predict this. And of course, the stock went from roughly $3, $325 a share and it troft at 90. It peaked at 375, it troughed at 90, and what an incredible decline that I'm sure investors just didn't foresee in 2021. But those are the things that can happen in a business that is so difficult to predict with so many moving pieces like meta. And what happened, of course, since then, meta has improved its ability to target customers

Starting point is 00:09:41 and deliver ads in a high-quality way. The CEO changed his mind. did a 180, decided to cut expenses after raising expenses significantly, reduced cap-ex significantly. And of course, the stock has been an absolute home run after troughing at around 90. Today is trading at over $500 a share. And that free cash flow number that we talked about, which started at $50 billion for 2023, troughed at $10 billion. They ended the year at $43 billion in free cash flow.

Starting point is 00:10:12 So what an incredibly volatile and difficult to predict journey. I think for investors that is a very, very difficult stock to hold on to and a very, very difficult business to predict. So I think it goes back to Buffett's four points. If you don't have certainty over the direction of the business, the direction of investments by the management team, it becomes so difficult to value this business and to hold on to it. because at the end of the day, in order to compound, you've got to be able to hold on to the business for a long period of time and allow the business to compound and deliver great returns.

Starting point is 00:10:51 And in the case of some businesses that are in the tech industry, it is just so incredibly difficult to hold on to. Let's contrast that with Roper technologies. Many of you may know it, but some of you may not know it. Roper operates 30 or so market leading vertical market software and technology and available products, businesses, and kind of very defensive niche markets. So about 30 businesses, very decentralized business. As you may know, it was turned around by the great Brian Jealouson, who took over in 2023.

Starting point is 00:11:24 He implemented a set of management principles focused on cash return on investment, a cash flow metric that he espoused and really made popular. And he re-architectedgeded the business over his tenure. he generated a 26 bagger from 2023 to his retirement, I think in 2017. But let's talk about what's interesting about it and why it's so predictable. And just to add, this is the seventh largest software business in America and a business with a $65 billion enterprise value today. So what makes this business interesting and predictable and how does this contrast with

Starting point is 00:12:03 meta that we just talked about? I think the first point, using the same criteria that we talked about, Roper focuses on niche markets, and so they tend to be the number one player in these niche markets. Recurring revenues is about 80% of the business. Organic growth has predictably been mid to high single digits. Margins have consistently improved. Cash flow grows relatively consistently and returns improve over time. So it's very, very predictable. And I should have mentioned that, you know, These businesses include the leading provider of ERP software for federal contractors, the leading provider of time and billing software for 97% of law firms, medical products, businesses,

Starting point is 00:12:49 highly recurring, very, very durable businesses that are predictable, comprise that set of 30 businesses. And so you've got to ask the question, can this business be predicted? Well, margins have improved, as we've talked about, relatively regularly. returns have improved. Capital intensity has declined. And, you know, through recessions, through the pandemic, organic growth has been solidly strong and positive throughout. So if you look at how the business has performed over this period of time, it's been a remarkable performer for a long period of time. And it's the type of business we think we can predict because of its

Starting point is 00:13:27 attributes, its management processes and strategies, which has made it much, much easier for us to hold and compound our capital for a long period of time. Let's talk more about that key word you mentioned there, certainty. To identify certainty within a business, you might look at a company with a lot of recurring revenue, like what Roper has. But then there are other businesses sort of like meta where a lot of their revenue is driven by ad spending and a lot of companies just kind of have their market. marketing budget and that they're going to be spending a lot of that through meta. So it's almost

Starting point is 00:14:01 recurring in a way, but they can turn it off at any point, though. Can you talk more about recurring revenue in relation to judging the certainty of a business? I'm reminded of the quote from Charlie Munger, who recently passed away, acknowledging what you don't know is the donning of wisdom. So in the case of meta, it's a constellation of factors that are difficult to know, which turn us off in the case of Roper, it's this set of certainty, which we think gives us the possibility of being able to analyze it well and hold on to the stock. You know, when you talk about recurring revenue, which is one of the pillars of our approach and of our strategy, we think it helps with certainty.

Starting point is 00:14:47 I mean, it's just so much easier to predict where revenue will be two or three years from now in cash flow, two or three years from now, when you have 80% of your business tied to two or three year or four-year contracts, a business like an aftermarket parts business, the part is specced in and the replacement is driven by miles flown. That makes it so much easier to hold on to and to value business. But we think, number one, it's easier to value. Number two, from a management perspective, it's so much easier for a management team to plan its expenditures, to manage its people, if it has line of sight to two-thirds of its revenue a couple of years from now. So from an execution perspective, it's so much easier for our management teams to execute a strategy,

Starting point is 00:15:40 compound free cash flow per share at an attractive rate, if it can plan its revenue and it has line of sight a couple of years in advance. What we've experienced is these management teams and these businesses have far fewer emergencies or catastrophes when they have so much contracted revenue. And so we just have fewer issues with these businesses to the extent that visibility is much stronger. And I think it also allows for management to deploy excess free cash flow to value enhancing activities like acquisitions or attract. active internal projects, if it has confidence in where the cash flows will be a couple of years from now. It's far easier to pay down debt. It's far easier to service your obligations. And it's far easier to make these longer term investments if you have confidence in the future and in the

Starting point is 00:16:34 visibility of your revenue. So it really is incredibly helpful. And when we think about recurring revenue, we think that not all recurring revenue is created equal. We would divide recurring revenue into two types of recurring revenue, transactional recurring revenue and subscription recurring revenue. When we think about transactional recurring revenue, we think about businesses like the credit bureaus where they're very tied to the growth of the economy, but you have very few options with regard to going away from them for the services that you need. So if you need a credit score, you're going to go to two out of the three credit bureaus because it's made. mandated and really a critical process that you have to follow.

Starting point is 00:17:20 And so we would view that as transactional recurring revenue. We think that it's attractive, but significantly less attractive than subscription-related recurring revenue. So when you think about subscription revenue, you think about ERP software, which tends to have maintenance agreements that go out a couple of years. You think about, you know, time and billing software, the type of software that Roper dominates and for law firms, and that's contracted a couple of years out. So we like the contracted revenue because we think it's significantly more predictable and can be counted upon,

Starting point is 00:17:56 but both are attractive. If you look at the volatility and the revenue streams of the two and the cash flow streams of those two businesses, you tend to see more volatility, of course, in transaction recurring revenue because you have the up and down of the economy. But sometimes those businesses can grow more quickly and they can be more attractive depending on the situation, but both, I think, are significantly more attractive and preferred to the businesses where you sell a product once and you may never see the customer for five or ten years. So think about automobiles or heavy equipment, those types of industries, which we've shied away from because they're just more difficult to value and to predict. Let's take a quick break and hear from today's sponsors. All right.

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Starting point is 00:22:48 I can't help but think of software companies. As you know, a lot of these software businesses tend to be fantastic investments, you know, high margins, sticky, recurring revenues. A lot of times a lot of pricing power when it's mission critical. And many of these types of companies also have. really strong modes as well. So how have you found a balance in your investment approach of, you know, getting exposure to these software type companies, but maybe not getting over exposed to these types of businesses? It's a great question. I think that we've taken a very deliberate

Starting point is 00:23:21 approach to investing in software businesses. And our focus has generally been to stay away from taking significant technology risk and to predicting exactly where the technology is going to go. That's one of our key principles. And the other key strategy is we tend to avoid the fast-growing organic growth, the fast-growing organic growth software businesses, because we don't want to be there when those businesses slow down and their multiples adjust to a more mature business, a tragic scene that we've probably experienced many times and, of course, witnessed and watching other software businesses many, many times.

Starting point is 00:24:02 So we tend to avoid those businesses. we favor the predictable organic growth businesses of the 5 to 7% range who can acquire or do something to amplify that growth from a bottom line perspective. But we've found great organic growth businesses that have a lot of recurring revenue, you know, their industry. So if you think about waste collection, a business that tends to have monopoly positions, which we like a lot. And that is to an extent transactional recurring.

Starting point is 00:24:31 But in reality, it is, it is. subscription recurring because volumes in waste don't move around a lot. They tend to be relatively acyclical. And so those have been incredible stocks for us and a place where we found attractive opportunities that fit our criteria. Same dynamics are in place in the aftermarket aerospace parts businesses where we've owned HICO and Transign for a long period of time. They fit that, you know, between transactional and subscription recurring, they can tend to sell sole service parts, which are irreplaceable, and have been fantastic capital deplores over time.

Starting point is 00:25:11 And so you can look at other industries and find features that you find attractive in the software businesses where you can find them in other industries and sometimes pay a lot less on a multiple basis. Sometimes you don't, you know, as you know, Constellation Software has been our largest position for the last seven or eight years. It's about 20% of the portfolio. And we look around all the time, looking for something that's better. And it's hard to find.

Starting point is 00:25:39 So sometimes you can't find better businesses than the best business in software or the one that you find most comfortable. But so far, we've been able to find other great opportunities that fit our criteria. Yeah, ever since I discovered Constellation, I've been trying to find a company with a similar dynamic that might be in the earlier stages of where they're at. And I wanted to transition here. One of the things that makes Constellation so special in one regard is the incentive structure. And it's amazing how we can peer into someone's thought process and why they do what they do just by looking at the incentives. And there's not saying that incentives drive all of human behavior. And we can thank Charlie Munger for helping us understand the power of incentives.

Starting point is 00:26:24 As he said, never ever think about something else when you should be thinking about the power of incentives. How about you talk about how understanding incentives can help us become better investors? I glad to do so. You reminded me of another munger quote on incentives. He said, if you have a dumb incentive system, you'll get dumb outcomes. We've witnessed that as well. But incentives are incredibly important. What you want to have is a management team that is aligned with what you're trying to achieve. So for us, we're trying to compound our shareholders' capital at a higher than market rate while taking lower than market risk. And our North Star for doing that is accumulating free cash flow per share growth in these

Starting point is 00:27:14 20 businesses at a rate that will exceed the growth rate of the overall market. And we think that that approach is what will generate higher than an average return. So we're looking for businesses that can compound free cash flow per share at a higher than market rate. So naturally, we're going to look for management teams that are incentivized to do that. So we're looking for management teams that have free cash flow explicitly articulated in its incentive structure and some other elements as well. And so I think that we think about making sure the alignment with our objectives and our investors is solid. And we think about it a second way as well. I think about it as incentives are there both to incentivize management

Starting point is 00:28:03 to play offense, but incentives are also there, in my view, to constrain the animal spirit of management. In my view, the animal spirits of management is to just grow the business and acquire in an unchecked manner. So we think about both incentives, playing offense to help drive the compounding objective, but it's also to play defense to constrain management from its own animal spirits. Now, for us, we try to invest with managers that we think are exceptional and are aligned with our goals and objectives and hopefully the goals of objectives and objectives of the management team. But sometimes you make mistakes when you judge people and you judge management. And so it helps if you have the safety

Starting point is 00:28:55 net of incentives to fall back on in the event that you make a mistake. Let me just spend a minute contrasting two businesses and their incentives and that might be something that will drive this point home. So I'm going to name the exceptional business, one that we own in the portfolio, but I'm going to leave the other one anonymous to protect the quote-unquote innocent management team. So I'll start with the great incentive structure, which is put in place by a company that we own called Walters Clure. Walters Clure is a information services business based in Europe and has been an incredible business run by Nancy McKendry, an American, who has been CEO of the company for, I believe, 20 years, which is an incredibly long period of time to be CEO, and her record has been just

Starting point is 00:29:46 exceptional. But what makes Walters Clure's incentive structure special is that they pay management on three key elements, sales growth, free cash flow growth, and return on invested capital. And so you have this offensive and defense setup here where they're paid to compound free cash flow per share and sales growth, but at the same time, they have to do it while maintaining and improving returns on invested capital. So you have this powerful combination of growing the business and improving returns, which has generated just an incredible outcome for investors in the case of Walter's Clure. And most interesting with regard to Walters Clure, if and when they do make an acquisition, they are not able to pull that acquisition out of the returns calculation. And so

Starting point is 00:30:35 they have to continue to improve returns, even though they make acquisitions, which tend to depress returns in the short run. So it's been an incredible business. If you look at it, I think that free cash flow has tripled over the last 10 years. And not surprisingly, the stock has more than tripled over that period of time and returns have improved significantly. So it's been, it's been a home run. And of course, not surprisingly because management has been aligned with investors on those metrics. If you look at the second business that we talk about, they've tied management incentives to EBAA and EPS growth. And EBITDA and EPS growth, that seems to be something that should be okay from an incentive's perspective. But what

Starting point is 00:31:20 tends to happen with businesses that generate a lot of free cash flow, but tie their incentives to EBITDA and EPS is you tend to see management teams engage in what Peter Lynch talked about, diversification. And so you see these companies buy these low return businesses and plug them into their high return existing business. And so what you have is a lot of dilution, both from an EPS perspective and from a returns perspective, and you see the multiple on those businesses go down over time, and you don't see the constraint of the animal spirits, which is exactly what happened in the case of this business, the acquisition of these large, low return businesses at high multiples, which have diversified the business and generated really poor returns

Starting point is 00:32:06 for investors. So you want to see that alignment and that constraint of the animal spirits put in place. You're right that the right incentive structure can really either drive value accretive or value destructive capital allocation decisions. And one of the things I've learned here as a host is many newer investors, I think, might be surprised to find that most acquisitions are not value accretive. And it's just a really, really tough game to play. And having the right incentive structure, I think, can really help ensure that you're not getting a bad outcome from these big acquisitions. You read about some of these tech companies that made massive acquisitions in

Starting point is 00:32:45 2021, and now the entire business is worth less than what they originally did the acquisition for during that year due to the tech bubble sort of popping. And I also recently read this book called What I Learned About Investing from Darwin by Poulac Prasad, phenomenal book. And one of the lessons I picked up from that is that his number one metric in analyzing a company and analyzing the quality of a company is return on capital employed or maybe a similar return metric, such as return on invested capital. And really, I think what he's getting at is how is management allocating capital and how effectively are they running the business?

Starting point is 00:33:24 So how about you talk more about how capital allocation might tie into incentives? Because you definitely understand that returns on invested capital are definitely very important. And ultimately, that's going to be driven by, you know, what decisions management is making. And, you know, with the free cash flow they're producing, they're going to need to figure out how they're going to be allocating that capital going forward. Sure. You know, when I think about capital allocation and poor capital allocation, the first group I think about are the credit bureaus in the United States.

Starting point is 00:33:55 I think of the credit bureaus and I think of a partner there, which we'll spend a minute talking about in a second. But as you may know, the credit bureaus, there's three of them in the United States, and they run an incredible oligopoly. If you want to secure a mortgage, get a car loan, rent. to home, they're involved in all of those decision-making situations by the owners of those assets. As an example, if you go for a mortgage, all three credit bureaus will be pinned to get a score on you. All of them will be paid a couple of dollars for that score, and all of that information that they're pulling is contributory data.

Starting point is 00:34:40 So there's a relatively insignificant amount of incremental cost to generate that score and deliver it to the customer. You know, it's a 95% incremental margin business. I mean, this is an incredible business. It's basically an override on all economic activity in the United States and outside of the United States where they play. And they're just incredible businesses. But surprisingly not incredible stocks. You know, how could that be? It's shocking to give you a sense.

Starting point is 00:35:10 Organic growth, if you look back the last five years for the businesses have been approximately 7% a year. So three or four times global GDP or U.S. GDP, they've outgrown the S&P, the average S&P business over that period of time. They started with 30% EBITDA margins at the beginning of the five-year period. So very, very profitable businesses. yet over the last five years, two out of the three credit bureaus have underperformed the S&P, and over a 10-year period, they've been just in-line performers with the S&P. And so, I mean, they run an oligopoly. How could that possibly be?

Starting point is 00:35:53 I used to be the credit bureau analyst, the TCW, so I'm very familiar with these businesses, and they're just incredible companies. And what happened is all three of these businesses spent more. more money on M&A than they generated in free cash flow over that five-year period of time. They spent more money on M&A than all of the free cash flow they generated over the last five years. And they generate a lot of free cash flow. And let me just tell you, this is not on synergistic M&A. This was, I mean, they would call it synergistic, but it's very difficult to synergize

Starting point is 00:36:30 a near utility that they operate. and instead of just sticking to their knitting, they decided to acquire a lot of different data assets that were incredibly expensive, generally from private equity, which doesn't give assets away. And those returns are always, the returns on those businesses are always going to be lower

Starting point is 00:36:51 than the returns on this incredible oligopoly that they've run. And so as interestingly as that, so of course, margins have been under pressure, Returns have gone way down for these businesses because of all the acquisitions, these poor acquisitions at high multiples. And one of the most surprising things is we looked at the data on this, two out of the three businesses engaged in near zero share purchases over that five-year period of time. So you have this incredible business, you know, these three businesses that run an oligopoly,

Starting point is 00:37:27 basically just an override on all economic activity. and they find all of these other businesses more attractive to allocate capital to than their own business, which is a 95% incremental margin business. Incredible. No wonder the stocks have not performed well, even though those businesses and those stocks should be like shooting fish in a barrel. So it's incredible. They bought back no stock, two out of the three businesses bought back no meaningful amount

Starting point is 00:37:54 of stock, and not surprisingly those businesses underperform. In contrast to that, they have a partner, which is Fair Isaacs. And so Fair Isaacs, which is, the ticker is FICO, FICO provides the formula to the credit bureaus, which generates the score. The credit bureaus contribute the data, and the data with the formula creates a score that they can then sell to their end customers. So the bureaus pay FICO a fee for the formula, and they take the formula, and they generate to score and they sell it to their customer. So you would think that FICO is basically in this

Starting point is 00:38:33 ecosystem, has similar growth dynamics, has similar returns going into that five-year period of time, similar EBITDA margins, tied to the same end markets, relatively similar company. Yet, over that five-year period of time, FICO took all of its free cash flow, all of it, and used it to repurchase its shares. And so over the last five years, FICO has reduced share count by 20%, has engaged in no meaningful acquisitions to dilute its incredible franchise

Starting point is 00:39:07 and has generated a five-bagger over the last five years compared to the bureaus that have generated 50 to 100% return, total return over that five-year period of time. So a five-bagger, which has outperformed the market by a ton, compared to an underperforming or an inline performance for the bureaus, I think just tells the tale of how important great capital allocation decision-making is, how important it is to be aligned with a management team

Starting point is 00:39:39 that understands how to generate value for shareholders. And I think for us and for everybody serves as a warning when we think about investing with teams that are acquiring businesses in general and certainly acquiring businesses, that are not as attractive as the core business. So capital allocation makes or breaks stories all the time, and incentives generally drive these decisions. But oftentimes it just takes an investor-oriented CEO

Starting point is 00:40:12 to see the big opportunity, which is usually in its core and not far afield. Yeah, it's amazing when you find those opportunities where, you know, management, wants to get better year after year. You see those returns on invested capital, March up, and maybe it's a situation where they're benchmarked against last year's return on invested capital and they're sort of forced to keep moving the ball forward because I think there's a natural human tendency to become complacent when things start going well and you find yourself

Starting point is 00:40:43 in a duopoly and there's no competition. Or, sorry to interrupt you, but or to hope your way out of low return on invested capital, capital allocation decision, and tell you, investors, well, it'll pay off in four or five years. Well, most of the time it does. Yeah, and you can't just say there's synergies there. It actually has to be there. Exactly. 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. So whether you're prepping for a SOC 2 or running an enterprise GRC program,

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Starting point is 00:44:28 we want to invest in businesses so good that an idiot can run it because eventually one will. And I'm reminded of his holding in Moody's. It might be a good example. because they operate in a duopoly as well, and they aren't constantly facing this fierce competition as a rating agency. And then I naturally think about your top holding Constellation Software. I think they would be in pretty big trouble if an idiot started running that company and replaced Mark Leonard. How about you talk more about your experience of understanding the importance of high quality management teams and maybe why you disagree with Buffett's opinion here? Yeah, I've encountered idiots ruining

Starting point is 00:45:09 great businesses. It does happen. I mean, it happens more often than we might think. And I think one of the reasons it happens is no franchise poorly managed is impregnable indefinitely. You can have a moat that survives for a couple of years, but moats don't survive for long periods of time without great management, great customer relations and service, and good capital allocation decisions. So in the short term, you can have an idiot run a business and perhaps you'll have an okay stock outcome. But in the long term, the idiot will eventually ruin even a great business. I mean, we just talked about the credit bureaus. Those are incredible businesses, so difficult to ruin. And, you know, the proof is in the performance. It's shocking.

Starting point is 00:46:02 But when I think about the positive examples of what management can do, and I think we're all aware of the importance of management. I won't belabor that. But I'll just talk about three examples where investing with great management can save you. I mean, it's not just doing well, but sometimes you need great management to make decisions that you actually can't see and to trust them to make great decisions. I'll give you a couple examples. So we've been investors in Broadcom with Hawk Tan for a long period of time. And he's just a brilliant, brilliant, brilliant. CEO, I think Broadcom today is the second or third largest semiconductor company in the United States and the S&P 500. I mean, it's remarkable.

Starting point is 00:46:49 This was a little division inside of HP, which was IPO at a couple billion dollar market cap in 2009 in middle of the recession. Now is the second largest company, semi company in the United States. And I think it's cracking the top 10 of the S&P 10. It's incredible under his leadership, what he's been able to do. But going back to what's been important and surprising, as you may remember, some time ago, he tried to acquire Qualcomm. And the FTC stopped that deal from occurring. And up until that point in time, Hawk had deployed a lot of free cash flow toward acquiring attractive semiconductor businesses. And that's what he knew.

Starting point is 00:47:31 He had been a public company CEO of a semi-business before starting Avago, which became Broadcom. So he'd spent most of his professional life in the semi-world, and he decided after the Qualcomm deal to not do any more semiconductor acquisitions. He decided to shift his focus and to acquire software businesses. And so what he found, I think, was two-fold. Number one, he'd been stopped by the FTC in acquiring other large semi-deals, most likely. He took notice of that. semiconductor companies have become a lot more expensive over that period of time. And he found software assets that were unloved and in his mind somewhat synergistic with the semiconductor business.

Starting point is 00:48:20 So after the Qualcomm deal, which was years ago, he has acquired one software business after another, one unloved software business after another, and attached what he calls software infrastructure businesses, to his existing semiconductor infrastructure franchise. So I wouldn't have predicted that as somebody who had followed him for a long period of time. But boy, are investors better off that he's done that? He's acquired higher return businesses that have more recurring revenue at lower multiples than what he would have had to pay to acquire these other large semiconductor companies that had become much more popular over time.

Starting point is 00:49:02 And so what an incredible outcome for investors. and I'm sure he'll be opportunistic if and when the semiducte industry becomes out of favor, he'll probably look there again. And having somebody who has that ability to be flexible and find the opportunities is just invaluable. I think the other example that I think about with Hawk is when we invested with him years ago, we never imagined, or maybe we should have, but we were investing along the lines of the businesses that he owned. But he saw where the future was going and he was developing an AI, a custom AI chip business a couple of years in advance of it becoming a huge market. So here we thought we were investing

Starting point is 00:49:48 in this set of semiconductor, infrastructure-oriented solutions and then the software solutions that were also infrastructure, highly durable, predictable, not incredibly fast growth businesses, but all along the way, he had developed and held on to this custom ASIC business that really has its roots in the original HP business that he took over a long time ago, but he saw that that was a valuable business and he developed it and nurtured it. And today, that is a huge growth driver for the business and has put broad common position to outgrow the semiconductor industry in a time where, A lot of the semiconductor competitors and peers don't really have a strong offering in AI,

Starting point is 00:50:40 and yet he's been able to participate. So betting with these great management teams has all of these kind of unforeseen positive outcomes that work out for you. When I think about Mark Leonard, of course, you brought him up. Hard to ignore him when it comes to great CEOs and great capital allocators. But when I think of Mark Leonard, I think of the shifts that he's made as he's gotten bigger. he's been able to decentralize capital allocation decision making and he's been able to take a lot of steps to decentralize it to a greater extent than he was able to do five years ago. If he hadn't

Starting point is 00:51:18 been able to do that, there's no way they'd be allocating basically 100% of free cash flow, even today at this scale to attractive acquisitions. The fact that he decided a couple of years ago to inform investors that he would lower his hurdle rate to do more deals because he felt as though investors would prefer allocating capital to deals that were maybe not as high return oriented as they were five years ago, but still attractive to receiving a dividend, which put the burden on investors to figure out what to do with that excess capital. I think about that as being an incredibly intelligent decision, which most management teams probably would not have made. Most of them would have created a dividend because it's too difficult to deploy this capital, and they would have put

Starting point is 00:52:10 the burden on the investors to figure out what to do with it. But he listened, he thought about it, he took the investor's perspective in mind, and the stock has been a strong performer after he's made that decision, despite the fact that the hurdle rate may be lower than it was five or six years ago. So for us, it's just been incredible to partner with somebody who can make decisions like that. And again, these are things that on the outside, we're not privy to. We're trusting the teams to make these decisions. And boy, are these incredibly important decisions that affect the returns for our investors and all investors over time. I think the third example is Ron Middlestead. who's CEO of Waste Connections, one of our long-term holdings.

Starting point is 00:52:58 And, you know, Ron was the great builder of Waste Connections for a long period of time. And he stepped away for a couple of years and a new management team or a new CEO took over while Ron dealt with some personal family issues. And he came back to the company about a year ago. He felt as though the company had lost a step. And he saw that employee turnover at the business. business was just way too high and much higher than it had been when he'd been CEO. An employee turnover in a service business just drives lower service for customers, higher

Starting point is 00:53:34 expenses for the business, and lower margins and returns for investors. And Ron was able to identify the issues, jump on them, and make a lot of progress on employee churn, which today is now manifesting in much better service levels for customers and lower expenses for the company and, of course, better profits for investors. So betting with these great CEOs has these unforeseen benefits that really accrue to investors over time. Yeah, I really admire your ability to pull all these lessons from all these great managers in particular. I know you knew Brian Jellison fairly well and learned a great amount from him. and he just had an amazing turnaround story at Roper Technologies.

Starting point is 00:54:23 And you also worked under many of these investment legends earlier on in your career before you transitioned to work with TCW. So two of the people in particular from Fidelity was Will Danoff and Joel Tillinghouse. And I was thinking about both of their investment approaches a little bit. And I might be oversimplifying, but it seemed to me that Danoff really sort of embodied a quality approach. I always think back to the story of him meeting with Howard Schultz before Starbucks went public in 1992 and held the stock for many years and did very well in that investment. Whereas Tillinghouse, who was on our richer, wiser, happier podcast with William Green,

Starting point is 00:55:05 he came across to me as someone who really put a strict emphasis on valuation and ensured that he wasn't overpaying. Yeah, so it seemed to me to have two slightly different approaches to the a game of investing. And for those of us who are, you know, stock bakers trying to figure out our own approach, we want to find an approach that works, but also we want to find an approach that also suits our temperament. So I'm curious from your perspective, after working under both of these legends, you know, how you came to identify a strategy that aligned with your temperament. The first thing I'd say is trial and error. There was a lot of trial and there was a lot of error over the years. So that's the first piece of advice I might share. But I think working under great investors

Starting point is 00:55:51 like Will Danoff and Joel Tillinghast, it gives you a sense as to how they do it and how they deal with it on a day-to-day basis. And, you know, as you talked about with Will, he was focused on earnings per share growth and focused on investing with best-to-breed businesses with Joel. He was a classic value investor who, if you read his book, gravitated toward higher quality businesses that had nice balance sheets but were inexpensive. He could go to the cyclicals and find good ideas. And when I think of Joel, Joel was somebody who ran multiple value strategies inside of his fund with great success. He had the flexibility to run multiple strategies there. Will was incredible with his ability to stick with great business.

Starting point is 00:56:43 management teams and to follow them to the next business and to the next business and to bet with great people and have great, great success. I think that for myself, it was really a trial-by-fire experience of being an analyst and covering small-cap semiconductor businesses when they were immature, unloved, not really diversified companies, very small-cap businesses, very volatile businesses. So trying to find the winners and avoid the losers over time was a difficult and extremely enjoyable learning process over time. Then having to cover the industrial and chemical sector, which was very congruent and similar to covering semis over time, very cyclical, highly capital intensive, and difficult to find

Starting point is 00:57:34 businesses that generated free cash flow. But through the process of following these businesses, learning from great managers like Brian Jellison and observing the great success that Brian had in turning around this classic industrial company that I had been following for some long period of time. All of these different industrial companies looked relatively the same. But Brian looked at Roper and he said, you know, I'm going to only focus on the attractive industrial assets that we have. I'm going to sell the non-attractive ones away. And I'm going to look for other attractive industrial assets. like a tolling business, which has recurring revenue and high returns associated with it,

Starting point is 00:58:17 like a water pump business, which has the same attractive aspects to it, and then build my company on the foundation of these more attractive assets. So I learned through a lot of experience and through learning from these great CEOs and great investment managers. But I think at the end of the day, it really comes back to understanding your behavioral biases and risks as an investor and making sure that those bad habits, which we all have, making sure that you as an investor don't fall prey to the habits that you know can create problems. So as an example for me, I tend to gravitate toward lower volatility businesses

Starting point is 00:58:59 because I know as an investor high levels of volatility is going to make it more difficult for me to stick with these businesses. So that's one of my behavioral work. And so I have to develop and devise a strategy, which is going to fit my psyche and behaviors and insulate myself from making mistakes which will hurt our investors. So I think it's trial and error and then experience and then knowing yourself to be able to know where you're good and maybe where you're not so good. It's been interesting to sort of see these rise over the years. And I guess I should say more and more people getting interested in quality investing.

Starting point is 00:59:38 And, you know, many value investors sort of point to the reality that value over long enough periods of time is outperformed. And I wonder if there's sort of a selection bias at play where quality has just worked so well in recent years. I feel that it's not really a fair question to say, you know, has the run and quality been too far? Because you can't just paint the market with a broad brush because each business is different. each situation is different. But I would rather pose the question of, you know, relative to when you started the fund 90 years ago, has it become more difficult to find the opportunities you're looking for

Starting point is 01:00:16 and finding the right price you're looking to pay for them? I think that, you know, our strategy is we own about 20 businesses. We're relatively low turnover. So we're only looking for maybe one or two new ideas every year. So our approach is to stick with the compounders over the long run, even when they get a little bit expensive, because we think that the quality of the business and the compounding aspects of the free cash flow and the skill of the team will power us through over, you know, powers through over long periods of time. And the higher valuation, which comes and goes over time, will wash itself out in much better performance over long periods of time. So we haven't had that challenge, I think, because of the strategy that we run. But if you think about quality in general, I think the most interesting thing about quality

Starting point is 01:01:13 investing is that there's a lot of data that indicates that high return businesses have very, very strong persistence. So there was a study put out by McKinsey, which looked at the median return on invested capital for S&P sectors excluding Goodwill and looked at the median returns for these sectors from 1963 to 2004 and more recent returns from 1995 to 2004. And what you found is that the high return sectors continued to have high returns 20, 30 or years later, and the low returning sectors still had low returns 30. years later. As an example, the utility sector, which tends to have low returns, had 7% returns

Starting point is 01:02:08 in the first period long ago, and 30 years later, the utility sector still had 7% returns 30 years later. The high returning sectors, like software, had 15% returns on invested capital 30 or 40 years ago. Today, those returns are higher, they're closer to 20%. And if you look across sectors, you'll see the same level of persistence. So generally speaking, high return sectors show a great deal of persistence, and low return sectors show the same level of persistence. And there's the famous Charlie Munger quote which says that if you pay a fair price for a high return business and you pay a low price for a low return business,

Starting point is 01:02:55 you will be far better off owning the high return business over time. And I think the data empirically will show that. So generally speaking, we've stayed true to the outcome of that study and focused on those high-returned businesses that tend to compound over long periods of time and tend to protect that moat relatively well over long periods of time. Of course, there are exceptions, but that's what we've encountered with the data. And I think that will continue to take place. You've previously talked about the importance of having a North Star, and that's a lesson that I felt was just really important. I believe you picked it up also from Brian Jellison at Roper.

Starting point is 01:03:40 Your North Star as an investor is this intense focus on the free cash flow per share and the rate at which free cash flows will compound into the future. I was curious if you could, just because it's so important, if you could talk more about the importance of developing and having to be. a North Star to always be working towards? I think that as an investor, you have to have a strategy that has a focus to it. And we believe that free cash flow is what physically move stock prices. It isn't revenue growth, EBITDA, earnings. All of those are approximations for getting to free cash flow. So as we think about it, we think free cash flow is what actually moves the enterprise value.

Starting point is 01:04:27 forward. And so because of that, we have this focus on finding those businesses that number one care about generating free cash flow, two, have a highly profitable business that can generate a lot of free cash flow as a percentage of the revenue it generates. And then as importantly, can take that copious amount of free cash flow and reinvest it to accelerate the compounding of free cash flow per share. So that's why it's our North Star. We've seen empirical data, which indicates that it is a huge driver of investor returns. And so it simplifies the process for us. It lets us know the types of businesses we should be focused on. It helps us understand the incentive structures that align with what we're looking for. And it helps us monitor and evaluate whether we're doing a good job as

Starting point is 01:05:23 as investors and whether management is doing a good job in their role of running the business well and reinvesting the free cash flow, as Buffett talked about in the 1996 letter, effectively. And so it serves as a real focus and simplifier for what we do. And when you think about great investors, they all have a specific focus. As you know, you mentioned Will Danoff. His focus is on EPS, and he's done incredibly well doing that. Buffett has his focus, and all of these great investors have a specific focus. This is our focus.

Starting point is 01:06:00 And so far, it has been, it has served us really well, and I think it'll continue to serve us well in the future. I'm also curious with regards to free cash flow per share, if there's any common adjustments that the listeners should maybe be aware of or mindful of, there's a common saying that, like, you know, you can't fake cash flow because, you know, it's real cash flowing through the business. Is there any common misconceptions around free cash flow or anything that maybe you've picked up or learned over the years that you'd be interested in sharing here? One of the interesting tricks that management tends to like to engage in is capitalizing

Starting point is 01:06:40 software expense. We see this in data businesses. We see this in software businesses, of course. We see this in video game businesses as well. And so instead of expensing cost, associated with generating software, developing software, on the P&L, they capitalize that. They pull it off the PNL in the short term. They serve to inflate earnings, IbitDA operating income in the short term while depressing free cash flow in real time. And so when you focus on free cash flow, you won't miss capitalized software, which is this, you know, the slight of hand that management likes to do.

Starting point is 01:07:20 So if management is paid on EPITDA margin operating income, they have this huge incentive to pull expenses off the P&L, put them on the balance sheet, and run them through the income statement later on. And so that's one of the adjustments that we spend a lot of time adjusting for because at the end of the day, we want to make sure that we're owning a business that is enhancing its economic value through improvements in free cash flow per share. and that's one of the things that is captured, but from a P&L perspective, sometimes isn't captured and is important for us and I think investors to monitor as they evaluate these types of businesses. In your previous conversation here on the show, we touched on a few of your holdings, including Constellation Software and Broadcom, and we just had Chris Mayer on to talk about how Constellations been developing over the past few years at least, so we don't need to

Starting point is 01:08:16 touch too much on that one, but maybe. could give us a bit of an update on Broadcom and any other highlights from some of your holdings, too. Sure. I'll just make one point on Constellation, which I think may be missed by investors. I think that their acquisition abilities, despite their size, have not diminished. And I just make one point about that. As you probably know, they acquired Altera in May of 2022, for $727 million. We think they paid five times EBAA for this business. This is the AllScript Software Business.

Starting point is 01:08:56 They paid five times EBDA. I think they paid, they disclosed they paid 0.75 times sales for this asset. And it was a negative growth business. And in the course of six quarters or so, they've taken the business, which was generating negative organic growth, negative maintenance growth, when they acquired it, and they break it out so you can see this to, in the last quarter,

Starting point is 01:09:24 in the December quarter, they reported positive organic growth for Altera, positive organic growth from a maintenance perspective for a business that they paid 0.75 times sales for. So this business is back to growing, is incredibly more valuable than what they paid for. They paid 0.7 times. you know, it's performing seemingly quite well. And that I think is an example of their ability to make value acquisitions that other people don't want to touch. And because of their expertise, and because of the talent at the management level, they're able to execute on an incredible

Starting point is 01:10:08 turnaround in what was a fraud and difficult business. So that's, that's one of, that's one of the, I think, proof points that things continue to get stronger for the business. I think what also gives us great confidence is that organic growth over the years from a maintenance perspective not only has been stable, but seemingly has improved. Used to grow before the pandemic at around 4%. Either they're closer to 5 or 6%. Some of that is certainly tied to inflation escalators, which may abate, but certainly at scale, after acquiring several assets that had negative maintenance growth, their ability to continue to grow just gives us great, great confidence in the management and in the persistence of the story. As we think about Broadcom, we're very pleased with how it's

Starting point is 01:11:05 performed. I would say that the closing of the VMware deal, which was announced when I was on the show a year ago, was uncertain at the time. We thought it would have to be. We're pleased that the deal closed. It will be an incredibly accretive acquisition for the company. And all indications are that VMware is growing much more rapidly under Broadcom management than under prior management and that the business is performing well. You can't really talk about Broadcom without talking about their exposure to AI. They had an AI day yesterday and I think just shows the extent that they are benefiting from what will be very very very, very strong demand in that market. And I think that the Broadcom story is very, very solid.

Starting point is 01:11:51 And they've got years of accretion to be generated from VMware, which will be hugely positive. And then, of course, with regard to Broadcom, it'll be about the next deal in the next couple of years, I'm sure. And knowing the management team, the way we know them, I'm sure they're already planning for that. And they have that in mind. And interestingly, for a business that is as large is Broadcom and it really is a conglomerate, apparently they're going to continue to be able to compound at high rates because management believes that they're going to be able to continue to do that and they have no desire to break the business up despite the natural difference between the software and the hardware business. But we trust Hocktan a great deal and think

Starting point is 01:12:35 that if that's the way he feels, this business will continue to get better. I think that management feels that there's great synergy between the software and the hardware business And from an owner's perspective, we like the stability that having approximately half the business being tied to software and half the business being tied to infrastructure semiconductors presents us as long-term owners for the company. So that business continues to get better, has a lot of exposure to the benefits of tailwinds of AI, has a lot of accretion coming from the VMware deal. And we think there's a lot of legs to that story as well. And I've also become quite fascinated with the story of Roper, you know, transforming from a low return business to something somewhat similar to constellation where they're making these fairly large VMS acquisitions.

Starting point is 01:13:25 And Brian Jellison, the former CEO, you mentioned, passed away in 2017. Have you been impressed with the management's transition ever since Jellison passed and how things have developed ever since then? Yeah, I think so. Under Jealousin, you know, I did a business breakdown on the business and on Jealousin, I think about a year ago. And I think that Jealousin did a phenomenal job of turning around the business. And then the management team under Neel Hunt has done a fantastic job of doing what was natural, which was to sell the lower return industrial businesses that they owned.

Starting point is 01:14:08 hold on to the high return, high cash return on investment, vertical market software businesses, the highly technical pumps business, and a couple of health care assets that were high return and high margin businesses as well. So that process took a couple of years. Now they're this pristine high cash return business that has acquired other high cash return businesses over the last couple of years. And, you know, they've stuck exactly to their strategy. They've applied the CRA framework that Jealouson popularized, I think, incredibly well. And I think the business went through a period of time, or the stock went through a period of time where investors were digesting the sales and the divestitures. And now you've got this pure play, really attractive, high

Starting point is 01:15:01 single-digit growth on an organic basis and better when they acquire assets. set that is really, really durable, that's highly diversified across many markets, has a lot of recurring revenue associated with it, not cyclical at all, and very, very durable. And so, you know, for us, we're not looking for the fastest growth business. We're really looking for durable compounding. And so, you know, it fits our nature. Awesome. Well, Joseph, I really appreciate you coming back on the show and sharing your time with me. It was very cool reading your recent letter to see that your fund outperformed 99% of its peers, according to NASDAQ investment. So congratulations on your success nine years in and wish you continued success going forward.

Starting point is 01:15:47 Before I let you go, how about you give the audience a handoff to how they can get in touch with you or learn more about the fund if they'd like? Sure, of course, they can learn more about the TCW America Fund on TCW.com, and they can find me, of course, on LinkedIn as well. Great. Thanks so much again, Joseph. Really appreciate it. Thank you very much. Thank you for listening to TIP.

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We Study Billionaires - The Investor’s Podcast Network - TIP622: Finding Certainty in an Uncertain World w/ Joseph Shaposhnik

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