My guest this episode is Tobias Carlisle, author, podcast host, and founder of Acquirers Funds.

Toby joined me in Season 1 where we discussed his background and overall investment philosophy. In this episode, we dive right into the well-documented woes of value investing.

Rather than rehash the usual narratives, however, I wanted to get Toby’s views as to how this environment is unique. We spend time discussing relative versus absolute cheapness, the potentially arbitrary constraints of value and growth definitions, and whether value can ever be effective for investing in the right tail.

In the latter part of the episode, we discuss the two funds Toby manages, including a large-cap long/short and a small/micro long-only. We cover performance in 2020, the practical difficulties of shorting, and how investing considerations are unique in the microcap space.

I hope you enjoy my conversation with Tobias Carlisle.

Transcript

Corey Hoffstein  00:00

All right 321 Let’s dance. Hello and welcome everyone. I’m Corey Hoffstein. And this is flirting with models the podcast that pulls back the curtain to discover the human factor behind the quantitative strategy.

Narrator  00:20

Corey Hoffstein Is the co founder and chief investment officer of new found research due to industry regulations he will not discuss any of new found researches funds on this podcast all opinions expressed by podcast participants are solely their own opinion and do not reflect the opinion of new found research. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of newfound research may maintain positions and securities discussed in this podcast for more information is it think newfound.com.

Corey Hoffstein  00:51

This season is sponsored by simplify ETFs simplify seeks to help you modernize your portfolio with its innovative set of options based strategies. Full disclosure prior to simplify sponsoring the season, we had incorporated some of simplifies ETFs into our ETF model mandates here at New Found. If you’re interested in reading a brief case study about why and how. Visit simplified.us/flirting with models and stick around after the episode for an ongoing conversation about markets and convexity with the convexity Maven himself simplifies own Harley Bassman. I guess this episode is Tobias Carlisle author, podcast host and founder of acquires funds. Toby joined me in season one where we discussed his background and overall investment philosophy. In this episode, we dive right into the well documented woes of value investing. Rather than rehash the usual narratives, however, I wanted to get Toby’s views as to how this environment is unique. We spend time discussing relative versus absolute cheapness, the potentially arbitrary constraints of value and growth definitions and whether value can ever be effective for investing in the right tail. In the latter part of the episode, we discuss the two funds Toby manages, including a large cap long, short, and a small micro long only. We cover performance in 2020. The practical difficulties of shorting and how investing considerations are unique in the micro cap space. I hope you enjoy my conversation with Tobias Carlyle. Toby Carlisle, welcome back to the show. excited to have you here. I think the last time you were on the show, I mean, it was season one. So it’s either three or four years ago, I can’t count very well, my addition isn’t great, but I’m super excited to have you here. I know. Value is sort of beaten to death story, in many people’s experience. But I know you’re gonna bring a whole new perspective. So thank you for joining me.

Tobias Carlisle  02:59

Well, thanks very much for having me. Cory. I don’t know that I’m going to bring a different perspective. I do think that valley is pretty beaten up. I can I can attest to that.

Corey Hoffstein  03:06

Well, maybe maybe if we’re lucky. I mean, the values rebounded quite a bit. And maybe this podcast will really mark the bottom of a multi year run. And we can say we were there. But so for sure. Yeah, exactly timestamp. So let’s dive in. I mean, as I mentioned, the woes of value have just been well reported. I don’t think we need to go over those. But I think one of the most intriguing aspects of value today to me is that it’s not really cheap on an absolute basis. So when we talk about maybe the spread of valuation versus something like growth, that level is pretty high. But the absolute level of valuation, just when you look at the long only basket itself is still pretty expensive. How does that sort of make this environment unique? And how should that affect how investors are thinking about allocating to value?

Tobias Carlisle  03:53

Well, when when you say that VAT is not cheap, what we’re talking about is we’re looking at any number of different price to fundamental ratios, we could be talking about, you know, Evey to cash flow price to sales price to earnings price to book that’s what we’re talking about Evie, EBIT, Evie butter. And then when we say that it’s not cheap, it’s about it. It’s a long run average, what we’re looking at is the price that you’re paying relative to those fundamentals. And what we’re ignoring in that is any kind of macro backdrop. So you might say, well, that potentially got down at the bottom of the crash last year to like 53 bibs or something like that. And now it’s like 1.6 pips, and everybody’s asking is that the reason why Valley sort of seems to have started working again, that there’s just sort of need to be outside of, of those sorts of instruments, and maybe moving back into value because you can get a lot more yield in value. So I don’t know if that’s I don’t know if it’s true to say that it’s not absolutely cheap. I don’t know if it’s true to say that it’s cheap relative to those, you know, other alternatives like the 10 year or something like that. It seems to be that there is a pretty big spread between value and alternatives like the tenure, but it’s certainly not cheap relative to its own long run average. But it is cheap again, relative to the more expensive side of the market, which is that this sort of historic, you know, I think in many instances are many of those ratios that are discussed before, it’s exceeded the 2000 peak, which is kind of extraordinary to think about, because that’s when people think back is like the most egregious sort of period of overvaluation, you would think it’s 2000. But it’s actually, it’s today, or it’s a few months ago. So I don’t know that this is a unique period, I think that every every moment in the market feels unique is unique, it probably rhymes with something else. If I’m being frank, this is probably the most baffled I’ve ever been in the markets. Because it feels to me that what’s happening in the market index is that if you look at spy or something like that, it looks pretty smooth. On the surface, it doesn’t seem like there’s a lot going on. But as we were discussing just before we came on the there are some very powerful undercurrents, pushing things around, you can see momentum sort of inverted over the last few months value seems to be having a run or there’s this sort of view that values having a run, but I don’t know that it’s necessarily value. I think that it’s some, as we discussed earlier today, it’s a small, cheap junk rally. And I you know, I have two funds out there, I have Zig which is long, short and deep, which is long, only small and micro cap. And so deep, being long, only small and micro cap is a huge beneficiary because it catches small and it catches cheap. It’s not junk, it’s got a very high quality rating. And so I don’t think it’s outperformed to the extent that it could have if it had had sort of a lot of a quality names, and funnily enough, but then Zig gets hurt because Zig is long, undervalued quality and short, overvalued junk. And just by virtue of the construction of the portfolio, the Long’s are a little bit bigger than the shorts at the moment. So Zig really gets dinged up when the shorts which are that junky and smaller, they get lifted, whereas my larger, higher quality, value names don’t sort of catch as much of that so incredibly kind of frustrating period in the markets and are completely confusing to me as well. So I’ll do my best to explain my confusion. But I don’t think we’re gonna be offering many interesting things.

Corey Hoffstein  07:27

One of the things I keep thinking about is the.com era is certainly still well within the cultural memory, right? And we all sort of look back now and go, Man, how did people get so caught up investing that way? And it’s going to be really interesting to look back 15 years from now on this era? And say, No, it really was different this time. And there was something wrong with value and how it was constructed? And we’ll talk about that in a minute. Or no, we all fell for it again. You know?

Tobias Carlisle  07:57

Well, I think it shows it just shows how hard it is to be in it. And to recognize what it is, you know, there’s that great David Foster Wallace, what is water? And I do think that that’s, that’s true. Now, it’s very hard to stand outside and say this is crazy. I’ve been saying that I think this is a little bit naughty. But I’m the one who kind of looks naughty, because I’m saying that at the moment. And I’ve read accounts of like, I think everybody in the late I was still in law school and not that 99 is but you know, it was it was just everywhere. People were day trading back then to people getting out of class to go on day trade, all that sort of stuff was going on. I think that everybody knew that this was a mania. But everybody’s just sort of wanted to be in it and didn’t fully expect it to last forever, but sort of knew that it was a new that it was going on for sure. I think that it took a long time for the mania to come into this market. I think that it was sort of overvalued and a bit odd for a few years, but over the last 12 months. You know retail mania has fully gripped it and I think you can see it and when you look at things like you know how have the most shorted stocks performed over the last 12 months, they’ve absolutely skyrocketed, you know, up five or 10 times what they had done over you know, it’s better bad trade. You don’t want to be in the most shorted stocks long. You look at the unprofitable tick same thing like that’s just just a losing trade on average year after year after year, except for 2020 when it’s just had this five or 10x stag and that’s blown up short funds. You know you can see it in you know GME in particular grabbed a few funds and turn them upside down. Now, Jimmy, I didn’t know the basis for shorting GME because when I looked at GME GME was in was in the cheap, small positions for me it didn’t ever make it into my fund because my fun. We only started that small and micro portion of that in October but it certainly would have if it had been formed even at the beginning of 2020. It’s an odd time in markets, but it’s hard to sort of stand outside and I think that’s you know, it’s useful. This is sort of why I’m not I wouldn’t describe myself so much as a quant but it is useful, I think, to stand back and look at the data and say, well, this isn’t a every period is unique. Yes, but this is not totally unprecedented. And we can see that that market does have this remarkable mean reverting mechanism in it.

Corey Hoffstein  10:14

Well, let’s maybe walk through some of the arguments. I don’t want to rehash all them out there. But I think there are a couple big popular ones that I want your opinion on as to why value may be fundamentally broken pun not intended there. But one that I think about pretty frequently is I was at a conference a couple of years ago, in the back of the room, getting miked up for a panel I was about to go on. And sky on the panel in front of me, we were talking about the panel was sort of on value. And a lot of people were lamenting values underperformance and he had done quite well. And he said, Well, maybe it’s not that value has stopped working, maybe you’re all just measuring value incorrectly. Right, this sort of idea that traditional accounting methodologies and ratios are really just two antiquated a means for understanding modern companies. What’s your take on that?

Tobias Carlisle  11:06

As you have pointed out in the past, the narrative tends to follow the price action, rather than the other way around, which is what you’d expect. So, you know, as we’ve discussed, price to book value gets buried as a metric, after price to book value has a terrible run, and not beforehand, although there were some people to be fair, I put them up when I was writing my blog greenback back in 2008 2009, I did get something from Goldman Sachs asset management where the guy said, price to book value as a metric is dead. It’s just too crowded. And that was right. Some people did foresee that true also for size, you know, size was buried, I don’t know 12 To 18 months ago, there’s not and you know, buy good shops who do good work. AQR, I think came out and said, there’s no statistical basis for size anymore as a factor. And then, you know, lo and behold, it’s come back to life. It’s roared back with a vengeance over the last, I don’t know, 12 months, I guess. So I’m always very careful when I try to fit a story to what’s going on. Because I just think you wind this for five years, and it’s going to sound pretty silly. But this would be my take. There are certainly some differences in think about tech companies. The way that many tech companies are run, is that they don’t capitalize improvements to the website and so on. That’s all expensed and so that runs through the p&l rather than being captured on the balance sheet. So that would be why, you know, that might mean that price to book value is a less good metric at measuring something like that. But then on top of that, and so I think that difference is about 15% in aggregate across the whole across the tech companies, but then you look at what tech companies do, they pay about 15% of their salaries come through in the form of option compensation, which is also not properly captured. It’s expensed but you know, is that the correct way? To capture it? I don’t know. So there are certainly some problems with capturing accounting is a very good system, double entry bookkeeping, wonders of the world. It’s a very good system for the most part at capturing what is going on. Is it perfect? No. And that’s the sort of the job of an analyst is to go through and try and determine the economic reality of what is happening in the business. Look through the accounting, read it and understand it. The reasons why value I think has really suffered. You know, sometimes it’s, I don’t think it’s necessarily a problem with the tools. It’s just sometimes the market favors things that you know that we’ve we’ve gone through six of these sort of periods since about 1950, where the market prefers very high growth, names, sort of more speculative names to names that are generating income right now, generating earnings and cash flow right now. Does that mean that if you’re then favoring those companies that if I’m a little bit more conservative, I favor income and earning that I can see now I like to sit them buying back stock? Lots of other little things like that? Do I then change my methodology? Because it’s just not working? Now, even though I know that it’s worked pretty well over the full set? Or do I say, you know, this, too, shall pass. And I’m sort of in that I’m in that latter camp, but I’m always updating and trying to see what the data is going to do. But as you have pointed out to in the past, it takes a lot of data to bury a metric, you can’t I think that Chris has this view that price to book value is not a very good metric is probably right. But if I, you know, the theoretical basis for price to book value as a metric is pretty good. You know, you say I want to buy the cheapest assets. And the reason I want to look at assets rather than flows is because flows very volatile, or that they’re more volatile and assets assets are pretty static from reporting period to reporting period. But then the problem that you run into is there are clearly there are some businesses that are better than other businesses that are some businesses that don’t require any capital in their business at all. A lot of tech businesses, they could just about paid or they’ve got virtually nothing in there. So they got massive returns on invested capital, like infinite returns on invested capital, basically. And it doesn’t have to be a tech business. It’s also been true McDonald’s and a few other things that have just bought back and paid out over capital, those are great businesses, price to book value is going to get that analysis wrong, because it doesn’t do it properly. Because it doesn’t account for the, for the book value properly. So you know, there’s, I think there are good arguments for both sides. Cliff says that it’s, it’s a less good metric. And so as value has performed really badly, price to book value has done a little bit better, because it’s not properly describing value. And so I think that’s why you want to be very careful as an investor, if your, whatever style or whatever fact portfolio you sort of identify with, and mines value and quality together, not just value. If you’re massively outperforming your, what you think you are, I think you’ve got to be a little bit careful, because you might not actually be what you think you are, you might be something else and and you might just hit an air pocket not performed for a number of years and not know why and not be able to kind of articulate why. So if a guy says he’s doing really well, when valleys doing really badly and identifies an investor, maybe not a value investor, maybe a growth investor, you know, those factors come in and out of favor. It’s just the nature of it.

Corey Hoffstein  16:21

So you teed me right up there, I don’t know if you’ve meant to, but you teed me up perfectly for where I want to go. Because one of the things I’ve spent a lot of time thinking about lately are industry conventions, that I adopted in my career without really giving much thought as to where they came from. And one of them is this dichotomy between growth and value very much, in my opinion, seems to be driven by the style box methodology that was adopted and promoted by Morningstar. And what’s interesting to me is when you start to constrain and bifurcate the universe and say value investors have to play on the left half growth investors on the right, it prevents value investors from ever saying a growth stock is trading cheaply, you know, is is perhaps value for itself. And so I guess that’d be sort of an open ended question to you can growth ever be value? Should we get rid of this sort of growth versus value mentality and allow ourselves if we are value investors to look at when growth is trading cheaply for its own sort of historical basis? So there’s

Tobias Carlisle  17:25

a lot in that? And it’s a great question. I like the way Cliff tees it up when he Cliff Asness when he says he thinks of it as expensive and, and cheap, rather than growth and value. But the reason that it’s called growth, as I’m sure everybody knows, but it’s worth, I always just go back to first principles, every single time that I do anything, I try to go back and rebuild it from first principles just to make sure that I understand exactly what we’re talking about. The idea is that I’m not an efficient markets guy. But it is also true that it’s hard to make money in the market, it’s there aren’t really very many pockets, where there are things that are just obviously mispriced, you have to do some additional work, it’s either hidden in the notes, there’s some behavioral reason for it, it’s just too small to get any kind of capital into it, there are limits to arbitrage those kinds of ideas. So what we’re seeing is that basically everything should be priced to deliver roughly the same return over the next 12, three years, 12 months, three years, five years, whatever, like Ford returns should be roughly the same. And so the way that we get to that when you look at what we’re paying a lot more for this stock, and we’re paying a lot relative to its fundamentals, and we’re paying a lot less for this stock relative to its fundamentals, the way that we bring those two ideas to say that we’re still going to earn the same amount out of each, is that we expect the fundamentals of the one that we’re paying a lot more for to grow a lot faster. And that’s how expensive stocks become growth stocks. Can have value stock, which is, you know, it’s sometimes when we’re talking about like definitional, things like is a value stock a low price to a fundamental, which is sort of value factor investing, even though the factor is literally price to book. But let’s say just literally price ratio investing. Can they become growth stocks? Yeah, only if they’re really cheap on a fundamental. But if we’re talking about, you know, let’s talk about the way that a value invest like Warren Buffett doesn’t, he’s looking for a company that is at a low valuation relative to where it will be in three or five years time. So what he’s seeing is that the overall value of the company will grow, and how does the value of a company grow? It needs to grow in terms of earnings, and it needs to become a bigger company, but it also needs to sustain its return on invested capital, because that’s what we’re saying that something is trading at a 10% return on equity is about half the value of something that’s trading at about a 20% return on equity. So there’s still it needs to be able to sustain that through that whole period. So can a value stock be a growth stock in that context? Yes, it can because what we’re seeing is we’re paying for three to five years of growth. In the value of this company, we’re saying, and you can hear Kathy Woods says that I’m a deep value investor, because Kathy would say, there’s going to be this enormous growth in these companies. So the price that I’m paying today is deep value. We can quibble about whether that’s true or not. But that’s her conception of what she’s doing. And I don’t think there’s anything wrong with viewing it that way. The difficulty is that growth is extremely hard to value and to predict, and it seems to disappoint. And I know that the assurances have done some good research where they show if we bifurcate the market into these two sort of arbitrary buckets of growth and value, and you look at the what the earnings of these companies do, and the multiples of these companies do. growth stocks, do, in fact, deliver higher rates of growth in earnings, it’s just that the multiple tends to compress over the holding period. So you do tend to find companies that are growing faster than the market. In that growth, the bucket. And the value bucket is the opposite. The earnings do tend to disappoint but because the multiple is so down, the outlook for these companies are so down, you get multiple expansion in those and so they do slightly outperform. So on average growth stocks tend to slightly underperform because the multiple compression is too great. growth stocks, it’s the other way around, they tend to outperform because they no longer compress the multiple expense. The problem with that is you come into a period like we’ve had over the last five years where growth stocks either multiple expansion value stocks, either multiple compression. And that’s how you get the big spread that we’ve seen over the last few years. That’s not unique in the market. That’s happened about six times for extended periods of time, or that famous market peaks. And then there’s some big crash and we go back into a market that looks better for value. I fully expect that that’s what will happen this time. I think that’s how it will be resolved. I don’t know when it’s going to happen. If you’d asked me five years ago, will it be one year? It will be soon I’d have said yes. Asked me now, will it be soon? I’ll say yes. But I don’t know could be another five years.

Corey Hoffstein  22:01

Anecdotally, I’ve noticed that a lot of people seem to be trying to split the difference between value and growth by adopting this sort of quality at a reasonable price mentality. And prior conversations, you mentioned to me that if you’re a value investor, and you try to control for things like quality and cash flow, a lot of the returns for traditional sort of value factor investing actually disappear, which I think is pretty interesting. Why do you think this is the case? And what are the implications for value investors?

Tobias Carlisle  22:34

Well, this is Effective question, right? This is this is solely related to price to book value as the value factor. When you think about what price, as I said earlier, I think the theoretical basis for price to book value as a factor is pretty good, you buying cheap assets, that for whatever reason, they’re just under earning right now. And you expect that through the business cycle, you’re going to get some expansion in their earning power, they’re going to do a little bit better as you go along. So the assets will start earning their keep, though. So the s&p 500, the average return on invested capital average ROI is about 13%. And so these things are under earning and as a result, they get a sub normal market multiple. And what you’re seeing as a value goes, I’m going to buy this thing while it’s under earning, because at some point, it’s going to start doing a little bit better. And we do see this very strong statistical evidence for mean reversion in when you actually look at the portfolio’s that you construct using price to book value as a ratio, you’re not getting $100 million of assets trading at $10 million, what you’re getting is a billion dollars of assets with $900 million of debt. So you got $100 million of equity, and then you’re buying those for $10 million. So what you’re actually doing is you’re taking a big bet on the, the this company paying down its debt, basically getting out of distress, that’s what you’re backing. When you try to control for and sensibly, then you would think well, what I’m going to go and do is I’m going to control for the quality of its business and its ability to repay and all of those sorts of things. The moment that you do that you kind of eliminate the return, this sort of statistical performance price to book value goes away. And so the only way that I can kind of resolve what is actually happening is many of these companies are the market is looking at them and saying there is this existential risk that this thing slips into bankruptcy. And what you’re getting when you’re holding these things, as you’re saying, I’ve got some divergent view that these things aren’t going to slip into bankruptcy or across across the portfolio of these things, enough of them in survive to make me money. And so I’m going to put together a portfolio. So what you’re actually doing is you’re sort of, you’re a grave dancer right on the edge. And you’re hoping that a lot of these recover. And then I think if you control for quality and you try to, you know, you look to see if they will in fact recover what you’re doing is you’re actually moving yourself away from those things that are right on the edge to things that everybody else agrees this thing’s not going to slip into bankruptcy and so that has kind of gone away. And so you know, Get the risk based performance, the risk based reward that the guys who are right on the edge get. So I don’t think that as a factor, when you control for those things, it doesn’t work. Having said that quality as a standalone factor that clearly works really well. And this is looking for very good quality things. And then I think if you’re, if you’re a value guy, so I’m a I’m a quant value guy in a sense that I like looking at the research and seeing what has worked. And I also believe that there are very strong behavioral reasons for thinking beforehand how you’re going to construct a portfolio, keeping your SP position sizes to a certain size rebalancing regularly. Because I just think there are a million ways that you can blow yourself up as an investor. And really, the name of the game is just to survive for as long as you possibly can until you get your little runs and your little eddies the tide turns in your favor, and then you have a good run for a period of time. So I’m not trying to construct a back testing to see if I can generate massive outperformance in a backtest, what I’m doing is I’m thinking as a value of what do I want in a portfolio, I want cash flows, I want to pay not much for those cash flows, I want pretty good returns pretty good profitability. I want to see management doing something with that profitability buying back stock. If it’s undervalued, that sends a very powerful message, the free cash flow is real management’s doing the right thing. They think it’s undervalued to lots of good messages in it. So that sort of tends to push my portfolio into the quality factor as well. You know, that’s sort of accidental. It’s not I’m not trying to be a quality investor, I’m trying to be a good value investor. And that definitely, I think that adds return over the long haul, to do those things to look for those kinds of things, but not in a price to book type world. It doesn’t help price to book but it does help as a value investor as sort of a quality value investor, I guess I think it does help returns over the very long haul. But, you know, they go through periods like today where it’s small, cheap junk, it’s not helping me.

Corey Hoffstein  27:09

That mental imagery of dancing on graves very much juxtaposes for me the press will call optimistic enthusiasm of disruptive innovation growth investors. And it calls into question for me is value investing fundamentally, in Congress with right tail investing, like investing for those big, you know, disruptive concepts that can totally change the earnings of a company

Tobias Carlisle  27:41

Savelli does get its, its wins. But when you go back to that sort of arbitrary bifurcation of growth and value, why do people it let’s assume that people who are investing in the market are fully aware of what they’re doing when they’re constructing portfolios? Why do you invest in the growth bucket? When you know that the growth bucket, the expensive bucket slightly underperforms? Because all of the best performance or the best single name returns, all of the lottery tickets are found in the growth portfolio, there are things that just never get cheap, because they’re just too good. Amazon really never gets cheap. You know, for a long time, Microsoft never really got cheap all of it. All the monster winners. And probably Shopify as an example. Now like Shopify, I don’t think we’ll ever get cheap, Shopify will always be expensive, because such a great business that’s going to grow for a very long period of time at a very high rate. They never get cheap. That’s where people hunt in that bucket looking for those sorts of monster winners that will run for years and years and years. Value doesn’t tend to get those sort of monster winners, although value does get really good returns over a longer period of time by buying those things when they buying the things that are very good. That do come down into that bucket because there’s some sort of period of underperformance. But typically, the big hits for value are things that it looks like it’s going out the door. They have some turnaround in place, and all of a sudden, it’s a different business. And it looks great again, and I include Microsoft and I raised it before for a long time, Microsoft was sort of invincible, but then in like the mid 2000s 2010 1112, there was this period of time where the stock had gone nowhere since 99 are super, super expensive. And then Bill Gates retired Steve Ballmer ran it for some time. And it had its first year of revenue, not growing and sort of 2011 12, something like that. And people looked at it and said, maybe it’s over for Microsoft, it can’t sort of it was still a pretty good return on invested capital. I think it got to like a free cash flow yield of like 11% Which seems crazy. And then you had Satya Nadella coming in and people said, well, he’s a new guy. We don’t know what he’s gonna do. Little do we know if we wind for 10 years that it will become this tick Software as a Service compound. Under staple. So that was a value stock that did become one. And I think that the way that you achieve those right tail returns as an investment, I think that, you know, Warren Buffett figured this out a long time ago. Really, the way that you do it is you have to hold for a long period of time, and I’ve done these tests, now, I had to rebuild my system. So I could do this, basically, I can look at holding, I can form a portfolio and then just look at that portfolio over the full data set that I have. And what you find is that in the portfolio, so the predictive power of a portfolio is about five years beyond about five years, there’s nothing and the only thing that I’ve found really that is predictive is value. Everything else sort of seems to the excess returns disappear pretty quickly, momentum excess returns disappear pretty quickly. quality and value together sort of seem to be quite predictive over an extended period of time. But even then, there’s a lot of luck in these portfolios, the former 30 stock portfolio, you get plenty of zeros in that portfolio. And these are quality stocks, you look at them, they get great returns on invested capital, lots of cash, lots of cash flow, that thing ends up being a donor over like a decade or 15 years. But in that portfolio, he’s absolutely monster returns. And so Microsoft is one from that. Microsoft gets picked up on multiple occasions through 2010 1112 13, I think might have been its latest. And there are lots of these companies that come in. And so the way you capture these right tail returns, I think, is you have to hold them for an extended period of time as they sort of transition into high growth, high quality compound type stocks. And I think that’s kind of luck. You know, you get a portfolio you hold enough, some of them are going to be donuts, some of them are going to outperform so massively, it’s not going to matter in your performance, then maybe you’re more like a VC we, you know VCs famously have one out of 10 positions that have one or two big hits one or two donuts, the rest in the middle sort of deliberate market performance. And then there’s a lot of luck in that. I don’t know how predictive it is. But I do think that that’s he captured the right tail. I’ve gone through and looked at those portfolios, like just for fun, form a portfolio of 30 stocks without knowing what happens afterwards, which of these other ones that I prefer, it’s impossible to predict which ones are going to do it and which ones aren’t like, all of the rules that Buffett applies, they don’t really work. He’s doing something that he I’m not saying that he’s lying about what he’s doing. I’m just thinking he’s not necessarily, maybe he’s not even able to articulate exactly what he’s doing, how he’s figuring out, which of these are going to be the big performance. But that’s how I think you do it, you got to get a little bit lucky. As you

Corey Hoffstein  32:40

alluded to a little bit earlier, the evidence for speculative froth in 2021 seems to be everywhere. But if we look towards history, like the.com era, I mean, the path to calling a top is just absolutely littered with graves. So if you’re a value investor today, how do you protect yourself from another three to five years of, of this type of market environment?

Tobias Carlisle  33:07

Well, again, I always try to go back to first principles and think about what I’m doing. And then think about what my objective is in this market. So what I’m doing when I’m buying stocks, I think that there’s there’s three sources of return. There’s the yield that you’re getting, that’s what the company is paying out dividends or buybacks. There’s the portion of the the earnings that are reinvested for growth, and then you assume that you get some roughly the same return on invested capital. And maybe it’s sort of mean reverts back to an average return on invested capital over over a few years. But you do get this period of, of perhaps super earning as it’s reinvested, so yield, you got growth. And then I would have said, when I wrote deep value, I would have said, you can just about bank on mean reversion to. But I think that that’s still true, but over very long periods of time, so five years may not be enough time, it may continue to, to widen over a period like five years, so I’m very comfortable buying the portfolio’s that I’m buying, I can see the return stream that I’m going to get out of there may be some multiple compression, further multiple compression, but I don’t really mind as long as the company. So one of the things that I like is buying back stock, a company that gets cheap and buys back stock. You know, that’s from my perspective, that’s an idea that can it can stay cheap for a really, really long period of time. And it just my holding it is increasing in value. Even if it’s not necessarily reflected in the stock price. If I’m getting some yield along with it. I’m going to be doing okay. Value hasn’t actually done that badly, you know, up to 2018 value. It’s been doing quite well. It’s been roughly delivering its long term returns. It’s just that the market had been doing much better and growth stocks been doing even better still. Since 2000. They tend to be in a different story. It’s been sort of under earning because it’s really seen it multiple Question. So I’m, I’m reasonably comfortable that the portfolio’s will either get better value or that we’ll see that mean reversion reflected in it. I don’t know how long it’s going to take, I can sort of survive for a long period of time, waiting for it to happen, whether investors can do that, too. You know, that’s the really difficult questions. The the old assets and liabilities mismatch, the assets are solid, but the liabilities, you know, they tend to flow in and out. I sort of think that that argument for value is so compelling at this point in the cycle, that it’s hard to see how somebody would want to bet somewhere else. But you know, if you’re looking at the track record, I can completely understand how you do it. But I think that valley, you know, looks about as good as it ever looks right now.

Corey Hoffstein  35:49

One of the really interesting sort of historical anecdotes to me is when you look@the.com era, value worked as such, or at least it seems to have worked is such a great defensive factor, because a lot of quality names had been sold off, sort of as we got further into the right tail, people had to fund purchasing all these high speculative names, high growth names by selling off their quality names, and it pushed quality into value. And so when the bubble popped value investors were in these very high quality names. That doesn’t seem to be as much the case today, or at least yet, quality seems to still be leaning very heavily into the growth or more expensive side of the equation. How do you think about navigating this? How do you think about the behavior of value when it’s junkier versus when it’s higher quality?

Tobias Carlisle  36:43

Well, that analysis, I think that comes from the the AQR, there was an IQ paper that came out, or a cliff paper that came out in the last quarter of q3 or q4, last year, maybe a year out from them until this year, I forget. Basically, they looked at return on assets, and a few other kind of quality metrics of the value decile, or the value portfolio and running it back to sort of maybe 25 years, maybe something like that. And it was pretty clear that ordinarily, what you’re doing when you’re a value guy is you’re, you’re getting a slightly worse portfolio at a much bigger discount. And so you’re kind of a handicap, you’re saying, Yeah, this is a worst portfolio. But companies in this portfolio have worse characteristics that don’t earn as much on assets that don’t have the same cash flow, conversion, whatever, than ever, the same growth, whatever the thing is, but I’m getting such a big discount that my portfolio is still better than a growth portfolio, because they are better companies, but you’re paying so much more, they just can’t catch up over the holding period. In 99 2000, they actually became such high quality, though the return on assets of the value portfolio was better than the return assets of the growth portfolio. And it was clear that they were going to do exceptionally well over that, you know, the next few years, maybe not clear to the market, because it seemed to catch the market as a surprise, because the market went backwards for two or three years for value sort of rocketed. And I think that that’s where a lot of people got this idea that value is defensive, and the value will protect you in a drawdown, I still think that to some extent, that is true. So when you look at, you know, the most expensive stocks at the moment are so expensive. And value stocks are sort of roughly where they are at the long run mean, it’s hard for me to see her value, know why value would draw down more than they would sort of to get back to parity that that expensive stuff is gonna have to draw down at what more than the value stuff is. So I sort of think that in the next go round value will be a little bit more defensive. But the thing that you run into is that nobody sells because they want to sell, they’re sort of panic sell, or they have to sell, because they’ve got a margin call, or, you know, they’re trying to fund something else. So there’s signs that bind or something else. So I don’t think that the kind of character of accompany is really comes into much consideration when that happens, although I do think a lot of the expensive stuff for some of these companies can come back 80 or 90%, and still be expensive. You know, I think Tesla can come back. I mean, Tesla’s come back a lot. Now, I think it’s come back 20% or something like that, but Tesla could still come back 80% and still be an expensive stock. So I think that something like Tesla will. And their Tesla’s not even most egregious example, there are lots of companies like that. I don’t think that value is necessarily going to protect people in the next go round. Although, I would say this, when you look at the value portfolios, that are the portfolio’s that I try to put together tend to have a lot more cash on the balance sheet. So to the extent that, you know, the Evie moves like beta, you know, they should have some protection by virtue of the fact that they’re carrying cash by virtue of the fact that they’re buying back stock, you know, in the in the extreme move like a march 2020 moves, that none of that is relevant. Nobody’s looking at what the fundamentals of the business side of it is. sort of selling willy nilly, if that happens, then all bets are off, everything gets sold at the same rate. So I don’t think that value is protective in that sense. But I do think that if you know what you hold, if you understand the value proposition of the business that you hold, and it gets sold down, it’s harder to panic, because you just so what this is a, this is an extraordinarily good bargain at this price. I

Corey Hoffstein  40:26

think one of the big misperceptions that I hear out there is that, well, value investors are just sort of stubbornly sitting on their hands and refusing to change their systems. I know from talking with you that that is definitively not the case, you’ve got a research graveyard that is just littered with different ideas around fixing value or exploring value from different angles, hoping you could maybe share some of the innovations you’ve explored over the past and those that just really haven’t worked out.

Tobias Carlisle  40:59

Yeah, the thing about being sort of quanti. And testing a lot of stuff is that I don’t know how much of his an innovation anybody who’s got access to any of those big databases has thrashed them to the point that they found every meaningful or not meaningful relationship. In those databases. This is what I have tried to do, I’ve tried to create something that does as well as the market over this period of time where the market runs a bit harder. And you will just naturally think about the things that you would expect it would work, it would be very high growth rates in revenues, or earnings or cash flow or those sorts of things. It tends to be less the earnings and the cash flow, because they don’t tend to have a lot of that it just tends to be very high growth rates and revenue. The problem that you run into is that that over the full set in underperforms and so this has been, the real challenge that I have had is that everything that I can find that works in a period like this, underperformed through the full set, the really the only thing that I think helps is that, you know, we’re sort of talking about a little before and that right till discussion, if you buy something for value, and then hold on to it, where it runs into, for whatever reason, it just becomes the more glamorous part of the market. And it runs with glamour. That’s sort of the only way that I can see. And so that’s probably the only innovation I have found, not innovation, but the only thing that I have found, that seems to help you keep up with the market is this idea of never so which has kind of been percolating through the fence. I gotta say it actually, it’s the only thing that I really do think works where if your view is, what I’m going to do is set out to buy portfolios, and I’m just never going to sell. And so that means I’m going to get stuff in there that it’s going to be up five times, and then it’s going to be a donut over my holding period. And I’m totally okay with that. I can come to terms with that sort of psychologically having all of that and not selling it at that time. Because I think where we fool ourselves that we’re going to pick the tops of the bottoms, nobody is able to do that, because we’re already saying, this is irrational, it’s irrational. It’s undervalued here, that’s an irrational idea. It’s mispriced, it’s overvalued here, that’s also an irrational idea. The way that I think that you sort of can keep up with the market is to do something like what Buffett has done, although he’s not getting the credit for it at the moment, because the rest of the portfolio seems to be dragging down, but he’s holding on to things for very long periods of time that do become so apples an example, then that’s a very short holding period to be deployed 50 billion into it. And 18 months later, it was up three times. So that’s a good trade, if you can do those every now and again, you’ll do fine in the market, hard to predict, prospectively. So I would say that this is the kind of the thing that drives me nuts, it’s the stuff that I can find that works in this market, just perform so woefully over the full set. The one kind of interesting thing that I have been looking at his path of my Hanrahan, who’s this Canadian academic, he has this idea of the G score, which is like the F score, which is the Piotrowski F score, except he applies it to the growth names. So he explicitly looks at only the most expensive names. And then he says, within this group, we are going to have these lottery ticket performance, which are going to be few. And we know that the very vast majority of these things are probably going to underperform the market. So he’s got this G score, which is like a version of the F score. He hunts in that very expensive part of the market. The funny thing is that most of the time, his performance, the G scores performance has driven on the short side, because it’s sort of it’s finding stuff that’s going to underperform the market. But through these last five years, he says that the performance has been driven on the long side. So perhaps that’s the that’s an interesting kind of counterweight to a value portfolio where you’re explicitly hunting at the most expensive stuff, which ordinarily be short. And then you’re running this analysis in there where you’re looking for basically looking for shorts, but you know that if you go through For a period where the market gets very frothy, then perhaps the Long’s will sort of help you through that periods. That strategy has been one of the best performance strategies over the last few years, from alongside where ordinarily, it’s driven from the short term.

Corey Hoffstein  45:16

So I know you actually spoke to Partha, on your podcasts, I think it was a little over a year ago, you run a very popular podcast called The acquirers podcast, one of my favorites to listen to. And I’m curious, how has your experience as a host, shaped or help reshape your own investment philosophy and practice?

Tobias Carlisle  45:38

Yeah, it’s been, it’s been an unexpectedly positive thing to do. I started out initially doing it because I wanted to promote the funds, and you have compliance obstacles to promoting the fund. So my solution was I’ll promote the firm or promote myself. And if folks get interested in what I’m doing, they’ll explore that, and then I’ll find the funds that I’m, I’m promoting. But I found that it’s good discipline to sit down for an hour a week, which is about all the interviews to take, and to talk to someone who’s got some expertise in an area that I’m interested in. And to sort of explore the way that they think about it, I’m sure you get the same benefit from talking to other people on this podcast, a lot of it is and you get to drive the conversation. So you get the same benefit that I have where I get to. I’m interested in stuff like that. So I heard from some other friends of mine, just in cabinet, and practical konjac forehand at Vidya. They told me that, and I’ve interviewed both of them on the podcast, they told me that Partha had them, the G score had been best performed on and I just talked about it on the podcast, and Partha came into the comments on the YouTube channel and said, you know, thanks for highlighting the research or something like that. So I reached out to him directly. And then that’s how he came to have a conversation, it turns out, he’s a fascinating guy is a professor of accounting at a Canadian university. And he’s, I think he’s degrees from Harvard, or something like that is super smart, really nice guy. And then we talked about exactly the G score, because it’s, it’s such a foreign, not a foreign idea to totally, you know, it’s totally analogous to the Escort totally understandable. But it’s unusual to find a guy who’s focusing exclusively on the most expensive stocks, you know, just doesn’t, you know, my DNA that just doesn’t work for my DNA to think in those terms. But then I would never have realized that the returns are driven from the short side, if he hadn’t sort of highlighted that to me. And then the fact that there’s been this little change in the market over the last few years, where they’ve been driven from the long side, it surprised him as much as it surprised anybody. So that was, that’s a good example of how I’ve learned something talking to these guys and stuff. I make it a habit to talk to I talk to academics or talk to practitioners or talk to value guys who run small shops, I talk to special situations, guys, to try to find ideas that I can reincorporate into my own process. I’m not sure. You know, just by virtue of I’ve been doing this for a long time, I’ve tested a lot of stuff, I’ve thought about a lot of stuff. And it is difficult. In the markets, a lot of stuff is counterintuitive. You know, like you would expect that high growth in revenues probably leads to pretty good returns, right? And it’s just, that’s just not the case, it’s just categorically not the case, there are a full data set, anybody can run a simple back test and show them. So that’s one of those, you know, if you’ve used other markets, that sort of seems bizarre that that would be the case. But that’s certainly the case. And then you have this other problem, too, in the markets where they’re always changing. So we know that, you know, the size factor was buried about 12 or 18 months ago, and here it is, the zombies come back to life price to book value is buried, but then price, the book value does better through a period where value doesn’t do very well by virtue of the fact that it doesn’t describe value very well. So that the market is tough. And I think it’s good to talk to other guys. And just just to hear what they’re saying about what’s happening. It’s been a very useful experience for me, and it forces that sort of hour of discussion, thinking deeply about their process. And then you know, you I’m throwing that into contrast with my own process what I’m doing and so it’s, it’s been an incredible experience. And then it gives you this network to have people who see it, like Partha did reach out and want to chat. So it’s been a wholly positive experience for me.

Corey Hoffstein  49:22

One of the things I want to make sure we spend a little bit time on is your process. And I know I think it was right after our last podcast, you launched the acquirers fund ticker, Zig. And I know you can’t talk about it on your podcast, but this is my podcast. So we’re going to talk about it. And I know like a lot of value funds it, it struggled, I think more than most people expected in q1 and q2 2020. But then, really, what was interesting to me and probably not fun for you to talk about is a lot of the value peers accelerated in q4 2020. And Zig really did didn’t. And I was hoping you could sort of walk me through where that sort of the meaningful deviations from maybe more traditional long only value funds came from in that period.

Tobias Carlisle  50:10

Yeah. So that was driven by the short. So what I have two funds, I have Zig, which is long, short, mid cap, large cap. And then I have deep which is long, only small and micro, it’s it’s silly to try to short and small and micro cap stocks, just, you know, GameStop as an example of why you don’t do that. But it’s still diabolically difficult shorting in mid and large cap stocks, and it’s become increasingly difficult over the years is there’s no rebate on the previously got the cash from the short, you get whatever, four or five or 6% on that. So you’re getting some earnings, you don’t get anything on it. And you know, you’re fighting with this the most overvalued stuff or the worst, the best shorts are always very crowded, because it’s you know, everybody knows that they’re great shorts. Tesla is another example of that, and Tesla’s had this, I think a lot of what Tesla’s performance is, by virtue of the fact that it’s very heavily shorted. And it’s got a small float. So there’s a lot of delicacy when you’re trying to be short, these names and so, like, I think I said at the start of the podcast that the zigs portfolio, it tends to be value quality in a mid and large universe. And so the long portfolio is, is value and quality. And the short portfolio is, you know, overvaluation extreme evaluation to the extent that I can come up with a value for these things, which typically I can’t, because they’re losing so much money in that they have this carrying so much debt, it’s just impossible to kind of come up with some sort of value for them. The problem for Zig in q4 Was that so it’s 100% loans 30%. Short. And the part of the, the way that generates return is that there’s a spread bit in there. And there’s a long only, you can think of it being 70% long value and 30%. Long, short, the spread. So the spread, closed up a little bit for value. But the problem that it is the problem that physique was that the run in the market wasn’t so much value as it was this small, cheap junk run. And as I said earlier, that portfolio tends to be long value and quality and short sort of junk out the shorts just for that particular period just tended to be a little bit smaller than the lungs. And so they got lifted. And it sort of got squashed, get caught in between the two. I think in the long run, typically the spread clauses and value quality slightly up perform. So I’m, I feel good that it generates returns over the long run, I feel really good if the market goes into some sort of breakdown. Because in that scenario, it should do very well. So I think that I’m sort of trying to be forward looking about the construction, these portfolios, I always think that the future for something like this looks very good. I get a little bit nervous about deep because it’s sort of had this, it’s had a phenomenal run. And the value guy in me gets nervous when I whenever I get that really good run like that, because I can see that run breaking down. But I do think that small has been so beaten up for so long. That run has got years and years and years left in it for for small over the market. For the long short value, I think that it’s you know, when the market falls over, and I don’t know when that happens, but I would much rather be in something that’s got that hedge on. And so I think at some stage that happens, and the hedge will be very helpful in that in that scenario.

Corey Hoffstein  53:35

One of the things I find intriguing about that long short is sort of to go back to what we said very early in the podcast is long only value is not particularly cheap from an absolute basis. But the spread between value and growth are cheap and expensive is still at historical highs. So it does give you some of that ability to capture that spread as it potentially comes in. But I do know that right? There’s a very big difference between shorting academically and shorting practically. And you mentioned some of that, and you mentioned some of the difficulties of your shorts might tilt to having a little bit of a size bias or a junk bias which has come against you. I’m curious as to how you think about shorting a little bit more from a practical perspective, right? The dangers of shorting had been front and center in 2021. How do you think about managing shorting risk, which is very different than the risks on the long side of the book.

Tobias Carlisle  54:33

We do a number of things to try to reduce the risk of shorting. The first one is you just don’t want to be short, the most heavily shorted stocks because you become captive to what the other shorts are doing in that instance, and Tesla’s a great example of that, but game stops a great example of that. You’ve got Wall Street vets out there actively hunting for these crowded shorts with low float. And so you know, I’m sort of surprised that people get caught in that because it’s you Most shorts know that you don’t want to be in heavily crowded shorts with a low float. So most people are trying to avoid that sort of stuff. And Jimmy in particular was a funny one because it was I thought that, you know, Jimmy had been deep value it had been in deep value screens, Michael Burry was long GME, I’d get very nervous if I’m on the other side of a trade from Michael Burry. And that’s not to say that, you know, he’s right all the time or anything like that, it just think that, in particular, if there’s anybody who’s drilled down and understood the situation, it’s Michael Berry, so you want to be careful trading on the other side of him. But I trade on the other side of you know, there’s always a super investor on your side and on the other side of any position that you’ve put on. So you can’t be to kind of worried about that. And it certainly wouldn’t really factor into my my thinking, the shorting in particular, were protected by the fact that we would keep the cash balance against the shorts. If they get to, we could just rebalance that. And if they go against the so we’re always taking down the size of the shorts. This The thing about shorting, you know, if it goes against you, the problem gets bigger and bigger and bigger. Whereas for a long, you’re 100% wrong and along, you just don’t get out of bed in the morning, eventually it goes to zero, you don’t really have to do anything to sort of survive, whereas the short, at some stage, you got to grasp the nettle, you’ve got to fix it up. So what, what we tend to do is we take down the size of the shorts, and a rebalanced date. So if it goes against us, we take it down goes against us, we take it down eventually, the idea is that it goes with us or we’re wrong, in which case, we just close it out. So you don’t want to be short, the heavily the most heavily shorted names. I also look at this, I tried to apply a momentum overwhelm that was a more recent thing over the last. I forget how long it is now, but four or five years because the shorts, if you’re thinking about the junky stuff that you want to be short, and I’m shorting stuff that’s got not so much on valuation, it’s short, because it’s got financial distress, it’s short, because it’s got statistical earnings manipulation or statistical fraud. And in addition to that, it’s got no earnings, it’s got negative cash flow, it’s got a whole lot of debt at some stage, it’s going to have to refinance, it’s going to raise more debt, or it’s going to sell some equity, while the markets support them selling equity, they can really keep that show going on for a very long period of time. And some of them it seems, can get to escape forces, it looks like Netflix, got to escape velocity doesn’t need to go to the markets anymore, even though it’s carrying a lot of debt. Tesla maybe gets to escape velocity? I don’t know, I don’t think so. But I think that that basket of you know, kind of junky fundamentals isn’t enough, you need to find things that have got negative momentum to or just bad momentum. And so again, that’s something that does introduce this additional risk in the portfolio. So every time you solve for something, you kind of introducing another risk. And the risk is that you run into a period when negative momentum kind of inverts, which is what happened as well in the last quarter of 2020. And I think that Michael Green is right, on this not being so much of value run as it is sort of a negative momentum run. And I don’t know why that’s happening in the market. I don’t know what’s driving that I don’t know, if that’s some big shop, trying to close up its shorts, or everybody has sort of been closing up their shorts, I think that the Wall Street bets, you know, Riot, or vandalism or whatever it is sort of scared a lot of guys into closing up their shorts. And so I think we’ve seen that happen. You know, I know that Bill Ackman came out and said, they don’t have any shorts that have taken them off. I kind of liked that idea. Now, all of a sudden, I’m one of the few people who’s got their shorts on still in this market. And I kind of feel like that’s the thing that, you know, that’s the event that makes that all turn around and run the other way. I don’t know if it necessarily does. But I like the fact that the spread is extremely wide, we’ve got the shorts on and we’ve survived through this period of time. If it turns around and goes the other way, then the performance turns around and goes the other way to

Corey Hoffstein  58:49

talk to me a little bit about what you’re doing in the micro and small cap space. I know. It was either q3 or q4 you launched the acquires devalue index, which is now being tracked by the ETF deep. How does looking in that space differ from the mid and large cap? What do you have to do differently think about differently,

Tobias Carlisle  59:09

they just tend to be smaller company, what mid and large cap it’s tends to be professional managers who’ve been in the markets for a long time, you’ve also got lots of private equity and activist hunting. So anytime they they get they never really get too far away from intrinsic value without somebody stepping in to try to push them back in small and micro is really kind of as close as it gets to frontier investing for for this stuff, because there are there’s a lot of wacky characters out there. There are guys who’ve got, you know, sub optimal kind of holdings in their business or the way that they hold their shares because they’re just interested in control. It’s run by the owner operator. In many cases, that’s good. You have to be careful. There are some guys who are you know, they make all of their money off the shareholders rather than with the shareholders. So the way that I get around that is we try to there are 100 positions. Isn’t the small and micro fund we’re looking for smaller holdings so that if any given management team has a bad act, or any given company doesn’t perform the way it should, it’s not going to impact the portfolio. It’s long only. So we don’t short and small and micro stuff. The stuff that we’re hunting for, though, is exactly the same philosophy as the mid and large cap in the sense that they’re undervalued, they’ve got tend to be more cash rich balance sheets, they tend to be cash flowing, and they’re buying back stock. And so I think if you if you go into Morningstar, and you look at the portfolio tab, which shows you the aggregated portfolio statistics of the fund versus the index, and you can do this zego, deep on every metric, the portfolios, the funds, digging deeper, both better than the market, the only one where the only one where that’s not the case is the expected growth in Zig in the zip portfolio. And anybody who’s done any testing will tell you that those Ford metrics just don’t work. They’re always overly optimistic. And so what I think that the market is just analysts are just over optimistic about the index prospects and insufficiently optimistic or too pessimistic about those companies that are in the fund. And that’s why they that’s why they’re cheap. That’s why they’re undervalued, because they they for returns are expected to be so small, but if you look at the, the historical earnings rates are huge, the historical growth rates are huge. They’re much bigger than the market. So even if they come in a little bit, they’re still going to be growing much faster, they’re still Generating Positive Cash Flow, they’re still using it to buy back stock, you’re concentrating in value over time, it should work. And it sort of seems to be working now in deep I think that zigs time is very close at hand.

Corey Hoffstein  1:01:46

One of the things I’ve been keeping my eye on in that small cap space is because you have had this huge junk run, the composition of your vanilla small cap index has changed dramatically, especially at the top of the scale, you start to look at total leverage ratios of the index, there’s just way more junk that is frothed up to the top, which might argue for playing smaller cap right now with a value or quality tilt to make sure you’re not over waiting, those names that have just run up because a lot of these companies have been blown out of their shorts or for any other number of variety reasons that this sort of composition changes happened. Yeah, I

Tobias Carlisle  1:02:26

couldn’t agree more. It’s I think that if there’s really a part of the world where quality works really well at small and micro cap, because the indexes are so poorly constructed that mean all of those in those value indexes are totally misnamed, because they tend to be they’re explicitly looking for low on a price to book value basis. And they have some other odd metrics in bad momentum, you know, other stuff in it, it’s not value either. And because they need to be roughly market cap, their growth portfolios have to be roughly the same market cap as the value portfolios, the growth portfolios are much smaller than value portfolios a huge and what we’re doing is when we don’t have approaches anything like that we’re trying to find the best in the in the case of zig we’re finding 30 names that are undervalued, strong cash flows, buying back stock, and small and micros 100 names. And I think it’s really easy to put together like I’m sometimes just sort of shocked at the quality of the portfolios that we can get hunting like that. It’s amazing how bad the performance of small and micro has been for like a decade given that the portfolio quality hasn’t been that bad. And I think when you look at individual investors who are good small and micro cap investors, in Castle, all those sort of guys, they’ve done really, really well, against the backdrop that is terrible, because it is kind of easy to find these undervalued gems in there. And so I think that deep, deepest beneficiary of that, I think it’s very easy to find some astonishingly good names. I’m always a little bit nervous about management teams are sort of a little bit untested, because they tend to be newer, that tend to be owner operators, which, you know, that’s a double edged sword. In many cases, that’s a good thing because their incentives are aligned. In other cases, they just don’t have that sort of experience of running a public company for an extended period of time. They’re not aware of all the levers you can pull as a public company CEO buy back your stock, if it’s cheap, you know, diverse stuff, it’s not working that well all those sorts of things that more professional managers and mid and large cap certainly they’re just thinking about that stuff all the time. But I do I like the prospects for both of those things. I like the prospects for small and micro and I like the prospects for for value and the spread.

Corey Hoffstein  1:04:33

Now I know that you are the author of several well known books on value investing right now, including quantitative value with our friend Wes Gray, deep value the acquirers multiple. But I know you’re actually working on a new one titled The Invincible industrialist. I think I got that right. All right, give me the basics and what’s inspiring you to write right now

Tobias Carlisle  1:04:54

the run in value has been so bad I’ve turned to philosophy. That’s how you know it’s got really, really bad it. So what I did, I looked at. I’ve spoken about Buffett a few times, he’s clearly an inspiration for me, when you look at what he has achieved, he’s 90 something years old. He’s the majority owner of the company that he’s been running since the 60s. And he’s, he still gets to make the decisions every day, when he wakes up, nobody can kick him out. He decides when he goes. And I thought, isn’t that a great way to have lived your life that you get to do what you love your entire life, and there’s no danger of being kicked out. He’s got this great line where he says, I wake up every morning and I have a look in the mirror. And then everybody who’s going to have this say, for the day has had this. But if it gets to the so what Buffett gets to do, and I thought, what are the properties that allow him to do that. And I just hit the like, I’ve tried to read Sun Tzu’s Art of War, maybe half a dozen times since I was in high school. And I come back to it, maybe every five years is certain, and it’s just impenetrable makes no sense to me. And I had this experience, maybe it was the black the pandemic or quarantined, or, I don’t know, maybe just getting an appreciation for it, Buffett was doing it. And I thought, you know, I’m slightly approaching this problem from the wrong perspective, it’s sometimes it’s like, I turned 40 years ago, coming up on two years now. Maybe it’s an age thing as well, but I just had this, I just had this, you know, when you’re young, what you’re trying to do is generate the highest returns you can possibly generate. And you think that that’s how you’re going to achieve everything that you want to achieve. And I think as as I get older, I’m more interested in staying in this game. I really love what I’m doing. I really want to be doing this for a very long period of time. I hope I still want to be doing it. When I’m 90 years old, I hope I get to 90 years old, I hope I still want to be doing it then if all those things are going well. And I still want to be doing it then how would I get from here to there. And so I went back and I looked at books like sons. So all of a sudden Art of War sort of made a little bit of sense to me, for the first time I had this like a little epiphany where I was like I can see some connections between what Buffett does. And I think there’s this sort of misconception about the art of war that it is, you know, they talk about and this is the philosophers have talked about this too. So Machiavelli and Sunsoo are sort of names just don’t mention in polite company, because they sort of, they talk about it as using practical methods rather than sort of moral ideological methods. And when you when you say practical, what you mean is brutal, or deceptive, cunning wily. And then if you go back and you look at, you know, philosophers have tried to square that circle for a long time. When is it appropriate to use counting? When is it appropriate? To use honor, they say, you know, should you fight in the in the Lions for all the lions skin? Or should you sell on the foxes patch? You know, that that would be the wildly thing. And so, Isaiah Berlin writes this great analysis of what Machiavelli does, and he says that, when you boil it down, you’ve always got two competing ideas, two competing schools trying to fight over some contested bit of ground or, or some, you know, nation or whatever the case may be. And neither of them’s right. There’s no idealism. It’s purely realism. And it’s not competing ideals as to who wins this fight. The right side doesn’t win, the side that wins is the side that has the strategic factors outside as Sunsoo would say, you need to have the strategic factors on your side. So Sunsoo discusses what the strategic factors are. So it was Machiavelli, I talked about what you should do as a sovereign, what you should do as a general sovereigns, the king, generals, the implementer, of policy, what they say is, first of all, you have to be aware of what you’re doing, you have to be sort of self aware, you have to be aware of the territory, you have to understand the game that you’re playing and who you are, and what your skills are, what your capabilities are, and what your weaknesses are in playing this game. And then you need these qualities for survival. That’s the first thing that you’re looking for, and what are the qualities of survival? It’s a really funny thing. When you go back and read Sunsoo talks about this, one of the very first things he talks about, you need harmony. And so I sort of I’ve read that a dozen times, and not really ever thought about that at all. But then John Boyd has, he’s the basis for maverick in Top Gun, but he he was a fighter pilot in Korea. And then he’s a sort of military philosopher, and they say that he’s, he’s America’s foremost military thinker. He’s the greatest sort of military philosopher since Sunsoo, which is saying something consensus, two and a half, 1000 years old. And he goes through and he does this analysis of Sunsoo. And he says, Boyd is the one who developed the OODA Loop, Oda, observe, orient decide act. But more than that, he’s developed this sort of theory where he says, he also focuses on this idea of harmony, where he says you have to harmony is the way that you get the people to follow the sovereign into achieving something. So it’s a lot about principal agent, which is a big problem in investing. It’s a big problem in industry principal agent problems. And you think about the event Instead of harmonized or unified, the US so the US didn’t want to enter into World War two Japanese bombed Pearl Harbor that unifies America into, into confronting that problem. There are lots of these sort of catalytic events that harmonize the people to achieving great things. And you think about what Buffett has done at Berkshire, he talks about this sort of stuff all the time. He doesn’t, you know, he’s not abrasive like Icahn is. But if it’s got a totally different approach and allows Buffett the sort of the nobody would dispute that Buffett isn’t a very shrewd, hard nosed negotiator. He knows what he’s doing. But he’s doing it in a way that he’s not inspiring attack from anybody. No, he’s looking for harmony. And so I, I’m not finished the book, I’m working way through it at the moment. But I look at these qualities that he has in his business and what he looks for in his investments. And then I think about how I could search for those in my own investments, and the way that I could construct my own my own business, and I can see a lot of parallels, and it’s been sort of revelatory to me to sort of think in these terms, because it makes some investments that had probably been marginal. For me, that’s a clear. And that it’s helped me to understand why other people do certain things that I would sort of not want to do. And then I understand why they’re looking for something. And I add this additional element of like harmony or something like that. And all of a sudden, so you think about I talked about Shopify before and Shopify and Amazon are two great competitors. Now, I would much rather valuations aside and size sort of a site I think that Shopify has business is sort of this incredible, potentially invincible business, because what they do is they provide to lots and lots of different store owners, they just provide the back end services to the store owners. So if any given store doesn’t survive, Shopify doesn’t care, they’ve got this portfolio approach to it. Amazon is sort of the store if you have some bad experiences with Amazon. And that’s increasingly the case you get knockoffs through Amazon or they do something wrong, that might start clouding your mental picture. As a consumer of Amazon, you might want to buy, you might say, I’m gonna go to Walmart, now I’m gonna get a target. Now, I’m not going to buy all of my stuff from Amazon and everybody else who I’ve worked with Shopify, you never really get that thought, because you’re never dealing directly with Shopify, you’re dealing with all these other stores. So they have what Boyd would call variety. They have repetitive. So Boyd says, there are four qualities you need variety, rapidity, harmony, and initiative. And so when I look at this thing, and it just, it’s just an additional way of me, or way for me to examine the strategies of these businesses, and to see whether they possess these qualities of survival, you know, through to invincibility, and then I’m just looking for another dimension to the investing. And so that’s what it achieves for me. And that’s what the book is trying to explain this process. As I say, I’m right in the middle of writing. I’m tangled up and trying to find my way out of the Gordian knot that I’ve created. But my hope is that I’ll get to this point where it is cohesive, it makes a little bit of sense.

Corey Hoffstein  1:13:06

Well put me down for a coffee. I wouldn’t expect it to be signed.

Tobias Carlisle  1:13:10

You can’t find them.

Corey Hoffstein  1:13:12

Yeah, last question for you. Pandemic seems to be hopefully coming to a close here. I know living in LA. When I was last there, things had gotten locked down again. But vaccine rollouts are proceeding fairly smoothly. What are you most looking forward to on the other side?

Tobias Carlisle  1:13:29

Well, the kids, you know, I’ve got three kids and my daughter kills my daughter not being able to go and see her friends like her big request is can I have people that are at my birthday party. So that would be one of the first things that we’ll look to do. I’m gonna go back and catch up with everybody in person, we’re gonna go and have lunch, you and I somewhere in the world. Go and have a beer and have a chat. See what’s happened. I want to get back out there and talk to people at the lockdown as to the extent that it’s served any purpose has now served its purpose and we need to we need to reopen and get back out there.

Corey Hoffstein  1:14:01

Or buddy, always great chatting with you. Thank you so much for joining me.

Tobias Carlisle  1:14:04

Likewise, Cory, always the best questions. Thanks for having me.

Corey Hoffstein  1:14:11

If you’re enjoying the season, please consider heading over to your favorite podcast platform and leaving us a rating or review and sharing us with friends or on social media. It helps new people find us and helps us grow. Finally, if you’d like to learn more about newfound research, our investment mandates mutual funds or associated ETFs. Please visit think newfound.com. And now welcome back to my ongoing conversation with Harley Bassman. As a fun bit of history trivia for our listeners. Our first interaction was actually about I think two years ago when I emailed you asking to join your mailing list. And as I recall it, I’ll admit I didn’t have the courage to go back and look at the emails but as I recall it, I received from you a pretty pointed critique of some Other things I had written in my research blog, which I’m going to just paint over by saying it was a misunderstanding between us. But as I recall it, the critique was mostly centered around the use of Sharpe ratios. And I’ve noticed that as a theme in your writing as well, that you find the concept, for lack of a better word, repulsive. Why are you so against Sharpe ratios?

Harley Bassman  1:15:23

Let’s be clear, I did not call you personally repulsive. Although that did occur to me at the time. Sharpe ratios is one of those hot buttons for me, because it’s a marketing tool, it is not an investment tool. Now, when it was created, and you’re talking going back some of the macro asset allocation ideas, I forgot what Professor it is, who did this Markowitz, he was right in the grand scheme of looking at equities versus bonds versus currencies. That made sense. But taking this macro idea, and then putting it into a micro framework is just foolishness. Because what you’re using as your measure of risk is daily realized volatility. Why is that a measure of risk? The fact that something has a small bit offers a big bid offer means that it’s going to change the eventual outcome of the asset a year from now? I don’t think so. Okay, what you care about is I buy something today? Where is it going to be in a year or two years or five years. And if it gets there by wiggling up and down a penny a day or five cents a day doesn’t make a difference to me. And this leads into this idea of reliance upon Sharpe ratio as a marketing tool, then leads to risk management processes, processes, where people look at your Sharpe and they allocate capital or risk for whatever you’re doing. And this encourages people. I mean, if you put the carrot left, people go left, you put the carrot, right people go right. I have been at firms that are very Sharpe ratio driven. What this does is it encourages you to go find very liquid low volatility assets, and then lever them up 345 to one, as opposed to buying some less liquid asset and sizing it properly and carrying that to to maturation. I think it’s a dangerous tool because not only is it not described risk properly, it encouraged you to add excess leverage. At the end of the day, you almost always see negative convexity and excess leverage at the scene of the crime.