In this episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle chat about:
- Why Did Warren Buffett Buy 1.2 Million Shares Of Restoration Hardware? – A Comprehensive Analysis
- Dan Rasmussen – The Way The World Should Work
- Is Price-to-Book Broken? Or, Does It Still Work Internationally?
- How Should You Treat Leases When Valuing A Company?
- Is Pay TV Starting To Unravel?
- Qurate – A Recap From Last Week’s Show
- The Internet Provides Great Opportunities For The World’s Bottom Billion
References in this podcast:
Dan Rasmussen – The Way The World Should Work
Tepper says stocks are cheap based on the Fed model. How predictive is the Fed model?
Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios
What Has Worked In Investing
Tweedy Browne Semi-Annual Report 9/30/2019
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Bill Brewster: This is Bill Brewster, welcome to Value After Hours. Jake, you want to tell us your topic for the week?
Jake Taylor: Hey value nerds. My topic today is Dan Rasmussen’s, The Way the World Should Work.
Bill Brewster: Toby, what are you going to be talking about this week?
Tobias Carlisle: I’ll be talking about the legendary Tweedy Browne and their semiannual report which just came out September, 2019.
Bill Brewster: And I will be talking about a battle of longs and shorts and Restoration Hardware and what I think is a very interesting story.
Speaker 4: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds or affiliates. For more information, visit acquirersfunds.com
Bill Brewster: I just wanted to say something generally about Cliffs, and in the podcast format generally, we’re chatting and I think that there may be some things that come out that are not precise, and for that, I apologize. I’ll always try to be accurate and then hopefully we’ll have some cleanup items in the show notes if anything happens. So that would be my only comment. Like for instance, saying the wrong target on Cliffs is not the ideal way to have a discussion about it.
Tobias Carlisle: Did it change its name? It was Cleveland-Cliffs, wasn’t it? Cliffs Natural Resources.
Bill Brewster: Well, Cliffs Natural Resources and then Cleveland-Cliffs.
Tobias Carlisle: I didn’t even know it had changed its name, but I know that [inaudible 00:01:35] COF Cleveland. What else do you need to know?
Bill Brewster: That’s right. Well look, at the end of the day, I think the story is more complicated and they’re using what he said was undervalued shares to make an acquisition, and I still think that it’s an example of a tough business throwing up tough decisions. I stand by the conversation but apologize for any inaccuracies. I know we have some financial analysts listening to this and I’m sure they were pulling their hair out. Some random resource investor saying, what are you talking about?
Tobias Carlisle: I think you flatter yourself. I bet anybody besides us is listening to it.
Bill Brewster: That’s fair. Well, I was pulling my own hair out.
Tobias Carlisle: Who’s buying the curate, let’s just recap that. What was the curate story?
Bill Brewster: Well I’ve been on this thing for a while about who is taking the credit risk and the duration for a lot of this paper that’s being issued corporately. I think that what I, I think the answer has to be people that are speculating on interest rates and credit spreads because if you have long duration paper, the way the math can work is if you’re right on the rates and the spreads compress a little, you can make a ton of money on the nominal value of your bonds increasing.
Bill Brewster: If you look at the return on treasuries over the past year, especially the long-dated ones, it was really impressive. But that’s not a cashflow buyer.
Tobias Carlisle: I saw somebody, I wish I could remember who said this because it was such a great line, somebody said something like, “People in are buying stocks for the yield and bonds for the capital appreciation.”
Bill Brewster: Yeah.
Jake Taylor: Was that Gundlach?
Tobias Carlisle: Was it Gundlach?, it was a great line anyway. I’ll give it to him.
Bill Brewster: That was a depressing interview. I almost had to take a value or something after listening to Gundlach? talk for 40 minutes.
Tobias Carlisle: What about the 40% prediction for decline next year?
Bill Brewster: It’s a well-hedged prediction, isn’t it?
Tobias Carlisle: That’s the non-prediction prediction.
Bill Brewster: That’s right.
Tobias Carlisle: The prediction you have when you’re not having a prediction. It just sounds good and then whatever happens, it doesn’t, you can never get called on. You just need to float it out there in the ether and not take any heat for it.
Bill Brewster: Well, yeah, and then when you’re right, you just say, see, I told you and then when you’re wrong, like you said, you just hedge it. I did find what he was saying very interesting, but it was not the most uplifting conversation that I’ve ever heard in my life.
Tobias Carlisle: What made you so depressed?
Bill Brewster: Well, I think he’s right on a lot of things.
Jake Taylor: When you think about all the fourth turning talk, how do you feel about that stuff?
Tobias Carlisle: That’s very zero hedge.
Bill Brewster: Yeah, it is a little.
Jake Taylor: We all have kids and I imagine nobody wants to live through actual real storm the best deal type of turmoil. But do you think that that’s what Gunlach was saying?
Bill Brewster: I’ll give it like a 3% probability.
Tobias Carlisle: 40% probability.
Jake Taylor: 40% chance.
Bill Brewster: I think it’s hard to look at politics these days and not see blow back. What I get concerned about with the market at these levels is compounding becomes tough for new assets if you are a true, in my definition, sort of cash flow investors. So I was looking at some quality companies and it looks like most of them are trading around two and a half to 3% free cashflow yield current. So what do their buybacks really get them if they’re buying back their shares, so the 33 times cash flow number. And then you’re getting 3% out of the gate. Like if you’re young, how do you compound money? That’s where I get nervous about all that.
Tobias Carlisle: Becoming an Instagram influencer.
Bill Brewster: That’s right. Or a podcaster.
Tobias Carlisle: a podcaster, there’s big money in podcast, wow.
Bill Brewster: We’re going to split an airhead when we go to Berkshire, right? Just carve it up into thirds.
Tobias Carlisle: How much are they these days?
Bill Brewster: I don’t know. Probably more than we’re making up this thing.
Tobias Carlisle: It’s like a $1.70 a day, split three ways, before tax.
Bill Brewster: It’s okay. If we just live below our 40 cents a day needs, we’ll be fine over time.
Tobias Carlisle: I think that was like when I was a kid, that was how much you could sponsor a kid in a third world for, 40 cents a day.
Bill Brewster: Now you can do it on a podcast. That’s good.
Jake Taylor: I will say that I was probably the most bearish last week talking about all that debt stuff. Probably a part of my errors and omissions should be to give a little bit more context in that in the short to medium term, I don’t like today’s prices for hardly any assets. However, as far as humanity goes, especially even the United States, I’m incredibly bullish over a long period of time. I couldn’t be more excited for what the world could look like. Just technology.
Jake Taylor: I think maybe the most interesting thing is the bottom billion people on earth. I think their lives are going to get dramatically better. They’re going to catch up a lot and that’s, being able for them to just go on to YouTube and figure out like how to program something that they need to fix in their little world and not, the ability to spread information, all these things are incredibly powerful. I’m really bullish that the world will be a better place, but it might just, all the asset holders who own the things today may not be the same ones as we go into the future, but the productive capability doesn’t disappear. Just the claim checks are probably not correctly arranged.
Tobias Carlisle: That might be one of the best things that happens for humanity. I’m sorry for laughing, just then I was thinking about getting them all a podcast so they can get their 40 cents a day,
Jake Taylor: Yeah, that would be good.
Tobias Carlisle: I agree with you. I think I’m in exactly the same boat. I think the future for humanity and the technological changes, innovations and the improvements to people’s lives are so great, and the future is very, very bright. But I think everything’s pretty expensive at the moment. So, there might be a reckoning in the short to medium term, but the long term is much, much better than it is today.
Jake Taylor: To me, it’s that quote of Benjamin Graham’s that, “It’s bear markets when stocks returned to their rightful owners.” I’m ready for that.
Tobias Carlisle: Why don’t we kick off the topics. Bill, do you want to take it away with Restoration Hardware [inaudible 00:08:26] RH.
Bill Brewster: I think it’s an interesting set up right now. When I say interesting, I’m not saying like, oh go out buy the shares. That’s not what I’m saying at all. I had a bias against Restoration Hardware. My mom’s an interior designer and she has always told me from day one or whatever about quality furniture and how all this other furniture is crap and it’s all made in China and this and that. So, I sort of inherently had a negative bias towards Restoration Hardware from a quality standpoint.
Bill Brewster: So, I read that the CEO is talking about we have no competition and we want to be like Louis Vuitton or [Airmaze 00:09:14] or Apple. I immediately have-
Tobias Carlisle: You scoffed.
Bill Brewster: That’s right. And like anybody that’s scoffing does these days, I took to Twitter real quick and laid out why I thought that that was silly.
Tobias Carlisle: It’s been a roller coaster ride of emotions, you and Restoration Hardware.
Bill Brewster: That’s right. I’m just drinking scotch on Saturday, it’s been a roller coaster. So anyway, it’s sort of an interesting process that I’ve gone through on it. Adam Robinson has said on, he said on Tim Ferriss’ podcast and I think Shane Parrish’s also, there is a lot of opportunity and things that make no sense and things that are blatantly obvious. And that’s something that I’ve tried to sort of say, okay, well I’m going to learn a little bit from that.
Bill Brewster: I started to dig in to the Restoration Hardware story. It led me to this book, The Luxury Strategy that Bluegrass had recommended a while ago. And the first time I picked it up I was like, this thing is, whatever. But now that I sort of have a motivation to understand the words that are written on the pages, I’m seeing the book a lot differently. I’m seeing what the CEO is trying to do a lot differently.
Tobias Carlisle: What are they trying to do? What’s the story?
Bill Brewster: They’re trying to take Restoration Hardware and become luxury of furniture or reposition the brand would be a better way to probably say. So historically, they have had the middle of the mall or less, I guess emotional retail engagements would be the best way that I can say it. They have invested a ton of money in these absolutely sick retail stores. The one in Chicago is incredible.
Bill Brewster: It’s a lot like what Starbucks did with the roasteries. And they’re trying to do that to reposition the brand. They’re going to put out a tangential, it sounds like it’s a hotel, now I think it might be more of a social club where you can live the Restoration Hardware lifestyle, which again, I scoffed at first, but with typical luxury goods, you can wear a Louis Vuitton purse and everybody’s, there’s a way to socially signal. With something like restoration hardware, you almost need a club in order to signal to the world that you deserve to go in or you’re sophisticated enough because all your stuff’s in your house and it doesn’t have logos on it.
Bill Brewster: So, I think it could take a ton of capital. I don’t know if it’s going to work, but I think it’s super interesting what’s going on there. And since it’s a financial podcast and then I’ll stop talking, you can’t talk about this story without looking at how he basically LPO’ed himself using convertible notes to retire just a ton of shares.
Bill Brewster: It’s just one of those things that I was originally closed-minded to, took a stupid hot take to Twitter. And now I sort of see why both sides are interested, and Berkshire’s long, I think it was Ted, I don’t know, but it’s an interesting peek into what somebody there saw. So it’s been a good thing to study.
Tobias Carlisle: On the luxury scale, can we just talk about that a little bit? I used this expression in a podcast a little while ago and I forget which book it comes from, but it was masstige, which is like mass prestige. And that’s like the BMW, it’s an expensive car, It’s a really well made car, but it’s not like a, it’s not a Rolls Royce, right? Rolls Royce is the pinnacle of luxury. BMW is something that you see pretty regularly on the road. So what is Restoration Hardware trying to be? Are they a BMW or are they a Rolls Royce?
Bill Brewster: Well, I don’t think that they can become a Rolls Royce. I think that they could probably become closer to BMW. What is interesting and the question that I think is a huge outstanding question is a lot of the expansion that they’ve talked about on the last earnings call is going to come from Europe. Whether or not Europe accepts America’s version of luxury furniture remains to be seen, because my perception of European luxury is it’s very historical based and not, like if I was European, I would scoff at the notion of American luxury.
Bill Brewster: So, to your point, I think it’s a BMW, and I don’t know if they’re going to be able to export the brand. I think that’s easier said than done.
Jake Taylor: How many Cadillacs do they sell in Europe?
Bill Brewster: I have no idea.
Tobias Carlisle: Do you know the answer to that?
Bill Brewster: I don’t know, but I bet it’s not a tremendous amount.
Tobias Carlisle: You gave the example Bill of Polo of Ralph Lauren. Did you say that was quite successful in Europe?
Bill Brewster: Yeah. I think Ralph’s upper label product scaled well. I think he did a really, really good job at associating himself with sort of the mega of American business. He was 1950s, 1960s images, very cultured. Ralph I think is probably the best example of an American luxury lifestyle brand that’s been exported. So can you do it in furniture is sort of the question.
Tobias Carlisle: Polo Ralph Lauren, it’s kind of confected, right? He’s made that up not that long ago. Started out selling ties in department stores and he’s built this thing. It’s kind of incredible. It gives you the impression of it being this like old east coast money, which funnily enough, they probably are now because it’s been so successful. It’s kind of a brand new invention. It’s only 50 years old.
Bill Brewster: Yeah. I mean, he did a great job steeping himself in that great American era. I saw his car collection in the [inaudible 00:15:16]. That’s balling. It was crazy. So I don’t know, it’s going to be interesting. It’s going to take a lot of capital to do it right but it’ll be interesting to watch.
Tobias Carlisle: I got to ask this question, like what’s happened to, I don’t know where they were, I’m familiar with restoration hardware, I don’t think I’ve ever bought something, but I’ve gone in there and looked at this stuff and I guess it’s kind of Ralph Lauren-ish, Polo-ish. But you say that they’ve gone, they’re trying to get up market from there to become, presumably that means you sell it more expensively. So, what has happened to the consumer who previously was in that part of the market buying Restoration Hardware stuff? Have they just gone away?
Bill Brewster: I think that they want them to go away. I think in order to execute the strategy, you’re not going to be able to be everything to everyone. Actually, I think that’s where Ralph got into a lot of trouble with his brand extensions. Once you could get RLX and RL Sport and all that stuff, what it was to be Ralph Lauren got diluted.
Bill Brewster: So I actually think that how this could work is margins could go way higher than people think that they’re going to go, but your actual transactions come in a little bit, which requires a lower inventory base and a shrunk capital base and a higher return on your invested capital, which you’re already seeing some of. But I think that’s probably where the CEO is trying to take the brand. [crosstalk 00:16:47]
Jake Taylor: Is this a long of inequality?
Bill Brewster: Yeah, maybe. I think it could also be a long of certification continuing and jobs sort of continuing to be like the cities being the, yeah, I guess it’s inequality but I’m not sure that I would capture it quite exactly the same way.
Tobias Carlisle: That was kind of what I was trying to ask. Has that just middle part that previously bought that stuff just gone away and now you either gotta be, you’ve got to buy flat pack furniture that you put together yourself or you get this sort of ultra luxury end of the market and there’s nothing kind of in the middle because there’s nobody in the middle.
Bill Brewster: Yeah. I guess like that’s where my aversion to the whole idea came is it’s not ultra luxury. But it doesn’t need to be. One, they just need to sort of create the perception of being a club that people have emotional engagement with. And that in and of itself can be some sort of mass luxury product. I did not think of that.
Jake Taylor: To me, I think you hit on my problem is the whole signaling mechanism. When it’s a Tiffany, a box that she wants to show off, or when it’s a fancy car or even a clothing label with an R and L on it or a coach bag, all those things are about status signaling. I just don’t think people have, people over often enough to justify the price tag. I don’t know, maybe I’m projecting-
Tobias Carlisle: Maybe if you filled your house up with Restoration Hardware, you would.
Bill Brewster: Yeah. You’re not the customer dude. Get out of here.
Jake Taylor: Yeah. Fair enough.
Bill Brewster: No, I think you’re right. So that’s why I think if you google these new showrooms that they have, the Chicago store is incredible. But I think that they’re going to need to have other social clubs around cities where you can signal that, where you can say, oh, almost like Soho House, if you guys are familiar with that. I’ve been to a couple of Soho houses, not because I deserve to be, they would hate me, but because I have a couple artist friends. I feel cooler when I’m there and it’s really stupid.
Tobias Carlisle: What is it for folks who don’t know? In LA, it’s like if you’re a director or an actor or something like that, you go there, right?
Bill Brewster: Yeah. They just hate finance and lawyers, I think. I don’t know.
Tobias Carlisle: There’s no way I’m getting in.
Bill Brewster: They would shun us.
Tobias Carlisle: What about podcasters?
Bill Brewster: Oh dude, we’re creative types now.
Tobias Carlisle: There we go.
Bill Brewster: All right, I’m applying tomorrow. I make one third of a $1.40 a day.
Tobias Carlisle: These guys win if Bernard or not decides that he wants to buy them because they’ve reached that level of ultra luxury that he’s after.
Bill Brewster: Yeah. So this brings me to another conversation that we had when I was commenting about LVMH and the Tiffany transaction. And you asked or you had commented that Bernard wants to elevate the brand, and I didn’t fully understand how he could do that. Maybe there is something intrinsic in LVMH that understands how to execute luxury that Tiffany has lost. Maybe that’s the synergy, I don’t know.
Tobias Carlisle: Let me give you a counter example. So J.Crew. So I used to love J.Crew and I bought a lot of J.Crew, like not recently, and not in the last decade probably. And now I go in there and I just think it’s expensive and I can probably get something comparable somewhere else. So I think they tried the same thing. They used to have bits that you could buy, pieces you could buy alongside expensive stuff. And now it’s just all expensive stuff. I don’t think it’s worked very well for them.
Bill Brewster: I’m not familiar, but I do have a similar perception of the brand that you do. I think if you look historically at brands trying to go upstream, it’s not an easy endeavor. So we’ll see.
Jake Taylor: Hey Bill, can you explain a little bit the convertible debt? And we were kind of joking that it’s sort of like the ultimate play for today’s environment.
Bill Brewster: Yeah, I can try to. I don’t have all the numbers in front of me. But basically what they did was when the shorts were coming after them with the knives out, let’s see what dates, 2020 they issued some, no, this is when they expire. So, I guess that they issued them around 2017, 2018, 2019, something like that. There’s 0% interest convertible notes that I’m pretty sure they can be stock or cash settled. I think that one was just cash settled but I haven’t been able to really dig into the terms yet.
Bill Brewster: But what they then did was they entered into a hedging transaction where they bought calls at the conversion price and then sold calls a lot higher. So, basically, they just moved the conversion price of the stock up. They took in, I don’t know quite how much in debt, but it was a lot. I think they’ve retired like 60% of their shares over the last three years. So they took in money today, varying 0% interest with the promise of settling in stock or cash in the future. And then they entered a hedging transaction to push the price up.
Bill Brewster: Today you’re probably going to look at dilution, but if you were a shareholder from back then, the dilution’s awash, like who cares? Well it’s not awash, you’re way ahead. I shouldn’t say it that way.
Jake Taylor: I found it amazing. So you’re 0% interest rates, all right, that’s already kind of an anomaly in the world. And then these warrants, I think the strike or is that like 125% or 120% of that day’s price. So, you basically were just showing, everyone could draw a straight line of what the stock had been doing and just had to keep going and be like, oh, I’m going to be in the money for these. This is great. It’s like ultimate momentum like sales job. I just found it to be fascinating.
Jake Taylor: The guy’s either like a genius or he’s going to totally torpedo it and it’ll turn into a massive zero.
Tobias Carlisle: Yeah, that’s smart financial engineering, isn’t it? It’s a clever structure anyway for raising money.
Bill Brewster: Yeah, it was super smart. I think that the implied interest that the company ends up paying is two and a half percent. If you just take the fees on the notes. And then the note holder, you’re probably thinking, well, if this goes well, I get the equity or if it goes bad, at least I get, I take care of Restoration Hardware. You have a claim on the company. The bankers are thinking that they’re going get fees. It’s an interesting transaction.
Tobias Carlisle: What’s your topic, Jake
Jake Taylor: Today talking about Dan Rasmussen’s recent, I guess you would say email or article about the way the world should work. And what’s really interesting about it is that we kind of all understand this idea of like, okay, you have government bonds, they set a certain kind of floor, the risk free rate. Above that is some corporate spread. And then above that is some equity risk premium. So, as we’re theoretically moving up the risk, we should be compensated more.
Jake Taylor: So, he looked at the data between the interest rates and the equity risk premium and then eventual 10 year returns from there and found no correlations at all as far as the interest rates starting. So basically, the equity risk premium didn’t really correlate that much with the 10 year return. It really was more with the starting price. So, we ended up with his, the real takeaway that everyone needs to know, the punchline was that paying high prices for stocks simply because interest rates are low is not sound logic.
Jake Taylor: Now, I know we’ve all heard our favorite rich uncle tell us if interest rates stay low for longer, equities are on sale right now. What do you guys think about that? Those two things are diametrically opposed at this point.
Tobias Carlisle: The thing that Dan is talking about, I think that that’s known as the fed model, right? That equity risk premium where you look at the yield on the equities over the yield on say the 10 year. And when that’s in positive territory, that means stocks are undervalued and you can buy. And there’ve been various people who, that is a pervasive myth.
Tobias Carlisle: People think that that is the case and there’ve been, I’ve seen for a decade, I think I remember writing about this on Greenback so that’s how long ago it is. This might be like 2009. I think it was Hussmann at the time who said there’s no relationship, or if you include the interest rate into the fed model, that equity risk premium, all you do is you destroy the informational value of what you’re looking at. The thing that is the driver of returns is purely the yield, which is the inversion of the multiple. So the lower the yield, the higher the multiple and vice versa. And the better the returns you get from lower multiples and high yields. And what interest rates are is irrelevant.
Jake Taylor: Yeah, so I actually followed with Dan and asked him, I quoted the Buffet quote about low rates and stocks are cheap. And he said that this low relative to what and cheap relative to what, which I thought was funny because he referenced both in the EU and Japan, they have lower rates and lower valuations. So they should be even more of an obvious buy than the US if you’re using that logic.
Jake Taylor: He did another research paper a while back that he talked about where he had four variables that explained a lot of the variance in EV to sales. It was the net interest margin, dividends as a percentage of revenue, two year forward revenue growth rate and then return on assets. So, this came up because I asked him, well, not all equity’s created equally. Maybe the US equity is better quality than these other places. Better return on assets, better capital allocation.
Jake Taylor: Well, those four variables that he put together, he controlled for the differences between the US and the other markets using these four variables that explained a decent amount of the variants. And he found that even with that, the US is still trading at a 30% premium relative to the rest of the world. So, I don’t know, I would probably say his takeaway would be to get a little bit more international exposure. If you’re listening in the US, maybe don’t suffer home country bias too hard.
Jake Taylor: And also that actually that US corporate debt is reasonably attractively priced compared to the rest of the world’s corporate debt, which I thought was kind of interesting giving our talk last week about how so much of it is probably overrated and there’s huge amounts of it and it’s kind of scary.
Tobias Carlisle: Is that because the rest of the world has negative interest rates or a lot of the world has negative interest rates?
Jake Taylor: The spread between the government bonds and the corporate bonds in the rest of the world is not as attractive as the US version.
Tobias Carlisle: I think that’s one of those, I think it’s super interesting. Once again, data destroys a pervasive narrative, but that’s one of those things, it just won’t die. That fed model is, it’s called the fed model, I think the federal reserve has at least two fed governors ago, fed chairman ago, that was something that people were talking about quite regularly about how attractive equities were. As it turns out, I think they were probably right, equities have worked really well. The data just seems to be, the data is decisive I think.
Bill Brewster: That’s interesting because I would think that equity benefits from low rates, as long as it can continue to recap its balance sheet and buy in the shares, right? Because your share shrinkage, come on, this is 2019, this is how we talk these days.
Jake Taylor: Financialization of the economy.
Bill Brewster: That should be, my feeling is that’s how math should work. I may not be correct. The data may prove me wrong.
Tobias Carlisle: I agree with you that the story is so compelling. How could it be any other way? You’ve only got a limited number of options to invest. You can go and get virtually nothing, you must be investing in treasuries and so on. Your real return must be negative at this point, right? Even if your nominal is minimal or nothing, your real return must be negative. Therefore you must look to get a real return somewhere and really you can get it, looking back over the last 10 years, you have been able to get it pretty decisively in equity.
Tobias Carlisle: How can that story be wrong and yet the data always seems to show that it’s not? I don’t fully understand why there’s a disconnect because I find the narrative pretty compelling too.
Jake Taylor: What about this. Is it a reversion to the mean of the interest rate? What ends up happening is everyone believes the fed model, they bid up the stocks to stupid levels and then returns going forward from there are then crunched. And then if you have any return to normalize interest rates, which we have had over lots of cycles, like we just happen to not have had it recently. But maybe the thesis if it’s lower for longer, forever, which I’m a little bit skeptical about, but if that is your viewpoint of the world, maybe the fed model does hold some truth for you.
Tobias Carlisle: So equity has the longest duration, and then anything else is a shorter duration bet than that’s a …
Jake Taylor: Other than Argentinian century bonds.
Tobias Carlisle: They’ve experienced a little bit of main reversion I think recently, haven’t they?
Jake Taylor: Yeah.
Bill Brewster: Well I was just doing a little bit of math. I had said some quality companies that I was looking at are trading, call it a two and a half percent free cashflow yield. So if you look at them as a spread, what if it goes to two? Think about the price appreciation. If you think about it as a spread over rates and rates go up, if that goes to a 4% free cashflow yield, you’re looking at a 38 and a half percent drawdown. Earnings need to grow a lot in order to offset that drawdown.
Bill Brewster: Now, over time, they could. But as an investor, you got to be willing to take that punch and remain convinced that you’re still right on the business. I have this general operating thesis that says that stock price drives narrative. So, I’d be interested to see who actually has the conviction.
Tobias Carlisle: You’re caught between the Scylla and Charybdis there. There’s a great article, I think it might’ve been a great note by James Montier, it was his first one, I think when he got to GMO, one of the first ones he wrote when he got to GMO, talking about investing in the age of financial repression. And he said, you’ve only got two choices. Either you believe that interest rates are,” and when we go into these very low interest rate environments, they tend to last for decades, 20, 30 years.
Jake Taylor: Where’s the analog for that? What’s the reference class?
Tobias Carlisle: I can’t remember specifically but I think he might’ve been able to find the US like maybe through the 50s was very low interest rates through to until, so 50s was the low and then early 80s was the high.
Jake Taylor: A low of 5%?
Tobias Carlisle: No. After World War II, the US had a gigantic amount, like comparable amount of debt having fought a world war as we do now having not fought a world war. You’re much weaker now than you were then for no good reason. He says that it takes such a long period of time, you have to kind of make this decision. Either you believe that it will stay very low for a long period of time and invest accordingly, which means equities are cheap or you think that you are going to see some mean reversion in the not too distant future, in which case equities are expensive. Flip a coin, I’ve got no idea.
Bill Brewster: I was talking to somebody yesterday, I own a little bit of Costco as like a growth bond replacement. I don’t like owning that stock here. It makes me terrified. That’s why it’s tiny. But part of the reason I have the allocation to it is I don’t know where the heck rates are going. If they don’t go up for a while, it should perform fairly well for me. If they do, it’s going to suck and I better have some money that I can dollar cost average down.
Tobias Carlisle: Maybe that’s the answer, you just got to have the portfolio that has both bits in it.
Bill Brewster: I guess as long as they’re rational. You don’t want to get too carried away with that because then you don’t have a view. I would rather own Costco equity than some of the bonds out there. I’m sure there will be a time when I’m crying, then you guys will say, remember when you said this? And I’ll say, yeah, I do. I don’t know what the answer is. It’s a very difficult thing to navigate in my opinion.
Jake Taylor: So many places where mean reversion is, there’s so much sand in the gears of it right now. I mean, profit margins abnormally high, interests rates crazy low, debt not really mattering, being able to refinance. None of these things are, it’s hard to imagine a world where eventually those things don’t matter or mean revert. It’s just like how long is your investment career?
Tobias Carlisle: I think we’ve reached a permanently high plateau.
Jake Taylor: Yes. Thank you Fisher.
Tobias Carlisle: So, should we move on to my topic?
Jake Taylor: Please.
Tobias Carlisle: When I first started in investing, when I first started trying to concentrate on one of the original documents that I read was this one by Tweedy Browne, What has Worked in Investing, not to be confused with Jim O’Shaughnessy’s book, came out in 1992. Basically it was a collection of every bit of price-to-book research, any bit of academic research that had been done, they turned them into charts.
Tobias Carlisle: The reason I bring that up, they have a semiannual report came out recently. They’re talking about the fact that price-to-book has sort of broken down as I metric. But they went through and they sit that the flow metrics have worked quite well, and particularly, they said that the Acquirers multiple type metrics have worked really well. So it’s kind of exciting as far as I know. I know I stole that title, that name from someone else, but as far as I know, I’m the only person who kind of uses that. [crosstalk 00:37:01]
Jake Taylor: Have to have, right? Where else would you come up with that? It’s not a common term other than from what I’ve seen, from you.
Tobias Carlisle: Out of my mouth, yeah.
Bill Brewster: Did you write them and ask them for some recognition over here?
Tobias Carlisle: Nah. I’m happy for it to be out in the ether.
Jake Taylor: Do you think that price-to-book is dead?
Bill Brewster: Yes.
Tobias Carlisle: No.
Bill Brewster: Good. Let’s do this.
Tobias Carlisle: Okay, good. Go Bill. Why is it broken, or why is it dead?
Bill Brewster: I think that if you had a metric that, Tobin’s Q is maybe a good example of something that I don’t think is dead. If you could have like a price to Tobin’s Q.
Tobias Carlisle: What’s Tobin’s Q for folks [crosstalk 00:37:57]
Bill Brewster: … replacement value.
Tobias Carlisle: Market value over replacement value.
Jake Taylor: Like an accounting value basically, replacement cost.
Bill Brewster: Right. So to me that makes a ton of sense why something like that would not be done or dead. Price-to-book is harder for a number of reasons. One, a lot of the really good companies that bought in so many shares that their book value is totally fake anyway. Maybe price to tangible assets I could get behind a little bit more, but just book, I think book is so perverted now.
Bill Brewster: I think it was Jesse Livermore did a pretty good debunking of book and how inflation affects it over time. So, I don’t know, that wouldn’t be where I would hang my, I’m sure it’ll have like a five year run or something like that because everything that gets this hated eventually bounces back. I wouldn’t invest according to it. I don’t believe in it.
Tobias Carlisle: I chatted too, I saw Corey Hoffstein over the weekend and we were talking about price-to-book because Hoffstein said, Hoffstein had this great thing where he said, you know, it’s got, whatever it’s got, 80 years of data, how many years of data do you need to show now that it doesn’t work. You need kind of a long, long run of data where it doesn’t work. If you go back through the French data, which is free, you can see that when that data series first came out from like 26 to 41 I think is the period, price-to-book, the value got absolutely smashed to pieces and it looked funnily enough a lot like it does now.
Tobias Carlisle: And so, there was nobody kind of criticizing it when it was working. Everybody was a believer when it was working. So when it stops working, then people come up with the narratives why it doesn’t work anymore.
Tobias Carlisle: One of the things that I like out of OSAM, they did this recent study where they looked at, looking back at that 26 to 41 period, what was it about that period that caused book value to not work very well? And what they said at that time was that was the invention or the popularization of the motorcar. The significance of that is that you need to build out an enormous amount of infrastructure. You need roads that can handle cars, you need fuel stations, so on and so on.
Tobias Carlisle: Chris Meredith I think wrote that one, I’m sorry if I get that wrong, but he would say that the modern equivalent of that is the internet, that you’ve built up this sort of infrastructure of the internet, whatever that means really, I’m not entirely sure what that means, but I guess it’s more than the internet, it’s the web being built out. Through these periods of disruption, it is the businesses that are capitalizing on that that go ahead and you don’t see the mean reversion in some of these other companies left behind, which is why cheap companies on a price-to-book value basis seem to have not worked recently.
Tobias Carlisle: How’s that struck you?
Jake Taylor: I think the argument for accounting decaying from price with like, book value as a metric, that signal to noise, and the disconnect between intrinsic value I think is probably a fair statement, especially in the US for more service-based or IP driven software companies. However, I look at the rest of the world and if they’re going to be catching up and they’re building a lot of stuff similar to the US or even better than we have now, why wouldn’t it maybe work somewhere else where maybe they’re not doing as much IP and they’re actually just building a building or some other things where that signal now comes back in and works.
Bill Brewster: I would buy that. The other thing is bringing it back to Restoration Hardware, they have a lease based model. So you’re not going to capture all the actual capital that that entity needs because it’s placed it off the balance sheet on somebody else’s. It’s basically just an intangibles company with some inventory now. So, I guess an aggregate, the entity that’s holding the assets maybe, I don’t know how all the math would work on it, but it just seems to me that some of these really big winners are intangible in our economy. But in foreign economies that are more manufacturing based, I could buy price-to-book.
Tobias Carlisle: Well, here’s my question. What drives a company to earn these sort of supernormal returns? Is it the mere fact that they’re sort of asset light businesses or is it because they’ve kind of defeated competition? My view is that, the kind of asset composition of your business shouldn’t really matter. The only thing that matters is what you can, what your competition allows you to sell your product for. I think at the moment it sort of all looks like it’s asset compounders that are the only things that are kind of working. Whereas I think it’s things that have got, for whatever reason, they’ve just been able to defeat competition either permanently or just in the short term.
Jake Taylor: I’m not as optimistic either on some of the actual returns of these companies. I think about like, I think they’ve actually accrued liabilities that aren’t readily seen. So for instance, if you’re Facebook and you allow everyone to publish everything and you get yourself into hot water, there’s potential legal liabilities, there’s potential government intrusion, there’s, and you see, I think their profitability has come down now that they have to hire a bunch of fact checkers to sit and look at all the things that everyone’s publishing. Whereas you didn’t have to do that when it was all quick and dirty.
Jake Taylor: While society adjust to these new technologies, I think some of the expenses start to come back in and push down these, even for the winner take all situations. I’m not as optimistic that it’s just going to be printing money all day for these guys.
Bill Brewster: I think some of that’s right. And then I also, Toby, to your point, I think industry structures matter a lot and supply constricted industries for whatever reason. Bruce Greenwald would say historically look at industries that don’t trade share often. You look at the outsize returns in beer and cigarettes historically. I think if you can combine consolidation and not a lot of share change, you can get some pretty outsized economic returns relative to what a book should tell you that it would generate. I don’t know.
Bill Brewster: Sorry. The thing that I’ve been thinking a little bit, and this may be stupid because now we’re 10 years away from the financial crisis, but one thing that clicked for me because I’m a quick thinker, it only took nine years, is coming out of the financial crisis, these companies that had access to capital of course they were able to squash the competition for a while. So, how many people are looking at these 10 years saying this is the future and now we’re sort of getting to the point where companies are getting recapped and you’re getting real competitors and sort of the competitive landscape is able to flourish again rather than just like the scorched earth that the financial crisis had left for a while. I’m not sure but it’ll be something to watch.
Tobias Carlisle: Is it a function of accounting not keeping up with book value and what would you change to make book value better?
Jake Taylor: I don’t know. I’ve thought about this a lot actually. Every solution that I’ve come up with violates the conservatism kind of tenant of good accounting. So I’m not sure what you would change. What are the other two listeners that are out there, what do they think?
Bill Brewster: Well, since I’m one of them, I’ll pitch in. I almost always capitalize advertising expenses if I’m looking at a business. I think that there’s got to be some level of R&D that you have to capitalize in some of these businesses too. The thing that gets really tough in these intangible businesses is, everybody says this land and expand stuff.
Bill Brewster: Well, let’s say I have a retail concept like five below that has really good economics on the units. They get a payback within a year. If I just threw out 5,000 of those all over the US and then shut them down as they didn’t work, people would say that’s an insane strategy. But if I just hire a super huge sales force and pay them a ton and hope to land and expand, it’s forgiven these days. I’m sure there are reasons for that that I’m not thinking of, but it’s something that I think of. Tangent, I’m sorry, but I get ranty sometimes.
Jake Taylor: You know, one thing I’ve thought about with the, we have older infrastructure now compared to a lot of the rest of the world because we just built it and we’re using it. You think about at the most simplest version of an old building that’s on the balance sheet that’s been amortized or depreciated down to zero, that book value doesn’t reflect that anymore.
Jake Taylor: There’s a lot of places that can happen where we write down things and then, but really, there’s still economic value there but price-to-book wouldn’t be capturing that as well. Which is sort of going back to my argument about maybe internationally it still makes some sense because if you’re building all that infrastructure, it’s probably carried on the books at closer to, at least it hasn’t decayed like it has here if it’s been sitting on the books for 50 years.
Tobias Carlisle: I think this is a good opportunity to segue to the question of the week, which comes in from Nico in South Africa. His question was about how you treat leases. Do you capitalize leases or what do you do?
Bill Brewster: I like that our other listener’s in South Africa. Well, I guess we have three. We’ve got one in Guantanamo also. We’re going global. I think you have to make some adjustment for leases. Now they’re on the balance sheet but I think you have to at least think about whether or not the management team is being reasonable with it. Historically, at least as it came to retail, you would capitalize and you’d take rent times, it would be sort of the shortcut to get to what a trued up version of the liability would be.
Bill Brewster: So if you’re looking at leverage, you do-
Tobias Carlisle: Why that multiple?
Bill Brewster: You know, I don’t know 100%. My best guess is that you’re capitalizing your leases at a 12 and a half percent cost to capital. Feels a little low or high to me from a cost of capital standpoint, but that’s the only math that I could think of. Some listener, please feel free to tell me I’m an idiot on that because I have been thinking about that.
Bill Brewster: Generally, I think that it should probably be a higher multiple given the interest rate environment that you’re capitalizing the rent at, but I could be wrong.
Jake Taylor: Do you guys have any sense of how much latitude management has on the reporting of these assets and liabilities now that it’s been forced to come on to the books?
Tobias Carlisle: I don’t, no. But I just assume that they’ve got enormous latitude and they’re gaming it as hard as they possibly can at the end of every quarter.
Bill Brewster: I assume the exact same thing.
Tobias Carlisle: I think that it creates, it does create this opportunity to renegotiate, which will, renegotiate your rent a little bit or find some creative way of pushing some of the costs that are captured on the balance sheet back onto the [inaudible 00:49:52], like you find someone who’s a private guy who doesn’t really, he doesn’t have to file, so he doesn’t care what the accounting treatment of it is. He just cares about sort of maximizing his return on it. He’ll do something that doesn’t make a lot of financial sense for you or for the [inaudible 00:50:09], but does for him.
Tobias Carlisle: I think it’s becoming increasingly important that you go through the financial statements and figure out what the economic reality is.
Jake Taylor: That would be my recommendation too is that all these things, I’m almost always hesitant to give any kind of prescription because really, for me it’s like, okay, I have to approach this as, what would a business owner look at and want to know and then work backwards from there. Because I’m not sure that the accounting now is always, it may be even getting further away from being helpful.
Bill Brewster: Well ideally what you’d want to know is how long are all the lease tenures, what’s your weighted average cost to capital. And then you DCF it and you got to get your present value number. But you only get five years of leases in a 10K. It’s all just sort of guesswork. Somehow they got to rent times eight and that was convention.
Tobias Carlisle: That creates an opportunity, if you weighted average cost of capital is not 12 and a half percent. If it’s lower than that, then you’re incentivized to do something there. I’ll have to think about what it is. But anytime there’s a little arbitrage, anytime you know that everybody’s doing one thing, you can do something else and make your company look a lot more attractive than it is.
Bill Brewster: I’m certain that times eight is wrong. I’m just also certain that if you’re wrong while you’re doing it, you’re wrong with everyone else.
Tobias Carlisle: I think I’ve heard that before. I think eight is the rule of thumb.
Bill Brewster: It is the rule of thumb. I’m not 100% about the math behind why.
Jake Taylor: I wonder if there’s any kind of a, like what is the average lease period? Is it five to 10 years?
Tobias Carlisle: I would have said 20 years.
Jake Taylor: Does that put you at eight then?
Tobias Carlisle: Yeah.
Bill Brewster: I don know. But you’re not going to capitalize them all in today’s dollars. I would need to do a lot of math that I am not going to do right now. I’ll tell you one thing that I found sort of interesting about that paper that you had referenced, Toby, they had a write up on Fox, and then I looked through the four funds and it’s a 0.9% position. I would argue that’s what doesn’t work in investing.
Tobias Carlisle: Doing all that work and then putting on a small position?
Bill Brewster: In one fund. I think they’re right, take a bet.
Tobias Carlisle: Maybe it’s a new position they’re just scaling in. I don’t know.
Bill Brewster: Possible. I’m just saying, swing.
Tobias Carlisle: Since you’ve raised it, what’s the Fox, what’s their idea?
Bill Brewster: In traditional media, linear TV, right now, the fear is that the bundle is unraveling. I think that there is a reasonable case to be made that the bundle will eventually hit some sort of a floor-ish, I mean, it’ll fade for a while. But as single family homes become a greater percentage of total subscribers, you would think that they turn less because they tend to have at least somebody in the house that wants to watch sports and say that person’s a kid, well, sometimes their parents want to watch news, and whatever you think of their political bias, Fox has a great product for a fan base.
Bill Brewster: So the probability that they’re going to be able to keep their economics or increase their economics as a percentage of the bundle or that the bundle becomes more expensive is sort of rabid users are the remaining subs I think is at a minimum a reasonable conclusion. It’s an interesting entity. It’s a play on live news and a secondary play on sports, which is where all the value is accruing.
Tobias Carlisle: It’s an interesting transitional period because they are going to have to start, like anybody else, like ESPN or any of the other companies that will probably getting a bit of a premium by virtue of the fact that they were in the bundle, they’re now going to have to compete on their own terms. They’re probably going to have to create their own [inaudible 00:54:20], which means they’re going head to head with Netflix and everybody else. You’ve got to look at what differentiates. They’ve got lots of years of experience of creating shows and running shows. I don’t see why that wouldn’t be helpful in this environment. That’d be a good thing in this environment.
Bill Brewster: Well yeah, and like especially Fox, I mean, they way the bundle economics work, I mean, you cross-subsidize a lot. So if they had to go direct to consumer, I don’t know what the economics of that business look like. So, the bet I do think is somewhat, the bundle stays together in some form. But that platform, I mean, Bill O’Reilly left, they didn’t have a hiccup. Megan Kelly left, they didn’t have a hiccup. Glenn Beck left, they didn’t have a hiccup. I mean, it’s crazy how good they are at replacing the stars and not having the ratings fall. I would not have guessed that. I bet they could lose Hannity and they’d just replace him tomorrow.
Tobias Carlisle: Did they launch podcasts those three, they all gone and got their own podcast?
Bill Brewster: They make real money, Toby.
Tobias Carlisle: Maybe they go and set up a podcast they get a billion followers immediately and then you can monetize that and maybe you can replace your income with that.
Bill Brewster: Glenn Beck has, he’s got his own sort of direct to consumer. I don’t know if it’s called Beck Nation or whatever, but he’s got a thing. I don’t think it’s nearly as successful as he was on Fox.
Tobias Carlisle: Well, I think that’s probably coming up on time. How do we normally close this thing off? We’ll be around next week. See you then.
Bill Brewster: That’s right. Yeah, Indeed.
Jake Taylor: Send us your questions.
Tobias Carlisle: Yeah, that’s right.
Jake Taylor: And any other comments, places where we screwed up, we’ll try to address those on the next, the errors and omissions section for next week. Consider this more of a dialogue that people drop into and then keep it going after.
Tobias Carlisle: Send the criticism to Jake, send the errors and omissions to Bill, and send all of the compliments to me.
Bill Brewster: Stay safe out there.
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