Tobias Carlisle, the Managing Director of Eyquem Investment Management LLC, also serves as a portfolio manager for Eyquem Fund LP and other accounts that are managed separately. He has gained a lot of fame and respect mainly as an author on his website named Greenbackd, but he has also earned a special place in the finance world due to his books, Quantitative Value and Deep Value.
Tobias worked as an analyst in a hedge fund before he founded Eyquem in 2010. He also has a lot of experience as a corporate advisory lawyer who excelled at mergers and acquisitions. With a graduate degree from the University of Queensland, Australia, Tobais has managed to prove his findings with hard facts in his book, Deep Value.
Deep Value provides several theories about activist management and intrinsic value while discussing geniuses such as Warren Buffett, Benjamin Graham and Carl Icahn. Simply put, the book explores the ideas behind finding severely undervalued companies and why investing in them is most effective.
Tobias, can you describe what your book, Deep Value, is all about? Secondly, I’m curious to know what your motivation was for writing the book. It seems like you wanted to provide hard facts to support some of your theories, but was there more to it than that?
Answer 1: Deep value is about the method that contrarian-activist investors, private equity firms and what professional investors use to value companies in their entirety when they are looking to take over and control the destiny of a company. During the process, I examined the idea of mean reversion, which is the force that pushes the intrinsic value and the fundamental business performance. Most businesses and stock markets are cyclical where they have periods of both good and bad returns. Mean reversion can sometimes fool you when you’re looking at the trend of earnings, so the point of the book was to show that most businesses experience the fundamental mean reversion. Few businesses can sustain high growth in the long run. If you can anticipate its implications and get something that’s cheap and is at the bottom of its business cycle with earnings that are falling, then you arrive at the difference between the market price and the intrinsic value and as you see the intrinsic value increase, you stand to make good returns. Due to the mean reversion the poor quality companies that you might expect to perform best, could perform the worst, and the opposite is true too.
Can we outperform the market with just a formula or a model?
Answer 2: A variety of value metrics that display phenomenal performances can be used, but in Quantitative Value, we rigorously tested all formulas to determine what worked best, and a lot of simple models like P/E actually perform very well.
Enterprise value proved to be useful in particular. In reality, you’re looking at the full price you will have to pay and then you compare them with the operating earnings you’re receiving on the other side. Once we applied a rigorous analysis, we found that those two outperform, so we’re actually looking at a large universe of market capitalization.
The best way I have found is to use this combined metric, which I call the acquirer’s multiple. Basically, you substitute the operating earnings, a metric you construct using the top of the income statement, so you take revenues, the cost of the goods sold and the SGA. The reason you get good results when you take it from the top instead of the bottom is because you’re missing out on any special items that aren’t necessarily a part of the operating business and moreover, if you use that metric you’re selecting the kind of companies that enable a large acquirer to take over, so they perform quite well.
So Warren Buffett has a famous quote: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”. The graph in your book challenges this quote. You show businesses with high returns on invested capital and also the ones with a low ROIC. With time, both the good and the bad businesses proceed towards a normalized ROIC, which provides an enormous value potential for underperforming businesses. Can you describe this and also tell us how you stumbled across this contrarian point of view?
Answer 3: First off, I don’t necessarily disagree with Warren Buffett’s quote. I think that the management is tied to the underlying performance of the business and this is one the big differences between Buffett and Graham. One of the points made by Graham in “Security Analysis” is that when you look at a business, it’s difficult to confirm whether it has a good management or it’s just enjoying a particularly good period and if you arrive at the conclusion that it’s a good management, you’re missing the fact that you’re potentially accounting for it twice. According to Buffett, there are some managements that are worth the money and the two things you require from a management is a relentless focus and maintaining a very high return on the invested capital. While you keep the return very high, you’re also going to have to take care of the capital that’s invested in the business, so you prevent a cash build-up in the balance sheet. You’re also very careful with the acquisitions that you make, you pay out dividends when warranted, and buy back stock when it’s cheap. To the extent that they don’t do those things, the intrinsic value of the business is destroyed. In fact, one of the points I’m making in the book is that the intrinsic value of the business can be improved when you find that they aren’t performing the capital allocation function properly.
How do you determine when to sell stocks that you have found derived from a model?
Answer 4: Often, there will be a catalyst or you will be buying another security that is even cheaper. We find that it is actually the discount to intrinsic value, which is the main driver for the stock to increase in value. Holding a stock for a year will give you the bulk of the return when exercising deep value strategies. In the US where you pay significantly less capital gains tax after a year, the best combination of profiting from the discount and limited taxation is often by holding the stock for one year and one day.
During your speech at Google in November 2014, you state that the “Acquirer’s Multiple” is a widely used metric to find the hidden value of the business. You also find that it outperforms other key ratios as FCF yield, Gross Profit yield and Book to Market. What is an acquirer’s multiple and why does it outperform other metrics?
Answer 5: The acquirer’s multiple is the operating earnings on the enterprise value, which is the full price that would be paid to own the entire business. Essentially, when you value a company, the enterprise multiple is the price you pay and the operating earnings is the income stream you receive, which can be allocated to dividends, investing and buying other stocks. This is probably the cleanest analysis that clearly tells you how much you pay and receive at the end of it all and that’s exactly why it has been doing so well.
I’m not really sure as to why it outperforms and it has also surprised me because while the Buffett investors are looking for a very solid cash flow yield where they expect it to be stable over a period of time, we are looking for fat returns in a very short term and the only way you can get that is through these “ugly” businesses!
Warren Buffett’s people manage their risk by investing in companies with very stable cash flow. You are managing your risk by buying into a portfolio of bad business, where some might default, but you make it up through a higher overall return?
Answer 6: I’m also looking at finding Warren Buffett stocks. I’m always looking for 10% FCF yield going out 2-3 year and 5% growth rate, stable return, and good capital allocation. For the other companies I look to buy into 20 different companies. You need to get a higher return – at least 25%, to account for the higher risk you acquire.
Tobias, many investors look at the P/E ratio and use it to determine the expected yield of an investment. Continuing with our previous question, could you quantify how the performance was when the acquirer’s multiple was used versus the P/E ratio? What would its performance be for an index of stocks?
Answer 7: In 2012 we found that over a 32 year period, the acquirers multiple performed about 15 – 16% per year and the P/E ratio was probably about 11% or 12%, annually. Therefore, it’s a substantial margin over a period of 32 years with an enormous outperformance.
How have the hard facts about pure quantitative models to find the best stocks changed your own approach to selecting stocks?
Answer 8: There are two broad approaches to investment and while one approach is the Warren Buffett style business-owner-investment method, the other is a probabilistic approach. The latter is a quantitative approach is where you test the data over a period of time using several different ratios in order to protect yourself. You can look at this as a casino owner or as a statistician. Once you find a good ratio, you have to apply that to the stocks without a fear of failure although it may not seem very profitable, but you will find that it if you try to cherry pick those ideas, they underperform the screen and the reason for that is because the experts tend to underperform these simple statistical models and use their discretion to override these models too often.
This is known as the “Broken Leg” problem and the reason you can’t use it because you’ll find too many broken legs with a considerable error rate. Therefore, this model has an error rate and when experts are bound to make ad-hoc decisions, they face this unknown fluctuating error rate. Through various unrelated fields, they found that the statistical model acts as a ceiling on performance and anything you do the screens actually underperforms. When I’m in the quantitative mode, I just run whatever is in the model and put them in the portfolio.
Preston – If you could pick only one investor other than Buffett, Munger and Graham that people should study, who would that be? Do you have any books you might recommend?
Answer 9: I have learnt a lot from Joel Greenblatt’s work and his book, You Can Be a Stock Market Genius, it talks about special situations he faced when he ran his fund initially. It’s an awesome book and I read that when I was a corporate advisory lawyer and it made perfect sense to me. It was how I started out as an investor and his other book The Little Book That Still Beats the Market gives you a similar eye-opening experience because he talks about how things can be done in a quantitative fashion.
Ask the Investors:
Is there ever a time where a high P/E is justifiable for a value investor?
Tobias’ answer: I have a lot of friends who are value investors running firms and it’s very interesting to take up this debate with them. Everybody has a process, but as I mentioned earlier, my process is to just purchase the companies with a different criteria and I quit worrying about it. However, other value investors who are Buffett stock guys follow a different process where they don’t look at the implied P/E of the intrinsic value calculation. Therefore, the answer is that you can absolutely buy any of these companies if the valuation is warranted, but as a Deep Value guy I wouldn’t do that. When I look at the acquirers multiple basis I don’t look at the P/E. The earnings are not representative for the operating earnings.
Books and resources mentioned in this episode
Tobias’ Blog: GreenBackd.com
Tobias’ Acquirer’s Multiple Webpage: AcquirersMultiple.com
Videos that Support this Podcast
Tobias Calisle’s Speech at Google
Tobias Carlisle on Sky News Discussing Deep Value
5 Good Questions about Deep Value