Bryan Lawrence (00:02:49):
Guidewire Software does all the policy, claims, and billing activities for the insurer and charges just 0.5% of the insurer’s revenues to provide all that functionality. Without that 0.5%, the insurer literally cannot function. That’s an example of cash flows that are durable because they’re so important to the customers.

Bryan Lawrence (00:03:09):
A second factor is, is the business operating in an industry structure that is favorable? Examples of favorable industry structures could be, is this a low-cost provider? So an example of that, a company we own called Interactive Brokers, allows its customers to trade stocks for a price of just one basis point, which as best we can tell is about a third of the cost that competitors are charging. And yet, despite charging one-third the cost, Interactive Brokers is enjoying profit margins of 60% because they’ve automated their operations in a way that Goldman Sachs finds it very difficult to compete with.

Bryan Lawrence (00:03:56):
Another favorable industry structure is either a natural monopoly or a duopoly. An example: cable networks providing us all with our internet service have to run cable past millions of homes, and the cost of doing that means that in most markets you find that there’s maybe one provider doing it or, at most, two providers doing it. Those are very interesting industries to study and invest in.

Bryan Lawrence (00:04:23):
A final factor is if there are attractive cash flows in an industry, we love to see it when smart, well-resourced competitors have tried to enter but have failed. An example would be Google’s attempt to enter the cable business with a big offering of fiber to compete with the cable companies. And despite all of their money, all of their intelligence, all of their resources, they failed. Walmart attempted to enter the used car business, and despite all of their money and of their intelligence, they failed. When we see a smart, well-resourced competitor entering a business and failing, we grow very interested and want to study that business more.

Bryan Lawrence (00:05:05):
In addition to those first two questions, there are three others, “Is the management team aligned with us? Are they going to treat us like we would like to be treated? Is there an evaluation that is cheap relative to the cash flows we see the business producing for shareholders? And importantly, is there a misconception in the business that is temporary and that therefore this cheap valuation will turn into a more attractive valuation later?” So in order to invest in something, we need a good answer to all five of these questions: Do we understand the business? Is it a great business? Does it have management aligned with us the shareholders? Is it cheap? And is there a temporary misconception about making it cheap?

Stig Brodersen (00:05:50):
Well, it sounds like a tall order, Bryan, but that’s also why Buffett is talking about hitting within your strike zones. You can just wait; you don’t have to swing. But perhaps, Bryan, we could illustrate your process with a case study. I know that Charter has been one of your larger investments. How did you develop your conviction to invest in Charter in the first place?

Bryan Lawrence (00:06:10):
Yes, we’ve owned Charter for several years, and it’s a good example of a great business. You may know Charter as a provider of internet services under the Spectrum brand name in the United States. Their network of cable connections passes 55 million US homes and small businesses, and it provides internet under the Spectrum brand to about 30 million of those homes and small businesses. There are two reasons, really, while Charter is a great business. First, people complain about their cable bill, pretty easy to get them to do that, but the price that people are charged by a cable provider like Charter is way less than the utility that that cable provider is delivering them.

Bryan Lawrence (00:06:55):
What do I mean by that? Charter delivers every month to an average household 700 gigabytes of downloaded data. And when you look at what that means, if you define it in its most data-dense form, that’s a bit more than 100 hours a month of streaming 4K movies to a big television. If you defined it as data streams to the smaller screen, someone watching YouTube on a tablet or something, it’s a lot more than 100 hours a month. But if you just take the most data dance form, the $65 a month price of a Charter internet subscription works out to about 60 cents an hour for that streaming video. I just question someone complaining about their cable bill. What other form of entertainment is cheaper than 60 cents an hour? Are you really going to turn off your internet given how dependent we all have become on it? I think it’s delivering a ton of value despite the apparently high price.

Bryan Lawrence (00:07:54):
The second reason Charter is a great business, it operates in a very favorable industry structure. So in order to get high-speed internet, in order to get those 700 gigabytes of data a month, 35% of Charter’s customers have a choice effectively of a duopoly, either Charter or a fiber provider like Verizon. And the rest of Charter’s customers, in the 65%, the rest of their markets, have a single choice to get high-speed internet, Charter. They can in that 65% of markets also get internet over DSL, connections which are the old twisted copper pair wires that used to bring us our telephone connections, or from satellite service from geosynchronous satellites in orbit, both of those, DSL and satellite, have physical limitations we could get into which mean they don’t have the physical ability to provide that 700 gigabytes a month at high enough speeds allow all of the streaming that people need and want today.

Bryan Lawrence (00:08:56):
And so, DSL and satellite are slowly losing market share to Charter as people realize this. They especially began to realize this in the pandemic when everyone moved home and needed to work from home. So, Charter is a mix of a duopoly in 35% of its footprint and an emerging monopoly in 65% of its footprint. And so, Charter is a great business; two great reasons why it is. But that’s not enough for us to figure out. We also have to be able to buy it cheaply, and that requires investors to have a misconception.

Bryan Lawrence (00:09:28):
Now, a misconception happened four years ago. AT&T and Verizon started talking up the idea of 5G to get us all to buy new cell phones, and a big selling point of their marketing pitch was that you could use 5G to replace internet provided over a cable. You didn’t need that cable connection anymore. And with all of this talk about 5G making cable unnecessary, investors worried that Charter’s profits would be impacted, and so Charters’ share price fell. We saw Charter’s share price fall, and we did a lot of work on the physics and economics of the internet delivered by a cellular network rather than buying a cable network. And it turns out that delivering a byte of data across a cellular network is 70 times as expensive as delivering it across a cable network.

Bryan Lawrence (00:10:20):
And how do we know that? We know that the average Verizon or AT&T cellular customer is downloading about 10 gigabytes a month, which is 70 times less than the 700 gigabytes being downloaded by a cable customer. But, your cellular subscription costs about the same per month as your cable subscription, the same price, but 70 times fewer data. And this fact is why people so quickly ask for the Wi-Fi password when they show up at someone’s house for the first time or you check into a hotel. People immediately very quickly ask for the Wi-Fi password. And it’s a good thing that they do ask for that Wi-Fi password. Without Wi-Fi connected to the cable network, AT&T and Verizon would be quickly overwhelmed by demand 70 times what they’re currently experiencing. No one would be able to make a phone call.

Bryan Lawrence (00:11:13):
So once we figured out that Verizon and AT&T were in marketing mode and that the physics and economics of cellular internet were unattractive relative to the physics and economics of cable internet, we bought a lot of Charter stock. And we have done well as investors realized over time about the physics and the economics, and Charter’s share price recovered.

Stig Brodersen (00:11:36):
So, Bryan, I can’t help but look up how has Charter performed. You picked it up at a very good time. At the same time, we can also see that the share prices have declined from, say, 30% ish from the high in August last year. What are your thoughts on the business now and the stock price performance?

Bryan Lawrence (00:11:53):
A really interesting point because I think there’s another misconception today that’s depressing the share price that makes it arguably as attractive today as it was four years ago. Over the past year, there have been lots of announcements from AT&T and Verizon, and other smaller players that they will be building out more fiber, wired fiber internet connections to American homes. And if you add up the announcements from all of these players, the 35% of Charter’s footprint that currently has fiber as an alternative, by five years from now or seven years from now might be 75%. If you just take all the press releases and you add up fiber that’s going to be built.

Bryan Lawrence (00:12:30):
Investors, once again, are worried about Charter’s profits decreasing as it faces more competition. So we’ve done a lot of work to understand the physics and economics of a fiber network. The first point is there’s no effective difference. If you’re a cable internet subscriber or a fiber internet subscriber, you’re going to get the same amount of broadband. But running fiber past homes is very expensive. Thousands of dollars of upfront investment to connect each new customer. The fiber guys are going to have to spend. And we’ve looked at a lot of the fiber business plan. Some of them are public, and some of them are private. We’ve looked at a lot of them. Every plan that we see needs $75 a month of revenue to earn an acceptable return on that investment compared to the $65 that Charter is charging. And many of the plans justify their investment in their pitches to investors to raise all the capital to build all of these connections, many of the plans say not $75 a month, but $90 or even $100 a month.

Bryan Lawrence (00:13:28):
What we think is, if a market moves from being a monopoly to a duopoly where the new player is charging $90 a month, we don’t see any reason why Charter can’t raise its price to $90 a month if that’s what in fact happens. And if Charter charges $90 a month rather than $65, and it splits its footprint 50/50 with fiber everywhere there is a fiber player, the math that we do, at least, suggests that Charter’s cash flows as a result of this new competition will actually increase because $90 a month is a lot more than $65 a month when you have a network whose costs are largely fixed. So what investors worrying about Charter’s profits going forward are missing is that the fiber guys are going to have to charge more than Charter’s $65 a month in order to actually make all these press releases turn into investments with acceptable returns.

Bryan Lawrence (00:14:21):
The bear case on charter used to be, as 65% of its markets became monopolies, that ultimately there would be regulation to control its pricing. But if you have a duopoly, I think regulation is much less likely. A duopoly is much better than a monopoly if it’s rational. Less risk of a regulator imposing price controls. So it looks like a rational duopoly emerging between cable and fiber. And as icing on the cake, Stig, because Charter can deliver bytes of data 70 times cheaper than the cellular guys, it’s entered the cellular business. And it’s bundling cellular plans with its internet plans for one half the price; either using the Wi-Fi routers attached to the network, either your own or your neighbors or the one at work, to allow you to, for half the price, have cell service. Just take your existing cell phone into a Spectrum store.

Bryan Lawrence (00:15:08):
It looks to us that Charter will disrupt the cellular business with its more efficient network. So far three and a half million people have signed up for this service. We think about 100 million people are within Charter’s footprint. Those 55 million homes probably have 100 million people plus living in them. So maybe it’s three, three, and a half percent share. We think it might go to 50% share. 15, 20 years ago, they did something with landlines. We all used to have a phone from AT&T. 50% of American phones are now through the cable network. And you don’t pay $70 a month for it anymore, you pay $15 a month. So we’re not putting any value on this happening, but we’re watching it closely.

Bryan Lawrence (00:15:43):
With Charter today, we have a great business that we understand. We have an attractive valuation. It’s trading at an 8% free cash yield on 2022’s results, which is pretty attractive with the 10-year treasury at about 2%. That free cash is likely to grow 10% a year as the network grows and as they raise prices. We have an aligned management team buying back, lots of stock, and what is cheap, and we think that there’s a temporary misconception about making it cheap. And so, I’m glad you asked that question because I think Charter for a second time in four years is afflicted by the misconception that we think is temporary.

Stig Brodersen (00:16:14):
How do you generate your investment ideas?

Bryan Lawrence (00:16:17):
Well, we read a lot and we talk to other investors. As a result of the reading and as a result of looking at what other investors are doing, we find about 100 businesses a year that we go into in some detail. What we’re doing when we’re reviewing those 100 businesses is we’re trying to find great businesses that we can focus on.

Bryan Lawrence (00:16:36):
Why focus on great businesses? As I mentioned before, we define a great business as one that has durable cash flows. And there’re two advantages, two fundamental advantages of investing in a great business. It’s like that joke, it’s just as easy to fall in love with a rich woman, right? Why not fall in love with a durable business? Here are the two reasons why. The first one is if you invest in a durable business, it’s likely that its cash flows will not only persist, but if you’ve chosen right, they’ll increase. And that allows you to hold the business for a long period of time, which from a taxable perspective is very attractive. If you hold a business for longer than a year, you get long-term capital gains. If you hold a business for way longer than a year, we have two businesses at Oakcliff we’ve held for 10 years, and you never realize capital gains tax.

Bryan Lawrence (00:17:22):
The second reason durable cash flows are great is that durable cash flows are more predictable. And the predictability of cash flows is a big advantage to a stock picker because they make valuing those cash flows more certain. And having certainty about valuation is a big advantage given how volatile share prices are, how volatile are share prices? This has amazed me since I started the business. When I started Oakcliff in 2004, I was lucky enough to find myself in a room with Warren Buffett and two dozen other aspiring stock pickers. We were very happy to ask him lots of questions, which pretty much all boiled down to, “How do we get to be like you but faster.” He very nicely broke to us the bad news that stock picking was a long game, but he said, “I do have a piece of good news for you, the average stock goes up and down by 80% in a year. And that’s an enormous advantage if you actually take the time to understand the underlying business because the stock price is not reflecting underlying value if it’s going up and down by 80%.”

Bryan Lawrence (00:18:17):
I said to myself, “80% in a year, he’s got to be out of his mind. He’s Warren Buffett, but he’s lost his mind.” I went back to New York, and I did the calculations he was suggesting, which was to compare the 52-week high to the 52-week low for every stock in the stock market and compare the percentage difference between those two things. And when I did the calculations, maybe not surprising because he is the Sage of Omaha, he was right. You can use Bloomberg and a computer to crunch these numbers for the thousands of companies. It’s about 4,000 companies in the US stock market going back 20 years. And if you do it, we do it about once a year, the answer is as astonishing now as it was in 2004 when I started.

Bryan Lawrence (00:18:55):
During a calm year like 2019, the average US stock price goes up and down by 50%, 5-0%. And in a crisis year, like the dot-com crash, we had in 2000 or the 08/09 financial crisis or the pandemic we just had in 2020, by up to 200%. Buffett, by saying 80%, was basically averaging a calm and a crisis year. That 50% in a calm year is also a median, and in a median year where it’s 50%, you have many stocks that are bouncing up and down by 80%. There’s no way that the intrinsic value of the average business is going up and down by so much each year, and this is a big advantage for a stock picker who’s done the work.

Bryan Lawrence (00:19:33):
So what we spend all our time doing at Oakcliff is working to understand great businesses. We own 11 right now, there are several dozen others we’d like to own. We wait for their volatile share prices to give us an opportunity to buy at low prices. If you stopped by our offices, if you went out, it looks like a library. It’s like watching paint dry. A lot of reading going on, a lot of crosschecking, but we move very quickly, very quickly when we see a cheap price for a great business that we’ve done the work to understand. It happens infrequently, sometimes once a year, but we don’t need it to happen often to do very well.

Stig Brodersen (00:20:09):
It’s interesting that whenever I ask this question, the first thing you said was, “Well, we read a lot.” And I do hear that from very successful investors like yourself that that is where a lot of the idea-generating comes from. How about meeting up with fellow investors at Berkshire or VALUEx in Switzerland, is that a generator of ideas for you?

Bryan Lawrence (00:20:29):
You never know where the next idea is going to come from. Some of our better ideas have come from people who have already done the work, and we’re able to hear what they have to say and then go back and replicate the work ourselves. That can be a big help. One thing that I will say is that the number of people in the market who are really digging into the businesses, who really are immersing is lower than you would think it would be. So what we find is that the number of people who we, my partner, John and I, are happy to talk to about ideas, it might be a dozen people who have really done the work. But those people, when they call or when they come by, we’re very happy to talk to them.

Stig Brodersen (00:21:09):
Going back to your next step in your investment process, that is to do what you call deep research, where you review, call it, 10 to 15 of these annually. This is a very interesting step as it gives you the conviction In case you decide to build a position eventually, given that the price obviously is in a good play. You conduct a series of interviews throughout this step. Could you please elaborate on that and perhaps take us to the final step in your process?

Bryan Lawrence (00:21:36):
We look and we look. Maybe it’s 100 companies we go into in some detail. About a dozen times a year, we find something that really seems promising. When we find that, then we do something we call turning on the afterburners. We really accelerate our effort to try to understand it. And it kicks off a process that… I’ve never worked as a journalist, but I know a couple pretty well. It feels like investigative journalism. You immerse yourself in it. Your objective is to become the best-informed investor in the public markets about this particular business. What that means is you read as much as you can about the company, its public filings, and news stories going back many years. You read what management has said in its publicly-filed financial statements, what they’ve said on earnings calls, what they’ve said at conferences.

Bryan Lawrence (00:22:29):
You read that for years of history and you compare what management said was happening and was likely to happen to what actually happened. What you’re trying to gauge there is management’s own grasp on their business, management’s own relationship to conservatism, or maybe over-promising. You want someone who’s underpromising and overdelivering. And you do dozens of calls with customers, competitors, suppliers, and ex-employees. And after about a month of doing all of this, we say, “Okay, let’s try to put ourselves in management shoes. What are the good things about the business? What are the challenges facing the business?” And then we approach management and we try to get as high up in the company as we can. Quite often we’re able to get to the CEO. We say, “Look, this is what we think is happening with the business. We’re a long-term investor. What are we getting wrong?”

Bryan Lawrence (00:23:21):
Management usually likes it at that step. They like that we’ve taken the time to understand. A lot of investors have not. And we find that those conversations with management are really informative for us. If management doesn’t like talking to us, that’s kind of a bad sign, which probably leads to an uninvestable outcome. But anyway, after that, if the thesis is still holding water, if we’ve shot as many bullets at it as we can shoot, exposed it to as much pessimism and conservatism as we can, if the thesis still holds water, if we think we have a good answer to all five of our questions, then we project what we think is going to happen to the business operationally and financially out for the next five or 10 years. And we boil that down to what is going to happen to us, the shareholders, in terms of cash flow per share, and we discount those cash flows per share back to us here at today’s share price.

Bryan Lawrence (00:24:10):
And if the expected rate of return, if the IRR as a result of all that work is in excess of 20%, then we’re likely to buy stock. But when we buy stock, that’s like a signpost in the journey, the journey’s not over, especially once we own stock. We’ve got to keep learning. We’ve got to keep crosschecking. When we find something new, we’ve got to call up management and ask them. What we’re doing as we own the stock, and we are going to learn more about it as we own it, is we’re comparing the operating performance that we’re seeing to what we projected at the time we did that initial immersion. Are the surprises good ones or bad ones? They’re surprises in life, but is this a good surprise company or a bad surprise company? Have we made an analytical mistake? Is the business getting better or getting worse?

Bryan Lawrence (00:24:55):
Our IRR will move as we adjust those assumptions. As our assumptions increase the cash flows per share that we’re expecting, our IRR will go up. As our change in assumptions deep increases the cash flow per share, our IRR will go down. And of course, the share price moving will move the IRR as well. As the share price goes up, the IRR will go down. As the share price goes down, the IRR will go up. And if we get a big change in IRR, we’re likely to adjust the position. If it goes up, we’ll add. And if it goes down, we’ll subtract. If we conclude that we’ve made a mistake, if we conclude management’s not credible or has misled us if we conclude we got something really wrong, then we move very quickly to the exit.

Stig Brodersen (00:25:37):
I just want to clarify to the listeners and viewers out there if you’re watching this on YouTube, that whenever Bryan is talking about IRR, which is mentioned a few times, that’s the internal rate of return or can be received as you expect your return on this investment, whenever you make the discounting.

Stig Brodersen (00:25:52):
Oakcliff’s net return to clients has underperformed the S&P 500 at eight out of 18 years, and yet your returns to clients outperformed the S&P 500 over time. I just wanted to mention some of those numbers. I also said it in the introduction before we kicked off this interview, Bryan, but I just can’t help but mention it because you’re too polite for you to say it yourself. But the S&P 500 with exception of Oakcliff Capital was 494.2% for the S&P 500, and net of fees is 718.3%. So, I mean, this is just an amazing track record. So bravo. You managed that impressive track record and at the same time, you underperformed the S&P 500 eight out of 18 years. I’m curious to hear your thoughts on that.

Bryan Lawrence (00:26:37):
Well, thank you, Stig. But we have had periods of underperformance, and those periods of underperformance have lasted for a year or more. This is not surprising. Warren Buffett gave a speech in 1984 about the super investors of Graham-and-Doddsville, which I would encourage your listeners to go find on the internet if they haven’t already. Just Google super investors of Graham-and-Doddsville and read Buffet’s speech and then the response by a professor at Columbia Business School, where he gave the speech. There are a couple of really interesting conclusions that can be drawn from that speech, basically, every concentrated value investor will underperform the market on an annual basis 30 to 40% of the time. It jumps out of the data. And this is data as of 1984, but you can carry this data forward and you’ll find it to be true.

Bryan Lawrence (00:27:29):
I think it’s an iron rule of underperformance. Joel Greenblatt talks about it. Warren Buffett talks about it. Here’s some data which is just fascinating. If you look at Berkshire Hathaway itself, okay, which is run by the patron saint himself, Warren Buffett, Warren has controlled Berkshire Hathaway for 57 years now, going back to 1965, and Berkshire Hathaway has underperformed the S&P 18 of those 57 years or 32% of the time. There’s that iron rule, 30 to 40%. You could say, “Oh, is that a function of the fact that he’s managing more and more money, making it more and more difficult for himself?” The answer would be no, because if you look at the first 25 years that he controlled Berkshire Hathaway, 1965 to 1990, he underperformed nine of those 25 years or 36% of the time.

Bryan Lawrence (00:28:21):
I think this is a reason why concentrated value investing, while it delivers great long-term results if it’s being done by people who actually have the ability and the temperament to handle it, why a lot of people kind of lose faith with it because you will find every practitioner of it having these periods of underperformance.

Stig Brodersen (00:28:42):
Bryan, what do you think your competitive edge is as an investor?

Bryan Lawrence (00:28:47):
It’s a really good question. I think it’s important for an investor to know what his or her edge is. If you don’t know what your edge is, you’re like the guy at the poker table who does not know who the patsy is. I think there are three sources of competitive edge. One is analytical, one is informational, and the last one is structural. Analytical, basically, can you analyze companies better, more smartly than other people? I don’t think that’s a source of edge for us at least. I mean, I think we’re smart, but I don’t want to claim that we’re smarter than… There are a lot of smart people in the market. Informational edge, I think we have a little bit of an informational edge because we have a strategy that concentrates on a small number of companies. We can, by just dent of spending more time on each business, get more informed than other investors. If we own 11 things and we’re competing with a mutual fund manager who owns 185 things, we’re just going to, by dent of being able to spend more than 10 times as much time on each one, we’re going to glean more information. So I think we do have something of an informational edge.

Bryan Lawrence (00:30:06):
I think our main edge is structural. What we have is patient capital, and patient capital allows us to have a long-term time horizon. What do I mean by patient capital? We have deliberately structured our firm to make our capital very patient. 22% of our money is ours, meaning the people on this floor who are making the decisions. And we have a lot of confidence in our work because it’s our work. The 78% that is not our money, that’s our client’s money, we have been very intentional about saying to them, “This is a game you should expect periods of underperformance. If we send you a letter showing disappointing returns either in absolute terms or relative to the market, that’s just part of the game.”

Bryan Lawrence (00:30:53):
An investor with impatient capital might not want to own Charter for fear of more news stories next month about people building more fiber. We call that headline risk. It might drive the price of Charter down as people worry about more of these news releases from the fiber overbuilders. Those news stories might drive Charter’s price down, and the investor with impatient capital would have to explain his poor short-term performance to his impatient clients. It might cause some of them to pull their money.

Bryan Lawrence (00:31:20):
We, on the other hand, because we’re confident in our patient capital might take the opportunity that Charter’s presenting us with a lower share price to actually buy more because we have confidence in the physics and economics that we’ve studied. Physics and economics may take longer to emerge than a bunch of PR from fiber overbuilders trying to raise capital. And so, having patient capital is a way to ride through that. There is much less competition waiting for the laws of economics and physics to be revealed over the long term than there is competing with investors worrying about next month’s news stories.

Bryan Lawrence (00:31:55):
A lot of firms claim to have a long-term focus, but they don’t have the patient capital that actually allows it. But a consequence of betting on these things where we think there’s short-term uncertainty and maybe share price softens and long-term share price strength is that we’re likely to have periods of underperformance in the short term. I think this paradox that underperformance a bunch of the time is the way that you get outperformance over the long term is why, an estimate I’ve seen, just 1% of the money, 1% of the money invested in the stock market is invested using concentrated value. And when you tumble through those numbers, the funny thing is that 40% of that 1% is invested by Warren Buffett.

Bryan Lawrence (00:32:38):
I find the fact that this demonstrably superior strategy is rejected by 99% of people, despite the fact that there’s so much evidence. Because it isn’t just Buffett, it’s lots of others, whether it’s Bill Miller, Eddie Lampard, the Tishes, or Bill Ackman. Concentration makes a lot of sense, except for it creates some underperformance issues that people don’t want to deal with.

Stig Brodersen (00:33:02):
Shifting gears here. One thing I’m struggling with is to reduce my position once I build a full position, and to me, that’s 10%. Here I don’t refer to not being able to hold onto the position if it’s suddenly 20% or even 30%, but rather that I tend to believe in stock or I don’t. So if the stock is near intrinsic value, I will consider selling a position. In other words, I’m naturally biased to a quite binary approach, if you like. I’m not the person who would limit my exposure from, say, 8%. Now I have to lower it to 5% because let’s say I still believe in the stock, but I have a lower conviction. Is to me is if I don’t have full conviction, I should be out of the stock. I’m curious to hear what you think about reducing your exposure.

Bryan Lawrence (00:33:52):
It’s decision-making in uncertainty, right? So you think about your position size relative to the IRR, the expected return. There’s no one right answer. I guess I have a couple of thoughts on it. First one, let’s say you do all this work and you get a conviction and you make something a 10% position, which would be for us a very full position, lot of conviction, and we’ve got an expected IRR of 20% and we’re very that we’ve made this investment. And then we’re even happier because the share price goes up by 80%. And let’s say that nothing’s changed about our underlying assumptions, the cash flows that we expect are still the same. We now have not a 10% position with an expected IRR of 20%. We now have an 18% position with an expected IRR of 10&. Julian Robertson used to say, “Every day you don’t sell a stock is another day you decide to buy it.” Right?

Bryan Lawrence (00:34:49):
So you have to ask yourself if you did all that work and you saw a 10% IRR as your expected result, would you make it an 18% position? And the answer is, of course, you wouldn’t. You might make it a 4% position, right? And so, there’d be a lot of pressure, I think. Borrowing some other factor, which I’m not quite sure about, maybe you’re going to learn something more about the business, but I think if something goes up that much and has no underlying change in what you expect it will do for you in terms of cash flow, there’s going to be enormous pressure to sell it.

Bryan Lawrence (00:35:24):
I think the second thought is that position size also has a psychological impact. What do I mean by that? Let’s say you have a position, you do a ton of work, and you make it a 10% position, and you got confidence it’s going to give you this great 20% return, and it goes up. You now have a dangerous situation psychologically, unless you’re thinking about it. Because when an idea has made you money after doing hard work, there are a number of psychological biases that come into place that will make you like that idea more. It’s very easy and quite dangerous to fall in love with a successful idea, especially because every day that you don’t sell a stock is another day you’re agreeing to buy it. It’s very important in the investment business when you’re investing with uncertainty and you’re constantly trying to add to your information base to always be looking for disconfirming evidence. That’s the most important type of evidence there is fair. Very important to figure out why you might be wrong. Come to work each day with a healthy dose of skepticism about what you believe deeply.

Bryan Lawrence (00:36:25):
It’s harder to do this. It’s harder to accept disconfirming evidence when something has made you a lot of money. There’s this saying that the human mind is a lot like the human egg; once impregnated with an idea, it’s hard to get another idea in. I think that’s particularly true when it’s been impregnated by an idea that’s worked. It’s so great to look at that name in your portfolio and think about all the happiness that it’s brought to you. Charlie Munger’s got this expression, a successful day for him is one in which he’s learned something new. But a super successful day is one in which he’s unlearned something dear to him. So I think the psychology of an increased position is such that you should subject it to extra scrutiny. And of course, there’s the counter that if it’s been a good surprise company and they’re presenting with good surprises, then you want to keep owning it. But you have to double down on your work if something’s made you a lot of money and underwrite it.

Stig Brodersen (00:37:13):
I can’t help but quote Max Planck, the Nobel Prize winner who said that science advances one funeral at a time. He was talking about how difficult it is just to relinquish your ideas. He made all his progressive work when he was young. And as he got older, he talked about how it was ironic that he was now one of those authorities that he always stood up to and how he had so many problems. It was so difficult for him to continue his journey as a scientist as he got older because now he “knew the truth”. And he knew the truth that he didn’t know the truth, but it was so hard for him to get out of because he had worked for so long. He didn’t have the open mind that he used to have.

Bryan Lawrence (00:37:55):
The Structure of Scientific Revolutions is a terrific book. It talks about paradigm shifts, that there’ll be an area of accepted science and then there’ll be challenges, and the challengers are laughed at or not given tenure or whatever, but then suddenly there’s a paradigm shift. I think that’s exactly right. People don’t want to give up their best-loved ideas. I think that physicists have their best ideas before the age of 25 or 30, and then spend the rest of their lives talking about them, pounding them in. Einstein spent the back half of his life trying to disprove all this other stuff that was coming in questioning his theories. It’s very powerful, and you have to fight against it as an investor. I think there are some clear human bugs or features in the human brain that are being demonstrated in the field of physics that I think also come to play in the field of economics. You’ve got to constantly challenge your assumptions.

Stig Brodersen (00:38:45):
So true. Just one quick book recommendation before we go back and talk about investing here. Walter Isaacson’s book on Einstein is just a fabulous book. So I just want to leave it at that and then move on here in the outline. I’ve been very excited about asking you this question. Who would you choose to manage 10 or 100% of your personal portfolio respectively if you couldn’t choose yourself?

Bryan Lawrence (00:39:11):
100%, I don’t think there’s anyone I would give 100% of my money to. Maybe if that were the only alternative, I’d say, I have such respect for the culture of Berkshire Hathaway, just put it all into Berkshire stock and you get this diversified group of businesses with a great culture and a ton of cash, and that might be the answer. If Oakcliff didn’t exist, there’s a shortlist of money managers I would trust with my family’s money. It’s basically those dozen people. I know them all. I know some of them better than others. Some of them are good friends. I don’t want to name names, they’re all talented and honest people with great track records. All of them practice concentrated value investing, which is obviously a strategy I believe in. So I think I’d advise that my family hold back some amount in cash for living expenses and allocate, I don’t know, 10 or 15% to each one of those investors, if they were actually open to new investment at the time, which many of them are not.

Bryan Lawrence (00:40:04):
All of them invest in inequities. Some of them focus in the US, some of them focus in non-US, but they’re all coming from this place where they’re sort of obsessive about businesses. This is what they do, and they enjoy it. It seems very clear to me that they’ll do it for a long time. That would be my answer.

Stig Brodersen (00:40:22):
One of the reasons why I’m asking you this question is… I don’t know if you experience the same thing, Bryan, but I’m often asked this whenever I’m at a dinner party or whatnot, “Who should I invest with?” And then they say, “And by the way, I want a high stable return, and I don’t want any downside risk.” I won’t ask you to answer that question because the premise is completely wrong. But rather I would like to ask you the question that comes before. How does the individual investor identify the right asset manager for him or her?

Bryan Lawrence (00:40:53):
There’s a lot in this question. There’s a book that came out, I think it was last year, The Psychology of Money, which is so interesting on this. I think you’ve interviewed the author. I just love that book. I’m trying to get all my children to read it. I’m offering to pay them a small sum if they write me a book report on it, I thought it was so good. And the question you’re really asking I think is about psychology and expectations. Look, of course, people want high and stable returns. Bernie Madoff managed to raise $60 billion promising a happy combination. We know how that turned out. And of course, it’s impossible to achieve, at least in the stock market. The irony is that volatility in the stock market, which we were talking about before, is actually increased by people not being able to realize this impossible dream. When prices go up, there’s something in human nature that causes people to fear missing out and people buy rising share prices, and prices fall, human nature causes people to fear more loss and they sell stocks that are falling.

Bryan Lawrence (00:41:50):
And this activity, buying high and selling low, which is what it boils down to, is a bad feedback loop that magnifies volatility in the stock market. People manage these fears by not just buying stocks high and selling stocks low, they hire outperforming managers and fire underperforming managers. I guess one way I would answer your question is people should think about that. If you go look at the work that a firm called DALBAR has done on this psychologically-driven, fear-driven activity of chasing the hot performing managers and firing the underperforming managers, the impact of that is a 4% point annual reduction in the returns that most people realize, and 4% points out over a long period of time, let’s say 30 years until someone’s retirement, is a big number. That’s like a 70% reduction.

Bryan Lawrence (00:42:40):
The best thing for individual investors to do is to find a strategy that makes sense for them and then make as few changes as possible, just trying to ride through the stresses. And it’s hard, but I would try to ride through it. I think my answer to your question, “What can an individual investor do?” Depends on their individual psychology. I think one answer that probably works for many, if not most people, is to own a mix of index funds in cash, which will reduce volatility because you’re diversified out into owning the broad stock market, and it will drive your fees down. I think another strategy would be to pursue the only strategy that I personally think can have a chance of beating the market, which is concentrated value investing. But only 1% of the money is managed this way, so you want to be very careful about the manager you choose or the managers, multiple managers you choose, and you want to be very thoughtful about choosing that person.

Bryan Lawrence (00:43:36):
I think there are some questions that you should be asking. You should be asking a manager, “What is your long-term performance? Are you talented or just lucky?” I mean, it’s an impertinent, impolite question, but it’s your money, so you should ask this question. I mean, this is the math of it. If you give 100 kindergartners coins to flip and you ask them to flip five heads in a row, three of them will flip five heads in a row. And if they’re money managers, they’ll tell you they have a great five-year track record, but they’re just coin flippers, right? I think you need to see longer and you need to get into why has this happened? What is actually happening?

Bryan Lawrence (00:44:14):
Second question, are they aligned? Do they have their own money up in this? Or are they trying to raise a lot of money to charge a lot of fees? And then I think a final question is, what is their strategy for dealing with the volatility that’s going to result from concentrating their portfolio? They will deliver. Definitively they will deliver more volatility than the market. What’s their strategy to profit from that, and what’s their strategy to help you, their client, deal with them? Is it communication? Is it a lockup? Is it something? So I hope that’s answering your question, but that’s the advice that I would give.

Stig Brodersen (00:44:49):
It is definitely answering my question. I have selfish reasons to ask this because I actually invested with a fund manager here not long ago. This was the first time in my life I invested. I interviewed hundreds of investors this year or the past eight years, and one investor made it through. I asked a bunch of questions, so I couldn’t help but ask you which questions you would ask.

Stig Brodersen (00:45:14):
The reason why I wanted to mention that… Please, to the audience, before you bombard me with who that person is, I’m going to do an episode about it here not too long from now. But I have a bunch of questions about fees, and funds that come here. So I just wanted to make that clear to people if you’re like, “You’re never really talking too much about out that on the show,” it probably comes from a selfish perspective here.

Stig Brodersen (00:45:35):
But going back to you here, Bryan, your fund, Oakcliff Capital, charges 1% plus 20% over a watermark of 6% performance. My point of the question is not to discuss or debate in any kind of way whether the fee is correct or not, but more about how you think about optimally aligning interest between fund managers and clients. For example, if you’re solely paid on the asset under management, or OMs as it’s often called, to some extent it incentivizes the fund manager to become more like a marketing company, just focus on expanding that OM. Then, if you’re on the other hand compensating on performance only, especially depending on how you define the watermark, you have a short-term incentive to be even more concentrated because it increases portfolio volatility. So going back to the original question, how can a fund manager optimally align interests with clients?

Bryan Lawrence (00:46:30):
There are a lot of misaligned incentives at many investment funds. For sure, that’s a problem. You’re right to ask questions about it. And of course, you can dispense a lot with the misaligned incentives by owning an index fund, and I think you might pay 10, 12, or 15 basis points in order to invest in an index fund. But that’s a low price, but it’s also the price that gets you average performance. And so, the question is, if you’re paying more than 10 or 12 or 15 basis points, are you getting better than average performance? But I think breaking that down a bit, you want to see management fees that are charged regardless of performance being spent on research that improves performance, right? That should be a foundational point. And you want to see investment managers make money only when their clients make money.

Bryan Lawrence (00:47:22):
At Oakcliff, our management fees have never been a profit center for us. Our research effort is expensive. There’s a lot of talking to experts. There are a lot of research services we use. There’s a fair bit of travel, and there are some modest salaries for us. That’s what our 1% fee has paid for overtime. As we grow either through compounding or as we grow as people give us more money, we are not going to let management fees become a profit center. We’re likely to reduce our 1% fee as a percentage of assets for all of our clients in order to share the benefits of increased assets with everybody. We’re not quite to that point yet, but that will come in the future.

Bryan Lawrence (00:48:01):
Other than modest salaries, we do not make money from a management fee. We make our money in two ways. The first one is the return on our capital, and the second one is the performance fee of 20% of profits over a 6% hurdle rate. And the way the math works, given how much money we all have up personally, just taking myself as an example, and we’ve done about 16% gross, 16% annualized returns before fees gross since its inception, if we had a 15% year and you look at how my profits are derived, my profits personally from doing all of this work, 75% of those profits in a 15% year we’d be the return on my capital. No fees charged to anyone, right?

Bryan Lawrence (00:48:48):
And so, I like the alignment at Oakcliff because we’ve got a lot of money up. When our clients make money, I make money. Now, as for our fees, here’s how to think about them. We think about this a lot. From inception through the end of 2021, Oakcliff has generated an annual return of about 16% points annualized before fees, and about 13 percentage points annualized net of all fees and expenses, compared to about 10% for the US stock market. Depends on how you define it, big companies, small companies, about 10%. So we’re very proud of this outperformance. I want to point out two things about it. Our 6% points of outperformance before fees, 16% compared to 10%, has been split between 3% points of outperformance for our clients and 3% points of fees to us. So 3% is 300 basis points. That’s a lot more than 12 basis points for an index fund, but performance has been well above average, right? You could pay lower fees to an index fund, but you wouldn’t have the outperformance.

Bryan Lawrence (00:49:45):
And the second thing I’ll say is that our outperformance has been achieved while holding an average of 16% cash as measured as the cash balance at the end of each year. And holding so much cash, which effectively in an age of low-interest rates, that cash has been returning very little in terms of return to us the partnership, it’s reduced our risk and it’s kept powder drive for market downturns. This really is our money. We’ve got a lot of client money up, but the money up that’s ours is a big percentage of our net worth. We are never going to put ourselves in a position where leverage gets us in trouble. And in a financial crisis, which seems to happen every so often, we have pandemics and housing crises and wars, we want to be the guys with ready cash buying things cheaply from other investors who have weaker hands. There’s a great expression. Ben Franklin was asked, “What do you want in a financial crisis?” And he said, “Three things. I want a loyal wife, I want a loyal dog, and I want ready cash.” And so we want to be that guy.

Stig Brodersen (00:50:50):
I just want to mention that your wife is also a friend of the podcast, that we had on Jillian. It was one of the first guests we have, I want to say because I remember it vividly. Preston and I just started out. We realized after the interview that the recorder didn’t work. I can’t remember exactly what went wrong, but it’s the only time in eight years that we simply ended the interview like, “Oh, we didn’t record it right, or something like that.” It’s just one big button. I have a really hard time seeing how you can push one button wrong. We actually called up Jillian and were like, “Could you please do the exact same thing again tomorrow?” She was very, very nice and is like, “Yeah, you can do that, guys.” I just want to mention that side story.

Bryan Lawrence (00:51:28):
That’s such a great story. It’s one of her favorite stories. She’s such a big fan of yours. She’s told that story, and my question is always, “Were you better the second time?”

Stig Brodersen (00:51:38):
I think Jillian would be out at the meeting together with you, at the Berkshire meeting. Other than being your wife, she’s also a brilliant writer. [crosstalk 00:51:46]-

Bryan Lawrence (00:51:46):
Yeah, Warren does this thing every year where he asks people who have written books that he likes to be in the stadium selling books. And so, Jillian’s going to be there selling books. It’s a bit competitive. She feels if she doesn’t sell enough books she’ll disappoint Warren. Just go find her, and she’ll do her best to sell you a book, and I suspect she might succeed. She’s very good at it.

Stig Brodersen (00:52:09):
Yes. So it’s good that we just gave it a plug. Please feel free, Bryan, just to talk for a minute about one of her books. She’s a wonderful writer.

Bryan Lawrence (00:52:19):
The things in New York that make New York New York are the people. She does a great job at capturing some of these personalities. And then getting there are 30 people she interviewed who have risen to the top of their game, including Warren Buffett, Michael Bloomberg, Sarah Blakely, and Kathy Ireland, and of them, she photographed them, interviewed them, and asks them about the tough times they had in life. The theme of the book is that no one who has gone up into the right, no one who has gotten there has not had tough times. And it’s really how you handle the tough times and what you learn from them that is really interesting. Maybe she’ll be selling both books, but that’s the book she’ll probably be selling in the convention center.

Stig Brodersen (00:53:00):
Wonderful. Yeah.

Bryan Lawrence (00:53:01):
You can get it on Amazon. This is a good plug, she’s going to be very pleased with me.

Stig Brodersen (00:53:04):
Perfect. Perfect. So let’s talk about one of those people who are lucky enough to be in her book, Warren Buffett. Warren Buffett has long talked about how the sheer size of his assets is causing a drag on his performance. During the last filing, we saw that the equity portfolio is 350 billion. And as a manager, you on one hand would like to show great returns, which everything else is easier with a smaller AOM, but you also maximize your company revenue, which is that’s another thing you want to do which is easier, everything else equal there, bigger AOM, because it also allows you to take some of that revenue and put it into more extensive research, which is very difficult to do if you’re sitting with $10,000. So, this might be a more philosophical question than specific math, but Bryan, is there such a thing as an “optimal fund size” for an asset manager?

Bryan Lawrence (00:54:02):
A 1% fee on them is basically now paying for the research effort, and there is more stuff that you could add to the research effort. So I think in order to have a fully-fledged, deep research concentrated value investing operation, I think you need a couple of $100 million of assets as a minimum. You can find ways to do it for less, but I think that’s a good, solid number. So that’s an economy of scale. The diseconomy of scale that starts to happen as you go from, let’s say, the hundreds of millions of dollars to the billions of dollars is this: imagine that you have a $5 billion fund, and concentrated value is your strategy, and you’re trying to put out 10% positions. So you’re trying to put out 500 million and you want to invest in publicly traded companies, which has been your strategy to get to the five billion, and you don’t want to have too many liquidity issues, and you don’t want to have regulatory problems, which start to occur when you buy more than 5% of a company, we can go into what those are, but do you want to be less than 5% of each of these companies, 500 million, less than 5% position in them in each company means a 10 billion equity market capitalization for the companies that you are investing in. 500 million is 5% of 10 billion.

Bryan Lawrence (00:55:27):
If you look at the US stock market, there are about a little under 4,000 companies. And the number of companies that have more than 10 billion of equity market capitalization is about 470. So you’re looking at about 12% of the companies actually are 10 billion and above. And so, for a $5 billion concentrated value investor is opportunity set is 12% of a smaller firm, right? So it’s in theory eight times harder to find ideas. That’s why I think $5 billion is a bit of a breakpoint for concentrated values of strategy. I think as firms have hit that, as their track record tracks more assets, as they compound the capital, I think you see a couple of things start to happen. The first is returns start to decline because their opportunity set is lower. The second thing, you sometimes see strategy shift, where they say, “Well, we’re not finding enough opportunities buying 5% of publicly traded companies. What we need to buy is 100% of companies. We need to take them private. Let’s develop some way to have permanent capital. Let’s start an insurance business. Let’s raise money in some sort of vehicle that can take companies private or whatever.”

Bryan Lawrence (00:56:45):
And the other thing that you start to see is, that at $5 billion as returns start to fall, a decision might be made by the money manager to return client capital and become a family office. And therefore, you now have enough scale as a family office to have those research efforts, but you get rid of the client capital that’s reducing your returns. I think we’re at about 270 million right now. I think we have the resources to do good research and we’ve got a big opportunity set. I think we’re well-positioned for the next 20 years, but you’re asking a really good question about the declining value, the declining returns to scale. I think by about five billion they’re very evident.

Stig Brodersen (00:57:24):
Staying in the same train of thought, how can we evaluate the skillset of a fund manager and the same time factor in the size of his or her portfolio?

Bryan Lawrence (00:57:33):
I think there are a couple of things in there. If he’s a fund manager who was small and has gotten big, you have to be thoughtful about it because maybe the skills that we’re able to make him money when he had a small pool of capital might not be the skills that he needs when he’s got a big pool of capital. Like, was he a specialist in smaller companies? Companies that are small now and he can’t find ways to put the amount of money that he’s now managing in them. Is there evidence that he or she has been able to transition the skills and change strategies now managing more money? I guess I’m answering your question about someone who’s gotten larger. Buffett’s genius is, “Oh, okay, my partnership is so large now. I’m actually going to buy a textile company and start an insurance business and start not only picking stocks but buying entire businesses.” The skillset for owning, let’s say, all of Burlington Northern is different than I own 2% of Burlington Northern, and if I decide that I want to, I can sell it next Tuesday. That’s a different set of skills.

Bryan Lawrence (00:58:37):
But if someone’s very small, do they have the resources to actually get the good research insights? If someone’s very large, is their opportunity set too small, or if they change their skillset to actually put that capital to work?

Stig Brodersen (00:58:51):
Bryan, in doing research for this interview, I had the privilege of reading through your letters to shareholders. There is one quote that I absolutely love on page two, and says, “To us owning 10-year treasuries yielding 1.8% with inflation running at 7% seems like a return-free risk.” Absolutely love that quote. That makes me consider how we as equity investors should factor in inflation whenever we analyze stocks. Perhaps we could go through a case study with Carvana, which is a vertical integrated online platform for buying and selling cars that’s 8% of your portfolio, or it could also be other case studies, including Transdigm, Guidewire, Charter, whatever direction you want to go. But I’m curious to hear that inflation piece and how you think that into your own portfolio.

Bryan Lawrence (00:59:41):
Yeah, it’s a great question. Everyone’s got to focus on it. And of course, when we wrote that letter in January, we didn’t yet have the war in Ukraine and higher energy prices. Inflation seems like it’s going to be with us for a while. All of us have to get used to more inflation. What we’re doing is thinking hard about whether or not the businesses that we own will do well in inflation. In general terms, a business will do well in inflation if it adds value to its customers well in excess of the price that it charges them. So in other words, there’s room to raise prices relative to the value that customers are experiencing or the alternatives that they have. A business will do well in inflation if it can raise prices to customers faster than the costs that it’s presented with by its suppliers. You have to outrun inflation.

Bryan Lawrence (01:00:33):
And also, it’s very favorable to already own the infrastructure that you need. If you’ve got a reinvest in dollars that are getting ever more inflated in order to stay in business, that’s much less attractive than if you already have the infrastructure and can just have prices rise and not have to reinvest. We’re judging every business we have against those tests. Here are some examples. At Charter, we were talking about that before, that’s the kit company facing the fiber new entrance, they’re charging 60 cents an hour for high def television. If they said to you, “It’s going to be 70 cents an hour,” would you really cut your cable internet bill? I mean, I know you’ve got to pay a little bit extra for Netflix and Amazon Prime, but would you really turn off your internet? How is your life going to work without your internet, especially if you have teenage children in the house?

Bryan Lawrence (01:01:26):
Let’s say you’re running your business from home. If they said 70 cents rather than 60 cents, are you really going to cut it, especially when the competitors need to charge way more than 60 cents an hour to build their competing networks? Also, the interesting thing about Charter is their network is already built. They have already passed 55 million homes. The fiber guys who are coming, who are going to build tens of millions of passings, now have to compete with each other to find workers and to find fiber and to pay diesel for all the bulldozers that are going to dig up the streets. I would much rather have Charter’s infrastructure in place and its ability to raise prices in inflation than the fiber guys having to invest with inflated cost inputs into building their infrastructure at Denovo.

Bryan Lawrence (01:02:12):
Another example is Transdigm. This is a company we own. It supplies parts to airplanes that fly commercially or fly militarily. These are small-dollar value parts. The average price is $2,000 or less. An example, they have an 80% plus share of the seatbelts on jetliners. If you look down, your seatbelt will say AmSafe on it. That’s a Transdigm company. A $300 seatbelt on a $100 million airline, and they are the sole supplier for 90% of what they sell. They have FAA approval on the equivalents in Europe and Asia. So you can’t, if you’re Delta or United Airlines, put a seatbelt in place that’s not an AmSafe seatbelt without spending millions of dollars getting FAA approval, and in practice, they don’t.

Bryan Lawrence (01:02:57):
And so, the total cost of what Transdigm charges, it’s like the little valves, like when you see the flaps come down in the wings, it’s the hydraulic valves delivering power to make the flaps go down, like a $1,500 part without which a $100 million airplane cannot fly. The total cost of what Transdigm charges are 0.3% of airline revenues. If they said to airlines, “It’s going to be 0.33%,” I mean, what are the airlines going to do? Right? That’s pricing power.

Bryan Lawrence (01:03:28):
Another one is Guidewire. I mentioned it before in your first question. It provides software that allows insurance companies to operate. It’s a duopoly. There’s another provider called Duck Creek, and then there are some smaller guys who really have a more marginal market presence. Every insurer is going to transition its software from this old COBOL stuff that they wrote in the sixties to either Guidewire or Duck Creek. And they are charging 0.5% of insurer revenues in order to allow all the claims, all the policy formulation, all the billing system, everything is run by these guys.

Bryan Lawrence (01:04:04):
Two things about that: their contracts say, “We get from you Mr. Insurer, 0.5% of your revenues.” Well, the insurer’s revenues are going up with inflation, so automatically they participate, their prices go up. And then if they said to the insurer, “You know what? I think next year it used to be 0.55% of revenues,” what is the insurer going to do? So subjecting each one of our businesses to that kind of question, “Is it really a great business with the ability to price in excessive inflation? Do they already have the infrastructure that they need?” Invert the problem, let’s talk about the other side of it. Let’s imagine you are an automaker. It could be General Motors, it could be Volkswagen, it could be Ford, it could be Chrysler. Those guys, for every car that they sell or SUV or pickup truck or whatever, you need a new model every five years. To do that new model and make it exciting so that you get customer acceptance, you’ve got to design it and you’ve got to put in new parts for it.

Bryan Lawrence (01:05:07):
Okay, all of that design and all of that refurbishing of the plant to make that new model has to happen in inflated cost dollars. Okay? The infrastructure needs to be renewed every five years. And then when they go to charge whatever they’re going to charge, like $40,000 for this car, it’s very unclear that they’re going to be able to pass through the increased cost of steel, increased cost of labor, the increased cost of energy, natural gas and electricity they use to run these factories. It’s very unclear to me if you have an 8% share or 12% share of the US auto market, and there are seven or 10 other people you’re competing with, do you really have the ability to pass through your costs? And if you look back at how the automakers did in the 1970s when we had inflation, it was not a pretty picture at all.

Bryan Lawrence (01:05:55):
So you just have to be very careful with your businesses. I think if you select the right business, it’s a lot better than owning cash, and I think the idea of owning government debt yielding, let’s say, 2%, the 10 years it’s come up a little bit since we wrote that letter as 1.8%, it’s now in excess of 2%. But the idea of owning a 10-year paper with a 2% coupon when inflation is running north of 8%, I mean, it’s like a certificate of confiscation. It just doesn’t make any sense.

Stig Brodersen (01:06:24):
Well said, Bryan. Let’s continue talking about cash. In March 2020, whenever we had this massive COVID crash in the markets, you invested 12% of your capital in businesses you already own. This was something that really impressed me. From that, you had a 132% gain. Just going to say that again, 132% gain to show the end of the year. It really makes me think about the right level of cash to hold. Because one thing you also said in your letter and you mentioned earlier here today is that you have had an average of 16% in cash since the inception of the funds you’re managing. I just find that fascinating. Because as investors, we know that we should hold enough cash to take advantage of big crashes as we saw with COVID, but on the other hand, we also know that it’s an expensive thing to do in opportunity cost to try and “time the market” and not to be fully invested. So how do you balance that?

Bryan Lawrence (01:07:26):
Yes. Part of the answer is the psychology of money, which I guess I’ll talk about in a bit, but part of it is also the opportunity and the nature of the business that we’re doing. Let me talk about, I guess, the opportunity and the nature of our business. Measured at the end of each year, we’ve held 16% cash on average. But that’s an average, and our cash balance has gone much lower at times.

Bryan Lawrence (01:07:52):
In October of 2008, we took cash to zero. Turns out the market bottomed five months later. But what was happening was as the market was going down, the expected IRR on things that we owned and wanted to own was going up. And we said, “Right, we’re 0% cash.” We were early, but ultimately we had a very good 2009. You can see in our numbers. In March of 2020, we went into the pandemic. In February of 2020, the expected IRR on what we owned was in the high teens, which was consistent with our historical results. That’s kind of what we’ve delivered over time. And 21 days later, the fastest drop ever, the expected IRR on what we owned was in the mid-twenties. It just… Wow.

Bryan Lawrence (01:08:42):
So we just started buying what we owned. We didn’t have time to research new stuff. We were just buying what we owned. John and I said to each other, “The market’s down about 30%. The market goes down to 40%, we’ll get to 0% cash.” We didn’t know when it would stop, but if it’d gone down another 10%, we would’ve committed all the cash. So this question of, do you own cash or do you own stock? Really, for us depends on what’s the expected IRR on what we could turn the cash into, but importantly, Stig, it’s, what’s the expected IRR on what we might be able to find next week? It’s a little bit like you’re at your high school prom and there’s an auditorium filled with possible partners and you’re told, “Find your marriage partner in this high school ballroom.” Okay, well what about all the other parties you’ll go to? Do you really want to commit now?

Bryan Lawrence (01:09:39):
The value of what we know about businesses, all of this work, watching the paint dry, like reading, reading, the 11 things we own and the several dozen other things that we would like to own, the value of what we know about those businesses goes up in a downturn. Maybe this is a psychology of money, we want to have the cash to take advantage of that. We want to have the ability when everyone else is panicking to lean in.

Stig Brodersen (01:10:05):
Going back to the discussion about the right level of cash, this is something I spoke with Mohnish Pabrai about here on the show. And he said that he previously considered holding a conventional passive index like the S&P 500 or Russell’s 2000, whatever that might be. We even talked about Berkshire Hathaway’s Shares to mitigate the opportunity cost of being in cash, but he still found that the optionality of cash outweighed that. I’ll be curious to know if you hold cash differently than just in the bank account. Do you have short-duration treasuries? And whenever you say cash, what are you specifically referring to?

Bryan Lawrence (01:10:46):
Yes. In the financial crisis, there were forms of cash that turned out not to be cash, which was really eye-opening. So we define cash very carefully. We say cash in our letters, but cash for us is one of two things. It’s either money market funds at JP Morgan where we custody all of our assets, in their private bank, which has a whole bunch of reasons we keep our money there. We think that’s one of the safest places to stuff money in the United States. JP Morgan has a type of money market fund that we have a lot of confidence in, that doesn’t have any weird stuff in it.

Bryan Lawrence (01:11:19):
There have been periods of time when the world starts to get weird. And at that point, what we do is we say, “Even JP Morgan money market funds, there’s the slightest risk that that won’t be there when we go to get it,” and we just buy treasuries. We buy 30-day T-Bills under the theory that that is the most liquid thing there is. And because we’re in a bank, we have direct custody of what we own and we just want to own treasuries. So it’s some mix of money market funds and treasuries.

Stig Brodersen (01:11:53):
Do you think differently about the “right level of cash”, which, of course, depends on the opportunities out there, but also given that we now see inflation coming, and as you mentioned, might stay here for a longer time?

Bryan Lawrence (01:12:07):
Yeah, I mean, obviously cash is not as good if inflation’s running at 8%. It’s being [inaudible 01:12:15] away, but still, the value of having that cash and having the opportunity to… John and I might find something. We came very close last week to buying something. We might find something two weeks from now. Taking the 10% cash we have and putting 8% of it into a new investment or 6% of it into a new investment with an expected IRR of 20%, just working all the time to find that 12th idea.

Stig Brodersen (01:12:41):
Bryan, what can I say? This has been absolutely amazing, having the opportunity and the privilege to speak with you here today. I would like to give you the opportunity to tell the audience more about where they can learn more about you and Oakcliff Capital.

Bryan Lawrence (01:12:55):
Say, it’s been a real pleasure speaking with you. It’s fun to talk about these issues, and I hope it’s helpful for you and for your audience. If you want to learn more about us, our website is www.oakcliffcapital.com. That’s how to find us. You’ll find the ability to email us or send us information.

Stig Brodersen (01:13:17):
Fantastic. I think I speak for everyone in the audience when I say that there were so many nuggets to take away from this interview, so thank you, Bryan, so much for your time. It’s really been a privilege having you on the show, and I hope we can do this again.

Bryan Lawrence (01:13:30):
Thank you, Stig.

Outro (01:13:32):
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