Dev Kantesaria (03:40):
And so in public equities, today information is available to everybody. Back in the 1960s, you’d have to write in the mail to get an annual report. There was actually an informational advantage in many cases. Today we have to assume that everybody has the same information and so the edge comes from interpreting that information, looking at future risk factors, finding that margin of safety, and distilling it down to a price you’re willing to pay for a company.

Trey Lockerbie (04:06):
Well, you mentioned being interested in inequities as early as eight years old. I happen to also know you’re a huge Warren Buffett, Charlie Munger fan just like me. I’m wondering if you can recall the first time you discovered them and their investing philosophy. I imagine it wasn’t at eight years old but maybe I’m mistaken.

Dev Kantesaria (04:22):
Yeah. Finance was my hobby. I used every free minute, every free hour that I had in my life to read about equities, read about finance. I looked at a lot of playbooks and I don’t remember the exact day or the exact moment but when you read Warren Buffett and Charlie Munger it is like you are reading the bible. It is a universal truth. And when you read some of their letters it just hits you as this has to be the path. And so for me early on their philosophy resonated with me. It seemed like the only playbook that made sense that I wanted to use to grow wealth for my family and now for others. And so again, I look at real estate, I look at bonds, I look at cold, cryptocurrencies.

Dev Kantesaria (05:05):
There are so many different opportunities out there but there’s really, even for me today, there’s only one universal truth. Only one path that makes sense to me. And that is to buy really high-quality businesses. What we all compounding machines. These are companies that can grow intrinsic value year after year for long periods of time. When you have something that’s a monopoly or a duopoly in its respective industry, it has pricing power, it’s capital efficient, its margins go up over time so these companies have operating leverage. Holding these companies for many years, it’s tax efficient. It’s absolutely worked for us over the last 14 years. It’s obviously worked for Buffett for over 50 years. And as we look at in the industry, the managers that have outperformed consistently over long periods of time, it is investors that fall within this camp of value investing. I would say that 98% of our peers in value investing focus on cigar buttstocks. Those are stocks that look cheap. Maybe they make washing machines and you want to buy them at a PE of 12. It’s tempting but what you find out quickly is that it’s cyclical. So when the economy is doing great it’s making money but three years later it may be losing money or it may have no earnings.

Dev Kantesaria (06:13):
And so as you look at energy, financials, heavy industrials, chemicals, materials, those companies are for the most part value traps. And the great contribution of Munger to that relationship with Buffett was that buying one of these compounding machines, even if you have to pay a higher multiple for it, even if you’re paying a fair price, in the long run, it turns out to be a much better way of making.

Trey Lockerbie (06:35):
Something you just said about value traps makes me think of how misleading metrics can often be. I’m curious if you use something like a stock screener to take your universe and distill it down to a select few companies to dig in more on or if there’s some other way that you go about distilling down the universe of stocks?

Dev Kantesaria (06:54):
For us, we have found that stock screens just don’t work. I wish they did. It would make our jobs a lot easier. But there are certain commonalities within our portfolio. We have a high return on the tangible asset which is a good measure of efficiency for a company. We have companies that are very low in capital expenditures. Our companies have demonstrated pricing power over long periods of time. But a standard stock screen does not find the companies that we want to invest in. The advantages that some of our companies have are subtle. They can’t necessarily be gleaned directly from a stock screen. But if you screen for companies that have high operating margins, high return on tangible assets, that will reduce the universe that you need to study but it’s not a great way for us to find companies. So unfortunately what we’re doing is reading a lot. We trade very rarely. 95% of the time we are reading 10K’s, 10Q’s, anything we can get our hands-on. Being mentally prepared to take action when something shows itself in the marketplace. Tomorrow morning a stock that we have been following for seven or 10 years could suddenly drop 40% in price and we need to act quickly because a lot of those inefficiencies don’t last very long. It might last a few days, a few weeks and then it’s gone.

Dev Kantesaria (08:04):
So we’re spending a lot of our time figuring out where we want to invest and then waiting for that catalyst. And it doesn’t always have to be a drop in share price. Sometimes market neglect will cause a stock price to trail the general market for example and present a great opportunity. A good example is Monster Beverage that we bought five, six years ago. There was a scare. There was a health scare with the company. It was a beverage company. We consider it one of the top five beverage companies in the world. The stock price dropped 40% over a few days and it gave us a great entry point. And we did very well with the investment. We don’t own it today but that’s a good example of an opportunity that is short-lived that you need … If you have committees and memos and 10 decision-makers you’re going to lose those opportunities. You need to be prepared and act quickly. And that’s one thing like love about the Buffet-Munger model. I don’t believe in having an army of analysts that meet every Monday to discuss ideas. I like to do the primary work myself and I don’t want it colored by somebody else feeding me that information.

Dev Kantesaria (09:03):
These opportunities don’t come along very often. We’re looking for one to three great ideas a year which means that we need to look at a lot of things, hundreds of companies to get at those few ideas.

Trey Lockerbie (09:13):
But just go into that example with Monster. Is it something that you had done a lot of research on? Maybe established an intrinsic value of and so when you saw it have that dip you said okay and you were teed up, ready to go? How much leg work had been done on a pick like that before you ultimately decided to enter?

Dev Kantesaria (09:32):
We essentially had completed our work and we renew that work. So a company like Monster would look at every quarterly earnings. We would update our intrinsic values. And to be clear intrinsic values are not precise numbers. They have some variance to them. Plus or minus $5 in the share price. Something of that sort. But no, we know at any given moment what price we want to buy our favorite companies at. When that opportunity shows up, and it could be a downdraft in the general market, it could be specific company news, we need to be ready to jump on it because those opportunities are very short-lived as I mentioned. Great businesses don’t go on sale very often.

Trey Lockerbie (10:04):
You mentioned one to three good ideas a year and I noticed that you’re currently running a hedge fund structure. And if we go back to Warren Buffett, he’s running a publicly-traded company which has advantages because it’s not like people are ultimately just pulling their capital out when things aren’t going their way and Buffett likes to say that he’s always waiting for that fat, juicy pitch. And so even if it takes years and the crowd is yelling, “Swing your bum,” he can still take his sweet time. I’m curious how the hedge fund structure that you’ve set up affords you that same kind of opportunity to be as patient as you mentioned.

Dev Kantesaria (10:37):
Sure. Well, I wish I had insurance flow to invest. That is a very strong position to be in when you know you have the capital to put to work when there’s a downdraft. And unfortunately, investors add to their accounts on the upswing, not the downswing. But today we manage approximately $2.7 billion. In our 14 year history, we have been very fortunate to have virtually no redemptions relative to that number. And so we’ve had very stable capital. We want to be aligned with our investors. We want them to understand what the partnership is about. And so by making sure that they understand what we’re doing, how we’re doing it, it leads to very longstanding relationships and stable relationships.

Dev Kantesaria (11:18):
So we have been fortunate in that regard unlike many of our peers that may have huge resumptions. We have not experienced that even across severe volatility. So going back to March of last year during the COVID scare we have 100 investors, 100 capital accounts across roughly 90 investors and we had only one phone call. Now when the market drops 30% or 40% and it feels like the end of the world is coming that’s pretty amazing to get only one call out of 90. And so I think that goes to the trust that we place in each other. We trust that they’re going to be there for us and they trust that we’re making the right decisions when it feels like the world is ending.

Trey Lockerbie (11:56):
And when the market does drop 30% to 40% I imagine you are sitting on some cash to take advantage of that. So what’s your typical cash allocation look like? What’s your strategy around that?

Dev Kantesaria (12:07):
Historically our cash levels have been higher. We’ve been as high as 20%. In more recent years it’s been in the low single digits. And one of the learning lessons I’ve had in running Valley Forge is that there really is no bad time to buy a compounding machine. And we know that market timing doesn’t work. If you’re trying to enter the market based on where you think interest rates will be or where an election result is going to be or fed policy decisions or a variety of macroeconomic or acute political factors, we know that that’s not a way to win the game. The way to win the game is to buy compounding machines and hold them for many years. So the learning lesson has been that there has been almost no bad time to buy a compounding machine. Even if you were to buy … You may know the famous story of the Coca-Cola IPO. If you had bought the IPO it initially went down 40% and you might have been lamenting your life or your situation if you had gotten into the Coca-Cola IPO but if you held it for the next 50 years you would have been pretty happy.

Dev Kantesaria (13:04):
So we are very prudent on entry. Our margin of safety. We have a very low loss ratio across our 14 years. So our winners to losers ratio are we think one of the best in the industry. So we do believe in a strong margin of safety. We are being careful at the price we get in but I think the general learning lesson is that when you buy a high-quality company with a strong organic growth rate there really is almost no bad time to be in.

Trey Lockerbie (13:27):
I want to go back to March 2020 a little bit more because I have a lot of questions, especially for you, around this time. The main one is about just generally speaking how you approach investing through a recession. Your firm performed over 27% in 2020. So you did quite well. Did you make any changes as COVID-19 began spreading throughout the world? In early Q1 were you repositioning in any way? Did you take full advantage of that drop? Just kind of walk us through the playbook that unfolded last year.

Dev Kantesaria (13:55):
So there were absolutely no new names in the portfolio in 2020 across that very volatile period. We didn’t sell anything. We didn’t buy a new name. And I think that is actually a testament to the decisions we made three or four years before that. Because if you made great decisions with your portfolio five years ago, four years ago, three years ago, and you’re still holding those names today and you’re still happy with those names, that means that you have good decision making at your firm. If there’s a lot of turnover in your portfolio, either you’re speculating or maybe your decision-making isn’t of the highest quality. Because if there’s something that you loved 18 months ago and you don’t love it today and that happens often enough then there might be a problem. So there were no changes in our portfolio and it was a great test for our companies. Prior to the volatility last year we had a certain downdraft. Brexit, the taper tantrum, small downdrafts. But it was the first real test for our companies. And what it showed to us was the staying power of our businesses. The pricing power they had. A number of our companies actually reported record margins during the worst GDP downdraft since the great depression.

Dev Kantesaria (15:02):
So the business quality of many of our companies actually increased during COVID which was an amazing thing to see. And so we were very happy with our portfolio. We were obviously opportunistic. Bought more of our companies at really fantastic prices for the long term. But we tested our companies during that period and they passed with flying colors.

Trey Lockerbie (15:23):
Well, I mentioned some of your pivots early on and one that really stood out to me is the fact that you have this medical degree. You didn’t become a doctor but you did go into biotech ventures for quite a while. And early on in the recession, there was a lot of this talk about investing in the companies making the COVID vaccine. Like Pfizer, Moderna, et cetera. Given your background, I’m just curious, were you watching that pretty closely? Did you have a horse in that race?

Dev Kantesaria (15:48):
We definitely had heard through sources about the timing of results. I would say that there was an upside surprise as to how well the vaccines worked and how quickly they were approved. And you saw that reflect in the market rally that occurred once those vaccines were introduced to the marketplace. Where we did have an informational advantage around COVID … So in early 2020, my doctor friends were feeding me information about how things were playing out with COVID. And so we saw a major informational advantage there. We don’t short very often in our fund. We’ve shorted I think five times in 14 years and we need to have a huge margin of safety. So the risk-reward has to be tremendously in our favor. Shorting is almost always a bad idea. But in this case, we actually layered on a large short position onto the fund in March of last year which was highly profitable for the fund. It turns out that that represented only 6% of the 27% performance for 2020. But anytime that we have a large informational advantage versus the general marketplace we’re going to take advantage of it. And I think it shows the flexibility of our thinking.

Dev Kantesaria (16:55):
There are many diehard value investors who just continued to do things a certain way. You have to learn to be flexible depending on the circumstances that are thrown at you. If you have a situation playing out that’s once in 70 years or something that hasn’t happened since 1919 since the last flu epidemic and you have an informational advantage versus the rest of the marketplace which we thought we had. We did something different that was out of the ordinary. We’re willing to deviate from our playbook if circumstances warrant it. And we’re going to do it very carefully and we’re going to do it with a large margin of safety. So that was an interesting thing for us. It’s probably never going to happen again in my career, hopefully. But it was something that we took advantage of and that was a direct use of my medical knowledge. People assume that Valley Forge is full of healthcare names. It turns out that Valley Forge has no healthcare. There are no pharmaceuticals. There’s no biotech. There are no medical devices. There are no hospitals. There’s no healthcare IT. And the reason for that is those businesses are just not predictable enough for us. We want to see businesses that over a five to 10 year period have a very predictable path to organic growth and higher free cash flow. And you just don’t have that in the healthcare sector.

Dev Kantesaria (18:06):
So although we know a lot about it and we could be somebody’s consultant on those companies, we don’t think they’re a very reliable way to make money. And that’s one of the reasons I transitioned from venture capital to public equities. That’s how we’ve ended up in public equities but I don’t use a lot of my medical knowledge day today just because our fishing pond doesn’t include a lot of those healthcare businesses.

Trey Lockerbie (18:26):
That’s what’s really intriguing because if you talk about the Warren Buffett circle of competence, it’s one thing to go into public equities, it’s another thing to shy away from this knowledge base that you’ve grown for decades. And when you’re looking at other companies it just kind of raises the question, what do you consider to be within your circle of competence? Do you have lanes that you say in and stay out of? And just walk us through your framework around that.

Dev Kantesaria (18:54):
Yeah. So if you look at the types of businesses that we like we avoid things that have high R&D risk. So that’s biotech, pharma, medical devices. But that’s also hardware technology. It could be minerals. Someone may open up a $10 billion potash mine without knowing what the price of potash is going to be when the project is done five years from now. So we avoid things that require large upfront investment without knowing what the return is going to be. We avoid companies whose prospects are tied to commodity prices for example. We avoid companies whose fortunes are tied to where interest rates will be. We avoid things that are highly capital intensive. So our fishing pond gets smaller when we avoid businesses that have those types of unpredictable factors. But we are fairly open-minded about market capitalization, geography, sector, industry, and we are looking for companies that provide essential products and services. That has a long history of pricing power. That has a dominant market position that we think is not subject to significant disruption. We like to see a company operate in an industry whose volumes are going up significantly over time.

Dev Kantesaria (20:04):
The companies that we invest in often have many different levers to win. And when their business quality does decline for whatever reason we don’t have tragic accidents. We don’t have companies that go down 90% in price because of some industry event or new regulation or a legal issue or some competitive threat. Our companies often take many years to get off the rails and it allows us to stay ahead of other investors and to switch out lower-quality businesses for higher quality businesses.

Trey Lockerbie (20:36):
Now that R&D risk as you put it, is this the reason you don’t have something like a Google in your portfolio because they are constantly trying to diversify away from their ad spend revenue even though they’re still … I mean, 85% are so of it is still ad spent revenue, or ad revenue I should say. Is that something that keeps you shying away from the FANG stocks in general?

Dev Kantesaria (20:58):
Well, it’s unfortunate that the FANG stocks have developed at a time when I was at the scene of the crime. There are many things at play. I wasn’t around when Coca-Cola had its glory days but I was certainly here when the FANG stocks were going public and developing their great business models. We have generally shied away from FANG stocks because of a lot of poor behavior. That includes poor capital allocation decisions. That includes excessive compensation. Things that … We’re purists. And so once the free cash flow is made we want to see that it’s invested properly. We don’t like CEOS to have many pet projects. We don’t like dual-class structures where the CEO is anointed for life. And so that was one of the reasons that have kept us from these companies. More recently the capital intensity of these companies has gone up as they’re fighting these wars with each other. But the business models are so good that their organic growth has more than covered for these sins. And so it’s been a mistake not to own these companies. We do own Amazon in a portfolio. We think that some of the services businesses that Amazon has could be fantastic over the next few years and really be competitive threats.

Dev Kantesaria (22:13):
The advertising business for example for Facebook and Google. But it’s been I think an error for us to be such purists about some of these other characteristics of these companies when the business models have been so good. And although it’s easy to say that the FANGs are too big or they can’t last forever, as I see them today they’re highly dominant. They have great organic growth profiles. And as you look at the general S&P 500 company they’re far superior businesses. I couldn’t argue with anyone that wanted to own a basket of FANG stocks today. I think on a risk-reward basis they will outperform. We think there are slightly better places to put money but we are of the camp that the FANG stocks are appropriately valued today for the opportunity that they represent on a risk-reward basis and they’re fantastic business models.

Trey Lockerbie (23:06):
So when you say that what comes to my mind is properly valued based on the opportunity cost at hand. Meaning the interest-free rate or the 10-year treasury. And with the 10-year treasury being so low it kind of raises the question for me as to what kind of discount rate you’re using when you’re looking at your picks. I imagine if you’re running such a concentrated portfolio as you are … I think I’ve read eight to 12 picks if that’s correct. You must have some kind of hurdle rate that you are using and so I’m curious as to what that is.

Dev Kantesaria (23:38):
Yes. So I think one of the mistakes that many investors make is they look at historical PE multiples to justify what is appropriate today. So they’ll look at the historical S&P 500 multiple at 16 and they’ll see the S&P trading at 20 today and they’ll say that the S&P is overvalued and stay away from equities. I don’t think that is the right way to think about equity multiples. Equity multiples are dynamic. They’re related to where interest rates are or where they’re going to be over the next five to 10 years. And today we’re in a very low-interest-rate environment. There aren’t many curves that I follow in finance but the one curve that I think people should follow is the S&P 500 earnings yield relative to the 10-year treasury which is the best proxy we have for the risk-free rate.

Dev Kantesaria (24:19):
Today the 10-year treasury is 1.4% to 1.4%. You have the S&P trading at roughly a 5% earnings yield for next year. That is a significant gap. In our view, the S&P 500 is a fine place to put your money for the next 10 years to grow your buying power. We in our portfolio obviously believe that we can significantly outperform the S&P 500 and so our collection of companies should grow at a significantly higher rate than the S&P 500. We expect the S&P 500 to grow organically in the low single digits top line. For our companies, we think about it more as free cash flow for share growth and we’re looking at companies that in an overall portfolio that can grow in high teens and some of our companies may even be able to grow in the low 20s. And what’s interesting about our companies is that we’ll buy them upfront at a significant discount, generally 30 to 60% below what we think they’re worth, but we continue to buy into our companies over time. And so we have some companies in our portfolio today that we owned 10 years ago but we might have bought into the 10 different times over the last decade.

Dev Kantesaria (25:24):
And so we find it could be a specific market downdraft like Brexit that gives us the general opportunity. It could be something specific to the company, a particular earnings release that gives us the opportunity. But we have the opportunity to buy into these companies at many different intervals because of the nature of the compounding intrinsic value pattern they have.

Trey Lockerbie (25:43):
Very interesting. So as we’re kind of moving out of this recession period hopefully, and they’ll be bumps along the way I know, but what is your outlook for say the next 10 years coming out of this recession we just came out of?

Dev Kantesaria (25:56):
I would say that the most likely scenario is that by the end of next year GDP growth here in the US looks very similar to where we were pre COVID. 1%, 2% GDP growth. I see a future that’s very much similar to what’s happened in Japan and Europe. Stale growth. Low-interest rates. We’re not prognosticators on those macroeconomic factors. No one can predict exactly where they’re going to be. But the most likely scenario would be low GDP growth and that interest rates stay in the low range. Generally, let’s say 1% to 3% on the 10-year treasury. And we have some secular factors playing out. We have automation, artificial intelligence, cloud services which will significantly pressure employment. And it’s hard to think about that today where it’s so hard to find labor and companies are raising wages and desperately trying to find workers but after this period here, this reopening and this large increase in demand that we’re seeing currently things will normalize. And when they do normalize we think there’s going to be significant pressure on employment. And so in that setting central banks will have to keep interest rates low to spur growth.

Dev Kantesaria (27:00):
When you have an environment like that it’s exceedingly hard to grow buying power. And we think the absolute best way to grow buying power for the next decade is going to be equities. In particular high-quality equities. If you can find companies that have strong organic growth combined with predictability, those are going to be prized assets in a low growth low-interest-rate environment. And we think that our portfolio is specifically focused on exactly that type of company. So we expect a really great decade for our companies.

Trey Lockerbie (27:31):
You mentioned pressure on employment. Could you clarify what you mean by that?

Dev Kantesaria (27:35):
So I think today if you’re a retail business and you are having trouble finding labor or your labor’s expensive, you are already implementing efficiencies. That could be different types of automation. It could be QR codes. You may go out to a restaurant today and see that you can order using a QR code, you can pay using a QR code. That requires less staff. And you’ll see that in factories, you’ll see that across retail outlets. It could take the form of autonomous driving. There’s just a lot of technologies that will play out over the next 10, 20 years that will replace human labor. And that human labor needs to become more skilled in order to be competitive in the future marketplace. And so there will be a continuous loss of jobs. In every recent recession, there has been a permanent loss of jobs. And you see that in the current recession as well where we’ve gotten back to old productivity levels but with fewer hours worked. And so that is a trend that we think will continue to accelerate over the next 10, 20, 30 years.

Trey Lockerbie (28:41):
This next question is sort of a three-in-one. You can take one and answer which one you want to take but here it is basically. What is the largest holding in your portfolio or the one you’ve held onto the longest or simply the one you have the most conviction on?

Dev Kantesaria (28:58):
Sure. So the companies that we’ve held the longest that we still love today in terms of business quality are the rating agencies. Moody’s and S&P Global. We had them in our portfolio 10 years ago. We’ve held them every step along the way. I’ve tried to give away those companies at dinner parties for as long as I can remember and they’re just not exciting for people. They’re not the hot technology company. They’re not the hot SPAC or the hot IPO. They bore most people to tears. But these companies are a natural duopoly. 90% of all the debt in the world has a Moody’s and an S&P rating. During 10, 12 years ago they ran into trouble. There were front-page headlines regarding their ratings, particularly around housing. They were sued by many market constituents. And so it gave us a great entry point for these businesses. Both companies have gone are up about 20 to 25X in the last 12 years from their low points. We think they have a lot more to go. But these are companies that today have learned from some of the past mistakes. So for example, they’ve really separated themselves from the underwriting process. So they’re not formally part of the debt prospectus.

Dev Kantesaria (30:05):
And so they’re really well protected from being accused of being part of the underwriting process which was one of the main thrusts of much of the litigation against them. The increased regulation which has been added to the industry has actually helped serve to solidify their duopoly because meeting regulation is costly. If you have lawyers around the world in every country filing paperwork and dealing with regulators, that’s very expensive. But the types of businesses we like in terms of monopolies or duopolies or oligopolies are natural ones. And what I mean by natural is that you don’t need to twist someone’s arm in order to use their products or services. And the reason that people continue to use Moody’s and S&P is that if you decide to use one of their competitors, Kroll or Morningstar, or Egan-Jones, you end up having a higher interest rate on a debt issue. Generally 30 to 50 basis points. And so if you’re IBM and you have a $5 billion debt offering and you have to pay 30 basis points or 50 basis points more a year on $5 billion, there’s no way for these smaller competitors to undercut Moody’s and S&P on price.

Dev Kantesaria (31:06):
You could go to IBM and offer your services for free and you still want to use Moody’s and S&P. So it’s a natural duopoly. They have inflation plus pricing so regardless of what inflation is they’ll layer on several percent on top of inflation. They’re exceedingly capital efficient. And they’re good at their work. People assume that they’ve made a lot of mistakes or that their ratings are not predictive but I think that’s absolutely not correct. Actually, their ratings have been highly predictive and they’re being asked to look at the future and what housing is going to be in the future or what a company is going to be like in the future or an industry. That’s a hard task. But if you look overall at their ratings, they’re highly predictive. They’re great business models. There are some very nice trends happening in the world. For example, in China and India, there’s a lot more debt reaching the mark in those countries. There’s disintermediation happening in Europe. Large banks are … Because they have to hold more capital on their balance sheets are not able to give out as many loans so companies are not going directly to the marketplace to raise debt.

Dev Kantesaria (32:04):
So these are fantastic businesses and we continue to love them.

Trey Lockerbie (32:09):
Well, that’s been a great pick and has performed outrageously well recently in the last couple of years. I have to kind of ask around some of the other periods if you did own it, like say for example in 2015 to 2017 or so. Because it was relatively flat. So if you’re having such a massive part of your portfolio in something like Moody’s and it stays flat for two years, how does that wane on you as an investor, and how do you maintain that conviction through periods like that?

Dev Kantesaria (32:36):
Yeah. I think temperament is hugely important in investing. We don’t get happy when the stock price goes up, we don’t get sad when it goes down. We are completely focused on bottom-up fundamentals. So the fact that their share prices were flat for a year or two didn’t bother us in the least. We’re all about what these companies look like five years out from now, 10 years out from now. And you’ll see that in our portfolio. You’ll see periods where there’s a year or two where there’s a pause where returns don’t look very exciting and then we have massive spurts. And that’s just the nature of investing and we don’t determine whether we’ve had a good year or a bad year based on our portfolio’s appreciation. We decide whether we’ve had a good year or bad year by the underlying earnings and whether the businesses have increased their business quality, their margins, how they’ve allocated capital. So that ability to avoid being influenced by share prices in terms of your thinking, being patient, disciplined across those periods, I think that’s hugely important to being a successful investor.

Trey Lockerbie (33:39):
You mentioned earlier that your win-loss ratio was very good but there are still some losses inevitably. Which losses have been the most impactful for your portfolio and what was the biggest learning from that?

Dev Kantesaria (33:52):
If you look at gainers or losers since inception, 14 years, over $10,000 just to remove some of the noise, we’ve had 39 winners and six losers. But the six losers have been very modest in terms of their impact on the portfolio. So we’re strong believers in the margin of safety, where even if the thesis doesn’t go exactly as you planned you can at least get your money back or walk away with a small profit. So if you look at our six losers, three of them have been very close to breaking even. Essentially flat to our initial investment in those companies. The worst loser that we’ve ever had was back in 2010. It was only about a 4% drag to our gross performance of the fund. And I think that’s a pretty remarkable statement to say across 14 years where you had a volatility of 2008, 2009, the more recent volatility of COVID, we’ve had some pretty tough market conditions over the last 14 years. We’re very proud of that ability to protect investor capital. But the company that we’ve had the largest loss in was a company called American Dairy. And this was a company that sold infant formula in China. It traded here in the US as an ADR.

Dev Kantesaria (35:00):
And if you’re a parent, you know about infant formula and what a racket it is. It’s an oligopoly. It’s so expensive here in the US that sometimes supermarkets will actually lock up the infant formula behind a glass case. So it’s an industry that has really interesting characteristics. A few companies dominate shelf space because they participate in the WIC program which allows them … The WIC program is infant formula for babies that are born into poverty and their state contracts and if you win the state contract you get all the shelf space in that state. You’re getting your profits from the other 50% of the babies and parents. But the interesting dynamic that plays out in infant formula is the higher your infant formula is priced the greater the quality the parents believe they’re getting. In fact, the ingredients in infant formula are regulated and they’re essentially the same. But if there’s infant formula on the shelf and one costs $10 and the other one costs $5, the parents are going to buy the $10 one because they think there’s something better about it. I sidetracked on just discussing why that whole industry dynamic is so attractive to us.

Dev Kantesaria (36:01):
But in China, which today is the largest infant formula market in the world, at the time back in 2010 it was the second-largest in the world. It was early innings. And we invested in a company that had a dominant market share in second and third-tier cities. The stock price had dropped significantly because there was a scandal that broke out where companies were using a chemical called melamine to thicken the powder. It was a cheap way for these companies to thicken the powder rather than using milk powder, which was more costly. And it was a big scandal. Executives were thrown in jail in China. But this company did not participate in that scandal but its stock price nevertheless fell significantly. We bought into the company at a single-digit multiple. We felt like we were being compensated for a lot of different risks. A lot of the management team members were from the US. Sequoyah had made a pipe investment. There were a lot of positive characteristics that we liked about the business.

Dev Kantesaria (36:50):
Unfortunately, it was a loss for us. And if we had held onto it longer, it ended up ultimately being highly successful. So it’s good to know that even our losers if we look out at some point, they end up being quite successful. And it happens with many of our companies. When we sold out of Monster Beverage or Nike, some of our more recent sales, they’ve gone on to be quite successful even after we’ve sold them. So for us, it’s confirmation that we’re still fishing in the right pond. But it was a company that just didn’t execute well. They had issues with their inventory. They used up a lot of cash on their balance sheet. And the learning lesson for us there was really that in the same way that there used to be 500 car companies in the US and we ended up with three, we got involved in that battle too early. And it’s really tough to pick the winners when you’re involved in an early battle like that. Ultimately, as I mentioned, the company was quite successful and the impact on our portfolio was minimal, but there were some interesting learning lessons in there for us.

Trey Lockerbie (37:47):
Have you had any experience where you’ve had to enact some kind of activism style or approach with any of the holdings that you have in the portfolio?

Dev Kantesaria (37:55):
I’ve wanted to. We never have. And we don’t believe in buying a low-quality business and fixing it up. The businesses that we buy, you don’t need Warren Buffett or Steve Jobs running them. The areas that have really angered us the most have been around capital allocation. It could be a wasteful R&D project or a pet project. It could be acquisitions where companies are overpaying for companies. We don’t see the strategic fit. Maybe the management is trying to smooth out earnings or appease Wall Street. And we certainly have private conversations with management and we’re very vocal about it. But as we’ve grown in size here, I think our voice is getting stronger and being heard. But there are certain situations where we’ve wanted to be a lot more forceful, mainly around capital allocation. And hopefully, as we get larger that voice will grow stronger and we’ll be able to have more impact in that area. But there is a lot of bad behavior that happens with capital allocation. And I would put executive compensation in that category. When you’re giving out a large amount of restricted stock and then claiming that you have a large buyback, you’re essentially running in place.

Dev Kantesaria (39:06):
If you give out 1% or 2% of your company’s stock and then you buy back 1% or 2% of your stock and brag about having a great buyback program, you’re just running in place. So capital allocation is something that we focus on intensely. We actually calculate our free cash flow yields for our company after the cost of buying back stock that is issued in terms of compensation. We think very few managers think about free cash flow that way. So it’s something that when we see bad behavior we want to have a voice there. But no, we prefer private conversations for now.

Trey Lockerbie (39:41):
Meaning you’re doing your free cash flow to share, meaning the denominator, the share, is actually the fully diluted capital basis of equity so it’s excluding all the options that may or may not come to fruition.

Dev Kantesaria (39:52):
Yes. Or let’s suppose they’re buying back a billion dollars of stock this year. We’ll subtract that from the free cash flow on an after-tax basis. So they’ll get a tax deduction for some of that buyback for the restricted stock that they’re issuing. It’s on an after-tax basis. We could also subtract that from the numerator. But in one way or another, we factor that cost as an actual cost and so we look at free cash flow yields adjusted after the cost of compensation.

Trey Lockerbie (40:21):
Interesting. So going back to your growth, and there has been a considerable amount of growth at your firm over the last few years, you’ve been running this concentrated portfolio and I’ve heard this saying that you should be concentrated to grow wealth and then diversify to maintain wealth, so to speak. So as you’re scaling and getting bigger and bigger, are you finding that it’s harder and harder to maintain such a concentrated portfolio?

Dev Kantesaria (40:43):
No. And the reason for that is it is a happy circumstance that when we look for really high-quality business models, companies that are very entrenched in their respective industries, generally have larger market caps. So at least mid-cap, but usually large-cap. So we have a very liquid portfolio. We can be highly nimble. We can sell out of a position entirely in a couple of days or a few days and switch to another position. So that nimbleness that we have had over the last 14 years, we still have today and we think we’ll have for the foreseeable future. So we’ve not experienced any style drift. What you often see with growth in AUM is that you might have started investing in small caps in Brazil and you’ve had to morph into something else. Because of the types of companies we look at we’ve had absolutely no issues. Our portfolio or the types of businesses that we invested in 14 years ago look exactly like the businesses that we want to invest in today. So that’s been fortunate for how we view the investment opportunity.

Trey Lockerbie (41:47):
You’ve touched on selling and having the stocks continue to run after the fact so it begs the question around selling and when you decide to sell something and how you decide to sell something. So walk us through your approach and when you come to that decision to sell something.

Dev Kantesaria (42:02):
Yeah. Every day we’re taking in new risk factors. We may learn something today but generally with the types of businesses that we hold we might learn something every few months or every few years that adds to our view of risk or future risk to cash flows. And that’ll be a determination of intrinsic value. So we have a general view of what intrinsic value is every day for every company in our portfolio and the companies that are on our shortlist. But something reaches 100% of our intrinsic value we have to justify why they are still in the portfolio. We have to have them compete against the short ideas that we like. The things that could cause us to sell a position are, as I mentioned, a change in the business quality or risk based on something new that we learned or a competitive dynamic that we see. It could be related to, as we’ve talked about, misuse of free cash flow by management or capital allocation decisions. It could also be that the company takes on excessive leverage. We don’t use leverage at the fund level, although we have the ability to do so. We don’t like leverage at our underlying company levels.

Dev Kantesaria (43:06):
So our companies all have some debt but it’s not excessive. So if a company were to take on an excessive amount of debt, that could be another reason that we exit a position. I would say for us the easiest decision for exiting a company is when we find something that we like better. So that is usually how most things leave the portfolio. As I mentioned, when we sell something, it often continues to do well even after we sell it. I thought of creating a second fund that just takes all the things that we’ve sold and see how that goes because I think that actually would do very well also. But we don’t sell very often but when we do those are some of the reasons why we get out of a position.

Trey Lockerbie (43:42):
It’s so interesting because it does seem that winners continue to win but you have to set some kind of boundary, right? Otherwise, how are you ever going to sell out of anything? One thing that occurred to me, you were talking about leverage and it’s just adjacent in my mind for whatever reason but even Buffett is known to utilize using options on a position. And given you have a concentrated position I’m wondering if you’re selling off covered calls or anything like that on the current holdings that you have.

Dev Kantesaria (44:07):
In my early investment career, I looked at things like selling covered calls and it was a lot of work and risk for not much gain. So if we want to get out of something we will just sell it completely. So buying and selling common stock positions has, in our view, been the most prudent way to get the exposure we need. Occasionally leaps will trade at a very attractive valuation where the embedded cost of buying those leaps makes the leaps more attractive than buying the common stock. And these are leaps that are severely in the money. So if we look at all of the equity instruments that are available to us, we will generally default to common stock positions. But we look at leaps. We look at selling covered calls. And very rarely you’ll find anomalies. So many years ago we help leap positions in eBay and Nike that did amazingly well for us. But we’ve only found two of those situations in 14 years. But I think it’s good for investors to know that we’re open-minded and we’re willing to look at those possibilities.

Trey Lockerbie (45:08):
What would be the reason to go into a leap other than just going long the common stock?

Dev Kantesaria (45:13):
Again, it goes to what the embedded cost is. The cost of capital that’s embedded in the price of the leap. So the leap is making some assumption about the cost of the money because you’re not putting up as much capital as you would if you were buying a straight common stock. So when we run those calculations there are times when we are being able to buy a leap that’s severely in the money or very little additional embedded interest cost if you will. So it occasionally makes sense to buy the leap. We will generally buy the leap and the common stock because day to day there’ll be days when it’s better for us to buy the common stock and other days when it may be better to buy the leaps, depending on what pricing has been given to us.

Trey Lockerbie (45:57):
Very interesting. All right. You’ve mentioned a few things that are all coming together for me around valuation. One of which is not being so much biased with the geography of a company, the market cap of the company. And that for me ties in with this bottom-up approach that you touched on as well. So when I think about all that, there’s just so much to distill down. So just walk us through how you approach valuation maybe once you’ve narrowed it down to a certain pick. Yeah. Just walk us through a little bit about your framework finalizing your valuation on something.

Dev Kantesaria (46:30):
Ultimately it’s what we learn in business school. It’s all about discounted cash flow. I think it’s fairly easy to create a five or 10-year free cash flow model and that’s generally not where you get your edge. Someone may factor in an additional 2% or 3% growth rate on top-line revenue. I think the real edge comes from determining the discount rate. And you’re factoring in a large set of future risk factors. We’ve associated in our business, risk, and volatility. We think that the volatility of the stock translates into risk and that is the best mathematical relationship we have around risk. But we don’t think that’s a great way to think about the future discount rate. So we’re trying to assimilate a large set of risk factors into the fair price we’d be willing to pay for a company. We are essentially running a discounted cash flow model. But in terms of day-to-day ease with our work we really try to look at what is the free cash flow yield we’re willing to pay for business for 2021, 2022, 2023? And we rank order businesses by the free cash flow yield that we think those companies should be trading at for their future quality and growth.

Dev Kantesaria (47:38):
And then we compare that rank-ordered set of companies against the risk-free rate, which is the 10-year treasury. Which is our proxy for the risk-free rate. So we want to see a large gap with the risk-free rate and we also want to find the companies that have the most promising gap between the free cash flow yield at which they’re trading today and what free cash flow yield we think they should be trading at. So for example, Moody’s. There have been times when Moody’s has traded at a 5% or 6% free cash flow yield. If you go back 10 or 12 years they might have even traded at a 10% free cash flow yield and we may have determined based on business quality that in fact they really should have been trading at a 3% free cash flow yield relative to the risk-free rate. So it’s not a precise set of numbers and spreadsheets and anyone that tries to bring that level of preciseness to stock investing is fooling themselves. Warren Buffett has talked often about how his calculations are really generally back of the envelope. And when you invest in a compounding machine that has a lot of different ways to win, pricing power, industry volumes, flexible cost structures so they can increase their margins or increase their margins steady during a recession, there’s a lot of different ways that these companies can get to their free cash flow targets.

Dev Kantesaria (48:51):
That gives us the margin of safety we need with some of these great businesses. So hopefully that gives you a flavor for how we try to think about valuation.

Trey Lockerbie (49:00):
Yeah. That’s fantastic. We have a lot of listeners that are honestly similar to your background. A lot of them are doctors or lawyers that have now made some money and maybe investing hasn’t become their full-time profession as it has for you but they certainly have an interest in it and are wanting to learn more. What books or any other resources would you recommend for folks like that trying to get their head around how to do something like an intrinsic value?

Dev Kantesaria (49:26):
I still haven’t found anyone better than Buffett-Munger. There’s a number of other investors out there that are famous and you’ll see them talking and then suddenly out of nowhere they’ll talk about what a great idea it is to buy gold or dabble in cryptocurrency. Or you make look at their 13F and you’ll see that they own biotech companies and you’ll quickly realize that there’s only one Buffett and only one Munger. So I have not found a third or fourth or fifth investor on the list that I admire and that I follow. I think the best place to go is to look at their letters, to watch every interview. I often watch their interviews on YouTube while I’m brushing my teeth at night. It’s a little bit like going to church. It just reminds you of some of the principles. When there’s chaos or a lot of silly things happening like they are today in the marketplace with SPACs and IPOs and cryptocurrencies and NFTs, it’s always good to remind yourself about the longer-term picture. CNBC has put out a wonderful website that aggregates all of their interviews, all of their writings. So it’s the place where it would take you, I don’t know, 100 hours, 200 hours … I don’t know how long. It would take a long time to go through it. And then you should probably go through it again.

Dev Kantesaria (50:43):
But for any person looking to really understand investing and how it should be done right, there is no better place to go than Buffet-Munger. And I hope that in some way that I can try to carry their mantle on a going-forward basis. I think there’s a small group of us in the current generation that tries to practice their philosophy well. And again, I don’t think there’s any value in being a purist. For example, if you’re a purist and you avoided technology stocks you might have missed some of the great business models and FANGs for example. But most of their core principles are timeless and it really resonates with me today as much as it did when I was 10 years old.

Trey Lockerbie (51:25):
Well, this has been a really refreshing conversation for me for that exact reason. We’ve been studying a lot of different topics on this show. A lot of macros, a lot of cryptocurrencies, Web3. There are so many things coming out today that I feel like it’s hard to even keep track of. It’s always nice to go back to basics a little bit and talk about these core principles as you mentioned with Warren Buffett with a like-minded individual such as yourself. So I’d love to do this again sometime soon. This has been really fantastic. Thank you so much.

Dev Kantesaria (51:54):
That would be great. Thank you so much for having me.

Trey Lockerbie (51:57):
All right everybody. That’s all we had for you this week. If you’re loving the show, please don’t forget to subscribe. Follow us on your favorite podcast app so you get the episodes automatically. We always love to hear from you so please reach out over Twitter, @treylockerbie, or leave us a review. And if you’re looking for more resources for investing, look no further than the tools and resources we have for you at theinvestorspodcast.com. Just google TIP finance. It’ll pop right up. And with that, we’ll see you again next time.

Outro (52:21):
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