Preston Pysh  01:03

We love having you. I told Stig that he’s going to go first and most of the reason I did this is because I’m really excited about his pick. We always tell each other what we’re going to pick so we can kind of do a little bit of research before the show. Each time I look through them like yes, I want it to make sense but this one here that Stig’s about the pitch, this is an over the counter traded stock. I’m telling you; this thing is kind of sweet. So Stig, fire away. I can’t wait to hear your pitch.

Stig Brodersen  01:32

Well, thank you, Preston. You’re definitely putting a lot of pressure on me.

Preston Pysh  01:35

How often do I lay up your pick like that, buddy?

Stig Brodersen  01:38

God, I don’t think that you ever done that before, buddy. So, I take that as a huge compliment, but you can hear the pitch and then you can decide for ourselves. My pick is I Got Games. The stock ticker is IGG GF. You can already tell from the ticker that it’s typically not something people trade a lot of. It’s a mobile game developer company headquartered in Singapore. The games are somewhat popular across the globe. They have 580 million users, even though you probably haven’t heard about the company, but you might have heard about some of the games.

02:10

The two most known games are Lords Mobile and Castle Clash. The way that they generate revenue is via in-app purchase to enhance the game playing experience. So, you can basically play the game for free, but if you want the fun stuff, you’ll have to pay for it. At the time we’re recording this podcast episode, we’re doing this June 9th. The enterprise value is about $1.2 billion, and the revenue and cash flows for 2018 or the fiscal year of 2018 were $749 million and $234 million. Already trading and attractive multiples as you can tell.

02:45

There are quite a few reasons why it first gone on my radar. It has significant financial strength. It’s sort of weird for many tech companies. We’re not talking about big tech here but is for many small tech companies to be so cash rich, having no debt, and actually being very profitable. It’s just to mention some of the key metrics I’ve been looking at, turn the quick ratios, just below three, and the cash and cash equivalents alone are more than 2.4 of total liabilities.

03:13

Another thing I would like to highlight is the high insider ownership. The two co-founders are both active in the business today, and they own a combined 30% stake. Especially for smaller companies that are quickly growing like this one, I really like the high insider ownership, plus the consecutive and growing dividend. Currently, the yield is 2.6%.

03:35

The gaming industry in itself, just to give a brief overview, it’s huge. It’s currently at $134 billion. The biggest players are Tencent, Sony, Apple, and Xbox. There’s a lot of networking effects in gaming. It’s not like whenever I was a teenager and had time to play computer. Back in those days, I primarily played single player games. Today, it’s very different. Usually you play multiplayer games, and if your friends are playing, you would typically be playing the same game too, even though that most often you would be playing with strangers.

04:10

Like everything in software, gaming companies are typically high margins. Gross margins are around 70%, specifically for this company, and operating margins are around 30%. Back the days, it could actually be slightly higher, but today you have artists, game designers, so many programmers. A computer game today is such a big project that it definitely cuts into the margins, but the pie, so to speak, is a lot bigger.

04:34

If we look at the valuation of the company, I wanted to be somewhat conservative. It’s actually trading at relatively good multiples, as we briefly mentioned before. We have a TIP multiple, just about five, and the way we calculate the TIP multiple is comparing the operating income with the enterprise value. Whenever you think of the size of just above $1 billion in enterprise value, it’s around 10, 11, 12 of the cheapest stocks in our screener.

05:01

Looking at the valuation, I really wanted to be somewhat conservative. I used a 10% probability for a 10% growth. A flat growth, I assigned 60% and a minus 15. I really want it to be negative here and minus 15% growth rate, I assigned that a 30% probability, and if I do that, I come up with an expected return of 14.4%.

05:24

That was my pitch. So I’m curious to hear your thoughts. Actually, I would really love to hear from you Preston, because you’re pretty excited, perhaps even more excited than me.

Preston Pysh  05:32

I’m excited when you’re looking at the growth of this business since inception, it hasn’t been anywhere near those growth rates. I guess this is just the matter of the way that I was calculating the value. I was calculating something not as high as what we’ve seen in the past because it’s been absurd how much this has been growing, but it was definitely all three bands were kind of in a positive range, and I just came up with a much higher intrinsic value than yours.

05:58

On top of that, I don’t see this company slowing down. The gaming industry, it seems like their operations has the Jim Collins protocol. They’ve got their do loop of success, and they’re just replicating that, and you’re looking at their top line and it is just screaming higher. I don’t know, I came up with a much higher intrinsic value than you got, and I know you’re trying to be conservative with your numbers, but this thing’s explosive, as far as I’m concerned. I’m curious what the other guys think when they’re looking at it. Are you seeing massive growth here?

Tobias Carlisle  06:28

It’s a little difficult for me because it’s a non-U.S. stock. I’m a little bit out of my depth when I look at it, but I do like the valuation. It seems unbelievably cheap for something that is growing at this rate. Stig, do you know why has it been depressed? Why is it trading here?

Stig Brodersen  06:45

It’s a good question. I think there are some skepticism. If you look at some of the risk factors, it’s the maturity of the games. It’s a very highly concentrated revenue model that they have. So, for instance, Lords Mobile, the game I talked to you about before. That’s 80% of the revenue, and Castle Clash, that’s 14.7%. They really rely heavily on that. There’s some maturity to that. I guess with the moat or the lack of moat that you have in the gaming industry. I don’t know how much of that can really be replicated until “Oh, this is a talented team. They can create a new blockbuster whenever it comes to computer games.” Imagine whenever this becomes outdated in a few years, what happens then?

Hari Ramachandra  07:23

Stig, do you know where they get the revenue in terms of geographic distribution?

Stig Brodersen  07:28

That’s a good question, Hari. For the year, 46% of the revenue came from Asia, 27% from North America, and 23% from Europe.

Hari Ramachandra  07:37

Okay, so my main concern is if their revenue is coming from China, for example, it’s basically completely uncertain how things would pan out. How they would be treated in China. That might be the reason why their value is where it is today.

Preston Pysh  07:56

And that is why we have a Silicon Valley programmer on our show, right there.

Stig Brodersen  08:02

I love it.

Preston Pysh  08:03

As a guy who looks at the numbers, and gets excited about the numbers, that is such a strong point what you just said. That is really worthy of a person’s research. It just goes to show you how important it is to fully understand what it is you’re buying before you buy, because Hari’s point could be very detrimental if you don’t understand something like that.

Stig Brodersen  08:24

A few other things, I think uncertainty also really plays a big part here. We had many years where we saw the cycles between PC games and the console games, like where the action happened. But if you look specifically at our company, I Got Games, all the revenue comes from mobile gaming, and you didn’t have that segment not too long ago, that might be another thing that plays into this. Like how are all the consumer preferences changing? Not only whenever it comes to the game itself, but also what type of medium would you use? I mean, you can develop the best PC game ever, but if everyone’s playing on the mobile, why does it really matter?

08:58

It does take years to develop a game like this, and a lot of things can change. The other thing is that the networking effect might not promote that much of a moat and the barriers of exit. I mean, yes, the value you get from that game from all the money you spend on swords and dragons or whatnot, that you bought, I haven’t really played these games, but that is what I imagine. You would, of course, lose them if you didn’t play the game.

09:22

You could say the same thing about other games, in relative terms, these are small games compared to some of the other games that you find out there. So, if we are talking about the networking effects, this might be a small fish. One thing I would actually like to bring into this piece about the valuation, I can easily see why based on the number she would be more optimistic. It might be an acquisition target, and it’s very obvious to mention someone like Tencent, who has been buying up a lot of gaming companies. So, the price it is trading at right now with these two blockbuster games, that might be a catalyst for realizing some of that shareholder value. I’m curious to hear more of your thoughts about this pick.

Preston Pysh  09:58

I know that if you get Tencent involved, then all of a sudden, your China problem goes away.

Stig Brodersen  10:04

Good point.

Tobias Carlisle  10:05

Is it a boom bust cyclical industry? Is that an industry where your fortunes go with the success of your current big game? And do they have that development cycle where they bring out one and then there’s a bit of a lull until I have the next version? And then everybody comes back again? Because that’s always an interesting and worthwhile modeling into the valuation.

Stig Brodersen  10:26

Yes, it definitely is. So that’s also one of the reasons why they might be a bit inflated. The other thing is, it’s really difficult to predict the success of these games. It’s kind of like whenever you do a movie, and perhaps it’s even more difficult than whenever you’re doing a movie. I mean, that’s why Disney keeps on making those adventure movies, right? Like they kind of like the idea of, yes, this is steady revenue. It’s difficult for a company of this size, they are so small. They’re so reliant on these games and actually, they do a few different things to extend that cycle.

10:54

There are a lot of things that have been popping up with the past few years that gaming companies, in general, have been doing. You might be familiar with Twitch which is a streaming platform where you can actually watch video games like it was sporting event. They actually have their own Twitch, so to speak, I Got Games called Pocket Social. That is one way and they also have their own tournaments in these games where they want the best player.

11:17

They also have the loyalty programs and they want to extend that cycle. But no, there’s a really, really good chance that it’s not going to be there for 10 years. Why would it be if you look at other computer games. Very few have been able to sustain more than 3, 4, 5 years, those are only the very, very best and biggest. They’re continuously being developed, by the way, even the biggest old games.

11:38

The last thing I wanted to mention is that Preston and I write out our analysis of various stock picks, and we do that over at our Intrinsic Value Index. We’ll make sure to link to that index in the show notes. It’s completely free. Another thing that’s completely free is subscribing to our newsletter. What we do is that once a month, we take the analysis that we wrote for the past month. For instance, I Got Games, and you can I subscribe to that over at tipemail.com. Alright guys who wants to go next?

Tobias Carlisle  12:07

I’m happy to give you my pitch, if that’s acceptable to everybody.

Preston Pysh  12:10

Absolutely.

Tobias Carlisle  12:11

So mine is a short. I run The Acquirer’s Fund, which is an ETF ticker ZIG. That’s 130-30 long short. This is one of the shorts in the short portfolio. We’re recording this on June 9th, so it’s possible that it trades out by the time that this airs. I don’t know. I’m just telling everybody, I don’t want you to think that I’ve pitched it as a short so I can then sell it to you, or buy it back from you, or whatever. I’m just telling you where we are.

12:36

The pitch is basically Real Page, the ticker is RP. It’s a property leasing software. It helps you with your accounting, marketing and some metrics, if you have a rental property. It’s sort of software as a service. I think it has many of the things that I like to find in a short. It’s a real business and it is making money. I just think it’s nosebleed expensive, and I think it’s going to turn out to be more cyclical than perhaps other software as a service business. I think it’s going to go where the rental market goes, and the rental market is as hot as it has been in a really long period of time.

13:16

So, what are you getting with the Real Page? The market cap at the moment, it’s trading at about $60, $59.63, close on Friday. Market cap is five and a half billion enterprise value was $6 billion. It’s carrying a little bit of debt, about $500 million in net debt from an acquisition that it made, but that’s not a great deal of debt.

13:34

My real issue with this thing is just the valuation. Enterprise value to EBITDA, which is the sort of acquisition metric is at 40 times, and when I run a valuation on this thing, I struggled to get it much above $5 a share. It’s $60 a share, that’s about 90% to 95%, down to where I think the value is. I think there’s an enormous amount of water in this thing. I don’t think that the stock is that ugly. I think the businesses are just a combination of the debt and constantly issuing stock, so you’re being diluted all the time. Plus, it’s already extremely expensive in a very cyclical sector.

14:11

It’s just something that I feel that it could be very weak if we go into some sort of drawdown. Given that it hasn’t done much for about a year, it looks like it’s sort of floating back down. Again, I don’t mind putting this position on, although I’d caution that I could easily roll out of it in the not too distant future, and you might look at the holdings and see that it’s not in there. So, I’m just telling you that we’re always watching the shorts very closely, but that’s my view on it right now.

Preston Pysh  14:33

Toby, I’m curious if there’s a competitor in this space, that would be interested in buying them for a strategic reason, not necessarily because it’s a value from the way we would look at it as investors but they’re looking at it more for a strategic reason to purchase it, and then that could maybe continue to give you a hard time.

Tobias Carlisle  14:52

That’s always the risk to a short in a really hot sector, but this thing is so expensive, for very, very little yield on an acquisiton like that. At that kind of price, it’s a pretty modest software I posted on a website like five and a half billion dollars, or $6 billion total enterprise value. I feel like I could build that. Give me a billion dollars, I’ll build it again.

Hari Ramachandra  15:14

I really like what Toby just said. It’s like Buffett’s, like if you have a company, if I give you say, a few billion dollars, would you be able to build a similar product to how the brand appeal. I don’t think they have any of those, and you don’t even need a billion dollar to build this product, frankly.

Tobias Carlisle  15:32

That is the hard side. Everything’s expensive in San Francisco these days.

Hari Ramachandra  15:35

I think nowadays, things are moving out of San Francisco too because of the same reason. So, if somebody builds it somewhere else, probably $50, $60 million, or max $100 million dollars. Somebody can build this kind of service. I’m only talking about the product as a technical stack. Of course, they would have to spend a lot of money building the rest of the support system, as you said, but it was founded in 1998, right Toby? Like really old? I mean, they’re like the granddaddy of SaaS companies.

Tobias Carlisle  16:06

Oh, but Silicon Valley since it’s only just *inaudible*, Hari.

Hari Ramachandra  16:10

Yeah, so I think I agree with you. It’s like insanely expensive for the niche market to have. One question I had though was, is there a peripheral, or just in markets they can expand to? Why are they so expensive?

Tobias Carlisle  16:25

I just think it’s Software as a Service. Anything that’s software sold over the Internet to address some sort of problem. They are making money. I don’t hate the business; I actually think the business is a reasonably good business. It’s just that it’s not worth $6 billion. They might be worth $500 million. I might buy it $500 million, but that’s $6 billion. There’s so much water and and I just think that if you got that much water in a really cyclical industry, which property is burned bust, particularly rental property, I think that we’re much closer to a peak in rental property prices in *inaudible or bottom.

Stig Brodersen  16:59

It’s kind of interesting looking at the numbers, you know, the coverage ratio is just barely two. And it’s really starting to look really, really ugly. And I guess that says something about the management also and the thing that they replaced management not too long ago. So, I think that’s another factor to include. I would probably like a little more shorting validation from the Morgan, the long-term trend that I’m looking at right now. It’s still more bull than its bear. And I know that you can always make an argue that it’s it is best to show up whenever that day when it’s most expensive, but it’s really, really difficult for all of us to do that. So how do you look at that trade off, Toby to see more validation from the shoulders?

Tobias Carlisle  17:37

That’s been a big learning process for me as a value investor, to get better at shorting has been that you don’t short on valuation, something that’s stupid, expensive. I think David Einhorn has a great line where he says something that’s two times overvalued is silly, but it’s no sillier at three times overvalued. It’s still just silly. And what he’s saying is that once it departs from underlying valuation, there’s no reason why can’t go 20 3050 times overvalued.

18:02

So, what I look for is the market getting a little tired of the story. And one of the ways that you do that is just by making sure that the stock hasn’t done anything for an extended period of time. When I look at real page, it’s trading where it was about a year ago. It’s been higher and lower in the interim, but it’s been more recently a little bit higher. And I think it’s coming off again, I think it’s one of those things that it’s just it’s really just waiting for some event to justify like slipping 30 to 50%. That may make it a bit of short at that stage, but I think it is a short right now.

Preston Pysh  18:31

I’m there with Stig on the validation because I’m so I pulled up our tip finance tool and I’m looking at the momentum status for this particular company and annual volatility on this is around 23%. So, as you’re watching the price action, just no other metrics other than the stock price, you should typically be able to see that the volatility on that bounce around quite a bit. 23% is a lot of volatility relative to some other company.

18:56

I mean, you can get away worse trust me, you can go way higher than that. But 23% is a Lot. And so when you’re looking at the low that this company had, what was it back in December 742 43? Yeah, it got down into the low 40s. And you’re seeing this thing up. Where’s it at right now? $59 right now. And so, you’re well within that volatility range, and you’re in that volatility range going to the upside. So our tool or momentum tool has this still in the green status, I would argue that you’re not seeing a statistical change outside of its normal operating volatility to demonstrate that you have seen that transition point where maybe it’s time to really plow into it, but you got to make these calls. Sometimes when you make these calls. On a short to get all of the juice to be squeezed. You got to make the bold call at the top where you’re not seeing that evidence yet. So

Tobias Carlisle  19:48

I wouldn’t say that this is necessarily the top I just on the on the price section. I’d say the 52-week highs is 10% higher, so it’s 66 bucks. 50 day moving average is below. It’s below. Its 50 day 257 So, you know, none of that really factors into what I’m doing. I’m just looking where it was about a year ago. And I don’t think you want to be trying to short these things at their 52-week highs and that’s not something that I would try to do. Because 52-week highs typically lead to more highs and 52 week lows typically way to more lows, just statistically, if anything, it’s coming off from where it was. It’s not charging ahead.

Preston Pysh  20:22

All right, I guess we’ll move on to our next pick. Hari, do you want to go, or do you want me to fire away?

Hari Ramachandra  20:28

Sure, I can go next. Today, my pick is Slack, Inc. It is not yet public, but they have filed for it. So, I’ve been watching and following this company for a while now. To give you a brief history about this company and the founders. One of the interesting thing about this company is unlike many of the famous Silicon Valley companies, it is not founded by pure students in their dorm. Its founders are really experienced entrepreneurs.

20:58

Stewart, who is one of the founders, was actually at Flickr. He founded Flickr. So, Stewart Butterfield is who I’m talking about. So he’s pretty famous in the Valley. He sold Flickr to Yahoo, I believe, too early, because he got probably $25, $30 million for a Flickr, but like that’s change for such a great service. Of course, Yahoo promptly kind of shoved it in the shelf. It didn’t go anywhere.

21:22

Stewart left Yahoo in 2009. The way Flickr started was he wanted to build a gaming company and then it didn’t pan out. One of the features in the game was sharing pictures, and that’s how Flickr came into existence. Back in 2009, all the founders of Flickr who were at Yahoo left again. They thought, “Okay, this time, we have money, we have experience, let’s build a gaming company again.”

21:48

The technology has moved forward, and they started building the gaming company again, but around 2012, 2013, they realize that it’s still not there where they could really gather more momentum. They had built an internal messaging communication system while they were working on this company. They felt that was something that they thought was groundbreaking. That’s how Slack was born, and it has been a phenomenal growth story ever since 2014.

22:20

In the rest, they started publishing data starting 2017.  They had $105 million in revenue in 2017. Today, they’re around $400 million in revenue. They have around 600,000 paid customers spread across 115 countries. 36% of their revenue is from international. They have around 500,000 free customers, the way they calculate customers is if an organization has three or more users using Slack, they call them as an organization. They have 10 million users today and some interesting data that they provide in terms their engagement, most of their users spend around 90 minutes per day on Slack.

23:07

One of the interesting things about Slack is they entered into a crowded market. Obviously, Microsoft is the big elephant in the room when it comes to productivity and communications. Google also has entered with Google Suite, and Amazon has also launched its own product in the same area called Amazon Chime. So what makes Slack special is they entered a market where all these big guys had a lot of sales force on their side and it was really hard for them to muscle through that and get into the C suite in front of the CIOs and sell that product, so instead they took a different route.

23:46

The founders came from consumer internet, they started marketing more through word of mouth, how you would do a Flickr for example. There’s a term called Shadow IT in the industry wherein if you’re in a big company, your IT organization dictates what you can use. Most of the engineers and employees are pissed because that’s not what they like, and then Slack offered this freemium model where if you are a manager within a group, you can say, “Okay, let me try out Slack for 20 – 30 employees that I have,” and then I start using it and slowly it spreads within the organization. Then from bottom up, the pressure builds up and then the VP just says, “Okay, let me just sponsor it for my org. I don’t care about what the IT for the entire org says.”

24:35

Then finally, enough organizations within a company start using it and then the IT buckles, and that’s what has happened in company after company. I have a story where there is a Fortune 100 company in Silicon Valley, I cannot name the company. One of the guys who works for the IT team said that it had a policy that they can’t use Slack or any other tools only, whatever that was dictated by the IT. But under their nose, the same organization, smaller teams were using Slack because their first slack was so good. So, I think the strength of this company is the product itself, and Stewart Butterfield, the founder, talks about it quite a bit.

25:16

The vision of the company is to make work pleasant and working lives simpler and productive for people in the enterprise. The value proposition has changed over a period of time. It started with communication, but it has spread to integration with other applications. I know folks in engineering who now use Slack to bring up services on the cloud. Sales folks used to track their leads through integration with Salesforce.

Hari Ramachandra  25:46

So, they have partnerships with Salesforce, Workday, Google, so you can pretty much do everything through Slack. The way I see is that, I see them as the WeChat of enterprise users. They are becoming one interface that most users are used to. They integrate with all other applications. A lot of these SaaS application are still quite *inaudible*, actually, in terms of user experience. So Slack kind of smoothens it out. That’s kind of the pitch. I also will talk about, what are some of the drawbacks and challenges, but I think Preston and Stig have questions which I’ll be happy to answer.

Stig Brodersen  26:22

Hari, I really like your pick. I just do want to emphasize what you also said there in beginning that we really can’t compare to a price. So, we know it’s a great company but we don’t know if it’s a good investment, because we don’t know what we’re paying for it just yet. TIP is using Slack. It is absolutely amazing, we’re actually free users and the very first thing we do whenever we onboard new members is to give them a Slack account.

26:43

It is sort of difficult to explain why it’s better than the other communication channels unless you try it out. The way that Slack is just organized, the way you communicate with each other, it’s just so much better than email and the other chat functions that you have out there, at least so far. I do want to say that as much as I love Slack, I’m also considering moving away from it. We actually talked about that for quite a few months. Now, one of the reasons is that we’re using so many different apps already that it’s really nice to have just one.

27:16

You mentioned GSuite before. As an example, Google talks about how the new Google Hangout, which is sort of the equivalent to Slack, will be upgraded in October. Apparently, it’s going to look exactly like Slack because the features in itself are not as complicated. It’s easy for me as non-programmer to do since it’s just a new way of organizing communication. I guess my concern is I really can’t see why it wouldn’t be possible for Hang Out to do that.

27:41

The networking effect you talked about, that’s not a lot, if you compare that to Microsoft or compare that to Google and you have everything combined anyway, especially whenever you compare it to the pricing. It’s definitely right. It’s not just about communication. That’s really where they started. Now they are more trying to compete with the other tech giants by offering different features like cloud space.

28:02

One example, Slack is $6.67 per premium user, and you would get 10 gigabytes if you did that. For Google for $6, you get 30 gigabytes, and if you pay $12 for a so called premium account, you get unlimited storage. That’s just one of those where I’m like, if one of the others fix the communication part, which I think and I hope they will, you get all the other bells and whistles that are much more developed with, for instance, Microsoft and Google.

28:26

I guess those are some of the concerns I would have as an investor in Slack, as much as I love the product. And yes, I do probably spend 90 minutes on it every single day. So, I’m really happy you mentioned that too. I don’t feel too weird about doing that.

Preston Pysh  28:39

So Hari, my only comment really kind of hits it with Stig opened up with which is the valuation. This thing can be the best tool on the planet Earth, but if we don’t know the price that you’re going to have to pay in order to participate in whatever earnings they produce, that’s is going to be the big question for me. Then the other big question for me is going to be how much more market share do we think Slack can take globally or whatever regions they have a dominant presence. How much more of that market share can they take when I’m doing my math and trying to figure out what I think it’s worth.

29:11

So those two factors for me are going to be more important than I don’t want to say more important, but I would say just as important as the quality of the product, which is what we’ve really kind of been addressing throughout the entire conversation. Without knowing that, I can’t really say whether it’s a buy or not, but I will be watching very closely as they do IPO and become a publicly traded business.

Hari Ramachandra  29:32

Yeah, those are really good points and questions, Stig and Preston. The reason I brought this up is exactly this, because I wanted to get a feel of as a business model and as a company, how viable they are in the long term. Is it something that is sustainable? And Preston, you brought up a very good point in terms of okay, Microsoft and Google. Just to do a comparison compared to Slack, which has 600,000 paid customers, Microsoft has 28 million businesses paid customers and their monthly active users are like 165 million monthly active users.

30:07

It’s not that they’re not growing. Back in November 2015, Microsoft had only 60 million monthly active users. So, Microsoft Teams pretty much has replicated everything Slack does. The only difference is that it doesn’t integrate very well with third parties as much as it integrates with their own ecosystem. Google also as Stig pointed out, is coming up. They have 5 million paid customers for their Google Suite. What Slack is facing is an uphill battle in terms of gaining those customers. I guess the small and medium businesses, they have won them so far, because you are not tied to Google Suite or Microsoft.

Stig Brodersen  30:49

It’s interesting that you would bring that up. I think that as a business owner, I don’t really care. It just has to be easy. Let me give you one example. As a free user of Slack, I can’t have calls with more than one person at a time, so we would use Skype for that. Whenever we outline tasks, we’re doing that in Google Sheets, so that would be Google, and then we’ll have the communication over Slack. I mean, to me, that’s not super-efficient. Why not just go to one place if I have one place that solves all that? By the way, for storage, we use Dropbox.

31:18

If all of that can be fixed, I have no sense of loyalty to Slack. I love the program, I love the features, and I don’t have any brand loyalty. I think as a business owner, you really focus on the product and you focus on a lot of different things. The tools you’re using to get to that point, it’s not really important. You just want that to be as easy as possible. You don’t spend time, you don’t want to have too many costs a month for that, whether it’s time or actually dollars thrown out of your business.

Tobias Carlisle  31:43

I’ve been using Slack for a few years in my business. I love the product. It’s really, really hard to describe to someone what it is. It’s like the old internet chat relay, Internet Relay Chat, IRC, but it does integrate with everything really well. It’s hard to describe and it is really addictive.  It’s got that really clever thing where they make you pay for your history. It gives you some limited history like a year, four months or something like that, and if you want to see something that you tweeted to someone a year ago, you got to pay for that which we have ended up doing.

32:10

I think it’s an absolute killer business with that viral mode where it comes in down the bottom and just takes over the host organism, like that’s an incredible business. The only question is what they’re going to try and sell it for. I know when it does, it’s going to be absolutely nosebleed expensive, so I’m probably not going to buy it in the listing.

32:25

Hopefully it gets beaten up at some stage because I think it’s a great business, and it’s going to get taken out by Google or someone at some stage because Google doesn’t have anything. I hope that Google builds something similar because I use all the Google spreadsheets, Gmail and all that stuff, but I think it’s a great pick. It’s just going to be a question of value.

Preston Pysh  32:40

All right, so you guys want me to move on to my pick?

Stig Brodersen  32:44

Yeah.

Preston Pysh  32:45

All right. A lot of people I don’t think know that I moved about a year ago, and I used to live in Bel Air Maryland now I live in Huntsville, Alabama. My pick today is Auburn National Bank. I apologize up front for all the Alabama fans out there that I’m going to be talking about Auburn here. But this bank came up on our filter.

33:07

So Stig and I built this TIP Finance tool. We have a filter there, we got a momentum tool, we have all sorts of stuff. This one came up very high whenever I was looking at smaller businesses, small cap businesses. I kind of wanted to talk about this one more because on the show, we very rarely talk about small cap businesses, that are under $100 million dollars for their size.

33:31

For this one here, it is small, it is really small, and a lot of the times whenever you’re buying a small cap business, you get into liquidity concerns. You get into liquidity issues. With the price action, the price action is usually really choppy. It kind of doesn’t seem to make a lot of sense because you’re dealing with such a small business.

33:52

With this one here, the top line, the sales for the business for last year 2018 was $29 million. So very, very small. I see Toby laughing, $29 million. The bottom line, the profit on the business, was $9 million. So, when you look at the profit margin here, we’re talking about 30% profit margin on this business. It’s massive. I want to say the S&P 500, correct me if I’m wrong, guys, if you know the number better than I do.

34:23

I would say the S&P 500 is probably around 12% margin on average, and that’s very high compared to historical standards. 12% is the highest of the margins we’ve seen in the market for decades.  So, for this company to have a 30% margin is extremely high in my opinion. From a financial standpoint, it has a lot of stability. When you look at the top line growth over the last 10 years, it has been just really steady. It’s not bouncing all over the place. It just kind of just keeps getting better each year. The profit that the company produces just keeps on getting a little bit better each year.

34:59

In the summer of 2018, the price on the stock got up to $53.85. Let me just tell you the ticker here because I failed to do that. The ticker is AUBN, that’s A-U-B-N. Anyway, so back in the summer of July, timeframe of 2018, the price got up to almost $54 a share. Then by the Christmas Eve crash there that we had in 2018, the price got down to $28. Today it sits at $33, as we’re talking about. So pretty big price drop in the last year on this company.

35:34

So, what I find interesting is you got a company that’s trading for $33.79, and the profit per share is right around $2.50. You’re buying something for $30, and you’re getting $2.50 of earnings out of it. Those earnings are pretty consistent each year. So really boring mortgage bank that’s lending money so people can buy homes. Some small business loans here in the local Alabama area, but very consistent and stable numbers and huge margin.

36:08

Whenever I do my intrinsic value based on the current price, I’m getting a pretty strong return in excess of 15% from a momentum standpoint. Back to our TIP Finance Tool, we have a momentum tool there that also represents whether it’s in a green or a red status for long term momentum trends. This is in a green status as of right now. In general, I liked it. I think it’s nice, small, boring, big margins. I think it has a great intrinsic value, so I’m kind of curious to hear what you guys think.

Tobias Carlisle  36:35

Can you just talk a little bit about how you get to the intrinsic value number? Sorry, Preston.

Preston Pysh  36:39

Yeah, no sweat. For me, what I do is I look at whatever I think the free cash flow on the business is. Whatever I think a sustainable free cash flow will be into the future. I’m kind of making an estimate for the growth rate. For this company I put in a what would be a conservative growth rate of around 5% from where it’s at right now. Based on that growth rate and based on the money market price, I come up with an intrinsic value. I basically do an IRR calculation and I’m getting an excess of 15%.

Stig Brodersen  37:08

So, what do you get, Toby?

Preston Pysh  37:10

Yeah, you’re looking at me like I’ve got something coming out of my ears. So, I want to hear what you got here, Toby.

Tobias Carlisle  37:17

Banks can be a difficult base to value. The leverage in them, it can be a slippery surf. They get some impairments to their underlying loan book, then that often takes a big bite out of their equity. At a very high level, let me decide. I really like the financials. I think the financials are really, really cheap. I think banks are really, really cheap. This is very steady growth. I think that Preston’s absolutely right about that.

37:41

It looks really good over the last 10 years and the stock price is crazy. It just dribbles up all the time pretty consistently. It tried to go to the moon late last year, but then what are we calling that, the Q4 massacre? The Christmas massacres? I think this is probably going to work out. I struggle a little bit with the valuation. I get that you have to be really super conservative deep value, guys. I think I’m getting 27 if I plug in a growth rate of 5%. EPS 252 terminal growth, I’m going to stick in four there. Maybe I’m applying too high a discount round playing 12%. What are you discounting at these days? What’s appropriate in this market?

Preston Pysh  38:17

I think that what you’re saying is as far as 12% sounds appropriate.

Tobias Carlisle  38:21

If this is about the mid-range of where I would put the value, so I’d put the value somewhere between 30 and 40. It’s just hard for me to kind of get my arms around this one. So, I should probably be making less noise and being more quiet, but that’s not the function of a podcast.

Preston Pysh  38:35

I want you to pick it apart, man.

Tobias Carlisle  38:37

Yeah, it is a very safe stock. I don’t think it’s got plenty of cash really nicely growing. It’s hard to see how you get the explosive upside, but I don’t think you’re going to lose money on it either. So that’s my two cents.

Preston Pysh  38:48

I definitely don’t think you’re going to have an explosive upside. I think what you’re going to have is something that is priced at a very reasonable rate that has a very consistent track record of just growing itself steadily. It pays a decent dividend. It’s definitely not a gaming company from Singapore by any shape of imagination.

Stig Brodersen  39:08

No, and that’s probably a good thing. Whenever I look at it, I really liked the numbers. It’s got stable numbers, it’s a profitable company. If you look at how it’s managed, it’s somewhat conservative, which I also like a the bank, especially at this point in the cycle. They have maintained a relatively low loan to total deposit. So right now it’s around 60%. It seems like the new normal is closer to 280 for banks like this.

39:32

I do want to say that as good as the numbers look like and I don’t see that you will lose a lot of money on this, as you also mentioned. It might not see an explosive upside, but I think more like a general trend in banking. Now that seems like everything is being more and more commoditized. Like the advantages of being the local bank today’s probably not as many as it was before.

39:54

More and more are moving online, especially with the younger generation. Being the top of mind for locals isn’t as important as it was in the past. I see some advantages going over to the bigger banks, not just because they’re systemic in itself, but also because that the digital products that they are offering the way banking is today, probably will be developed better by the bigger banks. Better offers and more functionality for you as a user.

40:21

I don’t know if you become a customer here for this company, Preston. But is that a concern itself? There’s definitely some concerns I’ve seen with smaller banks. I’m doing more international transfers, they’re just some limitations if you have more advanced businesses as a businessperson, I guess for some of the smaller banks.

Preston Pysh  40:37

I think that what you’re talking about Stig, is all really, really good highlights for risks. I guess if I was going to flip it on its head and try to argue the opposite side of it, I would probably say this company is so small, that maybe their competitive advantage is that they’re so small. They’re doing loans, they are then working a deal. They’re then selling off the loan to the big banks after the deal’s been done. I think they can get away with being so efficient and so small that maybe staying that way is their competitive advantage. I don’t know. I have no idea. That’s me just trying to argue the opposite side of what you said. Hari?

Hari Ramachandra  41:14

This is just a follow up question to what Stig just said, like considering big bank versus small banks. I was just looking at Wells Fargo in terms of their P/E ratio. It’s a better P/E ratio than Auburn, and their growth rate is similar in terms of revenue growth. I’m just looking at the numbers superficially. My question was, if I had to pick between Wells Fargo and Auburn, like what’s the difference? Why would I pick this bank versus a Wells Fargo considering the price point?

Preston Pysh  41:42

Well, the thing that really got my attention is the margin. So for a company to be banging out a 30% margin, that’s absolutely incredible. I said this when I started, that I really wanted to talk about this more because it was a small cap company. It had what I think are, really decent, stable numbers that we’re giving you returns above 10%. Anything above 10% is worthy of discussion at this point. I say 10% now, because Toby kind of came up with his valuation, I had my evaluation, and you’re never going to have anything that’s kind of the same number, because a lot of it has to do with how we’re projecting what that future might look like.

42:17

I haven’t run the numbers on, you said Bank of America, is that right, Hari?

Hari Ramachandra  42:21

Wells Fargo.

Preston Pysh  42:22

I haven’t run the numbers on Wells Fargo to do the comparison. I know on our Filter tool; I’m not seeing Wells Fargo kind of at the top where this one kind of came up at the top for a small cap business. So I’d have to dig in there and kind of do that analysis to do the comparison. I think it’s a very valid question, and if the intrinsic value would be similar as far as the return, I think you’d be crazy to own the small cap if you had a large cap that was giving you a similar return. So, I think that that’s an important consideration. Then you’d have to make the determination on how much more yield is the pick worth in order to be in a small cap versus a large cap.

Tobias Carlisle  42:57

One thing that I would add to your side of the argument, Preston, and I had a look at their insider trades. I’ve just about never seen something like this. They are almost all always buying. I look back over 10 years, most of the time, directors get options and they just pump the shares all day long, but these guys are actually buying what’s in there. So that’s about the strongest argument you can get for this being undervalued if the insiders are putting their money where their mouth is.

Preston Pysh  43:22

Yeah. All right. Well, I don’t have anything else on it. I would encourage people to go on Twitter, hit us up on all four of these picks. Let us know what you think. We’re trying to figure it out just like everybody else. If you have a little tidbit that you think could help other people out, we’ll retweet it. We’ll share it. We’ll talk about it. Go on our forum, we can continue the conversation there on The Investor’s Podcast Forum. We got a ton of people in there chatting about different picks.

43:47

Toby, Hari, thank you so much for coming on the show every quarter. I know that you guys are very busy people. It just means so much to Stig and I, and also our audience that you guys always make time to come on here and have such great conversations. Toby has an incredible ETF that he just recently launched. He also has a podcast. Toby, talk about that and then we’ll throw it over to Hari to talk about Bits Business.

Tobias Carlisle  44:12

Thanks so much. The ETF that I just launched is the Acquirer’s ETF. The ticker is ZIG, it’s 130 30 long, short, deep value ETF. We buy really strong companies on the long side and we short the junky cyclicals on the top side. You can check out my podcast, which is Acquirer’s Podcast. It’s on my website, Acquirer’s Multiple where we just interview value investors and find out more about this strategy for the most part. I’m on Twitter too, @greenbackd. It’s a funny spelling, it’s g-r-e-e-n-b-a-c-k-d.

Preston Pysh  44:43

Alright, Hari, talk to us about Bits Business real fast so people can learn more about you there.

Hari Ramachandra  44:48

I have a blog, bitsbusiness.com, where I share my learnings, what’s going on in the valley, and I would love to engage in conversations and get feedback. So, connect to me at bitsbusiness.com

Preston Pysh  45:00

Gentlemen, always a pleasure. Thank you so much. We really enjoyed it.

Tobias Carlisle  45:04

Thanks so much for having us.

Hari Ramachandra  45:06

Same here. Thank you.

Stig Brodersen  45:08

So, at this point in time in the show, we’re going to play question from the audience and this question comes from Amit.

Amit  45:13

Hi, Preston and Stig. I’m Amit from the UK. I started to learn about investing in October 2017, and I’ve been listening to your show since then. TIP has played an integral role in this journey. You are one of the best teachers I’ve ever had. I’m really grateful to you. So, thank you. My question is in a form of a request. Can you each share with us a mistake you’ve made in the past two or three years regarding an investment? How did you feel when you realize it was a mistake? How did you correct this mistake? What steps, if any, did you take in order to not repeat this mistake in the future? I would love to know your process. Love you guys. All the power to you! Bye.

Stig Brodersen  45:56

Oh boy. I made so many mistakes and not really sure where to start. So, let me start my response with the framework of my mistake. As you might remember, we had Bill Miller on the show on Episode 247. One of the key takeaways was as a stock investor, we need to distinguish between cyclical trends and secular trends. For instance, cyclical trends. One example that comes to mind is the auto industry. That has historically been a good example. We always see cycles in the auto industry, depending on where we are in the economic cycle. Basically, in good times, we simply buy more cars and in bad times we don’t, or at least we buy different cars.

46:35

Secular, on the other hand, means that things have fundamentally changed. So, what we see for cars now, for instance, is the trend into self-driving cars. This is not a trend that will change anytime soon. This is a fundamental shift. So, if you keep looking back on how companies have made money in the past, and assume they will continue linearly, I think that self-driving cars will have no impact on revenue generation in the future.

47:01

Well, then you’re likely headed for trouble. That’s also why you see some other car companies right now trading for very low multiples, and why more innovative car manufacturers are leading the self-driving and electric car movement, are trading at really high multiples. Across the board, there is a really good reason for that.

47:19

So, when you ask me about some of the many mistakes that I made, the difference between the cyclical and the secular trends is definitely something that I missed in the past. So specifically, for me, it was a mistake that I made investing in Bed, Bath, and Beyond. So if you consider my mistake and a company like Bed, Bath, and Beyond, and I guess you could say that for many other retailers, this was a stock that I bought for $21 and then sold at 15 before I realized my mistake, and this was in the bull market, keep in mind, so it is quite an accomplishment performing so badly.

47:51

I completely missed the mark. As a value investor, I’m trying to think that small companies grow more than larger companies. While that is still solid advice, there seems to be a secular trend whenever it comes to retail companies. There are so many other goods and services, they’re just sold so much more efficiently by machine learning and optimized websites.

48:12

The small companies are not catching up with Amazon. Amazon is just getting bigger, and the bigger they get, the better they become because they have more and more data. That’s the very heart of machine learning. So, the $12 billion top line of Bed, Bath, and Beyond that I was looking at, it actually showed that it had a harder time growing than the $250 billion-dollar top line of Amazon. Even if you only look at the retail division of Amazon, Bed, Bath, and Beyond simply didn’t have what it took to grow retail and compete with Amazon even though you might think then $12 billion base would be easier. It’s really not.

Stig Brodersen  48:49

Of course, there are limitations to how much Amazon can grow, but what I fail to understand was that the consumer preference of shopping and the value added of brick and mortar has changed more than I expected. This is not a cyclical trend, this is a secular trend, meaning it’s not going back to the way it was before. Of course, as a stock investor, you know that there’s typically a good reason why stocks are trading at a 52-week low.

Stig Brodersen  49:13

You know that very often, the stock is worth less than it was before, but you have to estimate what you think the new lower true value of the stock is, and then compare it to the stock price. So even though I was very aware of the impact of Amazon, on a company like Bed, Bath and Beyond, and I knew that it wasn’t worth as much as in the past, I underestimated how quickly it lost value. Much more than the already depressed stock price of $21 that I bought it at.

Stig Brodersen  49:39

Whenever you ask about the process for mistakes, one process I personally apply is the two-year rule. This is a rule that I learned from Guy Spier. That is, if you buy into a stock that you think is undervalued and where value in itself would be the catalyst that you’re looking for. If the stock has moved for two years, I need a really, really good reason to hold on to that stock because more likely than not, I’m just wrong in my analysis, and there’s a reason why the market has not rewarded that stock. Thank you for the question. I think was a great question. I think it’s very important that we are very open, and we learn from our mistakes.

Preston Pysh  50:16

All right, so I guess it’s my turn now. I think one of the biggest mistakes I made three years ago compared to my approach today would revolve around the lack of momentum that was integrated into my approach. I know I’ve talked about this a lot lately, but it’s just kind of such a drastic change to the way I was doing business. I can honestly say that if it weren’t for our guests like Wesley Gray, Toby Carlisle, Patrick O’Shaughnessy, his father, James O’Shaughnessy, I would have never even begun to think about momentum being a type of approach that would augment the way I invested seriously.

50:53

I have just enormous respect for those four guys, and the amount of research that they do for the way that they invest. I just realized that there must be something to this. I dug into it and I quickly determined and understood that there’s a lot to what they were doing. After doing some research and studying the methodology, I slowly started incorporating momentum into my style. Since doing that I don’t feel like I have my temperament tested nearly as much.

51:21

This is one of the things that when you go to a Berkshire Shareholders Meeting, Buffett and Munger always talk about this idea of temperament. They’ll say we were great stock investors because we had the temperament for it. What they’re really saying is they had the stomach for it, they were able to put on a position, it would move against them and it wouldn’t cause them to sell the position where many, many people can’t say that and they actually do the opposite of buying low and selling high. Instead what they do is they buy kind of high or what they thought was low, only to have their temperament tested and then they sell it even lower.

52:01

So that’s why I really like momentum. That’s why it’s become an integral part in the way that I invest now versus a few years back is because it’s just helped me manage my temperament by not putting on a value pick too soon. In fact, I can identify a whole handful of value picks quite easily at any given point in time, depending on where we’re at anywhere in the cycle.

52:25

I feel like I can list out a whole bunch of value picks at any time. I think the hard part is finding a value pick that won’t make you second guess yourself in five months or a year. That’s because many value-based picks continue to get punished by the market because of psychology, not necessarily because of fundamentals. So by wrapping momentum for me into my approach, it’s helped me not jump on the value based picks too soon, but to continue to monitor them, and then enter them at what I think is a better time and not have to sit through some of that difficult period where I’m having my temperament tested. I would say that that’s the biggest thing that I’ve learned in the last three years.

53:05

So Amit, we loved your question! We have an online course called our Intrinsic Value Course that we’re going to give you completely for free. Additionally, we have a filtering and momentum tool, which we call TIP Finance, and it does all this hard work that I just described for you by calculating whether something has a positive or negative momentum trend and it also does the deep value filtering that I talked about.

53:27

We’re going to give you a yearlong subscription to TIP Finance completely for free. Leave us a question at asktheinvestors.com, that’s asktheinvestors.com. If you’re interested in these tools, simply go to our website, theinvestorspodcast.com and you can see right there in our top-level navigation, there are links to TIP Finance and also the TIP Academy where you’d find the Intrinsic Value Course.

Stig Brodersen  53:50

All right guys, that was all that Preston and I have for this week’s episode of The Investor’s Podcast. We’ll see each other again next week.

Outro  53:57

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