18 November 2017

On today’s show, we talk with best selling author, Tobias Carlisle. Tobias is the founder of Carbon Beach Asset Management and is a luminary in quant value investing. He discusses his new book titled, The Acquirer’s Multiple, where an individual can effectively filter their stocks for the highest return. Tobias shares his ideas on backtesting and how it has helped him reveal the critical variable for finding stocks with large profits and low prices. Additionally, Tobias discusses how he manages risk, portfolio sizing, options, and much more.

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  • What is a good return on the stock market today?
  • Why is Enterprise value more useful than Market cap when you value stocks?
  • Can you be diversified owning just one asset class?
  • How do I size my positions when I buy options?


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Preston Pysh  0:03  

In today’s show, we bring on our good friend, Toby Carlisle to talk about his new book, “The Acquirer’s Multiple.” Toby has conducted extensive research on Warren Buffett and Joel Greenblatt’s Magic Formula, along with numerous other successful quantum investing approaches. Based on back testing of historical market results, Toby explains why his Acquirer’s Multiple approach might even capture a couple more percent than Greenblatt’s approach. 

For people who are not familiar with Toby, he’s the founder of Carbon Beach Asset Management. He’s an authority in the value investing community. In today’s episode, we’ll talk about what the enterprise value of a company is and why it might be useful for finding good stock picks. 

Alright, so if you guys are ready, let’s get started.

Tobias Carlisle  0:48  

You are listening to The Investor’s Podcast while we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Preston Pysh  1:09  

All right, we’re really excited to have our good friend, Toby Carlisle with us. Toby, I want to personally thank you on the show because I don’t know if we have talked about this, but I want to thank you for coming out to the New York event that we did back in August. You flew the whole way out from California. I just want to personally thank you for coming out to the event. I know a lot of people that came out really enjoyed seeing you as well.

Tobias Carlisle  1:30  

Thanks so much for having me back to the show. I honestly loved that event. The highlight of it was meeting so many great people, but the highlight of the highlight was getting that “Poor Charlie’s Almanack” signed by Charlie Munger.

Preston Pysh  1:44  

Toby, let’s cut to the chase here. So you got a new book that came out. We’re really excited to talk to you about this. We opened up the questions to our audience over Twitter, and one of the main things that people were asking us was: “What’s the difference between your new book which is called the acquirers multiple and your last book, “Deep Value”? What are the differences between those two?

Tobias Carlisle  2:06  

“Deep Value” came out in 2014. It was this quasi-academic long, kind of dense book on the mechanics of mean reversion. I found that as a handy tool. But from a lot of people, I get two main complaints. One was that it was hard to read, and that there was a lot of jargon in there. It was sort of unintentional. It’s just one of those things when you’re doing this stuff all the time, you sort of forget that somebody who’s smart, might not necessarily know what EBITDA, operating earnings or enterprise value is. 

I wanted to write a book for my family and friends who were interested in this stuff, but weren’t necessarily what I would call “stock market people”. They’re not doing it all the time. My mom and dad and various other people. 

Look, it’s not dumbed down at all. I saw that criticism on Twitter. The point of the book is not to be dumbed down at all. I think that you can see people trying to hide weak ideas in high language. 

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I think that the idea is strong enough that I want them to be communicated to a very broad group of people who aren’t necessarily just stock market people. If you’re a smart person, and you don’t have a lot of a background in this stuff, and you want a nice kind of entree into it, then I think this is a great book to start off with. 

It explains the terms. It explains the kind of the argument in the value investor community between the sort of Buffet type guys and the guys who are more into deep value, which is what I do.

Stig Brodersen  3:26  

Great. And Toby, we’re really excited to dig more into the approach here later in the show. The first question I have for you, you literally talked about you and your journey as an investor to find the right stock investing strategy for you.

Tobias Carlisle  3:41  

When I was in my undergrad doing Business, I read “Security Analysis.” I found it really hard to read. I read the first edition because I thought that’s going to be the one that he put all the really juicy stuff in before he sort of got the chance to edit it. 

I found it really hard to read. I don’t even know if I got all the way through it. But I got to the liquidation chapter. I was interested in the net-net. I had kind of heard that that’s what Graham did. 

Then I went to law school and I started working as a lawyer. I was doing mergers and acquisitions, capital raising kind of capital markets stuff in Australia and in the US. And just because of the time that I came out to the early 2000s, lots of these companies that have raised a lot of money in the late 1990s are now trading really cheaply like below their cash. 

I don’t think they’re even called activist investors. Nobody really knew what they were. They were just sort of corporate raiders from the ’80s. But that wasn’t a term that people were using. They came in and tried to get these companies to pay the cash. 

I was looking at them. I was looking at the businesses to the extent these companies even have a business, which often they didn’t. They were just sort of trying to attract eyeballs, trying to work out what they were doing. I couldn’t figure out what they were doing. Then I remembered that Graham had taken that approach. I went back and had a look at it. And then it became a little bit clearer. 

I thought next time that this happens, next time the market gets this cheap, I will remember this. I’ll go in, and I’ll start buying these little sub-liquidation value companies where there’s an activist. That was Greenbackd, which was the blog I started writing in 2008. I picked those kind of stocks. They all did really well. 

Pretty quickly, you’ll find that the problem with that strategy is that the net-nets aren’t around all the time. They’re some sort of animal that only comes out every 7 or 8 years. It’s like a cicada or something like that. It comes out very occasionally. 

I was looking for something that embraces that kind of idea of looking at the balance sheet as well as the business. I had read some stuff in my undergrad business about leveraged buyouts. I went into those old books, which were in the Social Science library at my university. I went through them and found about the buy-out in the ’70s, ’80s and ’90s. That’s the idea. 

So the Acquirer’s Multiple, basically is a way of finding very deeply undervalued companies with sort of hidden cash on their balance sheets, good operating earnings relative to what you’re paying. They’re the sort of things that attract private equity firms and activists who can get in and do something with the business. 

Stig Brodersen  6:16  

Toby, I’m curious, why do you think it makes sense to you? I’m sure a lot of people out there who are listening to this are like, “Yeah, that kind of makes sense that you will follow an activist or see if they have hidden cash on the balance sheet, but it also sounds very technical to identify.” So why did they appeal to you?

Tobias Carlisle  6:35  

What I did find is that a lot of the time, they’re just undervalued. It’s the main reversion that pushes them up to valuation. But I think you have to be doing this sort of stuff if you’re a discounted cash flow investor, or if you’re a Buffett compound. You need to be doing this kind of analysis. 

I think the difference in what I do is that I recognize my own limitations when I’m looking at a business and valuing a business. It’s very unlikely that I’m going to have any kind of insight that any other person out there who might be a professional in the industry or have a background as a consultant, or an investment banker in the industry who might have a better idea about where that industry is going or where that particular business is going.

I wanted an approach where if I assume that I don’t have any sort of unusual insight into the business that might give me an edge, how can I still protect myself and still do fairly well investing in stocks? I think that the way that I do that is I just try to buy them very cheaply, hoping that you get this sort of asymmetric return where a lot of the downside has been taken out of it. If something good happens, you get a lot of upside.

Preston Pysh  7:44  

So Toby, in your book, you talk about Warren Buffett’s early days. I think this was in the second chapter. You reference a quote which is really popular that a lot of people throw out there all the time. Buffett said that he could get a 50% annual return if he was managing smaller money around like a million dollars. 

From that, you teach people that Buffett would split his investments into three groups when he was first starting out with a small sum of money. Talk to us about this idea and what we can learn and take away from this. And can you identify those three groups that you reference?

Tobias Carlisle  8:16  

One of the three groups is the “Generals.” This is something that is just undervalued, with no sort of clear path for the undervaluation to be removed. There’s no catalyst. It’s just the sort of you might go and do a valuation, find that it’s undervalued, and think that over time. It should do okay. The valuation should sort of go back to average. 

The other two are sort of related to each other. It’s a “Workout” and a “Control Situation.” A workout is just any special situation. I’ve been on the show before talking about special situations. 

Basically, there’s a known catalyst which might be a big share buyback, or a spin-off, or liquidation, or some event where the decision is made at a board level to bring the valuation back in 1. That’s how you extract the value from it. 

There was a smaller group of that Workout group where Buffett was the guy who was in control. He was going to make that thing work out. He was the one who was going to make the company spin off, or pay some money out, or liquidate, or whatever. When he was doing his workouts, he often said that he was very happy to be a coattail rider, where he was on some other good investors’ coattail, or where he was confident that that person was going to do what he would do if he was in control. 

So those are the three groups: Workouts, Control Situations and Generals, and Coattail Riding or controls the way that he executed them. 

Stig Brodersen  9:36  

On and off the show, Preston and I have been discussing what a good return is. And this is for an investor picking individual stocks. Given the high market valuations, I guess one could argue that if you can get 6% to 8% return over the next decade, a lot of people would say that’s fairly decent. 

You also have the other side of the coin where you might even be able to get a higher return if you don’t invest in the stock market right now because it’s overvalued. You might wait for a crash, and then jump into the market. 

So Toby, I’m not going to ask you to predict when the next market crash will happen. Don’t worry, that’s not the point of this question. I’m curious about your thought process on how to achieve a good return in the stock market without taking on too much risk. Or would you rather just stay out of it?

Tobias Carlisle  10:32  

Yeah, that’s probably the most difficult question that you could ask anybody. I know exactly when the next crash is coming. But I just can’t tell it. I’m keeping it to myself. 

James Monti wrote this great article for GMO a few years ago saying that we’re in this very difficult position where you either have to be fully invested earning low returns where you may be able to get this sort of the stock market has been pretty strong over the last few years, even though it has been quite expensive. But you run the risk if you’re fully invested in having a big drawdown, which is what Buffett and Munger always say. 

If you’re not prepared to have a 50% drawdown, you shouldn’t be in the market. Whatever proportion of your money you’re not prepared to have go down that much shouldn’t be invested in the market. But the other problem is that if you don’t then want to take that risk, the risk that you take is that you sit in cash, which is earning nothing for a really long period of time. How long is it going to be before there’s a crash? I have no idea. 

So to answer the question to “What’s a good return?”. In the early ’80s, the market could have been expected to do something like close to 20% a year. I think that’s what it delivered. If you look at what the valuations imply now, the returns are going to be much lower than that. I think 2% is probably what the market is going to do if you can get a little premium over that by investing in value. 

I think that Valley has underperformed a little bit. I don’t think it’s got a little bit more outperformance in the market. Doesn’t it? The extent of that outperformance I can’t gauge. The Valley has some properties that make it a little bit less attractive than the market. You need a little bit more return.

I don’t really want to put a number on but a good return over the next decade would be, I agree, about 6% to 8%. But I don’t think that’s what the markets are going to do. The market’s going to do with a big *inaudible* and in between.

Stig Brodersen  12:19  

So Toby, let’s say, I gave you the opportunity to log in 7% return over the next decade. You are a far better investor than the average. I know that this is a reasonable question. Do you think that’s a good return for you?

Tobias Carlisle  12:34  

That’s a really good question. I want my money to invest in my own strategies. But do I think that I can beat 7% for no risk at 7%? That’s getting close to the number that I’d probably have to say. Maybe I’ll just go fishing.

Preston Pysh  12:46  

That’s your hurdle rate right now?

Tobias Carlisle  12:51  

You’re guaranteeing this too, right?I don’t have any counterparty risk in this trade. I think that’s a good return, but you can’t get that anywhere. That’s not a return that’s available anywhere risk-free guaranteed.

Preston Pysh  13:03  

So Toby, we throw around the term, “enterprise value” a lot on the show. I would like you to describe this to the audience. What is enterprise value? Help them understand what the terminology is.

Tobias Carlisle  13:14  

It’s a great question. It’s just one of those things that you have to learn one time so that you can remember. Just in very broad terms, the market capitalization of a company is its share price multiplied by the number of shares that it has outstanding. 

However, that doesn’t tell you the whole story about the company. Companies can have a lot of debt or a little bit of debt. They can have cash. They can have other types of preference shares. They can have unusual things like minority interests or other kinds of liabilities like underfunded pensions. 

What the enterprise value does is it approaches the company as if it’s going to be taken over in its entirety by an acquirer. And when they do that, they have to be prepared to support the debt. They’re able to get access to the cash. These companies really do exist on the stock market. It might have $100 million in cash. It might have a market capitalization of $50 million.

The enterprise value of that company is -$50 million. In effect, you can get access to that cash. The reality is that when you find companies like that, they have terrible businesses or they have no business. They’re just burning cash. It’s like a biotech trying to find a compound or trying to get FDA approval. 

On the other hand, you can have an enormous amount of debt with a small market capitalization. It might be a $50 million market capitalization with $200 million in debt. If you only look at the market capitalization, you’re missing that debt, which is a real cost that the acquirer has to bear. So it’s something that you have to bring into the equation. 

The enterprise multiple is just a simple step for sort of bringing all those things into one little quick analysis. You can see what you’re paying and then you can compare it to what you’re going to be getting.

Preston Pysh  15:03  

In really simple terms, when we’re talking about market cap. Let’s say that we have 10 shares of a company. Each of those shares is $10. The market cap would be 100. You’re just multiplying those two numbers together. 

If you’re talking about enterprise value, you actually have to add the debt in there as well. So the market cap plus the debt is your enterprise value. Is everything that I just described accurate, Toby?

Tobias Carlisle  15:29  


Preston Pysh  15:30  

So what’s nice is when you’re looking at the enterprise value, you’re accounting for the debt piece of it. Stig and I talked about debt to equity and some other leverage ratios that we’d like to throw out there. But when you’re talking enterprise value, you’re accounting for that in the market price that you’re talking about. 

So now talk to us about back testing and what it suggests. After you talk about the back testing that you’ve done, talk to us a little bit about comparing your back testing results to Greenblatt’s back testing results. 

For anybody who doesn’t know Joel Greenblatt is, he’s the professor out of Columbia University. He’s a very famous investor. I want to say his net worth is close to $900 million or something $700 million. It’s way up there. And he’s had enormous returns. Toby has some back testing results that are quite interesting. And I’ll let Toby describe it to you guys.

Tobias Carlisle  16:17  

I’m a huge fan of Greenblatt. I have been for a very long time. He wrote this wonderful book more than a decade ago now, which is about special situations. That was how I first found out about Greenblatt. It has sort of appealed to me as a lawyer. It’s a difficult book to read, and it’s a difficult strategy to implement. 

A little bit over a decade ago, he wrote, “The Little Book That Beats the Market,” which is probably the most successful value investing book of the last decade. The book describes his strategy called the “Magic Formula,” which he found by reading through Warren Buffett’s letters to shareholders. 

He found that Buffett’s sort of advocates these two ideas: a wonderful company at a fair price. So a “wonderful company” is something that earns a lot of money for each dollar invested in it. A “fair price” is a low price relative to the operating earnings of that company being combined together to get the Magic Formula. 

And then when he back tested that Magic Formula, he found that it outperformed over the period that he tested it. It was around 1993 to 2005, something like that, which is the period in the book. I thought it was a fascinating strategy, and I read the book in 2006. I loved it. 

I have this bias for deep value. I just had this sort of nagging question: is buying these companies right at the top of their business cycle? There’s a distinction between what Greenblatt is doing and what Buffett is doing. Buffett is looking for sustainable high returns on invested capital, whereas the Magic Formula is just looking for high return in invested capital at the time that they screen for it. 

It’s harder to find that sustainable high return on invested capital than it is to find a company just having a good year. It turns out that if you just remove that requirement for the higher return on invested capital, you get better returns. That’s essentially what the acquirers multiple does. It just says, let’s ignore what the return on invested capital for the company is. Let’s just make sure that the company is cheap and has pretty good operating earnings. It turns out that when we test that idea that we do get better performance than the Magic Formula in a backtest. Even though the Magic Formula does tend to beat the market.

Preston Pysh  18:24  

By how much, Toby?

Tobias Carlisle  18:26  

It varies depending on the universe that you’re looking at. It’s a material number. I’m always a little bit worried about giving the precise numbers because it’s a little bit meaningless. There’s so many different inputs and ways of doing these backtests. 

For the Acquirer’s Multiple, I asked this machine learning value investment firm based out of Seattle called Euclidean Technologies to do the backtest for me. I gave them the instructions that the backtest should look the same as the one that Greenblatt conducted. And then I showed them my own strategy and I said, “Can you test both of those?” They did that. It’s a few percent a year by ignoring the invested capital.

Preston Pysh  19:05  


Stig Brodersen  19:06  

I’m really glad we’re talking about this, Toby. Whenever we have back testing, I think a lot of people would say, “Will this work in the future?” Perhaps this question is more relevant than giving artificial intelligence and machine learning that you’re talking about, and how this would look in the future.

Tobias Carlisle  19:25  

Everybody knows about these strategies. Often, it’s not the knowledge of these strategies that is the limiting factor in the application of this in the real world and in investment. The thing that makes these strategies difficult to invest in is because they extract a certain amount of pain from you as someone who’s invested in them. The way that they do that is basically this thing called, “tracking error,” which is kind of the fancy academic term for not keeping up with the market or going down when the markets go up. 

That’s really painful. That’s something that any kind of value investor has experienced on and off, pretty regularly since value investing was invented. But certainly over the last seven years. This is because the Valley has sort of struggled to keep up with a very strong market. That’s sort of the answer.

Value strategies are always necessarily going to be strategies that can’t get as much money into them as other passive strategies or other kind of momentum style strategies. They have these periods of underperformance that make them unacceptable to many people who want to invest in the market. That’s sort of what keeps the performance there.

Stig Brodersen  20:28  

Interesting. So basically, what you’re also saying here is that even if you had a fund doing artificial intelligence. I guess for a fund like that it will probably be easier to track capital than saying, “I’m buying the Oculus businesses.” 

It’s basically what you’re doing with deep value, and then waiting for the outperformance. If I’m like that, I couldn’t survive. Even if it called to something else because if they were chasing that deep value outperformance that you’re talking about, people would bother taking out the money when they see continuous underperformance for a period of time.

Tobias Carlisle  21:02  

It’s very hard to know whether the reason for the underperformance is that the strategy doesn’t work or if it’s just going through one of its sort of periodic underperformance times. It’s that point where everybody just says, “This stuff no longer works. I’m getting out.” When value investors look their dumbest, that’s the time that value is generally about to start working.

Stig Brodersen  21:24  

Interesting takeaway. So Toby, I’m super excited to ask this question to you. I’ve really been looking forward to it. We’ve been following Ray Dalio for a long time here on the show. Ray and other great investors talked about how important it is to have 15 uncorrelated bets with a low downside and a high upside. You’re specifically there into different asset classes. 

When I’m speaking to you, or when I’m reading into your material, or whenever we’re talking about these excessive returns, they come from buying a basket of the third of the cheapest stocks. I’m curious to hear how diversified you find that bet.

Preston Pysh  22:08  

And specifically with the uncorrelated part because I’m curious to hear that too.

Tobias Carlisle  22:13  

Guys like Dalio who are global macro style investors can find in lots of different markets that there are uncorrelated bets. They might be able to find some particular trend following commodity strategy, value investing equity strategy, momentum equity strategy. They might have been doing it long or short as well. 

They find that if you put them all together, you can sort of rebalance the portfolios at different times. So when one’s losing, you can take away some money from one that might be winning and feed it to the one that’s losing. You can get a sort of smoother return by putting these uncorrelated bets together. 

Value is a component of that. But it is not an uncorrelated strategy by itself. The way that you could sort of get some of that impact is by holding some cash. When value is going very well, you take a little bit of money. When you increase your cash holding and when value is going worse, you take away from your cash holding and you invest more into the stocks. 

Value Investing does have its own idiosyncratic return path that doesn’t exactly follow the market. That’s a little bit of set tracking error that we were talking about before. Tracking error is actually indicative of strategies that work. 

If they have more tracking errors, they tend to do better. It’s just a painful thing to go through when they’re underperforming, but they are quite correlated with the market just by virtue of the fact that it’s a long equity strategy in the market. 

It’s also a long equity strategy, so there is some correlation. It varies. It’s low correlation now because the market’s doing so well and value has been underperforming. But there are periods of time where the correlation is 1. If we go into a big enough crash, the correlation will be 1. It means that it’ll be going down the same speed as the market.

Stig Brodersen  23:57  

Is it a problem that it’s not as diversified? I think my question gets at how do you look at diversification? Are you looking at this, as 30 companies? They’re real companies. It’s not an asset class in itself that they’re stocks. So you don’t necessarily need to diversify into bonds, gold, or whatever you want to call it. Is that how you see it?

Preston Pysh  24:20  

I want to piggyback on Stig’s question, Toby because he threw out the number 30. But from all the things that we’ve read from Greenblatt to Dalio, and other people, they’re saying that the number is 15. I’m kind of curious about the number part of it as well.

Tobias Carlisle  24:34  

Well, there are two questions there. What Dalio is talking about is uncorrelated strategies. So he’s talking about a value investing strategy with a momentum strategy and a trend following commodity futures strategy. Maybe it has an option strategy or an international equities bond set to global macro type of approach. 

The diversification is a slightly different question. Are you holding enough stocks so that if any one of those stocks goes to zero, will your portfolio sort of survive? That’s a question that when I read “Concentrated Investing”, that’s exactly what I was trying to dig into. 

In “Concentrated Investing”, it is one of those times when the academic literature and the sort of rule of thumb from old school value investors basically coincide. If you ask the academics, they’d tell you that somewhere between 20 and 30 stocks gives you enough diversification. If you try and buy a whole lot more stocks, it just becomes too expensive and too hard to manage. 

The additional diversification that you get that is fewer than sort of 15. By adding an additional stock, which might not be that much expensive, you do get sort of a material improvement in your diversification. But the old school value investors like Graham and Klarman will tell you it’s approximately the same number. It’s around 20 or 30. 

If I could find 14 uncorrelated bets, I don’t know, that would probably make me a global macro guy. I’ve conquered one, or maybe I haven’t. I’ve been trying to understand one and that’s sort of all I’m capable of. 

Stig Brodersen  26:03  

The reason why I’m asking is because right after reading “Deep Value,” I also read extensively about Ray Dalio. It was really interesting to go through the work and think about stocks. Not just stocks in itself, but also the worst stocks you can ever think of -how they outperformed and how you still might get that sense of measuring your risk. 

After all, you did have 20 or 30, or so. That wouldn’t just be one company that would go bankrupt. Then when you read about Ray Dalio, he talks about not just US stocks, international stocks, international bonds, but also about gold, commodities, and the importance of diversification. 

If diversification is not free, there are best ways of mitigating the risk without compromising much on your returns. What’s your thought process of doing something like that compared to your own strategy?

Tobias Carlisle  27:00  

That asset allocation question is often one for individual investors. They can allocate to a value investing strategy or just a passive market strategy. The things that Ray Dalio is doing are driven by the fact that he’s got $100 billion under management. He needs a sort of fairly exotic, sophisticated approach to attract that $100 billion, and then to put it to work. 

He’s got a whole lot of guys at Bridgewater who are working at these strategies all the time. I’m an old school value investor. I think I can sort of value a company. I know the reasons why it underperforms and why it performs. I sort of feel like I know it well enough that I can just sit in and let it run.

Preston Pysh  27:44  

Alright, so Toby, this next question comes from Ted Darling on our Twitter feed. And he asks, “Do you get rid of stocks with a high amount of short interest from the Acquirer’s Multiple filter? Is there an additional filter layer where you’re trying to extract picks that are really uglier than ugly?” 

Tobias Carlisle  28:04  

The website screening takes a lot from the book “Quantitative Value” where we sort of went into the mechanics of screening. There are lots of different things that you can do. You can look at financial distress risk, earnings manipulation by itself, and also as sort of a guide if there is potential fraud. There are lots of statistical ways of doing it. 

I use those statistical methods to filter out particular types of stocks. I also use short interest as a way of identifying things that maybe I can’t figure out where the risk is, or the statistical methods haven’t quite got there. But the short sellers have been able to identify that there is something going on there. That’s not quite right. 

The reason I do that is that heavily shorted stocks tend to underperform. That’s what the research shows us. That doesn’t necessarily mean you want to go and short them because by virtue of the fact that they’re heavily shorted, that means that the borrow can be quite expensive. 

For a long investor who is approaching these things quantitatively, not buying things that are heavily shorted seems to be a way to add a little bit more performance. I do filter out the things that are heavily shorted. I don’t use a fixed hard cutoff. I just say that 5% of stocks that are currently the most heavily shorted. Its short interest as a proportion of their outstanding float are the ones that we don’t want to look at. 

Something can be cheap or undervalued on an Acquirer’s Multiple basis. It should be on the screen and it can appear on the screen. And then the short interest might build up in the stock because somebody’s got a view about the fundamental picture or something else is going on. Often they come back after a while. The short interest is sort of leaked out. They’ve recently settled down at a low price but definitely aren’t.

Preston Pysh  29:48  

I’m curious. Is there a reason that you settled at 5%? Was there some statistical evidence that supported a 5% versus 10% or 15%?

Tobias Carlisle  29:57  

Well, you’ve got two problems. There needs to be enough stocks sort of getting through the filter to allow the ranking methods to do their job. For the most part, the cheaper something is, the better the performance over time. But you equally don’t want things that are too heavily shorted. 

5%, I can’t remember whether that gave the best performance or not. I’m not entirely sure. But it just felt like it. Often this is what I do. I’ll run a screen, and I’ll look at the things that have been pulled out. 

I’ll just look at the names and see if those are names that I would feel uncomfortable buying for whatever reason. I’m more interested in sort of balance sheet issues than I am with business issues. It’s just that again, that’s my bias. 

I think I probably did two things. I was probably looking at the performance and then looking at whether that was pulling out too many names. It’s just sort of a rough rule of thumb. I thought that was the best approach.

Preston Pysh  30:49  

This next question comes from Kiran McCarthy. He’s curious about your use of options with your investing strategy.

Tobias Carlisle  30:58  

We use options in our special situations portfolio, not in the deep quantitative value portfolios. The thing about options is that they’re highly leveraged instruments. That means that they can generate a lot of return. They’re also able to blow gigantic holes in your portfolio. 

You need to be very careful when you’re using them. You need to sort of understand what they’re going to do. The way that I like to do them is the way that Greenblatt described them in his little yellow book. 

Basically, there are two ways. If something is very cheap and the volatility in the position is very high, you can sell a put and that creates a return profile that looks like being long the equity. 

I don’t want this to be too technical, but basically your downside is an equity downside. If you sell a put which might have $1 premium and it’s a $10 stock, your downside is the other $9. You need to be careful when you’re doing that. 

Another way of doing it is to buy a LEAP which is a call option and has more than 12 months to run in it. You would do that if you felt that the stock was really cheap, and there was low volatility in the calls.

It’s something that I love to do when the premium is a very small amount relative to the price of the stock. That means a small movement in the stock price gives you a very large movement in the value of the option. The reverse is also true for a small movement down. 

Zero is entirely possible. When you’re using call options, you need to be aware that zero is a very real possibility. When your short puts, you need to be aware that you can lose an enormous amount of money on those. You need to be very careful the way that you use them. 

Stig Brodersen  32:40  

How do you size? Let’s talk about the call options first. Intuitively, it makes slightly more sense. Basically, what you’re saying is that you could just go all out the window. Obviously, you don’t want to put 50% or whatever your portfolio in that. How much should you put in if you want to manage your risk accordingly?

Tobias Carlisle  33:00  

It depends on how many positions you have in your portfolio. Let’s say you’re running 10 stock positions, and each of which has 10% in the portfolio. If you find one that you think, “Look, this is a really cheap stock.” But for whatever reason, the balance sheet isn’t ideal, or there’s some risk in the stock. You think that this stock could go down 50%. This stock could go to 0. 

There’s a chance that this stock goes up 10x, 2x, 5x or whatever. You may think that I don’t want to put my money at risk to 10% of the portfolio, because if it goes to 0, it will blow up 10%. But I want to have that possibility of capturing that 2x, 5x, 10x upside. Then I would go and look at the price of the course. 

I might put 1% of the portfolio value which would be 10% premium, relative to the position. 10% of 10% is 1%. That way, if it goes to 0, I’ve only lost 1% of the portfolio that I put into it. If it goes up 2x, 5x, or 10x, it’s as if I’ve been long 10% of the stock. 

So my return can be at that sort of size. That’s the way I approach the calls. Typically, I’m using them because the volatility is very low. It’s just a way to play that volatility as well.

Preston Pysh  34:21  

All right, so Toby, we have a last question for you. This one comes from Brandon Saylor. So Brandon wrote to you: “Read the book. Loved it. Can you have him walk through the implementation of the screen – when to buy, sell and rebalance?”

Tobias Carlisle  34:36  

It really depends on how much time you want to spend doing it. I write on the site. There are two basic approaches to it. There’s a quantitative approach, which just means you’re going to buy everything on the screen without fear or favor, while relying on the sort of statistical outperformance of value over time. 

You can also do this business owner approach, which is what we were talking about before you go through and actually do the valuations. Putting aside the business center approach which is for people who really want to spend a lot of time doing it. In the quant approach, you can buy the 30 positions once per year, and revisit it a year minus one day. 

364 days later, you sell your losers. You sell the stocks that are down so that you capture all of the short term losses in this tax year. And then you wait 366 days so that when you sell the winners, you get long term capital gains. Ideally, you sort of push the long term capital gains into the next taxable year. 

You can do it more regularly than that. You could do it on a quarterly basis. Just checking in to sort of sell, lose, and buy some more winners that seem to work fine. That might give your own portfolio. It might make the returns a little bit closer to the sort of the value factors returns. It’s perfectly fine to only do it once a year. 

The nature of value is that it takes undervalued stocks up to 5 years to sort of get back to valuation. The vast bulk of the return comes out in the first year, but they still tend to be outperforming 5 years down the road.

Preston Pysh  36:10  

I know in your screener at the Acquirer’s Multiple that you have the large cap open for anybody to go there and use. I’m curious. How do you find yourself investing? Do you find yourself typically buying the large cap, mid cap or small cap? I’m just curious.

Tobias Carlisle  36:25  

Yeah, my portfolio is not so big that I’m forced to have a large cap. I tend to use the all investable. That’s the largest 50%. But the best returns have tended to come from the small cap stocks. 

If you really like small cap stocks, you’ll realize that small cap stocks can be a little bit more difficult to invest in. They have wider bid ask spreads that tend to chop around a lot. There’s a lot of volatility in the small cap stocks.

I’ve been down a lot on occasion. If it doesn’t worry you so much then, go with the small cap stocks. That was where I started out. I find them really fun to sort of go through. But just because I tend to be pretty busy in the business, I think that all the investable is the easiest to sort of implement. They’re all fairly liquid and easy to trade. You can get into them and allocate them pretty easily.

The smallest in there, I think, is a sort of $250 million market capitalization. It might even be a little bit bigger than that now. So they’re liquid and they’re easy to invest in. So for me, it’s all investable.

Preston Pysh  37:21  

Awesome. All right, Toby. Thank you so much for coming back on the show. I know our audience is always looking forward to you coming back on. You’re always sharing such insightful information. If people don’t know who you are, and they want to learn more about you, where can they find you?

Tobias Carlisle  37:35  

Thanks so much for having me guys. It’s always a great pleasure to be on this show. 

The website is acquirersmultiple.com. The new book is called, “The Acquirer’s Multiple”. It’s on Amazon. You can get it in paperback or on Kindle. For paperback, it’s $9.99, and in Kindle it’s $15.99 in the US. 

You can find me on Twitter at @greenbackd. It’s a funny spelling. I’m on this sort of all day long, answering questions, posting stuff, liking, and doing all those things. It’s really fun. So if you want to interact, I’m always there and ready to chat.

Preston Pysh  38:09  


Stig Brodersen  38:10  

Thank you, Toby for coming on the show. I’m sure the audience is excited to know that you will also be featured on the very next episode where you’ll be pitching a stock to the Mastermind group. 

But guys, that was all the Preston I had for this week’s episode of The Investor’s Podcast. We’ll see each other again next week.

Outro  38:28  

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