15 March 2020

On today’s show, we have value investing expert, Vitaliy Katsenelson, to talk about market cycles and investing with the fundamentals.

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  • Why value investors don’t understand how Warren Buffett does factor in macroeconomics events.
  • The biggest misperception of dividend investing.
  • How to measure value in growth.
  • How to invest in companies with predictable earnings.
  • Ask The Investors: How to make a living in investing when your holding period is forever?


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  00:02

On today’s show, we have Vitaliy Katsenelson. Vitaliy is the Chief Investment Officer at the Investment Management Associates. He has written two books; one titled The Little Book of Sideways Markets, and the other titled Active Value Investing. He’s often featured on Bloomberg Businessweek, Barron’s, and the Financial Times.

I think it’s very important to note that this conversation was recorded more than two weeks ago; and as everyone knows, things in the markets have become quite crazy with national shutdowns and unprecedented volatility. With that said, many of the ideas that Vitaliy talks about are relevant for how to think about managing risk, and preparing for many of the things that we’ve seen happen since the recording took place. So, without further delay, here’s our conversation with Vitaliy Katsenelson.

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Intro  00:23

You are listening to The Investor’s Podcast, where 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  01:09

Hey, everyone! Welcome to The Investor’s Podcast! I’m your host, Preston Pysh, and as always, I’m accompanied by my co-host, Stig Brodersen. We’re really excited to have our guest here, Vitaliy Katsenelson.

Vitaliy, welcome to the show! We’re excited to have you.

Vitaliy Katsenelson  01:23

My pleasure!

Preston Pysh  01:25

We’re talking about your book, The Little Book of Sideways Markets, and I thoroughly enjoyed reading your book. I think you have some amazing content here. You have some amazing principles here for people that are especially getting their feet wet in financial markets. But what’s difficult is, in the past decade, we have had anything but a sideways market. We’ve had an aggressive bull market. Some would even define it as insane. I think if you look back into the 2000-2005 timeframe, the interest rates were 5-7%. Back in that timeframe, everything appeared somewhat normal. From a valuation standpoint, the economy was operating in somewhat a normal manner. Today, literally, since the economic crisis back in 2008-2009, they’ve kept interest rates at 0%. We’re literally at the top of a credit cycle.

When you’re looking at that, and you’re looking at the valuation of how that makes all other assets get priced with 0% interest rates, as a value investor, how does a person move forward in this kind of market and continue to use those crazy discount rates reasonably? Like you, I’m a hardcore value investor. I’m looking at these macro themes that we’re being faced with, and I’m saying, “Is this all going to change? How is this going to change? Because it’s all function of inflation.” So, I’m curious about how you see the current market conditions as a value investor.

Vitaliy Katsenelson  03:07

It’s kind of interesting. For a long time, value investors felt that they don’t have to pay much attention to the macro. One could be kind of blissfully ignorant because everybody looked at Buffett, and he said it doesn’t matter what Federal Reserve does, etc. Well, there was a problem because people, first of all, misunderstood Buffett. Buffett basically said his decision-making would not change even if he knew what the federal reserve is for the six months from now. But at the same time, Buffett wrote an article in 1998, if I remember right, about how the dollar was too strong and that it’s going to weaken. He was really talking about micro stuff. Buffett did pay attention to that.

However, Buffett was not trying to be a weatherman trying to predict what the weather would be six months from now. He was more like a climatologist looking at the big climate change events, and trying to adjust his portfolio decisions based on the risks and opportunities. He would see from those climate-changing events. So my point is this: As an investor, value any asset as a present value of strategic cash flow. But those future cash flows, in your analysis, will be influenced by what’s going on in the world around us. It’s becoming more and more complex every day, and it’s becoming more and more mutated by what’s going on in the global economy.

If you look at our economy, our earnings were basically flat last year. Now, the economy grew 2% real growth and 4% nominal growth, which is not horrible. We usually grow 2% real growth, except our debt is now over 100% of the GDP, and our debt grew 5.6%. In other words, to produce this 4% nominal growth, they had to borrow 5.6%, and so the stocks went up 30% last year even though earnings were flat. If you ask me why the stocks went up last year, usually my answer would be I have no idea. But I think the reason it went up is that interest rates declined. This is our economy. China is probably experiencing one of the biggest financial bubbles in the world’s history. If you look at how much debt went up over the last 10 years, etc., China has its own problems. So, the financial system is one click away from having a very big moment. Japan is an economy where its population is shrinking and its debt is growing. It’s the most indebted developed nation. And then Europe is a union of countries that kind of don’t want to be together, like a dysfunctional marriage of 20 plus countries.


Anyway, my point is this: As a value investor, you look at this picture and say, “It doesn’t look great. How is this going to play out?” Well, I really have no idea because I can make a case for high inflation and make a case for deflation. As a value investor, I want to position my portfolio to survive in any environment. I call it having an altering portfolio.

As an investor, I’m trying to err on the side of creating a portfolio that will do well regardless of either inflation or deflation, high-interest rates or low-interest rates. That means my portfolio will be sub-optimal if one of the extreme outcomes happen. But, at the same time, in either outcome, I would still be fine. I just won’t make as much money as if I just bet on the binary outcome.

You have to be a little bit humble. One of the mistakes people could make today is taking a binary point of view that they’re going to have inflation or deflation, or high-interest rates or low-interest rates, and they position the portfolio accordingly. If they get that right, they’re going to make a lot of money, but the problem is, the cost of being wrong with either outcome is too high.

Stig Brodersen  07:00

It’s interesting that you would say that. Once you start to identify which trend is emerging, you can adjust your very defensive position that is more harmonious with a more inflationary or deflationary outcome.

Vitaliy Katsenelson  07:12

Yes, I’m probably going to have to make changes as time goes by, because, at some point, I’ll have more data to make this. Today, I have no idea.

Stig Brodersen  07:20

When you look across the globe and you see the trend of the bond markets since 1981, it has not been hard to be a successful trader. Since rates have gone down, this has pumped up the value of bonds. Now we are approaching 0% interest rates in the US. In real terms, meaning subtracting inflation, you’re already at negative rates. In many other places in the world, including Europe, you have been at negative rates for quite a while now, so I’m with you. Because if you do get more inflation, all that unwinds *inaudible*. So, I’m kind of curious how you think about positioning yourself in this defensive way when you talk about a scenario with both inflation and deflation? What would a stock look like that is suitable for either those outcomes?

Vitaliy Katsenelson  08:04

High quality and with a significant margin of safety. When I say quality, what does it mean to us? It’s kind of like broad buckets. It’s a great business, with a great balance sheet, and great management. So what does a great business mean? Basically, a company that has a significant competitive advantage, high recurrence revenues, and high return on capital, which usually comes with a competitive advantage. The balance sheet is a function of the company’s business, as well. If a company has a very strong competitive advantage, you can afford to have a little bit more debt; but if there’s a less competitive advantage, the budget needs to over-compensate for that.


And then, when it comes to management, we’re really looking for two things: (1) how well they run the business, and (2) how well they allocate capital. Those are two separate analyses as one thing I’ve found is that when you own a large company, the biggest impact measurement is not in how they run the business. Usually, when you have a very large company, you already have a lot of layers of bureaucracy, so management can have an impact on it. But their biggest leverage is actually when they make an acquisition that adds or destroys value because they can make an acquisition at the strike of a pan. So ideally, I’d like to own a company where management owns a lot of shares because, at this point, we are in the same boat. So that’s quality. And then you need to have a significant discount to fair value because, coming back to sideways markets, at some point, the PE pendulum will swing the other way. When it does, the company that used to trade at 45X earnings now trades at 30X. *inaudible* no reason as to why it can’t go from 30X earnings to 15X or 10X. And when that happens, it’s going to be very painful for those investors.

An extra point that I want to make is somewhat like a public service announcement for investors today. A lot of investors are buying basically high-quality companies based solely on dividends. For example, Coke is trading 26X earnings. This is a company that’s barely growing. It has a lot of headwinds because people have been switching from sugary drinks to water, which is almost free, and it really only has 6X earnings. The only reason people are buying it is that the 3% dividend yield is better than 1.6% or whatever the 10 Year Treasury pays. People look at that yield and say, “Coke is not going anywhere; and therefore, it’s better than Treasury,” except they start treating Coke as a bond. But see, a bond is a contract. Contracts have a par value of 100, and unless the company defaults, you actually know exactly how much money you’re going to make. But the price of Coke is not a bond. In a different interest environment, it’s going to get revalued. There is absolutely no reason why Coke cannot start trading 30X earnings. Again, the company’s barely growing, and so if you are buying Coke because you’re getting a 3% dividend yield, you may feel good until you realize you disclosed 30% or 50% of your money when the stock price declines. That’s something that worries me.

Preston Pysh  11:20

When you say that you’re also looking for a company with a great balance sheet, are you talking more in terms of the idea that the assets listed on the balance sheet have an enduring competitive advantage? Or are you talking more from a numbers standpoint? I’m kind of curious to hear your thoughts on how you’re looking at the balance sheet.

Vitaliy Katsenelson  11:39

When I talk about assets, I usually look at the price-to-book metrics. I spend very little time looking at the balance sheet, and look at the book quality of the company unless I’m looking at a financial company. From the perspective of the asset, the balance sheet matters and price-to-book matters are when you look at the financial company. But today, when I look at the balance sheet from a defense perspective, I really look at how much debt and balance sheet liabilities a company has. So that’s how I look at the balance sheet. I’ll give an example. When we look at companies, we look at how the maturities staggered. Can the company pay off that maturity from the cash that’s in the balance sheet or from its cash flows? So, when I look at the balance sheet, I spend less time on the assets but spend a lot more time on liabilities.

Stig Brodersen  12:31

Vitaly, let’s talk about growth. In your book, you have a quote by Warren Buffett, “Growth and value investing are joined at the hip.” I love this quote because new investors, especially, look at growth and value as completely different concepts and categorize other investors as either value investors or growth investors. In your book, you talk about how value and growth do go hand-in-hand. Could you please elaborate on that for our listeners?

Vitaliy Katsenelson  12:58

One of my favorite quotes is that there is value in growth. Think about it. Again, the present value of any asset is the present value of strategic cash flows, right? So, if a company has grown cash flows over time, the growth has value. From an analytical perspective, the way we analyze companies is we spend very little time looking at the next year’s earnings, but we always look at earnings 4-5 years out. We also do discounted cash flow models, but the reason we always look at the earnings 4-5 years out and then discount them back is that, then, if a company has grown business, we capture that growth in our analysis.

The problem is that growth is valuable, but it’s not priceless. This is very important to understand. If you think about it, it’s almost a relationship of growth. For companies that are growing earnings very fast, a larger portion of their value lies in the future. For companies who are growing earnings at a slower rate, more of the value lies in the present. So if you think about it for a second, this is really a relationship between long-term bonds and short-term bonds. When interest rates decline for a long duration, long-term bonds go up a lot. Short-term bonds go up less.

In today’s environment, when interest rates declined and became negative, companies grew very fast. They went up a lot. And I see a lot of investors, with respect to owning these companies, they trade at incredibly high valuations. They do the same even for growth companies even if they value their future growth. They find ways to justify these high valuations, and the problem is that the narrative becomes that these companies are so great, and they are, and they’re growing so fast, and they do, that we can justify almost any variation. I think there will be a price to pay for that.

Vitaliy Katsenelson  14:57

So this is where you say growth is valuable, but it’s not priceless. I think that is a key I want people to understand. Because today you have a lot of companies that trade at 20-30X revenues and it’s become a new normal. What used to be 25X earnings was high. Now, we have 25X revenues and it becomes okay.

Preston Pysh  15:16

I think for anybody that’s hearing that, they’re saying, “How do we know when that transition happens?” Because if we would have been saying this five or six years ago, we would have missed out on a 100% upside based on how the markets move, because the markets continue to bid this. And so, although you’re 100%, right, that the realization is going to come, how do we know that the realization is going to come in a timeframe that makes sense to continue to exercise such a strategy? I know that this is an extremely difficult question, but it’s a question that everyone that’s listening is probably thinking.

Vitaliy Katsenelson  15:50

Well, for anybody who listens to this podcast, I have a simple answer for you. If you can figure out what the interest rates will do over the next 10 years, then you can either embrace or ignore what I told you.  This is an important point: There are so many different combinations for how bad things can play out because if you look at the global economy, we’ve been stretched so much by the amount of debt they have today. So, we could have a deflation with negative interest rates, or we could have a deflation where interest rates go up a lot. There are so many ways the bad things can happen. If bad things start to happen, then the message I’m giving you is actually a lot more valuable. But if we continue to have this kind of benign environment, and interest rates to go lower. Then you listen to me; I just did a disservice to you because you would have made so much more money just not caring about risk and just continue what you were doing.

When you see a bridge that’s built on sand, do you really want to try to figure out which truck is going to be the one that, when it goes over the bridge, it’s going to topple it? Or should you just say, “Okay, we have a brace that is unstable; and therefore, they should operate under the assumption that at some point, it’s going to topple. So, I am not trying to figure out what it’s going to do our economy in, what’s going to cause the price to earnings to decline, etc. I’m just trying to operate as if it’s happened. I’m expected to be wrong for a long time until I’m right. But that doesn’t mean that I’m not making money. It just means I will be taking less risk and probably will make less money than somebody who took more risk. And at some point, I’ll be rewarded for not taking excessive risks.

Stig Brodersen  16:55

I think that is an important thing that people don’t talk about. When you invest, it’s both the yield you capture, and also the associated risk you incur. Yield can be measured, but risk can’t. The investor with the highest return in one year is not necessarily the best investor. He might just have taken the biggest risk.

Vitaliy Katsenelson  17:59

In 1997, if you were concerned about market *inaudible* and the exuberance, then you would have been wrong because it continued 1998 and 1999, and then it blew up only three years later into *inaudible*. So, the people who were speculating the stock market in 1999 would have been making a lot of money; people like me and you would be making money, but not as much, and Buffett wasn’t making much money. Those people would look at us and say, “Well, these guys don’t understand, etc.” Then, when things blew up, they would have realized that the risk they took showed up in the returns. A lot of people lost 50% to 70% of their money, rationalized it, and came back to value investing. And Buffett was up in *inaudible*, if I remember, right.

One point I want to stress because I don’t want people to misunderstand me is I’m not saying you should time the market. What I’m trying to tell you is that investors should be valuing individual stocks. That process is how a portfolio is created. The amount of cash you have in your portfolio is by product. Can you find high-quality companies that are undervalued or not? If you can’t, you’re going to have more cash; and if you can, you’re going to have less cash. By the way, this could happen in the market. You can be fully invested in a market that’s making new highs. Suppose a market is blowing up, or it will be in the or north, you could look globally. I think that’s a luxury we have today. We don’t have to just look for stocks in the United States anymore. In fact, if I look at my portfolio, probably two-thirds of the buys I made of the last six months came from outside of the United States.

Preston Pysh  19:27

You know, Meb Faber is really big on international value investing. He talks about it a lot, looking at P/E ratios and other countries that have fantastic P/E ratios but aren’t necessarily countries that people in the United States are comfortable investing in. So I’m kind of curious to hear a little bit more about how you view this as well.

Vitaliy Katsenelson  19:48

When I invest in Europe, I almost feel as comfortable investing there as in the United States. If I start venturing into countries where I may or may not feel comfortable traveling to, then your position sizing should be so much different because the rule of law there is not as strong. You may wake up and find out that the company you thought you owned you don’t own anymore. So I think the allocation of those countries would be lower. Your position sizes should be lower because of that embedded risk. Again, in my mind, when I look at Russia, *inaudible* says when investors woke up and discovered that the stocks they owned, they don’t own anymore because of what government did or because they were minority shareholders. But if you take small positions, then you’re probably going to be fine in your portfolio context.

Stig Brodersen  20:33

One of the concepts you’re big on is predictable earnings. Can you please define what that is? How we can apply the concept for an investment strategy?

Vitaliy Katsenelson  20:43

When you look at the price per earnings, it should be in a very commonsensical way of doing it. You should really try to look at it and say, “Is that the business that would have predictable earnings?” This really comes from understanding the business.

So, if you look at homebuilder businesses, I don’t even have to look at the company’s income statements to tell you that business would not have predictable earnings. If I look at a company that basically has the nature of the product that has higher current revenues, then the company, generally, would have very predictable earnings.

If you take a company like Becton Dickinson or almost any pharmaceutical company, because the demand for its products is economically insensitive, and because people have to take the product, it’s going to have very high recurrence revenue; therefore, earnings can be predictable. Obviously, when you look at pharmaceutical companies, that predictability could be interrupted by patents expiring, etc. But the good thing about it, you can actually know exactly when it’s going to happen, for the most part.

When you look at financial statements, we basically look at what the revenues did during the financial crisis during the recessions. That’s another way for you to find out how economically sensitive the business is. If you look at a company’s cash flows, you see how stable the cash flow is, etc. Those are kind of little financial tricks. But I think, at the core, it’s really just using common sense. If you look at the business, you can actually figure out. If you look at defense companies, our defense spending only continues to go up. So, that’s a very high recurrence revenue. I don’t have to look at financial statements to know that these companies will have very stable earnings and cash flows, etc.

Preston Pysh  22:20

So Vitaly, I’m kind of curious what is an opinion that you have today that is unpopular that you think a lot of people would disagree with you on?

Vitaliy Katsenelson  22:32

I think that the market looks at the basic FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google/Alphabet) as they can continue to grow at very high rates for a long period of time. I would argue they can probably grow at a rate that’s above the GDP growth rate, but probably the growth rate is not as high as the market expects. I would say that part of my argument is that growth has been fueled in part by accesses in financial markets. Because of the venture capital market kind of accesses in zero interest rates. From what I’d argue, there is a bubble in the venture capital market which these companies have benefited from.

I’ll give you an analogy from 1989. Cisco was a great company. It had a competitive advantage. It dominated the router market, etc. But Cisco has benefited from that *inaudible*. That’s because of spoliation, which was incredibly high, but because a good chunk of its revenue came from customers that were dot-coms. They did not have sustainable business models. And so, when the 1989 bubble blew up, Cisco actually suffered because a lot of its customers went away. Consequently, the Asians suffered as well. And, I would say, if you look at Google today, its affiliation is not as high as Cisco’s was in 1989.

That’s not the analogy. The analogy is that a good chunk of its growth came from startups that were given money by venture capitalists who said, “grow.” The way you grow a company like that is basically some of its just plain engineers, some of that is on Google how to acquire customers. When the only objective is to grow revenues and at that time, it’s not even relevant to what your customer acquisition cost is because you’re willing to lose money ss long as you can grow revenues, then you will be involved in uneconomical spending. I would argue that FAANGs, in general, have benefited from that, and as this market becomes more rational, we’re probably going to see a slowdown of growth rates for these companies. And I think markets still do not expect that. So that would be my kind of unpopular thought.

Stig Brodersen  24:46

Warren Buffett is famous for saying that he doesn’t look at macroeconomic events and predictions when he invests. He was specifically asked about this after this dreadful week, where stocks were slammed almost 15% in late February, and he said, “You don’t buy or sell your business based on today’s headline.” And this was when he was specifically asked about the impact of the coronavirus. How much do you look at macroeconomic events when you invest?

Vitaliy Katsenelson  25:17

Seth Klarman said, “We worry macro and invest micro.” So, when I put my worry macro hat on, Coronavirus may end up in a big deal in the short term and may have a big deal in the long run for a different reason. In the short run, it’s not just about what happens to consumption in China, but also our global economy is so efficient and well-tuned to be a just-in-time economy. And China is so important in the global supply chain that… I think these numbers are as accurate or inaccurate as newspapers that report them, but there are 400 to 800 million people in some kind of lockdown. This is the country that produces a lot of components that go into global goods. So just that in itself and we see the numbers example already. That’s going to have a significant impact on the economy if it continues.

I read somewhere that the demand for cars in China declined by 90% or something. Again, I don’t know to believe these numbers or not, but to me, it’s commonsensical when people around you are dying from a virus, buying a car is probably not the first thing in your mind. I don’t know if that number is right or wrong, but directionally it’s probably right.

One thought I have about the coronavirus, and this actually relates to the trading dispute that the United States and China had. I think US companies are waking up to the fact that they should probably have less efficient supply chains, and that they should probably have a more diverse number of trading factories in more countries than just China. A country that could probably benefit from all this is India because If you are trying to diversify your supply chain, this is another country that has 1 billion people. India does not have the infrastructure as efficient infrastructure as China has, but maybe capital inflows could change that. This is a brand new thought for me, and I haven’t done anything about it yet, but one thing I realized is our economy was too efficient. For the global trade, it was coming along for so long and so well. We haven’t had much of interruptions, maybe we had this summer, maybe we had a tsunami in Japan. These kinds of things. But they were very short term interruptions as we become more nationalistic. And this is happening globally. I think you’re going to start seeing companies moving factories from China to other countries and maybe India will benefit from that.

But today as an investor, what am I doing today? We are doing a lot of homework on continuous companies, or companies that will get disrupted in the short run because of the coronavirus. It’s like preparing a buy list. I’ll give you a group of companies. One of the obvious choices would be companies that are great businesses like online travel agencies. They have phenomenal businesses, but they’re always expensive. We are preparing a list of them because global travel is going to get disrupted by what’s happening in China. And so we are hoping that these companies will decline. It doesn’t mean that we hope the coronavirus gets worse. Please don’t get me wrong. That’s not what I’m saying. But I think as companies start reporting their numbers, investors will start to realize this is actually real, and then we get an opportunity to buy those.

Preston Pysh  28:39

I think your comment on the just-in-time supply chain… Because, I mean, a fundamental that’s taught worldwide at any business school is how do you optimize your supply chain? And it really comes down to the variance of the arrival of the supplies, then optimization of that inventory that you’re sitting on. And so, any company that’s trading at a market cap above $50 million probably has a very aggressive just-in-time supply chain so that they’re not sitting on a bunch of inventory. Since this has become so systematized in our economy, we haven’t seen a shock like the potential that this has, in my personal opinion. And I think when you start going into some of these issues of just-in-time supply chain management, it is going to be very different… What an interesting topic! Like you, I feel horrible for all the people’s health and livelihood that this is impacting. Unfortunately, I’d like to say that I think that the trend is not going to get worse, but all the numbers are suggesting that it is. So, it’s going to be interesting to see how this plays out moving forward.

Vitaliy Katsenelson  29:51

I have a six-year-old daughter and she had a fever last week, and we went to the doctor, and the doctor says, “Well, she has a virus.” She does not have coronavirus, but just the thought of that, just the fear of it kind of engulfed me. And I realized that “My god! This is what’s happening in the rest of the world.” As a human being, I really hope it doesn’t last this long at all. My fears about this are overblown.

About the supply chain; one of my favorite books is Nassim Taleb’s Antifragile. There, he talks about if economists designed a human being, everyone would have one kidney because who needs two? It’s inefficient. And I feel like if you look at the global economy today, it seems like it has been designed by a lot of economists, right? Because right now, we kind of have one kidney, and we probably need maybe two or three. Yes, that’s going to be inefficient, etc. In the short run, they’ll be inefficiencies, but in the long run, it makes a business a lot more predictable and stable. And I think that’s where we’re going.

Stig Brodersen  30:56

Vitaliy, I’m sure people listening to this interview are as impressed with you as we are. Please give our audience a handoff to where they can learn more about you.

Vitaliy Katsenelson  31:06

So my articles that can be read at contrarianedge.com. However, if you’re listening to this podcast, you probably like to listen. We have audio articles in the Intellectual Investor Podcast, or if you go to investor.fm, basically, my articles get read to you.

Preston Pysh  31:25

Well, Vitaly, I can’t thank you enough for making time out to chat with us. I thoroughly enjoyed reading your book. Like I said in the intro, these are some great principles for investors to think about when they’re going through this. And we’ve experienced just a wild decade. Sometimes the best position to be in is to just do the exact opposite of what everybody else is doing. So the principal ideas that you talked about in your book are really, really good for people to reread, to understand as some of these transitions might be on the horizon. So I just thank you so much for coming on the show today.

Vitaliy Katsenelson  32:00

Thank you, guys!

Stig Brodersen  32:01

Okay, guys. So for this segment of the show, we’ll play a question from the audience, and this question comes from Bruce.

Bruce  32:08

Hi, guys! My name is Bruce, I am a huge fan of the show. Thank you so much for all you’ve done. I think I’ve learned so much more on this show than in school. And I have a few university degrees. So, thank you again for this.

My question is about compounders. We’re taught as disciples of Buffett to look for these great businesses at fair or cheap prices, if possible. But I’m wondering why we are doing this because most retail investors, and by retail investor, I mean somebody with less than a billion dollars, should be looking for doubles? Am I not right? Shouldn’t we be looking for businesses that are going to double quickly within a year, and then flip and move on? That’s how Buffett did it, if I’m not mistaken. Would we be not wiser to focus on Buffett’s partnership letters, read those deeply and try to understand what it was he did to get to the point where he then had that problem of how to compound my huge wad of millions? Curious to hear your thoughts, and thanks again for all you do.

Stig Brodersen  33:20

I think that’s a great question. I’m currently rereading The Essays of Warren Buffett by Lawrence Cunningham, and it’s a highly recommended read. Now, in the book, Buffett specifically addresses your question, so I wanted to mention it here. What he said was that it is possible to get higher after-tax returns, going in and out of the market, compared to the strategy of having compounders, which he also referred to. This is especially true if you have a small sum of money to invest for. Now, he says that the reason why compounders are such a great strategy for him, is “We have found splendid business relationships that are so rare and enjoyable, that we want to retain all that we develop.” So what does that mean to us? As you mentioned investors with less than a billion dollars, we are in a very different situation. In contrast to someone like Warren Buffett, we typically don’t have a relationship with the management.

Now, I personally buy compounders instead of what you refer to as doubles, for two reasons. The first one is that the long-term capital gains tax is 50% in the US, but I live in Denmark and the tax rate is 43%. So it’s very expensive to move in and out. But even so, even if I could pay the same lowest tax rate as you do in the US, I don’t think I would change my strategy because finding doubles and buying and selling at the right time is just very, very difficult. Not only because you get penalized for taxes, but you also pay commissions, rent, etc. whenever you trade. So for me, I just found it easier if I can even use that word to invest in compounders than so-called doubles. The strategy counts for a lot more stress, too, that’s just not suited for my personality. Compounds are typically easy to find, but it’s also easy for other people. So the trick is rather to find them at a good valuation. If you compare that to two of my long-term positions, Berkshire Hathaway and Mckell, I would say that I will have a much easier time to determine the intrinsic value, and I can buy the dip while they continue to compound intrinsic value for me. And so, whenever I specifically mention those two picks, I think most people would agree that they are great businesses. That is not hard to identify. It really does come back to the valuation.

So to answer your question, yes, measured in stock return, it would be better to find doubles if you’re a great stock investor. But if you’re more humble about your skillset, and I’ll put myself in that category, compounders would, on average, be a better strategy for you.

Preston Pysh  35:59

So Bruce, one of the things you have to think about is these companies that do these 2X- or 3X-type returns, typically speaking, have a smaller market cap. When you’re dealing with something that has a smaller market cap, it also has a lot more volatility risk and also has a lot more risk from a competitive advantage standpoint. So, these smaller businesses, if someone wants to compete with them, and take up a substantial portion of their market share, that can happen and it often does happen in that startup or small-cap space.

So, where I think it gets tricky is a lot of people that read Buffett’s earlier stuff have to understand his age. You have to understand his risk tolerance at that point in his career, versus where he is now, as a person who has a legacy, has a ridiculous amount of cash to move around, and can only really funnel it into highly capitalized massive businesses that aren’t going to be able to pull a 2X in a year. So, that’s where I think some of it kind of breaks down when you’re looking at those timelines. You’re looking at the change in his investing philosophy, not only because of his age but also because of the capital that he has. And also, the legacy and responsibility that he holds to all those shareholders to make sure that he doesn’t lose their money. So, I think those are some of the factors to reflect on when you’re specifically studying Buffett on your strategy.

Now, if your risk tolerance is very high, and you’re comfortable, and you feel like you understand the sector, and you want to go in there and put some of those highly-volatile type positions on, have at it. I think that’s something that only you can answer, personally, for yourself. And I would say this to you. If you have a company that just went 2X, and it’s because they developed a new product or service that’s revolutionary in that field of business, it might go 10X in the coming 2 or 3 years, especially if it was a smaller cap type company. That kind of stuff can happen.

So, it’s really important that if you start getting these big gains on something, you’re not looking at it from the point of, “I made a bunch of money, so let me take my money and run.” You’re looking at it from an owner’s standpoint. As a business owner, you have to understand your competition that’s going to come in and potentially take your market share. You have to understand your product and what kind of moat there is around that product or service. If you can answer those questions and you understand what those are, you might want to keep holding even if it even if it’s gone up 200-400% because you understand your business as an owner. So I would highly encourage you to think from that mindset and not be too quick to cut some of your large substantial wins as well.


Alright, so Bruce, for asking such a great question, we’re going to give you free access to our intrinsic value course. For anyone wanting to check out the course, go to tipintrinsicvalue.com. The course also comes with access to our TIP finance tool, which helps you find and filter undervalued stock picks. If anyone else wants to get a question played on the show, go to asktheinvestors.com, and you can record your question there. If it gets played on the show, you get a bunch of free and valuable stuff.

Stig Brodersen  39:16

Alright, so before we let you go, remember to check out our new feed with bonus episodes about how and why Preston I started TIP, the business model behind Zippy, and Tobias Carlisle even drops by and pitches Southwest Airlines. You can check out all our bonus episodes on theinvestorspodcast.com/extra or you can check out the links that we included there in the show notes. But guys, that was all the Preston I had for this week’s episode of The Investor’s Podcast. We’ll see you guys again next week!

Outro  39:49

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