Value After Hours S06 E11: John Rotonti Jr on best value firm processes and valuing buybacks

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Tobias Carlisle is the founder of The Acquirer’s Multiple®, and Acquirers Funds®.
He is best known as the author of the #1 new release in Amazon’s Business and Finance The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market, the Amazon best-sellers Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations (2014) (https://amzn.to/2VwvAGF), Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (2012) (https://amzn.to/2SDDxrN), and Concentrated Investing: Strategies of the World’s Greatest Concentrated Value Investors (2016) (https://amzn.to/2SEEjVn). He has extensive experience in investment management, business valuation, public company corporate governance, and corporate law.

Prior to founding the forerunner to Acquirers Funds in 2010, Tobias was an analyst at an activist hedge fund, general counsel of a company listed on the Australian Stock Exchange, and a corporate advisory lawyer. As a lawyer specializing in mergers and acquisitions he has advised on transactions across a variety of industries in the United States, the United Kingdom, China, Australia, Singapore, Bermuda, Papua New Guinea, New Zealand, and Guam.

He is a graduate of the University of Queensland in Australia with degrees in Law (2001) and Business (Management) (1999).

And we are live this is value after hours I am Tobias car joined as always by my co-host Jake Taylor our special guest today is John ronti Jr what’s up John how are you hi toas hi Jake thanks for having me on the show again I’m

Doing well yeah thank you doing well I see that I’m no longer esteemed co-host it’s I’ve been demoted to just regular co-hosts you steamed I I felt a bit bad I thought maybe that was like a that’s too much something you’ve been demoted now you’re just yeah now you’re just

Longtime co-host that’s no no veggies the spark is gone TC it’s we’re just going through the motions now ah sorry about that my esteemed co-host Jake Taylor there you go uh John for folks who aren’t familiar with your work give us a brief background left the mly

Fool up now uh so I left the mle full about a year ago almost exactly I was there for nine years I was a senior analyst and the head of investor training and development and since then I have uh been working on my podcast the jro show where I try to um

Interview portfolio managers portfolio Managers from some of the biggest most respected Investment Management firms in the country really about their philosophy but really their process as well so I’m not you know I’ve done I’ve I’ve published Eight Episodes now and I haven’t asked for one stock idea I love

Stock ideas it’s just that’s not what I’m going for on the podcast it’s just really about like what is the research process what is the daytoday um life of an analyst or portfolio manager at the firm what is expected of the analyst down to you know how many ideas are they expected to

Pitch year what is the deliverable expected to look like is it three pages is it 30 pages is there a model attached is there a PowerPoint attached just kind of deep into the weeds of what their day-to-day process looks like teach Amanda fish and that yeah and the other

One too is um oh gosh who was it now was it Picasso he had a a club like artists would get together and it was called the turpentine Club I think and it was because they didn’t want to get together and talk about like art history or

Whatever they want to know like where could you buy cheap TP love it love it yeah um last thing I’ll say about the show is I hope to um start releasing some different content on the podcast so uh I have just recently recorded a interview with the CEO of a

Company that I own stock in and so I’ll start be I I’ll start to roll out some of these CEO interviews what uh having conducted all these conversations with these guys what do you have any ideas about a good way to run a firm what’s what’s what sort of

Works what’s successful or what’s a what’s something to avoid commonalities yeah you know it’s interesting because um so I’ve done maybe two really um respected value investing firms in Harris oakmark and I’m going to release Diamond Hill next week and then I’ve done two sort of really

Respected uh garpy you know growth at a reasonable price firm in Poland capital and Parnassus um and there’s so many similari you know uh most analysts are expected to cover about 15 stocks you know on average most analysts are expected and you know on average across these four big firms uh most analysts

Are expected to pitch about three to four new ideas every year um all of those firms that I just mentioned the analysts are expected to do three statements Financial modeling so you know a lot of times when people hear modeling they just think about like a simple DCF that’s that’s not what

These firms are talking about so if you’re interviewing at these firms they want to know that you can you know build out all three financial statements like a like a Wall Street you know equity research report connect the financial statements um and they all model out you know Parnassus models out um earnings

Per share three years the others go out five to seven years so that that’s kind of common expectations cover 15 stocks find me three or four new actionable undervalued ideas a year um and you know model out keep it keep an upto-date model update it quarterly model out uh

Anywhere from three to five years um what you think per share you know economic value is going to be and then and then put what you believe is an appropriate multiple um those are you know those are some some commonalities I’ll tell you one that I think is common across them

And then you can ask me any questions you want um a lot of these a lot of these investors have learned to sell quickly and almost Ruth ruthlessly when something comes out of nowhere and surprises them it it’s not it’s not that they don’t have the emotional discipline

To hold on it’s it’s that if something comes out of nowhere surprises them that was not in their original analysis was not part of their original thesis rather than put investor Capital At Risk rather than risk uh a blow up in that name and you know some of these

Funds are concentrated and you give a blow up in one name that can really mess with the earnings compounding of the entire portfolio and so what they do is they will they will sell this doesn’t happen often where you get surprised out of nowhere but when it does they will

Sell out and and then rethink it and then rehash it before deciding to get back in or not so that that’s that’s a commonality I have found it’s a Julian Robertson tiger approach it it it is it is Julian Robertson you know Bill Miller adopted that approach

So I interviewed Bill Miller in print um 2014 or 2015 and I asked him some of the lessons he learned from his tough time during the global financial crisis and he said one of the biggest lessons and Corrections they made was that selling out quickly when just something unexpected

Happens yeah and so you know I think some other good invest have sort of adopted that practice as well um just before we came on we were talking about Ein Horn’s latest letter yeah so it’s something I’ve been thinking about a lot uh recently so I you know David Einhorn is investor that

I have deep admiration for in fact if you were to ask me you know who I want to have most on on my podcast at jro show it would it would be David Einhorn um and he’s done a few interviews where he’s talked about this

And then he wrote up he wrote about it in his year- end 2023 letter where he said that um he he can no longer his theory his philosophy is he can no longer wait for the market to properly value stocks so traditional value investing was you you buy what you

Believe to be an undervalued security and you wait for the market if you’re right sometimes you’ll be wrong but if you’re right you wait for the market to come around to your correct point of of view and the market will rate the shares higher and then you can

Benefit in two ways you benefit from the closing of the Gap um from the stock price to the estimate of intrinsic value Which is higher than stock price and then you can also benefit from growth of per share value over time ihorn believes that um the active fund management industry has been

Decimated that’s the word that he used in his 2023 letter not going read a quote if you’d like one out of 10 have been gone out into the field and killed themselves so right and so the enemy yeah and and and you know that certain companies have been forgotten or left

For dead they’re just not covered anymore and so he he doesn’t think he can rely on the market to properly value these Securities anymore at least not in a reasonable time period so he doesn’t think he can rely on the market to rate a company to a higher deserving Justified multiple

Uh and so he sort of shifted his strategy at least in his larger positions of investing in companies that are not only cheap um but that are currently returning you know gobs of cash to shareholders through either dividends BuyBacks or in some cases um interest on like a high yielding debt

Security so he’s getting current cash flow from the Securities um it’s something you know I’ve been thinking a lot about and then I was recent recently I read the the most recent issue of value investor Insight with Murray stall the founder of Horizon connetics and he said something

Very similarly you know here’s just one sentence but he said quote obviously some stocks deserve to be inexpensively priced but cheapness can also just be a reflection that fewer people care and no one is paying attention end quote and so I thought it was something very similar

To what David Einhorn was saying that some of these stocks even good businesses that don’t deserve to be cheap have just been completely forgotten and left for dead because there is so much um you know nearsightedness or even manic you know laser focus on some of these Tech names right now that that

Large swap of the market good growing profitable growing business are just forgotten about um do you do you agree that that is the traditional definition of value that it was price section that was the thing that delivered the returns Jake I think he’s probably asking

You uh well I kind of I think I know what JT’s answer is gonna be but JT would say no and I would I would agree with that but go ahead Jay please please we can have a larger conversation around this uh I think it depends on which lots

Of different flavors of value over the years like there have yeah you know and a if you buying net Nets it was probably more of a valuation reating but when you took existential risk off the table for a few of these companies like it’s a pretty big binary change there when it

Went from this company’s going to zero to wait this might actually last a little bit longer there’s a big step up there um kind of nonlinear in the other you know version of like oh never really a question about whether it’s a concern or not but just

More like it’s cyclical or you know maybe its best days are a little bit behind it but it’s not you know there’s still a viable business here that one might have been a little bit less on on just pure reating um but I would imagine that the

The neglect is is likely more of a benign thing now just from so much indexation I mean that’s there’s yeah there’s just enough people looking and John Huber would it’s not John Huber’s idea but John Huber talks about it a lot just the differential between even big well followed companies will vary widely

Over the course of a year from a low and the difference between the low and the high might be three times or 30% yeah Gat would start his class with he’d pull up the paper and show like the 52 we High and the 52 we low for 50% difference huge differences on these

Like giant blue chip you know very stable as far as you looked at any of the the business results are are relatively stable compared to these 50% swings in the price I I think your return is kind of embedded when you buy like you you whatever the stock price

Does you’re you’re getting this expected return and provided that the stock does what you anticipated that it would do you’re getting that return whether the market recognizes it or not but having said that I think that Buffett strategy is exactly that to buy something where the expectation is that he’s going to

Get a lot of his Capital back pretty quickly I think he’s done that in just about every single big acquisition that he’s done from the railroads to take a pick he’s looking for you know to oxy recently you know he’s pinning them to the mass by putting that plan to return

Capital in his own meeting night saying you said this we’re going to hold to this publicly ABS so I agree that even though I think iron’s being a little bit cute with the reasoning but I think that the the outcome is right yeah I agree

With the outcome so so the way you asked the question Tobias was do you think value investor returns have largely come from that no I I traditional traditional was that is that the traditional expectation right so I think I think the philosophy and where the returns actually came for may be different I

Think the philosophy was buying at a large margin of safety buying a dollar for 50 cents right with the expectation that it’s eventually going to be valued at a dollar right well is that was that an expectation of traditional value investors that the margin of safety would close and so you

Buy you know you buy at when it’s trading at 50 cents on the dollar and then if you’re right you start to sell you know when it’s trading at 90 cents on the dollar and then you’re out by the time it’s a dollar give the give the example of the of

Nig’s six times earnings right and so in the real world I do think did you just expl because we I think we talked about that offline talk about the yeah so in do that calculation for everybody absolutely so in my um most recent print interview with Bill nyen he

Says consider a stock at six times earnings where business value is flat if the cash conversion rate is 100% the company could reduce shares outstanding by 177% annually and grow per share value by 20% so just to recap he’s saying six times PE business value is flat earnings are not

Growing they’re just stable free cash flow conversion to net income is one times or 100% in that scenario the company could reduce shares outstanding by 17% annually and grow per share value by 20% so earnings per share are growing by 20% even though net income is growing

0% and actually nois put out uh a white paper like a week ago maybe two weeks ago talking about this very thing how low pees can drive massive EPS growth when when you’re buying in a discount so let’s keep this thought experiment going let’s say I own stock in a company

That’s doing that and it buys back stock and eventually it buys back all of the outstanding stock and I’m the only person left right do I care where the bid is in the market or am I getting the intrinsic flows that are far superior to anything that I’ve ever paid so this

Wasn’t uh this wasn’t planned but but so in the same interview nothing is on this show right no I love this in the same interview bill nagon says if a company generates a lot of excess cash and buys back stock when the valuation is too low that eventually forces the valuation

Higher so there’s a foring forcing mechanism so Tobias and Jake so think about I’m not even I don’t even need a I don’t even need a quote I’m saying I like this thing unquoted I love this thing I love so if if this let’s let’s choose easy math I can go through the

Math of the 17% the 20% if y’all want because I I broke it out for a student that I Mentor but um let’s just let’s do it let’s let’s let’s let’s do it let’s break it out so it’ll just take me a second I have it I have it right here so let’s

Assume um let’s assume ebit let’s assume zero uh zero debt just so interest expense is zero ebit is 125 $125 tax rate is 20% assume a 100 shares outstanding tax rate is 20% So 20% of$ 1225 is $25 in taxes so net income is 100 we also

Know based on the [ __ ] quote that free cash flow is at least 100 because fle free cash flow conversion is 100% so he gave us a PE of six right so uh PE of six we know that net income is 100 so 6 time 100 we know the market value is

600 so we have a market cap of 600 100 shares outstanding so stock price is six now you repurchase 177% of 100 shares outstanding which means you buy back 17 shares for $12 17 shares times the $6 per share stock price okay that’s $12 so you spent

All of your free cash flow free cash flow was 100 in this example we’re saying 102 uh net income is still 100 because remember he said earnings are stable or flat and BuyBacks come out of uh distributable or free cash flow not from net income so net income is still 100

Shares outstanding are now 83 we started with 100 shares we sub we bought back 17 we now have 83 shares outstanding so original EPS was $1 net income of 100 divided by 100 shares outstanding $1 the new EPS after the buyback is 120 net income of still 100 now divided by 83

Shares outstanding that’s a120 so EPS went from a dollar to a120 you get 20% growth in earnings per share when you buy back 177% of the shares when the PE is six net income did not grow one penny so that’s the power of BuyBacks at low pees

Or High free cash flow yields i s a good uh Twitter does this has been on Twitter for the last week but they said what is the if Michael sailor continues to buy back Bitcoin and he ends up owning all of Bitcoin what is the intrinsic value

Of Bitcoin oh I didn’t see that tweet did it did it give a answer well it’s got to be you know it’s a thought experiment but you can you can work it out if Michael sa owns all the Bitcoin but but Tobias here here is not a thought experiment so let’s just use

Easymat 10 times earnings and you’re buying back 10% of shares a year 10% of the Mark cap of year if the stock price does not go up then you end up owning the entire company after 10 years sounds that’s that’s the forcing me well I know you love that but that’s the forcing

Mechanism that bill nigin talked about in that interview when you’re buying back stock at low pees at but really at at large discounts to intrinsic value it forces the multiple higher otherwise you’re going to end up owning the entire thing while earnings per share are growing 20 30 40% a year because you’re

Buying it back at lower and lower pees I mean let’s do it this is how I win yeah this is how I win exactly right and so I gave a little like a it was kind of a private presentation I don’t know two or three years ago now

And I went through a lot of this math and used AutoZone as an example of kind of what what this looked like in an archetypal sense absolutely very minimal Topline growth margin stayed reasonably you know call it 11 12% lots of BuyBacks done at very and

They had the the opportunity to do it like they never got much above a 10 PE for that entire time and so it’s a beautiful thing it’s ATI it’s a very beautiful thing so then I I broke it down to really you could turn the world

Into two two types of investors the ones who on the day that they buy they hope to see the price go down and then there’s the ones who buy and they hope to see the price go up which one which one are you and this is like in in one

World like I would say the last 10 years or maybe call it the 2008 to 2021 maybe time period the you did better if you were the type who bought something and just wanted to see the price go up that next day uh my hypothesis is that the

Next 10 years this the 20s and and the title of the talk was the the boring 20s instead of roaring um in that it wasn’t going to be Topline it wasn’t going to be you know prices ripping and multiples going up it was going to be it was going

To be boring stuff like Capital allocation reasonable business results that then were translated into a really a cheap multiple turning into an attractive earnings yield on the purchase uh and that that was how you were going to win the next 10 years Jake

I I I not only love that but I grew 100 I agree 100% in C change which Howard marks wrote I don’t know year and a half ago he said basically the same thing what worked during the era of free money is not what is going to work going forward

Um Murray style had some other interesting you had some other interesting insights into Murray style too oh so I I just think that that Murray is um he’s an incredible thinker so I saw him speak live um last year at the uh project punch card conference in New York

Heard of that one what’s that about so it uh it’s actually the lineup is always incredible so last year’s lineup was like uh lee cooperman uh by the by the way Lee is the second guy that I want to get on my show the most so he he calls in over

Zoom everyone else is speaking live he call he calls in over Zoom from a car and he’s sitting at his desk in Florida uh I I just read his book by the way not to get off track but he he’s put out a book from from the Bronx to Wall Street

Or something uh he he’s he’s 79 or 80 he’s still working 17 hour days today 17 hour days he just loves it anyway and so someone in the audience asks him what he’s what he’s buying what he owns and he takes out off his desk a piece of

Paper a print piece of paper and he reads 15 must have been 15 of the 20 stocks that he owns he just read well I own this and I own this and I own this and I own this I’ve been buying this I’ve been buying this he was just so

Transparent and awesome but um Murray stall talked that year David Marcus David Marcus runs Michael Price’s family office the late Michael price just you know an incredible lineup but um so there Murr stalls um lecture was on investing in royalty companies because Murray stall believes that um inflation

Is going to be higher and more volatile for longer not necessarily you know 7% inflation but above the the 2% Target and it’s going to be more volatile and in a high and and volatile inflationary world he loves royalty companies royalty companies own land with natural resources and and Lease out the

Land to you know emps exploration production companies mining companies that’s how TPL do you can get you can get right on the royalty you can get a cut of the royalty too there’s different there are some different variations spefic land is a big holding of Murray

Stall and you don’t invest any capex or very little and you don’t have any expenses you’re just leasing out land and so Murray’s uh thesis on these royalty companies like Texas Pacific Land Is that the top line is going to grow with inflation but your expenses don’t grow with inflation so you’ve got

One of these expenses are flat top lines growing and so the margins expand and so in virtually any environment these things are generating 40 50% free cash flow margins across the cycle if you look at Texas Pacific lands margins some of the highest margins you’ve ever seen

What is software yeah exactly but higher but higher and so that’s what he spoke about then was how to you know how to invest through inflation um but the thing that fascinates me about Murray stall is on the one hand uh he’s a traditional value investor in the sense that uh he wants

To buy something at a significant discount to his estimate conservative estimate of intrinsic value um and you know he’s not scared to look at old economy companies um and and in the most recent issue of value investor Insight he was saying that you know some of these high valued

Tech names are going to come under pressure for a variety of reasons one of them being more competition from China but a variety of reasons um on the other hand he was one of the the earliest investors at scale at size in Bitcoin and he’s been mining Bitcoin for

Years now out of his basement no I’m just kidding I think it may have start you know may have started there but now he’s got a he’s got a full operation going and in this latest issue of value investor Insight he talks about how he plans to hopefully bring his Bitcoin

Mining company public um I’m going to sell the tools and sh I’m going to sell the energy to the Bitcoin miners right exactly yeah and so you know you have this this interesting dichotomy where he’s you know more traditional value focused and a lot of traditional value

Investors that I follow are not yet on board with Bitcoin and I don’t know if they ever will be but they’re not yet at least Murray is and he was early and he was in size and large and you know he’s he’s a billionaire I think he was a

Billionaire before a lot of the Bitcoin stuff but he’s definitely a billionaire now what do you think the risten is is for many value investors with Bitcoin well by definition by definition if you’re an intrinsic value investor it means you’re trying to Value the future cash flows of the business you know

Um you know the value of any of any cash flowing security any Financial Security any financial asset is the present value of future free cash flow you can’t do that with Bitcoin there so it’s a currency right it’s like a it’s much more sued to the macro guys who like you

Know they use cup and sorcerer or bearish Army to kind of work out which way bitcoin’s going but then you know I guess the intrinsic argument might be you just short the US dollar printing or you short Central Central Bank currencies yeah that that makes sense but I think I think their retit

Reticence is that uh it there’s no cash flows to Value it’s not throwing off any cash flows because of that they don’t believe it can be intrinsically valued yeah yeah well let me ask this what’s the right price for Bitcoin I wish I knew well that’s that’s why we I

I like that little frame that I saw it on sort on Twitter I apologize where I’ve stolen this from but the the frame was um if Michael sailor buys back buys all of Bitcoin what is the intrinsic value of or what’s the value of Bitcoin what’s Bitcoin worth you know if Michael

S owns a whole lot it’s not worth anything that’s interesting you know it’ll it’ll be micro strategy that owns it because I’ve I think he’s selling micro strategy shes a day or something like that of of micro strategy stock and so um it’ll be micro strategy that ends up owning it

But yeah that’s interesting let me do a quick shout out and then we’ll do some veggies uh VA is that what’s VA put me up Virginia Virginia Dubai Kena Georgia Val parasa gothenberg Sweden La in the house Tallahasse Antigonish s l Finland what’s up Tampa Miami Old Ocean Texas Hamburg Germany

Jupiter Florida congrats Porto MOS Portugal mesina California Quebec City Canada Boston what’s up some good ones in here Nashville Tennessee congrats that’s a good list what he got us for what what he got for us on the veggies JT uh London London UK uh so this is um called ants and

Lions hunting and private Equity so we’ll see if we can turn this all into making any sense out of it but so first a shout out to my man George for sending me this uh delicious little veggies prompt from it’s from a Scientific American little piece that’s titled

These invasive ants are changing how Lions hunt uh so we’ll start out with the idea that you know regularly almost every year at the hgms Mr Buffett will say that in economics you always have to ask yourself and then what and the same is true for another complex adaptive system

Which is Mother Nature and we’re going to follow a series of and then whats and we’ll see where it goes and then we’ll see if we canw draw some lessons back to business and investing so researchers were exploring a a regional ecosystem in in Kenya Africa and the there were these

Ants that were indigenous to that region and they were Fierce Defenders of these local ACAA trees so when an elephant would come to graze on the tree for instance or trample it over the ants would swarm the elephant and crawl up inside of its 9- foot nose and use their

Mandibles to pinch you know inside the elephant as you could yeah it’s uh rather unpleasant I imagine uh and as a result of these ants the elephants would largely leave these trees alone it’s not worth it right so and then the uh you know it’s it’s really not worth going and getting like

An ant netti pot uh every time you try to eat a leaf off of a tree so these these indigenous ants had long protected and their own living home in this symbiotic relationship well recently researchers found a new invasive species of ant has moved in and they’re killing

Off the local indigenous AA ants and these invasive ants are actually smaller than the AAA ants but they’ll they’ll team up and they’ll hold the ACAA ants down by their limbs and then basically like draw and quarter them uh you know they’ll dismember the ant uh which you

Know Mother Nature is not messing around um so in not too long after this this the new ants are displacing the old ants and shortly thereafter herbivores have figured out that the cacia trees aren’t being protected by their their little you know these tiny protectors and and

Especially the elephants who do a lot of damage rather quickly so the tree population of course has started to decline and with that less tree cover then we’re going you know again the series of and then whats uh with less tree cover the zebras are more safe

Because the the trees make it less trees make it harder for a lion to Ambush an unsuspecting zebra and make them their lunch so and then what what are the Lions doing now that they can’t eat zebras as readily well it turns out they’re they they’ve shifted to hunting Buffalo more

Only that’s a lot tougher and more dangerous for the Lions because the buffalo’s twice as massive as the zebra and they have a much better defense uh against Lions like there’s videos online of this Buffalo’s like chucking a 400 pound lion into the air to fend off

Attacks um and of course the lions are they’re they’re at least moderately successful so the buffalo population is suffering now uh and so this is like kind of a classic Butterfly Effect right you disturb one little small seemingly inconsequential thing and this case a tiny invasive species of ant and you get

This cascading effects where they lead to an eventual decrease in a buffalo population you know 10 links down the chain so the first lesson I think is that it’s it’s fish difficult to predict all of these complex interactions right and so it is with economics no matter

How many how much modeling expertise you have how much modeling you do it’s impossible to predict I think how shifting uh like in this let’s say interest rates for instance how they ooze their way into every crevice of the economy and and have and what will manifest because of these changes so now

We’re going to shift to talking about private equity and see if we can draw some parallels to our you know and then what exercise so um ban and Company came out with a recent report on all things private equity and this was flagged by a

Friend of the show Dan rasmon um so in 2023 the deal value fell by 37% from the year before and exit value slid by 44% so almost half as much and things are are not very much like they were in the go- go years of like 2021 uh and today

Nearly half of all Global buyout companies have been held for at least four years so there’s like there’s $3.2 trillion dollar of Aging unexit company value on pe’s balance sheet right now and just for context that was like one trillion in 2016 so and of course you

Know there’s a lot of discretion around how you mark these assets like good firms are still they’re they’re clear about their valuation policies to their LPS and and are appropriately conservative but of course you know I I think that uh Cliff Asis would agree that that volatility laundering is still

Alive and well in the PE industry um you know like if you think about it just from an incentive standpoint like why if you were a PE firm would you want to show bad results and and also if you’re one of these big pools of capital like

An endowment why would you want to hear Bad results if it’s possible that they might smooth them sus away over time right like of course like just don’t tell me and if it’s if it’s going to end up being better later um so I’m kind of left wondering to whom will private

Equity exit these $3.2 trillion worth of businesses to themselves each other public markets I mean those are the the IPO Windows been a bit Frosty lately um and then uh the Ft Alphaville um I gu if you guys follow and read that but they said that that PE is sitting on an

Astonishing 2.6 trillion of capital it’ll eventually have to deploy so um public companies tend to borrow in longterm and fixed and private Equity tends to borrow short and floating rate so often borrowing and they’re often borrowing in private credit markets rather than issuing bonds like a public

Company would and so the median sponsor backed company saw their borrowing rates already move from 4.9% in 2022 to 7.2% in 2023 whereas the the median S&P 500 borrower only move from 3.2 to 3.7 so the S&P is hardly even noticed that rat have gone up relative to private equity

Which has really seen them gone up really seen them increase so for for PE like basically what was once cheap debt isn’t cheap anymore and then what about like valuations this is kind of another you know issue that have been talked about private Equity closed transactions at 13.8 EV to eida in 2021

And 2022 that number used to be more like five times rather than 13 times when when David Swinson was putting up awesome returns at Yale by tipping towards privates um it’s so for from reference from 1990 to 2010 private Equity returned 14.4% per year compared

To 8.1 for the S&P 500 and that six 6% roughly outperformance was net of private equities 2 and 20 free structure so that means the gross return was really more like 20% a year for that that kind of Heyday um but you know that there there’s a feeling that a lot of

This compounding is kind of stalling and last year revenues for PE firms were actually slower growing than the S&P 500 4% versus 5% so and peack firms generally have lower margins than public companies so the rise in interest costs have meant that the median PE backed firm now is actually generating zero

Free cash flow uh all the margin has basically shrunk and been absorbed by by debt servicing um so after 40 Years of declining rates in our analogy like maybe these were sort of the ants that were protecting the ACAA trees perhaps the FED elephant has remove the tree

Cover and these lions are going to have a much more difficult time finding juicy zebras to Feast upon um and with so with this more expensive debt perhaps a less target-rich in Opportunity set higher valuations too much money chasing too few assets it’s I personally find it a

Little hard to be as bullish on the prospects for most of private equity and of course I’m sure there are exceptions of people doing smart things they’re always are um so perhaps they might be forced to hunt more dangerous beasts like Buffalo and are more likely than to

Suffer resulting injuries and in general whether it’s Mother Nature or Finance you got to be careful of these small seemingly inconsequential changes because they can lead to rather consequential consequences that just propagate throughout a system good one JT that’s excellent some good connections there that private

Equity model um is one way of converting that flat no growth fix PE stock that’s doing all the bubs it’s a way of like turning that into Equity appreciation because you’re using the you’re using the cash flows to pay down the debt and your Equity you know assuming that the Enterprise Value is

Staying steady your Equity should be going up as the debt comes down yeah how do you how do you become a billionaire in private Equity borrow a billion dollars and pay it back yeah that’s true uh I was awesome if my question is if everything is a complex adaptive

Adaptive system which I think it is markets and economies especially and we can’t predict the future because of that what do we do as investors right like that’s a conundrum which makes investing hard in the last couple years investing does doesn’t seem that hard right if you if you own a tech index

You’re doing great um if you own spy you’re doing pretty well exactly you’re doing spy you’re doing very well yeah um but it turns out it is hard because it’s everything is hard to predict yet as investors we’re trying to make predictions that’s what we’re trying to

Do we’re trying to see which stocks are going to be higher in the future and it’s a prediction my mind Goes My Mind goes to an insurance analogy and because that is also about predicting the future it’s about you know what risks are you taking are you being properly

Compensated to take that risk and I you I think there’s a couple different smart ways to do it I think that you could think of it like auto insurance like let’s say Geico as a for instance and I would like actually what Toby does to Geico which is you don’t know exactly

Which of the policies that you write is going to be profitable or not but you know that as a base you know large law of large numbers expected outcome that you you have a little bit of an edge there just based on what you’re choosing um you’re probably you know arbitraging

Some behavioral bias um and and you you know it’s not going to it’s going to end up working out okay and you’ll probably do a little bit better than than average because of that and then you could I think occasionally markets throw off just absolute no-brainer um things that just don’t

Make any sense to the even a reasonably intelligent business person who’s looking at the situation and you get paid really well to do that and and and recognizing those you kind of have to hang around and see them enough to to find them but they’re very very rare and

I would liken that then to like specialty insurance like a g Jane is writing where there’s these mispriced things where like okay we’re getting a ton of Premium relative to what we feel like the risk is that we’re we’re underwriting and you just have to be very Discerning at that point and

There’s and recognize that it’s it’s reasonably rare that those get thrown up but they do on occasion present themselves and so I think both of those make sense to me as as ways to mitigate the uncertainty of of the future I mean that’s how I deal with it

Especially the way that Tobias does you know there’s um overwhelming research and I shared I think a dozen slides on on X at one point in time I can send this to y’all showing that high-f free cash flow yield is far and away or owner ear owner

Earnings yield whatever you want to call it is Far and Away the best predictor of forward rate of return Far and Away um Bank of America looked at 40 metrics um this was about seven or eight years ago but it looked at 40 metric and Enterprise Value to free cash or

Free cash flow to Enterprise Value um outperform the market by the most Manning an Napier tro price um several other firms there like I said there’s like a dozen slides that I sent all showing that free cash flow yield High free cash flow yield is far in away the best predictor of Market

Outperformance over a fiveyear period far and away so it’s it’s empirical I think it it varies a little bit depending on the the time the date that you do it but free cash flow is it’s either it’s free cash flow or it’s operating income or it’s operating cash

Flow it’s it’s one of those more broader based uh earnings measures than just just the the E right the very bottom of the their statement but I think the interesting thing is how predictive it is so that’s one thing that I’ve spent a lot of time looking at how far out can

You so I always thought you know quality and there’s lots of different definitions of quality but you know we know return on Equity is pretty mean reverting but there are other measures of quality some of which are less mean reverting but of all of them I can’t find anything that really has any

Predictiveness that is anywhere near just the price ratio so price to free free cash flow at EV so that is predictive out to about five years Beyond five years nothing’s predictive and it’s only the price ratios out to about five years the quality metrics Fally enough seem to break down pretty

Quickly or I can’t find the No No that’s what the re shows so the 40 metrics that Bank of America looked at was weren’t just valuation it was quality ratios profitability ratios growth ratios and uh free cash flow yield far in way was the best predictor of five-year performance given that that is

The case what do you think is the utility of building those complex models that go out 5 to seven years marketing sorry I I’ll say I’ll say for um for cyclical Industries I think there’s probably some utility in getting a normalized midcycle number I think it

Doesn’t have to be you know five years is you know arbitrary but uh I think one of the mistakes some investors make when they’re earlier in their career or you know retail investors with a little less experience that just go to Yahoo finance or some other free site and get a PE is

Have no idea what’s in that e right like yeah they don’t know if that’s Peak earnings trough earnings if there’s ACH exactly exactly and and and so I I think I think modeling out a few years can at least help you get to a more midcycle number but also normalized number that

Takes out some of these non-recurring um one of the challenges of doing so let’s say three years we agree that you you have some predictability out to three years one of the problems with a threeyear modeling number is if it’s a high Growth Company the growth doesn’t

Really describe the value of the company until it has a few more years to compound so you’re always missing those you know I I don’t think that’s such a you know it’s a little bit of a bias of my method that it’s going to miss those higher growth companies but I think that

The the base rates for those higher growth companies has historically been so bad that it doesn’t bother me that they’re sort of not being caught in the method but I’m just like Curious what do you think does that does that modeling capture does a five or seveny year you

Know smoothing cyclicals makes sense but it is always it also lets you capture some of those higher growth companies uh in in my opinion if you miss some of the higher growth companies if you’re good at doing what you do you can generate the exact same returns or better than a high growth

Investor because you’re going to have fewer blowups you’re going to have fewer blowups a high growth investor was going to have more multi-baggers potentially um but more blowups and so in the end you know I I’ve I’ve looked into this I’ve back tested a lot of performance I’ve looked into a lot I

Think the best investors outside of Buffett and you know Marx and you know maybe a handful of others on one hand I think the best investors are doing 15% annualized over time over a career I think that’s right to I think that’s right buggy yeah the best of the best

Are doing 15 and some of those are the best of the best growth growth investors and some of those are the best of the best more value investors there’s a spectrum of course of value investing and a spectrum of growth investing but the rid will be very different but if

You look 10 to 15 years in the future I think you end up in the exact same place I think somebody you can do a sustainable 15 is Elite I think that that’s absolutely Elite I I think it’s elite that’s exactly right um I know a Grizzly old manager who says like anyone

Who’s aiming for more than that is basically almost assuredly gonna blow themselves up yeah people don’t want to hear that right now because everything’s going up every day by a lot right and so people don’t want to hear that right now but you know Tobias just back to what you

Said about the free cash flow it’s it’s such an important concept and back to the idea of you can buy in the whole company you know if the stock price doesn’t go up a lot of people don’t actually think about what free cash flow is but you know Warren Buffett’s got

This great quote Book value or invested capital is what’s been put into the business intrinsic value is what you can take out of the business that’s free cash flow it is it is what is left to investors after investing in maintaining and growing the business so that’s what

I was I was going to push back a little bit on the and do a kind of you know red team or uh Devil’s Advocate how do you avoid then not to name names but like let’s say like a Boeing situation where they they borrowed and did a ton of

Buybacks in a you know I don’t know let’s say before 2020 sure and now operationally have really not been particularly Stellar it seems uh did they underinvested their business how do you know where’s the right amount of Intel did the Intel did the same exact thing under their prior CEO where um you

Know Intel for a while was the leader in semiconductor manufacturing but then they just you know they made the decision to invest Less in the business Less in R&D they mortgaged their future they mortgag their moat in order to buy back a lot of stock and do this sort of

Financial engineering yeah there’s a time in place when BuyBacks are absolutely the best use of capital you know Buffett has a quote he says when your stock is undervalued it’s the shest way the shest way to grow per share value is is to buy buy buy backs at

Discount but not if you’re sacrificing your mode right not if you’re underinvestigated Financial engineering from rather than like after the fact where Intel stumbles Boeing stumbles whoops we should have paid attention when they were doing that five years ago how do you know five years ago that they

That they hard I mean it’s hard you know you can probably you can probably look at uh market share you know loss you know intel was definitely there was a point where it started to lose market share and those market share losses started to accelerate and they just came

Up with a bunch of excuses it’s not easy though you you know another thing is you know asml arguably the most important company in the world um Intel had ego what every want to call it saying we’re g to make the most advanced ships in the world without asl’s machines without

Their euv machines and they said we’re going to try to replicate this well Canon and Nikon tried it over a 20-year period and they and they gave up they they set unle they completely got out of the euv business completely it’s very hard to do and if you do do it you need

You need hundreds of billions over 20 years and Intel tried it and then they fell farther behind so you know but that’s all hindsight like you said I I wasn’t really doing a deep dive into Intel at the time um but so you know maybe market share losses something like

That um it’s hard to know I think probably that you need to take it even one more step back from that and somebody said it in the comments here but don’t buy fast changing uh Industries like that’s all these businesses essentially like Microsoft is a business that they’ve pivoted a few

Times over the years to get to where they are now and but that’s uncommon that’s unusual for businesses to be able to Pivot most businesses especially that large especially just Kodak you know they just like Kodak had the first digital camera yeah and you know B Buffett two three years two three weeks

Ago I posted you know I think eight quotes from Buffett saying virtually that you know he he said you know Berkshire hathway is just as fascinated by all of these Innovations as you are as the rest of the world is we’re just as fascinated by it we just don’t know

How to model it we don’t know how to predict it and you know when there’s lots of disruptive innovation happening the ground under those businesses are not stable and so it’s it’s it’s it’s a it’s an industry that’s very hard to build modes sustainable modes and it’s

Industry that’s very hard to build H bir entry um at one point Bill Gates I think in the late 90s said that he because of those exact factors that that Tech should probably really trade with a low multiple lower than most businesses because it’s that terminal value is kind

Of harder to underwrite with with so much disruption well those those ideas come into Vogue every every mid mid cycle so we’ve just gone through one where it’s a high multiple but we might go through and we take it’s a low multiple obsolesence it’s a big risk it’s it’s a

You know it’s it’s a big risk um but you know just back to that free cash flow that’s what it is it’s it’s what the owner could take out it’s what a sole proprietor could take out of the business every year and pay himself a dividend it’s it’s after investing and

Protecting that mode after inv investing in all of the growth down the income statement and the growth down the cash flow statement in working capital and capex and Acquisitions after all of that it’s what a proprietor could take out and pay himself or herself a dividend and so that’s why it’s so

Predictive of you know if if a dividend yield is what the company actually pays out as a as a dividend every year free cash flow yield is what the company could potentially pay out if it chose to return all of its free cash flow as a

Dividend and we’ you know in the show we went through the math talking about how even if the company is not growing 0% growth as long as it’s not deteriorating as long it’s not shrinking um company can grow 20% a year if it’s buying back you know stock at a single digit

Multiple and that can go on for a long period of time that’s sustainable growth it’s a shower not a grower it’s a shower not a grower what’s what’s Buffett’s little you know is it was it one of his lieutenants tato Todd has that Sunday lunch with him where they discuss do you

Remember the formula Todd goes to his house yeah the formula is uh they look at the s&p500 um and they they have three criteria uh what stocks are trading at a forward PE 12mth forward PE of 15 or less yeah which do you have a 90% confidence level

Earnings will be higher five years from now doesn’t matter how much higher just higher and then which do you have at least a 50% confidence level earning per share can compound by at least 7% over the next five years what a 7% compound over five years

Get you to is it 50% bigger or something like that yeah it’s 50% bigger what I what I think it does is if you’re buying 15 times or less today if you’re paying 15 times or less today and a company can grow High single digits seven eight n

You know you can grow into a 10 times free cash flow in five years that’s the kicker Jake said it earlier today grow into a 10% earnings yield that’s sort of like my rough fistic I i’ love I’d love to pay 10 times or less today for a

Growing business if I can’t I’d really like to see it grow into a 10% free cash FL yield by year five that’s sort of my rough juristic that I try to stick to and I’ll get I’ll just go one step further I know we’re running out of time

If it is one of these faster Growers that I get seduced by and I pay 20 or 25 times earnings earnings uh I’d like to believe that the earnings per share can grow fast enough so that it drops to a market multiple by year five so down to

15 or 16 times by year five those are rough your ristics for me look at a company like Builder First Source with um you know this is a company that um is it’s put out three-year guidance for three year forward EPS guidance of $18 of earnings per share it’s at 200

Today so you know Builder is trading at 11 times that’s the bot 18 is the bottom end of its guidance he’s trading at 11 times the bottom end of its guidance three years out um and you know this company serves absolutely a crucial economic need it saves its customers time money and

Waste uh and in the last two and a half years it has bought back 37% of the stock hold on I wrote this down uh so in the last two and a half years it’s bought back 37% of the stock at an average stock price of 83 it’s trading at 200

Today I mean that’s pretty impressive that’s are they still doing BuyBacks at 200 or do they oh sorry yes turn it down so no so over the next three years they gave medium-term guidance threeyear guidance so over the next three years they plan to buy back another 30 to 40%

Of the shares at at 11 times earnings you know three year forward 11 times earnings looking at three three your out numbers um do you ever worry that a company like Builder’s First Source is beholden to the building like we’ve got this little I don’t know I just don’t

Know whether this is SEC secular or cyclical but we we clearly we underbuilt for a long period of time following the GFC over 10 years I’d say over 10 years yeah and you can see that in the data that we haven’t built enough houses through that period of time and so now

There’s this unusual thing in the market where rates have gone up so quickly people who are have a mortgage pre-2020 or whatever can’t get out of there or it’s probably later than it pre 2022 pre 2023 are kind of stuck and they can’t move so these new houses that have

Traditionally been at a huge premium to um previously owned houses um they they now trade at about the same price so the builders are just shipping houses and sort of going through this unusual boom I don’t know whether it’s it’s going to Peter out this year

Or whether it’s got you know a decade to run I have no idea but do you to what extent do you sort of think about that when you think about something like Builder’s First Source so 2third of Builder First Source Revenue comes from new home construction um that’s an important part

Of their business it’s the most important part of their business by far um two two things I’d say is um the latest uh what’s that podcast the Deep dive bu um business Deep dive podcast I’m not gonna be able to think of the name right now but um it they did they

Did a deep dive on um DH Horton and the guest who knows the industry very well estimates it’s going to take could take 20 years to dig ourselves out of this hole that’s how underbuilt we’ve been I’ve done similar math suggesting it could take us seven to 10 years to build

Us out of this hole depending on how many new starts we have a year so I do think we could have an extended Up Cycle in new home construction because the supply demand and balance I feel is is acute it’s real we have record low Supply inventory’s

Home for sale or they’re about record lows at the same time when demand is is Skyhigh because Millennials are entering Prime home buying years and so there’s an acute uh Supply demand imbalance and so I think that’s I think that’s one thing the other thing with Builders First Source is they’ve transitioned

Their business model a couple years ago less than 30% of their business came from these value added Services value added means they’re doing things the the construction crew used to do like so they will completely prefab offsite Builder will prefab a roof trust or a floor trust or a whole wall panel and

Then deliver it and then install it so that’s that’s that saved labor right time um they do they install Windows Doors custom mill work they build it all offsite and install it so things that the construction crew used to do Builders is now doing for them that’s

Much higher margin 800 to 1,000 basis points of higher margin than simply distribution of lumber which is their older business model um there’s a lot they they’ve they’ve been a leader in consolidating the industry so the industry is much more rational when it comes to

Pricing um so I I think there’s a lot going for the company then you know just buying back a lot of stock 37% in less than three years I certainly like the BX I know you do I do too it’s weird that we’re talk we like we’re getting

Excited about BuyBacks and you know a lot of other investors are getting cited by the Nvidia conference yesterday which was very exciting don’t get me wrong it’s just you know there’s lots to think there’s there’s more than one exciting thing in the market happening right now was all I’m trying to say

What do you make of that is that um sustainable is that a little there’s a little AI kind of there’s a little boomlet going on a little bit like Cisco in the early 2000s or do you think it’s got a sort of longer timeline than that actually we’re

Coming up on TI speaking of time right that’s for next time have me back have me back yeah absolutely we will good good point uh that’s John ronti how can folks get in contact with you or follow along with what you’re doing I’m on Twitter jrro so j r o g r o

W and what’s your podcast called the jro show good night thanks uh Jake as always a pleasure great veggies Jake I’m getting stronger veggies thanks for coming folks we’ll be back uh next week’s same bat Time same B Channel I think we’ve got Eric cinamon coming on next week Jake managed to lure

Him out of um out of out of his absolute return bear cave hibernation hibernation cave yeah thanks