Episode #90: “The Crown Jewel of the Alternative Universe is Private Equity”
Guest: Dan Rasmussen. Dan is the Founder and Portfolio Manager of Verdad. Before starting Verdad, he worked at Bain Capital and Bridgewater Associates. Dan graduated from Harvard summa cum laude and Phi Beta Kappa and received an MBA from the Stanford Graduate School of Business. He is the New York Times bestselling author of American Uprising: The Untold Story of America’s Largest Slave Revolt. In 2017, he was named to the Forbes 30 under 30 list.
Date Recorded: 1/10/18
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Summary: In Episode 90, we welcome Founder and Portfolio Manager of Verdad, Dan Rasmussen.
We start with a brief walk-through of Dan’s background. It involves a Harvard education, a New York Times best-selling book, a stint at Bridgewater, consulting work with Bain, then his own foray into private equity.
Turning to investments, Meb lays the groundwork by saying how many people misunderstand the private equity market in general (often confusing it for venture capital). He asks Dan for an overview, then some specifics on the state of the industry today.
Dan clarifies that when he references “private equity” (PE), he’s talking about the leveraged buyout industry – think “Barbarians at the Gate.” He tells us that PE has been considered the crown jewel of the alternative world, then provides a wonderful recap of its evolution – how this market outperformed for many years (think Mitt Romney in the 80s, when he was buying businesses for 4-6 times EBIT), yet its outsized returns led to endowments flooding the market with capital ($200 – $300 billion per year, which was close to triple the pre-Global Financial Crisis average), driving up valuations. Today, deals are getting done at valuations that are nowhere near as low as in the early days. And so, the outsized returns simply haven’t existed. Yet that hasn’t stopped institutional investors from believing they will. Dan tells us about a study highlighting by just how much institutional managers believe PE will outperform in coming years…yet according to Dan’s research, their number is way off.
Dan then delves into leverage and the value premium, telling us how important this interaction is. He gives us great details on the subject based on a study he was a part of while at Bain Consulting. The takeaway was that roughly 50% of deals done at multiples greater than 10x EBITDA posted 0% returns to investors, net of fees.
Meb asks about the response to this from the private equity powers that be… What is their perspective on adding value improvements, enabling a higher price? Dan gives us his thoughts, but the general take is that doing deals at 10x EBITDA is nuts.
Next, the guys delve into Dan’s strategy at Verdad. In essence, he’s taking the strategy that made PE so successful in the 80s and applying it to public markets. Specifically, he’s looking for microcap stocks, trading at sub-7 EBITDAs, that are 50%-60% levered. With this composition, this mirrors PE deals.
The guys then get neck-deep in all things private equity… control premiums, fees, and illiquidity… the real engine behind PE alpha… sector bets… portfolio weights…
Meb and Dan land on “debt” for a while. Dan tell us how value investors tend to have an aversion to debt. But if you’re buying cheap companies that are cash-flow generating, then having debt and paying it off is a good thing. Debt paydown is a better form of capital allocation than dividends or buybacks because it improves the health of the biz, leading to multiple expansion.
The guys cover so much ground in this episode, it’s hard to capture it all here: They discuss how to balance quantitative rules with a human element… The Japanese market today, and why it’s a great set-up for Dan’s PE strategy… Rules that should work across geography, asset classes, markets, and time… Currency hedging… And far more.
For the moment, we’re still ending shows with “your most memorable trade.” Dan’s involves a Japanese company that had been blemished by a corporate scandal. Did it turn out for or against him? Find out in Episode 90.
Links from the Episode:
- 00:50 – Introduction to Dan Rasmussen and a brief walkthrough of his career
- 2:02 – American Uprising: The Untold Story of America’s Largest Slave Revolt – Rasmussen
- 3:01 – Dan’s broad overview of private equity
- 8:52 – The main drivers in the private equity model
- 17:23 – How Bain Capital responded to surveys suggesting that most private equity funds didn’t create any returns for their investors
- 20:32 – How Dan and his shop think about their decision making
- 23:22 – Advantages of Dan’s strategies
- 24:46 – Are there specific sector focuses for Dan’s firm
- 26:32 – Any focus on market cap?
- 27:30 – The leverage and debt portion of Dan’s investments
- 27:36 – Dan’s white papers
- 31:10 – What Dan evaluates when deciding if a company will be able to pay down debt
- 32:49 – How does Dan balance quantitative measures with human instincts
- 36:18 – Dan’s top line thoughts on global investing, in particular Japan
- 41:58 – Gauging where Japan is in the trend of capital allocation
- 45:45 – Are there any restraints on investing in global markets for Dan’s firm
- 47:09 – Does Dan hedge currencies
- 52:27 – “The Gospel According to Michael Porter” – Rasmussen
- 52:37 – What has Dan excited for the future
- 57:39 – Where might Dan’s strategy fit into an investor’s portfolio
- 58:45 – Dan’s most memorable trade
- 1:00:58 – Stay connected with Dan at Verdad, get on their email list
Transcript of Episode 90:
Welcome Message: Welcome to “The Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Welcome, podcast listeners. Happy 2018. Hopefully, you listened to our last podcast with the great quant, Blair Hull. Today we got a great show for you. Our guest is a New York Times bestselling author, has won top journalism awards, was a national medalist in rowing, won the Thomas Temple Hoopes Prize, which is Harvard’s top undergrad honour, and last year he was named to the Forbes 30 Under 30 list, all that for a young buck. He’s also written a couple of fantastic papers on private equity and replication on the SSRN. He’s now the founder, portfolio manager of Verdad Capital. Welcome to the show, Dan Rasmussen.
Dan: Nice to be on. Thanks for inviting me to join you.
Meb: Before we get started, you’re a young fella, but why don’t you give us just a brief walkthrough of your career? I know there’s been a couple stops leading up to the founding of your firm. But go back in time real quick and give us a quick overview before we get into the depths of what we’re gonna talk about today.
Dan: Sure. So I went to Harvard. I graduated in 2009. I studied the history and literature of the American South. And if you or your listeners are looking for a sleep aid, I highly recommend my book, “American Uprising,” which came out in 2011 and was briefly on the New York Times bestseller list, as you referenced. But my dad is a lawyer. And when I was thinking about what I wanted to do for a career, he strongly counselled me against writing or law under the theory that he said that he was, you know, at the top of his class in law school, and all the people that could barely pass their classes went into business, and they all retired 10 years before him and made 5 times as much money. So he thought, you know, if I was as smart as in business, it would be a good thing to do. So I ended up in college to intern for Bridgewater Associates, Ray Dalio’s fund, which was a wonderful, fascinating experience. And then after college, I went and worked for Bain Capital Private Equity for four years, and then went to Stanford Business School, worked with Charles Lee, who’s a great finance academic at Stanford, and launched this fund, Verdad, and refocused on leveraged small-value equities, which we think is a superior alternative to investing in private equity.
Meb: A lot packed into a little. Let’s talk a little bit about private equity in general. So you started, I believe, to set the foundations maybe when you were at Bain and Stanford thinking about private equity. And you think a lot of investors make some mistakes when it comes to private equity, specifically the kind of misunderstanding the true drivers and sources of return stream and some of the potential dangerous effects it can have. So why don’t you give our listeners a broad overview of private equity in general, what do you mean by private equity? Because, by the way, a lot of listeners, when they think of private equity, they actually think of venture capital and startup. So it’s a little different. But give us a broad overview, and we can kinda dive into some of the problems, too.
Dan: Sure. So, you know, when I’m talking about private equity, I’m talking about the leveraged buyout industry, you know, the Bain Capital, Carlyle, Apollo, Blackstone, the RJR Nabisco, “Barbarians at the Gates,” you know, that world. And I think what’s fascinating is, you know, I think the history of finance resonates with one great lesson, which is that when everybody agrees on something and when they’re borrowing money to bet on it, beware. And I think what you’re seeing now is this massive herding of really smart investors, David Swensen among them, you know, he’s one of the leading promoters of this, shifting a lot of assets into “alternatives.” The most important of which, you know, the crown jewel, the alternative universe, is private equity. And every endowment, every foundation, every large institution is saying, “Well, I’ve got to have a 20% asset allocation to private equity,” and they’ve been flooding the private equity market with capital.
And I think Crescent [SP] did a recent survey of these institutions, and they asked, you know, “Do you think private equity will outperform the public equity markets by 4% or more, 2% to 4%, you know, less than 2% even with private equity?” They didn’t bother to ask whether it would underperform, because that’s such an outlandish idea. And fascinating, 49% of institutional investors believe that private equity will outperform the public equity market by 4% per year or more. Another 45% believe it’ll outperformed by 2% to 4% per year. So, you know, 90% of institutional investors plus believe that private equity is basically God’s gift to investing.
And, best of all, I think what’s even more interesting, right, because everyone always…big returns are great, but what everyone wants is great returns, low risk. And if you look at historical private equity data, private equity looks to have about two-thirds of the volatility S&P 500. In the downturn in ’08, public equity in the S&P 500 was down 50%, junk bonds down 50%, private equity was down about 30%. If you look in 2012 to 2015 as sort of oil prices fell about 50%, public equity, energy stocks dropped 50%, 60%, junk bonds exposed to energy dropped 50% or 60%, and private equity and oil and gas private equity was marked at 1. They didn’t lose any money. And so you say, you know, “Gee, this is amazing, you know.” They’re getting these great returns. They have very limited drawdowns, very limited volatility. How could this be? Every time they plug them into their little Excel models, private equity just looks like the holy grail of investing. And I think what people are missing is, you know, first of all, private equity is highly levered micro-caps, okay? Median market cap of $200 million, median leverage levels of 65%, right, these are small, really levered companies. And most private equity funds are non-diversified. They’ve maybe 15, 20 holdings at a maximum.
So tiny portfolios of highly levered micro-caps are being bought by institutions through the private equity structure. And because private equity firms make up their own valuations quarter to quarter, they say, “What’s this company worth?” “About one, you know, one times about what we paid for it.” “What’s it worth this quarter?” “You know, maybe a little more than we paid for it.” You know, if something really bad happens, like the price of oil drops 50%, and they’re an energy company, and their business is collapsing, they might say, “Maybe it’s marked to 0.8, maybe 0.9.” And so you have this… And nobody is incented to challenge that, right, because the guy who’s sitting at the institution says, “Well, it’s great that it’s not marked down. I don’t have to explain to my boss or my investment committee why I made the stupid decision, because actually it doesn’t look stupid.” And they might call and say, “Oh, how is it that, you know, oil prices are down 50%?” And, you know, your portfolio is marked at one, and they’ll say, you know, “We’re looking through the cycle, you know. We’re basing it on large longer-term multiples.” And, of course, Meb, and if you and I could do that on our public equity portfolios, we’d be thrilled. But, unfortunately, my mother doesn’t have time to mark my portfolios every quarter, so I’m stuck with using the public equity markets.
Meb: That would be the beauty, I mean, and we used to do a lot of research on the endowments. And it’s almost like an ostrich sticking his head in the sand, you know, in July 4th, pulling it up again the next year and avoiding the weather the whole year. It’s like, is the average weather 70 degrees? No, of course, not. It’s crazy. And a lot of that endowment entire portfolios, when we looked at them and modelled them, we said, “Hey, they’re claiming a 20% loss, but the entry year drawdown for something similar was probably at least half, and some of them was even more.” And that’s on the broad allocation for some of these.
Okay, so you have a couple things wrapped in here, first of which, I appreciate the RJR reference, because I went to high school in Winston-Salem, as did my co-host, Jeff. So we actually went to RJR High School, which is kind of [crosstalk 00:08:36].
Meb: I know, right? It’s pretty amazing. It’s still named that. Beautiful high school, though. It’s on, like, the historic register for a gorgeous high school. But my grandfather was an RJR employee a million, gazillion years ago. Anyway, but love the reference to “Barbarians at the Gate.” But so you’ve had kind of… There’s been a different era in private equity. So when I think back to the ’80s, in the ’90s, you know, one of our favourite phrases here is “Flows change factors, and flows change asset classes.” So this flows of tons of money into private equity, maybe after…particularly when the Yale Model became popular, and you’ve seen, you know, really the standout example of this having just monstrous success. Do you see that as kind of the main driver of the challenges with the private equity model? Is it just so much money is going in? Do you think people don’t understand it? What’s kind of the main issue on why that may not be kind of an ideal allocation going forward?
Dan: Sure. So I love that. So I’ve never heard the funds change factors. That’s exactly what’s going on in private equity. I think a really, you know, wonderful way of summing it up. So, broadly, what you have…and going back to my time at Bain Capital, so we did a big study where we looked at every private equity deal done by our top 25 competitors, and we basically drilled down…we sort of did the Fama and French of private equity, right? We had all the underlying financials for every deal. And we said, “Okay, what are the quantitative predictors of success? What can we learn from studying 25 years of private equity history?”
And Bain Capital is one of the only firms that can do this, because it’s been around since the RJR Nabisco deal. And as we dug in, you know… I’d say, first, you know, what separates private equity from public equity? And this is a relevant question, because private equity from 1980 to 2010 beat the public equity markets by 6% net of fees per year. And at 2 and 20 fees, that’s a 12% per year out performance for the average, average manager, right? So this is totally different from public equity where the vast majority of active managers lose to the market, right? Somehow, you know, the average Joe that hangs out a shingle is beating the market by 12% a year. So this is just shocking, right?
And so what makes private equity special or what made it special, because I think that’s what I’m arguing, is that it’s changed. So private equity historically, it’s different from the public equity market in three ways. So, size, right? So, first of all, these are micro-caps. Average market cap of a private equity deal is $200 million versus $33 billion for the S&P 500 or over $2 billion for the Russell 2000. The second is leverage levels. So the average private equity deals levered about 60% to 65% on a net debt to enterprise value basis versus, you know, the Russell 2000 or the S&P 500, they’re generally levered about 15%, if at all. So, you know, 4x more debt, right? It’s the leveraged buyout industry. Naturally would expect a lot of debt.
And then the third and final thing is…and what’s really interesting is that, you know, in the ’80s, when Mitt Romney and a few others really started this, they were buying businesses for about four to six times EBIT, three to five times EBITDA. And they were able to do that really until the mid-’90s when other people started to get into the game and multiples started to get pushed up. And, you know, I found this wonderful old letter from Mitt Romney saying that…it was in ’92 or ’93, saying, you know, “We’re seeing prices above six times EBIT, and that’s really worrying us,” you know. And that was at a time when the public equity market was probably trading at twice that. So the first private equity guys, right, the first ones, really even the first 20 years of the asset class, they were buying businesses for half to a third of what was, you know, the equivalent public equity comparable company although, obviously, the public companies were much bigger. But, you know, the same industry or whatever, maybe a third of the valuation.
And they were buying it, they were levering it up 65% or so, they were using the cash flow to pay down debt, and then they were selling, often IPOing into the public equity markets or selling to public companies that could make creative acquisitions of much higher multiples. And so it’s perhaps not at all surprising that over that period, you know, tremendous returns were generated for investors. And you’ve gotta credit David Swensen, and Jim Bailey at Cambridge Associates, and others for having the vision to say, “Gee, you know, we should go into this asset class,” in the ’70s, and ’80s, and early ’90s. I mean, it was brilliant. But what happened is that, really starting in ’06 and ’07, institutional investors woke up, you know, the vast majority of them woke up to what the smart few had been doing and started to pour money into private equity. And that accelerated after the financial crisis really as a result of those two sort of competing desires, right? Everyone’s looking to beat the market. No one wants to deal with market-to-market volatility right after ’08, and so private equity looks like sort of the holy grail of investing. And so they start putting really about $200 billion to $300 billion per year of new private equity commitments, which is, you know, probably close to triple the pre-crisis average.
And, as that happens, you know, there’s only a limited supply of private companies that go up for sale every year. Because, you know, if you’re thinking relative to, say, some small public equity, right, that’s $400 million a market cap, you sort of look at the shareholder registry, and, like, it’s like 5 quantitative funds or passive indices, and then, like, maybe 1 active manager, and then, you know, 5 employees in the company. I mean, it’s sort of a grab bag. Right now you go into the private equity market, and you’ve got, like, a lawn care business in Des Moines with, you know, $15 million of EBITDA, right? You’re gonna get probably, you know…a good bank could probably get 400 private equity firms interested, maybe take 50 letters of intent, take 12 to the second round, and then end up, you know, in a horse race between 2 final round bidders to sell the darn thing for 15 times EBITDA. Because one of those people is gonna be desperate enough to put their dry powder to work that they’ll overpay.
You know, all these private equity guys have these amazing pedigrees, and they went to the best business schools, the best undergrads, and they’re just falling over themselves to create more optimistic Excel models to justify these big purchase prices. And so you just see this sort of speculative mania driven by fund flows, because all the asset allocators say, “Private equity works. So let’s buy private equity.” And there’s lots of people who are willing to create that supply to build a firm, to go and, you know, buy businesses and make them private equity companies.
And the problem is, what they haven’t realised, and this is really the core argument that I’m trying to make and really central to understand the asset class, is the importance of the interaction of value and leverage. You know, obviously there’s a value premium, right? We see that across markets. We see it in public equity markets. You know, we see it at sort of the country level, right? Countries with lower multiples do better, right? Everywhere, you know, the value effect is everywhere. But in private equity, it’s magnified, right? And so the spread between growth and value in private equity is even larger. It’s much, much larger than in public equity because of leverage.
And so, you know, if you take a five times EBITDA private equity deal with three turns of debt, three times EBITDA of debt, right, that company is probably generating…that deal would generate probably 25% free cash flow yield. Now, you double the purchase price, and you go up to 10 times EBITDA, and you put 6 times EBITDA of debt, that company is probably generating about a 3% or 4% free cash flow yield, because as you’ve increased the purchase price and increased the debt levels, you increase the interest payments. And so you’re not only increasing the denominators, the equity account gets bigger, but you’re dramatically shrinking the actual cash-flow-generating ability of the business because of the substantial interest payments. And so what we observed at Bain Capital when we looked at this is that roughly 50% of deals done at greater than 10 times EBITDA basically, at least from the ’80s till 2010, had 0 net returns to investors net of fees.
Essentially all the expensive private equity deals just hadn’t made any money for anybody in aggregate, and about 60% of the industry’s profits had come from below 7 times EBITDA. And you look at where prices were and are, if they were at 3 to 5 times in the ’80s or early ’90s, 6 to 8 times in the late ’90s or early 2000s, they’ve been above 10 times on average since 2014, 2015, right? So you’re talking about a market where the average purchase is now at a place where, at least according to every piece of work I’ve done, no money can be made, or no money in aggregate is gonna be made. And that’s largely because the dynamics of, you know, heavily levering up a company, right? It just doesn’t work. If you look at the public equity markets of companies that are leveraged six times EBITDA, I’ll show you a basket of companies that are on a path to bankruptcy.
Meb: You know, it’s funny as I think about this, because, you know, being a quant, this doesn’t surprise me. I’d like to hear a little bit about what the response was at Bain and as you guys kind of talked about this to whether it was co-workers, bosses, clients, whatever, what the response to this was. Because I imagine, if I had to guess, when a private equity shop does see this, they’d say, “Well, no, no, no. We’re different, because we’re top quartile. And, by the way, you know, we’ve done this in the past, and it continues to work,” which, by the way, I don’t know if it was one of your charts, but it might have been someone else’s that shows that the persistence, which used to be one of the biggest arguments for private equity of top quartile firms that used to be very high, has actually been declining over the past, I think, 15 years. But I bet the response for a lot of private equity, and correct me if I’m wrong, I would say, “No, no. Well, we offer a lot of value add on our operational improvements. And so we can pay more, because we have great people that we can install, and we’ve done it, and we know better, you know. Our track record, it’s gonna be great.” What was the response as you guys kind of teased out the data?
Dan: Yeah, well, I think this comes down to a worldview question, right? So I look at investing, and I’m very influenced by Daniel Kahneman, and Amos Tversky, and Philip Tetlock, and others who say, you know, “The best way to make a forecast or to make a decision is to ask how have similar things in the past performed,” right? And so basically you wanna say, “Okay, what are the statistically significant factors that describe this investment?” And then if you look at that combination of factors, you know, how similar companies that look quantitatively similar to this performed in the past, right? And that’s my view of how to make good investment decisions.
And if you look at the investment world that way, you’d say doing deals at above 10 times EBITDA is nuts, because it’s never worked. It just doesn’t make any sense. However, the private equity world is, you know, I think, very qualitative. A typical investment at Bain Capital would be six months of work, a team of six, four of whom had MBAs from Harvard. We’d probably have a $1 million diligence budget. We’d get a McKinsey team in there. You know, we’d do surveys. We’d, you know, unpack everything about the company. And I think that people that come from that world or from that approach don’t think about forecasting or investment decisions. They think that analyse it on a case-by-case basis, understand the company, its competitors, its trajectory, its future, its products, and then develop an operating plan to drive value improvements.
And when you’re thinking that way, you know, the purchase price is an afterthought to some extent, right? I mean, obviously, it’s important to the Excel model, and it’s gonna determine whether it makes sense or not, but it doesn’t take on the sort of looming significance it does to those of us who are, you know, informed by the more cornerman, Tversky, Tetlock-type world, where we’re saying, “Quantitative factors are more predictive of the future than, you know, expert judgment.” And so I think, by and large, the reaction to a study like this is, “Okay, great, you know. There are lots of studies. They’re just numbers, you know. What does it really show?” Whereas, I think, I’m more quantitatively inclined and want to base my investment decisions on evidence and data. And I think that, you know, look, that’s still a surprisingly small percentage of the investment world that thinks that way.
Meb: You took this insight. You said, “You know what, I’m gonna go start my own shop,” which you did, I think, back in 2015, 2014 maybe. Is that right?
Dan: That’s right.
Meb: Started your own shop. And walk us through kind of how you guys think about your investment framework, about the implementation. So you’ve taken these ideas and said, “All right. I wanna make private equity investable with public equities. I think we can match what they’re doing, if not better, after fees.” Walk us through your process, kind of what you’ve learnt. How do you put it together, and how do you kind of think about that portfolio, and all that good stuff?
Dan: Yeah, so I think, you know, the core idea is the one we’ve already discussed, which is that if private equity in the ’80s and ’90s was so successful, right, the average private equity manager is beating the market by 12% gross of fees per year, right, why in heaven’s name isn’t every public equity manager saying, “Well, gee, the average public equity manager is losing in the market by 1.5% per year. So why don’t we understand what those private equity guys are doing that’s so effective, right? Because clearly it’s working and what we’re doing isn’t.” And I think that my logic is, okay, well, what are the private equity guys doing from a quantitative perspective? How do we quantitatively define their investment strategy? And it’s small, its micro-capped, micro to small cap, right, $200 million a market cap average its value, so historically the vast majority of the returns are worth sub 7 times EBITDA, which would be, you know, the bottom 10% of the U.S. market today and probably, you know, the bottom 25% globally.
And then I’d say next is the leverage levels, right, the use of debt, the effective use of debt. And so if you buy a pool of securities that are trading at sub 7 times EBITDA, that are, you know, small cap, you know, sub $1 billion of market cap companies, that are 65%, you know, 50%, 60% levered, right, so they’ve got 3 or 4 turns of debt on them, you know, will those companies perform like private equity deals, right? Can you get the same results by doing that in public equity markets rather than doing it in private markets? And the answer is yes, you can. Quantitatively, we’ve tested this. It is true. It works. It’s exactly the same. It doesn’t make a difference whether its private or whether it’s public. Right now in private markets, yes, you’ve got the private equity guys claiming that they make operational improvements, right? Whether it’s true or not, certainly I think I’d assume that it wasn’t true on average even though it might be true for some firms, right? They’re claiming that they have this long-term view, because they bought the darn thing, and they’re stuck with it for a few years, so they have to take a “long-term view.” Whereas, you know, people like you and I, Meb, are short-termists, because we can buy and sell things whenever we want, and that obviously changes our thought horizon. And, you know, I think those are the ostensible benefits, and, you know, obviously the ostensible negatives are control premiums, massive amounts of fees, illiquidity, etc.
Meb: Don’t forget you can actually be more efficient at tax managing the portfolio if you care about that as the public guys as opposed to the private. There’s a little more wiggle room you could do if you actually care about that as a taxable investor. A lot of these aren’t taxable investors, but if you do.
Dan: Right, no, exactly, right? I think that public equity has a lot of advantages, right? Taxes being one of them, liquidity being another huge one. But I think that first conclusion, right, is that a lot of the stuff that private equity guys think is the source of their returns, like operational improvements, or their long-term view, or their deep due diligence in their potential investments, is in reality sort of the bells and whistles on an engine which historically was leveraged small value.
Meb: The cool part, and feel free to use this phrase, because what you guys are doing mirrors some of what we’re doing in other areas where, you know, what you’re essentially building is what I like to call, like, the investable benchmark. And in many ways, for private equity, I can imagine now, or a year from now, or five years from now, a lot of the private equity firms will be measured against essentially your algorithm and your funds where they say, “Well, look, if we can’t even hit this hurdle on after fees of what these guys are replicating in the public space, what in God’s name are we doing wasting all this time, and on effort, and liquidity, all that good stuff?”
Let me dive into a couple quick questions on the actual implementation. Do you guys make any sort of intentioned sector bets? Is this a go anywhere sort of algorithm and approach, or is it saying, “You know what, traditionally private equity exists in these sectors, or we’re mapping what private equity allocations have been in the last year, or 5 years, or 10 years. And, oh, we’re gonna put more in tech, or materials, or industrials, or healthcare, whatever it may be”? Or do you guys just kind of close your eyes and go anywhere, any sort of sector limitations or approach?
Dan: It’s a question I get a lot. And I think another sort of…as private equity people, if you talk to the sort of true believer, dyed-in-the-wool private equity guy, and you ask them how they make returns, they’ll say operational improvements, illiquidity premium, effective use of debt. And then they’ll often say, you know, “And we’re really good at picking industries or timing the industry things,” right?
But I think if you look empirically, that’s not necessarily true. I think that generally private equity tends to be procyclical. So you tend to see private equity folks herding into hot industries at given times. Energy in 2012, 2013, retail in the early 2000s, they’re these sort of hot sectors. And if you look, it’s sort of an inter-year, you know, period. You’ll see that actually following their sector allocations is sort of a recipe for following the herd and the public equity markets as well. It’s really not a judicious strategy nor is it actually a source of their returns. In fact, most likely it’s a negative source of…they’re probably losing money versus just market cap weighting their sectors, which they obviously can’t do.
Meb: And so are you guys actually targeting a market cap? Are you saying, “You know what, if we find all the cheap companies in the energy sector, the whole portfolio is gonna be energy?” Well, what’s the kind of constraints that you guys kind of mentally apply or not?
Dan: Yeah, so we’re trying to limit our sector exposure. Because, I think, fundamentally, what we think of ourselves as experts at is understanding the dynamics of small, cheap, highly levered businesses, and especially the deleveraging process as they pay down debt, and that accretes to equity holders. So our view is we don’t want to be the leveraged, small-value, dying retail funds. Maybe we’re fine having an exposure to that, but we want that to be, you know, no more than the market cap weight of that sector. So that’s largely how we think what we’re doing. If we find opportunities that meet all of our criteria, we’ll add them. But if we get to a point where there’s too much in one sector, we cap it. So generally we think about not having any one sector be more than 10% of the portfolio.
Meb: One of the things that you guys I know have written a lot about…and, by the way, listeners, we’ll post show notes with links to the white papers and a bunch of articles that Dan and crew had put out that are great. One of the things you’ve written a lot about is the actual debt component. Because I’m guessing there are some people listening to this show that are scratching their heads that say, “Okay, I get the value part. I get the small part. But shouldn’t I be investing in a company that doesn’t have much debt? So why are you picking these leveraged companies? Isn’t that riskier? Won’t that hurt returns?” So talk a bit about the leverage and debt portion. I know you’ve written another paper on this topic, and so kind of how you think about it. Because I think it’s actually probably 180 degrees backwards from what most listeners would expect that kind of a lot of the takeaways and expectations to be on debt in general.
Dan: Yeah, and I think, look, value investors, you know, since Graham and Dodd have sort of had this great aversion to debt, right? And they say, “We want fortress balance sheets.” I mean, there’s almost a virtual language about their preference for firms with cash rather than with debt, to which I respond, “It’s like, okay, well, all of you have watched the vast majority of, you know, public equity value investors lose to the market index, whereas over in private equity these guys are using debt out the wazoo and beating the market by 12% per year. You know, maybe you should be a little bit more open-minded about it given the returns difference between what they’re doing and what you’ve been doing.”
And I think that, with that sort of snark aside, you know, debt is a double-edged sword, right? It is, right? Debt can be good or it can be bad. I would say most of the time it’s bad. I mean, I think that if you’re buying expensive companies with debt, it’s bad. If you have too much debt, it’s bad. If debt to assets, or debt to EBITDA, or debt to any sort of income or cash flow statement metric, debt to interest, once those metrics get above a certain point, you’re on a road to bankruptcy, okay? I mean, it’s this iron logic of debt, right? And that’s why, by the way, high prices in private equity are so dangerous, right? Valuations can be forgiving, you know, if there’s growth, etc., but debt is not forgiving. And so putting large amounts of debt on a company is a really bad idea.
That said, if you’re buying cheap companies, right, that are really cash-flow-generative, and if debt is a bad thing, then paying off debt with cash flow is a very good thing, right? And so, you know, what we think of ourselves as doing is investing in that universe of companies that are the most likely to pay down debt, and they’re most likely to pay down debt because they’re generating a lot of cash. And, as they pay debt, right, if you think about, you know, the uses of cash, dividends, buybacks, or debt paydown, debt paydown is a much better form of capital allocation than dividends or buybacks, because it improves the actual financial health of the business. It reduces interest payments. It reduces bankruptcy risk. So firms that pay down debt see multiple expansion. They see all sorts of positive impacts. And so what we think of ourselves as doing is saying, “Okay, where are the firm’s that are most likely to delever and will benefit the most from deleveraging?” And that’s really the subset of really deep value companies that have debt.
And I think within that universe debt is very positive. Debt increases free cash flow yield. If you buy, what we do, our aggregate free cash flow yield and our portfolio is probably about 18% or 20%, which is not. And it’s nuts, because most people don’t look at deleveraging yield as a form of shareholder yield, and thus they miss the really great things that are going on in some of these businesses, because they just say, “It’s got debt on it. I’m staying away.”
Meb: Is there anything in particular you look for? There was a couple comments you made. One, you’re like, you know, there’s a certain level where companies are much more likely to go bankrupt. They have a certain level of debt. Is there any sort of ratio you look at there? And second was are there any variables or factors that you look at that say, “You know what, this company is more likely to be a good candidate for paying down debt”? What are you kind of looking at there?
Dan: The best predictor of whether a company, you know…persistence, right? So there’s a high persistence to debt paydown. Firms that have been paying down debt in the past are going to continue to pay down debt by and large. It’s not that hard, right? I mean, this is in Petrovsky’s work. I mean, firms that are paying down debt already continue to pay down debt. We’ve known this for years. It’s true empirically. It’s the most obvious and simplest predictor. And I think, you know, what’s kind of cool about that is that debt paydown has a big positive impact. If you look sort of ex-post at what are the drivers of shareholder returns, growing really fast and debt paydown are probably two of the biggest ways that you can drive equity value creation ex-post. And whereas predicting whether a company is going to grow or not or how fast it’s gonna grow is nearly impossible, predicting debt paydown is pretty easy. And so what you want to do is take the universe of, you know, highly cash-generative businesses that have low debt relative to their cash flow generation and where they’ve been paying their debt already and build portfolios from there. And that’s a place where you’re gonna see, as the deleveraging process unfolds, this natural expansion of equity value, which happens almost mechanically.
Meb: So, speaking mechanics, you know, you’ve written a lot about kind of man versus machine ideas, you know. A lot of what we talked about today is pure quantitative, moving away from, you know, the qualitative high-fee practice of private equity actually to a lot of quantitative measures and metrics. But I’ve also seen you talk a little bit about the way you do things where it’s not totally 100% quant-driven. So what are your general thoughts on kind of how to balance these quantitative rules with some human insight and instinct?
Dan: You know, look, I think this sort of tension for me comes from… You know, I worked at Bridgewater, which is a very sort of rules-based investment firm. But I think at Bridgewater, right, you start with logic, right? You say, “What logically makes sense?” Okay, then let’s test the logic. Does it work? You know, it’s sort of Bayesian approach. You know, does the evidence say that that logic works, and then can we implement that quantitatively? And then I think when I got to Bain Capital, there were no rules. It was sort of, “Hey, let’s study every investment on a case-by-case basis and come to whatever conclusions we can come to, because we’re smart people.” And I think, balancing those experiences, I’m much more on the Bridgewater side. But I think, nevertheless, when you look at individual equities, especially equities with complex, you know, balance sheets, there are ways in which a qualitative analyst can add value. And I think primarily when I’ve looked at this and I’ve studied it quite rigorously, how well our portfolio performs relative to a purely algorithmic version, what we’re good at is spotting firms that are slightly higher risk, that are perhaps more likely to go bankrupt, that have, say, a looming SEC investigation or accounting problems, or, you know, the cash flow generation was one time, or something along those lines. And, gee, I’d love to automate that, but maybe my coding skills aren’t good enough yet.
So my view is that if you start from a universe of things, which the quantitative algorithm likes, and then you go through and you say, “Okay, but I know the biggest problem with this universe of, you know, highly levered companies is bankruptcy risk. Are there things that I can do from a more qualitative perspective based on financial analysis to eliminate a higher number of those bankruptcy risks?” And, you know, so far we’ve been able to do that quite well. We’re gonna keep working to do it if we find that we can create automated rules, which we’re always trying to do. To replace our judgment with automated rules, we’ll do it. But some of those things are, you know, harder to discern than others. So I think I’ve sort of come to a… Deng Xiaoping said, you know, “It doesn’t matter whether a cat is white or whether a cat is black. It’s whether it hunts mice.” And, you know, so far we’ve found that mixing, you know, quantitative tools and some level of financial analysis can be really beneficial to our portfolio selection process.
Meb: You know, my favourite example in our world, and I saw you guys refer to as kind of the Vanguard of private equity in one of the articles, is Vanguard themselves. You know, we get into a lot of passive and active discussions in our world, because we’re quants, but the term is so meaningless to me. But my favourite example is always, it’s a lot of my Boglehead friends, that Vanguard actually runs something like a third of their assets are active, including they just launched a couple new active funds, and, actually, they actually manage more active funds than they do passive, which usually surprises a lot of people. But they often say, they’re the first to admit, they’re like, “Look, you know, there’s places for both, and in some areas in particular it makes sense to have some active controls.”
Anyway, so I wanna switch gears a little bit, because the people listening to this probably think we’re talking about U.S. stocks only. But I know you have a global focus. I know there’s one particular market that’s been on your radar these days. So why don’t, to start, we talk a little top-line thoughts on global investing in one market in particular that you’ve been pretty high on?
Dan: Sure. So I think you and I share sort of affinity for saying, “Okay, look, if you’ve done your quantitative work in one market, you should replicate it, and prove it works in other markets, and try to build up through that evidence that your strategy is not data-mined but rather is building on logical underlying fundamental rules.” And I think, you know, obviously, value is one of those fundamental underlying rules that make sense that it should work across markets, across time, across geography, across asset classes, and we’ve made a big effort to replicate our quantitative work across markets.
And one of the, you know, biggest places we’ve done that, or the most interesting ones, is Japan. And Japan is a sort of natural place to go after the U.S., because it’s, you know, second-largest country by market cap and by number of pure number of listings. It’s a developed market. And because of zero interest-rate policy, there’s a fair amount of levered firms there. And what we found, which is quite interesting in Japan, is if you compare it to the U.S., then the U.S. small-value and levered small-value, you know, my sort of specialty, is more volatile than the large cap indices. It has bigger drawdowns than the large cap indices, and that makes sense, right? I think we sort of think small companies should be more volatile than large companies, and levered companies should be more volatile than unlevered companies, and value stocks, I’m not sure where my intuition would leave me and whether value stocks should be more or less volatile. But, certainly, size and leverage should be increasing volatility.
But what we found in Japan is that we had a similar return profile, very attractive, looked like private equity return stream, but actually about half the drawdowns of the Nikkei and lower volatility than the Nikkei, which I just thought was crazy, right? I mean, how could that possibly be true? And so I said, “Well, first, you know, what about actual people?” You know, I’ve been backtesting, I’ve been studying the markets, but let’s make sure, just sanity check, you know, what is, like, DFAS Japan fund, how do they do in that way. And, you know, you pull it up. It’s down 30% when the Nikkei is down 50%. And so this is crazy. How is it that small caps are less volatile than large caps? And, you know, in my universe, how is it that leverage isn’t adding to the volatility at all? And what I found, and what’s really interesting, is that Japan essentially doesn’t allow bankruptcy.
So, technically, there are bankruptcies in Japan, but the actuarial bankruptcy rate is about one-hundredth of what it is in the U.S. Basically, in the Japanese culture, you know, sociopolitical scheme is entirely focused on guaranteeing lifetime employment and stability. The shame culture, if you, you know, do something shameful, it’s very consequential. It’s not like here where you can sort of reinvent yourself like a phoenix. And so, as a result, there are huge amounts of resources put into making sure that troubled companies don’t go bankrupt. And that has a negative effect in some companies, right? So this drives a lot of Japanese CEOs to hoard cash on the balance sheet to prevent the eventualities that some crisis causes them to, you know, have some issue where they can’t pay employees. They hoard cash. They do all sorts of other things to try and create per shareholders. But the levered portions, those that have debt on the balance sheet, are very oriented towards debt paydown where their capital allocation policies are good.
And because of the unique scenarios of what’s going on, you know, at Japan in the banking system, the political system, there have almost no additional risk of bankruptcy, and they’re borrowing at about, you know, less than 1%. So debt is almost free and almost zero risk. And so, you know, basically, in Japan, we’ve got this unique market where what we do works really well, but it works really well at about half the drawdowns and half the volatility of what we do in the United States.
Meb: You know, by the time this podcast comes out, the next day I will be leaving for Japan so I can give you some on-the-boots feedback, not on capital allocation, but rather something else that is not much known about Japan, which is one of the best skiing destinations in the entire world.
Dan: Oh, are you going to Hokkaido?
Meb: I’m gonna be in Hokkaido. One of the podcast sponsors was actually a ski pass, so I’ll hopefully get in a free few days at Niseko from Mountain Collective. You’re welcome, Mountain Collective, for extra free mention there. But they actually have more snow already in Japan than most U.S. resorts get all year. So it’s pretty snowy over there. I’m pretty excited. And we’ll squeeze in a few meetings here and there as well, but excited to go over there you. Are you a skier at all?
Dan: I do like skiing. Although I’ve never gone skiing in Hokkaido, I’d like to.
Meb: Well, the whole island of Japan is actually pretty great. It’s like they have all these tons and tons of mom-and-pop little resorts everywhere in addition to the big Olympic-sized places. But it’s really a special and different place, because not only do you get good skiing, but you could have udon at lunch, and sushi for dinner, and onsens in the afternoon. So, I highly recommend it. It’s pretty awesome. All right, we got totally off topic. What are we talking about?
So capital allocation. You know, it’s interesting, because we’ve noticed a slight cultural shift that at least it’s starting to play out a little more. We’re seeing more of a culture of focus on capital allocation in Japan. And I don’t know if this is, you know, gonna take a year, or 10 years, or 20, but you’re starting to see more in the way of like buybacks and more of kind of focus on the balance sheet and what to do with their cash. Is that something you guys see as well? Is that a trend? Or is that… Are they so far in the early stages that it just could last a while?
Dan: Yeah, I mean, I think the first striking thing is just to notice how dramatically different their policies are than in the U.S., right? If you just graph, Michael Matheson has done a great job, you know, you just graph shareholder yield in Japan versus the U.S., or dividend policies, or the amount of buybacks, I mean, it’s just exponentially lower in Japan. And all that capital is going towards hoarding cash on the balance sheet, right, which seems to be, you know, everyone’s favourite idea among CEOs in Japan. And I think, you know, you and I are the first ones to notice this problem, and it’s so obvious in the statistics. And I think a lot of firms out there have said, “Well, gee, you know, why don’t we go be activists, you know? You know, let’s get in a plane. Let’s fly over there, you know. Let’s meet with this Japanese CEO, and let’s explain to him the virtues of dividends and buybacks and explain to him that we’re buying, you know, 5% of his outstanding shares and thus he should listen to us.” And I think, by and large, you know, that approach has not really resonated with Japanese culture particularly well. It hasn’t really worked particularly well, and it’s been sort of a constant stream of frustrations and disappointments for those people who think that they’re gonna change Japanese culture to be just like Wall Street.
Yeah, and I think our view in contrast is, you know, why not work with the cultural logic of Japan? And I think, you know, look, every one of these CEOs really wants to hoard cash, and that’s their all-out goal. You know, why don’t we just find the ones that are really levered where the CEOs are gonna spend every day, you know, paying down debts because he’s so eager to be a cash hoarder? And that way, you know, we get all the shareholder return, and we don’t have to waste our time trying to convince any Japanese CEOs to dramatically change their culture overnight.
And it’s funny, because we were there in September, you know, meeting with a few of our companies who are invested, and they sort of asked some of these basic questions to understand the cultural logic as well as we understood the quantitative logic of what we were doing. And we started asking, you know, “Gee, you know, your debt’s free. There’s no bankruptcy risk, you know. Why in heaven’s name would you pay it off? You know, why wouldn’t you borrow more?” And, you know, one of the CFOs said, “Well, you know, gee, our banks want us to borrow more. In fact, you know, even two years ago when we broke every covenant and couldn’t really pay our interest payments, they actually just lowered our interest and gave us more debt.” And we’re sort of like, “Well, why in heaven’s name would you pay it down? This lenders seem amazing, seems completely risk-free.”
And they said, “Oh, well, they come over. Every month they come and they meet with us, and they ask us about spending and about capital expenditures, and they try to tell us not to spend money on things and not to buy things. And it’s so annoying. And we’re so eager to get those guys out of here so we can, you know, do acquisitions, and spend more money, and, you know, hire more people. And so we’re just focused on getting rid of those bankers and paying down our debt.” And my partner, Nick, and I just looked at each other and said, you know, “This is excellent. We can just outsource our strategic vision to the Japanese banks who are already monitoring this and making you do what we would have wanted you to do. And it’s, you know, you’re already doing because you want to, and we don’t have to convince you, or, you know, do any fancy PowerPoint presentations, or buy a large percentage of your shares to convince you to do it.”
Meb: Do you guys, kind of, when you look globally, similar to sectors, are you making any sort of constraints? Is it kind of go anywhere? Do you dip into emerging markets? Is it purely developed? What’s the kind of thinking as you look around the world?
Dan: Yeah, I think it’s similar to yours when we’re looking for value. And so, you know, Japan is great, because it’s the cheapest of the major developed markets. We have a dedicated Japan fund. We also have a global fund. Our global fund is, you know, 35%, 40% Japan. We also see a lot of attractive opportunities for what we do in North America and in the UK. But really, you know, we rarely, you know… The emerging markets, the big emerging market, China, way too expensive for us. Capital markets aren’t developed enough for firms to leverage. And, by and large, our strategy, right, we’re looking for firms that are gonna generate equity returns through deleveraging and cash flow generation, and that universe of things is not the high-growth emerging market. I do Alibaba. It’s not a bat, but these aren’t bats, or fangs, or whatever. We want the sort of things that people think are boring, and slow, and steady, and those are much more likely in a, you know, low-growth country like Japan, or mainland Europe, or, you know, the U.S. and Canada than they are in China or India.
Meb: Yeah, I mean, I remember Japan is actually the largest allocation by double for our foreign-developed value fund, so pretty similar viewpoint there. Do you guys think about currencies at all? Do you hedge out any of the currencies’ risk? I know a lot of the listeners would probably be…they always ask this question. They love this question for some reason. How do you guys think about currencies at all?
Dan: Hedging risk, you know, I think better than hedging risk is to find risks that you get paid to take. But I think, you know, in terms of hedging, you know, with the yen in particular, which is our largest, you know, FX exposure, the nice thing about the yen is that there’s a negative correlation between the yen’s movements and the returns of Japanese equities such that, you know, in bad environments, the yen goes up, and in good equity environments, the yen goes down. And so you have this natural added sort of dampening of volatility, and you sort of say, “Well, I’m happy giving up a little bit of returns when I’m doing well if, gee, I’m gonna get a big, you know, cushion on the downside as the yen appreciates any sort of bad market.” So because, I think, of the unique sort of flight to safety characteristics at the yen, you know, we sort of like having unhedged exposure.
And I don’t hedge my portfolios. I think, you know, Bridgewater sort of drilled into me that in the long term, you know, there should be no premium for currency trades, right? You know, everything should sort of come out the wash in the end. So unless you have some sort of very sophisticated currency trading system, you know, you’re better off not hedging.
Meb: Jeff had poked me a second ago for a question. We’re kind of past it, but still interesting. Is there sort of like an opposite cousin of Japan? If you look culturally, kind of the way the companies think in Japan, is there any sort of country you’ve come across where the companies just spin like sailors and where you notice sort of like a totally opposite approach to capital allocation? I mean, I don’t know off the top of my head if I can think of any, but…
Dan: Probably the United States. I mean…
Meb: Yeah, that would have been my guess.
Dan: I mean, we’re such an outlier globally in terms of creative destruction and bankruptcy rates in terms of shareholder policies and… And it’s sort of funny, like, you know, for me, you know, trading U.S. public equities and then going to Japan, there are a few interesting differences, right? One is, you know, the U.S., you know, small caps are much more volatile than in Japan. So it’s like trading stocks to trading bonds. And then, you know, it’s interesting the U.S. is so competitive. There are probably about 10,000, you know, funds focused on the U.S. public equity market. There are probably about 50 actively managed funds focused on the Japanese public equity market, right? So it’s just a, you know, crazy differential as soon as you sort of leave the, you know, sort of highly competitive U.S. market and go abroad. I think, you know, there’s much less competition and, I think, much more ability, you know, for alpha generation.
Meb: So we’re gonna segue a little bit. We got a couple more questions, would love to keep you forever, you know. Kind of like us here at Cambria, you guys are pretty transparent. You’ve written a couple of white papers we’ll link to. You’ve written a bunch of great mailing list articles, which we’ll put a link to. But you’ve also participated as one of the more highly rated participants on SumZero. Is that something you still are involved with? And it’s interesting, because, for the listeners, it’s a community of buyside analysts that got started by one of the, I think, original founders of Facebook. Any comments there, any thoughts? Because I know at least at one point you were pretty highly active there.
Dan: Yeah, and I still, I like posting some of our ideas. So we like to, once we’ve made an investment, to write up sort of the core thesis or the logic of it, which, if you read 50 of our write-ups, they basically all say the same thing, which is it’s cheap, it’s paying off debt, it’s going to get less cheap, and as the debt goes down, the equity value is gonna go up. But we find, you know, new and creative ways to say that about all different companies. But we still, you know, do post a lot of our ideas on SumZero.
And, you know, really the reason I do that and the reason I write as much as I do is because I think a lot of these ideas are controversial, right? I mean, in a world where 90% plus of institutional investors think that private equity is God’s gift to mankind, you know, saying, “Gee, you know, have you guys noticed that private equity has now performed [SP] the market since 2010? You would have been better off in the S&P 500 than in private equity funds, right? Have you thought about the dynamics of how big of a deal it is to go from three turns of debt to six turns of debt?” You know, these are controversial things that I think a lot of people don’t agree with, they find them unsettling.
And my view is that, you know, because I want to change people’s minds, because I think I’m controversial but right, I want to publish and share my ideas as much as possible, you know. I wanna write the white papers. I wanna, you know, show individual examples of this in the individual security level. And I wanna write in magazines like “Institutional Investor,” etc. to share broader ideas about how to make good investment decisions and what are sort of the common traps that people get into.
Meb: There’s a great article that we’ll post a link to that we’re not going to get in today that you talk about Michael Porter and Five Forces Framework. So we don’t have time to get into it too long, but we’ll post a link. What’s got you excited? You know, a lot of the research you’ve done, like us, there’s always refinements and new ideas. But what are you excited about now as looking forward? Is most of your time spent delving into these companies and kind of refining the portfolio? Like, how often are you actually trading this? Is this something where you’re doing like a once-a-year screen and then you’re picking a few stocks? Second is, like, how active is that, and are you actually…what’s the sale process? I forgot to ask that earlier. Is this something just kind of a time-based or… And then second is what’s got you excited going forward on the research world?
Dan: Yeah, we rebalance quarterly, like, I think, most quantitatively oriented people, as new data comes out, and then we manage the portfolio in the interim. And I think, just in terms of some research findings, one that we’ve been pretty excited about is just the importance of or the predictive power of short interest as a metric. We are sort of evangelist for the idea that, if you’re trading small-cap value, you should just be paranoid about any company that’s small-cap value and has high short interest. That’s a recent addition to our portfolio strategy, is really using that as a risk signal of getting out of anything where short interest goes up, using that as a negative screen against what we do.
So I think, you know, that’s an example. We spend a lot of our time on, you know, refinements, trying new quantitative tests. And I think, you know, as anyone would find, most ideas are bad ideas, so, you know, you try 10 things and maybe, if you’re lucky, 1 works. And then you wonder if that one thing is data-mined, so you test it somewhere else, and maybe half the time it works, it’s true, and half the time it isn’t. But I think we’re spending a lot of time replicating our approach in different markets, trying to tailor our approach to different markets. So this year we’re really focused on Europe of going UK, Italy, Germany, France and trying to discern, you know, whether our approach makes sense in those markets, what are the refinements we need to make to our model.
And then I think the other thing that we’ve, you know, been focused on is, you know, I think, trying to refine our sell process. I think, you know, you think about how much work we all put into figuring out what to buy and then how comparatively little other than sort of saying, “Well, you know, let’s sort of rotate into the things that are the most attractive buys and other things that are no longer attractive on our screens.” But are there better ways to refine that? I think that’s another big question we’re working on this year. So I think, you know, most of our time is on that sort of quantitative research. And I think, you know, then probably a third of our time is on the individual companies and trying to say, “Hey, can we dig into these things? Can we find, you know, sort of mitigating positive things about them that make them more attractive or negative things that are gonna make them not a good fit for the portfolio?”
And then, as we do that, are there things that we learn from looking at the companies that say, “I’m sure we’ve seen a pattern here”? You know, a lot of the times the computer is giving us a false signal on, you know, shipping companies, and, gee, we got to understand why that’s the case, etc.
Meb: And this is kind of split into two parts. Let’s say the listeners listening to this today, obviously, an institution, there’s a very clear bucket for this, which is you could substitute straight-up, you know, the private equity exposure for this approach you’re talking about. But let’s say there’s the individual listening in today, is this something that you would say, “You know what, I think you could sub out your entire equity exposure”? Do you think, say, “You know, no, maybe you just want to put it in for small-caps”? Like, what’s your theory? Where does this fit into an investor’s portfolio?
Dan: Yeah, so I think, especially outside of Japan, Japan, I think, is much lower risk, but for our global fund we’re in the bucket of higher volatility alternatives to mainstream. We’re not trying to fill the 80% of your portfolio that, I think, there are a lot of people that have views on how to do that, but that’s gonna be largely driven by more conventional equity exposures. We’re trying to say, “Hey, what can we provide you that’s an alternative to that and really that’s going to fit that, you know…” You know, I think the reason people allocate to private equity is because they want, you know, the really add and enhanced return profile that comes from private equity or came from private equity historically. And I think, you know, our view is that that’s really the bucket we wanna be in, you know. If Yale has 15% of their portfolio in private equity, I would say an individual investor should max out at their exposure to levered small-value and private equity at 15%, and that’s probably even more aggressive than I’d recommend.
I think we really talk to our investors about saying, you know, we are purveyors of hopefully beautiful niche investment strategies that work really well, but, you know, we’re not trying to solve 100% of your portfolio. We’re trying to fit in 5% or 10% where we can add some alpha, give you some extra return in a corner of your portfolio, and replace, I think, importantly. You know, we really are bearish on the private equity industry and the massive amounts of money flooding in there. And we’re really trying to talk to people and say, “Gee, you know, I know every investment consultant in the world is telling you that’s the best idea ever and that it’s incredibly low-risk, but be careful. It’s not gonna work as planned. And you’d be much better off doing what private equity firms did in the ’80s and ’90s when they actually made money for investors in access to the public markets than doing what they’ve been doing for the past 8 years, which has not beaten the S&P 500.”
Meb: Do you ever get any requests, or interests, or inquiries about the opposite side of the book, about shorting? Do they ever say, “You know what, Dan, I love your long-only private equity, but that’s gonna be too much risk for me, having a small-cap exposure. Can you pair this with some sort of short exposure?” Do you ever get any requests about that, or interests, or thoughts, or anything else?
Dan: Yeah, we do.
Meb: Shorting is hard. That is for sure. Dan, it’s been awesome. We gotta wind down. Our favourite question we ask, although we got to update it for 2018, what’s been your most memorable investment or trade of your career? Good, bad, the first one that comes to mind, is there any one that particularly sticks out?
Dan: Oh, that’s a good question. You know, I love that about a year and a half ago we invested in a Japanese chemical company called ISHIHARA SANGYO KAISHA, which was the sort of Exxon Valdez of Japan in 2002 and 2003. They’d been caught. They’ve been pouring chemicals into a stream. They were caught in, you know, a huge corporate scandal. And I think, you know, what’s, I think, sort of so fascinating about Japanese culture, rather than going bankrupt and letting the government deal with the clean-up, the company stayed public and agreed to take on a massive environmental liability, essentially taking a huge amount of borrowing, and then to use that money to clean it up themselves, and then use their cash flow over the next 5 or 10 years to pay off that environmental liability, which I thought was a very honourable and wonderful thing for a company to do.
But you fast-forward to, you know, 2015, 2016, 2017, this company, which produces a commodity chemical, was trading at, you know, three and a half times EBITDA. Global peers traded at, like, 11, 12 times EBITDA. And you started to ask, “Well, why is it so cheap?” And they said, well, you know, look at the bad things they did. They did those things in 2003, but, you know, in Japanese culture, it’s so shame, you know, nobody wanted to touch this thing with a 10-foot pole because of what they’ve done and their bad image and so. And actually, in 2016, they actually finished paying off all their environmental liabilities. You know, we invested in that. It was a great investment for us, and I think one of the things that I liked about it is it’s such a classic example of what we do. And, particularly in Japan, you know, the virtues of deleveraging, how oftentimes, you know, low valuation is a punishment for bad things that happened in the past rather than anything prospective about a business. And I think, you know, the benefits of, you know, being willing to take those sorts of risk.
Meb: I love it. Dan, this has been so much fun, super insightful. We’re gonna post a lot of the show note links. Where can people find more if they wanna keep up to date with your writing, everything else going on in the Verdad world? Where do they go?
Dan: So you go to my website, www.verdadcap.com. We write a weekly research email if you, you know, fill out a little form on our website. You can sign up for our email list. We try to be controversial, and interesting, and empirically driven, but that’s probably the best way to get to know more about us and our firm.
Meb: Awesome. Dan, thanks for taking the time today.
Dan: Thanks so much, Meb.
Meb: Listeners, thanks for taking the time to sit in and join us. You can always find more episodes at mebfaber.com/podcast. If you’re loving the show, hating it, whatever, please leave us a review. You can always subscribe on iTunes, Overcast, Castro, all the good apps. Thanks for listening, friends, and good investing.