Episode #255: Matt Peterson, Peterson Capital Management “We’re In A Global Pandemic; In A Recession…People Are Scared; That Creates Opportunity”

Episode #255: Matt Peterson, Peterson Capital Management “We’re In A Global Pandemic; In A Recession…People Are Scared; That Creates Opportunity”

 

Guest: Matt Peterson is the Managing Partner of Peterson Capital Management. 

Date Recorded: 9/16/2020Run-Time: 55:22

Summary: In today’s episode, we’re getting into concentrated, deep-value investing. We get into Matt’s long-term value based framework and a truly concentrated portfolio of about 12 names right now.

We cover his position entry strategy of writing cash-secured puts, which has helped the fund during periods of heightened volatility like we’ve experienced recently. We explore some interesting insights on Charlie Munger’s Daily Journal Corporation, and jumping on the opportunity to purchase Berkshire class B shares by writing puts as shares came down in price earlier in the year.

We get into some high level thoughts on the economy, the risk of holding cash and bonds, and the need to be prepared for some inflation down the road.

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Transcript of Episode 255:

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: Hello, friends, another awesome show. Our guest is managing partner of Peterson Capital Management, a long-term, value-based hedge fund. In today’s episode we’re getting into concentrated deep-value investing. We get into our guest’s long-term, value-based framework and a truly concentrated portfolio of about 12 names right now. We cover his position entry strategy of writing cash-secured puts, which has helped the fund during periods of heightened volatility like we’ve experienced recently. We explore some interesting insights on Charlie Munger’s Daily Journal Corporation, jumping into the opportunity to purchase Berkshire Class B shares by writing puts as shares came down in price earlier this year. We get into some high-level thoughts on the economy, the risk of holding cash and bonds, the need to be prepared for some inflation down the road, and what’s going on with Turkish stocks. Please join us in this episode with Peterson’s Capital Management, Matt Peterson. Matt, welcome to the show.

Matt: Thanks, Meb, pleasure to be here.

Meb: I’m a little nervous because your judgment seems a little questionable. You’ve recently left the land of milk and honey. Tell our audience where you are now. You left SoCal, the land of sunshine.

Matt: That is true. It’s still near and dear to my heart. I missed the dolphins at sunset but we did. In January, we put together our list of priorities and, sort of, scanned the nation and landed in Austin, Texas. So we followed the mass migration and we’re here now. And it’s been very nice, it’s been a very nice move for the family.

Meb: I think you’re, I mean, months ahead of what you would consider to be the curve. I mean, I imagine between January and probably now, property values, I would think, would be up from everyone wanting to leave the big centres of LA and New York, but have you noticed a steady inflow?

Matt: That is right, yeah. Things have been going up here for a couple of years but COVID has helped it along, certainly. It’s actually a seller’s market here in Austin if you can believe it.

Meb: I love it there. That was one of my last places that was on the itinerary. Pretty shut down was to be in Austin so, hopefully again, soon. Look, there’s going to be a lot of fun, despite the fact you’re not local anymore, we’re doing this virtually. We’re going to dive deep into investing, and stocks, and all that fun stuff. But first, give us a quick origin story, two-minute overview, where you’ve been, what you’ve been up to before leading to 2020.

Matt: I’ll make this quick. I’ve been interested in finance for since I was a young child. So I studied economics and math and had a career out on Wall Street doing risk management work. I was consulting for a whole bunch of banks for seven, eight years. I was at Goldman for most of them, but I was also at Morgan, and I spent some time with American Express, and Ameriprise, a couple of years out in London, and launched Peterson Capital Management in 2011, so we’re about to hit nine years with the fund. And that was all done in California, so I moved from New York out to Cali when we launched the firm. And now here we are in Austin.

Meb: Wasn’t there a Chinese stop somewhere on the way too?

Matt: Oh, there was, yeah. So I went too fast. I studied at an undergrad school called the University of Puget Sound up in Seattle, Washington, Tacoma, Washington, and graduated right at the tech collapse. And so, as a means to being abroad, I did go over to China for a while. I, sort of, anticipated coming up throughout my life and went over there and taught English in Beijing for a period, and let that, sort of, recession handle itself, and then came back and went out to Wall Street.

Meb: Awesome. Still on my to-do list, hopefully soon. I’ve been to Hong Kong but that’s about it. All right, let’s dive in. Before we get started on that, I want to hear a little bit. I’ve known you for a long time. We’ve chatted ideas for many years and love listening to you go deep on some of these. But for those who don’t know you, give us a little framework for how you think about investing in general, what’s your broad approach? We’ll spend a little time on that before we get to the specifics of some ideas.

Matt: We run a long-term, value-based fund, and I’ve been a value investor for two decades. And so we run a very concentrated portfolio of a few great ideas, typically bucketed in either…classify them as either, sort of, gram net net sort of idea, where you can buy $1 for 50 cents, but it isn’t really growing, or, ideally, we find fisher compounds. And fisher compounders are, sort of, you might have seen the scuttlebutt method before, but it’s, sort of, understanding, sort of, the long-term growth trend of a particular company and still buying it at a very fair price, hopefully a discounted price. But something that you can hang on to and let it compound for a very long period of time.

So there’s one framework that we do apply rigorously, and that’s our co-priorities framework. And it’s really simple but it’s just hard to find companies that fit into all the buckets. So we are looking for the most exceptional business models. We want to have a very strong business model, and that includes all sorts of moats, and competitive advantages, and etc. We’re looking for top-quality management, so the C-suite needs to have the shareholder interest in mind, should be exceptional capital allocators, and then, finally, the valuation aspect, which is, of course, key to our funds, so we’re looking at the standard valuation metrics, trying to understand future cash flows, and trying to buy things at a discount to what their intrinsic value truly is. So if something fits into all three of those buckets, we’re going to have a pretty good opportunity.

Meb: I was going to say that’s quite a tall order. How do you find these? Are you just screening quantitatively? Is it a more traditional following a set universe? What’s the approach?

Matt: I’ve actually spoken on this quite a bit and sometimes I get some pushback. But I have the view that screening has become much less effective than it used to be primarily because so many financial books have been written at this point and technology is so easy. You can set up a screener, and everybody can set up a screen and look for low EBIT, EBITDA multiples, and it’ll spit out something, have some universe of stocks to dig through. But I don’t necessarily think that leads you to the right place anymore. So we have a pretty specific process. But the first step, a lot of people… This is a really easy shortcut, by the way, so all your viewers can apply this. But it’s quite amazing, people don’t often talk about it. But any fund with $100 million or more, and this really works in value-based funds or someone’s holding a security for a long period of time. But any fund with $100 million or more has to file a 13F with the SEC. And so that’s really where we start every single quarter. We have a concentrated portfolio, we don’t need a ton of ideas. There’s about 100 funds that I monitor, and I basically will look through the 13Fs and understand what is being bought and what is being sold. And that will just narrow down the universe from like 10,000 investable securities globally to maybe 100 or 200. And all I’m asking myself is, “What is Bill Ackman buying this quarter? What has he purchased? I mean, he spent…” It doesn’t need to be right but it’s something interesting to know, “What’s David Einhorn doing? What’s Seth Klarman doing?” And by, kind of, narrowing things in this manner, you don’t always get stocks that would screen well, you get really quirky, kind of, opportunities. And Charlie Munger always says, “You have to fish where the fish are.” And from a value-investing perspective, this is where the fish are. And, actually, academia has proven that this creates alpha through this approach.

Meb: It’s funny you mention Klarman because it was an institutional investor, someone had a recent piece out that was basically saying that people were questioning, or turning down, or scaling back their Baupost allocations because they thought Seth and crew have lost their touch. And I was like, “That’s a great sign. Probably a wonderful countersign to be looking at some of their holdings.” Because my favorites as well are the ones you don’t really, in my opinion, want the hedge fund hotel names, where you see like 50 hedge funds all own the same thing, but rather, you look at and you’re like, “I’ve literally never heard of this company before, let’s do a little more research.” And Baupost is one of those that has that, sort of, to an extreme. I feel like usually I don’t know what three quarters of their portfolio is. But that’s fantastic. Good. We’ll hit you up for that list later because I love peeling through those ideas. And touching on your point, being a quant too is, everyone has the same data in 2020, everyone has got the same team of PhDs that’s tortured that data for the past 100 years. And so the former edge of investing based on a lot of those, particularly if you’re a big fund, is tough. So, okay. So you use 13Fs.

Matt: I absolutely agree with that, I absolutely agree.

Meb: All right. So keep going, that’s part of your idea for them. What’s next?

Matt: I can walk through the process. It’s pretty straightforward. I’ve simplified it in a way that it sounds straightforward but I will also add to that. This subset of firms, the firms that we ultimately put into our portfolio don’t necessarily need to come from this pool. However, often by searching through this pool, it will lead you down a trail where you find something very special, and so that’s all part of this. The second step, of course, is once you have this, or once we have this pool of securities that we’re looking through is standard fundamental analysis. So it’s understanding the competitive advantages and the moats, and it’s looking through all the quantitative data, making sure that they have strong balance sheets and liquidity, and taking a look at the fixed-income profile and making sure that bonds aren’t trading at 70% off, and maybe there’s clues in that if there is, and it’s understanding, truly, the gems within this pool of firms.

And the third step, then, just to move quickly, is, we actually don’t buy things through the traditional market or limit orders that most funds and certainly retail investors would do. So we’re not buying things, typically, through the New York Stock Exchange or NASDAQ. What we’re doing is, we go into the Chicago Board of Exchange and we write cash-secured puts. And so these cash-secured make them an unleveraged product. And we are simply using them as a tool to buy the equity. And particularly today, we just did our annual meeting, and I was explaining to everybody that we are in a totally new environment, and we can dive into this maybe when the process is done. But the VIX has basically gone from sub 9, 10 for a bunch of years, to 85 in March and it’s still extraordinarily high. So those factors feed into Black Scholes and that determines the price that people are willing to pay for a put contract, for a premium. So people are buying protection because they’re scared. We know something about the underlying security so we often use these as a tool to get in, and it is just an extraordinary time to be applying that step in the process.

And then, finally, the fourth step is optimizing portfolio construction. So we apply things like the Kelly Criterion to our approach, which leads to a highly concentrated portfolio. And, basically, when the odds are in your favor, you bet big. So, yeah, we end up with those, kind of, four steps lead us to the portfolio that we have.

Meb: And so, practically speaking, how many names do you end up owning and what’s the traditional, sort of, time in the security? Are you holding these for months, years? What’s the general…?

Matt: Certainly, we are holding them for years. And we are usually right around…we have four companies that make up over half of our portfolio and we have about a dozen firms in the portfolio, typically.

Meb: Awesome. And this one on sell, is it value-based, time-based, convictions on stories changed? How do you think about getting out one of these dudes?

Matt: Well, first of all, we’re following certain leading indicators with a given story and thesis that we have. So if it turns out that we discover that our thesis is incorrect, we’ll exit quick. But, typically, the sell is actually the inverse of our step three. So we will sell a covered call to exit a position, we will often do a very lot… These are, oftentimes, leaps if they’re available. So we’ll go out a year or two and pick up that time premium, and ultimately, maybe I’ll walk through an example with you, but when we sell, if a security is worth $100 and it’s reached $90, we’ll sell a 1-year covered call with a strike of $100 and pick up 10 or 15 bucks in premium. And if it goes above $100, those shares will get called away from us and we’ll be out at $100 plus 15% so we get a little extra on the top.

Meb: Let’s, maybe, do a case study or two. Pick out a name out of the hat…

Matt: Well, I’ll tell you something interesting. So first of all, I will share that, it’s an extraordinary time right now, primarily because I think we are, right now, living through the most uncertain time that many people in their lives have ever experienced. And markets don’t do well with uncertainty. Volatility broke all records. I mean, volatility, the VIX, which is the fear index, usually, kind of, bounces in the teens, and then we had a bunch of years, the last 4 or 5 years where it was really hard for value folks, where it was like sub 10, and just, everything was just, kind of, moving along. There have been a few spikes where it’s gone to 30 or 40, and in March, it broke all historical records and went to 85. And I think, rationally, people understand that you should be greedy when others are fearful, especially if you have a long-term mindset, but it’s really hard to do when the world is on fire. So you have to, kind of, ignore the noise and really get hyper rational.

So to put a case study together, I’ll explain something that I couldn’t believe existed and this isn’t even the best scenario, this is just one that was incredible. Berkshire Hathaway, run by Warren Buffett, obviously thrives during periods of uncertainty, and the shares sold off, indexes sold off, everything sold off. The B shares where these contracts are available actually fell from $230 a share down to, let’s say, $170, I think it was in the high $160s even. And I’ve studied Berkshire for decades, I’ve been a shareholder since 2003, it is a position in our portfolio. But as it was falling…and I actually have written a bunch of things on it showing that it’s worth about $1.7 trillion this decade. So, suddenly, Berkshire was selling for its cash, its marketable securities at a discount, and maybe Burlington Northern, they have 100 other subsidiaries. So that was just a total no brainer if you want to just buy a long-term holding. But we were actually looking at the options market, we were able to, as it crashed, we were able to sell 6-month contracts on Berkshire with a strike of $165 and pick up $18 in premium. So the IRR on that is 25% and it lowers. So if you’re going to buy for $165 but now you get paid $18, now your net cash outflow, if you do buy it, is $147. That’s just so unbelievable. I think their fair value today is probably around $280 or something. So we were able to, sort of, commit to buying it for $147 net or…and that’s if the shares continue to decline, or if they appreciate a little bit, we keep the $18 when the contract expires and make a 25% IRR on Berkshire Hathaway just in premium that people are handing us. And so that’s the kind of environment we’re in, and Berkshire isn’t the greatest opportunity. Go find your favorite anything. I mean, I love Tesla, in terms of the management, and the business is fine, the management is excellent, the valuation is hard for me to wrap my head around. But post-split, I think it was trading for $400. And I just checked, I don’t know what it’s at today, but I just checked maybe a week ago, and instead of buying it for $400, you could actually write a put that went out 1 year and pick up $175 for a strike [inaudible 00:17:00].

Meb: That’s great. That’s funny.

Matt: It’s just unbelievable.

Meb: Well, it’s funny because as you were talking, I was looking at Berkshire and we’ll have to dig in the two points. By the way, by the time this podcast comes out, the 1-week delay in between recording and publishing, Tesla could be anywhere between a $10-trillion company and $0.

Matt: That’s right.

Meb: So who knows, listeners? But it’s funny, you’re talking about Berkshire because, first of all, March feels like five years ago to me, but only six months have passed. But thinking back to that time, Berkshire has an interesting situation because you’ve had Warren and Charlie come on and say, “Look, we’ll start buying back stock at a certain level.” And they used to say it was like 1.1 times book or something, now it’s 1.2. I think it trades, I looked it up, it was like 1.3 now. But it went close…I think it went below 1.0 in March. And so it seems to be like a fairly low-risk trade that you’re talking about, which is, “Hey, look, they’ll come in with me if they haven’t already.”

Matt: Absolutely. First of all, I look at this particular strategy, our entry strategy, as a risk-reducing approach because we have a pretty volatile portfolio because we’re concentrated. But I think of risk as the probability of a permanent loss in capital. I don’t think volatility is synonymous with risk. So if you have volatile pricing around a really high-quality firm, that doesn’t bother me. So, Berkshire, I think, over 50 years, has fallen 50% three times. But, yes, to your point, exactly, it was trading for 1 times book. And actually, without going down too many details, I would argue that book is far understating its actual book value. However many…40 years ago, they bought See’s Candies for $25 million and it sits there at book. So that’s not a $25-million subsidiary anymore. But they’re not in the practice of marking things up. So their book value is understated and they’re trading for book value. And they have a meaningful amount of cash, about $145 billion, and it’s a great group of folks to be putting that money to work. So, very low risk opportunity.

Meb: What’s your time horizon on the $1.7 trillion, because right now we’re around $500 billion?

Matt: That’s this decade, that’s going out to 2030.

Meb: All right, looking forward to having you back on in 2030. Warren is going to be like, what, 100-plus or 102 at this point?

Matt: Yeah, he’ll be 100, actually, he just turned 90. So he’ll be 100, we can check back in, you can see how I did.

Meb: Berkshire. All right, we’ll see. So this year has been a lot of opportunity, but that’s markets. You have the volatility mixed in and if you can, kind of, keep your head without going totally bananas, it’s kind of like kid in a candy store. You can talk about anything else this year, but also, any ideas in the portfolio that we could use as case study too, as to how you’re seeing the world, what opportunity is out there, anything else?

Matt: We were talking just for a moment right before this, right before we started recording and we mentioned Daily Journal. Daily Journal is something that I actually gave a presentation in Switzerland on this last year because it’s a title that’s hiding in plain sight because it’s such an obvious example of exceptional management, clearly an exceptional business model, and an entirely undervalued circumstance and situation, and people don’t recognize what’s going on. It’s just completely hiding, it’s totally under the radar.

Meb: Well, good. Let’s get into it. You have been talking to me about this stock for a while, and I wish I had listened many percentage points ago. Just for the listeners out there, it’s about a $350 million market cap and trading about $250 and change. Give us the original thesis and, kind of, walk-through why this is so attractive. And take your time, go as deep as you want, we’ve got plenty of time.

Matt: Yeah, you want to hear it? All right, you interrupt when it gets long here. Why don’t we just start walking through on the lines of the framework? So who runs Daily Journal? A lot of people have never heard of Daily Journal, first of all, and those who have think that it’s a newspaper business because they have a newspaper called “The Daily Journal.” And it used to be a newspaper business, but that accounts for about 25% of revenue and falling quickly. But who runs Daily Journal? It’s actually run by Charlie Munger and a whole bunch of his buddies. So everyone knows Munger and Buffett have worked together at Berkshire for six decades, but a lot of people don’t recognize that Charlie is running this little micro-cap on the side.

So the background is that Charlie and Rick Guerin bought it maybe 43 years ago, they bought this little newspaper for 2 million bucks and started, kind of, expanding their newspaper empire. They brought up to 10 legal newspapers. Munger is an attorney and they brought in all their friends to run this. So it’s Gerry Salzman, and Peter Kaufman who is a very wise man. It’s stacked with high-quality management. And I mean, completely stacked, it’s like the best businessmen in the history of the planet. And they, sort of, run it like their own personal little firm. And they have no IR, there’s no industrial relations, they don’t do any earning guidance, they don’t do any calls. You really have to be a true insider to, kind of, know what’s going on here. So their headquarters are in LA. And so, actually, when I moved to LA, I started attending the meetings and I noticed they kept commenting, but very briefly, on this tech component, and that’s what everyone’s really missing. So they would say, “We’re trying to climb Everest, we’re nine years old, we’re never going to make it. But if we do, it’s going to be a really big space.” I, kind of, listened to them for three or four years and started wondering what they were actually building, and I found out that nobody knew. A lot of fund managers I spoke with, a lot of Munger groupies, nobody had any idea. So, long story short, I found a customer-training conference that was taking place in Utah for this subsidiary that they called Journal Technologies, and I knew that it was something having to do with courts and the legal system. But that was about the extent of it, it’s really hidden. I tried to attend but I couldn’t get in. I didn’t have a court ID or any sort of government credentials so I wasn’t able to attend. And so I flew out to Utah, I booked a room in the hotel, I sat in the lobby for three days, and I interviewed all of the customers as they were moving between their various seminars and training sessions. And what I learned was absolutely incredible.

So, basically, it is a court SaaS solution that provides all sorts of services for, primarily right now, the Justice Department. It interfaces with all sorts of external justice partners. And there’s so many factors to this, but one of the most incredible things that I learned is that, when they do this bureaucratic RFP and then multi-year implementation of this software, they approach the RFP process with a four to seven-year billing delay. So they go in, they pitch to these municipalities that they can transform their absolutely archaic software solutions for courthouse into a cloud-based SaaS solution that is more current in today’s economy. And when it’s purchased, it’s purchased 10-year licenses in 100 license units, and they don’t begin billing for 4 to 7 years. And so because of that, they accrue what’s owed to them from these municipalities, but it transforms the, sort of, cities’ IRR to a very positive one so they can do the implementation without upfront costs. But what is most notable is that all of this revenue is missing from the financial statements at Daily Journal. And so, not to go on for too long here, but I returned to LA, brought in an intern, and we went through this massively onerous process, city by city, municipality. We went through 3000 counties in America, trying to find… Because revenue was missing from Daily Journal’s financial statements, we thought it might be somewhere in the books of these cities. So we were going through city council meeting minutes and searching for Daily Journal, Journal Technologies, all sorts of keywords that might lead us to some tech implementation solution. We found well over 100 of these contracts. We found two in Australia, but we found LA owes them $5 million, Austin, Texas owes them a million bucks. We found all these small cities that owe them a few hundred thousand. We found 2 contracts in Australia that owe them…one owes them $16 million, the other is for $89 million.

So what’s going on in Daily Journal? Daily Journal is, kind of, three parts. It’s a newspaper sliver, just call it zero and now you’ve got just a hidden asset in there. I failed to mention thus far, that they, Rick and Charlie, bottom ticked the market in 2009 with 50 million bucks of their newspaper capital, bought Bank of America, and Wells Fargo, and a few other companies in a portfolio. That’s grown to about $150 million. So they have $150 million in an equity portfolio inside of this $350 million market cap you’re talking about. And then the rest of it is this tech piece. And they have, literally, hundreds of millions that are owed to them in revenue in almost the costs are being accounted for. So this is almost like 100% margin revenue when it finally comes in as cash flow. So it’s going to be really interesting what happens over the next decade.

Meb: What do you see is the timing on that? Is that starting to tranche now, where they’re starting to roll, starting to hit, or is it going to be in, like, 2025? When is the, kind of, catalyst of this revenue…?

Matt: it is happening now. It’s happening very slowly. But I don’t know if it’s knowable. Certainly, I guess a few insiders might know when that revenue is going to really start to hit, and we don’t want to miss it so we’re being patient. But they have a lot of revenue-generating sources so they’re doing the implementation, which is a one-time fee, but then they have these ongoing SaaS licenses. And in a bureaucratic environment, those are going to keep going. They have price escalators built into these contracts. The number of licenses they’re selling each year to a specific municipality is growing. So prices are growing, licenses are growing, and they’re selling new contracts to new cities. And, ultimately, it looks like $100 million to $150 million annual revenue is totally possible this year, and there’s other revenue generating aspects of the business. So $100 million to $150 million in revenue from a company that, excluding their equity portfolio, is selling for $200 million run by some of the best businessmen on the planet and women on the planet, and with an exceptional business model. It’s a really nice opportunity. But we look out a decade. We’re planning to hold this all decade long.

Meb: Awesome. So Charlie will be like 120. He is older than Warren, right?

Matt: Charlie just turned, I think, 96, or he’s about to turn 96 in January, maybe.

Meb: So listeners, if you haven’t been, what Matt was talking about is you can actually…it’s like a hack if you want to go see, well it used to when the world was normal, Warren and Charlie, and not have to go to an enormous stadium in Omaha, but literally it’s like in a small office, granted it’s usually standing room only. And people usually have a fun happy hour afterwards at a noon time somewhere downtown LA or thereabouts. But it’s a special easy way to get to see Charlie. And like you mentioned, in the ’90s, they probably don’t have too many more of these on the actuarial tables. But he’s a hoot. I went a few years ago, and my God, he’s as sharp as anyone my age for sure.

Matt: That’s right. It’s a really good environment. I mean, the folks that attend such a, sort of, strange, unique, sort of, annual meeting are, kind of, special in themselves. So I think there’s about 1000 people now that attend the Daily Journal conference each year.

Meb: All right, so we got the bull case, is that it’s somewhat underappreciated by the market. I’m assuming at $350 million market cap, you probably have 0 analysts or investment banks following this.

Matt: Zero.

Meb: But I imagine, you do have a few Munger, sort of, Charlie fanboys that are probably interested. It sounds like the bull case is, kind of, a straight up double or triple and not too far of a time horizon, sort of, target as the revenue starts to hit. Going back to your earlier comment on screening, this is a good example of something that won’t show up in the screens because…

Matt: That’s right, it screens terribly.

Meb: …it’s not a price-to-sale story, it’s not a price-to-earning story yet. It’s just not reflected.

Matt: That’s right.

Meb: Give me a bear case. What could be the challenge for this stock?

Matt: Yeah, that’s very interesting. And this is intentional, but the firms in our portfolio, one aspect that I’m looking for very carefully is, I really want asymmetry in our positions. So I want the downside to be really well protected, and the hope is that the upside can just go parabolic. And I don’t want to be too speculative here, but with that bull case, I will add, we are talking about the one product, e-suites. Once you run a municipality’s courthouse, it’s pretty easy, I think, to pivot into managing their public school systems, maybe sensitive data, maybe adoption agencies, etc. So this is, like, one product of many that can come on board so the double and triple can get quite large if everything works out perfectly. But not everything always works out well. So the bear case is, in this scenario, I think, very interesting. Because I mentioned, they own, first of all, they own a couple of office buildings, about $16 million worth, they have about $10 million in cash on the balance sheet, and they have, let’s call it, $150 million equity portfolios. So they might be at $175 million in round assets, but of very real assets. And then they have the most unique debt profile I’ve, I think, ever come across. So the majority of their debt is a long-term capital gains liability. So it’s just because their equity portfolio appreciated. So in a similar way to like float that comes from an insurance company, this is float from the government, they never have to pay it unless they sell their securities. First of all, they won’t liquidate their portfolio very readily and they’ll do it strategically, so it might not even really be a true liability. But it’s on the books. It’s interesting, in finance, how we, I think, we classify most liabilities as all being equal and they’re really not equal. So there’s a different type of liability. They also, in order to start this tech firm, they took a $30 million margin loan from their equity portfolio, and that’s how they built this in the first place. And that $30 million margin loan has a 0.75% interest. So if you thought your mortgage was low, they’ve built an entire business on 0.75 below the rate of inflation, and it’s serviced with dividends from the portfolio. So it just operates in perpetuity. So is that a liability, it’s non-callable, the rates are below inflation so your real interest rate is negative? It’s very, very interesting.

But the question is, what’s the bear thesis? The bear thesis is, and this is hardly a possibility, but the whole technology business fails. So they save hundreds of courthouses but the contracts we’ve identified clearly is a few over 100, like 130 or so. And so they’re already in these courthouses, the idea of them failing is not really realistic. But if they were to fail, if costs were to continue, they would shut down that piece of the business and it would become worth zero. However, they have $150 million equity portfolio, and so that equity portfolio, in my view, will compound to the current market cap of the entire business this decade. So I look at that as the bear case. There’s this floor of this equity portfolio which will actually stop things from getting into real trouble. And the debt profile is very, very secure. So the bear case, for me, is tech fails, you hold this for a decade, opportunity costs exists, you could have done something else with your money. But I don’t think you’re at a very high risk of losing capital, so I look at this as a very asymmetric risk-reward where if things really work and this becomes a $3 billion market cap firm, you’re up 10X, otherwise, you’re flat.

Meb: Why doesn’t Berkshire just buy it?

Matt: That’s a good question.

Meb: Too small?

Matt: Yeah, that’s a good answer also. Certainly, won’t move the needle at Berkshire. Charlie used to run Wesco, Berkshire bought that, but it won’t move the needle. I think it’s interesting why other firms don’t just go and buy Daily Journal, and I think part of it is because it has these newspapers, nobody quite understands what this business is. There’s 10 legacy papers that don’t produce a whole lot of revenue and it’s, sort of, a troubled industry anyway. Nobody really wants to deal with that. Tyler Technologies is the main competitor, they don’t want to deal with a whole bunch of newspapers suddenly. And then there’s this big equity portfolio. So I don’t know that people really want to deal with that much either. There’s also certain considerations. Although, again, it’s not a huge piece, but the equity portfolio, it’s a lot of Wells Fargo, Berkshire happens to be selling it. But before, they were at their regulatory limit. So for Berkshire to step up and buy Daily Journal might push them above, in the past, the regulatory limit. That thesis doesn’t necessarily hold today but it did hold until the last few months.

So, could there be a buyout someday? There certainly could be, it’s a possibility. I think, because of the nature of the business and because they’ve kept all of this so well hidden, it’s just not really in the public eye, it has some really quirky assets, and maybe it wouldn’t fit perfectly with the profile of a competitor. And so, hopefully, it stays standalone. I would be disappointed if it got bought out because we would lose our long runway that we have ahead of us.

Meb: Awesome. I love it. That’s a fun one while we have you. Any other names crossing your plate that you think are particularly interesting, or spaces, or sectors, or opportunities you’re digging into as you look around in 2020, end of summer, beginning of fall?

Matt: So I’m always looking [inaudible 00:36:29]. I don’t necessarily want to go through a whole bunch of stock tips here. We only have 10 and I give them all away, then… But it’s, sort of, interesting, and I’ll break with the value-investing tradition because I think it’s such a special time. But it’s rare for folks to have a macro view. First of all, I think that it’s very difficult to have predictions on the macro, but there’s some obvious situations going on right now that maybe your audience would enjoy a discussion on. And I think a lot of people are missing, especially if they’re not involved day-to-day. But it’s things like, we’ve had this 10-year run where the index, for example, has compounded at like 15%. And I don’t think people recognize how rare that is, and how unsustainable that is also. We are, for 200 years, I think Jeremy Siegel put together all the data in his book, “Stocks for the Long Run.” But the market returns something like 6.8% after inflation regularly in the U.S. over like two centuries. And we’re very, very likely to have some reversion to that mean, and, sort of, continue along that level of trajectory. But we’re in this zero-interest rate environment suddenly. And I just find it fascinating that folks are in cash because cash is… Somebody is going to pay for COVID. I mean, we just did $8 trillion in bailouts. During the financial crisis, it was like Hank Paulson was running the treasury and he was on his knees to Bush, like, begging for $700 billion, and we just opened the coffers and let out $8 trillion. And it’s like the Fed is actually trying to get inflation going. Powell spoke today and said, basically, that they’re going to let it run above 2%, the 2% target. We know, from a few months ago, that they’ve moved a very subtle shift but a very important one, instead of having a 2% target, they’re targeting an average rate of 2%. So we’ve been at zero for a long time. So inflation has been at zero for a long time, maybe they can let inflation run to 4% before they start lifting interest rates. And what that means is that, as Ray Dalio has said, like, cash is trash. I mean, who’s going to pay for COVID? Who is going to pay this $8 trillion? We’re going to inflate it out of our system. No one is saying it, but that’s what’s happening. So we let the dollar decline a little bit, we let inflation run a little bit. We don’t want hyperinflation, of course, but having a little bit of inflation is healthy.

And so, what does that mean? It means that holders of long-term bonds are going to be getting a negative real return, they’re going to be paying for COVID. Holders a cash are absolutely losing purchasing power, they’re going to be paying for COVID. So we’re in this new environment where I think it’s…you need to be prepared for a little inflation, and you need to get either some hard assets in terms of real estate or you want to be in the stock market. Because a lot of other things are just going to be eroded, and it’s going to be silent and hidden, and I think it’s going to blindside folks.

Meb: My good friend Eric Crittenden who’s been on the podcast before. Listeners, you can check out the old standpoint episode. He basically sent me a random… Not a random number generator, but it was a simulator for the next five years of bonds. And if bond yields go from 70 bibs from wherever they are now to 1 and a half, or 3, or 5, but also it’s a minus 1.35. But the interesting takeaway was that, in almost no scenario, can you generate a positive return. Rates go up, you get, kind of, pounded by the rates going up. Rates go down, though, you get the short-term juice, capital appreciation, but then you have a negative yield. And particularly the illustration he was making, and Eric, I don’t want to speak for you so apologies. But adding on an advisor fee for managing bonds. So he said, “Look, you charge a percent on this, there’s basically no mathematical way you can make money even if bonds go to like minus four.” So it presents a thorny problem, I think, for a lot of investors who have a significant fixed-income portfolio.

So in that sort of world, what’s the, kind of…you mentioned some real assets, and it just stocks in general, or are there any particular sectors or approaches you think are more thoughtful or interesting?

Matt: So I think we’re at the beginning of a wave? To answer that, I’ll, kind of, go around a circle here. But the reaction from the Fed and the Treasury this time around, I’ve been investing professionally for two decades so there’s a lot of similarities, but this time around, it’s different in the sense that it was granted in terms of PPPs, and high stimulus, and extra unemployment, and it went directly to consumers. So rather than during the financial crisis where it, sort of, showed up as bank reserves and then they couldn’t get anybody to lend, today, it went to consumers, and so money markets have suddenly $5 trillion, earning zero, which is just this unprecedented level, we’ve never touched it before, never come close to it before. And so there’s all this cash, and people will slowly start waking up to this inflation, and then there’s, of course, so much in bonds. So I think we are at the beginning of a wave where it starts rotating into assets that can generate a yield.

And then you have to ask yourself, and I’m, sort of, just walking through, I guess, a proof, sort of, here, but, or a thesis, what is the correct equity risk premium that you would expect investing in markets? Maybe, historically, you’d expect, sort of, 3% or 4%? So you take your risk-free rate, your bond rates, or whatever, and then you add a little equity risk premium. And that’s what you would expect to receive by investing in the stock market. And so it’s such a different world, now, you have to, sort of, reevaluate a lot of these old models and look at things from the perspective. So it’s not the best metric but people, sort of, look at PE ratios and talk about earnings multiples and say, “Well, usually they’re at, what, 17. So let’s say $10 is a great number to be a value investor.” But the reality is, if you only need a 3% or 4% risk premium, maybe a PE of $25 or $30 in an extended 0 interest rate environment ends up being correct. If that ends up being accepted by society, markets will push to that level. So you ask about sectors, and we actually have the ability to be in any sector. I’m looking for great business models that are selling for very low prices with excellent management.

But we’ve been tech-light in general. I mean, I’ve mentioned Daily Journal, which is tech, but a hidden tech. But we’ve been tech-light this entire decade. But it’s actually, there’s exceptional business models in that space. It seems expensive. I’m actually trying to adjust my own psyche a bit because it’s just hard to pay up for these companies. But if you have a company that requires very, very little incremental capital to scale and they’re trading for $25 PE and you’re getting maybe 4% earnings yield, maybe that’s a fine place to be as long as revenues growing and earnings are growing. So there’s actually a lot of attractive space. I actually think you can look at some of the washed-out space of COVID. As long as you have the ability to hang on and look through the crisis, you’ll want to find some safe space. But if you’re willing to go into commercial real estate, there’s opportunities there. If you’re willing to look at some of the entertainment companies, there might be opportunities there, and especially when you get things that are selling for single-digit earning multiples. We will look back once we’re beyond COVID, call it end of 2021 into 2022, this will be behind us, and I think people will look back at this time right now and say, “My God, those were the best prices, I can’t believe that I missed that opportunity.”

Meb: It’s funny how, back to what we were talking about in the beginning where you said, “Being in the moment and taking advantage of the possibilities of the dislocations and emotions.” And I remember being on the podcast and chatting with guests, and this is like the darkest of times. And one guest was a music fan. I was like, “When do you think is the next time you’re going to see live music again?” And he or she was, I can’t remember who it was, but they were like, “Not even in 2020, maybe 2021.” And I was like, “I totally agree.” And then fast forward like two months later, I was in Wyoming watching live music safely, of course. But I think the world has a way of figuring out eventually. But you touched on a point that I think is very…at the forefront of many advisors and investors’ minds, which is 10, 20 years ago, if we were to say, “Hey, look, we’re going to be in a world of 0 and negative interest rates, a world where you can get a margin loan for 75 bips or in, what is it, at Denmark, you can get a negative yield, mortgage.” All these, sort of, kind of, wonky, macro setups, it definitely pushes the boundaries of like traditional finance theory. But certainly owning equities or owning real yielding assets in that environment seems like a sensible alternative to something that’s a no-yielding or negative yielding.

Matt: That’s absolutely right. And, actually, if you think about where we are today, Meb, there’s some nuances between theory and practice that you’re, of course, very aware of. But in theory, we learn things in business school, like the efficient market hypothesis. And a lot of times, that’s mostly correct. But there are times when that’s totally incorrect. And I think of price as more as like a pendulum that are swinging around maybe the intrinsic value of a firm. And right now we’re in a global pandemic, we’re in a recession, we have $5 trillion sitting in cash. This is like the most uncertain time in people’s lives, unemployment went above double digits, everyone is locked in their house, people are scared. And so that creates opportunity. Even though the market and certain firms have pulled the market up, I think there’s so much fear out there that we will look back at these times and think, “This is the time of putting capital to work. You’ll be at the front of a huge wave.” If you’re willing to go out there and write put contracts as a tool to enter the equity, you get enormous premiums today. These opportunities don’t come around more than a few times in a lifetime. I think we’re in one right now.

Meb: You stay mostly domestic, do you ever look abroad across our shores for any opportunities?

Matt: Absolutely. I think that it’s important to have international diversification, actually. So we have, in two ways, some of our firms do business overseas so we get a little revenue overseas in that regard. I actually launched a firm called Talas Capital in Istanbul a couple of years ago. So I run, in addition to Peterson Capital Management, I have Talas. And Talas is focused on… We have a portfolio manager over in Turkey, and he’s been analyzing the same 400 companies on the Turkish stock market for 30 years. So he knows everybody, and where their children are going to school, and everything about every person in the business. And there are extraordinary mispriced opportunities when you start looking into emerging markets, frontier markets. And so, I do find that very interesting. And we do get exposure to those markets, we have some exposure to China. We look outside of the U.S.

Meb: Well, Turkey, I’ve never been. Istanbul is supposed to be a world-class city that I imagine is a fertile land of opportunity, given, like you mentioned, a lot of emerging markets, their decade, the 2000 till financial crisis was really an EM story, and then last decade was really a U.S. story. We’ll see what the 2020s are. But, Turkey being one of the, just broadly speaking, cheapest equity markets in the world, certainly.

Matt: It is. On like an earnings-yield basis, it is. I think, probably it might even be the cheapest right now. It’s the 17th largest economy in the world. My wife is actually from Turkey so I’ve spent a lot of my adult life over in Istanbul and met the number one Turkish equity analyst in the world through a conference, VALUEx Conference, from a guy Spier [SP] out in Switzerland. And we became very close and launched this firm together. But Turkeys is, kind of, like little China to Europe. They’re not part of the EU, but economically speaking, there’s a free flow of goods between those borders. And it’s very inexpensive there so they have companies like Arçelik that create what they call white good products, so your washing machines and dishwashers etc. And they can just manufacture the stuff at an incredible rate, at incredible prices in Turkey, and ship them all over Europe, ship them all over the Middle East. And we can get exposure to those companies through that. We actually own the Coca-Cola Bottling Company in that portfolio. I think it’s trading for three times earnings right now. So everywhere else in the world transfer 21 times earnings. For whatever reason, in Turkey, it trades for three times earnings. And it’s volatile. It’s volatile over there, that fund is volatile, but it’s a very interesting place and there’s some excellent opportunities.

Meb: Well, let me know next time you go over when the world gets normal, again, I’ll tag along.

Matt: Well bring you. We got to open the stock exchange during the last tour so you can come ring the bell with us.

Meb: Awesome. I will take you up on that. That’s a topic for a whole other episode. We’ll drag you back on in a couple of months and get some of the Turkey PMs and analysts, and we can chat at depth on that.

Matt: That sounds great.

Meb: What’s been the most memorable investment? You’ve been at this for a decade, professionally with your fund, almost. Congrats. The last decade was a graveyard for many hedge funds, some of the biggest and most famous in the world, and particularly for a lot of value guys. So the fact that you’ve done well and survived is a big compliment. But anything stick out as being the most memorable, good, bad, in between?

Matt: I guess there’s always going to be a few. We have many great returns. We have very good returns. We were in some top warrants early on. So during the 2009 crisis, basically the Treasury was giving warrants, 10-year warrants for all the bailouts to these financial institutions. And those were really attractive, and sometimes they became very mispriced. So we had some great opportunities while we were buying, sort of, like eight-year warrants on, like, [inaudible 00:51:32.316] and we actually were in GM for a while. Those were all great but maybe it’s not smart to always talk about losers. But one that will always stand out in my mind is, we were involved in this firm called Horsehead. And I’m not sure if you’re familiar with it but it turned into quite a story. We were heavily involved in Horsehead, there ended up being, essentially, fraud. There was a prepackaged bankruptcy where they had cash on their balance sheet and they had a debt profile. And they deliberately did not make a bond payment. Through that, it froze all their credit lines and they were forced to file Chapter 11. And it all happened very quickly, and it was done through some other funds like Greywolf who are buying up the debt, and then providing dips, and trying to abscond with all the assets. So we have a concentrated portfolio and it hurt us. We had an 8% position and it was a big learning lesson. I can’t remember who I heard it from, but, “Losers average losers.” So as it cut in half from maybe $4 to $2, we then took it back to 8. And then it went to $1 and we took it back to 8%. So it was just chopping off a piece of the portfolio, and it looked like it was a $20 stock the entire way. And there were some big names in it, Mohnish Pabrai was in it, Guy Spier was in it.

And so they filed bankruptcy. We ended up fighting in Delaware, so I flew out to Delaware many times. I was on the equity committee, so we fought for all shareholders. At the end, there’s still an ongoing SEC investigation in some other aspects that are taking place. I mean, you can Google it and read about it, it was just incredible what happened. But they basically did prepackaged bankruptcy, took the company under, went into court, claimed that it was worth less than the debt outstanding, took 7 recycling facilities and handed them off to Greywolf, management got paid 10% of newco, attorneys got paid 100 million bucks to make it happen. Greywolf walked away with a $2 billion firm and the shareholders had an empty bag, so…

Meb: That’s enough for PTSD.

Matt: It was quite the event, some of your listeners will certainly have heard about it.

Meb: If you’re an investor long enough, we all end up with the scars, painful ones. And even hearing the stories that not even my own, they give me sweaty palms. But that’s learn the lessons along the way for sure. Matt, this has been so much fun. Where do the listeners go to find more information about you, your writing, your presentations, all your thinking? What’s the best spot?

Matt: The easiest place is to go to our website, petersonfunds.com. There is a lot of information there. I’ve been writing quarterly letters for nine years, a lot of media appearances. And if anybody wants to reach out, I’m not that hard to find, matthew.peterson@petersonfunds.com, shoot me an email, happy to get in touch.

Meb: Awesome. We will add those links in the show notes, and I look forward to see you in Austin, maybe for some live music, something.

Matt: Absolutely. South by Southwest.

Meb: I don’t know. If you’re ever back in the land of milk and honey, come say hello too. Thanks so much for joining us today.

Matt: Thank you. Pleasure to be here, Meb.

Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback@themebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. My current favorite is Breaker. Thanks for listening, friends, and good investing.

 

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